This is very likely as today's inflation figure for February for China came in at 2.7%. M2 growth has been racing ahead at nearly 30% for several months while house prices are up over 10% year-on-year. Tellingly, food prices are up 6.2% and producer prices are 5.4%, both of which suggest that CPI is due to rise soon. Moreover, Chinese inflation follows the monetary aggregate of M2 fairly closely so double digit inflation is lurking unless policymakers get a handle on the liquidity issue. All of which points to why the talk in Beijing is de-pegging to the dollar. With all of the domestic drivers of inflation generating worry, removing the liquidity inflows from the exchange rate would be one step forward. This is why Beijing is likely to re-peg the RMB to a trade-weighted basket of currencies which was abandonned in mid 2008, but had been in place since July 2005 which saw the RMB appreciate by around 20% -- and lessening the corresponding liquidity pressures. It took markets by surprise then; it may repeat this shortly.

10 March 2010 Getting our money back from Northern Rock

Today's earnings suggest that it will be some time yet before we recoup the billions ploughed into Northern Rock as the bank posts its 3rd year of losses. That is unsurprising given the problems at Northern Rock that caused it to be nationalised.

The bank was split into two on January 1st into a "good bank" and a "bad bank" (Northern Rock Asset Management). The "good bank" holds the deposits and £10 billion of mortgages while the "bad bank" retains the poor quality stuff which dwarves the balance sheet of the good side, e.g., £50 billion in mortgages and £4.5 billion in unsecured loans. Having lost £2 billion since nationalisation two years ago (£1.3 billion in 2008), the reported loss for last year of £257.5 million is an improvement even if there was a one-off £445 million government rebate in 2009.

The earnings, though, may be artificial in that it has operated as a state-owned lender with an 100% government guarantee on deposits (which will now end in May) and issuance of new mortgages  only by the "good bank" with a clean balance sheet and thus at favourable rates since the bank is under less pressure to build margins as with a normal lender struggling with their balance sheet during an economic downturn. This is, though, what was intended by the separation and thus good news if that means that a buyer can be found for the "good bank" so that we can recoup at least some of our money. However, we are stuck with the "bad bank" likely for years and many will wonder why we are holding the poor quality stuff and selling the high quality loan book and deposits rather than keeping both in one bank.

Presumably, the government would say that the only way to get Northern Rock on its feet is to ring-fence the bad debts which can't be sold in any case, so we may as well sell what we can. It may be the only way of gaining the transparency necessary to privatise as no buyer will want a bank with such a loan book, which is why countries like Ireland have created a national "band bank" (see June 17th 2009 post). With lingering losses on the balance sheets such as at the part-nationalised RBS and Lloyds that feed the uncertainty of whether the impairments from toxic assets have peaked, some would say that this type of separation is precisely what is needed and worked in places like Sweden in the early 1990s.

These latest figures will make the sale easier, though the losses may be mild because of the government guarantees that have allowed Northern Rock to operate at an advantage in the banking sector, prompting the removal of the 100% guarantee in May, though the advantage of the implicit state backing is more important for lending in many respects as most deposits would fall under the new £50k deposit insurance scheme. Astute buyers may well question the viability of this bank; others may well want to enter the UK banking system by re-naming and buying up its northeast branches. What is clear is that we will be owners of Northern Rock Asset Management for years to come. It took the Swedish nearly a decade to see its bad banks turned around. We would be lucky if these 125% mortgages could regain value and not just end up in foreclosure and generating losses each year until the loan book is run down.

19 February 2010 The timing of cuts

It was once said by a British prime minister that if you put 20 economists in a room, then you'll get 40 opinions. At present, it's just 2 opinions but rather starkly different ones from some 80 economists in three open letters in national newspapers. The debate is over the timing of when the UK should cut its deficit -- this year as proposed by the Tories or next year as planned by the Government.

The issue is over whether delaying cuts until 2011 will increase the cost of borrowing on bond markets which will drag down recovery or if premature tightening this year will cause the economy to lapse back into recession as government spending is cut.

Interest rates on the benchmark 10 year gilts are only 4.2% which are low and roughly in line with current growth forecasts of 4%. Even if the forecasts are wrong, the real cost of borrowing is only around 2%, which means one year of an 1 percentage point differential. It isn't ideal but hardly damaging. 

The real issue is to have a credible, medium-term plan to cut the deficit once the recovery is underway. With Germany and Italy falling back into recession (see February 12th post), a double dip scenario is very possible given the record fall in consumption in January. Having just eeked out a recovery in December of 0.1% growth, it is hard to be that concerned about timing when even bond markets have said that they will wait until after the General Election in the middle of the year to decide on British credibility.

12 February 2010 Germany stagnates: start of the double dip?

The latest GDP figures show that Germany didn't grow in the 4th quarter of 2009. Having recovered in the 2nd quarter, its economy is now flat, which some will read as the "double dip" that we have been fearing. Italy's economy has actually "dipped," contracting by 0.2% while Spain is not yet out of recession, leaving only France of the big four euro zone economies (which account for around 3/4th of the single currency bloc GDP) to grow by 0.6%. Thus, the euro zone economy inched out just 0.1% growth in 2009Q4.

The "dip" 2 quarters later by Germany and Italy illustrates the danger of lapsing back into recession once the inventory cycle turns in a weak recovery. Indeed, the other major data release is the industrial output figure by Eurostat which shows a fall of 1.7% and an even worse 1.9% for the 27 EU countries whose GDP also rose by a mere 0.1%. Germany's industrial production fell by a large 2.6% whilst it remained flat for France which relies less on exports than Germany and more on domestic demand such that its growth in consumption has kept its economy up, while Germany's industrial output fell more dramatically than France (-7.4% versus -2.9% annual decline) due to its exposure to global trade which fell by 10% last year -- the first such contraction since WWII. France has kept up its government spending as well, such as keeping its car scrappage scheme in place, which could help explain its consumption growth.

So, having a quarter or two of industrial production could just reflect the re-stocking phenonmenon that will recede if there is no consumption to outweigh the turn of the inventory cycle -- either government or private. For those excited about the growth in industrial output in the UK in the last quarter should beware. True, industry is a smaller share of GDP in Britain than Germany, but the pattern of weak consumer demand (January retail sales were low), withdrawal of government stimulus (end of VAT cut, car scrappage scheme, end of stamp duty holiday on some houses) and that Britain still has de-leveraging of household debt (at least the Germans save), the turn of the inventory cycle could spell a double dip. In any case, the euro zone and the EU appear to be trundling along the bottom in this recovery, much as Bank of England Governor Mervyn King described the UK economy just yesterday.

10 February 2010 Say Greece defaults...

When Greece defaulted on its sovereign debt in 1987, it was bailed out by the EU. It bore its own consequences. But, if Greece were to default now -- despite the relative small amounts involved (51 billion euros), then it would jeopardise the structure of the euro and set off a domino effect in other debt-laden euro zone nations. As tempting as it would be to let Greece fail, the contagion could affect 1/4th of the euro area economies and all would suffer rising bond yields and therefore a higher cost of borrowing.

I suspect the most immediate aftermath will be even greater differentiation within the euro area economies such that Greece and countries like Portugal, Ireland, Spain and even Italy will not enjoy the low interest rates of the past derived from the euro, evident in rising bond yield spreads -- yet those are still buttressed by the implicit backing of the single currency. Another consequence would be rising resentment particularly from the Germans that prudent countries are forced to bail-out profligate ones, precisely the type of gaming the "Growth and Stability Pact" was designed to avoid. Politically, resentment often turns into punishment and even more hints of instability as wrangling continues over the conditions of the bail-out which looks to be in the works for Greece.

Letting in Greece suited the aim of expanding the monetary union and reducing the border and exchange rate frictions that impeded the functioning of the single market. Once in, though, countries lose control over their monetary and exchange rate policies, leaving fiscal policy and real productivity growth as the mainstay of the economy. And the euro hasn't disappointed even throughout the crisis, maintaining its stability in the face of extraordinary circumstances. Up until the Great Recession, the low interest rate and inflation regime created a much more benign policy environment than the previous monetary regimes in Europe. Unfortunately, the very worry that some nations will take advantage of that rather than promote their productivity has crystallized. Once in, the exit would be traumatic. Worse though is the market view that the euro is not as stable as its 11 year history had suggested thus far. The last thing the euro area needs is higher borrowing costs with even the Germans breaching the Maastricht Treaty rule of the budget deficit not breaching 3% of GDP.

4 February 2010 What are the implications of a weak currency?

The latest episode of rising U.S.-China tensions centres on the valuation of the RMB and inadequate market access in China. China's retort is as expected -- they claim that no revaluation is going to sort out America's economic problems. Selling more to China might... so the two issues are interconnected.

A cheap currency makes imports more expensive, which is one of the reasons why export growth (stronger with a weak currency) is traded-off against the standard of living (lower when disposable income is depressed by more costly imported goods and services). It makes foreign firms less competitive as their goods and services are priced higher than otherwise. It is another form of blocking market access but in a non-tariff sort of way.

The downsides also include making imported inputs (energy, commodities, intermediate products) more costly, driving up the cost of production. Of course, the upside is that exports are priced competitively. This implies that exporters are supported at the expense of non-exporting firms and households.

Every country is looking to exports to aid their recovery as domestic consumption is likely to be weak in the West and emerging economies have long relied on a model of openness to drive growth. And, China is the fastest growing major economy in the world. But, it too is oriented toward exports. This can work -- all countries aiming for exports -- if trade remains open on the import-side. If both exports and imports grow, then the net trade position of countries can be roughly equal but still benefitting from the efficiency gains from specialisation and scale associated with trade. Imported goods boosted its industrial upgrading and can bolster its consumption to help it achieve its stated goal of re-balancing. China grew at over 10% per annum with a balanced net trade position before 2005. It can do so again.

1 February 2010 Global problems, local bail-outs

This is one of the reasons why there has to be global regulation of banks. Larry Summers might be right in saying that the universal bank model of Europe can co-exist with a return to a form of Glass-Steagall in America that divides banks into retail and investment ones, but I do wonder if an American bank acts recklessly as an universal bank in Europe, then wouldn't the bail-out still come from Amercain tax dollars?

Although there is no agreement in sight, there is now a slew of regulatory proposals.

Global levy on banks: This is gaining favour among bankers for them to pay a levy into a fund that will cover the cost of bail-outs. Accepting that moral hazard exists for the banking sector which is special and thus will be bailed-out, the banks would opt to pay for their own failure. Under this model, presumably they could operate as they have currently and generate large revenues and bonuses. A self-insurance fund seems to be a good idea -- being similar to FDIC which is deposit insurance funded by banks -- but is it enough? How large would this fund have to be to cope with the systemic banking failure nearly countenanced with the collapse of Lehman Brothers and all of the counter-parties?

Limit on bank size/ban on proprietary trading: This is the Obama proposal that answers the question of "Whether banks that are too big to fail are just too big?" The ban on proprietary trading, including ownership of hedge funds/private equity firms, is referred to as "Glass-Steagall lite" for separating the "casino" element of banking from retail banks and those which can draw on the Fed's discount window. Despite protestations from banks that the line is hard to draw between own and client trading, this would address moral hazard to some extent. The question is whether it would have covered Lehman and Bear Stearns. Those broker-dealers were systematically important banks because of proprietary trading that dragged their creditors down with them, along with other problems which again points to the need for better regulation in other respects such as derivative trading. Or, would "living wills" have been able to prevent these banks from destabilising the system, as they otherwise did not jeopardise a great deal of deposits? In the UK, building societies and former ones like Northern Rock are referred to as examples as why size isn't the issue. But, with better and clear global rules for deposit insurance, would these small and non-systematically important banks have been bailed out?

Tax on bonuses/levy to recoup bail-out funds: These British/French and American measures are popular with the populace, but haven't prevented large bonuses or fundamentally addressed the moral hazard issue. Banks pay them but simply squeeze shareholder value to maintain performance bonuses.

Higher global capital/liquidity requirements: These are the proposals put forth by the Financial Stability Board charged by the G20 to come up with international financial rules. My January 12th post outlines these measures. This will reduce risk-taking through counter-cyclical capital requirements and have been worked through with banks. But, these measures had not yet dealt with systematically important banks and financial institutions and the FSB has been eclipsed by the Americans on the issue, causing furore among bankers. More capital and liquidity will help, but are these adequate to forestall leverage that expands balance sheets? There has been discussion of using a leverage ratio ceiling as a way of countering asset bubbles, including by Lord Turner of the UK FSA. But, is it possible to fashion global rules about local asset markets when emerging economies and advanced ones are at such different stages of development?

The debate has now moved to fundamental questions which is welcome. Wherever we end up, I doubt that we will return to the days when banking is just about deposit-taking and lending without leverage, but it does appear that banks are unlikely to return to the heady days of the 1980s anytime soon. I'm curious to see if Wall Street II will again tout that "greed is good" or if it will be about being "socially useful."

26 January 2010 Britain has exited recession but the picture looks flat

It's undoubtedly good news that after 18 months of the longest recession since WWII, the economy has stopped contracting. Looking at the ONS estimates, a more accurate descriptor than saying economy grew might be that activity was essentially flat. But, that's better than shrinking. 2009Q4 recorded a 0.1% increase from the previous quarter. The growth comes from a 0.1% percentage point contribution in the service sector of distribution, hotels and restaurants with a smaller boost from government spending. Most sectors, though, e.g., construction, business services, etc. look flat. Compared with a year ago, the economy is 3.2% smaller and it shrank by 6.1% from peak-to-trough, making it the worst recession in the post-war period as well. It makes one wonder that if people hadn't splurged over the holidays whether we would be out of recession.

Nevertheless, the two main indices of production and services both recorded small quarterly increases (0.1% each). As services is the largest part of the economy, this is particularly a promising sign. Difficult credit markets (the banking sector contracted) coupled with households continuing to shed debt never boded well for a recovery "bounce." For better or worse, real estate is picking up so it looks like the ever-unpredictable housing market is on the road to recovery.

19 January 2010 Why the latest UK inflation figures aren't a source of worry (yet)

CPI rose from 1.9% in November to 2.9% in the latest figures for December, just a hair's breadth away from breaching 3% and prompting a letter from Mervyn King to the Chancellor. The RPI registered an even more impressive jump to 2.4% from an annual rate of 0.3% in November and reverting to pre-recessionary levels last recorded in November 2008.

Worried? Well, don't be... yet. The November-December monthly increase of 0.6%, the ONS hastened to point out, is typical (same as in 2006 and 2007 and not 2008 where CPI fell by a record 0.4% in the depth of the recession). The increase is because of the extraordinary measures taken last December against which this figure is based. The VAT cut of 17.5% to 15%, falling energy prices and pre-Christmas sales in the recession meant that prices dropped last December. This year, no comparable cut in VAT and rising energy prices in sight of a global recovery mean that inflation shot up from a low base. The picture is even more dramatic for RPI which includes mortgate interest payments and housing depreciation too. Having been negative for most of the year until November, it has risen more steeply than CPI because of housing costs. The cut in interest rates and falling house prices of last December have had no comparable fall in mortgage interest payments and insurance costs have risen.

There is no cause for concern yet, as the much critiqued small VAT cut responsible for this jump in prices may not have been large enough to please those who wanted a stimulus measure, it did hold down inflation during the recession. Also, for those worried about more Quantitative Easing (with serious inflationary consequences as QE increases the monetary base) once the programme runs out next month, they will feel reassured that inflation will  likely tie the Bank of England's hands. Sterling's rally on this news goes to this view. And, the Bank of England saw this coming. They warned about energy prices pushing up inflation (oil prices have steadily risen this year) but see inflation coming down in mid 2010 even if the economy is in recovery mode because of the size of the output gap (the difference between potential and actual output) due to the depth of the recession. Cheap Sterling, higher imported goods/energy prices and an anemic recovery (that is, if figures out this month say that we exited in the fourth quarter of 2009) all point to inflation not looming on the horizon. However, for those very same reasons, inflation is likely to be volatile. Letters may need to be written, but the Bank will hope that these figures don't affect inflation expectations, e.g., all of us asking for higher pay rises with the recovery. Then, it will be a cause for worry.

16 January 2010 How to assess the business environment in China

The recent furore over Google's position in China raises questions beyond this particular case. The business environment in China has loosened a great deal in the 2000s, particularly with China's accession to the World Trade Organisation (WTO) in December 2001 when it agreed to a number of market opening measures. At the same time, China completed the large-scale restructuring of its state-owned sector in the 9th Five Year Plan that ended in 2000. This meant the downsizing of state-owned enterprises, significant reform of the labour market and granting status to private firms, all pointing to a significant degree of marketisation. With the large-scale restructuring that had taken place, China had the set-up of a corporate sector which needed governance, i.e., laws and regulation. The 2000s witnessed a slew of both (first ever M&A and Anti-Monopoly laws; rules improving corporate governance and setting up a futures and NASDAQ-type bourses). These facially neutral laws tend to exempt state-owned firms but for the most part apply similarly to domestic and foreign frms. This type of non-discriminatory and transparent rules are part of the WTO principles.

"Laws on the books" do not equate to effective rule of law, particularly when the judiciary is not independent of the ruling Party. Policy in China remains unwaveringly geared at economic growth. China may be a major economy (3rd largest in the world and the largest trader), but its per capita GDP is only around $3000, less than one-tenth of that of the U.S., and ranking it 105th in the world. Having a political motivation, however, further raises doubts over the willingness to develop an effective legal system if it might run counter to the goal of growth. China, moreover, recognises the challenges of continued economic development and the possibility that foreign multinationals overwhelm indigenous firms. This is most acute in the area of technology, but tensions are also evident in commodities and energy as China feels the insecurity of being a net importer of the inputs that it needs to industrialise.

These tensions have always existed but are made worse in the 2000s when the better developed legal system is expected to deliver. The strictures placed on foreign firms in China are unlikely to ease completely in the near term, but the otherwise seeming objective laws in place will make many who take those at face value bridle against the constraints. Google may not  leave China, but it may be a harbinger of things to come.

12 January 2010 The steepening U.S. yield curve

Yesterday witnessed the widest ever yield gap between short-dated (2 year) and long-dated (10 year) U.S. Treasuries at 290 basis points. The steepening of the yield curve normally suggests that inflation and recovery are on the horizon, but the Quantitative Easing programme and the reserve currency role of the dollar create uncertainty that is remnescient of the difficulty of reading the flattened yield curve prior to the global financial crisis. Record low interest rates are deperssing the short-end of the curve rather than inflation pushing up the long-end. However, when QE is reversed, the continual flow of bonds issued in the trillions over the next few years to finance the fiscal deficit will not have a large government purchaser and should push up yields unless central banks retain their appetite for Treasuries. It is likely since the dollar will not lose its place as the reserve currency imminently so the surplus countries will continue to buy, though the immense scale of the U.S. national debt (totalling $18 trillion over the next decade) may outweigh those purchases and yields will rise. Inflation -- commodities and energy -- could do that sooner. In any case, QE won't be reversed until the recovery is underway, so however the yield curve is being read, it still points to recovery however tepid with the December job data showing that 1 in 4 unemployed persons are now long-term unemployed and numerous others have exited the job market as discourged workers even as the unemployment rate stands at 10%.

12 January 2010 New global financial regulations

Very interesting sets of rules being proposed by the Financial Stability Board in the BIS meetings which include limiting bonuses and dividends to safeguard a higher level of capital and contingent capital requirements that are also counter-cyclical. The "through-the-cycle" provisioning for accounting could be more sensible than the current mark-to-market, depending on how those become formulated at the end of March. The new global liquidity requirements as well as higher overall capital requirements will likely mean more purchases of government bonds and reduce reliance on wholesale money markets. All of this is likely to reduce risk and therefore profits of banks, but may well make the sector less prone to excessive cycles.

