The Chinese Stock Market Meltdown

Source: http://a.abcnews.com/images/Business/gty_china_stock_3_kb_150708_16x9_992.jpg

Hi folks. We’re back after one long summer break. I did a lot of traveling and enjoyed tons of unexpected experience along the way. After the trip ended, I was so bored out of mind that I had to find some stuffs to do to keep myself busy. My overwhelmed free time makes me greatly miss school and my busy schedule. A lot of things have happened to me in the past few months and so have the world. Today’s topic will be about the recent calamity of the Chinese stock market. We’ll start off by giving some background stories that led to the stock market meltdown. In the next article, we’ll further discuss what the Chinese government have done so far to calm the market and restore investors’ confidence.

In the previous decade China has relished double digit growth thanks to its rise in productivity and overwhelming exports to other countries. One imminent thing is that the fun party can never go on forever. If the Chinese economy are to grow at a 10 percent rate every year, its GDP will double in every 7 years. If the trend continues, China will take over the world, literally. It comes to one prophecy: China’s economic growth will slow down. In 2014 China economy grew by just well over 7 percent which is still relatively higher than the growth of western countries. Despite the disappointing data, China is still one of the faster growing economy in the world. The latest data also showed that Chinese import and export dropped and key indicators such as factory outputs and real estate market also faltered.

To spur growth, last year the People’s Bank of China (PBOC) eased credit by lowering the key interest rate, hoping that commercial banks will channel the attractively low-interest fund to companies to boost investments, outputs, thus creating more employment opportunities. Conversely, a huge part of the fund was channeled to brokerage firms which in turn lent the money to investors to increase their stock purchase which is known as “margin trading.” (Wall Street Journal) Simply put, margin trading enables investors with a margin account, who lack sufficient fund, to borrow money from a broker to buy more stocks.This is also known as leverage in financial terms. To quote the legendary investor Warren Buffett, “Leverage is the only way a smart guy can go broke.” Debt financing, if used effectively, can reap huge return, but it also increases the risk of bankruptcy in the time when cash flow is short. The Wall Street Journal (WSJ) reported that the debt of margin trading has risen to about 2 trillion yuan ($323 billion) in early June, an almost five-fold increase from the previous year. 

As a result of the loose credit and margin trading, the Shanghai Composite Index in June 2015 has risen by almost 150 percent since 2014 and peaked on June 12. The Shenzhen index has also increased about 180 percent in just a year. (Bloomberg data) Such dramatic increase in stock price is unheard of and unsustainable.The number is also amazingly hard to believe given the already immense size of the Chinese stock market capitalization (market value). More importantly, the bull market with dramatic stock price appreciation happened at a time when key economic indicators signal big problems -  the economy is slowing down, factory’s output decreases, import and export drops and the property bubble bursts. In Finance the term “price” and “value” are two different things. An increase in stock price does not translate into an increase in stock value. Stock value depends on many measures including current and projected earnings, future cash flow, market share, sale volume and so on. Stock price is what you pay in order to get its value. Sometimes the price represents the true value and some other time it does not which strongly depends on the demand and supply in the market. In the same way, Chinese stock value didn’t increase 150 percent in just a year which only means one thing: the stock is overvalued.

Source: WSJ

Sensing the danger of margin trading in the week of June 15, the PBOC began to tighten its credit to commercial banks with the hope of curbing the excessive funding to margin financing to purchase stock. The PBOC’s action sent fear to investors which followed by a huge stock selloff in the market, plunging the Shanghai index and Shenzhen index. I remember an analogy from one of my professor about the 2007 financial crisis. He talked about a classic dancing chair game of how the banks were dancing along with the upbeat music because everyone was dancing. When the music suddenly stopped, everyone with fear tried to find his own chair to sit, while some people who couldn’t find their own chairs are the losers. The comparison between the Chinese market and my professor’s story is that now the music has stopped, investors in China want their money out of the market because they come to term with the reality that their stocks are overpriced. In one trading day in July, the Shanghai index plunged almost 8 percent in just a single day. So far the Shanghai Composite Index has fallen almost 30 percent from its peak on June 12. Almost 4 trillion dollars of market capitalization has been lost. (CNBC)

An op-ed in WSJ gave a brilliant description of why the Chinese market is in a bubble. He pointed out to four signs: prices do not reflect the economic fundamentals, massive debt financing to buy stock, excessive volume of daily trading by retail investors, and exorbitant valuation. 

Next time we’ll continue our discussion and talk about what the Chinese government have done to calm the market and restore investors’ confidence. This market turmoil is the toughest test yet for the new Xi Jinping's administration and the credibility of this new administration lies on how it handles this tough situation. We’ll be surprised that some of its interventions with good intentions may actually backfire, shatter the confidence and drive people further away from the market.

What are the Implications of a Strong Dollar?

