Global Economic Power Shift and Financial Market Effects

Looking towards the future, it is not surprising that the world will become much more interconnected and interdependent, formally refereed to as the term globalization. Through analyzation of the economics power shift/ spread and its effects on financial markets, we plan to educate the class on a glimpse of what the future could possibly look like.

According to John Walley of the University of Western Ontario, the three measures that can be used to define economic power are retaliatory power, bargaining power, and soft consideration power. Retaliatory is the act of using the relative size of a countries economy to determine how much it can unilaterally affect other countries. Bargaining power is the willingness of countries or groups of countries to cooperate in international negotiations or joint agreed arrangements. Soft Power is the use of persuasive and philosophical engagement to convince another country to do as one pleases in the greater good of both countries.

The global switch we plan to analyze is the power spread that is bound to happen from OECD member nations to non-OECD member nations. The OECD is The Organization of Economic Cooperation and Development. They promote economic growth prosperity and development throughout world and consist of 34 democracies, including the US, Australia, South Korea, and various European nations. Non- OECD nations consist of many emerging economies like China, Brazil, India and South Africa. Currently OECD nations consist of approximately 58% of the world GDP, between now and 2060 majority of the world GDP will be held by non- OECD nations at 57%. The former President of the World Bank, James Wolfensohn, has projected that by 2060 China and India will be 46% of the world GDP, the G20 will possibly remain the new G8, the world wide middle class shall grow by 2 billion of which 1.5 billion shall be in Asia, and per capita incomes should rise world wide to $20000-3000 in Africa, $30000-40000 in China, and $900000-100000 in US/ richer nations. Also the Global Income Distribution will change from 80%/20% in favor of the developed world to 65%/35% in favor of the developing world.

This relationship between the developed and emerging economies of the world will have a huge toll on international financial markets. There are many positive and negative attributes associated with international financial markets.

According to Schmukler who is a senior economist in the research group in the world bank, with the huge dynamic economic shift that is taking place over the next half century, all power will most likely not shift from country to another but create much more interdependence in the world . In order for us tall to grow and prosper, this will lead to integrated financial systems that involve developed and emerging markets. International financial integration is likely not to back scale because of the increased dependents on trade between countries. The interconnection of global financial markets in developing and developed countries has its benefits and risks. Developing world benefits can be seen by the development of their financial markets due to the demand for stable and better regulations by foreign investors and by upgrading the financial infrastructure which will lead to decreasing information asymmetry. On the developed countries side, there will be more diversity for investment and more opportunities to increase returns out of investments in profitable emerging markets. On the other hand, the interconnection of global financial markets has its risks. Developing countries will be more vulnerable and highly affected by financial crisis in other parts of the world. Also, if the local financial infrastructure in not strong before engaging in international markets, it will cripple out due to the lack of regulation. On the other side, developed countries risks will show up by the vulnerability to suffer from the consequences of negative activities in other financial markets and political effects on domestic business in foreign countries.

Sources:

http://www.frbatlanta.org/filelegacydocs/erq204_schmukler.pdf

http://bizbeatblog.dallasnews.com/2012/11/oecd-report-balance-of-global-economic-power-will-shift-away-from-the-west-in-the-next-50-years-video.html/?nclick_check=1

http://www.tutor2u.net/blog/index.php/economics/comments/unit-4-macro-global-economic-power-shift-continues

http://www.npr.org/blogs/health/2013/03/15/174339876/power-shift-underway-as-middle-class-expands-in-developing-world

http://www.worldfinancialreview.com/?p=1128

http://www.lse.ac.uk/IDEAS/publications/reports/pdf/SR012/dejonquieres.pdf

http://www.oecd.org/dev/pgd/45337859.pdf

Consequences of Not Raising the Debt Ceiling

The House and the Senate voted 81 to 18 Late Wednesday night to reopen the federal government until Jan 15th, 2014 and increase the nation's borrowing limit until February 7th, 2014 close to the deadline of when the Treasury Department faced the possibility of being unable to pay all of America's bills for the first time in recent history. Under normal circumstances, the government is able to auction off new debt in order to finance annual deficits. The debt limit places an absolute cap on borrowing, requiring congressional approval for any increase or decrease) from this statutory level. The U.S. Treasury has borrowed trillions of dollars over the past decade, a lot of it from foreign investors, to help finance two long wars, resuscitate its financial system, and encourage economic growth via fiscal stimulus. The country's ability to borrow is restricted by law, and Congress has usually been called upon to authorize the issuance of new debt space. The U.S. Treasury has the authority to take extraordinary measures to forestall a default which is the point at which the government fails to meet principal or interest payments on the national debt. The U.S. Treasury can under-invest in certain government funds, suspend the sales of non marketable debt, and trim or delay auctions of securities.