However, the yet-to-be formulated rules concerning systemically important banks are arguably the most important as this is the core of the contagion seen in this global financial crisis. A capital/liquidity surcharge is likely, but will they adopt "living wills" or more drastic measures of separating retail from investment banks at the end of March? Or do the regulators believe that the higher and counter-cyclical capital requirements are enough.

Of course, President Obama is already contemplating such a surcharge to be announced in the budget in February to get back the TARP funds, while the UK tax on bonuses is already in place and being contemplated in France and there continues to be talk of a Tobin tax on transactions. I suspect that it is unlikely that any regulation can change the implicit guarantee of the banking system which means that a surcharge that becomes the insurance/bail-out fund may well be the way to have the banking system pay for this guarantee rather than the taxpayer. It may even be more palatable than a transaction or bonus tax.

11 January 2010 China to allow short-selling and exchange-traded funds

China is pressing ahead with financial sector development, much as it has over the past decade but will proceed cautiously with permitting short-selling and exchange-traded funds in 3 months. A significant concern of investors will rightly be whether there will be a sufficiently robust regulatory framework to govern financial innovation. China's under-developed legal system isn't going to improve rapidly, but the regulator (the CSRC or China Securities Regulatory Commission) has quickly implemented a slew of regulations in the 2000s in response to earlier failings of the stock exchanges such as ineffective protection of minority shareholder rights and poor corporate governance. If this trend continues and the regulators prove to be more responsive to capital market developments, then the overall weakness in the legal system need not significantly impede the development of the financial sector though certainly contract security will undoubtedly remain a concern in an economy where the rule of law is not only incomplete but only granted legal protection to private property in 2007. The lack of diversification of investments plus a very under-developed capital market have hampered the efficient allocation of resources, so China does need to develop depth in its financial sector. Nevertheless, with the lessons learned from the global financial crisis, it would do well to move gradually with an eye toward the numerous global rules that are currently being formulated by the BIS, FSB and others. 

10 January 2010 Is China the next bubble economy?

In a word, no, but it may well be headed for serious inflation. China's growth at an estimated 8.3% last year, remarkable in the midst of a global recession, was achieved through a large fiscal stimulus and loose monetray policy. The fiscal stimulus was mostly funded by state-owned banks, which unleashed over 1/3rd of GDP in credit to finance around of of the $700 billion spending programme (including the later announced $125 billion on health and around $400 million on rural pensions). By using the state-owned banks instead of issuing government bonds, the control over the spending is even worse than other economies and thus the explosion of financing relative to the spending need.

The result is M2 growth of nearly 30% at the end of 2009 but no inflation which meant that the liquidity went into assets, e.g., stock market is up and house prices are growing. Monetary policy is tied to the ultra-low (0%) U.S. interest rate through the fixed exchange rate that was re-pegged to the dollar during the financial crisis. This means that inflation is likely to be on the horizon as inflation has just returned after 9 months of deflation.

The excess credit has led to worries of waste and inefficiency, which are probably right. But, real economy indicators like industrial output, employment creation and infrastructure development point to solid output gains. Employment of laid-off rural-urban migrants is particularly impressive. Though some of the 20 million estimated to have lost their jobs with the collapse of exports are under-employed or surplus particularly in agriculture, the road, rail and other public works have absorbed them into comparable low-skill jobs.

China's growth is undoubtedly funded by public spending, making up for the decline of external markets. The scale of the stimulus suggests that inflation will return and can cause severe volatility especially if the currency remains pegged to a weak dollar and commodity prices soar. Hints are already seen in emerging asset bubbles. Nevertheless, the outcome of the spending looks solid enough. China may have bubbles in its economy but the job creation and industrial gains do not suggest that it is a bubble economy driven by inflated asset prices and unwarranted expectations. The age-old culprit of inflation is a more likely candidate.

7 January 2010 Signs of tightening?

China caused a stir in markets today by increasing the yield on 3 month bills by 4 basis points,(just 0.04%) while the Bank of England surprised no one when it held interest rates at 0.5% and announced no change in the QE programme. The ECB also recently left rates at 1% and wouldn't be drawn on whether it would extend the 12 month fixed rate liquidity measures beyond the spring.

Everyone expects there to be tightening of both monetary and fiscal policies but the timing remains the tough call. In China's case, it is wary of inflation since it funded its fiscal stimulus through credit from the state-owned banking system. But, it wants to continue its government spending programme in 2010 due to concerns about slowing growth in a weak global environment. Thus, small measures like raising interest rates on government bills may drain liquidity sufficiently that it doesn't have to raise the base rate or reserve requirements.

For the ECB, the weak growth forecasts of just 0.8% in 2010 and 1.2% in 2011 point to the possibility of a "double dip" recession. Private lending remains down and falling industrial orders in the latest data for November along with a strong euro (France's Christine Lagarde called it over-valued today) highlight strong downside risks which led to it taking an accommodative stance.

In the UK (still in recession at least until we see the 4th quarter of 2008 GDP figure in a couple of weeks), fiscal tightening is also being hotly debated no less because there is an upcoming General Election. For the Bank of England, the lack of fiscal tightening until then puts more pressure on inflation though there is not (yet) the main concern. Being the last major economy still in recession and tight credit conditions remain paramount.

21 December 2009 Difficult 2010 for the UK economy

The CBI released their forecast for 2010 and 2011 today calling an end of the recession by the end of the year. Their forecasted growth rates for 2010 are similar to the government's (1.2% in 2010 versus 1.25% in the Pre-Budget Report) but more modest in 2011 (2.5% versus 3.5% in the PBR). Many believe that this recovery (when it comes) will be fragile and weak. The main reason is the lack of a strong driver of growth. Consumption will be dampened by the process of de-leveraging in the UK while exports will also be weak in the next year as U.S. consumers (the main source of global demand) also shed debt. The credit crunch & banks sorting out their spreadsheets will affect investment, stifling businesses which will be evident when the inventory cycle turns. Finally, government spending will continue to grow by 2.2% in real terms next year, but that is a weak engine and one characterised by growing public debt that will need to be serviced. That could lead to higher interest rates, especially when coupled with rising energy prices -- together implying a reduction in disposable income which will not help private demand further reducing the incentive for firms to invest.

The CBI represents firms that employ around 1/3rd of the private sector labour force, so when they predict that there will be wage cuts in the spring of 2010, we should listen. They also predict that unemployment will increase until toward the end of 2010 when it will peak at 2.8 million out of work. Reluctance to hire and possibly more firing if the outlook for growth is weaker than before the recession could result in rising unemployment even if the economy stops contracting. Unemployment has risen less than in previous recessions, but this could be due to more people becoming under-employed. More people in part--time work reflects a reluctance to hire and if extended could mean firing by firms who view the weak recovery as slower expected sales in the next few years. Given the greater number of people in part-time work whose positions are more precarious than permanent employees, how the economic forecast affects sales projections and how firms assess credit conditions will determine whether unemployment remains as muted as it currently seems.

Another reason for why the pace of unemployment has unexpected slowed is that the recession could have ended in the 3rd quarter. If the economy had stopped contracting between July-September, then the lagging nature of unemployment will show a declining pace of joblessness in the 4th quarter. The official ONS figures out tomorrow will reveal how much 3rd quarter GDP has been revised. If there isn't a significant upward revision from -0.3%, just keep in mind that they will continue to revise the figure over the coming months as more data becomes available, particularly in the spring when income tax information can be used. In any case, the larger picture isn't the small changes around whether GDP growth is slightly below or above 0% but the economic health of the coming year which looks tough.

14 December 2009 What characterises the 2000s?

Having recorded several interviews looking back at the decade and the past year (to be broadcast on CNN & CNBC over the holidays), there have been a number of fundamental developments in the 2000s but it was difficult to identify a theme like the 1980s and the rise of Wall Street and the age of greed or the 1990s and the technology revolution. For me, the 2000s belongs to the changed structure of the global economy. It is when emerging economies like China fundamentally transformed the world economy.

Starting in the 1990s and accelerating in the 2000s, emerging economies like China, India and Eastern Europe integrated into the world, e.g., China joining the WTO in 2001, India turning outward, EU expansion in 2004 and 2007 to nearly doubling its members by adding 10 countries from emerging Europe. The consequences of this structural transformation are mani-fold, including deflationary pressures on goods and services which contributed to the "Great Moderation" of a mild business cycle, but also of global imbalances which led to capital flowing from poor to rich economies resulting in excess liquidity. With cheaper imports and a credit boom, Western consumers (and governments and firms) borrowed to consume. 

As with the 1980s Wall Street crash in 1989 that led to a recession in the early 1990s and the tech bubble that burst at the end of that decade which was marked by an economic slowdown in 2000, the 2000s ended with a financial crisis and recession. As with the previous crashes and recessions, the reasons are complex but inter-related. Some would argue that this recession and crisis was more fundamental as we nearly had a repeat of the Great Depression and systemic banking failure. I would also look at the real economy worldwide and say that the world has changed in the 2000s. And, the 2010s will continue to be characterised by a fundamental shift in the global economic structure of production and consumption -- characterised by the growth of emerging economies entering the global "middle class" -- and any future policymaking must take the consequences into account.

10 December 2009 Market reaction to Britain's fiscal deficit reduction plan

A day later, the markets were muted despite headlines generally reflecting dissatisfaction with Britain's PBR particularly in terms of the lack of detail surrounding some 40% of the tightening needed to halve the deficit in 4 years. (A glance at the blogs and opinion pieces at the FT would give a flavour). This estimate of 40% comes from the Institute for Fiscal Studies, the respected think tank, in their annual post-PBR assessment.

The IFS also says that the amount of tightening needed is less than thought because the structural deficit (the portion of the deficit that is not tied to the ups and downs of the business cycle) is less than previously estimated. The PBR believes it is 5.2% of national income instead of 6.4%. Therefore, to close this gap by 2017/18, it implies that £76 billion per year will need to be cut instead of £90 billion. To halve the deficit now requires annual tightening of £38 billion instead of £45 billion each year until 2013/14. The recession was deeper than expected (4.75% contraction this year instead of the 3.5% anticipated in the Budget in April), but the assumption made that the value of our houses and financial wealth will be permanently less as a result of the crisis has been sonewhat upgraded. Therefore, the gap that remains after the economy has recovered is smaller.

This makes it more likely that the measures announced yesterday can be met, though again, the IFS estimates that we are missing information on 40% of the necessary spending cuts/tax rises to achieve that goal, so it is not simple to assess the credibility of the plan.

With a General Election coming up, it was unlikely that the government would be that specific and hand ammunition to the Opposition. One can hear the slogan already: Labour plans to cut your public services by 19% in the next 3 years (this was the figure that IFS calculated would result based on the PBR). They made this decision months ago when they decided not to undertake the Comprehensive Spending Review until next year and cited the uncertain economic outlook. Perhaps luckily, markets didn't expect any different.

9 December 2009 Pre-Budget Report: Is it enough to reassure credit markets?

The Chancellor needed to halve the deficit as a share of GDP in 4 years to reassure jittery credit markets that there is a plan to reduce the national debt. The first thing to note is the timing. No consolidation will happen until 2011 so it is really to halve the deficit in 3 years, implying the real pain will come after next year. The economic rationale is to not jeopardise the recovery, but the Conservatives would argue that it is political for the tightening measures to come into effect largely after the next General Election.

So, to halve the deficit means tightening of around £45 billion per year until 2013/14. Since the measures largely won't come in until 2011, this implies that most of the spending cuts/tax rises will be squeezed into 2011-2013. How close does the PBR come to reaching that figure?

In terms of taxes to fund the gap, the largest sources of revenue are unsurprisingly the broad-based ones. Allowing the temporary cut in VAT to lapse as planned by January 1st will bring in £11 billion per year and the increase in National Insurance by 0.5% (except on those earning less than £20,000) will generate another £3 billion per year. The eye catching new tax of 50% on banker bonuses will bring in £500 million -- though that will happen in this tax year, it is a one-off. Freezing the inheritance tax allowance until 2011 and the threshold for paying the top rate of tax of 40% in 2012 will also bring in revenue if inflation and house prices increase through "fiscal drag" where more people are pushed into paying inheritance tax and the higer rate. The temporary stamp duty holiday will also expire. Thus, if the aim was to close 20-25% of the gap by taxes, then the VAT reversion and NI increases would largely achieve that aim.

In terms of spending cuts which was to constitute the bulk of the fiscal consolidation, these are more amorphous. Some wage restraint and efficiency measures were announced. Public sector pay will be capped at 1% for 2 years from 2011, which will likely result in cuts in real wages once inflation picks up and generate £3.5 billion in savings per year. And, limits to public pension contributions will bring in £1 billion each year and efficiency savings is to generate another £12 billion each year. These aren't enough, so cuts to spending programmes will also be needed. The Chancellor said that he will wait for the Comprehensive Spending Review to specify where the spending cuts will fall. But, he will protect front line services (schools, hospitals, and police). In current terms, spending will increase by £31 billion (2.2% real growth) in 2010/11 and then by 0.8% until 2014/15 (around £7 billion per year). If certain budgets are protected, then this implies significant cuts in other public services especially after debt interest payments and benefits are taken into account. However, only £5 billion per year in spending cuts was specified in the PBR. This is where the numbers don't add up very well and could cause markets to be dissatisfied.

It is a broadly fiscally neutral budget. So, spending on green investment, promoting industry (rather than financial services) and helping the jobless are funded from cuts elsewhere. These are relatively small but laudable measures geared at supporting the unemployed (those under 24 and over 50), promoting R&D in high tech industries, financing for small and medium-sized enterprises, investing in a low carbon economy (boiler scrappage scheme and electric car tax holidays), but again raises the question as to which funding will be re-allocated.

Finally, the growth forecasts of 1-1.5% in 2010 and then above-trend at 3.5% thereafter will need to be right as well. These are broadly in line with independent forecasts, but sustaining above-trend growth after the initial blip from recovery is less likely, making the projected deficit reduction to 2013/14 look less certain.

If markets were looking for the kind of declarative statement to manage the budget deficit, then they will be disappointed. But, with a General Election around the corner, even the credit agencies recognized early on that a serious fiscal consolidation plan wouldn't be presented until after mid 2010. Nevertheless, the PBR had relatively few giveaway with just a few months to go which is reassuring, though the reduction in bingo duty from 25% to 20% may win the Government some votes.

8 December 2009 What works to bring down national debt?

The OECD report on lessons from successful fiscal consolidation provides a few pointers as to how countries have managed to bring down their deficits. Most countries have done so by a combination of public spending cuts (80%) and tax rises (20%). The Chancellor in tomorrow's PBR is thought to be following a similar route of 75% in cuts and 25% in tax increases to close the gap. To halve the deficit in 4 years by 2013/14 implies £45 billion per year consolidation, so roughly £34 billion in cuts in spending and £11 billion in taxes. This would reduce the deficit to around 6% of GDP, which is still twice the level under the Maastricht Treaty which guides the fiscal policies of the EU. In fact, the European Commission has given the UK until 2014/15 to bring the deficit down to 3% of GDP.

To achieve this, £12 billion in efficiency savings have been proposed across government. It is very difficult to assess when such savings have been achieved, but the OECD study suggests that slashing departmental budgets has been effective in countries such as in Sweden and Canada during the 1990s, particularly as it establishes the credibility of the fiscal consolidation plan. Importantly, in Canada, it did not affect the quality of public services, but rather shrank the size of government by 9.5 percentage points of GDP between 1992 and 1999. It implies that the choices or quality of government spending matters more than the size of the state, e.g., preserving necessary investment and delivery of front-line services but also imposing budgetary cuts. Wage restraint, such as has been proposed in the £100 million to be saved each year by curbing public sector pay by 20%, was also adopted. But, Canada still has one of the highest national debt-to-GDP ratios in the OECD, as compared with Sweden and Finland whose fiscal positions have improved but with a mixed record on public services.

On tax rises, it epitomises the difficulty of imposing fiscal austerity during a yet-to-come recovery. Increasing taxes too soon will certainly choke off private consumption which will mean a return to recession with the fall in public spending at the end of stimulus measures such as the temporary cut in VAT. Yet, tax increases are likely to form part of any fiscal package given that half of the increase in the deficit is from interest payments and entitlements, so that cutting departmental budgets and asset sales will already take the burden of cuts.

Economic growth will help to reduce the deficit, but a realistic growth rate has to be given so that markets (lenders) can assess the sustainability of the UK's debt. The sustainable debt rule is (r-g)(D/Y)=(P/Y), where r is the real interest rate, g is the growth rate of the economy, D/Y is debt-to-GDP and P/Y is the primary surplus relative to GDP minus debt interest payments. At present, the gilt market for government debt is requiring less than 4% nominal interest rate for sales of 10 year bonds. With inflation at less than 2%, the real interest rate is low by historical standards. If growth returns to trend after 2010, reverting to 2-2.5% thereafter will make for a more sustainable rate of increase in the debt so long as the cost of borrowing remains low.  But, if the forecasts are optimistic, the fiscal plan is not credible in specifying the extent of consolidation or the fall in tax receipts due to a loss in output from the financial sector is not taken into account, then the debt burden may be seen as not sustainable and bond markets will require higher rates that will increase the cost of borrowing in the economy and stifle growth for years to come. In other words, the government has to get this right tomorrow -- though the General Election in the spring will throw up its own uncertainties, which means that there may be a second bite at the apple in any case.

1 December 2009 Sovereign debt risk

If Britain loses its AAA rating on its debt, is that as significant as a debt standstill for Dubai? The answer shoudl be 'no' since a number of European countries have already lost their AAA rating on sovereign debt but that does not mean that they are about to default. For smaller countries like the UAE (GDP of $260 billion) whose federation includes Dubai, Dubai's debt of $80 billion exceeds its own GDP and cannot be serviced which means that it is on the brink of default unless creditors agree new terms (which is usually a technical default in the view of credit agencies). For the UK and others (Ireland, Spain), losing the top debt rating just means higher debt servicing costs, i.e., higher interest rates are required to attract purchases of government debt.

Morgan Stanley in a report has warned about the possibility of a UK debt crisis in the event of a hung Parliament where the lack of a clear plan to reduce the public debt in those uncertain circumstances could lead to a loss of its AAA rating. However, the likely implication there is not of default but an increase in interest rates on gilts, say from 3.65% to 5%. This could cause a double dip recession if the higher costs of borrowing stymies the recovery. But, this is a far cry from needing a bail-out. This does not mean that a credible plan to bring the debt down is not needed; but rather the reality that high interest rates and slow growth may well ensue. In any case, Dubai's debt can be rolled over by the IMF which is charged to help countries with liquidity crises. Tens of billions for Dubai can be obtained from the IMF's coffers (they recently asked for more money to do just that). But, if Britain's £1.5 trillion economy needed a bail-out, then that is a whole other kettle of (unaffordable) fish.

24 November 2009 Gold and the 1970s

As gold is now around $1,170 per ounce, some are asking whether this is a repeat of the 1970s when gold hit $850 (or around $2,200 in today's money) in 1980. What they share in common is a concern about inflation which led to a gold rally. However, unlike the 1970s, although rising oil prices are driving up the overall price level at present, there aren't the strongly inflationary, supply-side "shocks" from oil prices which was a hallmark of that decade. Instead, most of the inflationary concerns are due to the stimulative policies and bail-outs of banks. As a consequence, the management of inflation is more in the hands of economic policymakers than when it was driven by the "shocks" of rising oil prices from the Middle East.

Also, unlike the 1970s, debt-deflation is now receding but is a hallmark of this recession rather than the stagflation (falling output, rising prices) then. Oil prices are rising now because of the recovery which may choke it off but is not the cause of inflationary expectations. In other words, it is normal for commodity prices to rise as a result of the recovery whereas it was pretty abnormal to have rising energy costs during a recession. Now, how central banks manage inflation in the medium-term when the large amounts of public borrowing and loose monetary policies have to be addressed will determine whether it will be a significant concern and therefore whether gold prices continue to rise.

