July 30, 2015

World's Best Programs for Finance

As a follow-up to my recent post on UK's best programs for finance professionals, a quick glance at the world's best universities for finance. QS World Ranking has subject-specific lists, and I select "Business and Management" because presumably professional finance is included there and not in "Economics and Econometrics" which is more social science. Below is the picture of the Top 12 taken from their website. A note to aspiring Azerbaijani (and not only!) prospective students in finance and financial/economics: focus on the Top 10-15 programs in the world. If your IELTS/TOEFL scores are not high enough, take a year off and improve them while working. Take GRE/GMAT. Do NOT settle for second-best. Education abroad just for the sake of education abroad is stupid. Basically, follow the theory of how to get into LSE.

July 25, 2015

UK's Best Graduate Programs for Finance

Update: If you are wondering '...but what about the best finance programs in the world, and not just the UK', go here.

One of the most practical rankings out there, LinkedIn has a list of the best UK graduate programs for finance professionals. The practicality of the list is in its focus on one single (and probably most important) criterion - job placement. At the end of the day, graduate education is just a signal of credibility to potential employers. With all the millions of various rankings available out there, I think the most relevant ones are those which focus on the chance of getting a good job. Nice campuses, cultural diversity and all that are all very nice, but at the end of the day it is the job prospect which (should) attract prospects. For finance professionals it's all about getting into IB, PE, or the dark buy side.

July 17, 2015

Armenia: the Next Greece?

Unless you have been living under the cave for the past 5 years, you should be aware of the terrible reality that Greece is going through these days. That reality is the consequence of living on the money you don't have and spending more than you earn. We can argue (and indeed many economists and pundits are indeed in the heat of the battle) whether the cause of the problem is supply-side productivity deficiency, or demand-side mismanagement of fiscal policies, or both, but it is too late for that.

Our job as economists is to try to predict and prevent the next crisis, the next Greece, the next big short. While the world is witnessing the battle of wills between the Troika (ECB, EU Commision, and the IMF) and Syriza, I think we should be spending more time on trying to detect and perhaps even save other economies from turning into a walking debt bomb. One of such countries at the moment is Armenia.

Armenia is stagnating and the IMF is predicting that GDP growth will hit the bottom by the end of 2015. 0% growth is not the end of the world in today's global economic standard, but for a country which is heavily relying on external financing, solid domestic income is crucial. Armenia's external debt is approaching 10$ billion. Not a massive number by international standards, but suicidally high for a country with just 2$ billion in foreign currency reserves. This means that Armenia, if it was so required, would be able to independently absorb just 20% of its foreign obligations through reserves.

Source: Bloomberg, IMF

Stating that any particular indicator is bad without comparing it to a benchmark would be naive on my (or anyone's) part. So, how do other emerging/developing economies score on the reserves-to-debt metric? Countries such as Poland, Mexico, Hungary, Island, Indonesia - basically all of the names you can think of - have foreign exchange reserves which are several times larger than their short-term $-denominated debt. Armenia's reserves, on the other hand, does not come close. Even if you realise that short-term debt and total debt is a different thing, the comparison would not change drastically after adjustments.

Source: JPM. The graph is a little bit misleading since they put "%" on top. The numbers on the vertical axis indicate not "6%" but 600%. So Brasil's reserve/debt ratio is 10 times, and Russia's 6.2 times.

The debt to GDP ratio is growing and will reach, according to multiple sources, somewhere between 50% and 70% of GDP. I have always said that it is NOT the debt/gdp ratio which matters but the growth of the ratio over time, the credible belief that the country can generate enough GDP in the future even if it cannot at the moment, and the ability to issue debt in its own currency. That's why Japan, for example, running a massive debt/gdp ratio is not part of the IMF's agenda (at least not yet). There is realistic and defendable belief that they can generate higher GDP growth in the future, and Japan's currency is one of major reserve currencies in the world.

Armenia has a lot of debt in foreign currency. Reserves are not adequate enough to fulfill obligations, if necessary. Domestic economy is non-productive, lacks industry, and is excessively reliant on remittance from Russia. This is not bad per se, to depend on a single factor of growth that is. But if that factor is struggling, as is Russia for the past 6 months since the great oil price collapse, this will obviously hit at the country depending on that factor. Russia's incomes fall, remittance to Armenia diminishes, Armenian incomes fall, GDP stalls, debt keeps rising since taxes are falling but governmental obligations to its people (basic fiscal spending) are very very sticky. In order to fill the gap, they borrow in foreign currency from international financial markets at high rates, putting yet more pressure on domestic finances through debt repayment and the rising interest rate bill. 