We will continue from the last article about the causes of the strong dollar. Today we will discuss the implications of a strong dollar and what it means for investor. I really like this quote about the health of the U.S. economy: When America sneezes, the world catches a cold. As the dominant currency in the international market, the surging of the dollar’s value has both positive and negative implications not just on the U.S. domestic economy but also on the global economy.

 

Source: http://thumbs.dreamstime.com/z/strong-dollar-weak-euro-conceptual-illustration-hitting-currency-figure-white-background-49218515.jpg

 

Implications on the economies and markets

           The first major implication of a surging dollar is its adverse effect on the earnings of U.S. multinational companies which has a large proportion of revenue generated from foreign market. Given a strong dollar in exchange rate, the sales of companies in foreign currency is discounted when it is converted into U.S. dollar term. This is known as “currency risk”. The Washington Post reported that Johnson & Johnson, whose sales from international operation account for more than half of its total sales, posted a drop in sales of 0.6 percent in the fourth quarter, although there was an increase in prescription sale. Figure 1 shows that 46.3 percent of the total sales of the S&P 500 companies are generated from outside the U.S.

           The fact that the earnings of U.S. companies are lowered due to a strong dollar is only one side of the argument. A strong dollar benefits those U.S. companies who import materials from foreign countries. Because of a surging dollar, the materials can be bought at a cheaper price, thus reducing the cost of production and increasing the profits margins, according to Keith Lerner. The Washington Post also reported that the aluminum supplier company Alcoa posted a solid profit in the fourth quarter of 2014. Thanks to the strengthening dollar, Alcoa imported its materials at a lower price from Australia, Brazil and Jamaica. Despite a rising dollar, Alcoa sales were not significantly discounted, since most of its sales are generated in the U.S.

 

Figure 1: S&P 500 companies’ foreign sales as a percentage of total sale

Source: Mackenzie Investments

           

One positive benefit of a strengthening dollar is that it drives down price of imported goods to the U.S. and keep inflation at a low rate. Cheaper goods can improve the purchasing power of American consumers and grow the demand in the economy. The U.S. low inflation rate, despite the Federal Reserve’s past aggressive bond-buying program and increase in money supply, is partly attributed to the low oil price. The low inflation below the Fed’s target of 2 percent has prevented the Fed from raising the interest rate which could bring about volatility in the market and increase the cost of borrowing.

Implication on international trade

A rising dollar could also jeopardize the competitiveness of U.S. export companies in the world market which could lead to increased trade deficit. Given that goods in a strong currency is more expensive in countries with depreciated currency, the U.S. export products become less attractive to foreign consumers which would reduce the sales of American products. Furthermore, a strong dollar also makes it more difficult for U.S. producers to compete domestically with cheaper imported goods from countries with weaker currencies when converted from a weak currency into a strong currency. Such disadvantage could force U.S. producers to lower its selling price and profit margin, affecting the earnings of the company. A strong dollar could be a major hindrance against full employment recovery, wage growth and the U.S. economic growth rate. While it can adversely affect the U.S. producers, foreign producers can reap the benefit by boosting their exports to the U.S. even further.

However, while the U.S. producers face barriers in competing against other countries with weak currencies, the U.S. consumers are the winners whose surplus and purchasing power are increased. According to the World Bank’s data, the U.S. export of goods and service relative to its total GDP was only 13.5 percent in 2013. As a consumption-based economy, the U.S. should gain from a strong dollar in an aggregate effect.

 

Implication on investment

Return of investors from foreign market is also diminished due to a strong dollar. Although the return is high, it will be reduced once converted into dollar, thus reducing the overall returns. For example, the MSCI EAFE index or Europe, Australasia and Far East of developed market stock has risen 4.5% by September in its local currency. The return once converted into U.S. dollar was negative 1 percent (Kelly, 2014). Thus, investors who aim to diversify their investment portfolio by investing in foreign stocks should take into account the currency risk as a result of currency depreciation against the dollar in Europe, Japan and other markets and the fact that their return in foreign currency is reduced significantly when converted to the U.S dollar term.

Mackenzie Investments advised its investors that in a strong dollar climate it is wise to invest in U.S. equities but selectively pick the U.S. companies that benefit most from a rising dollar. Those companies should not have much exposure to currency risk and have most of their business operation in the U.S. and generate most of the sales within the U.S. Moreover, those companies should benefit from the cheaper import material from abroad. The recommended sectors are utilities, consumer staples, healthcare and telecommunication. Moreover, Mackenzie Investments also encouraged investors to favor mid- and small cap companies, since most of these companies’ businesses are operated domestically and do not face with currency risk significantly.

