Monthly Archives: March 2012

Just when you thought it was safe to go outside, it turns out that another storm is gathering on the eurozone horizon.

Spain was always on the ‘one to watch’ list. It now finds itself in that most awkward of positions: the financial equivalent of a vicious circle. The interest rate on its sovereign debt is rising, the economy is stalling and the government is fast losing the enthusiasm to deliver the austerity demanded by Brussels. The process then repeats itself.

Have Spanish yields risen because investors no longer believe the country is either willing or capable of delivering the necessary austerity? Or have they risen because investors think the eurozone’s creditor nations are just running out of patience? Either argument could be used to explain the rise in yields yet there’s a world of difference between deliberate slippage on behalf of the Spanish and a loss of confidence on behalf of their eurozone partners.

Calls for more fiscal pain do not deal properly with the interaction between growth shortfalls and the cost of borrowing within the eurozone. In the old days, weak growth was synonymous with low interest rates. In the topsy-turvy world of the eurozone, weak growth is now more often associated with high interest rates. Austerity, by delivering even weaker growth, leads to even higher interest rates. The only way to get around this problem is to recognise the symbiotic relationship between creditors and debtors. In the eurozone, that means a fiscal union, not the constant bullying of debtors by creditors. Continue reading »

Years ago, a simple chant united millions of Latin Americans in their desire to move away from dictatorship: cambia, todo cambia or everything changes. Well, the monopolistic, feudal and entitlement-based approach to appointing the president of the World Bank appears to be finally giving way to a more open, competitive, transparent and merit-based system.

As we count down to the official deadline on Friday, three highly credible professionals are on the verge of being nominated as official candidates to replace former president Robert Zoellick, namely José Antonio Ocampo from Colombia, Ngozi Okonjo-Iweala from Nigeria and Jeff Sachs from the United States.

This is not to say that America will not get its way. It could well do so, especially if the Europeans provide overwhelming support. But in order for this to materialise, the US must first come up with a highly credible candidate given the quality of the other candidates.

The world has waited a very long time for a more suitable and defensible system for selecting the leaders of the two most important international financial institutions. It could well be on the verge of getting it due to the courage of talented individuals, and the perseverance of many advocates for this sensible and overdue change. It is now up to the Bank’s executive directors to step up to their responsibilities. Continue reading »

The most controversial announcement in Chancellor George Osborne’s budget was the cut in the top rate of income tax from 50 per cent to 45 per cent from next year. Most of the opposition party’s response was directed toward this single measure, although it accounted for a mere £50m of estimated lost revenue in its first year. Mr Osborne must have calculated that the economic gain would outweigh the political pain.

He was supported in his economic case by an impressive new study by HM Revenue & Customs, based on the actual tax returns of the 300,000 people with incomes above £150,000. They comprise around one per cent of UK taxpayers, and account for around 30 per cent of income tax revenues. Continue reading »

Mr Assad’s days are likely numbered, and Syria’s next government may not be favorably disposed toward Moscow.

So where can Russia turn to maintain a Mediterranean base for its navy? How about Greece? Political officials in Germany and other core EU countries should take note.

The long-term effects of austerity on Greece’s economy, and the public resentment that comes with it toward Germany and European institutions, could change the terms of debate-both inside Greece and across Europe. That’s why the rest of Europe should take note. Greece has no parachute today. But over time, it might have more options than we think. Continue reading »

The fall of Bo Xilai, former party secretary of Chongqing, has raised concerns among China observers. Early last month, his right hand man and Chongqing police chief, Wang Lijun, went to the American consulate in Chengdu and stayed there overnight. It remains a mystery why Mr Wang did that, but what is clear is that the incident has led to Mr Bo’s sacking.

His fall signals that the party will continue on its pragmatic and centralist policy set long-ago by Deng Xiaoping. It has now been widely recognised that the reform process stalled in the last decade. However, it was a key theme in Mr Wen’s address to the recently-concluded annual People’s Congress. It seems that this was not just lip service, but would be backed by real actions.