If the situation worsens, two things will happen: a specualtive attack on Armenian bonds - yields will skyrocket. And a massive capital outflow. The source of the outflow will be foreign banks operating in Armenia which will probably close their branches, and Armenians themselves who (rightly so) will rush to escape the sinking ship by converting to Rubles or the USD. Sounds grossly familiar to the Greek story. The problem is that with the current political setting in Erevan, nothing will change for the better in the next year(s).

July 16, 2015

The Birth of Modern Behavioral Macroeconomics (Nerd Alert)

Michael Woodford and Mariana Garcia Schmidt include bounded rationality into a workhorse macroeconomic model with utility maximization, monopolistic competition, and a central bank. John Cochrane, Noah Smith, and many others discuss. Bounded rationality is, in basic terms, a detachment from the neoclassical economic paradigm of "perfect foresight" - absolute forward-looking rationality of agents. Behavioral economists have models of imperfect rationality but, to the best of my knowledge, there has never been such a comprehensive and bold attempt to tell a full macro story using behavioral economic ideas. Woodford and Garcia Schmidt are basically introducing behavioral concepts into standard macroeconomic models, something I have been personally dreaming of doing since I was in kindergarten.

Their presentation, which will surely be an influential paper soon, studies basically the behavioral economic puzzle of horizon selection, i.e. that selection of horizon can significantly impact asset pricing and/or any other model solution dynamic. The driver of WGS's model is bounded rationality. Using Bayesian updating, agents observe the length of time that the central banks decides to stick to a predetermined plan (fixed interest rate). Without Bayesian updating, i.e. in a perfect foresight equilibrium, the interest rate peg sticks. But WGS' key point is that the horizon of central bank's commitment matters.

If agents observe short-period commitment to a fixed interest rate, then perfect foresight works. Moreover, it works as an approximation to the bounded rationality equilibrium for small T (period of commitment) and large number of updates (n). As T grows, however, the solution explodes whereas the bounded rationality equilibrium is bounded for any T. Analysis of long-period commitments from central banks should be done through the prisms of bounded rationality and not perfect foresight - this is, I think, the main conclusion of the argument.

If the interest rate peg is permanent and not temporary, the perfect foresight solution has multiple paths and bounded rationality solution diverges massively. No bounded rationality solution, for any number of updates n (no matter how large), can be approximated by a perfect foresight equilibrium.

Basically, we have 2 dimensions for thinking here. First, whether the interest rate peg is fixed or temporary matters greatly. In the latter case, PFE works well for short commitments whereas bounded rationality (BR) is superior for long horizons. In the former case, neither of the two approaches is first best but, I think this is what WGS imply here, because BR solution diverges so spectacularly we should not seriously expect that interest rates being low for a long period of time can lead us to the expected solution (higher inflation). Second, the length of central bank commitment (horizon choice) matters. For short horizons, both PFE and BR work well with temporary interest rate pegs and diverge in indefinitely long pegs. For long horizons, PFE fails but BR survives when the peg is temporary and both diverge when the peg is permanent.

The argument does not imply that either production or inflation will necessarily explode under temporary or permanent interest rate pegs. The point is that perfect foresight analysis is inferior to the bounded rationality model for large T, which is basically the zero-lower bound story. Thus, the choice of the go-to model for policy analysis becomes obvious.

Much more to say and think about. Can't wait to read the full paper.

July 14, 2015

Income Inequality and Asset Prices

Update: Some more relevant papers on the link between inequality and growth: one, two

Is there a relationship between inequality and asset prices? The connection between inequality and economic growth has been examined and analyzed by academics (link 1, link 2link 3journalists, and pundits (Krugman). But I am here to ask a different question: can asset pricing metrics in countries with high levels of income inequality significantly differ from metrics in countries with low levels of income inequality?

The hypothesis is the following: more unequal countries have, by definition, a higher concentration of wealth in the top 1%. The richest 1%, in turn, are more likely to invest in riskier assets like stocks (after controlling for demographics, education) than the 99%, purely because they are more wealthy and have more unrestricted access to capital markets. This for now only suggests that the rich are more likely to hold stocks than the median household, which is sort of obvious. I am sort of ignoring the institutional investor base (sovereign wealth funds, pensions, etc) and am focusing only on the rich vs. median income disconnect and its relationship with asset prices.

We need somehow to argue that inequality in country X will lead to asset price distortions in that same country X, versus some other country Y which has a lower inequality level (and thus less distorted pricing). A seminal paper by French and Poterba (1992) (link) finds that investors tend to allocate a larger share in their portfolios to domestic assets, which constitutes an effective puzzle since a rational investor would tend to diversify away country-specific risk and get exposure to a variety of markets, distant and close.

