Who broke Bank of England?

Formation of Exchange Rate Mechanism

Since 1960s, the trade among the European nations was increasing more rapidly than that with the rest of the world. By 1992, around 60% of the trade of the members of European Community (EC) was intra-EC. A single currency would not only reduce the cross border transaction costs but also increase the price transparency, boosting the intra-EC trade as a result. Under Maastricht treaty of 1991, conversion of EC to Economic and Monetary Union (EMU) required three stages: Stage 1 would entail removal of all trade barriers to financial flows; Stage 2 would require member states to meet fiscal and monetary convergence criteria and prepare for a new European Central Bank (ECB); Stage 3 would usher into a single currency, with monetary policy managed by ECB.

But the path was not going to be that smooth for all the participating nations….

To converge to a unified European currency, Exchange Rate Mechanism (ERM) was devised, under which twelve countries’ central banks would keep their respective currencies within agreed trading ranges or bands relative to deutschemarks (DM). Since the German economy was largest and its currency least prone to inflation since 1950s, the interest rates, in principle, would be guided by German central bank, Bundesbank. If EC members resembled an “optimal currency area”, with relatively synchronized performance, the system would be less likely to face significant issues. But if various countries had disparate growth rates, their central banks would not be free to modify their interest rates as required by their respective domestic markets; thereby placing higher priority on sustaining ERM bands than managing domestic demand and monetary policies. This system of fixed interest rates would come under strain if there were significant and persistent differences in the member states’ economic performance, be it inflation, labor costs, government finances or even the timing of the business cycle.

However, two players were resistant to the common currency formation. The first was the Bundesbank which ,unlike German government, was not too keen to make economic concessions for the sake of gaining political objectives. The central bank was less concerned about its role as the ERM’s anchor which a bad news for the other ERM members. Its mandate remained to control the German inflation. And then there was British politics. Prime Minister John Major wanted Britain to be “at the heart of Europe” and he had to face elections in another two months. Signing the Maastricht treaty, the British economy would be indirectly controlled by the Bundesbank. Political stakes were high.

Events leading to the Black Wednesday

All countries appeared, more or less, committed to make ERM a success. However the geopolitical realities of the region were causing a strain in the system. In 1989, with the fall of Berlin wall, there were massive investments in the East Germany to bring it up to the standards of West Germany. In 1991 alone, total Germany capital formation rose by 36% and government consumption by 27%. As a result, inflationary pressures began to surface. To counter the inflation, Bundesbank responded with an increase in the domestic interest rates.

On the other hand, UK during that time was experiencing recessionary economy with low growth and high unemployment rates. Furthermore, requests by member states to have Bundesbank decrease their interest rates or revalue the DMs met with a political deadlock.

The goal of achieving higher international economic integration while maintaining national policy independence is counteracted by what economists refer to as the “trilemma” or “the unholy trinity”. A country can, at any point in time, exercise control only on two of the three factors: 1) fixed exchange rate, 2) free international flows of capital, and 3) an independent monetary policy (control of interest rates).

By 1990, most of the EC members had eliminated all the restrictions on financial flows across the borders. Given an incentive, anyone would have preferred holding stable DMs to other currencies such as pounds, francs and lira among others. Higher interest rates in Germany, with unchanged interest rates in countries with weaker currencies, would create perfect condition for undertaking carry trades. However, if the interest rates of other countries or exchange rates could float freely, this could balance the exchange and interest rate parity. If UK, Italy, France and other EU members were not constrained by ERM, their interest rates would rise along with that of Germany’s, in which case investors would convert their funds from other currencies to DM. This would cause other EU currencies to depreciate relative to DMs. As a result, exports from Germany would be more expensive and goods from other nations would be cheaper for consumers. This would eventually result in an increase in exports of non-German counties, thereby priming demand for depreciated currencies to bring back the markets in equilibrium. However, this cycle would never set in place unless the currencies are allowed to depreciate in the place. EU nations could not depreciate their currencies as they were committed to the ERM.

Being a member to the ERM, the exchange rate of pound was fixed to DM within a prescribed band, the international flow of capital was unrestricted and the interest rates were required to balance the absence of forex adjustments. As the interest rates available in Germany were higher than those in UK, investors were incentivized to sell pounds and buy DM to invest at German interest rates. This caused a downward pressure on the value of Pound. While an increase in interest rates in UK was essential to ward off this imbalance, the domestic conditions demanded low interest rates to prime the economy. Additionally, the UK government was committed in sustaining pound’s ERM parity.

