25 October 2007

CITIZEN OF EUROPE: Is EU really so socialist?

A couple of weeks ago, we wrote that the EU is going to regulate financial markets more tightly and make them more transparent...

Nothing new on that topic, but something definitely interesting is happening in EU international financial markets...

The new EU legal act MiFID (the Markets in Financial Instruments Directive) is due to be introduced soon.

For people not knowing the EU law: a directive is not a set of directions - it is a fully binding legal act that needs to be, nevertheless, transposed into national legal systems by member states parliaments before a set deadline.

I am now doing my homework on the EU institutional law and what's more the MiFID is not new to me: while working in corporate banking this summer, I heard many discussions on MiFID... And I must admit that he EU directive is surely a very interesting piece of legislation. As the Economist writes:

"Big Bang” or not, expect dramatic changes. The new rules end the monopoly (albeit a waning one) of national stock exchanges over share trading and throw open the field to newer electronic exchanges and even the big investment banks. Until now, some countries (such as Poland, the Czech Republic and Hungary) still required trading to take place over the national exchange. Others, such as Britain, have long been more liberal.

Handed an effective monopoly like the utility companies of yore, the protected exchanges took full advantage, charging everything from fat fees on membership to hefty tariffs on each trade. Even in more liberal regimes, over-the-counter trades have had to be reported to the exchanges. The exchanges charge members for the privilege of doing so and then, to add insult to injury, levy members again for access to those data in “real time”.

The new law dismantles each one of those monopolies at a stroke. "'

What is even more important:

"Under MiFID, these off-exchange markets will in effect become more regulated, because they will have to disclose more pricing information. They will also be freer to tempt business away from the traditional exchanges. This should encourage the traditional marketplaces to lower fees and increase the speed of transactions to become more attractive, which could make for leaner markets and larger trading volumes. On the other hand, it could “balkanise” trading; one of the tests of the new law's effectiveness will be whether it adds to overall liquidity or channels it in so many directions that it evaporates."

So as we can see: a new EU legislation piece means more markets and more transparency.

This is largely in contrast to what many of my Polish libertarian friends think of the EU. It's strange, but for some guys in my country, the EU is first and foremost a 'socialist federation', stiffling markets and spreading statism... Just look at the picture (scroll down, to the very bottom)

Bizarre... At least to some extent.

Not that I am a lover of Brussels, but still: a partially pro-market character of the EU cannot be denied...

17 October 2007

Carry Trade

Kasia Burzynska explains how to print money on your own. Kids, don't do it at home...

Printing money is not that difficult. Global traders have been doing it over the past few years thanks to the magical machine called carry trade. It all comes to the strategy in which an investor borrows a low-yielding currency and uses the funds to buy a higher-yielding one. Yen carry trade is the best example.

When the Japanese economy faced the crisis in the 1990s, the Bank of Japan decided to maintain for a very long time zero interest rates policy. Till today the rates are kept very low – at the moment it is 0.5 percent. On the other hand, the benchmark rate in Euroland is currently 4 percent, in the United States 4.75 percent and in New Zealand as much as 8.25 percent.

The traders have been eagerly taking advantage of this yield gap. They could borrow 10 000 yen from a Japanese bank, convert the funds into New Zealand’s kiwi and re-loan it out. The spread of 7.75 percent (i.e. 8.25 percent - 0.5 percent) makes up profit. And it can be even bigger when we take leverage, that is popular method of increasing profit by using borrowed money, into consideration. Common leverage factor of 10:1 boosts profit to 77.5 percent.

But carry would not be that interesting without risk. And carry trade can be a risky business. First of all the interest rates can change. The investors got used to very low interest rates in Japan and take it for granted. But after nearly 6 years of zero interest rates policy, Japan’s central bank raised rates to 0.25 percent in July 2006, then to 0.5 percent in February 2007. As the economic situation in Japan seems to be gradually improving, the Bank of Japan is likely to continue the hikes (Chavez-Dreyfuss, 2007) and the narrowing of the interest rate gap makes carry trade less attractive. Secondly the cross-currency carry trade involves the risk of moves in the exchange rate. If the lower-interest rate currency rapidly rises, the cost of debt relative to assets increases and at the same time the value of assets relative to borrowing decreases. That is why any strengthening of the yen worries traders. They can lose a lot in no time without a warning.

The investors must mind the risk from other sides too. Very often the money from borrowing the yen is invested in places like emerging markets, which are more unpredictable and riskier. When the economic slowdown comes, the risky assets will lose in value, which will lead to the situation in which traders will want to receive their money back to repay the debts in yen. This may make the yen rise and even more traders will have to go back to the yen, deepening the trend.

What is even more interesting, no one really knows how much capital in carry trade is involved. Its total size is estimated to as high as $ 1 trillion (Lenzner, 2007). But theoretically it should not even exist or at least not for long. The carry trade is against economic theory that says the high-yield currency compensates investors for the risk of depreciation. Similarly the low-yield currency should have the tendency to appreciate. Nevertheless, yen remains weak. The very actions of traders can be a good explanation of why it happens. They sell yen and buy other currencies. The more investors enter into carry trade the more they strengthen the tendency for the yen to fall and other currencies like the kiwi or won to rise.

