第二届中法金融论坛. Long term inflation trends: Why and how hedging the inflation uncertainty.

Transcription

1 1 2 nd nd SINO-FRENCH FINANCIAL FORUM Long term inflation trends: Why and how hedging the inflation uncertainty. 北京 2008 年 10 月 17 日 Beijing,October 17, 2008 北京香格里拉饭店 Shangri-La Hotel Beijing

2 Foreword 2 For most of the past 2 decades, executives of western companies and asset managers (pension funds, insurance companies, mutual funds) have enjoyed an important advantage when drawing up their business plan or investment strategy: the assumption of price stability The new business environment Commodities prices and Food prices have changed the global perception regarding inflation although the trend could be overstated and low by historical standards. Although companies differ in their ability to pass on their price increases or expectations this represents a renewal source of uncertainty and potential strain on their financial performance. Since the serious bout of inflation (2 decades ago) financial techniques have evolved, so have the financial tools designed to manage them.

3 Table of Contents 3 Part I A long term inflation trend: A new uncertainty Part II The measure of the trend Part III The financial tools designed to manage inflation

4 Part I : The Trend Global inflation has risen to levels not seen in decades 4

5 Long term trends in global inflation 5 Globalannualinflationratesincommoditiesandconsumerprices %y/y 70s 80s 90s 00s Oil Food Metals Developingeconomies DevelopingAsia Industrialisedeconomies Source: RBSGlobalBanking&Markets

6 Long term trends in oil price Real oil p ri ce ( eu ro s per barrel)

7 Long term trends in other commodity prices Real metalsprices(2008euros) Real foodprices(2008euros)

8 Long term trends in inflation rates: Industrialised vs developing countries Industrial countries Developingcountries

9 Recent trends in inflation rates: Industrialised vs developing countries Industrial countries Developingcountries Asia

10 Inflation can surprise, even in regions where central banks are very credible: : Euro area inflation forecasts Changes in consensus expectations of 2001 inflation Changes in consensus expectations of 2008 inflation

11 Inflation upside surprises have affected European consumers What do you think are the two most important issues facing (OUR COUNTRY) at the moment? What do you think are the two most important issues facing (OUR COUNTRY) at the moment? 11 Answers: Rising prices / inflation Rising prices/inflation Unemployment Mar-09 Dec-08 Sep-08 Jun-08

12 Central bank differing objectives might create additional inflation ion risks in developing countries 12 Difference between actual rates and Taylor rule implied rates, 2007 China Russia India Malaysia Hong Kong Phillipines Indonesia Thailand South Singapore Korea Sweden Japan Switzerland UK Taiwan Euro area US Norway Australia New Turkey Rate Gap

13 Large differences in consumption patterns 13 Food weights in CPI Share(%) United states 14 Korea 15 Euroland 20 Singapore 23 Japan 25 Tapei, China 25 Hong Kong 27 Malaysia 30 Thailand 33 China 33 Indonesia 42 Philippines 47 India 57 Source: AsianDevelopment Bank,National statistics offices

14 Part II Forecasting Inflation: the measure of the trend 14

15 Forecasting inflation: RBS Live inflation model (i) 15 Key applications 1. Inflation implications in real time 2. A reliable predictor of ECB forecast changes 3. Forecast evolution analysis 4. A logical framework for analysis 5. Scenario testing 6. Fully downloadable daily forecasts 7. Other countries to follow (UK first)

16 RBS Live inflation model (ii) 16 Decomposition of European inflation Energy HICPenergy = F{oil price futures, FX} Food HICPfood = F{world prices, food ppi, weather, FX} Total HICP Core Core Goods Core Services HICPcoregoods = F{imported inflation, output gap, FX} HICPcoreservices = F{ULCtrend, ULCcyclical, unemp gap, inf expectations, } Administ'd & volatile HICPadmin = F{tax, policies, seasonality...}

17 RBS Live inflation model (iii) 17 Changes in euro area inflation forecasts from RBS model Euro area inflation forecasts sourced from 0.5 RBS proprietary inflation model, according to different dates (see RINF <GO> on Bloomberg 0.0 for details). Ju n-08 Se p-0 8 Dec-0 8 M ar-09 Jun-0 9 Sep Mar Jul Oct 08

18 Future inflation trends 18 Short term trends: - Cyclical forces to push headline inflation down in the short term: global downturn, weaker commodity prices Long term trends: - Policy objectives from monetary and fiscal authorities - Credibility of institutions, Consumers expectations - Productivity / Unit labour costs - Degree of competition in sheltered sectors - Climate change - Labour markets / demographics

19 Part III Managing the inflation uncertainty 19 The resurgence of an inflation has created a burst of demand for instruments than can help manage the risk of rising cost (prices)

20 The demand 20 Entities that might receive inflation hedging Pension scheme providers (either stand alone pension companies or in house pension schemes. As most pension schemes are index-linked, pension providers have a natural appetite to receive inflation hedging. Life companies: if life assurance is linked to a salary multiple and the salary is deemed to be indexed linked then a inflation exposure bursts. Companies with large portfolio of leased property where rental payments are inflation linked. Banks and Building Societies that offer inflation linked savings/investment products

21 21 Asset managers In when interest rates were falling, many investors became concerned that the central banks s stance would lead to a resurgence of inflation. At the same time, the sharp sell off in the equities market had prompted a fundamental shift among many pension funds and insurance companies toward bonds. As a result pension funds, insurance companies were looking for new ways to protect themselves from inflation.

