The QE distortion fact of the day

Ewen Cameron Watt of BlackRock summarizes the demand-supply gap created by the scarcity of safe assets caused by quantitative easing (QE). On supply, he estimates,

The G4 supply of “safe assets”, net of debt repurchases, should total negative $300bn this year, we estimate, compared with an annual run rate of $3.5tn before the financial crisis. The result? Abnormally low yields and highly correlated price changes in bond markets, both up and down... 

On demand, his estimates are,

price-insensitive buyers (Life-insurers and foreign exchange reserve funds) have some $40tn of assets under management. Even with a decline in foreign exchange reserves this year, the first in the past 20 years, they require an additional $3.5tn more each year to reinvest the proceeds of their maturing bonds, we estimate. And this is just to stand still!... (pension funds, endowments, and banks increasing 'safe' capital) manages some $20tn of assets... Our best guess for this group’s minimal reinvestment needs is $500bn a year. Together these two groups have reinvestment needs of $4tn of high-quality liquid assets a year. Supply, however, is estimated by us at just $700bn this year. This includes an estimated $1tn of new investment grade corporate bonds and a negative $300bn from governments. This creates a shortage of high-quality, liquid assets of $3.3tn. How is this need supplied?

And about the road ahead, he writes,

Assume the Federal Reserve and Bank of England stop reinvesting the proceeds of maturing issues while the European Central Bank and Bank of Japan press on with QE. The shortage shrinks to roughly $1.7tn, we estimate. It is not until 2017 that equilibrium begins to return. This ends at best in a bigger dose of indigestion than seen recently. At worst, an uptick in the supply of high-quality liquid assets or change in rates expectation sets in motion a vicious circle of selling.

Update 1 (07.06.2015)

Avinash Persaud points to the irony that while the GFC was caused by risky assets, the next one may be caused by a bubble in safe assets. He writes,

Determined to prevent a repetition of the crisis, regulators are forcing the holders of $100tn worth of assets the world over to buy debt from the most creditworthy issuers: companies and sovereigns with pristine credit histories, which comfortably generate enough cash to cover their obligations. After so many banks were sucked down by doubtful debt lurking deep within their portfolios, the impulse to usher them on to firm ground is easy to understand. But corralling a huge amount of capital into a narrow band of the market drives prices to perilous highs. Even if these assets were safe to start with, the enforced concentration is enough to make them risky.

These assets have become so over-valued that their only likely trajectory is downwards, inflicting massive losses all round.

Update 2 (07.06.2015)

Nouriel Roubini points to market illiquidity despite the liquidity flood of QE. He identifies four reasons - illiquidity induced by HFTs who dominate the trades and whose trading periods are concentrated; fixed-income assets are traded over the counter; fixed-income assets are mostly held in open ended funds, where exit is easy, and the combined effect of illiquidity and easy exit can cause sharp price drops; banks role as market makers in fixed income markets is being reduced due to greater regulatory standards like higher capital charges.

Update 3 (13.06.2015)
The FT has two graphics that capture the problem. The first shows the sharp rise in German Bund yields.

The second shows the decline in US Treasuries once QE started.

The holdings of corporate bonds with more than one year maturity held by US primary dealer banks has dropped dramatically from $235 bn in October 2007 to $38 bn in end-April 2015. 

As banks have been vacating the space, asset managers have started to take an increasing share of the market making activity in bond markets (under-writing government securities auctions and buying securities on behalf of clients). The mutual fund bond holdings of the ten biggest asset managers in fixed income group rose from $921 bn on 31.01.2008 to $1.98 trillion on 31.01.2015.

A cautionary note on India's metro rail ambitions

The Government of India have declared support for metro-rail in cities with population greater than 2 million, to be constructed as joint-venture between central and state governments. Accordingly, metro-projects are on the anvil in many cities. In recent months, the government has also been courting Chinese and Japanese investments in metro and high-speed rail networks. 

Metro-rail, elevated or under-ground, is the most expensive mass transit mode. They impose massive upfront expenditures and consequent debt-financing burden, as well as high operating costs. It is therefore vital that the sustainability of each project is rigorously examined before its sanction. A failure to do so would leave local and state governments saddled with white elephants bleeding massive operating subsidies. It will also crowd-out resources from smaller transportation projects that deliver greater bang for the buck. A few considerations are therefore in order.