The recent ‘China: 2030′ report by the World Bank supports the thesis that the government is back on the path of reform. Among other recommendations, it calls on China to seriously reform its state-owned enterprises. The report is a joint effort between the World Bank and China’s executive branch. So the reform agenda is at least endorsed by some key sections of the government.

To see real changes, though, one may have to wait until the Communist party concludes its 18th congress and a new leadership takes shape in October. But the recent political developments and policy changes have raised hopes that reform is back on the agenda. Continue reading »

The recent payroll gains and the declining unemployment rate in the US have raised hopes that the economy will now start growing faster than the tepid 1.7 per cent rate last year. Optimists are expecting growth rates as high as three per cent for this year and next.

I hope they are right. While payroll employment has recently been rising by more than enough to absorb the growth of the labour force, the expansion in gross domestic product has been weak and most of that increased production has one into inventories.

There are strong headwinds that will make it difficult to achieve a robust recovery. The most important is the large tax increase that will occur next year unless there is legislation to block it. The Congressional Budget Office predicts that, under current law, the revenue of the federal government will rise from $2,456bn in the current fiscal year to $2,968bn in the following fiscal year. A sustained tax increase of that magnitude would push the US into a new and deep recession next year.

Many political analysts are predicting that Republicans will maintain control of the House of Representatives and become the majority in the Senate but that Mr Obama will be re-elected. While this “most likely” outcome may not occur, the potential tax consequences pose a serious risk to the economy not only in 2013 but this year as well. Continue reading »

The markets seem to have coped relatively well with “the biggest sovereign restructuring ever” last week. But they are already focusing on the next possible victim: Portugal’s bond yields have soared to levels close to those on Greek bonds a few months ago. European authorities have publicly declared that Greece was unique and that there will be no more debt restructuring. Undoubtedly, though, they will be tested in the coming months.

The best strategy is to immediately build a firewall that would ensure Greece is an exception. First, it should be recognised right away that Portugal may not be able to return to the markets next year and needs an additional bailout package. Second, the same could be done for Ireland, which requires an additional €80bn. The procedure to allocate these funds should be started right away by the national and European authorities. Third, the size of the EFSF and European Stability Mechanism must be further increased to allow them to provide additional funds to other countries.

Only by acting forcefully, in anticipation of what the markets will focus on next rather than under their pressure, can European authorities convince us that Greece was an exception and prove their commitment to do all that is needed to preserve the euro as a currency. Continue reading »

Tuesday’s release by the Federal Reserve of the results of its annual round of “stress tests” of the 19 largest American banks was yet another confirmation of the deftness with which the US government has handled the financial crisis. In stark contrast to the feeling of ennui that has often accompanied Europe’s initiatives to shore up its own financial system, the latest news from Washington was greeted with enthusiasm, with share prices jumping 1.8 per cent by the end of the day and the S&P financials index up by 3.9 per cent.

There is much to praise. The $700bn Troubled Asset Relief Program provided in late 2008 a solid financial firewall and stemmed the tide of fear and near-panic that had surrounded the banking system. It even turned a profit for the US Treasury, which invested just under $205bn in 707 banks and has so far received about $211bn back.

But clearly, the banking system is not yet perfect. Four banks failed the latest tests, most notably Citigroup, which said it would resubmit its capital plan, as required. However, even these failures must be seen in light of the severity of the stress test scenario, which assumes 13 per cent unemployment, a halving of stock market valuations and the kind of “market shock” that might be triggered by the collapse of a bank in Europe. Continue reading »

Many investors wish to wave a final goodbye to the disruption the Greek debt crisis has had on market valuations. Meanwhile, European politicians are already trying to move away from the dramas on the periphery and focus on restoring growth in Europe. Both impulses are understandable. Unfortunately, they are premature.

The debt reduction agreement put in place last week is the biggest sovereign restructuring ever. Yet it only goes part of the way in helping Greece overcome its core problem of too much debt and too little growth. And it won’t be long before this latest deal also comes under pressure.