3 November 2009 Another round of funding for British banks: is this the end?

The Treasury today announced plans to inject another £25.5 billion into RBS plus another £8 billion if circumstances worsen, taking the public ownership share from 70% to 84%. Unlike RBS which is also entering the Government Asset Protection Scheme (GAPS) that will insure its toxic assets up to some £282 billion with RBS covering the first £60 billion up from £42 billion, Lloyds will no longer join GAPS but the government will nevertheless put in another £5.7 billion to maintain its 43% stake. Last October, the government bailed out these banks to the tune of some £30 billion, making the RBS bail-out the most expensive in history.

The approach is different this time to make the most of a rising stock market. However, the appetite for risk may be back as the recovery is underway but are two part-nationalised banks holding toxic assets attractive to buy especially if the state is planning to back out? Also, the need for further recapitalisation points to the ongoing losses on their balance sheets. The IMF estimates that only 40% of troubled assets have been written down, which means that there is more to come. If there is a double dip or W-shaped recovery and traditional assets (consumer loans, housing, commercial property) decline, then RBS and Lloyds may well need more capital and we could be in for another round.

On a slightly better note, EU competition rules will require the break-up of these banks receiving state aid. This will hopefully reverse the consolidation in the past decade and which has worsened in this crisis. With more competition, consumers will gain. As would the government if they can sell at a good price. But, until we get on top of the toxic assets, the financial crisis just rolls on.

30 October 2009 U.S. (and the world) growing but for how long?

The U.S. had exited recession in the 3rd quarter, registering a 3.5% annualised rate of growth. Half of the growth was a result of fiscal stimulus (including a now expired cash-for-clunkers programme), a percentage point from a slowdown in de-stocking and another percentage point from residential investment as builders race to beat the expiration of a $8,000 tax credit offered to new home buyers. Unfortunately, these measures are temporary and growth can only be sustained if private demand takes the place of public spending. So, looking at consumer spending, it was up 3.4% whilst the saving rate fell as well as disposable income. Given the squeeze on income, expenditure looks to be supported by record low (practically 0%) interest rates. Adding more debt to households trying to shed debt does not make for a strong recovery, especially as unemployment is at a 26 year high at 9.8%. In other words, unemployment has exceeded the levels seen in previous recessions and nearing the dismal outcome of the early 1980s one. A weak dollar could boost exports, but there is a limited global market and has been for 30 years and will make imports for expensive, further depressing consumption.

That echoes the view of the IMF which has upgraded its growth forecasts for next year, particularly for Asia, adding another 1.25 percentage points to a 5.8% growth, though strong, this is below the average growth rate of the past decade. This seems to a harbinger of the type of growth that we are likely to see during the recovery phase of the Great Recession. Moreover, it has warned that a similar picture of government generated growth in Asia has limits and weak final demand in the U.S. and Europe means that the main export markets for the region will not bounce back quickly. China and India may be registering strong growth, but they are much poorer than the American/European consumer and will not make up the shortfall.

The recession has bottomed up and the recovery is starting, but it looks to be a bumpy one.

22 October 2009 Revisiting Chinese inflation with trend growth

China's 3rd quarter GDP was revealed to be 8.9% today, which is above the 8% target of the government that is around the trend growth rate of per capita GDP. This brings the annual growth rate for the first 9 months to an impressive 7.7% in the midst of the worst global recession in 60 years. Yet, China is still in deflation with consumer prices falling by 0.8% and producer prices are down a whopping 7%, all the while M2 money growth is nearly 30% near the peak of 34% during China's last bout with overheating in 1994. Thus, this is all quite unusual: deflation and excess capacity when the economy is growing at trend rates with such strong money growth and a fiscal stimulus package of around 15-17% of GDP.

A usual explanation is that the unleashed credit fuelling the government stimulus (contributing nearly 2/3rds of the growth thus far: 7.7% growth mainly driven by 7.3 percentage point increase in investment, 4 percentage point increase in consumption and 3.6 percentage point decrease in net exports) is creating asset bubbles. There is little evidence of that in housing except in urban areas where house price inflation is growing. Though again urban incomes have grown at 10.5% in 2009, so consumption of housing should follow. What is more puzzling is the stock market, which is now some 60% of its peak in the autumn of 2007 before the crisis hit. The peak of the market was likely a bubble, but is 60% when the economy grew at 9% last year and will exceed 8% this year? Probably and turnover is extremely high, but the price-to-earnings ratio is around the trend of 30 which is larger than other markets but not unsual for China and half of the peak two years ago.

With a not yet marketized economy, macro models don't always explain China's movements. Today's puzzling set of growth, excess capacity and price figures make that point quite clear.

16 October 2009 The Triffin Dilemma and the dollar

Last night on Newsnight, we discussed whether the U.S. dollar will remain the global reserve currency amidst talks that China, Russia and even the Middle East oil exporters are considering pricing energy in euros. The key issue for a currency to serve as the reserve currency was pointed out 50 years ago by Robert Triffin. If a country's currency is drawn upon for international transactions (e.g. purchasing commodities priced in the reserve currency, used in reserve accumulation to act as a buffer against currency speculators), then its capital account must be positive as capital outflows exceed inflows. This implies through the balance of payments identity that the current account must be in deficit, which is expected as strong demand for the reserve currency will decrease competitiveness and therefore exports while imports are cheaper and therefore more is consumed. However, running persistent current account deficits will increase concern about the sustainability of the country's balance of payments, eroding the very position of the reserve currency. Hence the dilemma.

Of course, Robert Triffin warned about this in 1960, but the dollar persisted through thick and thin due in large part to the lack of a credible alternative, particularly as the United States was the sole economic superpower for most of the 20th century and certainly since the end of the cold war which made it the "safe haven." But, as the U.S. deficit soars and gold (the classic hedge) breaches $1,000 per ounce, the tide has turned and the Triffin dilemma perhaps realised. To overcome it, the solution must be a set of reserve currencies, else the euro or maybe one day the yuan will suffer the same fate.

13 October 2009 UK inflation looks mixed but falling

Today's inflation figures paint a complex picture: CPI is down (but still up), RPI is down, RPIX is up. CPI is 1.1% (down from 1.6% in August), while RPI fell further to -1.4% (compared to -1.3% in August) and RPIX (which is RPI minus mortgage interest payments) is 1.3% (down from 1.4% in August) but still up year-on-year just like CPI. Core inflation, stripping out volatile items like food and energy, is 1.7% (down from 1.8% in August). As energy prices have stablised (7.3% annual drop which is the largest since records began), there is downward pressure on prices for households. However, this is more than offset by increases in costs of fuel for transport and clothing, which both caused CPI to record a rise despite the economy being in recession.This is evident in the core inflation figure and reflects the weak Pound since these items of fuel and clothing are imported. Once the cost of housing is measured, then the same trend is seen in the RPIX, though not the RPI which still reflects the dramatic fall in interest rates since last autumn.

The Bank of England believes that inflation will remain below target throughout next year. On today's evidence, that looks likely. In fact, if it were not for the weak Pound and the extent of import penetration, then the output gap and rising unemployment would surely mean deflation as seen in the U.S. and other major economies.

6 October 2009 Tories and the budget

The UK Shadow Chancellor George Osborne set out the principles of a Tory government on the economy, and it involves the expected public spending cuts. But, every cut included a sweetner to protect the less well-off. In total, the Tories would save £7 billion per year over the next Parliament and then another £13 billion each year from increasing the retirement age to 66 for men (and women by 2020) in 2016, a decade earlier than proposed by the Turner Review. Nearly half (£3 billion) would come from cutting the cost of Whitehall by 1/3rd, and the other half (£3.2 billion) from freezing public sector pay in 2011 (except for the lowest paid) -- though it's not clear how that 12 month policy generates savings per year from 2011 onward unless they intend to freeze pay for longer.

The current 10 year plan of the government to bring the national debt come down to pre-crisis levels by the early 2030s(!) means that the structural deficit has to be addressed via tightening measures. The IFS expects that there will be a permanent structural deficit of 6.4% of GDP once the economy has fully recovered. This is equivalent to around £90 billion in today's money. To halve the budget deficit to 3.2% of GDP within 5 years as has also been claimed to reassure markets implies tightening of some £44 billion per year, assuming that the cyclical element recedes and all other projections of above-trend growth from 2010 onward hold. This can be back-loaded if the recovery looks fragile, as it is unlikely there will be any tightening until after next year, so thus the 10 year outlook. To tackle it as currently planned til 2017, it is equivalent to £2,840 per household in public spending cuts or tax rises in today's money. Vince Cable, the Lib Dem Treasury spokeperson, is more pessimistic and believes that figure to be 8% of GDP in an article that he wrote for the think tank, Reform. As the Government and the opposition parties position themselves for the upcoming General Election, we will need to see if it all adds up.

This is particularly because half of the increase in the debt comes from debt interest payments (constituting 2/3rd) and benefits (making up the remaining 1/3rd). With front line services protected, the cuts in departmental budgets will be drastic, exceeding 7-10% per year if taxes are not increased. America faces the same dilemma and has used it as an opportunity to reform health care -- a priority of the administration due to the campaign promise of universal health care -- and also because entitlements, unlike debt interest payments, can be controlled. They, of course, do not have an election coming up in the spring.

24 September 2009 What can the G20 summit achieve?

The answer depends on which country you ask. As we are no longer in crisis mode, the focus of the participants will be more scattered. The priority areas differ greatly. Each country seems to have a different one, e.g., U.S.: financial regulatory reform (not pay caps but more capital held in banks), global imbalances, climate change through removing fuel subsidies in developing countries, Britain: global imbalances and financial reform, France/Germany: bankers' pay (and not global imbalances) and clamping down on tax havens, India: maintaining stimulus spending, China: exit strategies of the U.S. and EU to prevent them from inflating away their public debts, and so forth. But, they all agree that the recovery is fragile and financial regulatory reform is needed to prevent a repeat of the crisis. Now, if only the means to achieve these goals were as straightforward.

23 September 2009 Reducing carbon intensity + energy intensity = carbon emissions cuts?

China made headlines with a commitment to reduce carbon intensity at the UN climate change conference taking place today. President Hu vowed to reduce carbon intensity which is an improvement over just reducing energy intensity but fell short of announcing any emissions targets. President Obama similarly didn't commit to any targets to cut carbon emissions. Reducing energy inefficiency would increase the efficiency of energy used to produce each unit of GDP. China is 1/6th as efficient as Europe and 1/7th as efficient as Japan, so there is scope to improve energy use. Cutting carbon intensity would improve the mix of energy sources -- away from coal and toward more green fuels. As China's energy is primarily powered by coal, this is a notable shift.

Both, though, would only reduce the rate of growth of carbon emissions but not the level, which is expected to grow as China develops. It also suits the goals of the Chinese government in that they have wanted for some time to improve energy efficiency (and energy security) so using a mix of energy that is not reliant on imported fuels would allow them to achieve both aims. But, conservation and cutting emissions are different, and these efforts alone will not achieve the hoped for Copenhagen target of cutting carbon emissions by 2050.

16 September 2009 The case for narrow banks

John Kay's idea in today's FT, and which has been picked up on by Mervyn King of the Bank of England, to go beyond a "new Glass-Steagall" and create narrow banks is certainly worth debating. He argues that restoring the separation between retail and investment banking as had been done under Glass-Steagall is insufficient since the funds are co-mingled within universal banks. Instead, he proposes that retail, high street banks with full state guarantees and protected deposits should be narrow banks that make their money on lending to the real economy of firms and consumers. Investment banks, which will not be guaranteed, are entirely separate and allowed to fail if they take on too much risk and doing so would not risk deposits or taxpayers' money.

We debated this point in our last podcast in the Oxford 'The Credit Crunch and Global Recession' series, and the issue surrounds whether it is possible to prevent narrow banks from investing their money in the wider financial sector habited by investment banks. In the secondary banking crisis in Britain in the mid 1970s and the savings and loan crisis of the mid 1980s in the USA, it was building societies who failed in part due to over-exposing themselves to such risky investments as well as unsound strategies pursuing the real estate boom. Northern Rock is a current example of a bank that was overly reliant on wholesale money markets to fund their short-term borrowing to make long-term loans focused on a housing bubble. It is not a universal bank which undertook investment banking bets on troubled assets which went bad. It failed because short-term liqudity dried up and the housing bubble looked to be bursting.

If these narrow banks can be regulated to curtail such risky investments and strategies, including relying on deposits (guaranteed by state deposit insurance) to make their loans, then that may well ensure a more stable banking system in the future. It depends very much on regulation getting it right, but could harken back to a time when retail banking was focused on real businesses and not speculative investments. Also, the protection of deposits is key and this approach addresses that issue squarely.

15 September 2009 Will there be another financial crisis?

On the anniversary of the failure of Lehman Brothers that triggered the global financial crisis, that is the question on many people's minds. Unfortunately, the answer is yes as financial crisis occur on a fairly regular basis around the world: this crisis was preceded by the dot.com bubble in 2000/01, LTCM failing/Asian financial crisis in 1997-98, Peso crisis in 1994, ERM collapse in 1992, S&L crisis in the U.S. in the late 1980s, fist generation currency crisis in Latin America in 1981-82, etc.

Accepting that there will always be crises is not the same as not adopting better reforms. There are lessons that can be learned from this one to avoid a repeat of the prospect of systemic banking failure that makes this particular global financial crisis the most potent since the 1930s. Just as after the 1929 Wall Street crash, a new set of regulations (e.g., Glass-Steagall Act of 1933) and regulators (U.S. SEC was formed in 1934) were devised that has prevented such a systemic crisis for nearly a century, there is an opportunity now to do the same before we return to "business as usual" or other issues (public spending, health care reform) knock this off the agenda.

First, the regulations governing finance has to incentivize financiers away from risk-taking that generates paper profits that do not translate into real economic activity. Capital markets are supposed to allocate capital to their most efficient uses, and debt creation that generates revenues which becomes bonuses must be moderated. Leverage is important for firms as borrowing can help with cash flow, as is secrutization which can spread the risk. The issue is how to prevent excess. As such, counter-cyclical capital requirements and deferred bonuses (paid in shares with clawback provisions in the case of losses) are ways to limit such undesirable activities. Banks are also special in an economic system so they are unlike other firms and could end up taking more risk. Orderly dissolution (adoption of "living wills") can reinstate market discipline that bankruptcy is an option, and will not only increase transparency but also prevent the loss of confidence associated with the failure of Lehman.

It is also not just an issue of getting the right regulations in principle, but implementation at the global level. Regulatory arbitrage is always an issue, which is why global regulations are needed for global markets. For many, this is the biggest sticking point and why even the French will not unilaterally put a cap on bankers' pay for fear of Paris losing business to London, New York, etc. But, international norms can induce compliance where nations see it in their own self-interest to have better governed financial markets. The Basel Committee of the Financial Stability Board is a good example of setting capital rules which nations adopt voluntarily as finance is not an area where countries will race to the bottom since instability rather than profit will result. The reining in of tax havens is another good example where non-G20 countries such as Liechtenstein have agreed to conform to the global norm. The same would apply to Asian countries who in theory would benefit from having avoided the worst of the crisis and facilitate the shift in economic weight from West to East. Having experienced some of the worst financial crises in the recent past, they are more and not less likely to seek better global governance of capital markets.

We are past the days of retail banking as the central business of banks, and financial innovation has been beneficial in many respects, including funding riskier small businesses and allowing households to improve their intertemporal asset allocations. But, laws exist to set parameters of markets, and reform is needed. Asking the Financial Stability Board to consider the appropriate rules governing global markets is the right course as an internationally representative body. Adoption by the G20 later this month will send the right signal that lessons have been learned, though the road to implementation will undoubtedly be tough.

10 September 2009 China's "going out" policy

Following on from Nanjing Automotive Industry Holdings Inc.'s purchase of UK's Rover, Beijing Automotive (BAIC) is seeking to become a minority shareholder in a bid for GM's Saab, while another Chinese car marker, Geely, is interested in Ford's Volvo unit after numerous other recent queries including a deal for Hummer and a failed attempt to buy Opel. It is certainly a sign of the maturation of China's "going out" policy which was launched in the mid 1990s to encourage its firms to become global players, acquiring brands that can quickly establish them in world markets, particularly in atutomobiles where brand recognition and reliable supply chains are crucial.  

This is a state-direct effort in many respects. First, the Chinese government is partially opening its capital account to permit such outward FDI, which was only allowed in 2004. Second, the Chinese authorities recently announced that they will use their foreign exchange reserves to fund overseas acquistions by Chinese firms instead of buying Western government debt denominated in the same foreign currencies, e.g., dollar, euro. Third, BAIC and Shanghai Automotive (SAIC) which failed to make a success of a unit of SUVs from Hyundai are state-owned enterprises, charged from the very start of reforms to devleop this technology-intensive sector. Geely is a privately run company, but the largest companies in China still count state-owned enterprises among them, and therefore, the deep poickets of the state in funding the Saab deal.

The rationale makes sense for the Chinese in a number of respects. It has the fastest growing car market in the world and wants to serve it with domestic firms. Western car makers have the brands but are mired in cost and inefficiencies. Aftef decades of fostering the industry, it has few name brand cars, like the Chery, none of which are sold in developed markets. And, finally, allowing capital outflows will reduce its balance of payments surplus so that it can cease building its holdings of Treasuries. Even if the Chinese do not succeed in turning around these auto makers, the chance that the yield will be better than that on Western government debt makes it a worthwhile effort.

4 September 2009 Exit strategies and bankers' pay

The G20 finance ministers' meeting taking place today and tomorrow in London is to lay the groundwork for the G20 summit later this month in the USA. The agenda will be focused on coordinating exit strategies from the fiscal and particularly monetary policies used to stimulate the world's economies and also to prevent a recurrence of this crisis by better regulating the financial sector. Several central banks (the USA and ECB) have already laid out some measures that could be used to unwind their quantitative easing programmes. The use of interest rates to fine tune the economy whilst this is going on (the selling of accumulated government and corporate bonds), as suggested by the ECB, is a good manoever but a tricky one if the recoverty is as fragile as most believe. In other words, selling billions worth of government bonds into the economy will push up borrowing costs and depress growth. With a 1% interest rate in the Euro area, the ECB has some latitude to cut interest rates which is unavailable to the US and UK with near zero rates.

Preventing a recurrence of this crisis is the other big issue, which has been cast as capping bankers' pay by the French with the agreement of the Germans, while the Americans advocate greater capital requirements as the solution. The British position agrees in principle with the other Europeans but fall short of limiting pay as the outcome. As banking is special, risk-taking has to be deterred because the losses will result in a public bail-out. However, to achieve this aim is no mean task. Proposals also include a "will" for banks for orderly dissolution so that failure does not necessitate a bail-out, counter-cyclical capital requirements, limiting bank size, Tobin tax on transactions, etc. No single approach is likely to be enough and international guidelines are essential to avoid jurisdiction shopping, but at least while the political will is there to address this issue, there is some hope that we do not return to the excesses of the past decade that was clearly an unsustainable bubble.

31 August 2009 What moves the Chinese stock market?

The Shanghai composite index has reversed the gains of the past three months, but is still up over 60% since the start of year, nearly reversing the 72% slump from its peak in October 2007 at the start of the financial crisis. Per my post on August 11th, this pick up is not dissimilar to the movement in the European markets, though China has more reasons to be optimistic. Unfortunately, the history of the Chinese stock market makes its gains more suspect, and for good reason.

The main source of its volatility has to do with the restrictions on the market itself. Capital controls limit both domestic and international investors -- the former from investing overseas, the latter from investing in it. The predominance of non-tradeable shares held by the state or state-owned enterprises make it a market of limited liquidity, though the capital controls on domestic investors make it at the same time one of the most liquid (in terms of shares changing hands) of stock markets. This unusual combination often seems to overwhelm the link to corporate profitability that should underpin a bourse, and results in a stock market that appears to be driven by sentiment.

