Global
Mr. Knollenberg as Catalyst for Yen Strength
July 20, 2007

By Robert Alan Feldman | Tokyo

A new catalyst?

A potential catalyst to reverse the yen’s extreme weakness is emerging. Just as criticism of the weak yen is beginning to rise inside Japan, criticism in the US Congress is rising, most recently a bill introduced by Congressman Knollenberg. The bill, HR 2886, seeks to pressure Japan to sell excess forex reserves.

The more debate concerning the issue, the harder it is for investors to take long dollar-short yen positions. Thus, there is a higher the likelihood of a yen/dollar correction from current extreme levels. In view of (a) this turn in the debate and (b) the current cheapness of taking derivative positions, yen-call option strategies may be attractive.

Criticism of the weak yen in Japan

The yen has reached a 22-year low in real effective terms, and domestic criticism of the weak currency is rising. The extreme value for the yen concerns both exporters and importers. The exporters see little gain from any further yen weakness; indeed, they are more concerned about the strength of the US economy. The importers are bearing significant costs. For example, in 2004, the yen price of oil was Y4482/bbl.   (In 2004, WTI averaged US$41.5/bbl and the yen Y108/US$. Today, WTI is US$75/bbl., and the yen is Y122/US$.) Today, the price is Y9150/bbl.

An additional problem comes from the recent earthquake in northern Japan. The quake knocked out a significant amount of electric generation capacity. In order to meet likely demand, Japan may have to re-start oil-fired power stations. Clearly, a stronger yen would ease the burden of this adjustment. Indeed, if the real effective yen returned to its 1986-2005 average, the implied yen/dollar rate would be about Y90/US$, and oil would cost only Y6750/bbl.

Yet another worry comes from corporate board rooms, about potential foreign takeovers. The weak yen makes such takeovers cheaper, and acts as an effective subsidy to foreign bidders for Japanese firms. Japan clearly needs more FDI, and government policy over the last few years has sought this goal. However, efficiency-enhancing FDI is more likely when the exchange rate is at a reasonable value, rather than an extreme.

In short, the tide of public opinion inside Japan is turning against the current extreme weakness of the yen.

Meanwhile, in the US Congress

Meanwhile, Congressman Joe Knollenberg of Michigan (Congressman Knollenberg’s website is http://www.knollenberg.house.gov/) has introduced HR 2886, the ‘Japan Currency Manipulation Act’. The bill defines currency intervention as dollar purchases during a 3-year period that correlate with a weaker yen, and defines currency misalignment as a deviation from the exchange rate “that could reasonably be expected for the Japanese yen absent the intervention”. To determine a misalignment, HR 2886 specifies consideration of bilateral and multilateral trade balances, foreign direct investment flows and — here’s the key — “aggregate amounts of foreign currency reserve holdings”.

In subsequent sections, the bill calls for consultations with Japan within 30 days of passage, consultations within the US government within 60 days, consultations with Europe to join efforts to pressure Japan within 60 days, and a call for convening a special meeting of the IMF to consider the matter (no timetable). Interestingly, there are no sanctions mentioned in the bill, in contrast to the sanctions mentioned in recent bills on the Chinese currency.

The key part of HR 2886, in my view, is the emphasis on levels of foreign exchange reserves as a determinant of currency misalignment. Even if the bill does not pass — and prospects seem low at this stage — the legacy of the bill for the debate on exchange rates could be important. Viz:  In measuring currency misalignments, the cumulated stock of past interventions matters, along with the flow of any current interventions.

Market implications

Regardless of the motivations, defects (HR 2886 omits important parts of the picture, such as the importance of interest rate differentials on exchange rate levels and the potential impact of Japanese official dollar sales on US interest rate levels and the US economy), and prospects of HR 2886 itself, the focus on levels of foreign reserves as a factor in determining misalignments is likely to rise in importance.