What the debt reduction deal really delivers is a bit more time for others to reposition for the next, more disruptive, act in this unfolding Greek drama. For European policymakers, this means even more urgent building of firewalls to protect countries such as Italy and Spain, continuing to strengthen the core through better fiscal and political integration, and forcing banks to raise capital. For investors, it is about reducing their exposure not only to default by Greece, but also risks connected with a potential exit of Greece from the euro. Continue reading »

In an army of 150,000 US and Nato soldiers in Afghanistan one rogue solider who massacres sixteen civilians, including nine children, does not necessarily mean that discipline and morale of the whole force is breaking down. However, when the spate of recent incidents are put together – US soldiers burning copies of the Koran, footage apparently showing US Marines urinating on bodies of dead Taliban fighters and a spate of accidental killings of civilians during US attacks on the Taliban – the situation looks far more grim. There can be no doubt that the western presence in Afghanistan faces a grave crisis of confidence across the Muslim world and in their home countries.

The Afghan people are exhausted by a war that has gone on in one form or other since 1979, when most American soldiers now in Afghanistan were not even born. Increasing numbers of Afghans would agree with what the Taliban have been arguing for almost a decade: that the western presence in Afghanistan is prolonging the war, causing misery and bloodshed.

After the spate of incidents this year, there should be no doubt in Washington that seeking a negotiated settlement to end the war with the Taliban as quickly as possible is the only way out. Mr Obama has to put his weight behind this strategy to ensure an orderly withdrawal and to give the Afghan people the chance of an end to this war. A power sharing formula with the Taliban, which now appears increasingly unavoidable, and an accord with neighbouring states, to limit their interference, will be key.  Continue reading »

The US employment report for February contains further evidence that, on the surface at least, the American labour market is returning to normal. The unemployment rate of 8.3 per cent is 1.7 percentage points below its peak in October 2009. Yet consumer pessimism about job prospects remains almost as bleak as it was in the darkest hour of the recession. If the labour market is really improving as much as the official data imply, no one seems to have told middle America.

Employment gains have certainly been strong in recent months. But over a longer period it seems that the labour force has been growing much less strongly than normal. The participation rate has actually fallen from 65 per cent at the height of the recession to 63.9 per cent now.

This shrinkage, part voluntary and part involuntary, leaves the potential output of the economy lower than it was before, and may explain why Americans do not perceive this recovery in the labour market as a genuine one. It is a major relief that the labour market is now clearly improving. But the financial crash of 2008 continues to cast a very long shadow on America’s economic potential. Continue reading »

The release of February’s economic data confirmed that Chinese growth is slowing down. Consumer inflation fell to 3.2 per cent last month, the lowest since June 2010. Weaker industrial production, retail sales and export data all support the same pattern. China’s days of double digit growth are, at least for this century, probably over. The data releases following a “forecast” from outgoing premier Wen Jiabao that gross domestic production growth would be “only” 7.5 per cent this year, an estimate that seemed to surprise many observers. Does this mean China’s glory days are numbered and reforms including currency reform are over? Not at all.

Lower GDP growth is not a hindrance to reforms, it is an essential ingredient. Softer but more balanced, sustainable and higher quality growth requires reforms, including of the renminbi. To complicate matters, currency reform does not equal currency appreciation. The renminbi is going to become more volatile like other currencies. It will go up as well as down against the dollar, partly because China’s current account surpluses are coming to an end, but also because it is opening up its capital account. In recent weeks, policymakers have published detailed guidelines and in some ways, a timetable for all sorts of reforms. Many of them can’t be achieved without currency reform. This includes better-quality GDP albeit at a slower rate. Continue reading »

Calls to fundamentally change the way governments appoint the heads of the International Monetary Fund and the World Bank have been growing louder in the past decade, and rightly so. But these demands for a merit-based process have failed to overcome America’s and Europe’s grip on a feudal entitlement that suits their interest but is unquestionably outdated and harmful.

Now that it is time to select a new World Bank president, I have the feeling that some progress may finally be made, not because of the enlightened vision of governments, but due to the courage of some highly-qualified individuals.

