Wednesday, 26 October 2011

Insider Trading in China – what is and what should never be

Several newspapers reported yesterday that two Chinese officials have received jail sentences of six and five years for leaking confidential economic data to traders prior to their official release.   In one of my favourite films, Trading Places, the anti-heroes Randolph and Mortimer Duke try to obtain the crop report in advance of its release so they can corner the market in frozen orange juice.  Like their Chinese counterparts nearly 30 years later no good became of them either.  Insider dealing laws prevent those who have information in advance of the market, or public, from acting upon it.  And quite rightly so.

The news from China though can be understood at a number of levels.  First it confirms that economic news on the Chinese economy is sufficient to move to asset prices in a substantive and predictable manner.  Thus the market having formed expectations, news that does not completely verify those expectations leads to asset prices adjusting.  By the by, rational expectations does not mean that we know the news, it means that we have worked out the probability of different events and the payoff from those events.  When the uncertainty is resolved by the actual publication of the news, the event that actually happened goes from being a mere probability to a certainty and that is why asset prices move.  That Chinese data is valuable enough to change asset prices is significant enough and a positive development, per se.  We, or the financial intermediaries we employ on our behalf, are therefore forming views about the Chinese economy and then re-evaluating those views as news emerges.  The scrutiny, rather than the tyranny, of the market is a good thing.

Secondly, the successful prosecution means that authorities understand that market sensitive data must be released to all market participants simultaneously.   This does not mean that no information should be released or that only certain bits of information should be released.  All data on the state of the economy, revisions, warts and all, should be released on a well understood timescale and produced by a well-documented statistical process.   Such a process will facilitate the development of views on the likelihood of different state of nature and also – this is the important bit – facilitate the transfer of information from the private information set to the public domain.  The trader or analyst with a bearish view will 'sell' his or her analysis to market participants and be amply rewarded if they turn out to be right as prices will move to reflect the accuracy of the originator’s private information set.  The key is that the traders are rewarded for their private information and so have an incentive to work out what it might be through analysis. 

What is less clear is whether any of the clear sanctions against the release of public information will have any impact on what we have come to call 'guidance'.  It should not.  Guidance involves statements by policymakers on the implication of a given stream of data for likely future policy or backward-looking explanations of why what was carried out when.   Guidance, if given to all and is free to access, is helpful as it clarifies public thinking and so pools information.  The guidance is not private information nor is it data per se.  It helps markets interpret the large flow of information and understand better the conditions under which policy is currently being set and the parameters that might cause it to change.  To the extent that guidance accelerates learning and forces policy makers to spell out their reaction functions, guidance is less something to be proscribed but more an obligation.   The debate about the effectiveness of transparent as opposed to opaque policy relies on such guidance.  So at the same time that sanctions are developed again insider information, governments should work harder to explain, warn and advise.

Thursday, 20 October 2011

Have the MPC Blown It?

Inflation measured by either the CPI or the RPI has risen to over 5% this summer and autumn and is at levels clearly inconsistent with price stability.  At these inflation rates the price level will double in less than fifteen years.  The battle for price stability in the UK was fought over a prolonged period from the IMF programme of 1976 onwards and it seemed for a brief period in the 1990s and 2000s that the battle had been won.  The war, however, continues and there has been a significant rearguard action.

The chart shows not only an upward creep in the level of inflation but also its volatility from around 2003/4 onwards.  And to some degree that seems mirrored in the financial market perceptions of the inflation 10 years ahead, which also seem to have drifted up from lying in the range of 2-3% in 1997 through to around 2005 to now lie between 3-4% since 2008.  There are a number of technical reasons why the inflation forwards cannot be read at face value, particularly given the liquidity characteristics, but the trend does not seem terribly encouraging.  If we also believe that QE has lowered nominal forwards then the measures from the inflation forward may in fact be biased downwards.  And worryingly the Bank's own survey of inflation expectations from August places the median of medium inflation expectations at 3.5% compared to 3.2% and 2.8% a year and two years ago.  The temporary inflation overshoot looks as though it may turn out to be more persistent.

Perhaps it should not really surprise us. In response to a cost-push shock over the past few years, the MPC has eased monetary condition by allowing real rates to fall and committed to low interest rates via its programme of QE.  In the kind of models the Bank used to use, a cost-push shock required higher interest rates not lower ones and the argument used to be that acting against inflation was the best way to ensure that an inflation shock was temporary rather permanent.   It seems that we are now hoping that "something will turn up", or rather down. 

Naturally, the policy decisions have been rather more complicated than having to deal with a single cost-push shock as we did not start from steady-state and financial conditions remained tight in a recession.  As the cost-push shocks emerged at a time when there was considerable slack in the economy they will have acted to help close any output gap, it may then mean that the low current rate of growth is as likely to be related to the supply side as it is the demand side and so may not really be responsive to further monetary stimulus.  Low growth and high inflation? That sounds curiously familiar. 

Saturday, 15 October 2011

Spot the Asymmetric Shock

The crisis in the Eurozone has dominated financial market sentiment over the summer. And so I shall restart my blog by asking the following question. What is an asymmetric shock? The question, of course, stems from the basic condition for a sustainable monetary union: that the kind of shocks that lead to changes monetary policy should be highly correlated across any such union. If they are not highly correlated this will place the sustainability of the union under pressure as member countries face less then ideal policy rates. The more a country is different from the average the more it larger the boom and bust we will will observe over succesive business cycles.

The chart above shows the soveriegn debt bond spread over the Bund (10 year German benchmarks) from 1993 onwards for the nations that went on to join the Eurozone. The changes in spreads represent changes in market prices for default risk, liquidity premia and domestic preferences for holding debt. What we note is that there was dispersion in bond spreads prior to the adoption of the Euro and again after the start of the financial crisis. The bit in the middle corresponds to both the heyday of the Euro but also the period of excessive liquidity creation by the financial system.

It would seem at first glance that going back my original question it is the first and third periods that suggest asymmetric shocks. And that it is the middle period corresponds to some elimination of differences. The compression of spreads in the middle period tells that financial markets were treating different sovereign debt instruments denominated in Euro as very close substitutes during the Euro's heyday.  In effect, the markets treated the price of sovereign debt of countries that had different fiscal paths and growth prospects almost identically. 

This equal treatment of unequals seems to me to have imparted the ultimate asymmetric shock.  Rather than rationing debt with higher prices, the heyday of the Eurozone - possibly as the result of  some form of implicit centralised guarantee - encouraged financial markets to treat the various nations' debt as identically priced and so cheap to issue by any government.  In fact, many treated the convergence of spreads as evidence of Eurozone credibility when in fact it was storing up future problems.  Some of these nations responded, in some degree, by issuing too much debt and not correcting dangerous fiscal paths.  This meant that when there was a negative demand shock - a recession - some fiscal paths became unsustainable and financial market fears of default triggered contagion.  Asymmetric shocks are in the eye of the beholder.