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Friday, June 22, 2007

Carry On Up The Carry

Bloomberg this morning

Japanese finance companies will market more than 1.5 trillion yen ($12.1 billion) of foreign-currency investment trusts before month-end, according to data compiled by Bloomberg. The funds are aimed at individuals seeking higher yields.

Hegel once famously said that "theory is grey bu life is green". Here we have another very clear example of just how right he was. We are still far from understanding what the long run implications of all this are likely to be. But open a tear in hyperspace, and through they go.

In one sense what is happening is an enormous rebalancing, since "underheating" in domestic demand in some elderly economies (Japan, Germany, Switzerland) is feeding through to "overheating" is domestic consumption in some younger developed countries (New Zealand, Spain, Ireland), some Eastern European economies with structurally damaged demography (Latvia, Lithuania) and in dome new young developing economies (India, Thailand, Brazil). What is curious here is that since Japan needs to maintain growth (and this means export growth) to keep the fiscal deficit from going completely out of control (some current estimates put the present deficit at around 170% of GDP) then the Japanese economy is the direct beneficiary of overheating elsewhere, hence if economics is a game where each one pursues their own self interest, then the Japanese have every interest in keeping this one running.


``There's been a lack of warnings from the monetary authorities on the yen's weakness,'' said Seiichiro Muta, director of foreign exchange at UBS AG in Tokyo. ``As interest rates have to be kept low, it can't be helped that the yen is somewhat weak. A weak yen also benefits exporters.''

Unemployment in Brazil

The contents of this Bloomberg article this morning makes the role of the demographic component in sustainable economic growth pretty clear I feel:

Brazil's unemployment rate was unchanged in May from the previous month as quickening economic growth prompted more people to come into the workforce, offsetting gains in hiring.

Unemployment in Brazil's six largest metropolitan areas was 10.1 percent, the national statistics agency said, higher than the median forecast of 9.9 percent in a Bloomberg survey of 16 economists.

``Unemployed people are looking for jobs as the positive outlook for the economy boosts companies' confidence to spend more on hiring,'' Sandra Utsumi, chief economist with BES Investimentos in Sao Paulo, said in a phone interview. ``Even though the jobless rate didn't drop, the perspective for the labor market is positive as the economy is growing.''

The difference with Germany, Japan etc (or Latvia, Lithuania for that matter) couldn't be clearer. The rate in Brazil doesn't fall dramatically with growth due to the large numbers of younger people who are continuously coming online.

Companies are hiring more as slowing inflation, lower interest rates and rising family incomes encourage consumers to boost their spending, said Utsumi. Market analysts expect the economy to grow 4.25 percent this year and 4 percent in 2008 compared with 3.7 percent in 2006, according to the median estimate a June 15 central bank survey.

Brazil's central bank slashed the benchmark interest rate to 12 percent, a record low, on June 6 from a 19.75 percent in September 2005, as inflation reached the lowest level in eight years.

Meanwhile back in Latvia annual wage inflation is running at 33%.

Wednesday, June 20, 2007

Herd Behaviour in Austria

Just a quick afterthought on my last post on the Swiss Franc carry trade. As I note there, Claus Vistesen had a post earlier in the week on Japanese housewives shorting the yen. Now interestingly a guy called Wim from the Netherlands immediately posted a comment pointing out that this isn't only a lucrative activity for the Japanese housewife, and that he was effectively able to do the same from his own living room:

"As a retail investor in Holland it is easy to short yen and invest in something else. You only have to open a brokerage account with InteractiveBrokers and you can do the same yen carry trade as these japanese house wives. I am doing it myself and invest the money in gold, commodities and mining companies. Gold expressed in yen is certainly in a bull market. JPY JPY LIBOR1 (Spot-Next rate) 0.613%"

So why is this important, well let's go back to what happened in Austria in the late 1990s. Dimitri Tzanninis explains the situation like this:

The practice of borrowing in foreign currency (mainly Swiss francs) began in the western part of the country, where tens of thousands of Austrians commute to work in Switzerland and Liechtenstein. This partly explains why the share of these loans was higher in Austria, even during the 1980s. Word of mouth and aggressive promotion by financial advisors helped spread the popularity of these loans to the rest of the country. By the mid-1990s, newspaper ads placed by banks began to appear, fueling public interest.

