Pre-election margin trading, the Romania’s case

31 mai 2013 • All, Banking at Large, Money matters

the-wizard-of-oz

Romania is in a peculiar situation, which favors pre-election margin trading.

More often than not, the behavior of the National Bank of Romania (NBR) was perceived to be different than the one adopted by other central banks in European countries, mainly during pre-election periods. October 2008 – January 2009 is such a case study.

Compared with other central banks, NBR reacts in a very different way. We argue that the explanation for the idiosyncratic NBR behavior may not be found using main stream theories.

Our conjecture is that NBR actions should be academically challenged against the “agent theory” (personal incentives and relationship with those appointing the NBR Board) and be interpreted via a so called “personal loss function”. Occasionally, the latter goes astray from the “public loss function” in a pre-election environment.

Private loss function can be defined as the private incentive of board members, and we will mainly refer to the NBR Governor as the main exponent given his long tenure, to be reelected for a new term.

The main goal of Romanian Central Bank, the inflation target, was systematically missed but the Governor was still reelected implying that the levers are different than pure arms length performance as with the other central bank governors.

The main goal of Romanian Central Bank, the inflation target, was systematically missed but the Governor was still reelected implying that the levers are different than pure arms length performance as with the other central bank governors

Our conjecture is that NBR actions should be academically challenged against the “agent theory” (personal incentives and relationship with those appointing the NBR Board) and be interpreted via a so called “personal loss function”. Occasionally, the latter goes astray from the “public loss function” in a pre-election environment.

The public loss function is the departure of the actual metrics from a given target such as inflation and/or GDP growth and/or employment.

The board and Governor of the National Bank are appointed by the Parliament for a five-year term that may be renewed multiple times. Consequently, it is highly important for whoever wants to be re-elected/elected to be friendly with politicians in general, and with the envisaged new parliamentary majority each time general elections are held in particular.

The “responsive” attitude is stronger when NBR board nominations take place near parliamentary elections as was the case of Romania in late 2008.

The exchange rate regime is the so-called managed float; hence the Governor of the Central Bank is the main decision maker when it comes to deciding FX interventions and what exchange rate levels are temporarily protected.

The local currency is fully convertible, the market is shallow and the main player in the market is the Central Bank, while the policy rate is generally maintained at high levels by European standards-of market interest rates given the very low inflation targets.

One of the main trading strategies globally is the so called carry trade.

According to investopedia.com, the carry trade strategy is “A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.”

In an example based on Romania’s circumstances an investor entering a EUR/RON carry trade sells EURO, a low yielding currency, and buys RON, a high yielding currency. The investor entering such a strategy captures the difference between the two interest rates as long as EUR/RON doesn’t shift, meaning that the strategy is profitable as long as the interest rate differential is higher than RON depreciation against euro.

When leverage is used here comes the margin trading and profits could be huge. According to investopedia.com, the leverage is: “The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment”.

In an NBR “controlled” environment such as the managed float currency regime, with long periods of low currency volatility, trampolines for re-entering fresh positions and a large interest rate differential, the carry trade also via the margin accounts (therefore the profit being boosted by leverage) is the strategy to be pursued mainly if the information is not only publicly available.

In an NBR “controlled” environment such as the managed float currency regime, with long periods of low currency volatility, trampolines for re-entering fresh positions and a large interest rate differential, the carry trade also via the margin accounts (therefore the profit being boosted by leverage) is the strategy to be pursued mainly if the information is not only publicly available.

Maintaining such a large interest differential including during periods of deep recession (minus 6.6%[1] in 2009) departs from the overall trend of other central banks to support the real economy, moreover in the absence of inflationary pressures.

The risk in a carry trade is related to the uncertainty related to the exchange rate developments, in Romania’s case being RON depreciation.

Split by two dimensions, interest rate differential and currency volatility, the Romanian currency traded against Euro (and in the past against US Dollar) falls into the category of High Interest Rate Differential and low currency volatility, the investors’ bonanza. Of course, building up imbalances was the price to pay for maintaining such a status quo in Romania for years.

Given that the NBR Governor has a very poor performance in “inflation targeting”, his main goal is to ensure the “benevolence” of politicians from each new parliament. Thus, his behavior in the pre-election period should be scrutinized, including for actions which should benefit the margin trading accounts.

Given that the NBR Governor has a very poor performance in “inflation targeting”, his main goal is to ensure the “benevolence” of politicians from each new parliament. Thus, his behavior in the pre-election period should be scrutinized, including for actions which should benefit the margin trading accounts.