The global economy would be well served if the brave actions of such individuals were to serve as a tipping point. They could turn out to be the much-needed catalyst that prompts other qualified and interested candidates to also step forward, that effectively energises emerging countries to support strong candidates, and that forces Europe and the US to finally adopt the type of approach that they have no hesitation in advocating for others: one that is open, transparent, competitive and merit-based.

Call me an eternal optimist, but I’m seeing rays of hope on an issue that is important for the wellbeing of the global economy. Continue reading »

A myth is developing that private creditors have accepted significant losses in the restructuring of Greece’s debt; while the official sector gets off scot free. International Monetary Fund claims have traditional seniority, but bonds held by the European Central Bank and other eurozone central banks are also escaping a haircut, as are loans from the eurozone’s rescue funds with the same legal status as private claims. So, the argument runs, private claims have been “subordinated” to official ones in a breach of accepted legal practice.

The reality is that private creditors got a very sweet deal while most actual and future losses have been transferred to the official creditors.

Greece’s private creditors should stop complaining and accept the deal offered to them this week. They will take some losses, but those losses are limited and, on a mark-to-market basis, the debt exchange offers them a potential capital gain. Indeed, the fact that the new bonds are expected to be worth more than the old bonds suggests that this PSI exercise has further transferred losses to Greece’s official creditors.

The reality is that most of the gains in good times – and until the PSI – were privatised while most of the losses have been now socialised. Taxpayers of Greece’s official creditors, not private bondholders, will end up paying for most of the losses deriving from Greece’s past, current and future insolvency. Continue reading »

As Barack Obama and Benjamin Netanyahu discuss next steps regarding Iran, investors are becoming increasingly jittery. At one point late last year, the Brent oil price had dropped back towards $90 per barrel. Now, it’s well above $120, reflecting both renewed economic optimism and fears over how, precisely, Iran’s nuclear ambitions can be contained.br />
There is, however, more to the story than just Iran, important though it is. Oil prices have been steadily rising since the beginning of the millennium, a remarkable turn of events given persistently-disappointing growth rates in the developed world. In the past, US economic weakness would have been associated with falling oil and other commodity prices. Not any more. Oil prices – and other commodity prices – are increasingly determined by burgeoning demand in China, India and other fast-growing emerging nations.br />
Oddly enough, the west’s pursuit of quantitative easing may simply have hastened this process. With western households and companies busily deleveraging and with investors still on a quest for yield, the benefits of loose monetary policy have increasingly flowed to the more dynamic parts of the world. The recent increase in oil prices reflects not only the impact of Iran but also misjudged attempts by western policymakers to kick-start their own economies. Continue reading »

During the past decade the US sat on the sidelines while many nations around the world competed aggressively to win larger shares of manufacturing output and employment. The next decade is likely to be different. In several recent speeches and policy proposals, President Barack Obama has laid out a compelling case for why manufacturing matters for the health of the American economy and has signalled that the US will be a more active player in the intense global competition for manufacturing.

His 2012 budget proposal calls for $1tn in discretionary spending cuts over the next decade, reducing the share of discretionary spending to five per cent of gross domestic product by 2022. Despite its overall austerity, the proposal contains measures to boost manufacturing. Many of these – including policies to increase high-school graduation rates; workforce training programs at community colleges; more funding for basic research, infrastructure investment, and scientific, engineering and technical education; and immigration reform – would benefit other sectors as well. Continue reading »

Mr Obama is facing an extremely difficult task: remaining tough on Iran without sabotaging the US economic recovery. While the strategy of squeezing Iran financially is logical, it comes with serious economic risks that are not often recognised. We’ve entered a new era in which the distinction between the financial and security spheres no longer holds: geopolitics drive markets even as markets drive geopolitics.

Enforcing oil sanctions against Iran could threaten the global economy. In the context of improving global growth, removing too much Iranian oil from the world’s energy supply could cause an oil price spike that that would halt the recovery even as it does some financial damage to Iran. For perhaps the first time sanctions have the potential to be “too successful”, hurting the sanctioners as much as the sanctioned.