Now Dimitri Tzanninis refers to this as an example of "herd behaviour" (see note at foot of post), in the sense that the process is clearly non-linear, and subject to some kind of press driven and "word of mouth" process. The following charts of news stories in the Austrian press sum the situation up pretty well:

Now all of this could simply be though of as anecdotal, until we take a look at what is happening right now in New Zealand:

The New Zealand dollar rose to its highest against the U.S. currency since the central bank intervened on June 11 as the yield advantage enjoyed by the nation's debt widened.

The yield spread between New Zealand's December 2017 government bond and 10-year Treasuries rose to 1.68 percentage points, from 1.49 points on June 12, after a report showed a drop in U.S. home building. New Zealand's 8 percent benchmark interest rate is the second-highest after Iceland's among Aaa- rated countries, fueling a 22 percent gain in the currency in the past year.

The New Zealand dollar also rose to its highest in almost 20 years against the yen. It has gained 31 percent against Japan's currency the past year, buoyed by so-called carry trades, where investors borrow at Japan's 0.5 percent rate, the lowest of the major economies, to buy higher-yielding assets elsewhere.

Japanese individual investors, who have set up 600,000 accounts to trade currency with borrowed yen, stepped up purchases of the New Zealand dollar after the Reserve Bank said it sold the currency.

600,000 individual accounts, and from Japanese retail investors who are allegedly conservative and exhibit historically "home bias" (just like the Austrians in the mid 1990s?)! Clearly we have a "herd-type" phenomenon in Japan right now, and one which increasingly places central bankers under a lot of difficulty when they want to intervene. The long term implications of what is happening are hard at this point to foresee, but they surely are going to be important. Financial de-regulation plus the internet seems to constitute some kind of "killer-app". As Keynes famously said, in the long run we are all surely dead.


Herd Behaviour

I reproduce below the explanation of the herd behaviour phenomenon offered by Dimitri Tzanninis.

Herd behavior occurs when people do what others do rather than rely on their own (incomplete) information, which might be suggesting something different (Banerjee, 1992). The suppression of private information could lead to “information cascades” when decisions are made sequentially and a large enough number of people choose identical actions. In such settings, the decisions of a critical few people early on are enough to tilt group behavior toward a certain direction. Mimicking the behavior of others might be rational because of uncertainty about one’s own information as well as the need to economize on information-gathering costs. Rational herd behavior is the subject of a recent strand of behavioral finance (see Montier, 2002, for an introduction).

Herd behavior can arise in a variety of environments, including in financial markets. However, it is difficult to disentangle empirically the effects of macroeconomic or other fundamental determinants from those caused by herd behavior. Herd behavior often results in volatility because it is susceptible to abrupt shifts or reversals, and thus has the potential to destabilize markets.

Empirical studies have shown that the dynamics of herd behavior often resemble an S curve: initially only a few adopt a certain behavior, but, past a certain critical mass, a take-off state takes hold where a rapidly growing number of people adopt this behavior. Toward the end of this process, a moderation of the dynamics takes place as the potential pool of adoptees is exhausted.


Banerjee, A. V., 1992, “A Simple Model of Herd Behavior,” The Quarterly Journal of Economics, Vol. CVII(3), pp. 797-817.

Montier, J., 2002, Behavioural Finance: Insights into Irrational Minds and Markets (Chichester: John Wiley & Sons Ltd.)

Waschiczek, W., 2002, “Foreign Currency Loans in Austria—Efficiency and Risk Considerations,” in Financial Stability Report 4, OeNB, pp. 83-99 (Vienna: Oesterreichische Nationalbank).

Tuesday, June 19, 2007

The Swiss Carry Trade

With all the fuss about the Japanese carry trade in recent months (and don't miss this latest piece on the Japanese housewife angle from Claus Vistesen), another important piece in this global puzzle seems to be escaping notice: the Swiss connection.

Like Japan, Switzerland is a country which has aged fairly rapidly in recent years (median age now around 40.5), has a balance of payments surplus, relatively flat internal demand, low inflation (currently around 0.8%), and consequently comparatively low interest rates (now at 2.5% since they have been rising recently). The result of all of this has been a growing tendency in parts of Central and Eastern Europe to contract loans denominated in Swiss Francs.

What now follows is a brief account of what we know about the current extent of this phenomenon, and about the prominent role which the Austrian banking sector seems to play in it . At the end of the post I return to the issue of Switzerland as an elderly economy with specific structural problems, problems which lead Switzerland to play such a leading role - one is both distict from yet similar to that played by Japan - in the carry trade phenomenon.