So, the home bias in equity markets drives home the conjecture that more unequal economies will, on average, have a stronger asset price channel. More wealth is concentrated in the hands of the few in unequal societies, and those few will buy more domestic stocks, thus implying oversaturation. In more equal societies, less wealth is concentrated in the hands of the rich, and thus fewer domestic stocks are bought, implying undersaturation. Here, I am implicitly assuming that the marginal propensity to save in risky assets is higher for the rich than for a median household, which is plausible.

We need to select now a set of countries and indicators for comparison. I choose a sample of 28 OECD countries for which the GINI (most popular measurement of inequality) coefficient is available. I use cross-sectional data from 2010. As a proxy for stock market pricing I use the Price/Dividend ratio, calculated as the reverse of the dividend yield and scaled up by 100 for simplicity. The hypothesis is, therefore, that a higher GINI coefficient will be associated with a higher P/D ratio. In other words, equity markets in more unequal economies will, on average, have more saturated (overpriced is too harsh of a word here) asset markets.

Some of the more unequal countries in the sample are Turkey, Russia, Portugal - hardly the countries with the highest GDP per capita. So the argument that higher GINI is endogenous to a more advanced level of development doesn't score. Let's look at the results.

The blue dots are the 28 OECD countries which I used. There was no data available for: Iceland, Slovak Republic. P/D ratios are for each country's respective stock market index and for December, 2010 (to make it comparable with the GINI for 2010). Results suggest that there is some positive correlation between inequality and asset prices. However, when I do the same exercise for 2005, the relationship vanishes, although the sample size for 2005 is just 18.

So, a quick look at the relationship between asset prices (proxied by equity price/dividend ratios) and inequality didn't produce any powerful results. I need to experiment with alternative indicators for the stock market. Also, an intertemporal analysis would be nice as well: as inequality in country X grows over time, asset markets grow in valuation for country X faster than for countries with a smaller rate of inequality growth.


July 13, 2015

Accounting 4 All

My former colleague and good friend Nicat Hacixanov, currently a graduate student at Australian National University, is running a great center in professional accounting training in Baku. The center is supported by Azerbaijan State University of Economics: a place where I have been teaching economics for 3 good years. If you are into ACCA, CIMA, CFA or similar financial/accounting certifications, make sure to check out his page!

July 10, 2015

SOFAZ Hits the Jackpot with Chinese Bonds

The State Oil Fund of Azerbaijan (SOFAZ) recently announced that they started to invest in the Chinese Yuan. There has been some confusion regarding this investment among local news sources, which was escalated on social networks by our pseudo-economists (more on pseudo-economics later). So, I am here to enlighten you. As the analysis below will demonstrate, investing in Chinese bonds now was a stroke of genius from Shahmar Movsumov. I didn't always agree with SOFAZ's timings (link), but with Chinese debt I think they hit the bull's eye.

Before we go any further, as the press release in the link above clearly states, SOFAZ is buying government and agency bonds. Not stocks. They have no exposure to China's equity market and are not losing anything from the ongoing stock market crash. Quite the opposite: investors exiting the equity market will probably not exit the country altogether (some might) but will instead reallocate to a substitute asset - bonds. This means the pressure on bonds will push their prices up and rates further down across mid-to-long maturities: an attractive entry point from capital return perspectives.

Second, was investing in Chinese bonds a good long-term decision? In order to answer this question we need some sort of framework. SOFAZ is earning money (and reporting its revenues) in USD. They take 1 USD, convert into Chinese yuans using the spot exchange rate, and then allocate the yuans into assets. Let's say they buy a unit of Chinese government bonds. The bond will pay a nominal interest rate (coupon). What we care about is real return, which equals nominal rate minus inflation rate in the country. After a certain period (or when the bond matures), we convert our real return in yuans back into US dollars using the new spot exchange rate and report the return.

So, there are basically 3 primary factors that affect return explicitly: the exchange rate, the nominal interest rate in the country, and the inflation rate. A simple formula below binds everything together:

Real return in USD=1 USD*Exchange Rate_today + (Nominal Interest Rate in China - Inflation Rate) * 1/(Exchange Rate_tomorrow)

where the exchange rate is defined as USDCNY (how many Yuans can 1 US Dollar purchase)

Investors also care about the so-called "capital return", i.e. the difference between the asset price now and the price that you paid for it yesterday. The price of the asset is inversely related to the interest rate in the market. For example, if you buy a Chinese bond today and tomorrow the interest rate (yield) is lowered by the People's Bank of China, then the price of the asset in your hands has grown.

