The Wit and Wisdom of Government....

I cannot verify that the following is true, but here is a reputed quote from a British Columbia Utilities Commission publication:

"The high cost of having several companies instead of a monopoly is evident if one contemplates the possibility of several sets of electrical wires connected to each customer".

If you cannot tell me what is wrong with that statement (and more importantly, the implications of that statement), then I would strongly advise you against taking ANY economics course- as you will fail! Unless of course one of the following applies....

1) you're still wearing nappies/diapers, and have not yet learned to talk
2) you're currently in a coma, from which you will recover before taking the course
3) for some other reason you're temporarily lacking full command of your mental faculties.

Actually, given what I understand of BC (I lived there for a year.... diligently studying Economics), maybe 3) can help to explain this.....

Predicting Financial Crises....

Financial crises are rare events that seem to creep up on us, and then unleash a torrent of turmoil, laying financial waste to the macroeconomic environment. They seem unpredictable - in part because the final trigger of a crash may be something seemingly minor, and of little real financial consequence it its own right. Yet our inability to predict them doesn't stop analysts from trying. At any given point in history, there are sure to be some predicting a crisis just around the corner!

Sometimes it's a useful thought experiment to consider the state of the macroeconomy and try to figure out risks to its continued growth, and growing imbalances that might lead to future crises. It forces us to spell out our underlying model of the macroeconomy, and the implicit assumptions we make about financial markets.

For your bedtime reading, Mark Gilbert outlines one such thought experiment in the context of a story on Bloomberg here.

Related Reading: "Why Stock Markets Crash."

Bond Prices

"What is the relationship between bond prices, interest rates, and other macroeconomic variables?"

The behaviour of bond prices can seem a little mysterious at the best of times. Let me try to demystify them a little in this post.

Let's start with the relationship between bond prices and interest rates. A bond is an instrument that guarantees to pay a fixed sum of money at some point in the future, perhaps with regular interest payments along the way. Once the bond is issued, the amount that the bond will pay and the interest are both fixed. However, the value of the bond can vary with market conditions.

Bond prices and interest rates move in inverse to each other. To see why, consider a bond that will pay out $1 at maturity (principle plus interest), with no additional interest payments along the way. If that bond has a price today of $P, the return (or interest rate) on that bond is given by r = (1-P)/P. Clearly an increase in P corresponds to a decrease in r, and vice versa.

That's the easy part. Now what about the relationship between bond prices and the macroeconomy? The simplest way to understand this is to think about the relationship between the return (or interest rate) on bonds, which tend to be relatively long term, and short term interest rates.

Consider an investor deciding whether to invest in long-term bonds or leave their wealth in a savings account. In the margin, they should be indifferent between the two. That means that the return on a bond must be related to the expected return from leaving your money in your savings account over the same period of time, adjusting for factors such as liquidity (savings accounts are more liquid- easier to spend- than bonds, and therefore offer lower returns on average). This idea lies begind the "expectations hypothesis" (see here
for a concise explanation). It allows us to reduce a long-term interest rate to a sequence of short-term interest rates.

So bond prices depend on expected future short-term interest rates. Then where do short-term interest rates come from? In the case of Hong Kong, our short-term interest rates depend heavily on US short term-interest rates, since any large deviation between the two would open up an arbitrage opportunity that investors could capitilise on (see here and here for more on this).

Then where do US short-term interest rates come from? The shortest term rate is the Federal Funds rate that is set by the Federal Reserve Board. It's the interest rates that major financial corporations pay/receive when receiving/making loans to meet their daily settlement needs. It also tends to be a trend-setting rate that influences other short-term interest rates, such as those you receive on a savings account.

Putting these pieces of the puzzle together, long-term interest rates depend on the expected future behaviour of the Federal Reserve. So what determines the interest rate setting behaviour of the Federal Reserve? To answer that, we'd need to look at what the Federal Reserve is trying to achieve when it adjusts interest rates.

The Federal Reserve has the job of trying to ensure that the US economy grows as fast as possible without triggering too much inflation (for a more precise definition, click here). If they think the economy is going to grow too fast, they'll raise short term interest rates. And if they think the economy is going to grow to slow, they'll lower interest rates.

Investors try to guess which way the Federal Reserve is leaning when deciding whether to buy bonds or not. If they think that the Federal Reserve is thinking that the economy is going to grow too fast, they expect future short term interest rates to rise. As a result, they're less willing to hold bonds, so the price of bonds falls today.