The Chinese are used to it. But, as global markets follow the Chinese movements, expect the unexpected.

27 August 2009 Tobin tax and the future of finance

Lord Turner's suggestion of a Tobin tax on financial transactions has sparked a worthwhile debate on the future of finance. A Tobin tax levies a small (say 0.1%) tax on transactions to introduce friction into an otherwise very liquid financial markets. The idea was revivied in the late 1990s when rapid flows of "hot money" or short-term portfolio flows derailed Asian markets by triggering a currency crisis on the back of a finanical crisis in those economies. In other words, when Thailand first experienced bankruptcies that put pressure on its banking system, capital quickly flowed out of the economy which put downward pressure on the exchange rate that in turn worsened the financial crisis insofar as numerous loans were denominated in foreign currencies that became more expensive with devaluation, and giving us the first currency and financial crisis which is the hallmark of the third generation models. By imposing a transaction tax, then portfolio flows would slow and not be so quick to either enter or exit an economy, and limiting the damage of liquidity.

Opponents point to the benefits of liquid capital markets, which give pricing signals and enable financing that promotes investment. However, in the current financial crisis, it's apparent that trading also generates significant revenues and thus large bonuses which cause excessive risk-taking. By imposing a Tobin tax, the friction will reduce trades (which were the largest revenue generator for most of the banks this year) and, by extension, bonuses.

Whether the link is clear as that, the proposal certainly adds to the current debate over financial regulatory reform. The G20 principles on bankers' pay that have been implemented most energetically in France focus on linking bonuses to profits and not revenues, and introducing a "clawback" if there are future losses. The failed American insurer AIG had a bonus system linked to profits but still ended up as the largest bankruptcy and bail-out in history. No single tenet is enough, and more debate seems warranted. Along those lines, I will be a cross-examiner in the CNBC Global Debate -- The Future of Finance: New Rules, Same Game? on October 1st in Doha and broadcast on October 12th. For the sake of all of us as taxpayers, this issue of bankers' pay requires much more discussion.

24 August 2009 Where is Chinese inflation?

With China's commercial property sector developing rapidly on the back of over 7 trillion RMB of lending in the first half of this year and now rivalling that of the U.S. and UK, renewed concern arises over an asset bubble and inflationary pressures in China. Adding the fiscal stimulus package of 4 trillion RMB plus an additional trillion on health and rural pensions, China's nominal GDP should be around one-third larger. This is coupled with a healthy current account suplus clocking in an additional $177 billion in foreign exchange reserves in the first half of of 2009. With this amount of spending, liquidity and economic growth in the second quarter of just under 8% which doesn't suggest significant excess capacity, it is not surprising that these concerns arise but puzzling that China is in deflation.

M2 growth, however, exceeds target and both asset classes (stocks and real estate) have grown at double digit rates since the start of the year. It seems that assets are bearing the brunt of inflationary pressures which has tended to be the case in the 2000s, which has escaped the inflationary cycles of the 1980s and 1990s. But when this last occurred in the late 1990s in the aftermath of the Asian financial crisis, Chinese growth itself was questioned in the presence of deflation and falling energy consumption. This time, energy consumption is up, but growth is again occurring in the midst of deflation, though potential asset bubbles exist in its main investment classes. Undoubtedly questions will be raised about the sustainability of China's asset growth, but perhaps also its economic growth.

22 August 2009 It's not only the banking system that harkens to the 1930s

The abandonment of the gold standard by the United States in the 1930s had the effect of causing an inflationary spiral in China with echoes of today's attempts to emerge from the global financial crisis. In 1933-34, to fight deflation from the Great Depression, the U.S. devalued the dollar against gold by 40% and also instituted rapid money supply expansion. Monetary growth was fuelled by large-scale silver purchases whereby the U.S. issued silver certificates in exchange for silver and these certificates were used as currency, thereby adding to the domestic money supply. However, in the early 1930s, China (and the British colony of Hong Kong) linked their currencies to silver. As demand for silver grew which pushed up its price, China and Hong Kong experienced significant inflationary pressures that led to the abandonment of their currency regimes.

This episode has unfortunate parallels in the aftermath of the current global financial crisis when concerns about ‘debt deflation’ due to the banking crisis coupled with the de-leveraging efforts of households and firms in the U.S. has led to expansionary monetary and fiscal policy with some worrying consequences in the eyes of the Chinese and other emerging economies. Some may view a historical episode as too removed from the current dilemma. However, the Chinese perspective is well-known to be long-term. When asked what he thought of the French Revolution two centuries later, the then Chinese Premier Zhou Enlai said that it was too early to tell. Trying to decipher Chinese policy would be remiss if the historical context was dismissed, and something that President Obama should bear in mind when he makes his first visit to Beijing in mid November.

18 August 2009 Is Britain being left behind?

With Germany and France, and now Japan coming out of recession, Britain and the U.S. are alone among the largest economies to still be in recession. China, the third largest economy in the world, recorded over 7% growth in the second half of 2008 and the first half of this year, so it was never in recession. Topping it off, Australia also grew in the second (and first) quarters, so it avoided a technical recession, whilst other major economies like fellow G7 member, Canada, also appears to be doing better than the UK. Even Italy, the remaining member of the G7 and third largest economy in the Euro Zone contracted at 0.5% in the second quarter, which is better than the 0.8% decline in Britain and 1% contraction in the States.

I discussed the Euro Zone in last week's post (August 13th), so focusing now on the non-European major economies of Australia and Canada, they have fared better because their banking systems were not embroiled in the securitisation business that has derailed the U.S., UK and Western Europe. They have suffered from the credit crunch but their real economies are not leveraged (indebted) as is the case in the UK and USA, which also explains why France and Germany have experienced a growth spurt while the US and UK contracted in the second quarter. Both economies are major commodity, including energy, exporters (making up over 1/3rd of Canadian exports and over half of Australian exports) which benefit from the stimulus programmes around the world that are geared at infrastructure, namely in the U.S. and China. Notably, Australia's exports are linked to China's growth, while 80% of Canadian exports go to America, and Australia has outperformed all of the other major economies. Their economies are similar to Britain (e.g., services-dominated, trade deficit/consumption-oriented), but they did not splurge so much during the credit boom so are better positioned. Also, their significant endowments of natural resources support their export sector at time when the developing world is experiencing industrialisation (e.g., China, India), placing them in a favourable position that is fairly unusual for developed economies.

Is Britain lagging? Yes, in the sense that the UK (and the U.S.) are still in recession while other major economies (even those with credit exposure like Germany's banking sector) have pulled out. The main reason has to be the cost of the bank bail-outs and resultant credit crunch. The financial sector boosted growth during the boom and industry shrank as a proportion of GDP. Thus, Britain doesn't have the re-stocking boost seen in other economies, and suffers from dear credit and even positive inflation (CPI out today shows 1.8% for July), which stymies consumption. Britain also has to de-leverage and re-build its economy to take the place of the smaller financial sector to avoid a permanent decline in output, so there are significant challenges ahead. However, the inventory effect can be temporary so the other major economies may well fall back into negative output growth. In any case, the recession has likely levelled out for Britain and America due to the slowing of output contraction. In the longer term, the structural changes necessary (reversion to saving, reduced reliance on financial innovation) and a strong services sector (especially at the high value end) are positives. It's not an easy task and impossible during a boom, but the global financial crisis has altered the approach to growth. The internationalist outlook of Britain alongside a history of good governance makes it possible that the UK will not remain a laggard.

13 August 2009 Recession ending in Germany and France?

Technically, with 0.3% growth in Germany and France in the second quarter, recession has seemingly ended in the two largest economies in the Euro Zone. The Euro Zone itself registered a 0.1% contraction, better than the 2.5% fall in the first quarter but not yet ending the recession. As guest presenter on CNBC Europe this morning, no one seemed particularly optimistic that there won't be a dip later in the year. There are a number of reasons. De-stocking had been so fierce that re-stocking has bumped up industrial production leading to industrial growth in May of 0.6% but then a fall of 0.6% in June in the Euro Zone which points to an inventory effect, particularly significant in Germany and France as industrial powers. As industry constitutes 1/3rd of GDP in those economies, an upturn in industrial output would generate growth. But, by the same token, the downturn may well drag down growth again, leading to a weak, W-shaped recovery. Second, export growth for Germany has resumed at 7% (fastest rate in 3 years) and registers a current account surplus of around 3% of GDP because imports have fallen more quickly due to a low consumption base. Exports of capital goods are driven by infrastructure spending in the fiscal stimuluses of America and China. Once those funds end, then export growth will taper off. Third, consumption growth looks weak in the recovered economies of Germany and France, more so in the former due to a savings rate exceeding 10% and an economy geared at exports. Where consumption is growing is related to fiscal policy such as the car scrappage scheme in France which has driven household consumption upward by 0.4%. Other countries in the Euro Zone like Spain and Ireland have to de-leverage or shed debt, offering little in support of consumption growth in the euro area. Fourth, global re-balancing will involve Germany which had the second highest trade surplus in the world only after China before the crisis. As Americans save (saving rate has increased five-fold since the financial crisis), there will be global re-balancing in that consumption will decline and the trade deficit fall which will be matched by shrinking surpluses elsewhere. Without the boost from exports and fiscal stimulus spending, exports will not much of an engine for sustained recovery. Fifth, Germany and France both have short-time workers which has staved off unemployment and maintained incomes, particularly as wage compression reins in costs. If final demand does not increase, then these schemes can't be maintained and a squeeze on income will follow.

Although the Euro Zone and Germany in particular have suffered greater contractions in GDP than America and its banks are estimated by the European Central Bank (ECB) to have 800 billion euros of toxic assets, the rebound from recession is sharper than in the U.S. and the UK, both of which are still down 1% and 0.8% in the second quarter and mired in recession though bottoming out. Perhaps the sharp contraction leads to a V-shaped movement for the reasons aforementioned, but this is good news as any growth is welcome. The real question is whether it will last beyond a couple of quarters.

12 August 2009 Bank of England inflation conundrum

In today's Inflation Report, the Bank provided the backdrop to its unexpected decision to expand quantitative easing (QE) last week (see August 6th post) by £50 billion by sharing its latest economic forecast. But, the report increased the inflation projection from a low of 0.6% to just under 1% to be reached in the autumn, suggesting that inflation is more stubborn than they had thought in May. Usually, an upgrade of the expected inflation rate signals an increase in interest rates but not this time. By injecting another £50 billion, not ruling out more QE and downgrading GDP growth to -5.5% with no recovery expected until 2010, the Bank is signalling that interest rates will remain low for some time. Stubbornly high inflation is likely due to the weak Pound pushing up import prices, but that would typically tie the hands of the central bank working to an inflation target to not continue with loose monetary policies. In other words, its QE programme and the level of government borrowing are driving down the value of Sterling which is in turn fuelling inflation.  By doing the unexpected is another typifier of how severe this recession is.

11 August 2009 Was the UK VAT cut passed on?

In the ONS monthly Economic and Labour Market Review journal published today, an article stated that 34% of stores did not pass on the 2.5% VAT cut in December 2008 when the new 15% VAT came into effect. By February 2009, half had raised prices back to what they were in November before the cut (36%) or even increased them (16%). The stores cited higher import prices, reflecting the weak Pound, as the reason.

The ONS estimates that the VAT cut reduced CPI by 0.5 percentage points which helped inflation stay nearer target. However, the bigger controversy is whether the cut has worked as it is the centrepiece of the government's £25 billion fiscal stimulus) and should it be continued as it is due to expire at the end of the year. If it isn't passed onto consumers, then the cost of £12 billion will seem wasteful as inflation was due to fall as a result of the worst period of economic contraction in any case. Although the cut would have increased store margins and left money in the economy instead of paid in taxes, not being passed through to consumers removes the most important part of the Keynesian multiplier which works through consumption. As extending the cut beyond the end of year is debated, whether the VAT cut stimulates growth or is just another source of the ever expanding fiscal deficit will matter.

11 August 2009 Does a stock market rally and rising house prices amount to a recovery?

The European stock market is up 42% over the past 5 months since its trough in March, nearly recovering from the 51% drop since the start of the financial crisis around June 2007, while the UK housing market is showing signs of stablisation. The Royal Institute of Chartered Surveyors (RICS) no longer believes that house prices will fall by 10-15% in 2009 and the last quarter of the year may see higher prices than the end of 2008. Does this equal a recovery? Not necessarily. Although equity prices can be a leading indicator (preceding the business cycle) insofar as stock prices reflect the discounted present value of future earnings of a company, they have historically been more accurate for the U.S. than for Europe. Moreover, even in the S&P 500 Index, although some 2/3rd of companies reported profits in the first half of this year, the drivers were restructuring debt and cost cutting rather than strong revenue growth. Thus, the rally may subside unless there are signs that demand has recovered. Markets, though, sometimes have a logic of their own.

As for house prices, it is undoubtedly the case that significant under-supply continues to drive the housing recovery. Cheap rates on mortgages, although large deposits of 25-50% are now required, are fuelling a segment of the market, particularly in the south of the country. The Bank of England has not only lowered interest rates to 0.5% (with inflation at 1.8%, it is a negative real interest rate), it has also undertaken quantitative easing which will increase nominal GDP by over 10%, fuelling liquidity. Houses are an asset class, so price rises reflect liquidity and it is a particularly poor sign in Britain where housing suffers from structural under-supply. In another post (July 28th), I outlined how new private residential housing starts could be a better indicator, but again not so for the UK due to planning lags. Therefore, insofar as the stock market rally and housing reflect improved investor sentiment, that is positive. However, with all of the liquidity and cheap (new money) in the economy, these assets may just be a reflection of loose monetary policy.

7 August 2009 RBS rounds off a week that shows the financial crisis is ongoing

The Royal Bank of Scotland (RBS) posted pre-tax profits of £15 million in the first half of 2009, but an impairment loss of £7.5 billion. Like Lloyds, it is partly state-owned with taxpayers holding 70% of the bank and will access the Asset Protection Scheme (APS). Unlike Lloyds, even though it has the British government behind it and thus cannot fail, it is not saying that bad debts have peaked. This is probably because its bad loans are a mixture of toxic assets and property; the former is difficult to value whilst Lloyds was primarily affected by the latter. By the same token, market reaction to RBS is less positive than for Lloyds even though Lloyds had announced twice as many bad debts. 

RBS embodies the troubles of the banking sector. Like Northern Rock, it was too reliant on wholesale money markets; like Lloyds, it made a bad decision to acquire ABN Amro which accounted for much of its 2008 losses that was the largest in British corporate history (£24.1 billion loss in 2007, mostly due to a £16.2 billion write-down on the value of ABN Amro); and like Barclays and HSBC, it was caught up in the US sub-prime mortgage market and laden with troubled assets.

RBS eeked out a profit today due to some one-off measures and restructuring (buying back debt at lower interest rates leading to a £3.8 billion gain, shedding non-core businesses in Asia including selling its stake in the Bank of China). Its investment banking arm made a profit on the back of the various government guarantee schemes outlined my August 5th post like Barclays and HSBC, but the rest of the business looks weak. It is the right thing to do to de-leverage, but RBS's outlook will remain poor until it shows its hand as to the extent of bad debts. With a bail-out of £20 billion and RBS poised to access the APS, the taxpayer will be paying tens if not hundreds of billions for this bank. With the size of losses already seen and still to come, we may own all of RBS before long.

What this week's bank results are showed was that bad debts are high and not yet peaked for all of the banks, retail banking is not a strong growth driver though lending to homeowners is up but business lending is down, banks need to repair balance sheets so are unwilling to lend to businesses that look riskier during a recession, traditional assets (mortgages, commercial property) decline in a recession that is adding to the impairments caused by troubled assets, and profits are only found in investment banking which is implicitly or explicitly in the case of the part-nationalised banks backed up by government guarantees. The picture it paints is of a clogged and weak banking sector that may well choke off a real economic recovery. The actions of the Bank of England yesterday look warranted, though it may still need to lend directly to companies as the Americans have which has increased the money supply (1.2% increase in M2 in 2009Q2) in the U.S. instead of trying to increase money and lending through a still clogged banking system.

6 August 2009 QE surprise

Taking markets (and most economists) by surprise, the Bank of England increased its quantitative easing (QE) programme by £50 billion, exceeding the £25 billion left in the £150 billion that it had announced back in March that it would spend. Today's decision was taken with the economic growth and inflation forecasts in hand, so the MPC would have seen unfavourable predictions about the state of the UK economy which we will be told about when the inflation report comes out on August 12th. Citing the slow growth in money (M4) and tight credit conditions, the Bank sees the banking system as being too fragile to support the recovery. Despite the signs of more positive economic data, the judgement of the Bank of England is that the UK economy is still in dire straits.

The Bank of England also announced that it will purchase gilts of 3 and 25 year maturities, extending its remit to try and influence shorter- and longer-term borrowing rates, and over a longer period of a further three months. Given that M4 "broad money" growth is the weakest in a decade and corporate lending is down £14.7 billion in the second quarter coinciding with the start of the QE programme in March, there is a question as to the effectiveness of this programme which still relies to some extent on the banking system to work as a money multiplier. In other words, by buying government bonds, the Bank is putting money into the hands of bond sellers who should either then lend out the money or put it in banks and the banks would have more deposits to lend. If this isn't increasing lending because banks are rebuilding balance sheets, then there is an argument to bypass the banks and lend directly to corporations. The Bank has the remit to buy corporate bonds but has so far only bought less than £1 billion. It would increase the risk on the Fed's balance sheets and arguably the type of corporate bonds that they would buy are of firms which can access credit in any case. However, the U.S. Fed has done just that and are currently reining back their extraordinary monetary measures. From today, it's evident that the UK is not in a position to do so.

3 August 2009 Week of bank earnings and financial stability

Profits of around £3 billion each for Barclays and HSBC announced today in their half-yearly statements for the first 6 months of 2009 will lead a week in which some profit may also be expected for Lloyds Banking Group and the Royal Bank of Scotland (RBS), though not Northern Rock. Ironically, the profit driver is the investment banking arm -- the same source of the toxic assets that nearly brought down the banking sector last autumn. A smaller set of remaining investment banks and government backing of lending, including asset-backed securities (UK: Credit Guarantee Scheme & Asset-Backed Securities Guarantee Scheme; US: Term Asset-Backed Lending Facility; USA/Europe: wholesale lending guarantees) have boosted investment banking in those banks which did not receive direct government bail-outs. Indeed, the earnings projection is weaker but still positive in those which did -- Lloyds and RBS -- but the latter's expected profits will likely reflect debt restructuring and one-off transactions, such as RBS selling its stake in the Bank of China, typical of the de-leveraging taking place across the corporate sector at this point in the cycle.

With lingering bad debts in the system, the banks which have not been bailed out are benefitting from the market signal that their positions are sounder than those which been part-nationalised. However, the continuing write-downs of toxic assets as well as declines in traditional assets (commercial property, credit cards) also revealed in the earnings statements indicate that there is bad news in retail banking and lending, likely with more impairment of the balance sheets to come. Thus, the accuracy of this supposed market signal remains to be seen. Nevertheless, any sign of financial stability will be eagerly grasped because it is a pre-requisite to sustained economic recovery. The likely view from this week of earnings will echo the mixed picture in the real economy which shows a bottoming out of the downturn but weak and uncertain prospects going ahead.

UPDATE: 4 August 2009 -- Northern Rock has reported losses of £724.2 million in the first half of 2009 on account of bad loans tripling. Unfortunately for tax payers, this is a wholly nationalised bank that accounts for 8% of our national debt. The plan to divide it into a "good" bank holding deposits and new mortgages (BankCo) and a "bad" bank (AssetCo) retaining the risky mortgages that are turning bad with the recession (falling house prices and rising unemployment) is intended to make it easier to sell. However, with mortgages in negative equity rising from 33% to 39% on its books, it is hard to see who would want to buy AssetCo. Selling BankCo while the market is depressed may also not get the best price. Keeping the two together may depress our national balance sheet in the short term, but it may just help taxpayers to recoup some of that investment in the future.