Emerging markets may suffer the most from a strong dollar. Flanders and Dryden (2014) claimed despite relishing the boost in exports to the U.S., some nations of the emerging markets may face high inflation rate and foreign capitals diverted from within the countries to other stable markets which could results in “serious market volatility” as experienced during the Asian financial crisis in the 1990s. The two J.P. Morgan’s analysts also stated that equity prices in emerging market economies are negatively correlated with the trade-weighted dollars. This phenomenon may be explained by the fact that the dollar generally depreciates when the commodity price is low and foreign capitals flowing out of the emerging economies. They also found that countries of EMEA (Europe, Middle East and Africa) and the U.S. dollar have a -0.31 correlation, MSCI Emerging Markets Index and the U.S. dollar has a -0.82 correlation and Latin America economies and the dollar has a -0.86 correlation.

 

Will the dollar continue to rise?

The recent trend of the dollar appreciation caused currency experts and investor to bring their concerns on “Dollar-Euro Parity”. When two currencies is at parity, it simply means that both currencies have the same value and are traded 1:1. Robin Brooks, a strategist at Goldman Sach, predicted that Dollar-Euro parity will take place in the fourth quarter of 2015. The strategist even further forecasted that the Euro could be traded at a low 0.80 dollar by the end of 2017, which will be the lowest exchange rate since the inception of the Euro currency.

Predicting the movement of the currency exchange rate is a challenging analysis. Whether the dollar will continue to rise takes into account many factors. First, it depends upon the state of the U.S. economy, that is, whether the U.S. economy can still outperform the developed market. The outcome of the ECB’s version of quantitative easing and expansionary monetary policy still remain to be seen and it is too early to judge whether the QE could attain its goals. Forbes reported that if Europe’s economy showed sign of positive economic data, the dollar-euro parity will unlikely happen.  Second, the strength of the dollar also depends upon the decision of the Federal Reserve of when to raise the interest rate and by how much. Given the current positive data from the labor market and price stability, the Federal Reserve’s interest rate hike is imminent and is likely to happen by the end of 2015 which is predicted by many analysts.

Hedging against the U.S. dollar

In the climate of a rising dollar and foreign currencies depreciation, hedging against the dollar has been popular among investors who aim to mitigate the currency risk of investing in foreign markets. Hedging currency can take many different forms, including sophisticated derivatives, that is, forward contract, foreign exchange swap, currency options, purchase of a currency-hedged mutual fund or exchange traded fund (ETF).

The method of forward and option to hedge is sophisticated. Since the currency-hedged ETF is more convenient, investors start to pour fund into ETFs to protect their investment from a surging dollar. The Wall Street Journal (WSJ) reported that currency-hedged ETFs, mainly offered by WisdomTree Investment and Deutsche Bank, is currently worth 50.3 billion dollar thanks to the growing concerns of the recent trend of a rising dollar. The figure below from the WSJ also showed that the returns of currency-hedge funds consistently beat the returns of unhedged funds since 2014. However, it should be noted that the performance of a fund within just a short period of time does not represent a full and complete picture of the returns in the long run nor does it indicate that a currency-hedged fund will continue to exceed the return of an unhedged fund in the coming years. Since the currency-hedged ETF is new to the market and hedging can be expensive and reduce the return when the global economic condition and world market change.

The WSJ also presented an argument against currency hedging. Hedging against the dollar can yield benefits in the short run given that the dollar is rising at the moment. However, currency movement goes in both directions - a currency can appreciate and depreciate over a period of time. In the long run, the currency risk is minimal and returns should be generally the same for hedged and unhedged funds. However, there is a cost incurred when you decide to hedge which could diminish your overall return in the long run.

Figure 2: Currency-hedged ETFs asset, one year return of hedge and unhedged funds

Source: The Wall Street Journal

 

Whether or not to hedge against currency, investors are advised to gauge the magnitude of the currency risk and its degree of likelihood, understand your time horizon in holding the securities, weigh the potential benefits and costs of hedging.

 

Conclusion

As a dominant international currency, the value of the dollar against other foreign currencies results in several implications which bring concerns to investors and the world market. Several factors are attributed to the rise of the dollar value in relative to other foreign currencies, including the relatively more impressive U.S. economic growth compared to other developed nations, the potential of the Federal Reserve’s interest rate hike, the quantitative easing program of the ECB and BOJ, capital inflow to the U.S. market and the U.S. energy revolution.

Major implications include the decrease in earnings of U.S. companies whose sales are mainly generated in foreign countries, the decrease in the return of investments in foreign market once converted to the U.S. dollar, the negative impacts on the competitiveness of the U.S. producers, the more expensive U.S. export products and the cheaper import products to the U.S.

Against the backdrop of the current economic condition, a currency strategist at Goldman Sachs predicted that the dollar and the euro would be traded at parity by the 4th quarter of 2015 and the euro-dollar exchange rate could even further drop to the lowest rate at 0.80 dollar per euro by the end of 2017. However, the prediction would not remain valid if positive economic data in the eurozone start to emerge in the near future. In the time being, investors need to pay attention to whether or not the ECB’s quantitative easing program is a success.