Prior to 1917, the United States had no Debt Ceiling. A debt limit was passed with the Second Liberty Bond Act of 1917, and Congress has raised the cap more than seventy times since 1962. People argue that by requiring legislative consent, the debt limit affords Congress some oversight authority and creates some fiscal accountability.

Most recently the federal government hit its debt limit once more in December 2012, the Treasury was forced to take emergency measures to extend borrowing for several weeks. In February, President Obama signed the No Budget, No Pay Act of 2013, a bill that suspended implementation of the debt ceiling till May. On May 19, the federal borrowing limit came back into full force and was raised $305 billion to $16.699 trillion.

The United States failed to pass an annual spending measure by October 1, 2013, the start of the fiscal year, resulting in a partial shutdown of federal services that analysts say could eventually drag on economic growth, and even cause a recession. Neither keeping the debt ceiling where it is or raising it is good for the US. Increasing our debt to gdp ratio is bad. However, the effects of that will be inconsequential compared to a not raising the debt ceiling.

If we didn’t the raise it the nation would continue to be at risk of default. If this issue remained unresolved longer and resulted in a default it would definitely come with its share of negative consequences. Had this ordeal resulted in the us government no longer able to meet its financial obligations we would have been subject to government services being slashed, high interest rates and market unrest. The effects of a default would also be international, as economies such as Japan, and China which own substantial portions of our debt will have severe issues in their financial markets.

One of the consequences of defaulting would result is cuts in government services. This would be because over the next year we are estimated to spend roughly around 30 billion more every month than taken in. So if the debt ceiling were not raised the government would eventually have start cutting government services in order to comply with our financial obligations. According to  the Congressional Research Service they estimated that if the debt ceiling was raised for a year government would have to either slash discretionary spending by 33%, Hike taxes by 12%, cut mandatory spending by 16% a month, or a combination of the three.

Also thing is the postponement of the raising of the debt ceiling would increase market preoccupation of the possibility of a US default. Thus, causing a sell off of US treasury bonds. Which would in turn raise the interest rates, meaning increased borrowing costs and mortgage rates. In the end it was crucial that we extended the debt ceiling. We are still not out of the woods yet on February 7th the debate of raising the debt ceiling will be on the table again.

By:

Luis Alberto Sanchez Cordero

&

Benjamin Frye

Sources

http://www.cfr.org/budget-debt-and-deficits/us-debt-ceiling-costs-consequences/p24751

http://finance.yahoo.com/blogs/hot-stock-minute/september-hiring-misses-estimates-unemployment-rate-falls-130358302.html

http://www.usnews.com/news/slideshows/6-consequences-if-the-debt-ceiling-isnt-raised/6

http://www.bloomberg.com/quicktake/the-debt-ceiling/

http://money.cnn.com/2013/10/07/news/economy/debt-ceiling/

http://www.huffingtonpost.com/2013/10/16/government-shutdown-debt-ceiling_n_4111483.html

The Effects of the Government Shutdown

The shutdown of the United States government has been all over the news in the past month. Therefore we thought it would be interesting to look at how financial markets were affected before and after the shutdown along with what could have happened if the shutdown continued.

The U.S. government shutdown began on October 1, 2013 when congress could not pass a budget for the 2014 fiscal year. This was mainly over the issue of Obamacare. Republicans did not wish to fund this program and could not develop a resolution with Democrats before the September 30^th deadline. With no budget, the Federal government could not be funded and had to be shutdown. The government reopened on October 17^th which prevented the U.S. from defaulting on its loans.

The money market during this period varied depending on the maturity of the bond. Yields of 1-month bonds initially jumped to .10 and peaked at .32 on the 15^th. As for 3-month bonds yields steadily rose during this period and peaked at .14 on the 15^th. The yields on long term bonds were relatively unchanged however. One year bonds only varied by .05 and all of the longer maturity bonds had even less variation. After the shutdown, 1-month bonds and three month bonds returned to their pre-shutdown yields within a day or two. Long term bond yields were once again relatively unchanged. The see a complete chart of these yields, use the following link: yield chart. The minimum variation in the long term bonds and the return of the short term bonds to their normal level shows that investors still view U.S. bonds as a safe investment. Had this not been the case, short term yields would have remained at a higher rate and long term yields would have gone up as well.