UPDATE: 5 August 2009 -- Though it reported a pro forma profit (due to the price paid for HBOS being less than its fair value), Lloyds' results show a loss of £4 billion with 80% of the write-downs due to its takeover of HBOS. Interestingly, its losses are primarily due to the decline of traditional assets like commercial property as a result of the recession and not because of the complex securitised instruments which have impaired the balance sheets of other banks. It isn't even due to its mortgage books. Unlike Northern Rock, its arrears ratio is similar to the industry average, though nearly 1/3 of its buy-to-let mortgages are in negative equity. However, similar to Northern Rock, its portfolio is disproportionately in property rather than corporate loans or investment banking and thus did not benefit from the growth driver of the government guarantees of corporate lending that helped Barclays and HSBC offset its bad loan write-downs. In fact, the corporate loan book inherited from HBOS was also of poorer than average quality. For taxpayers, it means that the £13.4 billion impairment charges in the first half of the year confirms that it will draw on the Asset Protection Scheme which provides a floor of 10% or an estimated £25 billion on its losses (plus a £16 billion fee) but we as taxpayers will cover the other 90%. At least, the government own 43% of Lloyds, so if there is an upside, then the taxpayers will partake in it since we are clearly paying for the downside.

31 July 2009 A law and economics perspective is needed

My new book out today (The Law and Economics of Globalisation) is a collection of papers by lawyers, economists and inter-disciplinary scholars examining the evolution of the global economic system. What this global financial crisis has highlighted is the importance of the governance of markets, at the domestic and also the international level. Although not about the crisis itself, the volume analyses cutting edge issues in the globalisation arena in this area. Economics has come under a great deal of criticism in this crisis. Another area where economics needs to evolve is to expand the law and economics field from microeconomic analysis of the impact of domestic laws to encompass the international dimension of the emerging global system of economic governance. The minimal attention paid to the latter was a reason for the lack of monitoring of globalised capital markets. Examining the economic impact of international law is both fruitful academically and can help shape the current debate about how best to regulate the increasingly integrated world economy. This book is a step in that direction.

28 July 2009 Are rising house prices a good sign?

The Land Registry recorded the first increase in UK house prices since January 2008 before the start of the recession. A 0.1% rise in June is a very small, almost negligible monthly increase, but one nevertheless. It mirrors other housing surveys which have suggested stabilisation in house prices, but the Land Registry is more accurate as it is based on actual transacted prices, though other indices based on mortgage approvals tend to be more timely.

Is this a positive sign in a recession? Not necessarily. With record low interest rates and an under-supply of housing in London and the south east in particular, it is not surprising that these two regions -- as well as the south west and the east -- experienced price rises. Other regions, primarily in the north, registered falls.

Generally, economists prefer new private housing starts as an indicator of future economic activity, a leading indicator of the business cycle. Due to the lag involved in house building, expectations of recovery will drive housing starts. Looking at the U.S., two months of increases in new housing starts suggests that recovery is on the horizon. However, this may not be such a good indicator for Britain. Supply constraints such as planning prevent residential housing from responding as well to changes in demand in the UK. In any case, it is still better to look at new housing starts than house prices since the latter could simply reflect the view of housing as an investment when the interest earned on savings is near zero.

27 July 2009 When a dialogue is a dialogue

It's not unsual for policymakers to play down expectations of what can be achieved at summits, but the current US-China Strategic & Economic Dialogue (S&ED) really is pitched as a dialogue. The semi-annual meetings started under Hank Paulson used to just focus on economic issues and thus were known as the SED. But, the first in the Obama administration will be led by Hilary Clinton and Timothy Geitner each running a stream as well as a cross-stream of talks to cover foreign policy as well. With the agenda ranging from currencies to climate change to North Korea, and global re-balancing to US debt to human rights, the two days in Washington are not enough time to produce substantive policy without the groundwork ahead of time. Thus, realistically, this dialogue is actually what it says on the label -- talks to open lines of communication on foreign affairs and economic issues.

What will be interesting to observe is whether the U.S. suggests this S&ED to be equivalent to a G2. Under Bush II, the Americans proclaimed their relationship with China to be their most important bilateral relationship. Or, by starting a similar dialogue with India as just has been announced by Clinton, the Americans are aiming for a multi-polar world. This may be symbolic or could actually point to where US-China relations are headed. Without anything else concrete to watch out for, the directionality of policy may be the most fruitful outcome as Obama begins to reveal where he stands vis-a-vis the other half of the twin engines of global growth in the world.

24 July 2009 The UK still in recession: second quarter GDP is -0.8%

Although Britain is still in recession and the second quarter figure is above the consensus forecast of -0.3%, the good news is that the pace of decline has slowed. After 4 quarters of accelerating contraction, the economy is shrinking but not as quickly in the 5th quarter of decline. However, the worse than expected figure points to the prerequisite for recovery which depends on financial stabilisation. Credit conditions still appear to be poor -- lending is expensive despite record low interest rates, and scarce because of the withdrawal of foreign lenders who are in their home countries mending their own balance sheets. Also, compared with the recession in the early 1980s which was also characterised by a global recession, indebtedness of households is a further hindrance. In that recession, the peak-to-trough fall was 6.4%. In this one, today's figure brings that to just under 6%, suggesting that the economy may have further to go before the recession is over.

Construction has been hit badly by both the credit crunch and the real economy contraction. Accounting for 6% of GDP, it has registered larger declines than even manufacturing. In the second quarter, the figures were 2.2% vs. 0.3%, respectively. However,  the pace of decline has slowed considerably -- construction fell 6.9% in the first quarter. A less dramatic contraction in GDP and in this sector give some cause for optimism. In today's ITV News at Ten, we will visit two construction companies to see if they can shed some light on where we are in the cycle. First, new housing starts are a leading indicator of the business cycle. If firms believe that housing demand will pick up, then they will build and the lead time involved means that they will precede the cycle. Second, commercial property is more coincident and pro-cyclical to the needs of firms. Meeting two such companies will indicate whether the recession has bottomed out and whether recovery is on the horizon.

23 July 2009 Retail sales growth is not as promising as it appears

The latest retail sale figure for June in the UK shows an increase of nearly 3% from a year ago, but it's due to volumes growing as a result of price cuts whilst sales have falled in value terms for non-food establishments. Price cutting is another indicator of recession as firms get rid of stock in the down part of the cycle. Volumes and values are up for food retailers, but they have fared well throughout the recession as spending on food and necessities do not usually fall and indeed could rise as consumers cut back on restaurants. The closure of restaurants and pubs attests to the weakness of that sector and points to why retail sales is a limited indicator of consumption since it omits hotels, restaurants and other forms of consumption other than spending in retail establishments.

Coming back to the sales figure, the squeezing of margins and de-stocking by firms point to the inventory effect. Because firms cannot cut stock forever, they will order and boost production temporarily if there is no sustained growth in final demand (British or overseas consumers). This would lead to a 'W' shaped recovery, which may well be what this recession is given the amount of consumer debt being paid back and thus tepid consumption until that process concludes.

21 July 2009 The cost of the crisis

Today, the ONS stated that public borrowing for June has taken the public debt to 56.6% of GDP.  Rescuing the financial sector cost a whopping 10% of GDP (excluding financial sector interventions, public debt is 46.6% of GDP). Bailing out banks has cost £141.3 billion with Northern Rock and Bradford & Bingley accounting for £118 billion. The Budget predicted that by March 2010, national debt would rise to 55.4% of GDP, so the current figure is roughly on track. Despite the massive growth in debt, there is nothing surprising in these figures. The Treasury stated in the Budget that public sector borrowing will be £175 billion this year. The monthly figure of £13 billion for June is on course. Where the uncertainty will lie is whether there will be more funds needed for financial sector interventions. As the recession progresses, traditional assets like credit cards and commercial property will be affected. The latter contributed to the failure of West Bromwich Building Society already. Also, the failure (and private sector rescue) of the American bank, CIT, this week shows that banks which been cleared by the stress tests are still vulnerable.

Fed Chairman Ben Bernanke has warned against the spread of the financial crisis to other non-toxic asset classes, and there was a mention in the Bank of England semi-annual Financial Stability Report of this risk. If Friday's second quarter GDP figure shows that the recession continues as expected, then there may well be another round of a banking crisis that will surely derail public finances. Total public sector debt has now reached £798.8 billion. Even without more rescues, debt will reach £1 trillion next fiscal year. These rescued banks now owned by taxpayers, though, are not worthless. As the economy recovers, mortgage backed securities will rise in value. We can only hope as taxpayers that we recoup that 10% of GDP eventually. Public finances will sorely need it.

16 July 2009 China grows

China's government spending has made up for enough of the decline in global demand to achieve a growth rate of 7.9% in the second quarter, bringing growth in the first half of the year to an impressive 7.1% in the midst of a severe global recession. When government spends instead of the private sector, there are consequences, particularly if the spending is funded by loose credit. China's fiscal stimulus of nearly the size of the American one (despite being a much smaller economy) was funded largely by state-owned banks, with a quarter funded by the central government via deficit spending which is also not without consequence. But, the funding of spending through state-owned banks without regard to the accumulation of non-performing loans is akin to funding government spending by seignorage. M2 growth was nearly 30%, exceeding even the very generous target of some 5 percentage points below that level. The record accumulation of foreign exchange reserves exceeding $2 trillion and two not entirely successful bond auctions point to an inability to sterialise inflows and add to the liquidity and inflation in the economy. The reining back of lending by the state is the expected response. In the past, the government -- without the ability to fine-tune due to limited monetary and fiscal policy tools -- goes too far and puts a brake on growth.

Without a credit crunch or financial crisis to contend with at home, this is not dissimilar to China's other business cycles. What the government will be hoping for is that the foundation of this expansionary policy is a preferable stimulus package geared at infrastructure and social spending, such as health. Therefore, there will be longer term output with eventual returns and the non-performing loans will not materialise because these are productive investments. As China needs roads and better support of its citizens, it may well be different this time and China will emerge from this global downturn with a more sustainable economic structure and improved infrastructure. In any case, as with other major economies, government spending to counteract the worst global asset bubble seen in nearly a century was warranted. By achieving its self-imposed growth target of 8%, the Chinese government will rest easier.

15 July 2009 Economic pain during the recovery

Unemployment is what economists call a lagging indicator because it tends to worsen even as the economy begins to recover. Employers are reluctant to hire until they are confident that the recovery is permanent and their businesses are on a sound footing. Vacancies at the moment are at a record low and redundancies are at a historic high. In the last two recessions in the early 1980s and 1990s, the unemployment rate rose to 10%, equating to 3 million people out of work. The UK has been in recession since the second quarter of last year and the unemployment rate has streadily risen from around 5% to 7.2% for the three months ending in April. Today's figure is expected to show a further increase in both the unemployment rate and those claiming unemployment benefits, the claimant count, which is currently 1.54 million. Government projections show that the claimant count could rise to 2.87 million during this recession, showing how much more pain there is to come.

Rising unemployment, particularly if it is long-term, is particularly damaging to individuals and the economic recovery. It can breed insecurity both in those who are unemployed and also those who fear losing their jobs. This in turn depresses consumption, which dents demand. This process can prevent the economy from coming out of the cycle. As firms cut prices to sell inventory, purchasing power of consumers increases that can in turn lead to higher demand and to business investment which heralds a recovery. Firms which are investing and growing will then increase employment, and the economy grows again. If, however, unemployment results in "scarring" and the insecurity severely dampens consumption, then the economy will not recover well. This is where government measures play a role, as most vividly seen during the Great Depression when Keynesianism advocated measures to address demand deficiency as a driver of business cycles.

Thus, unemployment will tend to rise during the peak-to-trough side of the cycle and afterward. At the moment, most of the increase in unemployment is a result of redundancies and fewer vacancies, particularly for graduates. Although this unemployment is broad-based and has hit manufacturing areas particularly hard (West Midlands, Yorkshire and the Humber), the rise in joblessness is still largely cyclical. Keeping a watchful eye to prevent it from becoming long-term will be crucial. 

Update: Today's figures show that unemployment has risen to 7.6% or 2.381 million unemployed. Another 281,000 people are out of work from March to May, showing the largest quarterly increase in unemployment since such measurements began in 1971. The claimant count is at 1.56 million, adding 23,800 people to those claiming Jobseekers' Allowance. This is the smallest monthly increase since last May, though the overall number of claimants is expected to continue to increase despite fluctuations in month-to-month measures. Given the extent of the credit crunch and the scale of the financial crisis, unemployment is another sign of the severity of the downturn. More so, it is further evidence that unemployment is the issue to tackle to sustain a recovery.

14 July 2009 Short-term gains versus long-term aims for China

It's not surprising that Chinese competition authorities will scrutinise the Rio Tinto and BHP Biliton production joint venture as it will affect 75% of all iron ore purchased by China. Ever since the passage of the Anti-Monopoly Law last autumn, multinational corporations were aware that they would have to abide by competition rulings from Beijing as well as Brussels. What is somewhat surprising is the myriad of entanglements with Rio Tinto over accusations of industrial espionage. Although denied by the Chinese authorities, there is a suspicion that this charge is related to the failed deal between Chinalco and Rio Tinto, derailed by Australian politics in the view of the Chinese, and is happening at the same time as the regulatory scrutiny.

From Coca-Cola to InBev, China is making its presence on anti-trust issues felt. This is not unexpected as its market grows in importance. What is worrisome is if China's application of its competition policy -- facially neutral except for the exemption of state-owned enterprises -- becomes a tool of the state. So far, China's legal reforms have aimed to provide the institutional foundation for increasing certainty in a market ruled by a one-party state. If, however, the law becomes an extension of the state's own economic pursuits and dislikes, then the real loser will be China itself. It may appease its short-term frustrations, but could sacrifice its long-term aims if investor confidence is dented as a result since the development of a well-functioning legal system is crucial for economic growth.

10 July 2009 Why it's better not to be ambitious at summits

The G8 summit is wrapping up with a laundry list of laudable goals ranging from global recovery to resumption of the Doha trade round and agreeing what a sensible price for oil should be. But, many will find the summit to be unsatisfactory because by trying to do everything, world leaders risk achieving nothing. The push of President Obama on climate change and international aid, therefore, appears to be an effective way of focusing the attention of the G8 and the 16 countries of the Major Economies Forum. He insisted that the latter be formed to bring in the G5 (China, India, Brazil, Mexico, South Africa) as well as other countries like Egypt to the usual meeting of the G8 rich nations to talk about climate change. This is a clear recognition that global issues require a wider set of participants than Western ones plus Japan and Russia.

Despite this, there was no concrete agreement that shows a way to conclude the Copenhagen agreement later this year to supercede the Kyoto Protocal which is due to expire. There was recognition of the ultimate aim to halt climate change, but goals are not the same as action. Today's focus on preserving international aid commitments might be more fruitful, particularly as this crisis has highlighted the fragility and volatility of developing countries to the fortunes of the world economy. The shift in aid from donations to agricultural assistance to help farmers to produce their own food is a positive one, if they can agree on the steps to achieve that aim.

In many ways, a focus on climate change and aid are more realistic goals for rich nations, since the G20 has to take the lead on the global economic crisis. However, this financial crisis stems from the Western countries and they could have said more about whether their banks are on a sound footing and how they intend to return to prudence. For instance, Europe has not published the "stress tests" of their banks, unlike the United States, which results in uncertainty that could jeopardise the financial stability needed to underpin sustainable economic recovery. Also, the lack of detail about concrete efforts to reduce fiscal deficits and the manner in which quantitative easing will be reversed will continue to cast a shadow on the recovery in the West whereby emerging economies will be wary about the intent of these countries to inflate their way out of recession. The limited progress on international issues and even in the areas where rich nations could have addressed makes one wonder if there is any need for an annual G8 summit. The large emerging economies are invited anyway, and it increasingly seems that unwieldly as it is, the G20 summits (the next one is scheduled for September in the USA) will be the forums to look to.

8 July 2009 Macro-prudential and micro-prudential regulation

The former refers to regulating systemic risk, while the latter monitors the actions of firms at an individual level. Today's Treasury's proposals is expected to provide more detail on the latter, while the former is still to be fleshed out. There is undoubtedly a need for better regulation at a systemic level, but does it involve changing the inflation targeting regime of the Bank of England to one that includes asset bubbles? The transparency of the inflation target and the independence of the BoE were both intended to avoid the "time inconsistency" problem whereby central banks will act to gain output at the cost of inflation if their aims include objectives other than price stability. There is, though, a significant question as to the role of central banks in the pricing of money/credit and risk which has been evident in this crisis. By focusing on inflation and thus keeping money cheap during a liquidity build-up because prices were low as a result of global deflationary pressures, monetary policy was too lax in the face of an evident housing bubble and unsustainable global imbalances. To expand the remit, however, presupposes to an extent that central banks can identify asset bubbles as compared against strong growth as a result of economic fundamentals.

Micro-prudential regulation, by contrast, shows that the Treasury has firm and somewhat differing views from the Bank on the issues of financial sector reform. It, along with the FSA, prefers counter-cyclical capital requirements so that firms will be asked to build up capital during good times instead of capping size, and the FSA will inspect banks individually to assess their risk profile and linkages throughout the financial sector. There will be an orderly winding up procedure so that banks which fail do not generate systemic failure. The tri-partite system will remain in place, but with unanswered questions concerning macro-prudential regulation. There will not be a cap on remuneration nor on the more restrictive rules governing hedge funds as proposed by the EU. So, the Treasury does not believe that banks which are too big to fail are too big, but is aware of the need to impose greater regulation of systemic risk and counter risky behaviour and the bonus culture through capital buffers. It's a welcome start to propose micro-prudential regulations that seem plausible to implement. Whether these will be reconcilable with the EU proposals or even the Bank of England remains to be seen.

2 July 2009 Permanent loss of output due to the financial crisis?

An affirmative answer is the conclusion of a report by the European Commission that the Euro Zone economy will experience a permanent loss of output due to the financial crisis which will decrease the long-run trend growth rate.  Similar questions have been asked in the UK where there is an acknowledged permanent loss of revenue on account of the collapse in the City, leaving a 4% structural deficit. The argument is that the financial sector will no longer be as significant as it had been in the economy, so there will be less output and growth due to a diminished sector that accounts for 1/5th of the economy in the UK and is also sizeable in Western Europe. This assumes that no other sector arises to fill its place.  However, the UK experience might suggest otherwise.  When Britain de-industrialised in the 1980s, it was able to maintain its trend growth rate of around 2.5% to 2.75% in the subsequent decades because services quickly grew and made up for the decline in industry.  Indeed, specialisation in services in a globalised world hastened the de-industrialisation process.

The question is whether this can be replicated. What type of economic activity might arise to fill the gap left by a shrunken financial service sector? Candidates are "green" industries and a knowledge-based economy. Even if these are the promising new sectors, it will take some time for Europe to make the structural adjustments necessary as there will be a mismatch of skills between jobs and labour for a while, e.g., workers will need to shift from being financiers to high-tech workers. Also, it takes investment and entrepreneurship to establish new industries, particularly in a globalised world with intense competitive pressures. Nevertheless, productive workers are likely to seek out new work to maintain their earnings. This is perhaps where the other part of the EC report looks discouraging. It points out that more than half of the population in the EU today is over 50. In 50 years, there will be almost twice as many elderly people than the young. Unfavourable demographics had already led to a downgrade of the Euro Zone growth rate after 2020 to a weak 1.5%, falling to 1.3% after 2041, and substantially below the current 2.2% trend growth rate. This crisis will worsen those figures unless the birth rate increases or younger workers are brought into the euro area, which can help with the structural adjustment in old Europe.  Even if there is disagreement over the permanence of the effect of this crisis, the demographic challenge is evident.