For investors, therefore, a new dynamic has emerged: Total levels of reserves are well known. If reserve levels are benchmarked against an agreed global standard, then it will be easy to predict sales of excess reserves. Markets would likely jump quickly, even before such sales actually occur. On this logic, a sharp movement of yen/dollar becomes more likely.

In addition, new rules concerning excess reserve levels may also prevent misalignments. When investors see reserves for a country approaching excess levels, there will be a high level of confidence that intervention will stop, and even be reversed. Hence, the penchant for overshooting in forex markets will wane.

This debate also has implications for sovereign wealth funds. Such funds are set to grow tremendously in coming years, as my colleague Stephen Jen has predicted (see How Big Could Sovereign Wealth Funds Be by 2015? May 3, 2007). To the extent that such funds remain under the control of governments, there will always be concerns about whether asset allocation has a political element.   (I have argued that there should be a political element to fund allocations, to the extent that the funds are held for the benefit of the people of their respective countries and can be used to address common global problems such as environment and energy. See SWFs:  Save the World Funds, June 10, 2007.) Hence, particular attention is needed on the governance of such funds, in order to ensure that the funds are used for legitimate public purposes, and not to manipulate currencies.

 

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Japan
The Delicate Relationship of the Output Gap and Prices
July 20, 2007

By Takehiro Sato | Tokyo

Is the potential growth rate being calculated correctly?

A recent Nikkei column carried an interesting observation on the output gap, asking the simple question of whether it can really be the case that the output gap alone is positive (i.e., in a situation of excess demand) when prices and unit labor costs remain negative (in other words, the output gap could be still negative).

As explained below, the column’s author expressed strong doubts about the view of the government and the BoJ on the potential growth rate. To quote, “The BoJ believes that the negative output gap has disappeared, and that the Japanese economy is currently in a situation of demand surplus. In that case, it is a mystery that both unit labor costs and prices are still not rising, yet (the BoJ) claims that prices will rise at some point”, and “Isn’t it the case that it appears that the output gap seems to have disappeared because (the BoJ) has underestimated the potential growth rate?”

However, the relationship between the two is not so clear-cut that a positive output gap automatically spells higher prices. Below, therefore, we run through the relationship between the potential growth rate and prices in simple terms.

Link between output gap and prices: speed of change, not level, is what matters

The measurement error for potential growth and the output gap derived from it is large. It makes no sense to discuss (as some do) changes in the output gap measured to the first decimal point implied by each set of quarterly GDP data. Measurement error appears to be large because of underlying problems with the raw statistics — e.g., the basic data used for estimating the production function is private-sector real capital stock on a gross basis, not net of depreciation, etc. — and also because of technical issues with interpreting capital stock volume, which differs depending on how the figure is smoothed to exclude the impact of privatizations, etc. The presence of measurement error for the utilization ratio for capital stock, one of the factors of production, exacerbates estimation error (the Solow residual) with the result that TPF (total factor productivity) changes become hard to accurately identify. We can indeed observe in Cabinet Office estimates of potential growth obvious disparities that seem to be attributable to measurement error. Thus, small changes measured to the first decimal point should not be seen as meaningful.

The BoJ does not take the path of estimating potential growth and the output gap from production functions, but instead appears to make an indirect estimate of the gap from the utilization ratios of capital stock and labor, two factors of production. This has the advantage of meaning that even if there is a large downward revision of past economic growth rates, as in the SNA for F3/06, measurement of the output gap itself is not affected. However, this is still subject to measurement error depending, for example, on how utilization rates of production factors in non-manufacturing industry are viewed. In other words, as both the Cabinet Office and the BoJ repeatedly point out, estimates of the potential growth rate must be seen as having considerable latitude.

Moving beyond consideration of the issues with estimating potential growth, the price implications of the output gap will vary depending on whether a model is used that focuses on the level of the output gap (the deviation from potential GDP) or on its speed of change. For example, when the focus is on level, the conclusion will be that as long as the output gap remains negative, prices are not going to rise. Yet even making allowance for measurement error, this view cannot necessarily be made consistent with actual price changes. In 2003 and 2006, for example, prices showed temporary improvement, with help from special factors, even though the output gap was deeply negative.