The financial markets fared differently. From October 1^st through the 9^th the Dow Jones, NASDAQ, and S&P 500 all fell. However, they all started to rise before the government reopened. This could be attributed to Democrats and Republicans moving towards making an agreement, but there can also be a variety of other factors involved. An in depth analysis would have to be conducted to see which factors were causing this rise and by how much. After the shutdown ended, each of the indexes dropped but recovered to over the opening value of the first day. Now they are all above the pre-shutdown rate and the S&P 500 is at a 52 week high. This trend could be contributed to an increase in consumer confidence, but once again there could be many factors involved.

What is scary is to look at what could’ve happened had the government not reopened and defaulted on its loans. It is unclear what exactly would’ve happened, but here is a chain of events that could be considered the worst case scenario. Initially there could’ve been a global stock market crash. Some predictions say the Dow Jones could have fell by as much as 1000 points and the Asian and European markets would be hit soon as well. This would then lead to a global recession as many people would lose the bulk of their assets. As the stocks dropped, investors would also rush to withdraw their funds in money markets. This would cause a collapse of the money markets since they would have a funding shortage. The collapse of the money markets would cause a run on banks which would not be able to be fully prevented by government bailouts. Only the strongest banks would be able to survive and all of the others would fail since the government wouldn’t be able to bailout all of them. Finally, lending would seize up since funds would not be available due to so many bank failures. Even though this situation is a worst case scenario, it is for the best that the government avoided even the slightest chance of this occurring.

2013 Nobel Prize Winners for Economics

This year three economists split the Nobel Prize for economics. They were recognized for their contributions to the measuring of asset pricing. Although these economists did not work directly together, their research, sometimes even conflicting, has been instrumental to our understanding of financial markets today.

Eugene Fama
Eugene Fama, a professor of finance at the University of Chicago, improved theory essential to the Efficient Market Hypothesis. Fellow academics sometimes refer to him as the “father of modern finance” and the “father of the Efficient Market Hypothesis.” He studies risk and return and implications of portfolio management. While still in graduate school at the University of Chicago, Fama began researching and publishing findings on Random-Walk theory. This theory was not new, but he contributed to it and added statistical analysis. His findings said that stocks often respond unpredictably to news in the short-term, but analysis can find trends in the long-term, suggesting that it is nearly impossible to beat the market. He believes stocks are priced based on all available information.
His research led to the creation of stock-index funds. These funds are a type of mutual fund made up of a portfolio that attempts to track or match an index. The benefits of this strategy are a broad coverage and low transaction and operating costs. The broad coverage is a diversification method that lowers risk. The low costs come from the idea of a “passive investment,” where the stock-index is established then left alone for the most part. Top investors such as Warren Buffett, Charles Schwab, Jack Bogle, Nobel-winning economists, and large U.S. pension funds invest in these index funds. Although slow to catch on, index mutual funds made up about 15% of the assets in U.S. stock and bond funds as of 2012.

Robert Shiller:
Robert Shiller is a Sterling Professor of Economics at Yale University. He completed his B.A. at the University of Michigan and he completed his Ph.D. from MIT in 1972.
Unlike Fama, he is not a supporter of the efficient market theory. Instead, Shiller asserts that markets are driven more so driven by human psychology or the present human appetite for risk. He believes that market trends that are deemed “unpredictable” by the traditional economic theory are caused by “quirks” in human psychology.
Dr. Shiller is known also known for the Case-Shiller Index. This index is the leading measure of residential real estate prices in the U.S.

Lars Peter Hansen:
Dr. Hansen is a David Rockefeller Distinguished Service Professor at the University of Chicago. He completed his undergraduate coursework in Political Science and Math at Utah State University (1974) and completed his Ph.D. in Economics at the University of Minnesota in 1978.
Dr. Hansen is widely known for being the lead developer of the Generalized Method of Moments (GMM) which is a generic method for estimating parameters in statistical models. The GMM is used in econometrics to broaden assumptions that researchers deem reliable.
The GMM has been used to analysis data and asset prices thereby, allowing for economists to better test theories on what drives the market. For example, the GMM was used to build on Shiller’s work by helping to establish human behavior as the cause of volatility in prices. In essence, This more strongly established the idea of that mispricing was correlated to people’s desire for risk.
All in all, in December, these three American economists will be awarded the $1.2 Million on behalf of the Nobel committee. Congratulations to the three of them!