1 July 2009 No quick recovery is assured

The Office for National Statistics (ONS) released yesterday a revised estimate of GDP that showed a -2.5% fall quarter-on-quarter, steeper than the previous figure of a 1.9% decline. Taken year-on-year, GDP has shrunk by -4.9% from the first three months of last year to this year, which is the largest fall on record.  The initial releases are always subject to revision, and this one may well still be revised since the ONS also state that this new figure is based 85% on data and 15% on forecasts (as compared with the previous figure which was 45%-55%). This revision is largely driven by replacing forecasted construction data with actual information, and showed that that sector fell by 6.9% as compared with the previous quarter which is some five times higher than the original estimate and thus pulling down overall GDP.

This is thus far the worst annual decline in national income and output in British history with some time yet to go so it may also be the worst peak-to-trough recession. Looking at productivity (output per worker) which has fallen 4.2% in the first quarter as compared with a year ago as well as a fall in output per hour worked which fell 2.4%, the downward trend is evident. In manufacturing, output per job basis was down 8.3%, while unit wage costs grew by 3.6% as output growth fell. Services output fell for the consecutive 10th time, measured quarter-on-quarter, with only the government sector registering growth out of all 5 service sectors. Since services comprise three-quarters of GDP, a fall of 4% in the first quarter of this year as compared wtih the first quarter of last month again echoes the dramatic deterioration in economic activity.

Getting a better picture of where we were at will help with mapping where we might be headed. The extent of the fall in output across the economy -- in manufacturing and services -- as well as declines in productivity suggest that there will be less slack in the economy, which will mean a better rebound if firms will need to purchase to meet demand and thus raise production. The fall in consumer spending, though, as households de-leverage and continue to increase their saving rate sounds a wary note as final demand may be stymied. The uncertainty in the housing market will also dampen the willingness to consume because of the inverse of the "wealth effect" whereby consumers will be less inclined to borrow to spend if their "wealth" held in their housing asset is stagnant.  The contraction in the trade deficit improves the overall economic position and reflects the weak Pound, but it also makes consumption of imports more expensive and thus inflation will also hold down consumption. Unless demand picks up from home or abroad, no quick recovery is assured.

26 June 2009 Rocky road ahead

The Bank of England’s latest Financial Stability Report warns that there are still substantial risks in the financial system. More worryingly, it points out that future public support measures may not be as effective. In addition to continuing write-downs on troubled assets, the Bank highlights potential problems in more traditional assets (e.g., commercial property) and also stemming from emerging markets (e.g., emerging Europe) as a result of the recession. If this wasn’t enough of a concern, it also says that the government’s support of banks may not be as effective because rising public deficits will raise alarm in markets and in turn lead to higher borrowing costs for banks. To assess how bad it could be, the UK has the second largest bank assets to GDP ratio (over 400%) among major economies, smaller only than Switzerland (some 900%) and unfortunately larger than Ireland (just under 400%) which has been predicted to have the toughest recovery in the OECD. For the United States, the ratio is the smallest (less than 100%) partly because its economy is some four times larger than the largest European nations like Germany and the UK.

The rest of the report sets out a cogent set of issues for financial regulatory reform, along the lines of more self-insurance in banks and better management of risky assets as well as a more systematic view that would arguably limit bank size. Among these are sensible suggestions to provide more orderly winding down of banks and a better funded (and presumably more efficiently paid out) deposit insurance scheme. This would have addressed the Northern Rock debacle where the lack of such measures led to the first bank run in a century. Others have to do with imposing counter-cyclical capital requirements so that banks build up a capital cushion during good times. The idea, though, that there should be contingency plans to access capital during downturns is not evidently workable. Perhaps debt-for-equity swaps put in place that are triggered during those times? But, will investors want eqity in troubled banks? The Bank is also proposing trading securitized assets on exchanges or clearing houses so that complex instruments are better monitored as well as central counterparty clearing. The former would have brought the shadow banking system into the system by monitoring the activities of derivatives trading by hedge funds and private equity firms, for instance. The latter of these suggestions would attempt to avoid the linkages seen in the case of the failure of Lehman Brothers which brought down other counterparties and spread the financial crisis globally. There was also mention of resolving global imbalances but stated that this problem dates back to Bretton Woods in 1944 and has not found a satisfactory solution. Finally, the report raised but did not recommend a particular stance on the issue of whether banks that are too big to fail are just too big, but said that banks should not be too big or complex.

There are several areas, though, where the report raises the issue but does not say much. For instance, it proposes that there should be explicit principles governing when there should be a bail-out, but stops short of saying what they should be. In other words, why rescue one bank and not another? It doesn't fully contend with the possibility of taxing banks to fund their own bail-outs as a further form of self-insurance, such as a scheme similar to the one for deposit insurance. If the banks must pay into such a fund, then there will be a curbing tendency on their risky behaviour. In many ways, structuring incentives in this manner could be more effective and prove to be operationally efficient – both key criteria in a well-functioning regulatory system. Also, the report does not delve into separating retail and investment banking within banks. This is favoured by the Tories and the Lib Dems but not Labour. The Treasury’s view is that this is not going to prevent the next banking crisis, though they are aiming to ring-fence investment from retail banking. Finally, the report recognises the difficulties of implementing counter-cyclical requirements since it is difficult to ascertain if there is an asset bubble. Taking it a step further, the Bank wants regulatory oversight restored to it. Will this also mean adding ‘leaning against an asset bubble’ to its objectives when it sets monetary policy?

This report doesn’t provide all of the answers to these questions and some notable ones remain outstanding, including as well those raised in my June 22^nd blog about how the regulatory system should work at the global, regional/EU and national levels. But, these are mostly the right issues to consider, so it is a pity that the Bank hasn’t been consulted on the current government White Paper on regulatory reform.

24 June 2009 Protectionism and "Buy China/Buy American"

The current case brought by the EU and USA against China before the WTO challening China's export taxes and quotas on select raw materials which limit exports and result in a cheaper price to domestic producers is yet another instance of protectionism in this recession. It may well be the case that WTO rules do not explicitly cover this issue, but China agreed in its terms of accession to reduce such export taxes and quotas, making it likely that they will lose before the WTO.  Also, the recent shift in policy to "Buy China" for its stimulus package goes against its previous stance of contrasting itself against the "Buy American" provision in the U.S. stimulus measures. The Americans passed the package with the restriction intact by modifying it to be consistent with international treaty obligations. This refers to the limited coverage of the WTO. Government procurement, as well as competition policy, are part of the "Singapore issues" which were dropped fairly early on in the Doha Round negotiations. As such, China and America can restrict foreign bidders for government contracts. With such actions taken in two economies with the most notable stimulus spending in the world, the rhetoric of the recent G20 summits sounds increasingly hollow. That being said, this is not a wholesale reversion to rampant protectionism as these measures are so far relatively restrained as policymakers seemingly recognise the need to be open to trade and investment, but are also wary of the political ramifications of rising unemployment at home. Even if the recession has bottomed out, unemployment will continue to rise for some time. Let's just hope that protectionism does not increase as well since that could have the potential of strangling sustained recovery in the same way that premature policy tightening could.

22 June 2009 New financial regulations within a multi-layered system of governance

Both the U.S. and the EU last week announced reforms to their financial regulations which leave much unanswered and expose lingering divisions over the nature of such reforms. The first issue erupted within Britain between the Chancellor and the Governor of the Bank of England over whether banks which are too big to fail are just too big. If a bank poses a systemic risk, then surely it is "too big" and ought to either increase its capital or indemnify the government against a bail-out which is inevitable. Limiting size is not favoured by the Chancellor or the U.S. Treasury, raising the prospect of regulatory arbitrage if large banks and financial institutions flock to jurisdictions without size limits. This suggests the need for some degree of regulatory harmonisation or even a global regulator, as pushed for by the French.  Second, the Fed has received greater powers to regulate the banking system with oversight in the Treasury, which is not in the works for the Bank of England. The divestiture of responsibilities for financial regulation was one of the premises of central bank independence in 1997, but the Bank wants the power restored, which raises a larger challenge to the continuation of the central bank independence from political oversight model. The "time inconsistency" problem whereby central bankers could set monetary policy to achieve aims other than low inflation would return; though, the current crisis has already raised questions about the focus on inflation rather than asset bubbles in the purview of the central bank. Third, as implied already, the lack of a global regulator is potentially problematic if global financial markets continue to be governed only nationally. Is the enlarged Financial Stability Board within the Bank for International Settlements sufficient to operate as an 'early warning' system?  Fourth, the EU has set up on Friday a European wide regulatory body, but bail-outs are funded by national taxpayers, so the principle that such a pan-EU regulator should not impinge on national fiscal policy is a needed one since the EU is not itself a fiscal authority. Finally, the balance between Euro Zone and non-Euro economies has been struck so far at the insistence of the British to not undully place the ECB at the helm. However, although necessary given the European-wide exposure of many banks, the need for both "macroprudential regulation" governing systemic risk and "microprudential regulation" at the firm level raises further questions as how this multi-layered system of governance will work. More importantly, will the sharing of oversight with supra-national and within the various bodies of national regulators avoid the trap faced in the UK with the tripartite authority in which nobody seemed to be in charge at the onset of a financial crisis?

17 June 2009 The first "bad bank" in the euro area

Ireland has created the first "bad bank" to take on the troubled assets of its banking system in the Euro Zone countries. The National Asset Management Agency (NAMA) will take on €80-90 billion worth of bad assets from Irish banks, which will worsen a fast deteriorating budget position from an expected 59% of GDP this year to doubling it. The budget deficit this year is 10% of GDP, considerably above the Maastricht Treaty's 3% in the Euro area. However, without an independent monetary policy and possibility of currency devaluation, the reliance on fiscal policy is expected. Interestingly, despite 2 downgrades of its sovereign debt from AAA to AA+ to AA, Ireland has raised €1 billion of bonds this week as investors seemingly sought the higher yields and discounted the prospect of default.

This may explain the creation of a "bad bank" which has not been done elsewhere. If bond investors are willing to purchase Irish debt, then taking the fiscal hit now may forestall a lingering banking crisis. If Sweden's example is repeated, it may even mean eventual profit from the troubled assets when markets recover. This, of course, is premised on the willingness of the bond market to support Irish debt. Since the ECB implicitly stands behind Ireland (and explicitly in the case of Sweden in supporting the Swedish central bank's propping up of Latvian debt), this may well be founded, though only time will tell with future bond offerings.

On a different, somewhat related, but intriguing issue, Latvia's precarious clinging to its exchange rate peg is being supported by Sweden because potential losses from loans to Latvia could amount to 5% of Swedish GDP. The Swedish krona is in turn supported by the ECB. If Latvia experiences a currency crisis as a result of a financial crisis, then it would fit the third generational financial crisis model seen in Asian in the late 1990s. However, if Sweden is dragged into a currency crisis because of exposure to Latvia and the krona shadowing of the euro is disbelieved, then that could pose an interesting case of perhaps a new form of a currency crisis.

16 June 2009 Two sides to being the global reserve currency

The BRIC (Brazil, Russia, India and China) countries held their own and first ever summit in Russia today, providing a counter-weight to the G8 summit that took place in Italy (which includes Russia plus the G7 countries). The issues discussed at the two summits were expectedly different. The G8 focused on sustaining any signs of economic recovery and to maintain vigilence over further weakness in the banking system. The BRIC summit looked instead to the implications of those policies for emerging economies, notably, the U.S. dollar. The BRIC countries are slowly but surely moving away from a view of the dollar as the global reserve currency. Russia and China are poised to purchase IMF bonds, which are denominated in SDRs (a unit of accounting that is comprised of the dollar, euro, Pound and yen) and would also give them a greater stake in goverance. More importantly is that these countries are discussing using their respective currencies for units of trade and agreeing bilateral currency swap agreements that will divest the dollar of some of its role if the RMB or Real is used instead.

To be clear, these are not large steps, but a series of small ones that reflect that anxiety of these economies toward the looming U.S. budget deficit. The reason that these have to be small steps is because even SDRs are mostly weighted toward the dollar, which reflects the U.S.'s significant weight in the global economy. Also, energy is priced in dollars as are commodities, making it difficult for Russia or Brazil to diversify significantly. International business and investment are largely denominated in dollars, so India's financial transactions abroad are likely to be weighted toward the greenback. China's exchange rate is pegged fairly closely to the dollar despite re-pegging in 2005 to a trade-weighted basket, which will favour the dollar due to the U.S. being its largest trading partner (the EU is, but not Euro Zone countries alone). These countries will continue to demand dollars, but the concerns expressed should still raise red flags in Washington DC since even diversification at the margin for such large holders of dollars will affect yields.

The BRIC countries have benefitted from their various links to the U.S. dollar and the Americans have gained from the primacy of their currency, including strong growth and low interest rates. However, the Americans have to set domestic policies always with an eye to the external global economy.  Indeed, when the Fed started to raise interest rates in 2004, they did not see the response in bond markets. Interest rates continued to rise until 2007 when the housing market burst. Emerging economies had helped to flatten the yield curve, rendering U.S. monetary policy less effective than expected in counter-acting the excess liquidity that was part of the housing bubble. Therefore, as with all issues in economics, there is a good as well as a not-so-good side to being the global reserve currency.

12 June 2009 The financial crisis has still to run its course

The debt-for-equity swap (of sorts) brokered for West Bromwich Building Society and Barclays selling BGI as well as the report from the Bank of England that the number of mortgage holders with negative equity has reached around 1 million in the span of just 18 months all point to the ongoing nature of the financial crisis. The IMF estimates that banks have only written down one-third of their losses from securitised assets, which means that there is several hundred billions more to come. With house prices falling by 30% in the USA since 2006 and nearly 20% in the UK since the autumn of 2007, 1 in 6 mortgage holders in America and 1 in 9 in Britain are in negative equity whereby their mortgages exceed the value of their homes. The IMF estimates the house prices are still overvalued, by some 10% in the UK, implying that the negative equity position will worsen. If repossessions increase, then banks will need to recapitalise. Where these are securitised, then there will be further impairments to bank balance sheets. So far, although the drop in house prices is dramatic and exceeds the last housing market bust in the early 1990s which saw house prices decline by 15% from 1989 to 1995, repossessions are low due to historically low interest rates and government measures to avoid foreclosure as much as feasible. If unemployment, though, rises as well as interest rates -- both of which are expected over the course of the next couple of years -- then the situation may change and negative equity will be realised with potentially significant impairments on bank balance sheets.

Also, as pointed by the U.S. Federal Reserve Chairman Ben Bernanke recently, banks could also suffer write-downs due to other asset classes declining in a recession, notably, commercial property and credit cards. The rescue of West Brom BS due to over-extension on not just residential buy-to-let mortgages but also the commercial property market, similar to the collapse of Dumferline BS in March (which had taken on £650 million of commercial property loans), point to the collapse of these other asset classes. With unemployment expected to rise even as the economy stabilises, credit cards may well also begin to affect banks. Shoring up balance sheets while there is an equity market rally seems to be the strategy of a number of banks at the moment, including the 10 U.S. banks paying back TARP funds and even the sale of a division as with Barclays.

Most banks are offering mortgages with a 25% deposit which will guard against further house price falls up to that amount of equity, but existing loans on their books may give them pause. With credit conditions tight, consumers worried about negative equity will be further induced to save. Any recovery will thus be tepid, but perhaps that is the most which can be expected in a financial crisis of this severity characterised by the need to shed debt and de-leverage in all sectors of the economy.

10 June 2009 Is the recession over?

The National Institute of Economic and Social Research (NIESR) believes that the recession in Britain ended in March as GDP growth in April and May was positive in their estimation. Separately, Markit finds that the latest PMI figure indicates expansion in all sectors, leading other major European economies as pointed out by Paul Krugman in the New York Times, and confirming the positive industrial output figure reported by the ONS that industrial output expanded by 0.3% in April, and manufacturing output rose in both March and April. Business surveys point to an expansion in the services sector, another positive sign.

However,  at this point in the cycle, it is not apparent whether this pick up in output is a re-stocking phenonmenon, whereby stocks held by firms for future sales are being replenished after being allowed to run down during the recession, or production in response to an increase in final demand. Inventories (though a small proportion of total expenditure as compared with consumption, for one) was the largest component of GDP decline in the first quarter.  As the most volatile component of GDP, output could rise while firms replenish stock which had been allowed to decumulate due to pessimism. On the other hand, as final demand recovers, replenishing stock will cause inventories to rise ahead of other indicators.

It is too early to say whether this expansion in output is a result of replenishing stock or a rise in final demand. If it is the former, then there will be another drop in GDP as firms cease to build stock if demand is not there. Monthly figures used by NIESR are more subject to such volatility than the quarterly official figures, but does give an earlier glimpse as to what is happening in the economy and we would all want to know as soon as feasible if there are signs that the worst is over.

2 June 2009 Pause in monetary policymaking: deflation in short-run & inflation in medium-term

The Reserve Bank of Australia (RBA) today kept its base rate on hold at 3% after cutting 425 basis points since last September, and a pause is also expected this week for the Bank of England (base rate at 0.5%) and the ECB (base rate at 1%). The U.S. Fed is maintaining a nominal interest rate of effectively 0% (range between 0-0.25%), so nothing is expected there either. This could signal that central banks believe that the worst of the global recession is over, so they are waiting and seeing for the moment. Perhaps more likely, because monetary policy operates fully over a 2 year horizon, they are taking stock of the effect of previous cuts that have been aggressively made since last autumn. Also, real interest rates are 1.5% in Australia, -1.8% in the UK, 1% in the Euro Zone and around 0.2-0.4% in the USA. Deflation is therefore tempering the impact of monetary policy in the USA and potentially the Euro Zone, whilst bolstering Australia and Britain for the moment.

Thus, there is still the challenge that should not be under-played of navigating between the risk of deflation in the short-run and contending with inflation over the medium term. Inflation is below target for most major economies, but steepening yield curves point to the inflationary consequences of loose monetary policy over the longer term. For most countries with a banking crisis, this is compounded by the quantitatitve easing programmes that have expanded the monetary base to directly inject credit into the economy, bypassing the clogged banking system. There is also a concern that Western governments will attempt to reflate their way out of indebtedness. Thus, deflation now will lead to further cuts in rates, which in turn worsens the inflation problem in the future. Traversing this line will require a clear plan to roll back monetary policy, but not too soon.

25 May 2009 Warning shot to Britain over debt, but no need for panic (yet)

22 May 2009 Japan following global fortunes

Japan's -4% contraction in GDP in the first quarter (-15.2% on an annualised basis) ranks its recession as the worst in the post War period and on par with the volatility usually associated with developing countries. With a contraction of -9.7% year-on-year, it is remarkably close to a 10% decline that some would term a depression.  And, yet today, the Bank of Japan has issued the first positive assessment of the economy for three years and the government is expected to follow suit. An upturn in industrial production of a monthly gain of 1.6% in March (though it is likely to be related to inventory replenishment) and a slowing decline in exports (particularly as China's stimulus package takes effect) are the reasons. The BoJ expects the economy to turn a corner at the end of this year as a result, which sounds fanciful in view of the dismal growth figures. But, the world economy is expected to bottom out this year and return to positive growth but less than 3% in 2010. As such, Japan will be unlikely to recover until 2011 since its fortunes are closely tied to exports, as consumption remains as weak as ever, so investment follows the needs of exporters.

There is, in sum, little that the Japanese government can do except for easing the unemployment pains, which is what they have geared their large fiscal stimulus packages toward, and loosening the credit system even further to set the environment for investment and spending when global demand picks up. As such, the BoJ has expanded the collateral that it will accept for open market operations from commercial paper and corporate bonds to even stocks and sovereign debt from the US, Britain, Germany and France. The latter move will ease the credit crunch for exporters and does not fundamentlaly affect the profile of holdings of the BoJ since its foreign exchange reserves already include these bonds.  With core CPI (excluding food and energy) at -0.1% in March and CPI for the year expected to fall to -1.3%, inflation as a result of these quantitative easing measures is not a concern. The IMF has kept its GDP growth forecast of -6.25% for 2009 unchanged, which is considerably worse than the Japanese government's forecast of -3.3% to March 2010. We'll see on Monday whether the more upbeat assessment will convince the IMF to shrink this considerable gap.