Carry trade has been used by the Japanese households to get higher returns by shifting the money from their bank accounts to relatively secure but higher–interest-rate assets like New Zealand, American or Australian bonds. International investors, like hedge funds, have found carry trade applicable also for more speculative, leveraged trades.

All these flows of cheap money cannot stay without impact on global economy. The Economist’s Big Mac index from July 2007 suggests that the yen is undervalued against the dollar by 33 percent. The weak yen favours the Japanese exporters. And the high-yielding currencies are getting stronger. As O'Brien and McIntyre (2007) report Australia's dollar has gained 18 percent versus the yen in the past 12 months and the New Zealand dollar strengthened 12 percent. The same tendency is seen in the value of the won – it has been rising against the dollar and meanwhile the yen has dropped against the dollar as well as the won. That is why South Korean Finance Minister Kwon Okyu says the low value of the yen is “deepening global imbalances” and sees carry trade as “a potential threat to the international financial markets”. Carry trade hurts a lot of exporters in South Korea or New Zealand too, first of all worsening the competitiveness of small and medium-sized businesses.

Latest report from UN Conference on Trade and Development (2007) draws attention to the danger of unwinding of carry trade. It can be a threat especially for developing countries. “The web of different funding and lending currencies of otherwise unrelated economies causes the countries involved to become interdependent and subject to reversals of perceptions and to contagion effects”. Unexpected changes in exchange rates can trigger “a large unwinding of investments and this can spill over to emerging market economies”.

Carry trade is a major source of financial liquidity in global markets. It causes asset prices to rise worldwide. Unwinding of carry trade and thus drying up of this source can create market volatility. When the traders suddenly begin to sell the assets in order to raise cash to pay back their short-yen currency positions, the yen will jump accelerating further selling. And so the declines will deepen, which can lead to global crisis.

For the time being, yen carry trade still exists and still works. But it becomes even riskier. Former Federal Reserve Chairman Alan Greenspan said: “at some point it's got to turn”.

Author: Kasia Burzynska


Adam, S., Batchelor V. (2007), “APEC Says Flexible Currencies Will Reduce Imbalances”. Bloomberg.com.

Arnold, W. (2007), “Yen carry trade falling from favor”. International Herald Tribune.

“Carry on living dangerously” (2007). The Economist.
“Carry on speculating” (2007). The Economist.

Chavez-Dreyfuss, G. (2007), “Japan inflation shock could fuel carry unwind”. Reuters.

Chen, S.-C. J. (2007), “A Yen For Currency Trading”. Forbes.com.

Chen, S.-C. J. (2007), “Yen Carry Trade Unraveling Faster”. Forbes.com.

Da Costa, P. N., Kadoya T. (2007), “Greenspan says carry trade has limited room to run”. Reuters.

Lenzner, B. (2007), “A Meltdown From The Yen-Carry Trade?”. Forbes.com.

O’Brian, E., McIntyre E. (2007), “Australian and N.Z. Dollars Gain on Demand for Nations' Bonds”. Bloomberg.com.

Pesek, Jr. W. (2006), “Japan's Boom May Explode Yen-Carry Trade”. Bloomberg.com.

Smith, P., Pilling D. (2007), “Japan faces carry trade scrutiny”. Financial Times.

“What keeps bankers awake at night?” (2007). The Economist.

Young, A. (2007), “Eye on the Carry Trade”. Business Week.

16 October 2007

Investment high-flyers...

Imagine that you are a CEO of huge multinational and you are looking for a suitable location of a foreign direct investment (e.g. opening a factory, a chain of shops or aquiring such entities abroad). Where would you go?

China? Slovakia? Estonia? Chile? Brazil?

None of these countries...

According to Investment Performance Index for prepared by the Irish National Bank, the top three FDI high flyers are:

1. India
2. Poland
3. Thailand.

(for an article on the index click here)

15 October 2007

Nobel Prize in Economics goes to...

Speculations of who will get this year's Prize were pretty intense, but finally the verdict is there:

Leonid Hurwicz, Eric S. Maskin, and Roger B. Myerson.

(click for bios; for the rationale of why the Prize went to these three American economist, go here)

Many of you may be probably wondering what the mechanism design theory is and, more importantly, since Noble Prize winners should make a contribution to humanity, what practical relevance it has for us. Well, it had an impact on the development of game theory, allowing economists to analyse the sources of market failure. It seems to me that Guardian is offering a pretty good explanation of what this economic animal is.


Talking about the game theory, I have seen recently an interesting BBC three-part documentary: "The Trap. What Happened to Our Freedom".  

It touches upon game theory and modern economics, putting them in a wider social perspective.