On the other hand, as a more flexible interpretation of the Phillips curve, the second approach — the thesis that rates of change in the output gap affect rates of price increase/decrease — appears to explain the reality more convincingly. In this case, even if the output gap is negative, improvement in the rate of change can allow for improvement in the direction of current prices, regardless of price level.

BoJ’s position: may have already given up forecasting major price improvement

Where does the BoJ stand on this? Judging by its externally released official information (the text and tables in its Outlook Report, and comments by its senior officials), the BoJ like the Nikkei columnist believes that the level of the output gap is what affects prices. Until last October, the BoJ made indirect references to a linear relationship between the output gap and rates of price increase in its appended tables of the Report. It also seems that the BoJ’s basic views on current prices are founded on the level of the output gap.

However, if we interpret this linear relationship on terms favorable to the BoJ, it can be read that a change of 1% in the output gap can also be read as implying a x% change in the core CPI inflation rate. In the past, BoJ senior officials have actually made this explanation externally. However, in the tables appended to the most recent April Outlook Report, the BoJ did not make such an argument. It may be that the flattening of the Phillips curve has drastically lowered the responsiveness of prices to the output gap, making this type of argument largely redundant, and signifying that even the BoJ may have abandoned expectation of a remarkable improvement in prices.

Not much joy for the price outlook

In fact, taking the second, more realistic approach does not offer much joy to look forward to. If the pace of economic growth is only in line with the potential growth rate, the output gap is unlikely to improve all that much, and ultimately we might have to accept that prices may not rise remarkably for a long time.

For example, GDP growth in the April-June quarter (TBA in mid-August) is likely to be almost zero, and the earthquake this month may affect industrial production due to shutdowns of lines at auto and other plants. The typhoons and earthquakes over the holiday weekend have also soured mid-month department store sales in July, sapping consumption for the July-September quarter right at the outset. Therefore, we are not hopeful that the Jul-Sept GDP, as well as the Apr-Jun GDP, will give much reason to expect a pick-up in improvement in the real economy and the output gap.

Following the BoJ’s practice of looking at GDP over three or four quarters, it is possible that the tone of growth even in the June and September quarters could be seen as preserving moderate growth in line with the potential growth rate, in the shadow of high growth in the preceding December and March quarters. However, the output gap will not improve much under growth that simply matches the potential, making it likely that — contrary to the market’s feisty expectations — prices will not rise far from the top-down perspective. Actual prices development is also likely to follow a trend of near-zero small declines for some time. 

Policy implications and risks

Even with prices currently dropping and the real economy expected to slow, an August interest rate hike has become a near-formality. More or less the only thing that could derail this now is political chaos that threatens to hurt the market over the medium term. However, Japan’s track record suggests that election results do not define the market’s trend over the medium and long run, and Abe’s plummeting support ratings have already lowered the market’s expectations for what would constitute success for the LDP (alone) from 51 seats to about 44 or even less, so the market is now well prepared for the loss of a majority by the ruling coalition. This minimizes the risk that the election result will seriously unsettle the market, and leaves a rate hike in August intact as the main scenario.

Having said that, one of our concerns is that in raising interest rates based on the austere goal of securing a long-sustained growth path while cautiously avoiding overheating, the BoJ could end up sending a negative message on the outlook for domestic demand and asset markets to investors both at home and abroad.

Addendum: are cell phone charges dictating prices?

As we write about the risk of a long-term slump in prices, news has just come in about yet another cut in cell phone call charges. We have highlighted before the constant downward price pressure from tariff cuts for quasi-public services of this sort as deregulation leads to greater competition, so this news does not make our conservative bias on prices any more pronounced. Our price forecast already discounts charge cuts of this nature.

