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Monday, June 1st, 2015

Political risk plus reversal of flight to safety effects sees utility betas rise
posted by Dr Andrew Lilico & Dr Stefano Ficco

 Figure 1: Rolling Asset Betas (2-years of daily data)

EE calculations based on Bloomberg data.


The “beta” of an asset tells us how the riskiness of that asset changes relative to the sum of all assets in the economy.  The beta of all assets is by definition equal to 1.  Periods of crisis don’t usually affect all sectors equally.  For example, in the Great Recession financial and construction (“Materials”) stocks came to be seen as more risky than before.  If their relative riskiness and hence betas go up, the relative riskiness of other stocks such as utilities must (mathematically) go down.  This is part of what is sometimes called a “flight to safety”.

By contrast, over the past eighteen months, as the UK economic recovery has become more secure, the riskiness of financials and materials stocks has fallen back again.  So that part of the flight to safety effect has reversed, with utilities betas rising.

Another factor, however, may have been political risk in the run-up to the 2015 General Election, with the main political parties competing to propose various means (e.g. price freezes) to be “tougher” on utilities.  It remains to be seen whether, with the unexpectedly decisive General Election result, this shift is reversed or exacerbated.

04:25 PM | Permalink

Friday, June 7th, 2013

Turkey’s protests threaten to unnerve the economic electorate too
posted by Brian Biggs

After days of protests, ballooning from a niche sit-in over green space in Istanbul to country-wide demonstrations calling for a change in government, Turkey’s Deputy Prime Minister Bulent Arnic conceded “we do not have the right and cannot afford to ignore people. Democracies cannot exist without opposition.”  This insight is better late than never, but recent market movements have focussed attention on the relationship between socio-political stability, image and economic prospects in Turkey.

Emerging markets are often dependent on capital from abroad to finance expenditure.  This can be due to underdeveloped domestic capital markets or the desire of foreign investors to buy into good growth potential where domestic creditors simply can’t meet the demand for funds.  Alternatively, emerging markets — like developed markets — sometimes take in foreign capital to finance current account deficits.  The former usually comes in the form of foreign direct investment or long-term portfolio investment, whereas the latter is typically made up of short-term portfolio investment.

Since Erdogan took office in 2003, Turkey’s current account deficit measured on a moving average basis has grown a staggering 14 fold.

Table 1. Turkish current account deficit (12 month moving average), 2003-2013

Source: Central Bank of the Republic of Turkey; Bloomberg

Short-term investment is, by definition, far more mobile than long-term investment.  Leaning heavily on short-term investment is precarious position to be in for any country, but this is especially true for countries exposed to strong reputation risk.  If alarmed, investors can pull out of a country in a moment’s notice and leave the country starved of capital. 

Since 2010, Turkey has become increasingly reliant on short-term foreign investment.  Were investors to stage a mass exodus, Turkey would find itself lacking the resources to fuel its historically strong growth, keep inflation subdued, and service its debts — all trumpeted achievements of the last decade.  This could explain, in part, the recent tumult in Turkish equity, credit, and currency markets.

Figure 2. Short-term and long-term foreign investment in Turkey, 2007-2013


Source: Turkey Data Monitor; BBC

Another key source of growth for many emerging markets is tourism.  As in economic performance, Turkey as a tourism destination has shot up the league tables since 2003.  Turkey is now the sixth most popular tourism destination in the world.  The country’s tourism industry is valued around $30 billion.  Services comprise around 63 per cent of the Turkish economy, and tourism comprises a significant chunk of Turkish services.  Any hit to the country’s image as a safe holiday destination could seriously bruise economic growth.

Although talk of a “Turkish Spring” has been played down by many commentators — indeed, I would also caution against such comparisons — patterns in post-Arab Spring tourism in Egypt, Tunisia, and other such countries act as a warning to Turkish politicians.  Tourist arrivals in Egypt fell by 4.5 million following its episode of political upheaval.  This was a key drag on the Egyptian economy. 

In terms of tourism, Turkey actually benefitted from the Arab Spring, as the country was seen as a substitutable product but without the risks.  This time, that relationship could be reversed. 

Admittedly, tourism as a per cent of total employment is somewhat lower in Egypt than in Turkey (14 per cent in the former and 8 per cent in the latter).  Nevertheless, a significant drop in foreign footfall could pose a real threat to the country’s economic prospects.

The direct impacts of the demonstrations on the Turkish economy, such as strikes and damages to property, are likely to be minimal.  The real threat comes from falling out of favour with those bringing cash into the country.  Investors and holiday-goers, like the Turkish electorate, have been voting for Erdogan over the last decade by bringing their money to Turkey.  And also like political votes, those economic votes are likely to disappear unless the current situation is managed delicately.