Capital Return (Price) = 1/(interest rate)
Let's go over each of the 3 factors one by one and see if buying Chinese bonds made sense.

1. Exchange Rate. We want the Chinese Yuan to be stable and not to depreciate vs. the US Dollar in the future (if you don't understand why some currencies are losing vs. the Dollar, then catch up on the news). How has the Yuan performed relative to other major currencies over the past 12 months?

So, the Yuan was the only currency other than Swiss Franc (not shown) to survive the Dollar aggression. True, Renminbi is very much influenced by the PBOC. Most of the time, however, the concern is that the Yuan is undervalued rather than overvalued. Some pundits have argued that PBOC keeps the Yuan undervalued to boost exports. At least, this has been the historic rhetoric until  recently. So, if the Yuan was to float freely, there is a good chance that the currency would appreciate vs. the Dollar.

Yuan will soon be added to the IMF's reserve currency basket. It is not a question of if but when. This means that Yuan liquidity will be enhanced across markets, and the currency will have a much lower risk of "speculative" attacks. Plus, if the Yuan does become a reserve currency, a lot of Dollars will be converted into the Yuan. This will put pressure on the currency, i.e. it will appreciate over time. This naturally means a win situation for SOFAZ as their Yuan returns will be converted back into USD at a much better future rate.

Internationalization of the Yuan (its inclusion into the reserve basket of the IMF) will surely be accompanied by further liberalization of the capital account. Currently, only 3-5% of Chinese Yuan bonds are being held by foreign investors. Most market analysts and economists expect this number to grow substantially by 2020. Meaning that once China becomes more open to foreign investors, the currency becomes more widely acceptable, more money will flow into the domestic debt markets. The share of the market held by foreigners can grow to as high as 25% in just 5 years. This, of course, will greatly increase the capital value of the bonds that SOFAZ is currently holding.

2) Nominal Interest Rate. We want the nominal interest rate to be stable or decreasing over the period of our investment. Why? Because we care about capital return. In order to check interest rate dynamics let's look at the behavior of interest rates on 1-year, 2-year, and 5-year Chinese government bonds over the past 12 months. If the rates are dropping, it may signal for a good time to enter! If rates continue to go further down, capital returns are growing.

Interest rates have been dropping in China for the past 10 months or so. The 1-, 2-, and 5-year bond interest rates have fallen by 1.2%, 1.15%, and 0.84% respectively. This is a LOT for fixed income securities nowadays. And there is room for rates to continue to move down. For most of us this is not breaking news, since both the government and the central bank in China are trying to stimulate the economy by providing better liquidity terms for banks and corporations. This naturally leads to lower borrowing costs and dropping interest rates. Prices of bonds, on the other hand, are growing; assets of those holding the bonds (like SOFAZ) are gaining in value. Going forward, if the economy doesn't recover too quickly, more stimulus will be required for longer. This implied more explicit funding, and falling yields, and rising bond prices.

3) Inflation. It's all very nice with the interest rates on bonds, but what about real return? If the inflation rate in China is 5% then all of the interest gain is being eaten up by the falling value of money. It turns out that CPI growth is just 1.5% (year over year), has been consistently low and dropping over time. An important indicator of future CPI, the production price index (PPI) is negative, which puts pressure on consumer prices to go down if prices across the whole supply chain are deflating. This implies, naturally, a solid real return on Chinese bonds.

To come back to our formula, all 3 of the factors of bond return are favorable for China: exchange rate is strong with an appreciative bias going forward; nominal rates are dropping; inflation rate low and is likely to go down further. SOFAZ's got this one spot on.

Note: all the data used in graphs is sourced from Bloomberg.

June 23, 2015

AccessBank, Deposits, and Me

The CEO of AccessBank (one of the premiere banks in Azerbaijan) - Michael Hoffman - yesterday issued a statement, presumably at a press conference, about the peculiar pricings of deposits in local banks. In particular, he said that interest rates on both local-(AZN) and hard-currency (USD) denominated deposits should not be equal. This erodes any motivation to hold money in local currency deposits, especially considering the 33% devaluation several months ago.