In the current rising dollar climate, currency hedging can yield higher return and protect investments in the foreign markets in the short run. However, the returns of hedged and unhedged funds are generally the same in the long run because the value of a currency can either appreciate or depreciate. Investors need to take into account the cost associated with hedging which could affect their overall returns. Investors should also understand the magnitude of the currency risk, time horizon of the investment whether investors opt for a short term investment or a long term investment and weigh the costs and benefits of hedging before deciding whether to hedge against the dollar.

What are the Causes of a Strong Dollar?

Source: https://acethetrade.files.wordpress.com/2011/04/us_dollars-6907.jpg

 

A few days ago I learned that my good old friend has received an offer to pursue his master's degree in Economics from two of the most prestigious universities in Australia. While I am a bit disappointed that it is highly unlikely for him to study in Canada (since I could visit him in Canada easily), I am also happy that Australia could be his next pit stop because Australia is a wonderful country and my heart has always had a special place for Australia. I still remember some of the lyric of Australian National Anthem "Advance Australian Fair". As we were talking about his degree, I told him that he was very lucky to study in Australia, owing to the fact that as of the late the Aussie dollar is relatively much weaker against the U.S. dollar (USD) which means he could buy more Aussie dollar with his USD. To my surprise, he told me to shut up and confidently said he already know all of the stuffs that I’ve said. The sheer arrogance of this dude who is admitted to the top Australian universities is beyond belief. I also told him that I wouldn’t be able to discuss anything with him related to economics once he completes his PhD. Anyways, all jokes put aside, I think it would be an awesome idea to discuss the causes that leads to a strong dollar, thanks to the brilliant discussion on Australian dollar and USD exchange rate. Let’s get to our main discussion: the causes of a strong dollar.

Introduction

The United States dollar has appreciated gradually against other currencies over the past two years. In fact, the U.S. Dollar Index, which measures the value of the dollar in relative to a number of major currencies from developed market comprising of Euro, Japanese yen, Pound sterling, Canadian dollar, Swedish krona and Swiss franc, has risen around 15 percent since June 2014. The euro was traded at 1.058 dollar as of April 2015, according to Bloomberg’s website. The dollar appreciation has brought legitimate concerns to multinational companies, investors and the international market.

    As a result of globalization, the world has become increasingly intertwined and the role of currency exchange rate in promoting economic growth has also been amplified accordingly. The strength of this dominant and international currency known as the U.S. dollar can have broad implications to not only the U.S. market and economy domestically but also the global market.

Causes of a strong dollar

Many currencies of both developed and emerging market have depreciated significantly against the dollar in 2014 which can be attributed to several factors.

           The first factor is that the U.S. economy is recovering at a much faster rate compared to other developed countries counterparts. In contrast to sound economic recovery and low unemployment rate (5.4%) in the U.S., the European Union members are still plagued by mounting debt crisis, high unemployment rate and decrease in consumers and investors’ confidence. Spain’s unemployment rate was at 26.6 percent, according to the World Bank data in 2013, meaning that 1 in 4 person is jobless. The World Bank data in 2013 also showed that unemployment rate among youth was around 57.3 percent or half of the young people is without a job. Greece is still struggling to cope with its high debt and austerity economic policy which the world fears that Greece may exit the EU in the near future. In Japan, despite its expansionary monetary policy and quantitative easing as part of what is known as Abenomics, experienced a surprise technical recession in the second and third quarter of 2014, largely attributed to the government’s sale tax increase from 5 percent to 8 percent to pay down Japan’s huge amount of debt. A healthy and growing economy is often associated with the rise in investor confidence.

 

https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgkhf7n9sN-8Tz12EdOk4opyPTwqRSDMnnuWEWdXN1QRqyLq-WdWpZFRo_Gq6U9ua0Wk1GDjztI0GvTpdzo6tBmgRGW6B9buMSS47ykWUtvk3wm4HmmxlhOAy5nMtqIU2IoZ9IdTt9dR6I/s1600/QuantitativeEasing.png

           Another major cause is the U.S. Federal Reserve has ended its Quantitative Easing policy and begins to tighten its monetary policy. Many analysts expect the Federal Reserve to raise the interest rate in 2015 given that the U.S. healthy economy is showing positive sign of normality and full employment. Contrastingly, the European Central Bank (ECB) and the Bank of Japan (BOJ) are implementing its expansionary monetary policy and Quantitative Easing program aimed at stimulating the demand in the economy and targeting inflation rate at around 2 percent by significantly increasing the money supply in the economy. The ECB has announced a 1.1 trillion euro quantitative easing plan by making a monthly purchase of 60 billion euro of government bonds and private sector assets. The Wall Street Journal reported that the BOJ also intensified its already aggressive quantitative easing plan by raising its annual asset purchase from 60 and 70 trillion yen to around 80 trillion yen (730 billion dollar). J.P. Morgan’s strategist Dr. Kelly stated that investors are pouring capital to the U.S. by buying the U.S. dollar expecting to reap the benefit when the Federal Reserve begins to raise the interest rate in the near future.