Nonetheless, we estimate the actual impact on the CPI of these latest cuts as a mere -0.01%. Our telecom analyst also believes that other carriers are not likely to respond with further cuts, avoiding a new price war.  Admittedly, we have a cautious view of prices overall, but with regard to the call phone factor we think that the market is overreacting. 

 

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Indonesia
Rising Excess Liquidity
July 20, 2007

By Chetan Ahya, Shweta Singh and Deyi Tan | Mumbai, Singapore

Excess liquidity stock rising rapidly

Indonesia is now joining the group of countries in the region that are facing a continued rise in foreign exchange reserves and excess liquidity. Over the last six months, Indonesia has witnessed an annualized rise of US$17 billion in foreign exchange reserves. However, relatively slow growth in credit so far has meant low domestic absorption of this rising liquidity. The central bank has had little choice but to consistently sterilize (issuance of bonds to absorb excess liquidity) these foreign inflows. On average, Bank Indonesia has sterilized about 61% of the foreign inflows by issuing bonds in this period. As a result, the excess liquidity stock has increased to US$40.3 billion (10.4% of GDP) from a low of US$12.5 billion (4.5% of GDP) in September 2005.

BoP surplus not all due to volatile capital inflows

A large part of the increase in foreign exchange reserves in the last 12 months has been due to the current account surplus. Indonesia’s four-quarter trailing current account surplus improved to a high of US$10.5 billion in June 2007, based on our estimates. Of the total balance of payment (BoP) surplus of US$8.1 billion in the first six months of 2007, only about US$2 billion is due to less stable non-FDI capital inflows. The healthy trend in the balance of payments is due to strong growth in non-oil exports. Non-oil exports have accelerated to 20%Y as of May 2007 from as low as 1%Y in September 2005. The acceleration has been driven by strong export growth registered in the manufactured goods and machinery & transport equipment segments. Within manufactured goods, exports of wood & cork manufactures and paper, paperboard & articles have seen a pick-up in growth.

Choosing the corners of the impossible trinity

While so far policymakers have managed to intervene in the FX market and the money market effectively, we believe that this will increasingly become tougher as excess liquidity stock builds up. The cost of sterilization is high as domestic interest rates are significantly higher compared to that in the US and its neighboring countries. Considering that there is little choice for policymakers to control capital inflows, they will increasingly need to choose between control of monetary policy and exchange rate policy — a challenge that most other central banks in the region are facing (see US$1 Trillion Excess Liquidity Tide — Triggering Policy Surprises? May 10, 2007).

The burden of adjustment will gradually shift onto the exchange rate

If the global risk appetite environment remains intact, the continued rise in capital inflows will only add to the excess liquidity challenge. We believe that in the next six months the central bank may choose to cut policy rates further by an additional 25-50bp. However, we believe that Bank Indonesia will be constrained to cut interest rates aggressively (i.e., more than 50bp cut over the next six months) and will have to let the burden of adjustment of rising excess liquidity shift to the exchange rate. While investment spending is recovering, it is not strong enough to fully absorb the liquidity. Aggressive rate cuts at a time when the pick-up in absorption of business investment is slow will increase the risk of a rise in inflation.

Domestic demand growth acceleration to continue

We expect both investment and retail credit growth to accelerate further. The banks’ credit-deposit ratio also remains low, at 62% as of May 2007. With the government deficit remaining low, at around 1% of GDP, there is minimal government demand for liquidity. With rising excess liquidity within the banking system, banks are likely to push through more loans. While policy rates have already declined significantly, loan spreads are still relatively high. Currently, banking sector lending rates for investment credit and consumption credit are about 540bp and 835bp, respectively, above Bank Indonesia’s policy rate, as of May 2007 (last data point available). We expect the banking sector’s loan spreads to compress further from current high levels. Moreover, overall leveraging in the system is also relatively low compared with other countries in the region. Indonesia’s total bank credit to GDP ratio was 24% as of end-2006, compared with 44% in India and 115% in China. Indonesia’s retail loan to GDP ratio was at 10.6% at end-2006 versus 18% in China and 14.8% in India.