20 May 2009 Quid pro quo at the EU-China summit

Summed up in a sentence, the Europeans want to sell things to China (particularly as China's spending nearly as much as the United States in its fiscal stimulus programme) while the Chinese want technology. Much of the groundwork had been laid in the earlier trade and economic dialogue on May 7th & 8th to pave the way for more trade and investment. Although there are signs of "Buy China" at the local government level, China needs the technologically advanced capital goods of Europe, while the Europeans (particularly big exporters like Germany) are keen to see global trade re-started -- and the only respectably growing major economy in the world this year is China.  The same calculus is evident in the climate change issue. The Europeans want the Chinese to increase their energy efficiency, while the Chinese want the technology with which to do so.  The Chinese have complained for some time of the barriers on European exports of  high tech goods. With the Europeans more keen than ever, the Chinese view this as a good opportunity.  Similar to Rahm Emannuel, Obama's chief of staff, they are surely not wanting to waste a good crisis.

15 May 2009 Stress tests and bailing out insurers

In a week where there has been talk of the worst of the recession being behind us and the positive reception of the U.S. stress tests conducted on its banks as well as Fed Chairman Ben Bernanke reaffirming the U.S.'s strong dollar policy, six major insurance companies have petitioned for rescue from the TARP funds. These insurers hold 18% of all corporate bonds, so stemming their investment losses is viewed as consistent with the aims of TARP which is to unclog the credit system. The vast majority of funding in the U.S. is from bond markets and not bank lending, so this is a crucial segment to prevent further financial ripples in the system.

Bailing out insurers was always the next possibility after banks since institutional investors are among the systemic players in the financial system. Coming on the back of the U.S. stress tests for its banks, it begs the question as to whether the assessment should have encompassed all systematically important players? Bernanke himself in a speech on Monday pointed to the possibility that traditional assets (not just those associated with sub-prime mortgages), such as credit cards and commercial real estate, could be vulnerable.  Are we thus headed for another round of financial sector rescues? If so, then we are not yet over the worst of the recession.

11 May 2009 What do the British and Chinese want from their bilteral summit?

In general terms, these countries want to see global trade resume and a sustained global recovery. This was also the conclusion from the EU-China summit that preceded the bilteral one between the UK and China in London today, when Europe and China called for a resumption of the WTO Doha Round and reform of financial regulations. As tends to be the case with these meetings, the aims sound agreeable but are too general.

Promisingly, the British and Chinese are poised to promote China's "going out" policy whereby its commercial firms will seek to establish themselves on the global stage. British firms are well placed to offer advice, particularly since the main challenge for Chinese firms will be to show that they are commercial entities rather than state-owned firms undertaking the outward investments. To do would require much greater transparency and disclosure, which are needed even for the listed firms that could still be under state control despite being publicly traded on international bourses.  Although state-led overseas investments will continue as China seeks energy security, the prospects for its economy will rest with private firms gaining know-how from global markets.  The non-state sector is the reason for China's successful transition and sustaining their productivity levels will thus be imperative. The Chinese recognise this, as this policy was launched during the mid 1990s when the economy's TFP (total factor productivity) growth slowed after the initial reform period that started in 1979.

Since Britain runs a surplus in the export of services (within an overall current account deficit relative to GDP of -3.8% in 2008), promoting this aspect has the best chance of realising economic recovery via international trade. Comparative advantage would reassuringly support this conclusion.

7 May 2009 Will the ECB undertake quantitative easing?

The European Central Bank (ECB) is expected today to cut its interest rate from 1.25% to 1% in the face of worsening forecasts from the European Commission that the Eurozone economies will contract by over 4% this year and reach an unemployment rate of 11.5%. Unlike other central banks in the U.S., UK, Japan and Switzerland, the ECB has not yet undertaken quantitative easing or the adjustment the money supply. However, with inflation at 0.6%, the real interest rate will be fairly close to zero, placing the ECB on the flat part the LM curve -- meaning that it may not be able to stimulate borrowing by cutting the interest rate any further, leaving direct changes in the money supply as the alternative. The still high Libor rates for borrowing as well as reports by businesses of tight credit conditions suggest that the credit crunch has not eased and the current policy of using fixed rate repurchase agreements may not be enough if it continues to work through the clogged banking system.

Unconventional monetary policy would instead allow the ECB to bypass the banking system through purchasing corporate bonds to stimulate the real economy. It can also, more conventionally, purchase government debt which is how open market operations typically operate to expand the money supply. Without the money multiplier of the banking system, the amounts will need to be larger than otherwise, which is a standard problem for other central banks as well.

What is not a standard problem is whose government debt to purchase and which corporate bonds (or commercial paper) to buy? This is a question that the 10 year old ECB has never had to face before. Because the euro counts 16 countries which have different credit ratings, it will need to decide which bonds to buy and thus which economies to boost. If it decides to avoid this issue and directly lend in the corporate bond market, then it also needs to assess which bonds to buy and there is again a disproportionate weight in terms of France accounting for 41% of the corporate bond market while Spain has 2.5%. The economies most in need of credit easing may not be the large economies such as France where its largest two banks posted positive earnings in the first quarter of this year, but rather the smaller ones most affected by the property bust (Spain). Thus, the decision is not only a political one but to craft a QE policy that will be effective.

The ECB may well do nothing unconventional and stick to broadening its current policies. With the amount of bad economic news in the Euro area, one can't help but wonder if a headline cut in the interest rate of 25 basis points will be enough to do the job. 

UPDATE (including BoE rate decision):

The ECB has cut the Euro Zone interest rate by 25 basis points to 1% and announced an unprecedented QE measure. It will purchase 60 billion euros worth of euro denominated covered bonds -- corporate bonds linked to property loans or loans to public institutions backed by a borrower's pledge to pay.  The foray into Pfandbriefe (as they are known in Germany) covers some of the worst affected assets in this crisis, according to Jean-Claude Trichet. The effectiveness of this policy in helping to ease credit conditions will depend on where these bonds are situated. As these are primarily a German asset, the spread of this policy may well be tilted accordingly, as I suggested above, and could affect its effectiveness.

The Bank of England kept interest rates on hold at 0.5%, but announced that it will use all but £25 billion of the £150 billion of the authorised funds for quantitative easing over the next three months. What's surprising is that it is announcing another £50 billion to be injected when the current tranche of £75 billion has yet to be all spent, though it is on course to do so by June. The rise in yield of the benchmark 10 year gilts after the Budget to levels before the QE programme was implemented is likely to be a reason. Also, Libor spreads are higher in the UK than in the U.S. and Euro Zone, so this may also kick off purchases of corporate bonds to bypass the banking system and ease credit conditions. The latter may work, though it will increase the riskiness of the BoE balance sheet. The bigger worry looks increasingly to be the limited ability of the Bank of England to affect long-term interest rates. Usually, short-term interest rates are targeted because they are more effective, whereas longer-term interest rates reflect expectations about the economy. From this, it appears that the Bank of England is fighting against a sober bond market that recognises the borrowing burdens of the UK government and is pricing in higher interest rates as a result. This would not be welcome news for either the Treasury or the Bank -- the former because debt will be more expensive to service and therefore economic stagnation after recovery will look more likely and the latter because the cost of borrowing that is stimulative of the real economy is not coming down as much.

5 May 2009 Achieving global stability

Nearly a quarter of the world's countries have sought the assistance of the International Monetary Fund as of March. Some 48 countries (with 3 pending) have utilised some form of short-term liquidity from the Fund, though some are precautionary facilities and others are drawing upon the newly created flexible credit lines (namely Mexico while Poland and Columbia are pending approval). None of these are in East Asia (with the exception of Mongolia) or the Middle East/North Africa.  Eastern Europe/Central Asia, Central America and swathes of Sub-Saharan Africa acount for the bulk of the lending. Iceland stands out for its own reasons as a rich economy in trouble.

None of these have banks near the source of the financial crisis, but the global credit crunch has hit them hard as well as the collapse in global trade. The Bank for International Settlement estimates that global cross-border lending fell by an astounding $5 trillion in the nine months to last December, the sharpest fall on record, while the WTO forecasts that world trade will contract by some 11% this year, also the largest since the Great Depression.

29 April 2009 U.S. recovery?

The latest figures show that the U.S. economy contracted by 6.1% (annualised rate) in the first quarter of this year, barely changed from the 6.3% recorded for the last quarter of 2008. The U.S. government predicts that the economy will contract by 1.2% this year, followed by growth next year. As mentioned in my blog of April 22nd, the IMF would disagree with expected growth next year, and these would seem optimistic given the dismal showing in the first three months of 2009, following from 2 previous quarters of negative growth.

However, markets are up and there is talk of some signs of recovery. Inventory de-stocking accounted for Specifically, consumer spending, which accounts for a whopping 70% of GDP, is up 2.2%. Durable goods purchases increased GDP by 1.5 percentage points, and spending on services is also up. Although business and residential fixed investments are down (the former knocked some 8.83 percentage points off of GDP), the focus is on consumption because of its weight in GDP. Consumer confidence is at a 2 year high and there are some signs of an uptick in home sales -- though from a very low level.

Nevertheless, given the deleveraging in the household sector in the U.S. and 500,000 people each month losing their jobs (unemployment is at 8.5% and expected to reach some 10% by the end of the year), relying on the U.S. consumer may not be enough. The $787 billion fiscal stimulus package is expected to take effect in the second half of the year, adding some 5.5% to U.S. GDP. Since exports and investment are both down, government spending is the only other sector to look to -- so those "shovel ready" projects may be the driver of a U.S. and therefore global recovery. Now, of course, to pay for it and cope with inflation as well after the massive quantitative easing programme undertaken by the Fed, it is a whole other problem to contend with the consequences. And, finally, some half of the contraction is due to a fall in inventory which is viewed positively if that means that firms will then increase capital spending after de-stocking. To finance it, though, would require resolving the credit crunch -- and the Fed and the US Treasury programmes will again be key.

24 April 2009 The UK is shrinking faster than expected

The economy in the first quarter of 2009 contracted by 1.9%, which is worse than expected. As this is a quarterly estimate, the annualised rate of decline for the year would be double the magnitude set out by the Chancellor just two days ago (between -7 and 8% versus -3.5% in the Budget). It dwarfs the IMF estimate of -4.1% as well. But, the likelihood is that we won't have 4 quarters of such contractions, so the yearly change of just over 4% decline from the previous quarter in 2008 might be a better gauge (ONS preliminary estimates). Declines in manufacturing output accounted for the biggest factor pulling down GDP, similar to the last quarter of 2008, even though it accounts for only 15% of the British economy. By getting the growth figure wrong, the borrowing figures will also be wrong. Come the autumn when the Pre-Budget Report is presented, the stock of debt may well near £1 trillion a year early.  If this Budget was gloomy, then it's hard to see how the next one will cheer us up.

22 April 2009 A tough Budget

The 2009 Budget unveiled today by the UK Chancellor expectedly showed record borrowing for the year and also an optimistic view of growth. He downgraded growth for 2009 to -3.5% from around an 1% contraction forecast in the Pre-Budget Report (PBR) last November, which confirms this as the worst recession since World War II. The early 1980s recession recorded a 2% contraction in GDP. The Chancellor then predicted recovery by the end of the year, growth of 1.25% in 2010 and a jump in growth to 3.5% in 2011, followed by reversion to the trend growth rate of 2.75%. Unfortunately, the IMF today also issued its own forecast for the UK which is worse and does not project recovery until after next year: -4.1% in 2009 and -0.4% in 2010. The government's growth figures were in part premised on recovery in the global economy, which is expected to contract by 1.3% this year and grow by 1.9% next year. Negative growth in the global economy is unprecedented in the post-war period and a growth rate under 3% is considered to be a recession since global growth has to take into account population growth. Therefore, the government's figures are not only optimistic but also unfortunately grounded in a global recovery that might not materialise.

More worrisome is the reliance in large part on growth and recovery to halve the budget deficit in 5 years. It is predicted to fall from 12% of GDP this year to 5.5% in 2013/14. This means that the national debt is expected to grow from 50.9% in 2008 to some 79% of GDP in 2015/16. The government expects this to fall in about a decade.  Borrowing of £175 billion this year (well exceeding the £118 billion forecast in the PBR) and a similar magnitude of £173 billion next year will cause the stock of debt to rise to over £1 trillion from £743.6 billion today.  If the IMF is also right that there are more bank losses to come which will require government rescue, then the borrowing figure will be even higher since the government has at present figured in 3.5% of GDP or some £52 billion in losses.  Also, because the financial sector contributes 27% of tax revenues and that is not expected to continue at such sums, the Institute for Fiscal Studies has estimated a 0.4% permanent increase in the structural debt that will not go away even when the economy recovers, adding another £5.8 billion in debt each year.

To get debt levels to begin to fall, fiscal tightening measures were announced for 2010 onward with some fiscal expansion this year. The fairly small scale-stimulus measures would offer welcome help to the unemployed, homeowners, savers and small businesses. However, after this year, austerity will kick in.  Public spending will fall from an annual real increase of 1.2% announced in the PBR to 0.7% from 2011. Although this is the most austere stance on public spending since 1945, to increase public spending at all should mean higher taxes in order to bring down borrowing. However, there was only one new significant tax announced -- which is on the rich (also brought forward to take effect in 2010 instead of deferred to 2011 as in the PBR): those earning over £150,000 will face a new tax rate of 50% and additionally personal allowances will be withdrawn from those earning more than £100,000. For the top tier of earners, they will also suffer a reduction in tax relief from their pension payments. The government expects these measures, along with excise duties (petrol, cigarettes and alcohol), sales of assets such as the Royal Mint, and the 0.5% increase in National Insurance announced in the PBR as well as the reversion of the VAT to 17.5% in 2010 to go some way toward stabilising the debt while increasing public investment and maintaining front-line services like education and health. This may well be possible for the indirect taxes and NI, but the IFS doesn't think that taxing the rich will yield that much. Adding in NI, the top marginal tax rate is over 60% and there is some evidence from the U.S. that tax receipts fall once taxes reach that level.

All in all, it is the optimistic growth forecasts that should generate the most concern. If the economy does not grow next year and stagnates (according to the IMF which predicts 0% growth for the United States in 2010 which is better than the forecast for the UK), then it is hard to see how the government can tighten fiscal policy as that would worsen the recession and delay the recovery.  By extension, borrowing will get even worse.  For the sake of the country, we can only hope that the Chancellor has gotten it right.

7 April 2009 China predicted to recover by the second half of 2009

The latest World Bank report on developing Asia forecasts that China will recover by the second of the year and propel growth in the region (except for Japan, Korea, Taiwan, Singapore) to grow at 5.3%. Although down from 8% growth in 2008, that would be an achievement in a global economy predicted to contract by between 1-4% this year. It may well be possible if China's massive stimulus programme of nearly $600 billion boosts GDP by some 8% this year and next, as well as newly announced social spending measures of some $125 billion for health care and others. This could increase GDP by 10%, thereby largely counter-acting the fall in exports. The current account surplus had accounted for over 10% of GDP in the past few years, so this increase in government spending goes some ways towards making up for it.

As such, government spending will rise from 18% to 22% of GDP once the double counting in the stimulus is removed. China is considerably below the level of Western economies with welfare states in which the government component accounts for around half of GDP once a social safety net is in place. With a low deficit that will rise from 0.4% to around 4% this year (although a lingering non-performing loan problem remains), China is capable of spending more on social welfare. At the moment, it is even below the average for developing countries which spend 25% of GDP on redistributive and social policies. By doing so, China will not only grow, but will spend on its people that might just reorient its economy toward domestic demand and generate a growth momentum that is more sustainable than exports.

6 April 2009 Japan is first off the mark

2 April 2009 A sensible compromise at the G20 summit

The headline figure in the G20 communique is the $1.106 trillion to the IMF and other international organisations. But, there will be no new government spending to shorten the recession or details of a global regulator. The figure of $5 trillion or 4% of global GDP to be spent by end 2010 is based on the existing commitments of governments. There was also no coordination that was supposed to increase the effect of the national stimulus packages and lead to job creation/saved of 7 to 19 million worldwide. It seems that the German and the French position (as well as the Bank of England) has won the day and the coordinated 2% of new discretionary spending pushed by the Americans is out.

On regulation, President Sarkozy didn't get a global regulator, but he stayed. They did put some final touches to some already agreed principles in place: expand the authority of the Financial Stability Forum (re-named the Financial Stability Board) to provide an early warning system of global asset bubbles, regulate the shadow banking system of hedge funds and tax havens, as well as control bankers' pay and bonuses to deter risky behaviour. A common approach to toxic assets was also agreed, but there were no details. The same could be said for all of the regulatory reforms, except for the issue of tax havens.

The most significant thing to emerge from the summit, it turns out, wasn't recovery and reform, but rather global stability to rescue countries. This is more to prevent a worsening downturn than to stimulate growth. For example, if Iceland fails, UK savers and banks could lose money. China and India have been growing while the West is in recession but global exports are plumetting, so their effect is not notable due to being poorer. However, it is a significant amount of money that will be made available: $750 billion to the IMF ($500 billion + $250 billion in SDRs), $250 billion to support trade finance (or ease the credit crunch for exporters) and another $100+ billion to aid developing countries (which is presumably geared at meeting the Millennium Development Goals of halving global poverty by 2015 from 1990 levels). With the money coming not just from the USA, EU and Japan (each giving $100 billion), China is also putting in $40 billion and the rest will come largely from emerging economies. In return, global institutions will be reformed to give them a greater say and the USA and EU have given up their tacit understanding that one always appints the head of the World Bank and the other the IMF. This denotes a shift in economic power which is very noteworthy. Perhaps that is the most notable outcome from this summit, though it had been apparent for some time. But, did the summit achieve its ultimate aim to shorten the global recession and sustain our recovery? The answer is not an obvious yes. A package that I shot for More4 News on the measures of success can be found here.

25 March 2009 What it takes to be a reserve currency

An independent UN panel chaired by Joseph Stiglitz is reported by the Wall Street Journal to be prepared to recommend that a global reserve currency be created at the London Summit of the G20 countries next month. Comments by the Chinese central bank governor Zhou Xiaochuan has brought the issue to the forefront as such a move would mean creating a reserve currency that is not the U.S. dollar. A leading candidate is the IMF's Special Drawing Rights (SDR) which was created in 1965 and now consists of the U.S. dollar, euro, Sterling and yen, whereby the dollar accounts for some 44% of the basket. But, that's not 100%. Whereas international business, commodities and oil are all priced in dollars, making it effectively the reserve currency for the global economy with resultant benefits and downsides.

One notable benefit is that demand for the dollar is detached from the fundamentals of the U.S. economy, such that it can run deficits and loose monetary policy and still enjoy low interest rates. Another is that investors view the currency as a safe haven so that the Americans will find funding their debt much easier. In recent years, this reserve currency effect has also led to global imbalances whereby Asian and Middle Eastern exporting nations grew via exports by keeping their currencies competitive vis-a-vis the dollar. 

Can any currency be a reserve currency? The currency market needs to be deep enough for other countries to draw on the currency as needed for their external liabilities and trades. The SDR is a possibility, but will it be sufficiently divested from the dollar? If so, then which other currencies will take up the space? For the Chinese RMB to perform that function, it will have to overcome the initial hurdle of being convertible. And, that's been a tall order so far.