           Third, the U.S. 10 year government bond is currently yielding around 2 percent, although is a small return, is relatively more impressive than the near 0.2 percent yield of Germany’s 10 year government bond and other developed market. The higher U.S. government bond yield has attracted a huge capital inflow into the U.S. and increased the demand of the dollar. The simple economic concept of the law of demand and supply will explain that the increased demand of the dollar will accordingly amplify the price of the dollar in the international currency exchange market.

           Another likely contributing factor is the revolution of U.S. energy which cut U.S. import of oil significantly over the past few years which was made possible by the previously high oil price which enabled U.S. energy companies to make profit from extracting oil from the oil shale. In 2005 the U.S. imported 12.5 million barrels of petroleum a day or 60 percent of the total daily petroleum consumption. In 2013 the percentage of daily imported petroleum dramatically dropped to only 35 percent or 6.6 million barrels, according to Dr. Kelly’s article. Such reduction in oil import has reduced the U.S. trade deficit and saved billions of dollars. According to Flanders & Dryden, strategists at J.P. Morgan, all else being equal, a lower supply of dollar in the market leads to a dollar appreciation.

The sharp fall in commodity prices has also been a major negative impact on the economy of emerging markets. Countries which rely on commodity exports including Russia and Brazil have seen their currencies value drop sharply against the dollar.

This post is getting uncontrollably long and so for the sake of simplicity, we will end it here. There will be a continuation of this post and we will look at the effect of a surging dollar on the U.S. economy, the world economy and what it means for investors.  Until then, have a great weekend.   

The Conundrum of McDonald's: We're NOT lovin it



Source: http://i.imgur.com/puZNbva.png

I remember the first time I ate a McDonald’s burger when I was a child back in the year 1999. It was not a pleasant experience to me at first, to say the least. I pondered why in the world people would eat this kind of thing. As time passed by, from one burger to another, the taste started to change and yeah I was loving it.My parents usually took me to a McDonald’s restaurant almost every weekend. The thing that was close to a burger in Cambodia at that time was the Cambodian Num Paing Pate (Cambodian-style meat in a French baguette), but it was no longer on my menu.

McDonald’s is the epitome of fast food extravaganza. I think it is safe to say that the first thing that pops up into your when you hear the word “fast food” or “American food” is McDonald’s. To understand how big McDonald’s is, let’s go through some numbers. McDonald’s chain restaurants serves 68 million hungry customers everyday. McDonald’s presence is ubiquitous,  operating in 119 countries with a total of 35,000 restaurants. The Economist, a British magazine, even uses the price of Big Mac in different countries to measure the exchange rate and inflation of different countries, known as the Big Mac Index. McDonald’s annual revenue for 2014 is 27.44 billion dollars with a net income of 4.76 billion dollars. To put the revenue of the Golden Arches into perspective, its annual is equal to the combined gross domestic product (GDP) of Cambodia and Lao.

The company grew rapidly in the past decade and as the party seems to never stop, it eventually did. 2014 was a bad year for the world’s biggest fast food restaurant. Revenue fell 7% to $6.57 billion in the fourth quarter, while net income fell 21% to to $1.09 billion, or $1.13 earning per share. The poor sale and stock performance have culminated in the sacking of ex-CEO Don Thompson. So what has gone so wrong for the once Golden McDonald’s?

1. The new trend of millennials demanding quality and healthy food: Some customers are willing to pay a little premium just to get a better quality food at Shake Shack, Five Guys, Panera Bread and Chipotle Mexican Grill. These restaurants have carved a niche of their own in the market called the “fast casual restaurants segment”. They apparently position themselves somewhere between the normal unhealthy fast food chains and full service restaurants. They differentiate themselves from the traditional fast food chains by putting more emphasis on healthy ingredients to appeal to health conscious consumer. For example, Chipotle Mexican Grill promises its customers that it will only use meat from animals raised without using hormones and antibiotics. Chipotle also removes GMO vegetables (Genetically Modified Organism) from its menu to show how dedicated the company is to quality and healthy food. McDonalds seems to be very slow in responding to this new trend. In 2014 McDonald’s was severely hit by a scandal in Asia because it was found that McDonald’s meat suppliers used expired meat.
2. Growing competition: The fast food market is heating with Burger King’s $1 dollar menu and other fast food restaurants with the likes of Wendy’s, In-and-out burger competing with McDonald’s at the low price point.
3. McDonald’s menu was getting bigger: Over the past few years, McDonald’s has tried to diversify its meals to include salads, oatmeal, McWrap, sophisticated coffee drink to appeal to a wide range of customers. While at a glance it’s a move to expand its market share, McDonald’s faces the risk of complicating the kitchen operation and thus slowing the service of delivering food. McDonald’s is popularly known for its speedy service and that quality is what customers expect from this giant fast food restaurant. It was found that the average waiting time at the drive through has increased gradually with the advent of a bloated menu items. However, it is not an easy decision for McDonald’s executives, whether to keep its diversified menu to appeal to a larger customer base or to simplify the menu to maintain speedy service.