03:20 PM | Permalink

Tuesday, May 28th, 2013

Three Monetary Policy Insights from Last Week
posted by Brian Biggs

Ben Bernanke spoke, and the world shuddered.  Testifying before Congress, the chairman of the Federal Reserve indicated that the FOMC could start to scale back the pace of its asset purchases “in the next few meetings.”  In suggesting that the Fed might start buying less than the current $85 billion of bonds per month as early as September, he pulled the trigger on what Warren Buffet called the shot heard around the world.

Markets around the world went into a tailspin.  All of the main G10 equity markets suffered declines on Bernanke’s words.  Most notably, the Nikkei 225 tumbled 7%, its largest single day drop since the Tokohu earthquake and tsunami in 2011.

This is remarkable.  Bernanke was clear that change to QE would involve buying fewer securities, not ending the programme entirely.  In his prepared statement, Bernanke struck a dovish tone, praising extraordinary monetary operations for their role in supporting the real economy and making it clear that the Fed did not want to pull back on stimulus measures prematurely.  Continuing Buffet’s analogy, Bernanke might have fired the shot, but the gun was full of blanks.

We did, however, get a preview of how the market might react when monetary conditions do begin to normalise.  Three insights are apparent after seeing how financial markets could react if the Fed were to begin to change the direction of monetary policy.

1. There’s no such thing as strictly domestic monetary policy.  Formally, the Fed will keep with accommodative monetary policy until the FOMC is sufficiently confident that the unemployment rate will fall below 6.5 per cent.  All central banks are bound by their domestic mandates, such as price stability or promoting full employment within their respective borders.  Recently the Fed has been focusing on the employment side of its mandate.

The sell-off that met Bernanke’s suggestion of slowing QE underscores the truly global nature of domestic monetary policy decisions.  Discussions of monetary policy coming out of central banks around the world often begin with the domestic picture of, say, the labour market and price levels and then turn to international headwinds later.  To the extent that international reverberations of domestic monetary policy can have an impact on a central bank’s domestic policy goals, it is indeed within a central bank’s mandate to consider the global implications of monetary policy.  In other contexts, such as recent fears over currency wars, the international community can exert significant influence on domestic policy.

So in spite of the Fed’s domestic mandate, the international picture is important as well.  If Bernanke just hinting at winding down QE can have such a strong impact on asset prices globally, it’s likely that the Fed doesn’t just look at domestic labour market and price level indicators when deciding on US monetary policy.

2. Asset prices are highly sensitive to stimulus withdrawal.  This seems obvious on the face of it, but no one really knew (or knows) how tightening monetary policy will impact asset prices.  We have no modern precedent.  The last time the Fed raised its benchmark interest rate was in June of 2006, when the target rate was increased from 5 per cent to 5.25 per cent.  Interest rates at that level aren’t even conceivable in the current policy environment.  We’re in uncharted territory, both with regard to the level and duration of interest rates and the size of the Fed’s balance sheet.

The frenzied downside reaction to Bernanke’s testimony highlights how sensitive global asset prices are to central bank largesse.  This is especially true considering the Fed didn’t actually do anything.  He hinted at the possibility that the Fed might consider scaling back the pace of QE.  Even so, scaling back asset purchases probably wouldn’t alter the path of the Fed’s balance sheet materially.  Also, interest rates would still remain pressed up against the zero bound.

The fall in pro-cyclical asset prices probably wasn’t entirely due to Bernanke.  China is slowing, and many investors were likely taking some profits off of the recent bull run, particularly in equities.  Nonetheless, it’s clear that Bernanke’s comments pushed prices down to some degree.  If asset prices were indeed justified by fundamentals, then Bernanke’s comments would have had a more muted effect.  The sharp fall in risk assets suggests that central banks are blowing bubbles in the financial markets.  The extent to which asset prices are due to bubbles versus fundamentals might be proxied by how steep the drop in prices were in response to Bernanke’s comments.  However measured, last week offered some clues about just how dependent on stimulus some assets really are.

3. When monetary normalisation does occur, it will be slow and announced far in advanceEventually, monetary policy conditions will have to return to normal.  Some might argue that future monetary policy will be radically different to pre-2008 trends due to the “new normal” situation in the real economy.  I think monetary policy indicators will eventually revert to the long-run averages.  Regardless of which camp you might be in, virtually no-one agrees that monetary policy can remain as it has been for the last five years.

This raises the question of how central banks will unwind highly accommodative monetary operations.  Like all central bank operations, monetary normalisation will be as much about communication strategy as it will be about the technical details of the policy change.