22 22 Entities that might pay for inflation hedging Utility companies : their ability to raise prices maybe linked to inflation Property companies: tenancy agreements may provide for inflation linked rent PFI transactions: the income stream generated in PFI deals frequently contain some link to inflation Finance houses: where inflation linked finance has been provided to their client base Retail companies: where their performance is influenced by retail prices

23 23 Inflation Market Simplified Market Overview Corporate, Infrastructure, Utilities, Retailers, Real Estate Inflation Linked Cash-Flows Insurers, pension funds: longterm strategic ALM Inflation Linked revenues Sovereigns, agencies, supranationals, municipals: EIB, KFW, etc Hedge funds: short-term investment IL liabilities Financials: banks (ILmortgages), etc Intermediaries: banks and brokers Banks, retail investors: short-term investment

24 The instruments 24 The problem has traditionnally been that there is more demand for inflation protection than counterparties will to provide it. Inflation Linked Bonds The biggest suppliers of inflation linked Securities have been governments: the UK government has been issuing index linked gilts since the 1980s while the US treasury, started issuing Treasury Inflation Protected Securities (TIPs) in the mid 1990s. France is, with UK the most regular issuer of inflation linked securities, the last one lead managed by RBS in March As of today, France represents 33% of the total volume issued and a large demand is coming from French insurers and assets managers.

25 25 European Inflation-Linked Bonds All GBP i-linked Issuance Since 2000 All EUR i-linked Issuance Since ,000m 50,000m 20,000m 40,000m 15,000m 10,000m Private Public 30,000m 20,000m Private Public 5,000m 10,000m m m European i-linked Issuance Since 2000 Luxembourg Sweden 2% Other Greece 2% 2% 4% Germany 5% Italy 19% United Kingdom 33% European Market for inflation linked bonds has grown substantially since 2000 reaching over $ 1 trillion In Euro most of the issuers were public (public sector or central governments) In GBP the private sector has been significantly present. UK, France and Italy represent the bulk of the issuance ( and a very substantial part of the investor base) France 33%

26 26 European Inflation-Linked Bonds UK i-linked Issuance Since 2000 French i-linked Issuance Since ,000m 3,500m Montly UK i-linked Issuance ,000m 102 1,500m 1,000m m 8,000m 101 6,000m ,000m 100 2,000m 99.5 m Monthly Issuance 2,000m CPI 2,500m Monthly Issuance 3,000m 103 m - 500m 12,000m IT CPI ( = 100) Montly Italian i-linked Issuance 8,000m 101 6,000m ,000m 100 2,000m 99.5 m CPI nd SINO-FRENCH FINANCIAL FORUM Jul-08 Apr-08 Oct-07 Jan-08 Jul-07 Jan-07 Apr-07 Jul-06 Oct-06 Jan-06 Apr-06 Oct-05 Apr-05 Jul-05 Jan-05 Jul-04 Oct-04 Apr-04 Oct-03 Jan-04 Jul-03 Jan-03 Apr-03 Jul-02 Oct-02-2,000m Jan-02 Apr M onthly Issuance 10,000m 102 M ay-07 Sep-07 Jan-08 M ay-08 M ay-06 Sep-06 Jan-07 M ay-05 Sep-05 Jan-06 M ay-04 Sep-04 Jan-05 Jan-03 M ay-03 Sep-03 Jan-04 Choosing the Index and Trusting the Index is key for successful issuance Consumer Price Index is the favored index and present the advantage of short delay between data collection and publication, high visibility and low revision risk. Italian i-linked Issuance Since ,000m Jan-00 M ay-00 Sep-00 Jan May-08 Sep-07 Jan-07 May-07 Sep-06 Jan-06 May-06 Sep-05 Jan-05 May-05 Sep-04 Jan-04 May-04 Sep-03 Jan-03 May-03 Sep-02 Jan-02 May-02 Sep-01 Jan-01 May-01 Sep-00 Jan-00-1,000m May Jan-02 M ay-02 Sep Jan-01 M ay-01 Sep-01 CPI 12,000m FR CPI ( = 100) Montly French i-linked Issuance UK CPI ( = 100) A good CPI is : Representative (fairly representing consumption spending) Transparent (investors can see how it is calculated, weighted, indexed etc..) Stable ( Methodology cannot change radically and/or frequently) Timely (publication according to define time table with the shortest possible inflation lag)