By Zacher Bayonne and Tom McCartin

http://www.chicagobooth.edu/faculty/directory/f/eugene-f-fama

http://www.bloomberg.com/news/2013-10-14/fama-hansen-shiller-share-nobel-economics-prize-academy-says.html

http://www.bloomberg.com/news/2013-10-14/fama-s-nobel-work-shows-active-managers-fated-to-lose.html

http://www.investopedia.com/terms/i/indexfund.asp

http://www.marketwatch.com/story/13-reasons-index-mutual-funds-and-etfs-rule-2013-07-24

Government Shutdown

The Federal Government is supposed to approve a budget every year.  The budget is necessary as it is used to allocate funding among the various agencies.  September 30 was the last day of the government’s fiscal year.  At this point in time, the house and senate were unable to come to an agreement on the budget for the 2014 fiscal year.  This disagreement has caused the government to shutdown.

            A government shutdown seems scary to many people, however, there are lots of misconceptions regarding it.  All laws will still be enforced, social security will still be paid, and our military is still active.  What the shutdown does is reduce, or in some cases, eliminate funding to all non-essential agencies and services of the Federal Government.  The agencies affected by the shutdown include, but are not limited to the following: FCC, NIH, EPA, and the IRS.  The moment the shutdown ends, these agencies will receive full funding again.

            The primary cause of the most recent shutdown was a disagreement over the Affordable care act, a.k.a. Obamacare.  Obamacare is heavily supported by the Democratic Senate and White House.  The Republican led house strongly opposes the measure.  The budget passed by the Senate included funding for Obamacare, whereas the budget passed by the house did not.  It is important to note that Obamacare exchanges opened on October 1, the day the shutdown commenced. 

            The effects of the shutdown through two day have been minimal to non-existent. On the first day of the shutdown most markets and indexes were up. Those that were down decreased minimally.  On the second day most markets decreased minimally. 

            However, there is much debate on what will happen if the shutdown continues for more than a few days.  The economic impact of the shutdown is hotly debated with different sources claiming different numbers.  Goldman Sachs, for instance, believes that a three week shutdown could cost the economy 0.9% of its overall GDP, approximately $150 million.  This is significant because as of January 1 the economy’s GDP has only increased 2%.  A three week shutdown has the potential to reduce this year’s growth in half.

            It is also worth noting that the DC area will be affected more than other areas of the country because of the high concentration of government employees.  Of the 800,000 people who will be furloughed for the duration of the shutdown, nearly 700,000 of them live in the DC area.  The State of Maryland estimates that it will loose $5 million per day in tax revenue for the duration of the shutdown.

            Another important aspect is that the Federal Government is going to reach the debt ceiling in approximately two weeks. The ceiling is currently set at $16.999 trillion.  These negotiations could very well be complicated by the disagreement over the budget.  This is also a far more pressing issue, because if the House and Senate are unable to compromise the government will be forced to print more money or to default on its debt.  Neither one of these options is good, as printing money will cause inflation. However, the effects of that will be inconsequential compared to a credit default. In the event of a default, interest rates will skyrocket and US financial markets will be in a situation unlike anything we have seen before.  The effects of a default would also be international, as economies such as Japan, and China which own substantial portions of our debt will have severe issues in their financial markets.

Story of Seemingly Illogical Low Yields of the Japanese Government Bonds

Paul Krugman, a Nobel Prize-winning economist and a regular contributor to The New York Times, wrote in 2010 that he was perplexed about the different bond yields between the Italian Government Bonds and the Japanese Government Bonds.

Think about it: Italy’s debt-to-GDP ratio is 126%, Japan’s ratio is 214%, and US’ ratio is 73%. Whereas Italy’s 10-year government bond yield is 4.61% and the US 10-year -- dubbed “risk-free” -- rate is 2.64% as of 9/30, Japan’s bond 10-year government yield is a mere 0.68%! This low yield seems to be very illogical for the following reasons: (1) Japanese economy has performed terribly in the past two decades, where Japan grew at a virtually 0% for twenty years (Some critics call the period as the Lost Decades); (2) Japan’s debt-to-GDP ratio is enormously high to the point that it is beginning to be choked by debt interests. Then why are the yields so low? What’s happening?