Currency speculators opined that the Bank of England will have to devalue pound in wake of market forces (Lira, a strong case point then, had already been devalued earlier that month). With this belief speculators took a position against the Bank of England, where they borrowed large quantities of pounds in the open market and sold them short to purchase DM.

Bank of England, on the other hand, made strong efforts to maintain low interest rates (to pump up the receding economy) and the peg to DM. It bought large amounts of pounds from the open market at the expense of depleting foreign currency reserves, primarily in U.S. dollar.

By 16th of September, 1992, UK was losing hundreds of million dollars every minute in supporting the pound’s value against DMs. The central bank ultimately resorted to increases in interest rates that went as high as 15%. However this proved futile in sustaining the peg. In the days to follow, pound fell by 15% against DM. Speculators bought back the shorted pound at the depreciated levels to repay their debt. The unused DM were the profit earned by the speculators. Bank of England’s reserves had depleted by $27billion.

George Soros had shorted $10 bn worth of pounds and traded it for DM only to buy them back when pound had depreciated. Soros took positions in interest rate futures, betting that the UK interest rates would increase in defense of the home currency. He made $1billion by shorting pound and another $1billion by participating in derivative markets. Soros was responsible for $10 billion of the total loss of $27billion suffered by the Bank of England, thereby known to be the person who broke the Bank of England !!

Predicting next asset bubble

The recent quantitative easing announced by the US Federal Reserve to pull out the US economy from double dip recessionary forces have created doubts in other central banks.

The US economy has been in the clutches of great financial crisis since 2007 and the confidence has been shattered amongst the Americans. Due to this money multiplier has plunged from about 9 to 5.5. Money multiplier depends on the percentage of loanable funds which banks mandatory need to keep with themselves, funds which banks keep extra as a buffer and percentage of funds which public keep with themselves. money multiplier falls when there is low confidence in the market and hence funds mobilized by the federal reserve are not able to reach corporations, the intended audience. There is not much fed can do to increase the money multiplier. Money supply is defined as multiple of money multiplier and monetary base (Fed's balance sheet). The quantitative easing is buying the medium term bonds from the market and flooding with money and hope that money is circulated in the economy to reduce the credit crunch.

Due to increase in the money supply in the economy, the medium term interest rates (7-10 years) fall down, which reduces the cost of capital for the corporations. Add to this the Federal Reserve has reduced the fed fund rates to near zero, which has flattened the yield curve. This provides opportunity for the fund managers to raise low cost debt to finance the industrial operations in the US or invest FDI in other high yielding economies.

On the other side,  the inflationary pressures in the emerging countries have been increasing. To curb the inflation, the central banks have been increasing the interest rates. Due to this differential in interests high amount of carry trade is possible. This has fueled the equity markets and other asset prices in the emerging economies. Though emerging economies are registering life time peaks in the equity markets, the foreign money might be fueling asset bubbles. Unlimited low cost money can be invested in only in limited investment opportunities. Once these limited opportunities are exhausted, the asset managers, under pressure to produce higher returns, invest in poor investments.

Similar capital flows happened prior to Asian Financial Crisis of 1997 when risk aversion of asset managers to fell due to higher expected returns and pushing up the asset prices.The currencies are getting appreciated and countries are being forced by the exportes to maintain the currency at 'optimum levels'. Exporters usually have good relations with the govenment to pressurize the officials.

It is in the interest of the recipient nations to receive the money, in real and financial assets, since it creates more jobs. But this can parallel increase the risk of asset bubble formation. Countries are in the dilemma to impose capital controls. The equity markets, real estate, currencies, gold are potential victims for bubble prices.

Returns based on Estimate Revisions

Estimate revisions are an important as representation of near term business dynamics of the companies being considered.

Estimate revisions provide a measure of direction and magnitude of the change in the expectations about a company’s earnings. The assumption is that rising estimations are associated with the above average stock returns and falling estimations are associated with the below average stock returns. Revisions tend to be positively serially correlated i.e. positive revisions are followed by positive revisions and negative revisions are followed by the negative revisions. It is difficult for an analyst to judge how far a positive or negative trend will go on once it has begun. Studies show that analysts are sluggish to respond to new information. They react slowly to a change in the direction of the underlying fundamentals because of a natural unwillingness to believe the change. In behavioral finance this is bias is known as anchoring where analyst remains anchored to his earlier forecasts and does not fully incorporates the new information due to conservatism. This phenomenon is strong on the downside because of the reluctance of the analysts to make negative comments about a company with which he may have investment banking relationships. As a result, the analysts issue frequent, minor revisions instead of marking their estimates down all at once.