In the last few weeks, the price of bonds has been dropping dramatically, and as a result their interest rates have been rising. That's because investors believe that the likelihood of the Fed raising rates in the future is increasing.

Of course they might be wrong. In that case, bond prices can increase or decrease without really signalling anything about the future behaviour of the Federal Reserve, or for that matter, the macroeconomy more broadly.

So coming back to the original question, what macroeconomic variables influence bond prices? Anything that would help to indicate whether interest rates are likely to rise or drop in future. That includes anything that the Federal Reserve is likely to look at when trying to determine the future path of the economy. And that covers virtually all macroeconomic variables!

Inflation in Hell?

A common custom in this part of the world is to burn "money" as a way of transferring wealth to the dead, so that they can enjoy a higher standard of living in the afterlife (BigWhiteMale gives a thorough discussion of the background).

But if there's money, there must be inflation! Chewxy provides a careful economic analysis of the issues. The conclusion? It must be hell to live in Hell- due to the rampant hyperinflation! I'm sure the residents of Zimbabwe would agree (with inflation now running at 4530%)!

Thanks to Marginal Revolution for the pointer- check their original post for a related joke.

China vs. US... round 574322

So some American senator's are once again trying to pressure China to cause the RMB to appreciate, by various diplomatic and legal means. That's nothing new. But how can we be sure that the RMB is undervalued? The simple truth is that we cannot.... and there are compelling reasons to believe that the RMB may actually be OVERVALUED at the current time.

What we know is that at the existing exchange rate, RMB demand exceeds supply. The People's Bank of China responds by selling RMB in exchange for USD and other currencies. If this was the full story, then we could make a strong case that the RMB is selling for below its market value, and is therefore undervalued.

But in the case of China, we do not actually observe the underlying market supply and demand for currency. That is because the market is heavily distorted by capital controls. Investors in China cannot freely invest in other parts of the world. This does not only reduce capital outflows, but capital inflows as well, as outsiders may be less willing to invest money in an economy from which it may be difficult to extract the investment later.

I would argue that the underlying equilibrium value of the RMB is the value that it would take, absent capital controls. And if China were to remove capital controls today, both capital inflows and outflows would likely rise. The former would put upward pressure on the RMB, while the latter would put downward pressure.

Which one of these is likely to dominate? The best place to look for this is the presence of distortions in asset prices. If controls are disproportionately discouraging inflows of capital, China should be a sea of promising investment opportunities that offer higher risk-adjusted returns than those available elsewhere. In contrast, if capital controls are disproportionately discouraging outflows of capital, too much money will be chasing too few assets in China, driving up asset prices and therefore driving down asset returns.

We don't need to look any further than the arbitrage opportunities that exist between H-shares and A-shares to find compelling evidence that the RMB may be OVERVALUED. Based on equivalent shares trading in both Hong Kong and Shanghai, Chinese asset prices are approximately 3 times higher than they would be without capital controls. A correction in asset prices sufficient to remove this arbitrage opportunity would likely require a massive capital outflow, and with it a large depreciation of the RMB in the short run.

Prediction: just as with all earlier rounds, the senators will once again lose this round with China.

(For an excellent analysis of the underlying economics of the RMB/US exchange rate, check Menzie Chinn here.)

Is Increased Chinese demand for oil driving up the world price?

Not as much as you think. In part it's substituting in part of US demand. See this Marginal Revolution link for more.

"Big Brother" in America

I'm currently in Boston for a couple of days. In recent visits to the US, I've noticed a worrying trend. When you enter the border, you're bombarded with tight security requirements. They want your photo, your thumb print, as well as the opportunity to interrogate you on why on earth you are trying to enter their country.

Of course all these steps are perfectly acceptable and legitimate for any country, especially one that has faced terrorist attacks in recent years... although you wouldn't know that this were the reason from the official explanation for the tighter security. I listened with half an ear to the Homeland Security video played on the Cathay Pacific flight as we came in to land, which tried to sell these changes as increasing the efficiency of travel.... which it clearly does not! I guess a sales pitch of "we're going to take a close look at you because if you're a terrorist, we want to make your life hell! Otherwise, we hope you'll put up with the inconvenience. And have a nice day" might not appeal to all, but at least it would be honest. And when a government doesn't come clean about the real reasons for their actions, it leaves plenty of room for us to wonder what "big brother" is really up to.