There are three reasons: 1) financial repression; 2) home bias; and 3) dysfunctional equity markets.

Financial repression

Financial repression is governments' measures to channel funds to themselves, which would go elsewhere, such as to private consumption, in a normal market.

Japan has a unique financial system that is resembles more of the East Asian countries. Although it follows a free market structure, the government exerts strong influence over the economy, both formally and informally. Although Japan's economic development is primarily the product of private entrepreneurship, the government has directly contributed to the nation's prosperity by helping initiate new industries, cushioning the effects of economic depression, creating a logical economic infrastructure, and protecting the living standards of its citizens. Indeed, so pervasive has government influence in the economy seemed that many foreign investors have popularized the term "Japan Inc." to describe its alliance of business and government interests. Following the Lockheed Martin scandal in the 1970s, which jailed the incumbent prime minister and a series of reforms in the 1980s and the 1990s, some critics have voiced that government influence has waned, but its agencies still exert heavy influence through various policies.

The Ministry of Finance (MOF) requires banks to hold a certain amount of their capital in "safe assets," which in practice means the Japanese Government Bonds (JGB) only. Foreign bonds are considered risky by this regulation even if the exchange risk is hedged through currency swaps. A vast majority of the demand for the JGBs come from small and regional banks, whereas large banks are slowly shifting to shorter-term JGBs. For an example, Bank of Tokyo-Mitsubishi-UFJ, the largest Japanese keiretsu bank which was born out of big mergers, holds Y38 trillion JGBs, which comprise 18% of its total balance sheet. During the global recession from 2008 to 2010, its holding of JGBs more than doubled from Y15 trillion. This pushed down the 10-year yield to approx. 1%. The banks nevertheless had to purchase more bonds, and the yield now stands at roughly half the ratio of 0.68%.

The ever-increasing demand for JGBs has allowed the central government to borrow money at, if we include inflation rate and other variables, a negative interest rate. The cost was levied upon the households. Dr. Michael Pettis, a professor at Peking University’s Guanghua School of Management, calls it a “stealth tax” because it eventually depresses household consumption.

The extremely low JGB yields pushed down deposit rates on Japanese households’ saving accounts to 0%, since the banks need to maintain their spreads coming from the purchase. As a result, the Japanese households have incredibly low net household saving rate. Japanese households have increasingly begun JGBs as relatively attractive investments and began buying JGB-related products.

Domestic bias

Then a question arises: “Why aren’t the Japanese households buying foreign bonds, such as the U.S. Treasury Bills, that are safer and pay higher yields?” In order to answer this question, we have to dig deeper into the country’s recent economic history.

Between 1981 to 1984, the Japanese yen depreciated by approximately 50% against the U.S. dollar. The U.S. industry found itself in a difficult competition against increasingly cheaper, higher quality Japanese goods and lobbied the U.S. government to take action. The Reagan administration passed protectionist measurements and pressured other Group-7 (G7) states to draft the Plaza Accord, in which central banks of the G7 nations would intervene in the foreign exchange market to appreciate their currencies against the U.S. dollar. The Plaza Accord had an effect that was much greater than originally anticipated. After hitting a low of ¥350/$1 in January 1985, yen appreciated by 51% in just two years! (On a separate note, yen is currently valued at ~¥100/$1.) In other words, the Japanese exporters lost 51% of their income in terms of yen. A series of wide fluctuations led the Japanese investors to avoid securities that involve foreign exchange.

Underperforming Equity Market

Resulting recessionary effects on the Japanese export market (1985 - 1986) incentivized the central government to intervene with the monetary expansion policy that led to the Japanese asset bubble of the late 1980s. In January, 1990, the stock market began to collapse, followed by the collapse of the overall asset price in 1991. After hitting an intra-day high of 38,957.44 on December 29th, 1989, Nikkei 225 -- analogous to the Dow Jones Average -- quickly collapsed and closed at 7,054.98 on March 10th, 2009, which makes it an 81.9% drop from two decades ago.

Most American investors believe that the stock market rises in long-term, but the opposite belief is true in the minds of the Japanese investors. This mindset is reasonable if we take a look at the Nikkei 225, which has largely been in a huge downward trend in the past 15 years (See Figure 2). Therefore, the Japanese were correct -- if not making a self-fulfilling prophecy -- that at least their equity market goes down in long-term.