24 March 2009 Teetering on the brink of deflation

The RPI for the UK was 0% in February 2009, which makes for the first time since 1960 that the price level has not risen year-on-year. The CPI remains stubbornly high at 3.2% despite the economy contracting and the same pattern of constancy would be expected of core inflation which strips out the volatile items of food and energy. This would be good news for borrowers since inflation would erode the real value of their borrowing as households and firms de-leverage and pay down debt. This suits the Bank of England's liquidity injections which are intended to reflate the economy. For savers, deflation would have increased the real value of their savings, since a 1% price fall would equal a 1% increase in real returns on saved funds. Inflation has the opposite effect and so British savers now face a negative real interest rate on their savings as the Bank of England base rate is 0.5% while CPI rose to 3.2% from 3.0% in January.

Despite the Bank of England having to write a letter to the Chancellor to explain the breach of the 1% bound on the 2% inflation target, this is not a bad situation to be in. With the real economy expected to contract by 1.6% this quarter, deflation and the heavy cost on repayment of debt that would entail remain the primary concern. The weak Sterling pushing up imported food and energy prices and the effects of quantitative easing are all working toward reflating the economy. The Bank can only hope that it is not too successful as deflation can quickly become inflation and that would be very difficult to contend with if liquidity boosts and fiscal stimuli are still on the agenda then.

20 March 2009 Lessons from Northern Rock

Today's report from the National Audit Office makes for uncomfortable reading for the government. There were a chronicle of errors which led to the eventual nationalisation of Northern Rock in February 2008 months after injecting it with public support and then another round of financing was needed later that summer. In many ways, the most damaging aspects of the report are that the tri-partite authority of the Bank of England, the FSA and HM Treasury did not priortise dealing with the possibility of bank failures back in 2004. This included not revising upward the maximum deposit insurance from £33,000 or streamlining the payment process should there be a bank failure. This inaction led to the troubles of Northern Rock causing the first bank run in Britain in the modern era. Deposit insurance has since been reformed and the FSA has just announced comprehensive reforms to financial regulation. Also, the later nationalisations of Bradford & Bingley and HBOS were arguably conducted better. Nevertheless, this report underscores how far behind markets the regulators were. If there are any lessons to be learned, then this must surely be a crucial one.

19 March 2009 The U.S. plans to inject $1.2 trillion into its economy

A surprising announcement was made today that the Federal Reserves plans to buy $300 billion in long-term government debt (2-10 year maturities) and another $750 billion in mortgage-backed securities over the next six months. This follows from a $800 billion injection last December when the central bank also boosted money supply and thus undertook quantitative easing. This equates to a $2 trillion increase in the money supply in the U.S. and the Fed's balance sheet could hold an estimated $5 trillion of assets, some of which will be commercial paper and mortgage-backed securities that are not riskless.

To give a sense of magnitude, the U.S. is enlarging its nominal GDP by 10% which is similar to the UK's quantitative easing programme, but the absolute value is staggeringly large. There are only 14 countries in the world with an economy larger than $1 trillion and only 7 over $2 trillion, not adjusting for PPP. The U.S. may be creating credit and bypassing its clogged credit system to help a worsening economy, but all of these dollars floating around the world could transform a credit crunch into one characterised by excess liquidity. Liquidity was one the drivers of the current crisis and potentially the next one. If the emerging economies do not hold down prices, then there may be inflation to contend with as well the next time.

18 March 2009 UK unemployment exceeds 2 million

The latest ONS figures show that unemployment reached 2.03 million in Britain, bringing the unemployment rate to 6.5%. The number of people out of work rose by 165,000. The alternative measure, the claimant count, was also up by 138,400 from the previous month and reached 1.39 million. In terms of vacancies, there are now only 1.8 jobs per 100 employee jobs.  The dramatic falls in employment are found across the private sector, particularly manufacturing, which should not be surprising given that the credit crunch affects all aspects of the real economy. The city, for instance, accounts for only 1% of the labour force. Thus, the rise in unemployment in London was exceeded by the industrial Northeast and Wales.  The key driver appears to be redundancies, similar to the last quarter.

The redundancy rate of 10.5 per 1,000 employees was a rise from 10.2 in the previous quarter. These figures represent a significant jump from the start of 2008 when the rate was just over 4. This suggests that shedding workers is the largest driver of unemployment. This comes on the back of an IMF report that expects the recession to last into 2010, which means that unemployment could exceed 3 million or 10% of the labour force at the current pace of contraction. Stemming job losses would be crucial or the UK would face 1 out of 10 people out of work by the end of the year. So far most of these workers are short-term unemployed. The inactivity rate was 20.6%, which is only down 0.3 percentage points from a year earlier. If the recession turns into a depression, then workers could become discouraged and the inactivity rate would rise and the possibility of real recovery will be ever farther.

17 March 2009 The financial crisis and Africa

One of the most notable turnarounds is the change from negative to positive growth in sub-Saharan Africa during the past few years. The continent vividly represents the real gains made during a period of high growth but also asset bubbles in the West.  Africa will suffer the real economic downturn as global exports fall. But, so long as China and other industrializing countries such as India continue to demand exports of raw materials, commodities, energy, etc., then the impact on Africa will not be as severe as other developing (and developed) countries reliant on exports of manufactured goods which has contracted sharply. Although demand will not be as large as that which fueled the recent commodity boom, there is still a tremendous appetite coming particularly from China. This is evidenced by China’s recent investments of around $1 billion for Australia’s Midwest, a steel and iron producer, $2 billion for Oz Minerals, the world’s second largest zinc miner, nearly $20 billion for shares in Rio Tinto, including its mining operations around the world, and $25 billion invested in Russia in exchange for 20 years of oil supplies.

The terms of trade improvement, generated by rising export to import prices, seen in much of sub-Saharan Africa as a result is likely to continue, though at a much more moderated pace. The challenge for African nations is how to transform these real income gains into sustainable development. This will centre on two main factors. The first is to foster the process of industrialization so that modernization occurs rather than just resource extraction which does not help the country move up the value chain. Second, prudent macroeconomic management and maintaining a competitive exchange rate will be important, as robust exports can cause currency appreciation that erodes the competitiveness of other goods and services sold in global markets. Finally, countries that benefit from globalization are those which manage the process, including the terms in which foreign investment are made.

The last few years has seen robust economic growth in many African countries in contrast with the stagnation evident in much of the previous three decades. There may be an asset bubble that has burst and caused a global financial crisis, but the real economy gains are evident in Africa and in other emerging economies. Seizing this opportunity through gaining a better understanding of the changed global economic structure will be crucial.

13 March 2009 Not so much a global new deal as a new Bretton Woods

PM Gordon Brown is clamouring for a global new deal of coordinated fiscal stimulus policies to be adopted by the G20 when they meet in London next month. Today, leaders from the G20 will gather to lay the groundwork for the April 2nd summit. US Treasury Secretary Timothy Geithner has called for this group of 19 of the world's 25 largest economies (plus the EU) to spend 2% of their GDP to boost their economies and counter-act an expected contraction of that magnitude expected this year in the world economy. As these nations account for over 90% of global GDP and the bulk of world trade, this is the right gathering. But, this is unlikely to be what comes out of the London Summit.

There are two main aims of the G20 meeting. The first is to coordinate recovery programmes, since some of domestic spending will into imports that helps another country's exports. The second is to reform the intrnational economic system. The first goal is hamstrung by disagreement between the US/UK and continental Europe (although the UK Chancellor Darling also doesn't seem keen on more spending) over more packages that will lead to high government debt levels. The Germans and the French argue that there are more automatic stabilisers in their economies (e.g., social security spending that rises in a recession) than in the U.S., making it less necessary to use discretionary spending as a stimulus. Also, Europe, particularly those outside of the Eurozone, do not have the benefit of the reserve currency effect of the U.S. dollar which makes their borrowing costs much higher and thus more expensive to reduce government debt. Those in the Euro will worry about the implications of high debt for the sustainability of the single currency, though all European nations are likely to become indebted in this recession.

This leaves reform of the international economic system. The Americans and the Australians want to increase the IMF's funds available to bail out countries from $200 billion to $500 billion, and for this sum to come from the Chinese. The Chinese, though, want to see an increase in their stake in the IMF and other bodies before they put in more money so that the funding is commiserate with their control rights. That implies diluting the shares of existing countries, like the U.S. which currently has an effective veto over the IMF due to its large stake of around 12%. Also, the Europeans are keen to push for global regulatory reform while the Americans are reluctant. Nevertheless, there is general agreement that the global governance structure does not match the structure of the new global economy. Thus, progress is more likely. But, this is about what happens in the future and less about solving the current crisis. And, it took 2 years of preparation before the Bretton Woods system was set up. We mustn't get our hopes up about what the G20 can come up with by April.

11 March 2009 The Bank of England starts easing

Today starts the Bank of England's quantitative easing programme where £2 billion has been injected into the economy through the central bank buying gilts and therefore putting new money into the economy. As Mervyn King says, changing the quantity (supply) instead of the price interest rates) has been done before. But, there are unconventional aspects to this policy that make its success somewhat uncertain.

First, the Bank is authorised to purchase not just government bonds (the usual mechanism for open market operations) but also corporate bonds and commercial paper. This increases risk, but bypasses the clogged credit system. It also expands the monetary base without the benefit of the money multiplier whereby banks lend a multiple of its expanded reserves. This explains why the figures are so large in that the UK will increase its nominal GDP by 5% within three months when £75 billion will be injected into the economy.  Second, the purchase is of longer-term gilts (5-9 years) so that is attempting to influence future interest rates and not just short-term ones. It looks to be successful as the price of gilts has risen while the yields have fallen for 10 year bonds. Normally, medium/long-term interest rates are affected by the anticipated economic condition in 5 or 10 years and not by short-term interest rates which is why central banks focus on that segment that is more usually under its control. This effect may be due to the government taking on one-third of the gilt market, of course. 

Third, the Bank will be issuing some £150 billion of new government bonds to finance the government's debt. Thus, it is buying up to £150 billion whilst then planning to sell roughly the same amount on behalf of the Treasury.  This is not per se unusual in that deficit spending and loose monetary policy often go hand-in-hand during a recession. It is just a question of timing and this one appears to work by pushing down longer-term interest rates which will ease the cost of borrowing for the Treasury as well as boost the economy at a difficult time. But, it also emphasises the extent to which the government is counting on the nominal boost to the economy. When prices adjust to the 10%/£150 billion injection, then the real economic effects disappear since there are no new goods/services produced but it's just more money chasing the same amount. However, in the meanwhile, GDP is boosted and the Treasury borrows a bit more cheaply which helps the recovery. With deflation more likely than inflation, this policy may just work if investors are willing to sell gilts, though there doesn't seem to be much else to buy.

10 March 2009 Why rich economies should not be export-led

Japan's dire economic position -- 12.7% contraction in GDP in 2008 that looks to be downwardly revised, a plummetting stock market and a financial crisis like other rich economies -- underscores the fragility of the world's second largest economy despite its $5 trillion GDP. Double digit falls in exports to the U.S. and EU, particularly of cars which make up some 1/5th of its exported goods, is the cause, just as it was the engine of growth during the 2000s where Japanese GDP expanded by some 1.5%, a rate that is similar to France and Germany.  However, exports have collapsed.  Exports fell over 40%, leading to a record monthly current account deficit of $2.74 billion in January. 

Of course, Japan had little choice but to rely on exports to maintain positive growth during its "lost decade." Domestic consumption stagnated due to the deflationary trap, leaving firms to look for consumers elsewhere. Government spending racked up debts of 170% of GDP since fiscal policy was the only tool left as monetary policy was ineffectual when an economy is in Keynes's liquidity trap whereby changes in interest rates/quantity of money has no effect on the real economy, so that the economy is not self-righting. Nevertheless, this reliance on exports has caused it to have the worst recession among the rich countries. Even the UK, with an arguably worse financial crisis, a housing bubble and is also an open economy, has fared better thus far.

Japan is purported to be proposing to spend another 2% of GDP to stimulate the economy.  It will certainly hope that the London Summit of the G20 leads to coordination of these packages since Japan's recovery will depend on those Western imports of its cars and electronic goods.

7 March 2009 Asset Protection Scheme and Lloyds

Lloyds Banking Group has come to an agreement to take part in the Asset Protection Scheme offered by the UK government to insure £258 billion worth of troubled assets and the government will hold up to 75% of the shares of the company in return. Similar to the recent deal with RBS, this will guarantee that Lloyds will not incur more than 10% of losses from the troubled assets. The rescue was expected as the scheme was designed to help such troubled banks. With the cost of this insurance scheme (around £600 billion to insure Lloyds and RBS) and the nationalisation that it entails, the prospect of a "bad" bank looks more appealing. Or else we may well face lingering disclosures of troubled assets and write-downs as the recession drags down bank balance sheets, which then lead to more rescues and nationalisations that further depress the economy and it enters into a downward spiral. Taking the financial hit all at once could break that spiral and may even help ensure that there remains a commercial banking system at the end of this credit crisis.

5 March 2009 The Bank of England's plunge 

The most notable part of the decision taken by the MPC was the announcement of £75 billion to be used as part of the Bank's quantitative easing policy. By cutting interest rates by 50 basis points to 0.5% and announcing an increase of the money supply by up to £150 billion, the British central bank is intending to boost nominal GDP by at least 12% (since £75 billion roughly equates to 6% of GDP) on top of the stimulative effects of the interest rate cut. However, neither may boost to the economy if the monetary transition mechanism -- through which interest rates and purchases of government bonds/gilts operate in the real economy via the banking system -- remains clogged. The first half of the quantitative easing measure is geared at gilts and the interest rate operates through the banking system as well. We may have to wait for the second half of the funds that could go to purchase corporate bonds and commercial paper (longer and shorter term corporate debt instruments) to operate, as that bypasses the banks and puts liquidity directly into the pockets of business. As such, these are more risky than the usual buying and selling of government bonds in open market operations. In other words, when the Bank of England used to target the money supply (quantity instead of price of money which is the interest rate), it is done by purchasing and selling government bonds from/to the banking system to get the money into the economy. It doesn't just print money and spend it. The money multiplier, whereby banks keep some and lend out the rest, increases the effectiveness of the policy. Buying corporate debt bypasses the banks but also the money multiplier, so more has to be injected. And again, corporate bonds are not as riskless as government ones, so this part is untried but reflects the extent of the credit crisis for businesses which power the real economy.

With financial deregulation in the 1980s, it became harder to target the money supply, so the price was used instead in a regime of inflation targeting. Going back to trying to control the quantity of money may not be as straightforward as this plan appears. Taking on corporate debt as well may increase credit directly but will also raise the risk profile of the Bank of England.

4 March 2009 The Special Partnership: UK-US relations in the midst of the economic crisis

There may have been no announcement of specific policies to benefit the UK and although it was brief, the meeting between President Obama and Prime Minister Brown is important in establishing the relationship between these two leaders and also provides some political cover by showing agreement over their approach to the financial crisis. Obama and Brown may not see eye to eye on every issue, but neither is in denial over the scale of the economic downturn. Both are in favour of the aggressive use of fiscal policy. Each has already introduced fiscal stimulus packages which exceed 1% of GDP and shown a willingness to borrow heavily to finance bank rescues as well as use unconventional policies like quantitative easing. But, they face opposition parties at home which are concerned about the scale of the borrowing required as the credit crisis continues. One interpretation of the honour accorded to Prime Minister Brown to address both houses of Congress could be that the Democrats in charge are presenting a European leader who emphasises the need for deficit spending and is a show of international support for the approach taken by the Obama administration. Brown’s address to Congress suited the controlling Democrats while Obama inviting Brown as the first European leader to visit him in the White House accorded status to the PM.

As part of a country’s stimulus spending goes to imports, one country’s spending will spillover and benefit another. Although no practical help will come directly from the US to the other side of the pond, the measures taken by the Americans will certainly be beneficial in stimulating global demand. For an open economy like the UK where trade accounts for over one-third of GDP, that may be the most helpful of all.

A shorter version appeared in the London Evening Standard.

24 February 2009 China’s banks may be the largest in the world now but the old problems remain

With Western banks losing market value, the largest banks in the world are now the Industrial and Commercial Bank of China (ICBC) and China Construction Bank. However they may have escaped unscathed from the sub-prime mortgage fallout, China’s banks still face their own problems stemming from the legacy of transition.

The accumulation of non-performing loans (NPLs) or bad debts in China's banking system is a direct result of years of subisidising inefficient state-owned enterprises through the state-owned banking system. This has led to banking crises in other transition economies. The Chinese government attempted to rid the NPLs via two main methods. First, recapitalisation, for instance, by injecting some $45 billion from its foreign exchange reserves into 2 of the 4 state-owned commercial (SCBs) before their IPOs. Second, in 1999, they formed 4 asset management companies (AMCs) -- each attached to 1 of the SCBs, which took the NPLs off of the books of the banks, totalling some RMB 2,400 billion in the past decade. In turn, these AMCs issued bonds which paid around 2.5% interest to the banks for taking the assets. For the banks, a troubled asset has become fee-generating. For the AMCs, it had assets to peddle.

They attempted to sell the bad assets to private investors, including joint venture funds. Some of these were bought, initially because foreign investors believed that debt-for-equity swaps were possible, which would have allowed equity purchases into SOEs that had been difficult with China's restrictions on foreign investment. However, of the ones which were sold, the debt-for-equity swaps never materialised, so the appetite for these assets further dwindled. This meant that the better assets were sold, while the AMCs are left with the worst ones and still burdened with paying interest on the bonds, which they may not be able to afford. As the AMCs are state-owned and run, as are the banks, the common view is that these are liabilities of the state, pushing up China's national debt from the official 18% to some 22% of GDP.

Even this figure under-estimates the extent of the NPL problem. The issue is not just the stock but the continuing flow of bad debts. Before 2000, NPLs were substantial and around 1/3rd of the banking system's assets in 2001 when it agreed to open its banking sector to competition as part of WTO membership. Official estimates are that the NPL ratio fell to just over 5% for the SCBs in the past year, though these figures exclude the China Agricultural Bank (CAB). The CAB's position was so poor that China's sovereign wealth fund purchased a 50% stake. These measures, though, led to successful IPOs for the other 3 SCBs which also sold minority equity stakes to foreign banks, attracted by the size of China's banking market.

But, other estimates of NPLs are not so sanguine because it is the continuing build up of bad debts that are the problem. With the removal of the NPLs and recapitalisations, the Chinese banking system may look solid, but it has just transferred the problems elsewhere that ultimately all accrues back to the state. With the financial crisis squeezing Chinese finances and slowing its growth rate, the system looks to be less sustainable. Although many had characterised the state banking system as insolvent but flush with cash, if depositors lose confidence and turn to the foreign banks increasingly permitted to take deposits via their domestically incorporated subsidiaries or move their money abroad, then a banking crisis may well occur. It will not be of the sub-prime variety, but a plain vanilla transition banking crisis. In any case, it is not a model for emulation.

China's view of its place in the new world order is still in the formative stages. It does not view India or other emerging economies as a benchmark, but rather its focus is on the United States. As proposed by the former U.S. national security advisor Zbigniew Brzezinski in a piece in the FT on January 13th, they could form the G2 or Group of Two. This is for economic as well as other reasons, but certainly the economic might of China is what has propelled it to become one of the twin engines of global economic growth alongside the United States in the past couple of decades, fortifying its long-standing political influence with corresponding economic power. This combination of being one of the five permanent members of the UN Security Council as a prominent but non-democratic political power that has gained economic influence is one of the reasons for the wariness that accompanies China's emergence. Not all are wary, as businesses have largely overlooked much of the institutional weaknesses to embrace China's marketisation. Nevertheless, hesitancy exists for many, which interestingly reflects China's own evolving and sometimes contradictory view as to what it means to be a global power. China's focus has been, and remains, predominantly inward-looking, as its priority is delivering growth for its people. Recognising that its actions have wider global consequences is happening. The financial crisis may have hastened China's external role, but it was already occurring. How China engages the G20 or even the G2 will say a great deal about the contours of the emerging multi-polar world. What has been clear is that China recognises the importance of the global economy in contributing to its extraordinary growth in the past decade. Sustaining it should be both an internal and an external priority.