Anchoring leads to earnings surprise. Positive earnings estimates are followed by positive surprises. For example, analyst has predicted that earnings of a company will increase by 10%, he receives the information that earnings will increase by 25%, but due to anchoring, he may not fully incorporate the news and uses only 15% increase in earning estimates. Over the time, when 25% earnings increase is reported by the company, stock will outperform the analyst expectation by 10% (positive earnings surprise). The positive earnings surprise leads to frequent positive estimate revisions. There is a kind of virtuous cycle when company’s earnings are improving. Of course, opposite is true when underlying fundaments are deteriorating.

To trade in this market by stocks which report positive earnings, of course we assume that markets are inefficient due to the heuristics.

P.S.: The extra returns based on near term business dynamics are difficult to capture than those based on the measures of value because of the greater trading activity required.

Acquisition through Stock or Cash?

In a an acquisition with cash deal, the roles of two parties are clear but in a stock deal, it is less clear who is the buyer and who is the seller.

In cash transactions, acquiring shareholders take on the entire risk that expected synergy value embedded in the acquisition premium will not materialize. In stock transactions, the risk is shared with the selling shareholders; more precisely, the synergy is shared in the proportion to the percentage of the combined company the acquiring and selling shareholders each will own.

For instance, Buyer Inc. wants to acquire the competitor Seller Inc. The market capitalization of Buyer is $5 billion made up of 50 million shares priced at $100 per share. Seller’s market capitalization stands at $2.8 billion-40 million shares each at $70. The managers of Buyer estimate that merging the two companies can create synergy value of $1.7 billion by acquisition of Seller. They announce that an offer to buy all the shares of Seller at $100 per share. The value placed on the Seller is therefore is $4 billion, representing a premium of $1.2 billion over the company’s preannouncement market value of $2.8 billion.

The expected net gain to the acquirer from the acquisition-called as Shareholder Value Added (SVA)-is the difference between the estimated value of the synergies obtained through the acquisition and the acquisition premium. So if Buyer chooses to pay cash for the deal, then SVA for its shareholders is expected synergy of $1.7 billion minus the $1.2 billion premium, of $500 million.

But if Buyer decides to finance the acquisition by issuing new shares, the SVA for the existing shareholders will drop. Let’s assume that Buyer offers one of its shares for each of the Seller’s shares. The new offer places the same value on the Seller as did the cash offer. But upon the deal’s completion, the acquiring shareholders will find that the ownership in Buyer has been reduced. They will own only 55.5% of the new total of 90 million shares outstanding after the acquisition. So their share of the acquisition’s expected SVA is only 55.5% of $500 million, or $277.5 million. The rest goes to the Seller’s shareholders, who are now shareholders in an enlarged Buyer Inc.

Fixed value or Fixed number of shares

Boards and shareholders must do simply more than stock or cash while making or accepting an offer. Companies can either issue a fixed number of shares or they can issue a fixed value of shares.

Fixed shares: The number of shares to be issued is certain, but the value of the deal may fluctuate between the announcement of the offer and the closing date, depending on the acquirer’s share price. Both parties are affected, but changes in the acquirer’s price will not affect the proportional ownership of the parties in the combined company.

Fixed value: In these deals, the number of shares issued is not fixed until the closing date and will depend on the prevailing price. As a result, the proportional ownership of the ongoing company is left in doubt until the closing date. Let’s go back to Buyer and Seller Inc. Suppose that Buyer has made stock offer and its share has fallen exactly by the premium it is paying to the Seller- from $100 to $76 per share. At this price in fixed value deal, Buyer has to issue 52.6 million shares to give Seller’s shareholders $4 billion worth. But that leaves Buyer with just 48.7% of the combined company as compared to 55.5% they would have had in the fixed-share deal.

Questions for the acquirer

There are primarily three questions. First, are the acquiring company’s shares undervalued, fairly valued, or overvalued? Second, what is the risk that the expected synergies will not materialize after the acquisition? The answer to these questions will help in making the decision between a cash and a stock offer. Finally, how likely is it that the value of the acquiring company’s shares will drop before closing? The answer to this question should guide the decision between a fixed-value and a fixed-share offer. Let’s take each question in turn:

Valuation. If market is undervaluing the acquirer’s shares then it should not issue the new shares to finance the transaction because that would penalize the current shareholders. When a company issues stock to finance the transaction, it may give a signal to the market that managers think the stock is overvalued and stock may fall after the information is disseminated. Acquirer may believe that its shares are undervalued, but in real world, it is not easy to convince a disbelieving seller to accept fewer but “more undervalued” shares. In this case it is logical course to proceed with the cash offer.