The use of Swiss franc denominated loans has become a widespread phenomenon in Eastern Europe. In Hungary, to take one important example, over 80% of all new home loans and half of small business credits taken out since early 2006 have been in Swiss francs. A similar pattern of heavy dependence on foreign currency denominated loans is to be found in Croatia, Romania, Poland, and the Baltic States, although the mix between francs, euros, and the yen varies from country to country.

The fashion for borrowing in Swiss francs really took off in Eastern Europe when Swiss National Bank dropped interest rates to 0.75% in order to stave-off a perceived deflation threat, turning Switzerland in the process into the cheapest source of loan capital in Europe. External lending in Swiss francs reached $643 billion in 2006, according to data from the Bank for International Settlements . The huge scale of the borrowing in fact drove the Swiss franc to a nine-year low against the euro, and has lead to an accelerating slide in its value over the last two years - even though by this point the Swiss National Bank had been busy raising rates (Swiss interest rates have now been increased 7 times since the 2003 trough). The extreme weakness in the Swiss Franc is in fact rather perverse (shades of Japan, of course, here), since currently Switzerland enjoys the highest current account surplus in the developed world (some 17.7% of GDP in 2006). At the same time the Swiss hold more than $500 billion in net foreign assets, making them in these terms the wealthiest nation on earth.

A recent issue of the Bank for International Settlements publication Highlights of International Banking and Financial Market Activity has some revealing comments on the Swiss situation(the data used for the report came from 2006):

Total cross-border claims of BIS reporting banks expanded by $1 trillion in the last quarter of 2006. After more modest growth in mid-2006, a pickup in interbank claims accounted for 54% of this expansion. A surge in credit to nonbank entities contributed $473 billion, pushing the stock of cross-border claims to $26 trillion, 18% higher than in late 2005.

The flow of credit to emerging markets reached new heights through the year 2006. Claims on emerging markets grew by $96 billion in the final quarter of 2006, bringing the volume of new credit throughout the year to $341 billion. This amount exceeded previous peaks ($232 billion in 2005 and $134 billion in 1996), both in nominal value and in terms of growth. The current annual growth rate has risen to 24%, having surpassed for the sixth consecutive quarter the previous peak of 17% recorded in early 1997.

Emerging Europe overtook emerging Asia as the region to which BIS reporting banks extend the greatest share of credit. Since 2002, growth in claims on the region has consistently outpaced that vis-à-vis other regions. With a record quarterly inflow, emerging Europe received over 60% of new credit to emerging markets, bringing its share in the stock of emerging market claims to 34%. Less of the new credit went to the major borrowers (Russia, Turkey, Poland and Hungary) than to a number of smaller markets, notably Romania and Malta, as well as Ukraine, Cyprus, Bulgaria and the Baltic states.

The currency denomination of cross-border claims on emerging Europe tilted further towards the euro. In the stock of claims outstanding, the euro and dollar shares were 44% and 31%, respectively, but the gap in the latest flow data was more pronounced (61% and 5%). While the sterling share has remained close to 1%, the yen has lost ground to the Swiss franc, thus continuing a trend seen over the last six years. Yet there is little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending in several countries. Borrowing in the Swiss currency remains on average below 4% of cross-border claims, and exceeds 10% only in Croatia and Hungary.

Nearly 20% of reporting banks’ foreign claims were in the form of funds channelled to emerging market borrowers. Claims on residents of emerging Europe continued to account for the largest share of these funds.
So, although the BIS find "little evidence in the cross-border data of unusual borrowing in Swiss francs that might correspond to Swiss franc-denominated retail lending", they do make an exception in the cases of Hungary and Croatia, where they note that lending in Swiss francs to retail clients reaches over 10% of the total retail loans in those countries, and indeed, as I indicate above, swiss franc loans now seem to account for over 80% of new housing related credit in Hungary.

This tendency to borrow in Swiss Francs is not, however, restricted to East Europeans, as Nils Bernstein notes in this report for the BIS on the Danish economy, the Danish farmers have also been at it:

As can be seen from the above chart, Swiss Franc denominated loans have been steadily rising in Denmark since 2001. Nils Bernstein makes the following observations:

In our case, the strategy is pursued by private borrowers, often farmers it is said, who raise loans in Swiss francs rather than in Danish kroner. A lower level of interest rates for Swiss than for Danish instruments makes this advantageous, at any rate for as long as the Swiss franc does not strengthen excessively against the krone.