For a start, we need to eschew the notion of metro projects as an aspirational symbol. Our cities need good urban transit systems, not necessarily good metros. Based on traffic and distances, urban transit modes span a wide spectrum from regular bus services to bus rapid transit, and light rail to metro rail. Each city should identify the appropriate mass transit mode based on its demographics, economic activities, commute patterns, land-use density, and metropolitan configuration.

Second, evidence from across the world, developed and developing, shows that metro-rail projects, even the most efficient and with adequate traffic, are heavily subsidized. Not only do they consume massive public grants for construction, generally raised through taxes or government grants, but also their operation and maintenance (O&M) require large subsidies. In fact, the ticket collection receipts as a percentage of O&M costs, or fare-box recovery ratio, is generally much less than half the operating expenses. Even the highly acclaimed Hong Kong metro received just 28% of its income from fare-box receipts in the 2001-05 period.

Third, apart from demographic considerations, metro rail systems generally need a peak traffic of atleast 40000 passengers per direction per hour (phpdt) to make any commercial sense. Just a handful of our cities would meet this requirement, even two decades from now.

In countries like India, with fiscally strapped state and local governments and a very tariff sensitive demand-side, the risks associated with operating and maintaining good quality metro systems are considerable. State governments will find it difficult to subsidize metro rail systems for too long. Given the difficult political economy surrounding tariff increases, large volumes are the only insurance to atleast slightly mitigate commercial risks.

This assumes even greater significance since global and Indian experience show that reliable estimation of traffic is a problem with transport projects. This is no less true of our metro projects. In the anxiety to push through projects, governments and promoters make optimistic traffic forecasts – high economic growth rates, planned toll increases, unrealistic diverted traffic from other modes, and large induced traffic. Further, when the economy is on the upswing and financing is readily available, the disciplining forces of credit markets take a back seat. Post-mortems of such projects from across the world, done during their inevitable renegotiations, invariably reveal considerable optimism and froth in traffic and revenue assumptions.

Once traffic volumes fall short, governments are forced to subsidize and operators skimp on maintenance. The latter will pose considerable quality deterioration and safety risks, thereby engendering a downward spiral of lower demand, larger O&M deficits, and even more skimping. Furthermore, as these trends play out, the physical infrastructure of elevated metros, already a blight on urban form, will fall into disuse, dragging down property values in the neighborhood. It could be a very short distance from urban regeneration to urban degeneration. 

Fourth, there is more to metro railway systems than mere mobility improvements. The most successful examples of metros are those which have used it as an instrument to guide urban growth by integrating mobility with land-use. Those cities have used metros to promote transit-oriented development (TOD) by encouraging high-density mixed-use developments surrounding metro stations. They have employed proactive planning in the form of higher floor space index (FSI) in the vicinity of stations to concentrate growth.

Such policies have helped cities like Copenhagen, Stockholm, and Singapore effectively manage the spill-over growth from the main city radially outwards in a planned manner. Instead of one massive urban sprawl, these metropolitan areas are characterized by a central core connected to smaller population centers interspersed with rigidly enforced green belts.  Copenhagen has used the metro to develop a “finger plan” of radial growth of master-planned smaller towns. Singapore’s “Constellation Plan” involved the planned development of eight master-planned towns in the form of a “string of pearls” around the main city. 

Unfortunately all our metros, including Delhi, have overlooked this objective. The new metro-rail projects for Mumbai, Hyderabad, and Bangalore present a rare opportunity to recover lost ground and profoundly shape the city’s growth trajectory through a TOD plan.

Policies like higher FSI and mixed-use zoning around metro stations promote density and transit use. These policies, when supported with investments to improve infrastructure carrying capacity, will encourage consolidation of land and vertical redevelopment. Affordable housing mandates, with more zoning relaxations and transfer of development rights, should be incorporated into these redevelopments. Another requirement for TOD is for the metro corridors to emerge from the metropolitan development plan and the strict enforcement of the region’s master plan. Since all such policies take time to yield results and require painstaking co-ordination among multiple agencies, they are rarely pursued with intent.

Finally, the burden of financing such projects can be cushioned by capturing a share of the increase in property prices generated by the metro through policies like betterment fees, tax increments, and registration cess. Innovative use of zoning regulations – land use conversions and height relaxations – can also be used to capture a share of the increase in property value due to the new infrastructure.

Metro rail projects that incorporate all these considerations, instead of being mere construction projects, can be powerful catalysts for urban transformation and smart growth.