Do I personally recommend watching it? Yes, if you like uncovering fallacies and sophistry (which is something economists are good at and do like...)


Coming back to international economics, let me present you the article headlines for this week. On Wednesday, we should have a brilliant piece on carry trade by Kasia Burzynska of Gdansk University (Poland) and later (on Saturday) a research article on how Indonesia adapts to changing conditions in international economics by Barbara Kits of University College Utrecht (The Netherlands).

10 October 2007

CITIZEN OF EUROPE: Between Scylla and Charybdis...

The first consequences of the financial crisis are clearly visible... The EU has plans of regulating financial markets more tightly, i.e. introducing more transparency, but also standardising and limiting the complexity of financial instruments...

Most of the readers would say that this is a definitely appropriate move... And I agree, but only to a certain extent.

As usually, there is something that some economic tiggers like the best...

I have no research on the topic at hand, but my intuition is that public choice theory may be relevant here - the number of lobbyists in Brussels is overwhelming and some of the new regulation may be detrimental to market players and the general population...

For me, public policy is always walking between Scylla and Charybdis. Scylla of market failure and Charybdis of government failure...

04 October 2007

China, Japan and Baltic Tigers...

The Economist has a brilliant article on the China's economy. The article describes and analyses all possible threats to the Chinese economy at the moment, except one: a currency crisis.

As I wrote earlier (backed by research by more authoritative authors, e.g. Eichengreen or Allen), a currency or twin crisis is a viable threat in China and it is strange that the Economist does not take it into account. I bet that if hedge fund use all of their resources, the famous Chinese reserves may not be sufficient...


My column collegue, André, is a big "fan" of inflation... In my favourite financial newspaper, I found a peculiarity that may be of interest to him.

Lowering inflation due to globalisation or other factors has usually been seen as a positive development, making the work of central bankers easier. Nevertheless, this is not the case in Japan:

A price war aimed at Japan’s 100m mobile phone users could have a significant impact on the core consumer price index, potentially prolonging the country’s brush with deflation, economists warned on Wednesday.'

This may not be a development stemming from international environment, but FT also writes that earlier there were fears that the Japanese fragile inflation may be lowered by a drastic plunge in prices of flat-screen TVs, which I do think may be due to China. I am just wondering whether Japanese alterglobalists will adopt it as an argument against globalisation... I am also wondering how alterglobalists, in general, respond to the argument that globalisation moderates inflation. Low inflation is, as we know from textbooks, less changeable, which means stability for employers and consumers and, thus, higher economic growth and lower unemployment. I guess that they could argue that low inflation is based on low wages in Third World countries. This is to some extent true, but you need to remember that costs of living in Third World countries are smaller than in the West, of which alterglobalists usually tend to forget...


As a prelude to my article on the Baltic Tigers, please take a look at an interesting piece from FT. It seems that making appropriate (?) reforms is not always enough to create conditions for the long-term macroeconomic stability. In a week, we will delve more deeply into the topic and try to see whether the Baltic Tigers will be able to join the Euroarea soon...

01 October 2007

Mishkin is pop, people are irrational and other news

I was going through our blog yesterday and a very interesting headline was showing up in our news section: "Fed's Mishkin downplays globalization as a factor in low inflation". In an earlier post on the theme, I defend that globalization can impact inflation through imports prices as well as through policy incentives and other mechanisms. Forbes reports:

Mishkin did say globalization may have helped in 'subtle' ways, such as by spreading a 'common culture that stresses the benefits of achieving price stability.'

[H]e said that while it is 'plausible' to hold the theory that lower priced imports from China and other countries are lowering inflation, research suggests that the importance of this factor 'should not be exaggerated.'


The Fed governor seems to be particularly under the spotlight ever since the media have called attention to his clues about the 50 basis points cut during last open market committee meeting. The Wall Street Journal blog had a very good piece about this. One passage above all others caught my attention:

There’s only one problem. Most of those four speeches came on nights or weekends. The March inflation speech was on a Friday night. The Jackson Hole paper was presented on a Saturday and last week’s “important”-downside-risks speech was given at 7:30 p.m. EDT, which might as well be midnight for Wall Street.

It is clear to me investors were not using all available information, which brings us to a question about the efficient market hypothesis and rational expectations theory, which claims "expectations will be identical to optimal forecasts [...] using all available information"[1]. It does not explain why the relevant and available information above would be ignored, perhaps because it doesn't address costs and benefits of gathering information.

But even if we account for that, wouldn't it be rational to assume that the expected benefits of gathering information about a Fed governor's public speeches outweigh costs?


Back to international economics, Brian Caplan points out 4 other irrational beliefs people have in The 4 Boneheaded Biases of Stupid Voters. Check out the "Anti-Foreign Bias".


Finally, Greg Mankiw points out The Rationality of Harry Markowitz and attends a seminar in Behavioral Macroeconomics.

[1] MISHKIN, Frederic, "The Economics of Money, Banking, and Financial Markets", 8th edition, p. 157.