The banks’ lending to households in Swiss francs has risen steadily since 2001 and today totals almost kr. 20 billion. During 2006 the increase in Swiss franc lending flattened out, however, and by the end of the year the net lending was negative. At the same time, the Swiss franc had weakened to its lowest level against the Danish krone for 8-9 years. The decline in net lending may be due to expectations that the Swiss franc would rally. This is confirmed by statistical analyses of data for a large number of years. The analyses find significant correlation between a weaker Swiss franc and diminishing net lending.

It is interesting that the Danish carry speculators show a different reaction pattern to the yen carry speculators. The yen carry speculators leave their positions when the yen strengthens, apparently fearing that the strengthening forewarns an imminent stronger adjustment of the exchange rate. Our domestic Swiss franc speculators increase their positions when the franc strengthens, apparently believing the strengthening to be temporary.

So what else has been going on in Europe involving the Swiss Franc? Well, from the outside this is very hard to determine, although in this connection the 2005 issue of the IMF publication Selected Issues Austria makes very interesting reading. Chapter two focuses on the growth of Swiss Franc denominated mortgages in Austria in the 1990s and is entitled - "What Explains the Surge of Foreign Currency Loans to Austrian Households?". The chapter was prepared by Dimitri Tzanninis, and in it you can read:

Following years of relative stability, foreign currency loans to Austrian households entered a phase of explosive growth around 1995. Even though their growth has moderated since 2001, foreign currency loans still account for about half the growth of total credit to households. By end-March 2005, 30 percent of outstanding loans to households were in foreign currency, compared with about 5 percent for the euro zone. Nearly all these loans are in Swiss francs and, to a lesser extent, Japanese yen. The vast majority of these loans finance domestic transactions. The popularity of foreign currency loans among households is a uniquely Austrian phenomenon in the euro zone.

Now the following charts make all of this even clearer. Firstly loans to Austrian households in foreign currency have risen sharply, and the process really took off in the mid 1990s:

In the second place, annual growth rates for these loans spiked sharply at the turn of the century and since that time the rate of arrival of new demand has declined significantly (this turning point coincides, of course, with the introduction of the euro, and interestingly enough Denmark is not part of the eurosystem).

In the third place we should note the way in which outstanding loans to Austrian citizens in non-domestic currency have increased (and continue to increase) as a percentage of Austrian GDP, and of total household debt:

Finally, Swiss Franc loans massively predominate in the Austrian foreign currency loan market:

As the IMF notes this was essentially a refinancing - rather than a construction - boom:

The boom in these loans appears to be reflecting currency substitution rather than a lending boom. Growth of credit to households (in all currencies) has been relatively subdued (second panel of Figure 1), suggesting that a considerable part of the growth of foreign currency loans has been the result of refinancing. Indeed, because of refinancing of previous schilling or euro loans, the contribution of foreign currency loans to the annual growth of total loans to households approached or exceeded 100 percent in six consecutive quarters beginning in late 1998.

Another interesting question to ask is just how did all of this got started, since evidently there may be lessons here for the spread of such practices in the East of Europe, and, of course, the fact that chart for the growth of foreign currency denominated loans is surprisingly reminiscent of the sort of S shaped curves which were so evident in the spread of the use of mobile phones is very revealing.

Well, apparently:

The practice of borrowing in foreign currency (mainly Swiss francs) began in the western part of the country, where tens of thousands of Austrians commute to work in Switzerland and Liechtenstein. This partly explains why the share of these loans was higher in Austria, even during the 1980s. Word of mouth and aggressive promotion by financial advisors helped spread the popularity of these loans to the rest of the country. By the mid-1990s, newspaper ads placed by banks began to appear, fueling public interest (text figure). Another factor facilitating the spread of these loans could be the belief in the stability of the exchange rate deriving from Austria’s hard currency policy (a peg of the schilling to the deutsche mark) since 1980.6 The success of this policy may have created a psychology of an exchange rate immune from risks, notwithstanding the appreciation of the Japanese yen and, to a lesser extent, the Swiss franc since the mid-1980s.