Synergy Risks. A really confident acquirer would pay for acquisition with cash so that shareholders would not have to give any of the anticipated merger gains, synergy, to the acquired company’s shareholders. But if the managers think that the risks are substantial, they can be expected to try to hedge their bets by offering stock. By diluting the ownership interests, they will also limit the partition in the losses incurred. Hence, stock offer sends two powerful signals to the market: that the acquirer’s shares are overvalued and that its management lacks confidence in the acquisition.

Preclosing market risk: Through a research by Journal of Finance it has been found that more sensitive the seller’s compensation is to changes in the acquirer’s stock price, the less favourable is the market’s response to the acquisition announcement. Hence the greater the potential impact of preclosing market risk, the more the important it is for the acquirer to signal its confidence by assuming some of the risk.

Questions for the seller

In case of a cash offer, the selling company’s board faces a fairly straightforward task. It just has to compare the value of the company as an independent business against the price offered. The only risks are that it could hold out for a higher price or that management can create a better value if company remained independent. For example, Buyer bid for $100, representing a 43% premium over the current price of $70 of Seller. Let us suppose that they can get a 10% return by putting the cash in investments with similar level of risk. After five years, the $100 will compound to $161. If the bid were rejected, Seller will have to earn 18% return on its currently valued $70 share to do as well. So uncertain a return must compete against a bird in the hand. The questions Seller needs to answer are: How much is the acquirer worth? How likely is it that the expected synergies will be realised? and, How great is the preclosing market risk?

Should China Allow its Currency to Appreciate?

Post April 2005 China allowed the Yuan to appreciate gradually against the US dollar, but since 2008 China has maintained a hard peg against the USD at 6.8 ensuring that Yuan followed the dollar as the latter depreciated against the yen and euro.

China has emerged as world ace exporter, surpassing Germany in Dec 2009, and has come under scanner to keep its currency undervalued to shore up its economic and trade competitiveness. Beijing's policy of keeping the Yuan weak has helped China become the first key economy to recover strongly from the world financial crisis but at the expense of its key trading partners still nursing the wounds of recession, some analysts contend. The USD has depreciated substantially relative to other currencies since May of 2009. Since the Yuan is tied again to the dollar, the Yuan has depreciated by the same amounts, including 16% against the euro, 34 % against the Australian dollar, 25% against the Korean won, and 10 % against the Japanese yen. This substantially depreciation of the Chinese currency has made many other countries angry at China's policy of locking it to the US dollar.

The US and other countries worry that the undervaluation of the Chinese currency increases the demand for Chinese exports, and reduces China's demand for imports from countries like the US. Since China has largest population, and demand for the US and other countries grows, but the goods are uncompetitive in the Chinese market. The US especially wants to help reduce the high levels of unemployment found in many of these nations. US companies that would like to export more to China are hurt by the maintenance of the Chinese currency at an artificially low value relative to the dollar. As a result, employment by these companies is lower than it would be, so that this may contribute a little to the high rate of US unemployment. But I believe the benefits to American consumers far outweigh any loses in jobs, particularly as the US economy continues its recovery, and unemployment rates come back to more normal levels. This is acting as double whammy for the developed nations which are trying hard to get out of recession: Their imports are increasing and exports are becoming uncompetitive.

The opposite effects hold for China. Their consumers and importers are hurt because the cost of foreign goods to them is kept artificially high. Their exporters gain, but as in the US, that gain is likely to be considerably smaller than the negative effects on the wellbeing of the average Chinese family.

This policy will make the Chinese exports competitive and help China to amass foreign reserves, now more than two trillion dollars, could result in protectionism and even spark a trade war.

According to Purchasing power parity, the Yuan, if allowed to freely float, should trade at 3.8 per 1 USD. So there is no doubt that China is intentionally holding the value of its currency below the rate that would equate supply and demand. By pegging the Yuan to USD, China has virtually adopted the Monetary Policy of US.

With huge pile of foreign exchange reserves, China is investing back in the US in treasuries. The US has little to complain if China wants to hold such high levels of low interest-bearing US government assets in exchange for selling goods cheaply to the US and other countries. China's willingness to save so much reduces the need for Americans and others to save more, but is not differences in savings rates also part of the international specialization that global markets encourage? To be sure, why China is willing to do this is difficult to understand since they are giving away goods made with hard work and capital for paper assets that carry little returns.

One common answer is that China hopes to increase its influence over economic and geo-political policies by holding so many foreign assets. Yet it seems just the opposite is true, that China's huge levels of foreign assets puts China more at the mercy of US and other policies than vice versa. China can threaten to sell large quantities of its US Treasury bills and other US assets, but what will they buy instead? Presumably, they would buy EU or Japanese government bills and bonds. That will put a little upward pressure on interest rates on US governments, but to a considerable extent, the main effect in our integrated world capital market is that sellers to China of euro and yen denominated assets would then hold the US Treasuries sold by China.