Bottom line

If the global risk appetite trend is maintained, Indonesia’s excess liquidity stock is likely to rise to new highs. From a macro perspective, this would imply: (a) the central bank could reduce its policy rates further by 25-50bp over the next six months; (b) post these rate cut(s), increasingly the policymakers will have to choose to allow moderate appreciation in the exchange rate; and (c) a further decline in banks’ lending rates will continue to support the recovery in credit-funded domestic demand growth.

 

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Currencies
The Biggest Dollar Diversifiers Are American
July 20, 2007

By Stephen Jen | London

Summary and conclusions

The dollar is very weak relative to most currencies.  While cyclical factors have played an important role, I don’t believe that cable is trading at 2.05 and EUR/USD at 1.38 due only to these rather innocuous cyclical factors.  Other structural factors may be at play.  One possible structural reason for the dollar to have had a gradual downward trajectory since 2002 is, I suspect, portfolio diversification by US real money managers. 

Cyclical explanations for the weak dollar

There are ample cyclical reasons for the dollar to have underperformed recently.  First, the US economy is weaker than almost every other economy in the world.  Though we may have seen the trough in the US business cycle in 1Q, the recovery trajectory is likely to be modest, after a surge in 2Q.  The rest of the world, however, continues to surprise to the upside, showing no sign of lagged effects of the softness in the US economy from 2Q06 to 1Q07.  No longer do investors doubt the ‘de-coupling’ thesis.  Monetary policy between the Fed and other central banks is in direct correspondence to this expected divergence in economic growth.  As a result, the dollar may sag as long as other central banks remain in motion. 

Second, in addition to these central case expectations of the US and the rest of the world, due to the problems with the sub-prime market and the housing sector, the risk to the US outlook is biased to the downside, with limited spillovers expected for the rest of the world.  Investors have the collective memory that the Federal Reserve eased interest rates by 75bp in 1998 in response to the failure of LTCM, despite the fact that the general macro conditions were positive and inflation was drifting higher. (The Federal Reserve eased the FFR from 5.50% in August 1998 to 4.75% by that November.  It returned the FFR to 5.50% in November 1999.  Inflation was drifting higher during this period, from 1.5% when the Fed began cutting rates to 2.5% by the time it returned the FFR back to 5.50%.  Inflation eventually rose to 3.5% by 2000.)  With this track record, investors believe that the Fed may have difficulties raising interest rates if the sub-prime problem persists. 

Third, higher oil prices are positive for EUR/USD.  Not only do oil exporters have a marginal propensity to consume European goods that is twice as high as that for US-made goods, but the fact that the ECB targets headline inflation while the Fed targets core inflation may also have encouraged investors to expect EUR/USD to rise with oil prices. 

These three cyclical factors are legitimate dollar-negatives.  However, I expect them to fade later this year, for reasons I’ve explained in previous notes. (I have proposed this hypothesis before, in The Real Diversifiers are American, Not Asian, May 18, 2006.  However, back then I thought that the US real money accounts had already diversified and my focus in that note was that any bout of risk-reduction would trigger repatriation back to the US and that the dollar would rally.)

