Archive for March 1st, 2019

History and future of fixed income markets (in UK)..

March 1, 2019

Nice speech by Rohan Churm, Head of Foreign Exchange Division of Bank of England.\

The United Kingdom is home to one of the oldest financial centres in the world. Starting from within the
confines of London’s square mile – The Square Mile – but now spread widely around the country, the
United Kingdom has also become one of the world’s leading financial centres. In doing so it has been
central to centuries of innovation and evolution in the financial system.

The Bank of England’s first foray into fixed income markets came at its inception, in 1694, when it raised
£1.2m over 12 days, in order to lend to the government. This was an innovative way for the government of
the time to fund a war effort. But the original Royal Charter explained that the Bank was founded to
‘promote the public Good and Benefit of our People’. That aspect of the Bank’s mission has remained
timeless, even as the financial system has radically changed. That the Bank today can deliver its mission is
testament to how it has also innovated and evolved alongside financial markets and their participants.

If it feels like financial market participants must constantly adapt in order to thrive, then it would be helpful to
know we are not alone in this experience. It brings to mind the ‘Red Queen hypothesis’, which arose as the
academic field of evolutionary biology drew on the literature of Lewis Carroll. This idea was originally
proposed by US academic Leigh Van Valen. It posits that organisms that survive in a constantly changing
environment have themselves adapted and evolved. In Lewis Carroll’s book ‘Through the Looking Glass’,
the Red Queen warns Alice that it “takes all the running you can do, to keep in the same place. If you want
to get somewhere else, you must run at least twice as fast as that.” No doubt some of you can identify with
that as you consider how the City has changed over your careers, arguably innovating more rapidly than
ever before.

The Bank of England innovated in 1725 with the introduction of printed bank notes – moving away from the
handwritten ones.1 In the 19th century its lender-of-last-resort operations were novel and groundbreaking.
More recently, operational independence to set monetary policy and the new responsibilities for
macro-prudential regulation have significantly changed the shape of the Bank.

As we meet today at the London Stock Exchange (LSE) it is worth reflecting on how exchanges have
evolved. Not least because the LSE now has 14,500 listed debt securities and is hosting a fixed income
forum! When the Bank was founded in the 17th century stockbrokers would meet in the coffee houses of
Change Alley in order to exchange information and strike trades. Prices were first transmitted via the electric
telegraph in 1830. Today, in many markets algorithms ‘meet’ in a server centre to trade within fractions of a
second. Despite this, coffee shops are thriving.

He points that automation has been limited in debt markets:

at their core, FX and equities markets are based on homogenous instruments. As one moves towards
related but potentially bespoke products, such as FX and equity options, trading is far less automated.
The logic applies to fixed income markets, where bespoke aspects to bonds are often a central feature. A
typical large bank may have more than one thousand unique debt instruments associated with it, varying
across currency, coupons, maturity dates, optionality, and seniority, to name some dimensions. This
compares to ultimately only one equity claim.

This feature of fixed income markets is not a bug. It reflects product innovation that allows debt instruments
to suit the preferences and constraints of the investor, which ultimately lowers costs for the borrower. But it
does reduce liquidity. Most obviously, for any given amount of debt, more debt instruments means smaller
sized individual issues available to trade in the market. The bespoke characteristics also lead to market
segmentation as any individual investor may only be willing to buy a subset of bonds from a given issuer.
And from a practical perspective, investing in automated trading, with potentially bespoke programming, is
less likely to be worth it for small and unique issues with non-standard characteristics.

This means that fixed income markets remain somewhat slower.

Saying that, electronic trading is now a very standard part of fixed income markets. Automated trading has
also increased markedly, in particular in standardised or liquid instruments such as government bond futures
or on-the-run US treasuries.

Electronic trading is also increasing for corporate bonds. Our market intelligence suggests that around 50%
of all gross notional in the European corporate bond market is now being traded electronically. This has been
helped by the electronification of the corporate bond ecosystem, including the pre-trade, execution and the
post-trade phase of the trade lifecycle. And we have also seen growth of electronic trading platforms,
serving the dealer-to-dealer, dealer-to-client, and all-to-all segments.

Also discusses what next for Fixed income markets…

From hard to flexible to integrated inflation targeting…

March 1, 2019

A new BIS book by Pierre-Richard Agénor and Luiz Awazu Pereira da Silva.

Carstens, head of BIS in foreword explains:

the GFC reminded us of the consequences of insufficiently restrained financial systemic risk. The crisis was an effective reminder that simultaneously achieving two objectives, such as macroeconomic and financial stability, was a complex task and required the usage and coordination of two instruments. Moreover, the GFC also produced unprecedented levels of volatility and massive capital flows across countries. The spillovers associated w ith these flows magnified threats to financial stability, especially in MICs with an IT regime. This prompted a review of their IT policy frameworks, in particular regarding the role of interventions in foreign exchange markets to smooth volatility, policies to maintain financial stability, and the combined utilisation of both macroprudential and monetary policy.

The authors suggest that, in a context where central banks and regulators are concerned with achieving and maintaining both price and financial stability, monetary and macroprudential policies are largely complements. The technical discussion in the book emphasises that because both policies work through the same transmission mechanism in the economy, they need to be calibrated jointly to produce optimal results.

They label this proposed framework integrated inflation targeting (IIT). The book also discusses many other issues associated with the design and practical implementation of IIT regimes, such as the institutional mandates that should be delegated to policy entities and the need for consistency of the overall macroeconomic policy framework.