   

    The Golden Arch has no one but itself to blame for not adapting to the new trend of what consumers demand. Its former recipe for success is now in the past and investors are eyeing on its turnaround plan amid several months of disappointing sale. Come to think of it, it has been about 6 months since I last ate a Big Mac and I found myself going to Chipotle for many times. I’m hungry now. Let’s have a happy meal.

Thanks for reading and have a great summer everyone.

The Rise of Obamacare

I’m back once again after a brief hiatus, since I devoted most of my time on reviewing for my final. Last time we talked about American health insurance industry and the need for a major reform due to the lemon problem that leads to market failure in the industry. If you haven’t read my previous article, I would highly recommend you to spend your time on reading it. Here is the link: http://econoobics.blogspot.com/2014/11/the-health-insurance-sector-asymmetric.html.

To remedy this market failure, the Obama’s administration enacted one of the most important piece of social policy legislation in American history in March 2010 known Patient Protection and Affordable Care Act (PPACA) or Affordable Care Act (ACA) in short. To simply understand the Affordable Care Act (ACA) A.K.A Obamacare, the legislation could be separated into three main parts. Dr. Aaron Carroll made an analogy between Obamacare and a table with three legs. Without further ado, let’s go through each of the three main parts.

http://www.freedomworks.org/content/obamacare-politicians-dreams-are-debased-slothful-governance

In the previous article I hope you still remember that the health insurance companies, in order to maximize its profit, would deny health insurance coverage enrollment if you are found out that you have any pre-existing condition due to the fact that you are more likely to get sick than other clients. Even if you are already insured by the insurance companies and constantly pay the premium to the insurance companies, chances are that you also could be denied payment of your medical cost in the event that you have any pre-existing condition but you purposefully or inadvertently conceal that information during your enrollment. Thus, to fix this broken health insurance sector, the Affordable Care Act (ACA) issues a mandate that prevents health insurance companies from discriminating health coverage against Americans with pre-existing conditions or denying medical payment to those with pre-existing conditions. What that means is that I will be able to claim my medical payment for the prior sickness that is not reported during the enrollment. In addition, young adult can stay covered by their parents’ health insurance plan until they are 26.

http://www.frontpagemag.com/2014/dgreenfield/va-switched-to-processing-obamacare-applications/

The first mandate is probably a bitter pill for the insurance companies to swallow because they would be in trouble if only sick people purchase health insurance coverage when they know that they would get ill soon and healthy people refuse to purchase health insurance until they are at the age of being vulnerable to sickness or know that they would get sick soon. It seems like Obamacare is hurting the insurance companies. Awesome as it may appear to American people, the insurance companies would not be foolish to enter this health insurance market given that there is a high chance of making a loss or possibly raise the premium of the health insurance. The question is how can the government make everyone buy a health insurance. Well, one way is to raise awareness that health insurance is a buffer against future financial hardship in hope that people will buy the insurance which takes longer. There is another way which is more immediate and the federal government has every rights to do so which is to force everyone to buy one. To remedy this situation which is unfavourable to the insurance companies, we come to the second leg of the table - the second mandate of the ACA known as the individual mandate. At the consumers side, the ACA mandated every Americans older than the age of 26 to purchase a health insurance coverage or otherwise face a penalty. You see, the aim of this individual mandate is that the insurance companies would be able to identify the distribution of risk (getting sick) of the American people when a large proportion of Americans buy the the health insurance due to a classic and beautiful statistical concept known as the law the large number. The large of large number simply states that the larger the sample is, the closer and closer the sample mean is to the population mean. From this distribution, the insurance companies can have enough information to charge a health insurance premium commensurate with the likelihood of a person getting sick. In addition to understanding the distribution of getting sick, the ACA also needs young and healthy people who are less prone to illness to help pay for the cost of people who get sick. But that does not mean that there is no point for the young and healthy people to buy the health insurance. You see, sickness and accident is not foreseeable and it does not necessarily mean that a young person never get sick. Thus, to prevent any future financial hardship as a result of a disease, it is wise for the young people to get the insurance. If this mandate can go as planned, the ACA will be able to solve the lemon problem that is a result of asymmetric information.