Diversification by US real money accounts

While the cyclical factors I mentioned above may help explain why the dollar has depreciated recently, they don’t give a satisfactory explanation as to why the current level of the dollar is so extremely low.  In retrospect, since 2002, the dollar has had its ups and downs, but the underlying trend has been downward.  I have long argued that the dollar is structurally sound, and provided reasons (such as the ‘de facto dollar zone’, valuation, geopolitical hegemony, dominance in the global financial markets, etc.) justifying why the dollar’s hegemony will be preserved.  I am still convinced by many of my arguments.  However, I am now taking more seriously the thesis that US real money investors have been steadily diversifying away from USD assets since 2003.   (Not only will the US economy and the sub-prime situation stabilize, but I also expect consumption in the UK to decelerate, pushing down cable, and EUR/USD should also decline in sympathy.  Further, with the EUR being so high against the USD and the Asian currencies, the trajectory of the refi rate may be altered.  In any case, 2.05 for cable and close to 1.40 for EUR/USD are very high levels, from a valuation perspective.  The median fair values from our valuation framework are 1.63 and 1.15 for cable and EUR/USD, respectively.) The dollar may thus still be structurally sound, but not as sound as I had thought. 

US real money accounts consist of four key categories of funds: mutual funds, private pension funds, state and local pension funds and life insurers.  The Fed’s Flow of Funds data track the sizes of these funds.  As of 1Q07, the total assets under management by these four categories reached US$20.7 trillion, up from US$12.6 trillion in 1Q03.  At more than US$20 trillion, real money under management in the US is close to four times the size of the world’s official foreign reserves.  Any signs of diversification by these real money accounts would have great implications for the dollar.

While I don’t have a breakdown of the asset allocation of all four categories, the Boston Fed’s Monthly Mutual Fund Report shows that mutual funds’ allocation to international equities has risen from around 15% in 2003 to 22.5% now.  This trend diversification is gradual but determined. 

If we apply this outward investment allocation ratio to the total stock of mutual funds, the cumulative outflows of mutual fund investment since 2003 are around US$400 billion.  But if we apply this outward investment allocation ratio to the entire stock of real money accounts, the cumulative outflows since 2003 total US$1.16 trillion: US$190 billion in 2003, US$295 billion in 2004, US$324 billion in 2005 and US$352 billion in 2006.  These outflows are indeed massive.  I have the following thoughts:

1.Prudential motives.  This trend diversification out of USD assets need not be a reflection of US real money managers being structurally bearish on the US.  Rather, this could be a natural unwinding of the ‘home bias’, i.e., investment portfolios that are excessively concentrated in home (USD) assets.  In other words, such a diversification trend could reflect a prudential motive ─ the desire to rebalance toward a more diversified portfolio to better capitalise on a globalised global economy. 

2.A global trend.  In fact, this could very well become a global trend, whereby every country starts to diversify out of its own assets.  ‘Home bias’ in the world will decline.  Already, we have witnessed this trend in Japan, with retail investors aggressively diversifying out of JPY assets.  From the perspective I proposed, this trend in Japan is part of the global trend, not an idiosyncratic development in Japan. 

3.Tug-of-war between cross-currents.  As different countries start to diversify their private financial portfolios, exchange rates will be affected.  Obviously, financial globalisation is not necessarily dollar-negative.  It appears to be dollar-negative now only because the US real money managers are larger and are early in this process.  The JPY being even weaker than the dollar proves that whoever is more aggressive in this diversification process will see their currency weaken.  Ironically, despite the presumed need for European investors to diversify out of the EUR-zone, due to the legacy currencies being replaced by the EUR, there have been scant signs of wholesale diversification, which may be another reason why the EUR is strong against both the USD and JPY. 

4.Currencies to be misaligned during this process.  This globalisation/diversification hypothesis of mine also suggests that exchange rates could deviate from levels that are consistent with economic fundamentals for an extended period, and that capital flows may be more important in driving exchange rates ─ precisely the pattern we’ve witnessed in recent years.  Specifically, during the risk-reduction phase of February-March, I observed that all the G10 exchange rates moved towards their fair values.  But when capital flows resumed and risk-taking recovered, these exchange rates again drifted away from their fair values.  This suggests to me that exchange rate misalignments may very well be due to international capital flows of the type that are motivated by factors other than economic fundamentals, such as prudential diversification as I propose in this note. 