While this is not a bullet proof demonstration of the conjecture, there are certainly some elements raising a lot of questions:

ü The market interventions are done via specific banks benefitting from asymmetric and private information on the intention and the levels targeted by the NBR actions which could favor margin trading accounts

ü NBR performs in tough market conditions such as the liquidity squeeze of October 2008, swaps with just a few numbers of banks as per the written opinion of an adviser to the NBR Governor;

ü The margin trading accounts are not offered by all banks but only by some; the accounts are kept both onshore and offshore, the lack of liquidity and the inherent big spreads being addressed by “bilateral” back to back transactions;

ü In certain situations the market participants were asked not to work with non-resident banks in order for NBR to be able to shift the exchange rate to desired levels;

ü In certain situations NBR asked the commercial banks to remove certain treasurers to facilitate reaching a certain exchange rate level;

ü In certain situations, NBR distorted communication in order to hide certain actions and to create false scenarios. For example, in October 2008, NBR removed liquidity from the market and the interest rates jumped, being traded via foreign exchange swaps at implied local currency yields as high as 1000%. In a pre-election period and with market circumstances significantly departing from what NBR previously suggested to politicians, NBR tried to hide the market situation from the public opinion. In a first move, NBR used “moral suggestion” to make 5 out of 10 Robor (Romanian currency Libor equivalent) contributing banks to keep the interests in the fixing page in the 18/24 interval while the remaining where quoting the market in the 30/99 interval, given the extreme conditions of lack of liquidity . The move was similar to what vice-governor Tucker from Bank of England did with Barclays but to a larger extent and more ample consequences for the interest rate fixing. To hide this intervention to keep the interests low just in the fixing page, far from depicting the market conditions and prices, NBR generated a well received story broadcasted by the not so independent part of the Romanian media, that the other 5 banks, which in fact were posting the real market quotation, attempted to manipulate the market. NBR used such allegations, perhaps inspired by the American movie “Wag the dog”, as a decoy to divert attention from what it actually did. To confirm its allegations, NBR induced an investigation by Romanian Competition Council. After examination lingering for 4 and a half years, including consultations with European counterparts, the Competition Council concluded there was no collusion between banks. At a later stage, NBR administratively capped the Robor at 18,25%, action that perpetuated the strained market conditions for several months affecting the real economy, precipitating and deepening the recession;

ü In certain situations NBR leaked bank names to the press to exert media pressure without a valid justification;

ü In October 2008 NBR launched the story of the currency “attack” on Ron, right before the parliamentary elections, in order to induce the good/bad metaphor in the imaginarium of the electorate even if the NBR interventions were maintained at the same level in 4th quarter 2008 versus 1st quarter 2009 , and the depreciation of Romanian currency in 1st quarter of 2009 surpassed 11%, almost double than the on ein 4th quarter in 2008;

ü In certain situations the NBR representatives lacked emotional control because the market rates did not follow their personal wish, given that the public rhetoric of NBR is without a “lead” on the exchange rate desired level;

ü NBR allowed an exchange rate far from equilibrium, facilitating the carry trade strategy e.g. kept the exchange rate out of equilibrium by removing the liquidity from the market just in the pre-election period and allowed the exchange rate to jump by 14% just after the elections, maintained it at the new level with low volatility over an extended period, accompanied by liquidity assistance for new investment positions to open up;

ü Offered trampolines for the investors coming at different moments in time, according to the same opinion of advisor Croitoru;

ü Overuse of double talk with “apparent” miss-information of certain decision making politicians who most likely knew better and the clear manipulation of population to accept monthly changes ( and sometimes even weekly) in NBR opinions and forecasts;

ü The pre-election margin trading could be a good source of money for parties that are part of the game.

All the above hypotheses/facts form arguments supporting this conjecture.

The political economy, checking the behavior of central banks across 100 countries and over 30 years shows that before elections the central banks are more prone to intervene in the market even if there are major costs for the economy as the private loss function takes over the public loss one e.g. the interventions favoring ron intensified in 4th quarter of 2012 even if the the ron was flat or even in slight appreciation.

Within a “controlled” environment by NBR, maintaining a managed float currency regime with low volatility and seldom “trampoline” jumps and high interest rates , the private loss functions and incentives push away from the society and real economy interests and well being

[1] Subsequently revised from -7.1%

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