Update 1 (09.08.2015)

This Business Standard article examines the DMRC balance sheet and shows why metro rails are commercially unviable. It has this graphic about the projects currently on in India

China, US, and India - household savings fact of the day

MR points to the difference between the composition of household savings between China and US,

Roughly 50% of Chinese savings – amounting to as much as half of GDP – lie in real estate alone, with 20% in deposits, 11% in stocks, and 12% in bonds. To compare, in the United States, real estate, insurance, and pensions each account for about 20% of total savings, with 7.4% in deposits, 21% in stocks, and 33% in bonds.

If the Chinese savings pattern is skewed and inefficient, see the graphic below on India, where land and gold locks up 71% of the savings. This is most likely an under-estimate given the fact that a significant share of this is unreported or 'black'.

This has engendered a liquid savings deficit in India which has the potential to undermine economic growth. 

The infrastructure financing problem

Where does infrastructure financing money come from? I blogged earlier about how, contrary to conventional wisdom, the overwhelmingly dominant share of infrastructure financing comes from bank loans and the bonds have a marginal role.

But for China, syndicated loans form the lion's share of infrastructure financing. The total annual infrastructure bonds raised have been around $10-12 bn for all emerging markets excluding China.

And about infrastructure debt funds, the amounts raised globally are minuscule compared to the requirement. Just $4.7 bn was raised in  2011, the highest ever raised globally in a year by infrastructure debt funds.

Infrastructure equity funds, which leverage capital from pension funds, while larger, too form a small share of the total infrastructure financing and are concentrated in developed markets, especially the US and Europe. Globally, they formed just above $36 bn in 2013.

Furthermore, structured equity or debt financing - infrastructure equity fund, infrastructure debt funds, or bonds - is rarer still in the construction phase, where bank loans are the most risk-appropriate form of financing. So as India explores various infrastructure financing alternatives, it would do well to keep in mind the reality that bank loans would necessarily have to form the lion's share of infrastructure financing. Alternative sources like structured debt and equity can only contribute marginally. This again underscores the importance of restoring bank balance sheets and their recapitalization.

In any case, whether financed through loans or structured capital, rigorous project preparatory work is critical to the success of any long-term project. These projects will be able to attract private investments only if adequate preparatory work is done and rigorous enough feasibility and commercial viability studies and detailed project reports are available. Its preparation generally takes at the least 18-24 months. It may therefore be appropriate if, atleast to the extent of flagship infrastructure projects, a shelf of works are identified and their due-diligence and documentation initiated immediately, through public finance, and kept investment-ready.

Update 1 (31.05.2015)

The sample of the latest Preqin report is here and it contains this graphic which points to the rising share of infrastructure assets in the portfolios of investors. In 2014, institutional investors had just 4.3% of their assets invested in infrastructure assets, against their target of 5.7%. The report states that 67% of the investors surveyed had plans to increase their infrastructure allocations.

As the FT reports, even a one percentage point increase of allocation can be dramatic. Pension funds, insurers and other big pools of long-term investors seeking investments in assets other than cash, stock, and bonds have $65 trillion in assets. Even a four percentage points allocation is several times the current investments. In fact, of the $296 bn worth unlisted infrastructure assets under management by June 2014, over $100 bn are yet to be committed funds, of which $13 bn is earmarked for Asian markets.

There is a long-term dynamic driving this movement towards long-term infrastructure assets. Stagnant low yields in standard asset classes have forced asset managers to lower their target returns, making infrastructure assets extremely attractive. 

Chequebook justice in US financial markets

Early this week Citicorp, JP Morgan Chase, Barclays, and RBS pleaded guilty to conspiring to manipulated the benchmark price of US dollars and euros exchanged in the forex sport market and agreed to pay fines of more than $2.5 billion. Separately, UBS pleaded guilty of manipulating the LIBOR and other benchmark interest rates and agreed to pay $203 million criminal penalty. This would be the first time that the bank holding companies, and not their subsidiaries or business units, themselves have pleaded guilty.

They used electronic chat room and coded language to manipulate price information, and colluded to manage liquidity (by withholding bids or offers) in these markets at certain critical times so as influence prices. The US Department of Justice Attorney General said,

Today’s historic resolutions are the latest in our ongoing efforts to investigate and prosecute financial crimes, and they serve as a stark reminder that this Department of Justice intends to vigorously prosecute all those who tilt the economic system in their favor; who subvert our marketplaces; and who enrich themselves at the expense of American consumers. The penalty these banks will now pay is fitting considering the long-running and egregious nature of their anti-competitive conduct.  It is commensurate with the pervasive harm done.  And it should deter competitors in the future from chasing profits without regard to fairness, to the law, or to the public welfare... The five parent-level guilty pleas that the department is announcing today communicate loud and clear that we will hold financial institutions accountable for criminal misconduct

Really! All the five firms colluded to manipulate information that affects large financial contracts thereby boosting their profits at the expense of their clients. And instead of being charged with criminal liability and those responsible convicted and sentenced to imprisonment, they are allowed to get away with a small (relative to the size of these banks and their earnings over a long period from such manipulation) penalty.