Bottom line

Contrary to popular presumption, US real money mangers are the biggest dollar diversifiers, not the Asian central banks.  Controlling assets that are four times the size of the total global official foreign reserves, US real money managers have been steadily diversifying out of the US since 2003.  My calculations show that cumulative outflows may have totaled US$1.16 trillion in the past four years.  This may help explain the downward drift in the dollar in recent years, and why the dollar is so weak now.  

 

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Europe
Better Mortgages for a World of High House Prices
July 20, 2007

By David Miles | London

Across much of Europe people now have to borrow a great deal more than they did a few years ago — relative to their incomes — to buy houses. House prices across most of Europe are much higher than 10 years ago; and in many countries the real cost of a typical house is more than double what it was in the mid-1990s.

In recent months, interest rates have increased across Europe, and they may go higher. It is therefore not surprising that governments and central banks are concerned about the affordability of mortgage debt. Higher house prices, and the more recent increases in short-term interest rates, raise big questions about the best design of mortgages.

These issues are clearly serious in the UK, where most mortgages are either variable-rate contracts or else the interest rate is fixed for a relatively short period. With house prices so much higher relative to incomes than even a few years ago, it is understandable why the government is focusing on the types of mortgage typically sold in the UK. But given what has happened to house prices right across Europe, the issues of risk and affordability of mortgage debt are much more widely relevant.

House prices across Europe have been mostly driven by higher incomes, and to a lesser extent by rising population. Low interest rates have been an important factor. But in many countries, expectations of further price rises have also played a big role. That factor is likely to be volatile and transitory, so declines in prices are clearly possible, and in some countries even likely. Where interest rates will go next is uncertain.

So, what types of mortgage will best suit such an environment, where house prices are higher relative to incomes, but may be volatile and cannot be assumed to carry on rising?

Across Europe today, a mortgage largely remains a nominal contract with repayments unrelated to movements in consumer or house prices. In many countries — particularly the UK — the repayment is also very significantly affected by movements in short-term, nominal interest rates.

There are disadvantages with this type of loan: the overall real (inflation-adjusted) cost of repaying it is uncertain, and the initial cost of servicing the mortgage is typically higher in real terms than it later becomes — which is a strange feature, given that as time passes, most people get higher incomes, not lower incomes.

There are potentially big advantages in having the cost of mortgages more predictable in real terms and also having some element of the cost of repaying debt linked to changes in the value of the home.

Mortgages with these features are called indexed mortgages. In a recent report, Vladimir Pillonca and I considered in some detail the characteristics of this sort of mortgage. (Financial Innovation and European Housing and Mortgage Markets, David Miles and Vladimir Pillonca, July 17, 2007)  It is of course not a new concept. For 25 years, the UK government has — very successfully — been issuing index-linked debt. Other countries across the world have followed suit.

With indexed mortgages, the scale of repayments can depend on consumer prices and potentially on house prices. Repayments are linked to real interest rates. Crucially, real interest rates are less variable than nominal rates.

Indexed mortgages have the twin benefit of generating a less downward-sloping real burden of repayments over time, and also a less volatile one.

The burden of servicing the debt is much lower in the early years of the mortgage than it is with a standard (nominal) mortgage; this is a desirable feature, since that is when affordability issues are most acute.

Right now, indexed mortgages are offered hardly anywhere across Europe. Will lenders want to offer them? This depends on whether such a product would create a correspondingly attractive financial asset for investors, and there is every indication that it would.

As a result of this sort of indexed mortgage lending, securities can be created that allow investors to receive streams of income that are linked to consumer price inflation, and potentially also to overall house price inflation. These could come to represent a useful addition to the supply of existing index-linked bonds that create a return that is some fixed amount in excess of consumer price inflation. At the moment, these bonds are overwhelmingly issued by governments, with some limited private sector issues (often from utilities companies).

There are strong reasons to believe that innovation will come because indexed mortgages create financial assets that should suit investors — as well as creating very big benefits to borrowers.

 

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