John Williams of the San Francisco Fed opined that policy movements could be up or down, but that would be out of step with the Fed’s policy since the crisis.  The Fed, along with its peers around the world, have tried to blunt the uncertainty associated with being off the monetary map by communicating its policy decisions in advance and even tying policy to some concrete dates or indicator values.

Last week, the Fed saw the effects of announcing the potential of tapering QE months in advance, and they were nasty.  Barring a substantial spike in inflation, the Fed might eschew the Volcker approach to monetary tightening and instead slowly communicate to the market that QE will be slowly winding down and, eventually, interest rates will slowly rise.  That is, not only will policy be announced far in advance, but policy changes will be gradual.  This could allow asset bubbles to deflate prior to the tightening itself, which would hopefully minimise volatility in the markets.  It may also allow firms and individuals that hold deflating assets to realise losses more gradually and remain solvent.

This blog has focused on the Fed, but the same arguments apply to the Bank of England or the European Central Bank.  In short, the episode surrounding Bernanke’s testimony before Congress gives us a glimpse into what to expect when central banks globally start cooling down the printing presses.


12:19 PM | Permalink

Thursday, May 23rd, 2013

Unbundling of Airline Services in India – an Economic Perspective
posted by Saattvic

On April 30, India’s Ministry of Civil Aviation allowed airlines to unbundle charges for services including drinks (except drinking water), carriage of sports equipment, seat selection, baggage and so on.  While some airlines have implemented additional charges for some services and reduced their free baggage allowance, base fares have not yet declined.  The Air Passengers’ Association of India opposed the unbundling decision and worries that the decision would merely be a licence for airlines to indirectly raise fares.  Airlines contend that base fares would reduce once they acquire a clearer picture of the potential revenue generating power of ancillary services.

In our article of 3 May 2011 for the Competition Law Insight analysing the Surcharges Supercomplaint by the UK Consumer Forum Which? to the UK Competition Commission (, Dr Stefano Ficco and I analysed the practice of airlines charging extra for online booking services in the UK.  The Supercomplaint contended that the charges were unfair and anti-consumer.  Our analysis at that time is very relevant to the current situation in Indian aviation.

A package of services

In our article, we had written that the product in question was a package of services that enabled the customer to move from one city to another.  This includes the price of the ticket as well as that of any ancillary services.  There is even an argument to include transport to and from the airport within the package (as evidenced by many airline booking sites offering to book a taxi pick up and drop off with the ticket).  It is the price of the complete package that the customer takes into account while making a purchasing decision.

Unbundling and efficiency

Consumer preferences naturally vary when it comes to a bundle of airline services.  Some consumers might be flying for a short time, and would not wish to carry too much baggage.  Passengers with slight mobility issues (such as the elderly) may place a premium on being able to sit in the first two rows.  When the entire bundle is priced at a single price point, airlines are unable to take into account the different willingnesses to pay of different customers for different parts of the package.  Unbundling allows service providers to adjust to variations in consumer preferences.  Moreover, if certain ancillary services are priced in proportion to cost, this could reduce or eliminate perverse incentives facing customers.  For instance, charging for baggage could incentivise passengers to carry only as much as they require, leading to reduced weight and subsequently savings on fuel.

Since the price of the complete package is taken into account by the customer, unbundling would have the effect of allowing providers to provide several, slightly differentiated, products where earlier they could only differentiate based on limited criteria like class of travel.  The Indian aviation sector is sufficiently competitive – data from the Directorate General of Civil Aviation shows that the largest carrier has a market share of 30 per cent and four carriers have shares of over 19 per cent – and this would limit the ability of airlines to use pricing of ancillary services to extract any more surplus from customers than they are currently doing.

Theoretically, at least, unbundling should lead to an efficiency gain.  Consumers, faced with an incentive structure for every service can calibrate their package according to their preferences, and being able to charge for ancillary services should lead to a reduction in base fare as the price for the total package remains the same, or reduces due to properly incentivised consumer choices.

The death of traditional aviation in India?

Of course, the model described above has been adopted consistently for a long time by low cost carriers in Europe (like easyJet and Ryanair).  This has not led to the complete elimination of airlines offering only the package rather than its constituent parts.  Two insights from behavioural economics can easily explain this.

First, there is a known disutility associated with making too many choices – a mental transaction cost.  For some customers, the extra time and mental energy spent deciding on each of the constituent parts of the package may not be worth the monetary savings in relation to deciding on a package price.

Second, since flying with low cost carriers may be seen as a signal of belonging to a lower economic class, there might be a ‘social status’ premium that some fliers might attach to not flying with a low cost carrier.

These factors, specially the first, should guarantee that traditional all-inclusive tickets will remain a part of Indian aviation.