27 27 Inflation-Linked Bonds Not exactly a hedging Instrument for Borrowers But a self adapting liability to real asset yield Private issuers tend to have their income correlated with general price indexes and/or to have very long duration assets. Public issuers are naturally hedged against inflation linked as taxes are levied in nominal terms. ( VAT best example?) But a true hedging Instrument for investors Unique asset class truly hedging unexpected inflation. Research demonstrate that savings in countries suffering from low level saving rate and /or volatile inflation expectations would strongly benefit in providing index linked saving instruments ( Bach, Musgrave, Sarnat). Pensioners and pension funds have a very low level of risk appetite when it comes to inflation. This investor base is willing to buy protection against inflation allowing borrowers with relatively neutral risk aversion to benefit from the arbitrage pricing of their liability. Growing demand in Europe Long term investors feared inflation growth during H1 2008, providing more opportunities for borrowers. Although the current financial crisis may have reduced all borrowing and investment activities, it was expected this year to see a record issuance of inflation linked transaction with a potential Euro 50 billion market, whilst ECB forecast inflation to lay between 3.2 and 3.6% in 2008, and 2nd SINO-FRENCH 1.8%FINANCIAL and 3%FORUM in 2009

28 28 Inflation-Linked Bonds: conclusion Not a financial innovation Borrowing indexed over the priced of goods (basket or commodities) has been used quite often in the past 200 years. The proof by Central banks that they firmly believe in their ability to control inflation Credible monetary policies focusing on price stability will encourage issuance of inflation linked bonds A way to securitise inflation and enable financial engineering to better structure asset and liability management for pension fund and very long term asset managers An incentive to increase savings rate Bringing additional protection to the retail investors that their saving will suffer no erosion ( bridging risk aversion limit ) The independence of Central Banks and stability orientated monetary policies are likely to curb to the potential spread of indexation in the economy as a whole. While the issuance of inflation-linked bonds in the past may have triggered fears of widespread indexation, such fears seem much less likely to materialise nowadays in an environment of low and stable inflation. The credibility of monetary policy, reinforced by the independence of the central banks and the consistent delivery of price stability, should suffice to discourage any attempt to extend indexation beyond financial assets. extract ECB occasional paper Inflation linked bonds from a central bank perspective- june nd 2 SINO-FRENCH FINANCIAL FORUM

29 29 Over the counter market: inflation derivatives Principle Two counterparties agree on a long term contract based on an agreed inflation rate: if at the end of the period (contract) prices are higher than originally expected the seller of inflation makes a payment to the buyer (and conversely) The three most common derivatives are: (brochure attached) RPI Income swaps: objective by swapping the inflation exposure from floating to fixed the company will know how the income stream will grow during the life of the hedge Real estate Swaps: the real estate swap is similar to a conventional interest rate swap however, although the client normally receives floating libor, the «fixed leg» is split in two parts: the fixed (or «real estate»), plus or times a variable rate linked to the change in RPI. 2nd SINO-FRENCH FINANCIAL FORUM

30 30 Limited Price inflation (LPI) Structuring similar to the ones described above but where the RPI flows are subject to maximum and / or minimum constraints. Description of the type of deals that have recently been concluded Insurance company RPI Income Swap where we receive fixed & pay RPI. Pension company Conversion of conventional bond into RPI linked bond where we pay a fixed rate * RPI, and link the maturity value of the bond to the change in RPI. (Same structure as an index linked Gilt). World Bank & EIB Conversion of conventional bond into RPI linked bond where we pay a fixed rate * RPI, and link the maturity value of the bond to the change in RPI. (Same structure as an index linked Gilt). Pension company Converted a conventional bond into bond paying an LPI linked coupon. 2nd SINO-FRENCH FINANCIAL FORUM

31 31 Conclusion Inflation is increasingly becoming a global phenomenon, with the fast and efficient transfer of good and labour between regions causing prices to converge. Hedging inflation risk should suppose a prerequisite: a CPI index which is: Representative (fairly representing consumption spending) Transparent (investors can see how it is calculated, weighted, indexed etc...) Stable (methodology cannot change radically and/or frequently) Timely (Publication according to define time table with the shortest possible inflation lap) Hedging inflation in Asia, ex Japan was previously difficult as, apart from South Korea, no country has an inflation linked bond market. Banks are now looking at providing a liquid «proxy hedge» by using a static weighting of inflation from Europe, the USA and Japan as well as commodities exposure. Such new index has still to be tested with investors. We strongly believe that the specific expertise developed in Europe (and in France) not only in forecasting inflation but also by designing hedging instruments to match client s underlying exposure (through inflation linked banks or swaps) will be (should be) available to Asian (Chinese) companies and investors. 2nd SINO-FRENCH FINANCIAL FORUM