First we move towards inflation targeting to avoid central banks from looking at too many things. Then we add flexibility to the framework to look at decline in growth. And now add integrated to the framework as well.

Slovakia appoints its finance minister as Central Bank governor

March 1, 2019

I had blogged about how Slovak central bank Governor had quite before his term and the finance minister Mr Kazmir expressing interest in the job.

Apparently, the FM did get the job:


Inflation Expectations of Households: Do They Influence Wage-Price Dynamics in India?

March 1, 2019

New RBI WP by Sitikantha Pattanaik, Silu Muduli, and Soumyajit Ray.

This paper examines the usefulness of survey based information on inflation expectations of households in the analysis of inflation dynamics in India. Hybrid versions of New Keynesian Phillips Curve (NKPC) are used to study whether inflation expectations of households work as proxy of forward looking expectations to predict inflation. Both three months ahead and one year ahead inflation expectations emerge statistically significant in explaining and predicting inflation, but they effectively work as substitutes of backward looking expectations given that household expectations are found to be adaptive.

When transmission of inflation expectations to inflation is assessed through wage dynamics, no robust evidence is found on expectations induced wage pressures influencing CPI inflation. Short-term food and fuel shocks explain significant part of variations in inflation expectations of households. Notwithstanding limited evidence on spillover of inflation expectations of households to wages and prices, the high degree of observed inflation persistence and significant sensitivity of inflation expectations to food and fuel shocks warrant sustained emphasis of monetary policy on well anchored inflation expectations.

Essential Adam Smith and Essential Hayek

March 1, 2019

Two free e-books on the two scholars: Smith and Hayek. The essentials summarise the key ideas of the two scholars…


The Central Statistics Office is an institution that matters

March 1, 2019

Indira Rajaraman in this piece says we need to ensure CSO is well managed:

We don’t need economists to tell us this, but institutions matter. In an empirical literature too large to cite, the strength of institutions is shown to be what sustains any country through good times and bad. We have many strong institutions in India, only we don’t think about them. The best institutions don’t shout their contribution from the rooftop, but do their work quietly to keep the country humming.

One such is the Central Statistics Office (CSO, renamed from what was once the Central Statistical Organization). National accounts estimation in colonial times was mostly confined to economic activity within the boundaries of British-administered India, and with a limited focus on goods and large-scale service networks like the railways. After Independence, the territorial coverage had to be expanded to include the former princely territories, and the service sector needed inclusion in all its variety and spatial spread.

Extending the post-Independence estimation back to the start of the 20th century was painstakingly performed by a statistician named S. Sivasubramonian, who established that per capita income had remained essentially stagnant during those 50 years. When we remember that several segments of society saw substantially enhanced income during colonial rule, it became clear that the remainder must have become worse off if the average had remained the same. No further explanation is needed for why the movement for political independence gained such widespread traction.

Then she looks at recent GDP revisions which are problematic:

Some years ago, a new series of GDP was issued with base year 2011-12, with a substantially altered method of estimation. Extending the new series back to earlier years has been mired in controversy.

The back series controversy is not that serious, only because people can continue to use the old real growth rates for years prior to the new base year, and shift to the new growth rates for the years after. As far as the nominal aggregates are concerned, a simple splicing factor can be constructed by every user.

But the new series continues to pose a problem because of the constant revisions being done within its period of coverage. The entire series going back to 2011-12 was revised two years ago, on 31 January 2017, followed by another overhaul of the entire series on 31 May 2017, and yet again on 31 January 2018. On these standard issuance dates, only recent year data are normally revised. This year, on 31 January 2019, there has been yet another overhaul of the figures going all the way back to the base year 2011-12.

This latest revision does not alter the GDP growth rates for the early years too much, but growth in 2016-17 has been radically revised upwards, from 7.1% to 8.2%. There is a less radical upward revision for 2017-18 as well, from 6.7% to 7.2%. There will have to be a corresponding revision in the second advance estimate for 2018-19, due on 28 February 2019.

Gross value added (GVA), which is a measure of production without the overlay of indirect taxes like the goods and services tax (GST), or the corresponding pre-GST levies, has been revised upwards for 2016-17 as well, from 7.1% to 7.9% (and less radically for 2017-18, from 6.5% to 6.9%).

I prefer to look at what I call core GVA, after removing the agriculture and government sectors, not because they don’t matter but because they are subject to exogenous vagaries like the weather and Pay Commission upgrades.

The upward revision in core GVA for 2016-17 is more startling still, from 6.7% to 8%. The further widening was on account of the government sector, where the growth rate has been revised sharply downwards from 12.7% to 8.6%. Such a sharp fall, by 4 percentage points, is most puzzling for the government sector, since final audited figures of accounts for 2016-17 would have been available at the time of the last revision, on 31 May 2018.

With government sector growth revised downwards, core GVA sectors have seen a more sharp upward revision in growth rates than GVA as a whole. Growth in the construction sector in 2016-17 (the year of demonetization) has been revised upwards from 1.3 % to 6.1%. Construction estimates are normally based on upstream output of manufactured inputs like steel and cement, and are not normally revised so substantially. Other sectors that have been revised upwards, though not as much, are financial services and real estate (6% to 8.7%), trade and transport (7.2 % to 7.7%) and electricity and utilities (9.2 % to 10%).


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