Potential pitfalls – search costs

There have been recent media reports to the effect that the Indian Ministry of Civil Aviation is likely to ask airlines to increase transparency regarding the services they would charge extra for and is considering capping the number of ‘privileged’ seats that may be reserved on payment of a fee.  This is closely related to an issue we raised in our article for the Competition Law Insight in May 2011 – that of search costs.  The issue, in a nutshell, is that the total package price is not known to the consumer a priori.  The customer has to search for the prices of ancillary services, which are often revealed only at the end of a lengthy booking procedure in order to learn the final price.  The time and energy invested in learning the price entails a cost.  I quote from our 2011 article:

“In economics, search costs are known to detract from competitive forces – effective competition relies on consumers being able to compare all package prices, but with costs involved in learning package prices, consumers are less likely to want to search for information on all package prices from all airlines, hindering their ability to compare. This gives airlines market power as it allows them to charge more than they would be able to in the presence of effective competition.  Naturally, the higher the search costs, the lower the willingness of consumers to carry out an additional search, and the higher the market power enjoyed by airlines.”

The Ministry of Civil Aviation is correct to ask for greater transparency – publishing a list of ancillary services along with their prices on the home pages of websites (for example) would significantly reduce the costs faced by potential customers in learning the final package price.


Whether or not unbundling will ultimately benefit the Indian consumer and whether base prices do eventually come down are things that time will tell.  The Ministry of Civil Aviation can, however, increase the likelihood of this move being successful by pre-empting attempts to sabotage the move by artificially increasing search costs.  In this regard, transparency and ease of access to information requirements would play a major role.


06:07 PM | Permalink

Friday, May 17th, 2013

You Can’t Fight Fundamentals Forever…
posted by Brian Biggs

The Maastricht Treaty, the cornerstone of the Eurozone as we know it today, sets out some straightforward criteria for membership of the single currency area.  A strict inflation target, low government debt and deficits, a prudent pre-euro exchange rate – taken together this package of economic requirements became known as the “euro convergence criteria” and is meant to bring a country’s economic structure in line with an ideal EU average prior to joining the euro.  In practice, many of the Eurozone’s founding or early members fell short of these criteria, either through outright falsification before joining or ignoring their self-set rules subsequently.  Indeed, joining the euro, the European Commission recognises, allowed many macroeconomic imbalances to remain or even worsen.

One area where the Eurozone did manage to achieve convergence is in government borrowing costs.  The Maastricht Treaty, economists argued, had the effect of minimising currency risk premiums among future Eurozone countries over time, and effectively disappeared with the introduction of the euro.  Countries enjoyed investor faith in the euro, which was viewed as a hard currency.  If this is the case, then it stands to reason that if investors were to lose faith in the euro as a hard currency, or that economic fundamentals had not come into line sufficiently to minimise currency or default risk, then borrowing costs should rise.  Unsurprisingly, this is what happened.

Figure 1: Annual average yield on 10-year sovereign bonds, 1995-2012

Source: United Nations, Bloomberg, Europe Economics

In fact, those countries that benefitted the most from joining the euro are precisely those countries that are now seeing their yields rise.  In order, Greece, Italy, Spain, and Portugal saw their borrowing costs fall the most between 1995 and 1999.  Finland, France, Germany, and the Netherlands also witnessed yields on their sovereign debt come down, but less than the GIPS group. 

Core countries benefitted from the reduction in risk premiums brought on by the euro, but it also appears their fundamentals were more in step with what investors prefer, as yields on their debt since 2008 have fallen as well.  That, or they’re the “cleanest dirty shirts” for investors that can’t get out of their euro exposure.

GIPS countries, on the other hand, borrowed at lower rates almost exclusively due to the risk premiums effect of the euro.  As Eurozone members, they allowed their fundamentals to go haywire and drift substantially in the wrong direction away from the Eurozone average.  Now they are, literally, paying for it.

Figure 2: Change in annual average yield on 10-year sovereign bonds

Source: United Nations, Bloomberg, Europe Economics

The hope of the Maastricht Treaty was that economic management principles imposed on countries before joining the Eurozone would minimise differences among national economic structures, allowing for a well-functioning currency union.  Instead, differences persisted, but were largely papered over — by euros.  The sovereign debt crisis exposed lingering differences and began to pull yields of distressed countries towards their pre-euro levels.  Rates on GIPS sovereign debt have fallen recently, thanks in part to economic reforms, and in part to the Draghi Put.  But you can’t fight fundamentals forever.  In the long-term, distressed Eurozone sovereigns, if they wish to remain in the single currency area, will need to continue to bring their economic fundamentals in line with their non-distressed peers to borrow at affordable rates.


11:43 AM | Permalink