The Times has described such plea bargaining as "prosecutorial indulgence" and had this to say about the action taken so far on all banks on investigations of forex market rigging,

In all, the banks will pay fines totaling about $9 billion, assessed by the Justice Department as well as state, federal, and foreign regulators. That seems like a sweet deal for a scam that lasted for atleast five years, from the end of 2007 to thee beginning of 2013, during which the banks' revenues from foreign exchange was some $85 bn. 

For a long-time prosecutors have let off financial institutions with deferred prosecution agreements (DPA) or non-prosecution agreements (NPA) which suspends criminal charges in exchange for fines and other concessions. Though in all such cases, it would be axiomatic that some employees be charged, only in a third of such cases were any employees charged and always they were lower-level staff.

Plea bargains, while supposed to come with revocation of certain privileges by the SEC as well as further investigations to fix employee level criminal charges, have increasingly become indistinguishable from DPA or NPA. In this case too, the plea bargains came only after the SEC agreed that there would be no restrictions on their business practices and market activities. Employee level investigations are unlikely to be followed up vigorously by prosecutors. Minus the shame and the small change, it would be business as usual.

This also explains the conundrum about how in the investigations in the aftermath of the financial crisis on interest-rate rigging, ratings manipulation, money laundering, securities fraud, dubious business practices, and excessive speculation, no major banker has yet gone to jail. It clearly appears that they have become "too big to jail".

Update 1 (03.06.2015)

Zero Hedge has a long list of manipulations and rigging penalties paid by JP Morgan in settlements with regulators across the world.

Credit cards and cognitive biases

This is a summary of a series of links from two articles on how credit cards exploit our cognitive biases to make us spend more than what we otherwise would have. First, the Atlantic has a nice article,

Consumers fancy themselves immune to this financial anesthesia. But study after study has documented credit cards’ ability to get people to spend more than they otherwise would, even when cash, credit, and debit were randomly assigned to experimental subjects: Credit cards make people more likely to forget how much they spent on something. They make frugal people spend recklessly. They make people willing to spend a lot more on one-off purchases. And large credit limits promote the illusion that daily purchases are inconsequential. 

A Times article last year on the same topic had this to say,

One of the most well-known studies, published in 2001 and titled “Always Leave Home Without It,” showed that in certain contexts, people were willing to pay up to twice as much for the same item when paying with a credit card instead of cash. This is known as the “credit card premium.” A study in 2008, titled “Monopoly Money,” featured a gift card denominated in dollars. Even though the gift card lost value instantly when people used it, people were still more likely to spend freely with it than they did with cash. And a 2011 study showed that people considering using credit cards tended to focus more heavily on product features when shopping, while cash buyers paid closer attention to costs.

As the credit card markets deepen in emerging economies, these findings should serve as an important note of caution for governments. The standard response involving financial literacy and regulatory interventions are unlikely to make a dent to the problem. A more effective strategy would be through nudges which counteract these cognitive biases. 

Broken windows theory and public policy

From Vera T Velde, a fascinating list of experimental findings that validate the 'broken windows' hypothesis - some evidence of law/norm violation will encourage people to break others. For example,

Bikes are parked in a row next to a fence with a conspicuous "no graffiti" sign, and flyers are attached to each bicycle such that they must be removed to use the bike. If no graffiti is on the fence, 33% of subjects will litter their flyers. If graffiti is on the fence, 69% will. This was so surprising that a news station paid the researchers to replicate the study while they watched from rented rooms looking down on the area. The finding replicated very closely, and now the Netherlands requires immediate removal of graffiti. 

This reinforces the importance of choice architecture - framing of the environment in which human beings engage or transact - in designing public policies that can induce behavioural change. For example, consider the case of littering and cleanliness. Since the best choice architecture of keeping the place clean is tautological, a next best alternative is to keep exceptionally clean certain important locations within each city or neighborhood - say, the public transit station, park, an important pedestrian shopping area etc - and then use them to as cognitive reminders. This coupled with aggressive awareness campaigns can be a powerful strategy in the more effective implementation of campaigns like the Clean India program.