International Diversification: Does it still hold water?

The Capital Asset Pricing Model (CAPM) and the Modern Portfolio Theory (MPT), suggest that individual and institutional investors should hold a well-diversified portfolio to reduce risk. Empirically there has been a low correlation between developed capital markets and emerging markets and conventional wisdom says that if the correlation between two asset classes is low, you can combine the assets into a portfolio with lower risk than the individual asset class. It is also argued that since differences exist in levels of economic growth and timing of business cycles among various countries, international portfolio diversification can be used as a means of reducing risk.

Financial crisis like that of Great Depression (1929), Asian Market crash (1997), Dot-com bust (2001) and Credit crisis (2007-08) have shown that these are the times when the investor needs the effects of diversification the most and in these times emerging and developed markets tend to be highly correlated. The volatility in the markets affects cross market correlations and after the crash, the co-movements of markets increase significantly, implying that the benefits of international diversification decreased considerably.

Emerging markets had a great decade. Their story was strengthened by the resilience of countries like Brazil, India and China and other Asian economies to the financial crisis which was seen as largely a developed world issue. Looking forward the story remains intact. For many people the future of investing can be summed up in two words: emerging markets. There has been a fundamental revaluation of the relative risks of the larger emerging markets and questions are raised whether the term emerging market is any longer appropriate. Moreover, stock markets across the world are becoming more integrated and it has been found from the studies that correlations have remarkably increased over the time and the incentive to invest in these markets is diminishing.

Another interesting result observed is that correlation coefficients are uni-directional, correlations going from the U.S. to Japan are not the same as those going in the opposite direction. This is due to the fact that trading hours of the markets are different and that the market that opens later typically contains information on what happened in the market or markets that had already closed. This result may indicate that the Nikkei 225 returns are much more correlated with the S&P 500 returns after the close of the U.S. market than would be the reverse case.

Although all the economies move through the various stages of the business cycle over the time, these cycles are not always synchronized across countries (e.g. one country may be in recession while a second country is in early upswing). The degree of synchronization of the economies is increasing over the time as the international capital markets become more integrated. However, it is very unlikely that they will ever be completely synchronized. The key implication of the lack of complete business cycle synchronization for investment analysis is that international diversification of equity portfolios is valuable. This is because, to the extent that country business cycles are not synchronized, global return covariances will be lower and portfolio managers who diversify globally will realize better returns-to-risk tradeoffs and higher risk adjusted portfolio returns.

References:

http://gbr.pepperdine.edu/072/diversification.html

http://www.apexinvestmentguru.com/investmenttalk.php?id=5

Quantitative Easing

Background

During the current financial market meltdown, banks were holding the collateral for the loans which were considered to be of low quality and when the borrower defaulted, banks were not be able to recover the loan amount. Banks became too much cautious while making the new loans to the businesses. This created the liquidity crunch in the economy due to uncertainty. The money released by the central bank could not reach the business which were cash strapped and need money for the operations; credit market became frozen. The reason is that due to uncertainty banks were not willing to lend the money fearing that businesses will default over the loans.

Moreover, the uncertainty was so much that the banks did not even lend to each other. The central bank cut the federal funds rate to facilitate banks to lend to each other and let the credit markets free up. The rate was reduced to 0-0.25%. Banks started raise the funds at this rate and invest in long term Treasury securities, yielding 2-3% return, which are considered to be safe and add certainty to the repayment. This process returns the money released by the central bank back to itself defeating the purpose of increasing the liquidity in economy. The businesses get deprived from the liquidity.

Added function of Central bank

The pipes which deliver the money from central bank to the business are either broken or clogged. Now what central bank can do? Either increase the flow or mend/create new pipes.

The central bank starts to buy the toxic assets (low quality MBS, CDO, CLO, Bank loans to bankrupt companies, etc.) of the banks which are kept as collateral for existing loans. With the default risk transferred to the books of the central bank, banks can look out for loans to the economy.

Furthermore, central bank starts to buy the treasuries in open market operations. The demand of the treasuries brings the yields down which acts as disincentive to the banks. To generate the revenues, banks start to look out in the wider economy (companies, businessmen, etc.) which can give 5-8%.

With these two processes the central bank can print currency as much as it wants to induce in the economy. This is called Quantitative Easing.

Downside: Even after buying the treasuries from the market and toxic assets from the banks, banks may not loan to the businesses. This will devalue the currency which will make the exports more competitive. But if the currency is too much depreciated, market will start selling it leading the further problems.