At Yahoo: Market Interventions

I write at Yahoo on Market Interventions:

(Posted in entirety)

There were riots in Bangladesh on Monday when markets went down 9% in an hour. Stocks fell, presumably because their central bank decided to tighten down on bank exposure to equity, and the general index has been slowly sliding from December. It may sound unreasonable to have such an event create a loss of 9% in a single day — or indeed the 27% loss in a month that Dhaka saw — but it comes on the back of a 2010 that saw the index rise 95 percent. Now that fall doesn't seem quite as bad, does it?

Shaken by the public furore, Bangladesh's central bank instructed banks to please buy stocks — and as expected, their index rebounded by 15% on Tuesday. The idea is to never mess with a good thing, I guess.

Intervention doesn't always work. In 2008, Pakistan's stock markets fell about 43% and to somehow stop that, the authorities decided to set a floor price on the index; meaning, stocks couldn't go below a certain value. What happened then, was that the floor became a ceiling — stocks would simply not trade above that level. When the floor was removed in December 2008, stocks fell another 35% before they rebounded.

Regulators impact markets in different ways. During the great fall of 2008 in the US, financial company CEOs pressed the authorities to ban "short-selling" — or, the ability to borrow and sell stocks, in the hope of buying them back later at a lower price. The ban, though in effect for a while, did nothing to salvage hopes of financial companies that were in deep distress — indeed, shares of Citigroup are still less half the levels they were before the ban.

In the early 90s, the Bank of England tried to keep the British Pound at a certain floor exchange rate to the German Deutsche Mark, but the fundamentals dictated otherwise: The UK was seeing high inflation but interest rates weren't as high compared to Germany, although at 10% one might think it was quite high — Germany was at 9.5%, and seeing an economic boom. This combination can't work for long — the British Pound would have to fall; but for a while the BoE thought they could support it. Eventually they gave up, and BoE opted out of the fixed exchange rate mechanism, in the process making George Soros famous (and rich!) for betting against the Pound.

But market interventions have taken on a different form — of forced non-transparency. During the sub-prime crisis, banks have been able to convince authorities that the securities they held, containing mortgage bonds, were being sold in a panic. So the prices weren't real, and weren't really "fair-value", so they should be allowed some freedom in valuing those assets. (If the value of assets banks hold should fall, they can violate capital requirements, which means they're in trouble if they can't raise equity fast.) From Europe to America, authorities have given banks leeway in mark-to-market rules — but even today after one might admit that markets are in better shape, the suspension or watering-down of mark-to-market continues. It is indeed acceptable to live in a dream, as long as you don't have to wake up.

Strangely, that intervention rarely happens when prices go out of hand on the upside. Indeed, it can be career-threatening, or just bad karma. In 1996, Alan Greenspan, chairman of the U.S. Fed, stated that stocks were seeing "irrational exuberance" — but prices continued to go up, peaking nearly 70% higher in 2000. When housing all over the world went to unheard-of prices, the defense was that we have reached a new permanently high zone, not that the sudden price explosion was undesirable. Just before the Great depression of 1929, economist Irving Fischer said "Stock prices have reached what looks like a permanently high plateau" — note, not something like "these prices are unrealistic". Closer home, in October 2007, SEBI decided to request more information about certain investors who invested through P-Notes, and the markets hit the 10% lower circuit — no one likes it when they stop a good thing, no matter what shady deals were made to get there.

More recently, intervention has taken the form of replacement. Banks have horrendous assets on their books? Let the central bank buy them. In no other time would it be acceptable for a central bank to buy mortgages; if the RBI even so much as suggested it, all hell would break loose — but lo and behold, the US Fed has been buying them quite openly.

It has also been considered irresponsible if a country's central bank were to buy the country's bonds — a sure-recipe for inflation, if anyone in the non-developed world tried it, or so we have been told. But today, we'll throw those rules out the window. From the Fed to the European Central Bank, the daily routine is now to figure out how many more dollar or euro bonds they can buy, in the name of "stability". How could you blame the RBI for getting in on the act and buying our own long term rupee bonds?

The idea is to distort asset prices, because they are prices we like to look at. If bond prices are good — that is, yields are low — then people will believe that countries are solvent. But if you put lipstick on a pig, it's still a pig. Even with all that intervention, Greek bond yield spreads against the German bund crossed 10% - a sign of serious distress. Portugal will offer more bonds on Wednesday, but the markets are looking at 7% as a sign of "too much to bear". But everything is relative, really. In isolation, these yields look high, but Indian bond yields are already at 8%, and we are hardly an economy in distress. Even in India, where people argue on TV about whether the economy will sputter and choke to death if the RBI raises short term rates to say 7%, it was just 10 years ago when interest rates were 9% and higher.

Intervening in a market just because prices have gone to an extreme is sometimes required. Markets may be consumed by panic — where everyone sells because everyone else is selling and no one wants to be left holding the bag. The downside pressure could be eased by shutting down markets for a while, but it should also be understood that "extreme" usually does not violate long term boundaries. The US had not seen housing prices drop for 15 years or so before 2006, but price declines have been an inalienable part of US housing over the century, and regardless of interventions, that market will find its way down to longer term averages, and probably over-correct as well. In India, we've not seen a recession of any serious sort in the recent past; even a real estate shock may be unknown to the broker with 10 years in the business. So there will be calls for intervention when there is an "extreme" price move, but in reality, we need to recognize that we have been out of whack for way too long. Our markets are overvalued. Inflation is going out of control by all historical measures. Our interest rates aren't high enough. We have to be ready to take a serious jolt through either extreme interest rates or a big slowdown (or both!) before inflation can come back under control — but the easier choice will be to intervene on extremes, "calm" our markets and people, and kick the can down the road. After all, in the long term, we are all dead.

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