More importantly, I fear that the changes are part of a more disturbing trend. Since 9/11, America has become more paranoid and less trusting of the rest of the world. Of course this is a two-way street... the Iraq debacle has left the rest of the world more paranoid and less trusting of America. However, I fear that this may start to have an increasing effect on the world economy. Not only are American's increasingly paranoid about people entering at the border, but they're paranoid about capital flows (remember when China tried to buy an American oil company?), free trade (loss of low skilled jobs to Asia), Russia, and most of all China. In a democracy, that will likely lead to a less open economy in future.

Openness is a sure driver of economic growth. It allows skilled migrants to move where their skills are most valued, ensuring maximum social return on their human capital; economies to specialise in producing the goods and services for which they have a comparative advantage, ensuring efficient resource usage; rapid technology diffusion, allowing poor countries to catch up more quickly to rich countries; and reduced levels of corruption, since corruption is essentially a tax on domestic firms, and puts them at a disadvantage relative to foreign competitors.

Paranoia, on the other hand, will lead to reduced efficieny and reduced growth. In the end, both America and the world economy will suffer the consequences.

HK vs China equities....

Mainland equities continued their downward correction this morning (they've since rebounded a little)... while Hong Kong equities move in the opposite direction. Given that many companies are listed in both markets, how is this possible? The only explanation is that Hong Kong investors are ignoring price movements across the border.

Normally investors might interpret changes in share prices as reflecting new information on the underlying value of the shares. In that case, share prices falling in one market can lead to similar falls in other markets- commonly referred to as "market contagion."

We're not seeing market contagion this time around, which can only mean that Hong Kong investors are interpreting failing share prices as completely divorced from market fundamentals. Clearly Li Ka-Shing is not the only Hong Kong investor who had concluded that mainland share prices represent a bubble!

Given that Shanghai's 'A' shares started trading at a 200% premium to Hong Kong's 'H' shares, they may rationally ignore falling prices for a lot longer.... the cumulative decline in mainland share prices so far is only 16% so far.

Will it burst or won't it?

China equities are down 7.7% today, with over half the equities in the CSI300 dropping by the maximum 10%. They've fallen 16% since the stamp duty was trebled on May 29th. Is this the beginning of a serious correction, or just a short-term aberation? Only time will tell.

For the latest Bloomberg news story on the action, check here.

How do Housing Bubbles Burst?

Further to my earlier post, Calculated Risk provide a more detailed account. The fall in house prices in the US starting in October 1989 lasted several years. That's much like Hong Kong starting in 1997 (see this graph), although the process here was drawn out by SARS and other negative shocks unrelated to the original bubble.

The bottom line: housing bubbles can take a few years to burst.

Maybe "bubble" is not quite the best analogy of this process. How about "incredibly slowly swinging pendulum" or "feather falling in a weightless environment"? Actually, they're worse... let's stick with bubble.

The China "Threat"

Recent headlines have focused on the perceived "threat" of China to the rest of the world. Whenever an economy develops rapidly, it's ability to threaten other countries increases. But should the rest of the world be alarmed by China's growth?

Let's start with the assumption that the leadership of China is rational- which seems a plausible assumption. (They may have made mistakes in the past, but in general they seem to have learned from them. At the very least, their worst mistakes have not been repeated.) A rational government will not invade another unless it is in their interests to do so.

The more integrated that an economy is with the rest of the world, the less are the gains from any potential military action. In the case of China, these links are strong. The economy is heavily dependent on other developing countries as the source of inputs for production. In turn, it is heavily dependent on developed countries as markets in which to sell its output. Additionally it has huge capital outflows- in the case of official reserves, largely to the United States. The effect of all these factors is to increase the potential costs to China if it were to ever initiate military action.

The increase in economic ties is a tried and true check on military ambition. It lies at the heart of the increasing integration in Europe following World War II, which was just the last in a long series of intra-europe conflicts, spanning many centuries. I believe that it is also the largest check on Taiwan and Beijing; I cheer whenever I hear of increasing investment and trade flows between the two.

Much of the supposed "threat" from China appears to be manufactured by US politicians, playing to a domestic audience in the run-up to presidential elections. Novel Holdings chief Silas Chou, as quoted in the SCMP, sums up the remedy to this perceived threat quite nicely...

"Forget all that political bull****. If Americans would just come to China and make a bit of money, we'd have a happy relationship."

I think he's right. Maybe we should nominate Economics for the Nobel Peace Prize.

For a related view, read here.

The Bubble that Won't Go Away....

So the mainland stock markets have bounced back, already regaining much of the loss induced by the tripling of stamp duty. In fact it's getting worse.... the number of new accounts being opened each day has increased to over 400,000, from the 300,000 average so far this year!

It's time for more draconian measures, like a capital gains tax.

Some related links here and here.