Hoffman is absolutely right. I guess somebody has been reading my blog! I was among the first ones to notice the failure of proper transmission from our devaluation shock to deposit interest rates. Going back 4 months ago, I wrote:
"...because the USD deposit rate is too high, there is an 8.3% annual [pseudo] arbitrage profit on the table. In order to eliminate the arbitrage, banks need to bring down the USD deposit rate to 2.6%, but it’s currently 11%... [to switch to USD deposits] is a perfectly rational decision to make for any concrete individual. But collectively, if every Manat holder will pursue the same dominant strategy, this is a stupid trust-destroying public disaster." [emphasis added now]
I acknowledge that there are difficulties for any particular single bank to move interest rates up or down substantially. Some of us researched this thing a while ago.
"...a considerably incomplete pass-through is present in the case of all banks, the finding consistent with a non-competitive banking sector. The average pass-through effect is 25% and the average period of adjustment is 5 months. Sectoral analysis reveals that pass-through is the strongest for industrial loans and the lowest for consumer loans, suggesting that banks exert more monopolistic pricing powers on consumers while hedging against risks associated with industrial lending."
But there are multiple strategies that banks can implement collectively to move rates in any direction. We are a very, very small market. It should not be rocket science to manage it.

The bigger point to the story is much more depressing. Nobody among serious policy-makers and bankers in Azerbaijan actually reads research papers or informative blog posts that our very own Azerbaijani economists write. I am sort of getting used to it.

June 19, 2015

Emering but Sensitive Markets

In a recent post, I discussed emerging markets equities and the Fed's rate hiking cycles. I also argued that emerging markets are much more sensitive to shocks originating abroad rather then at home:

"... small emerging countries are much more likely to be affected by big economies (not geographically speaking, obviously) through the various international transmission mechanisms. Inflation can be imported, an exchange rate can face depreciation pressures, exports can stall if they are not purchased."

IMF has a nice graph which supports this idea: external factors (such as United States, risk premium on emerging markets, China) account for roughly 50% of the long-term average GDP growth in emerging countries. The original source is the IMF's paper entitled "On the Receiving End? Conditions and emerging market growth before, during, and after the global financial crisis." They derive these numbers, I assume, from their structural VARs which they run over a 20+ year-long sample. While always taking backward looking regressions with a pinch of salt, this is a useful diagram which shows that country-specific idiosyncrasies are roughly as important as external factors; which is, of course, quite amazing.

June 18, 2015

Ramadan Economics 2

It is that time of the year: the month of Ramadan has started. Hundreds of millions of muslims around the world will be fasting for 30 days - not eating or drinking from sunrise to dawn. Ramadan is, of course, a very important economic phenomenon. It affects demographics, and thus is an important factor for policy-makers, economists, investors, etc. I wrote up some ideas about Ramadan's impact on economics and asset prices a year ago, and wanted to revert my readers to that post.

Also, some few additions to the things I have already said. First, productivity. Needless to say, fasting can make your brain operate at below-par capacity, given that your body is low on sugar intake and is basically dehydrated. If a large enough pool of workers simultaneously decides to fast, and if fasting indeed lowers individual productivity (which is not obvious and needs empirical proof), then the aggregate degree of productivity can fall following explicit aggregation. Granted that any normal production function is linear (or not, this is not essential) in productivity for any set of production factors, a negative shock to productivity will lead to a fall in output. Since fasting lasts for just a month, this is clearly a temporary shock. In principle, (disregarding some important details which are beyond the scope of this blog, and at times beyond the scope of my brain), Ramadan can explain some cyclical movements in the business cycle of certain muslim countries.

Naturally, Ramadan is not the only thing happening to major muslim economies during the Summer months. But it is possible to control for a set of external and some domestic factors, to somehow bring fasting-induced productivity decline to the surface. As a caveat, many muslims who fast actually enjoy doing it. Of course, they struggle physically, but mentally and socially this may actually make them more sharp and "engaged". So, it is not that obvious that productivity in the neoclassical sense of the word falls.

Second, I want to restate my point about the potential importance of Ramadan for asset prices. Ramadan is basically a natural temporary exogenous shock to human behavior and preferences. Fasting agents may have a more concave utility function because risk-loving quality is dampened by lack of glucose and general tiredness. Or, they may have a less concave utility function during the month of Ramadan, and especially after they break the fast (the marginal piece of the pizza will taste much tastier than for non-fasting agents, because they are hungry all day long). Thus displaying lower risk-averseness. Exogenous shifts in risk-averseness may explain price fluctuations not only over time, but also across products and services. Fasting agents may reveal their preferences more abruptly and strongly; since they have just 1 chance to eat and drink over the whole 24-hour period, they might as well consume the foods they truly love at a place they enjoy with the a group of people they value.

The morale of the post is not that we are uncovering some mysterious dynamic asset pricing formula and will make a ton of money. The key point is that everything in life, even supposedly unrelated religious events, can be actually very "economical".