Untitled

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The increased strains from the euro area debt crisis continue to weigh on global economic prospects and caused the IMF to sharply cut its forecast for global growth this year, have dimmed prospects and financial stability risks have increased noted in the latest market update (IMF Global Market Stability Report “GMSR” Market Update, Jan. 2012).

 

Since the last GMSR, the risks for stability have increased, despite various policy steps to contain the euro area debt crisis and banking crisis.  European policymakers have outlined significant policy measures to address the medium-term issues contributing to the crisis, and some of these have helped improve market sentiment, but sovereign financing remains challenging and downside risks remain. 

 

If funding challenges result in a round of de-leveraging by banks, this could ignite an adverse feedback loop to euro area economies.  The US and other advanced countries have homegrown challenges in the removal of financial tail risks, including overcoming obstacles to achieving an appropriate pace of fiscal consolidation.  Developments in the euro area also threaten emerging Europe and may spillover elsewhere. 

 

Further policy actions are needed to restore market confidence.  This effort will require building larger backstops for sovereign financing, assuring adequate bank funding and capital, and maintaining a sufficient flow of credit to the economy possibly establishing a “gatekeeper” charged with prevent a disorderly bank deleveraging. 

 

Emerging markets, outside of Europe, and Asian countries are exposed to downside risks as weaker macroeconomic prospects make them vulnerable to spillovers from the European debt crisis.  Authorities in advanced countries will need to address banking issues, make necessary adjustments without a large impact on growth prospects.  Policymakers in other areas may need to address issues relating to funding and credit strains, especially if global growth continues to stall

For more information on this follow the link: www.imf.org/external/pubs/ft/fmu/eng/​2012/01/index.htm

Filter

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

I was at a meeting last week and someone tried to insult me by saying “there you go, talking without your filter again”.  They may have meant it as an insult, but I take it as a compliment.  They implied that I was being politically uncouth by saying what I thought and believed, rather than by saying what everyone wanted to hear. 

 

How effective are filters in your risk department?  How often do they get changed?  How clogged are they?  Do you need them?  Do you want them?  Do they actually help?  Do they actually help in the long term?

Mispricing of Sovereign Risk & Policy Errors

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The recent surge in the peripheral European country bond spreads has been a major source of concern to financial markets, as investors try to estimate whether it is a change in fundamentals or shifting market sentiment.   It is similar to risk management where we have to understand the source of risk.  Paul de Grauwe and Yuemei Ji attempt to address this issue in a Jan. 2012 VOXEU communique called Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone.

 

De Grauwe & Li note that markets were wrong in placing the same risk premium on Greek bonds as on German bonds from 2001-08.    Since the start of the sovereign debt crisis, financial markets are making errors in the other direction – they overestimate risks...  Now they are wrong in overestimating the risk that the peripheral countries will default. 

           

The surge in peripheral country spreads since 2010 is disconnected from fundamentals such as debt-to-GDP ratios and current-account positions, and is more attributable to negative market sentiment.  De Grauwe & Li note that after investors long ignored high debt-to-GDP ratios, the resulting surge in negative sentiment caused a rise in spreads.  However, standalone countries with high debt ratios were immune to these liquidity crises and did not experience an increase in spreads.  This was consistent with earlier research that found government bond markets in a monetary union are more fragile and susceptible to self-fulfilling liquidity crises. 

The Eurozone crisis is also a story of systemic mispricing of sovereign debt, which in turn led to macroeconomic instability and multiple equilibria.  The underpricing of sovereign risk in 2001-2008 in the peripheral countries led to unsustainable booms in consumption and real estate.  The overpricing of sovereign risk since 2010 led to a self-fulfilling downward spiral into bad equilibria characterized by solvency crises and deep recessions. 

The lesson for policymakers is that when spreads are tightly linked to underlying fundamentals such as the debt-to-GDP, the best option for spread reduction is to improve debt fundamentals. In contrast, any disconnect between spreads and fundamentals, a policy of exclusive focus on debt reduction will not be sufficient and force countries into a bad equilibrium.  This can be achieved by active ECB liquidity policies that prevent a liquidity crisis in government bond markets turning to a self-fulfilling solvency crisis.

The lesson is that any policy aimed at improving fundamentals through fiscal austerity and a policy of liquidity provision from the central bank are not substitutes, but complements.  In contrast, any country that is a member of a monetary union hit by a liquidity crisis that leads to a disconnect between spreads and fundamentals, will require both policies.  These policies should not be seen as “either/or” options.

The systematic mispricing of sovereign risk in the Eurozone intensifies macroeconomic instability, leading to bubbles in good years and excessive austerity in bad years.  The failure to address these issues has increased the duration and the cost of crisis resolution.  Perhaps, we can learn some lessons for risk management.

For more on this follow the link:  www.voxeu.org/index.php?q=node/7553

 

 

System D Economics

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.,

www.RSDsolutions.com

info@RSDsolutions.com

 

 

Spending a yucky Saturday afternoon catching up on last month’s Wired (just got this month’s issue in the mail so I need to clear out last month’s).  Wired is one of my favorite magazines and I always seem to find something useful in it.

 

In the January 2012 issue however I was initially ticked off by one article titled Slumdog Economist, which highlights some of the work of economist Robert Neuwirth who studies the underground economy.  I reason I was ticked off is that I always wanted to study the marketing habits of street vendors.  He stole my idea!  How dare he!?

 

Kidding aside, it is a great article that looks at the underground economy of street vendors or those that work under the table.  Neuwirth calls this the System D economy.  Some fascinating ideas and facts in the article and I highly recommend that you take a moment to take a glance at it.

 

One of the surprising facts that comes up in the article is that currently 50% of workers globally are part of System D and that is projected to rise to 2/3rds by 2020.  Take that you global multinationals!

 

Neuwirth explains many of the reasons for this surprisingly rapid rise of System D, but the most telling response to why the rapid growth is in this statement; “Because it’s based purely on unfettered entrepreneurialism.  Law-abiding companies in the developing world often have to work through all sorts of red tape and corruption.  The System D enterprises avoid all that.”

 

In my work as a consultant with many corporations what I see is a lot of red tape and corruption.  True, the corruption may be slightly different than the type of corruption that Neuwirth is implying, but in my scheme of things, political interference is still corruption, and red tape is red tape.

 

Risk departments (all departments) should be allowed to do their work in the absence of red tape and corruption.  That may be an obvious statement.  What might not be so obvious is that risk departments should also work on a principle of pure unfettered entrepreneurialism.  Is yours?