Last but not least, the ACA does not end here. What happen to those who can’t afford a health insurance plan? There certainly will be a group of people who are not able to afford the health insurance premium, as this may not surprise you since health care in America is very costly. To help those at the bottom of the pyramid so that they are also insured, the ACA also provides subsidy to those who can’t afford it. More specifically, you will be subsidized if your income is less than 400% of the federal poverty level (FPL). That is, subsidy will be provided if you make less than approximately $46,000 if you live alone or approximately $94,000 for a family of four according to Dr. Carroll’s Youtube’s video. You can see the information on the FPL in detail by going to this link: https://www.healthcare.gov/glossary/federal-poverty-level-FPL/. The Federal Poverty level in 2014 is $11,670 for individuals and $23,850 for a family of four.

Folks, those are the important parts of Obamacare: health insurance company mandate, individual mandate and subsidy. We would like to wish that the ACA will be a success but it seems like that not many people are happy with it especially the Republicans who is now controlling both the Congress and Senate. When a social policy is as huge as the ACA, it is almost impossible to avoid talking about politics. Obamacare is one example of how the government can intervene in the market and takes the matter into their own hands without relying on the invisible to do its job. The debate is still going on and we have to wait and see whether the ACA will achieve its goals. I hope to see you in the next article possibly related to efficiency and equity. Have a Merry Christmas and a delightful New Year! See you New York City and DC!  

I have learned a lot from Dr. Caroll and I added some of the information from him. You can view his video at: https://www.youtube.com/watch?v=wBr3fniyb4w

(This blog does not represent the view of any organization or institution)

The Health Insurance Sector: Asymmetric Information and The Lemon Problem

Source: http://www.cnn.com/2012/06/27/politics/btn-health-care/

Last time we talked about the disadvantage side of a universal health care. We also learned that the United States does not have a universal health coverage for American people unlike other industrialized countries. Today we will again focus on health economics and discuss some of the market failures of the American health insurance sector. Most of my arguments are inspired by Professor Gruber of MIT who is known as the architect of the new health reform in the U.S. You can find my reference at the end of the article and view his interesting lectures about the health insurance sector in America. I apologize for not preparing a standard reference of the articles that I cite. For simplicity I will show the link to the original articles so that you can use for future reference.

The World's Ranking of America's Health Care in the World

No doubt the United States is the most powerful nation on earth. Generally speaking, America loves to be number one. America is the number one largest economy in the world. America is number one when it comes to her total mighty military spending. America is number one in the movie industry, that is, the Hollywood movies generate billions of dollars at the box office. America also claims to be a leading country in promoting democracy and human rights in other countries. Well, the lists can go on and on. Despite having said that, when it comes to healthcare, America is nowhere near the number one spot in the world. That is according to the World Health Organization (WHO). Surprisingly, WHO ranked American healthcare system at number 37 in its 2000’s World Health Report. (http://www.who.int/whr/2000/en/). France’s health system was proudly ranked at number one. Another 2014 report of The Commonwealth Fund titled “Mirror, Mirror on the Wall, 2014 Update: How the U.S. Health Care System Compares Internationally” shows that American health system is ranked last among other 11 industrialized nations. You can find the latest report through this link. (http://www.commonwealthfund.org/~/media/files/publications/fund-report/2014/jun/1755_davis_mirror_mirror_2014.pdf)

Despite being on the number 37 spot in WHO’s world health system ranking and last in the latest 2014 The Commonwealth Fund’s report, as a matter of fact, Uncle Sam is spending a lot more on healthcare as a percentage of the GDP than any other industrialized countries in the United Europe. In fact, the U.S. spent 17.9% as a percentage of its GDP on healthcare in 2012, that is, almost 1 in 5 dollars in income is spent on the cost of health care.(http://data.worldbank.org/indicator/SH.XPD.TOTL.ZS) It leaves us perplexed to learn that the most powerful nation is not number one in healthcare or at least in the top ten list.

Source: http://www.lean.org/images/shook_hcchart.gif

The Rising Cost of Health Care

According to the U.S. Census Bureau, 48 million Americans did not have health insurance coverage in 2012. To put the number in context, 15.4% of Americans were uninsured, that is, about 2 in 10 Americans were not covered by health insurance. (http://www.census.gov/hhes/www/hlthins/data/incpovhlth/2012/highlights.html). As a result, overwhelming health care spending on tests and hospitalization has been a leading cause of personal bankruptcies and homelessness in America. That is at least according to the National Health Care for the Homeless Council (NHCHC). In 2008 NHCHC estimated that health problems were responsible for 50% of personal bankruptcies in America. (http://www.nationalhomeless.org/factsheets/health.html) It is indeed a very concerning data for the 48 million uninsured Americans.