Now this taste for Swiss Franc denominated loans in Austria is interesting, since as Chapter 3 of the 2007 issue of the IMF Selected Issues Austria (which is devoted to Cross-border Banking Issues for the Austrian Banks and their Supervisors) tells us:

Austrian banks play a major role in many countries in Central, Eastern, and Southeastern Europe (CESE). Almost all of the large Austrian banking groups have subsidiaries in several countries in CESE. In quite a few cases, these subsidiaries are large compared with the host country’s financial systems. Moreover, some of these subsidiaries would probably be judged to be of systemic importance to the financial systems in the host countries. At the same time, the holdings in the CESE are important for the Austrian banks, as they represent a significant part of total assets and provide a major contribution to overall profitability.

In other words the Austrian banks have leveraged expertise they developed for external currency loans based on an initial wave of domestic demand to gain a comparative advantage in a much larger market.

The Austrian financial system is dominated by the banking sector. At roughly 300 percent of GDP, total banking sector assets are far larger than those of insurance companies and pension funds. Mutual fund assets and stock market valuation have increased considerably over the last five years, but also remain small compared with the banking sector. Domestic credit provided by Austrian banks is in line with levels elsewhere in Europe.

In the early 1990s, Austrian banks were among the first to enter the Central and Eastern European (CEE) market. During that period, driven by geographical proximity, historical ties, and a saturated domestic market, most of the larger Austrian banks moved into the region. Generally, expansion started in Hungary and (then) Czechoslovakia. From there on, expansion continued, and currently comprises virtually all CEE markets. More recently, Austrian banks have entered Southeastern Europe and the CIS. Between 2003 and 2005, their expansion led to increases in domestic market shares in almost all of CESE, with the increases in Romania and Bosnia and Herzegovina especially large. Some Austrian banks have expanded further east by entering the market in some of the CIS countries, most notably in Russia and Ukraine.

As a consequence, Austrian banks now own subsidiaries that are of key importance in several of the host countries in CESE. Even though Austrian banks are not large by international standards, their CESE subsidiaries are of considerable size. As the host countries are emerging markets, their financial systems are generally small by international comparison, and their financial markets are still deepening. As a consequence, some of the Austrian-owned subsidiaries are large in relation to the size of the financial systems of the host countries and could be considered of systemic importance.

As the IMF author also goes on to note, the exposure of the Austrian banking system to any carry-trade "unwind" type development is thus proportionately much higher than that of virtually anyone else, a situation which becomes very clear when you look at the following chart:

To conclude, and returning now briefly to Switzerland, the IMF had a 2005 issue of Selected Issues Switzerland which examined a lot of the longer term demographic issues which Switzerland faces. According to this document:

"The full force of aging is projected to be felt from 2015 onward."

In relative terms this isn't a very long time horizon. The following is also worthy of note:

The rapid increase in the number of pensioners in relation to the working-age population has been remarkable. This is related to the increasing generosity of the social security system, not aging itself, and the tendency to contain long-term unemployment during the protracted stagnation of the 1990s. Since 1990, the number of pensioners increased by 35 percent while persons over 65 by only 17 percent. Still, early retirement has been less prevalent in Switzerland than in other industrial countries.

In fact GDP growth rates in Switzerland appear to have peaked in the 1980's at an average rate of 2.1%. In the 1990s Switzerland's GDP grew at an average rate of 1.1%, and between 2000 and 2004 GDP growth averaged 1.3% annually. A similar pattern can be seen in the total number of hours worked, which rose at an annual average rate of 1.1% in the 1980s, falling to a 0.1% annual rate of increase in the 1990s and FELL by an annual rate of 0.1% in the 2000 to 2004 period.

The Swiss also tend to save significantly. As the IMF notes:

"the thrifty Swiss households save about 10 percent of their disposable income and also have accumulated significant private assets."

At this stage of my analysis quite what element in this saving is population age-related, and quite what is cultural-behavioural is far from clear. This is a theme I will try to follow up on as and when time permits.

In the meantime what I have tried to draw attention to in this post is the situation vis-a-vis the Swiss Franc carry trade in Eastern and Central Europe, the role and exposure of Austrian banks in this trade, and the striking feature that Switzerland is a fairly "elderly" society. In this context the comparison with Japan simply jumps out at you. Now, as I have said above, these two economies are at one and the same time similar and different (in terms of the structural features they present). All that can be prudently said here is that what has actually been going on in Switzerland in recent years bears closer examination to try to discover what may be learnt.