The cost of health insurance has also surged gradually over the past decades. In fact, the 2014 Employer Health Benefits Survey conducted by the Kaiser Family Foundation and the Health Research & Education Trust (HRET) found that “the average annual premiums for employer-sponsored health insurance are $6,025 for single coverage and $16,834 for family coverage.” (http://kff.org/report-section/ehbs-2014-summary-of-findings/)

Imagine a person who earn $2,000 per month and could he pay this kind of health insurance premium? This is why it is crucial to have a job in America so that you can be covered by the health insurance. As health insurance is getting more expensive along with the growing cost of health service, more and more people are unable to buy a health insurance plan. Young and healthy people also hesitate to purchase health insurance given its cost and perceived benefits.

Market Failure of the Health Insurance Sector

A large proportion of Americans receive their health insurance plans paid by their employers which is one of the means to attract talented individuals to work for their companies. Although some people are able to afford a health insurance plan, it does not necessarily guarantee that your health insurance application will be approved by the insurance company. To be more specific, some people are not qualified for health insurance given their pre-existing conditions. In other words, say for example John (a make-up name) has been diagnosed with kidney problems. To insure himself against future health hazards, he decides to obtain a health insurance policy from an insurance company called XYZ. Imagine if you were the one who run the insurance company XYZ, would you provide health insurance to John who has kidney failure, although you somewhat know that John has a high chance of getting sick at anytime? The insurance company might be generous and it is willing to help their clients, because the clients and the companies should grow together. That sounds good right? Insurance companies, however, are undeniably profit-oriented and there is a high probability that they would make a loss in the future if they decide to cover John. So is that a good business decision? Unsurprisingly, that is one of the many reasons why many people dislike insurance companies and labeled them as bloodsuckers and immoral. But that is what businesses do and how they operate to minimize cost and maximize profit. Are their behaviours right or wrong? There is no clear cut answer here. The answer lies in the gray area.

In addition to those who are not approved to be covered by health insurance, there is another market failure identified by economists in the health insurance market, caused by asymmetric information or in other words, the situation in which someone holds more information than another person. In the health insurance market, the buyer of the health insurance more often than not understands more about his own body and health condition better than the insurance companies. To avoid paying high premium for his health insurance coverage, the buyer could obscure his real health condition. Let’s say prone-to-illness people would be more inclined to buy a health insurance than healthy and young people. Because of asymmetric information in this insurance product's transaction, the insurance companies risk making a loss due to covering the cost of the opportunistic and unhealthy people. The insurance companies, consequently, would mitigate such risks by raising the premiums of the health insurance coverage. This increase in health insurance premium would ensure that insurance companies can make a profit in light of these kinds of uncertainty. In turn, more healthy people would stop paying the health insurance premium due to its increased cost, which drives the insurance companies again to raise the premium. This vicious cycle is a market failure in the economy or what economists specifically call the Lemons Problem or the Market of Lemons. That is the reason why insurance companies may choose to deny coverage of the buyers with pre-existing condition or even refuse to renew the coverage if he is found seriously sick.

Source: http://insideops.com/wp-content/uploads/2014/06/used_car_lemon.png

There is another group of uninsured people. They certainly want to be insured in the case of any personal calamity, but the problem is they simply cannot afford to pay the health insurance premiums. They are the people who are living under the U.S. government’s poverty line. To be more specific, the poverty threshold in 2013 on average for a family of four is $23,834, according to the U.S. Census Bureau. (https://www.census.gov/hhes/www/poverty/data/threshld/)

The bottom line is that due to asymmetric information, health insurance premiums have gradually increase which make it not affordable for many American and cause healthy people to stop buying the insurance coverage. On top of that, insurance companies also deny health insurance coverage to those who have pre-existing conditions or stop renewing the health coverage once the policyholder get sick. That is why there are close to 50 million Americans who were living without health insurance in 2012. These are some of the problems to manifest the fact that there is a market failure in the health care system in the U.S. The explanations also justifies the role of the government to intervene in the healthcare insurance industry. So how would the government fix this problem? I planned to discuss Obamacare in this article, but it appears that this article is unexpectedly long already. For this reason, I decide to keep the discussion on Obamacare for the next article. Thanks for spending time reading this long article Stay warm everyone!

- The article is for educational purpose. (No copyright infringement intended)

- The article does not represent the view of any institution or organization.

You may also want to go to MIT's OpenCourseWare from which I learn a lot about American health insurance market.

Gruber, Jonathan. 14.01SC Principles of Microeconomics, Fall 2011. (MIT OpenCourseWare: Massachusetts Institute of Technology), http://ocw.mit.edu/courses/economics/14-01sc-principles-of-microeconomics-fall-2011 (Accessed 17 Nov, 2014). License: Creative Commons BY-NC-SA