One solution would be for Mr Obama to maintain his tough public rhetoric on sanctions, no matter how harsh it appears, while privately signaling China and India – and only China and India – that it is fine for them to purchase Iranian crude, but at a significant discount from market price. Forcing Tehran to sell discounted barrels would provide the desired result: a substantial reduction in Iranian revenue with less impact on global energy prices and less harm to the US and world economies.

It’s a tricky diplomatic line to walk, to be sure. It will likely not assuage the administration’s critics either domestically or in Israel. But it may be the only way out of the dilemma. Continue reading »

This year’s session of the National People’s Congress takes on added significance with the impending anointment of the next generation of senior leaders. China would seem to have many reasons to be self-satisfied given the strong prospects for a “soft landing”, a mountain of foreign assets that Europe is eager to tap, and an expanding regional presence that the US has had to take notice of.

Yet the leadership recognises that the country faces daunting economic, social and environmental challenges including vulnerabilities created by past excessive credit expansion. Wen Jiabao, China’s premier, warned on Monday that growth is set to slow this year.

But these are likely to be seen as technicalities among those gathered in Beijing. Far more worrisome for the political elite is the question of how to deal with rising social unrest. This was underscored by the global attention given to the Wukan village land-related protests that pushed provincial leaders to support more open local elections. Other disturbances such as recent unrest by migrant workers at Foxconn reflect the tensions stemming from decades of widening social inequality that seems out of place for a regime that originated from egalitarian ideals.

If the incoming senior leadership wants to deal with the systemic issues that have spawned rising social unrest, it needs to rethink some of the unintended consequences of its current growth driven model. Paramount is to reshape China’s economic institutions and control over basic resources in ways that moderate, rather than exacerbate, disparities. Continue reading »

As it begins the search for a new president of the World Bank, the Obama White House risks repeating the very same mistakes that all too often in the past have led to the wrong person being appointed. Every time this process begins, those in charge ponderously – and mendaciously – announce it will be “open, transparent and merit-based”. They know this is not true, as some of the best candidates are automatically disqualified: only US citizens connected to the occupant of the White House at the time are considered and the process is closed, and only tenuously determined by merit.

So how does this flawed process work be reformed? In the past, it has led to the appointment of candidates who knew little about the bank. The consequences were confusion over its mission and obstacles in the way of providing assistance to countries in need. This is partly the result of the fact that those in charge of making – or influencing – the decision often base it on wrong notions about the ideal background of the Bank’s president.

Mr Obama should look for a professional who already knows this field, its ideas, players and traps, who has a vision for the World Bank rooted in practical experience with development and who has already run successfully a global, organisation. This is not the time or the place for ‘on-the-job-training’. Nor for paying back political favours. Continue reading »

For some time economists have been engaged in an arcane controversy about the significance of the imbalances in the joint settlement system used by eurozone central banks, called Target 2. In a series of contributions, Hans-Werner Sinn of the CESifo research group in Munich has drawn attention to the fact that central banks in the northern part of the eurozone were accumulating claims on central banks in the southern part via Target 2. From about zero in 2007, these claims have risen to €400bn in 2010 and €800bn lately.

The notion of a balance of payment crisis within the eurozone was alien to the concept of a monetary union. It was routinely assumed that for countries within it, balance of payments would become as irrelevant as they are between regions within a country. This assumption was wrong. Countries are not regions, largely because much their banking systems are primarily exposed to their sovereign and to domestic borrowers. So when the sovereign is in distress or private borrowers partially insolvent, the banking system is contaminated and there is a stigma attached to being a bank from country X or Y. Foreign lenders become wary and stay put. Target 2 balances largely reflect this counterparty risk.

But a symptom is not a disease. It is the diseases that must be cured. This certainly requires more than letting the fever subside through a huge injection of central bank liquidity. Public finances must be made convincingly sustainable, bad loans on banks’ balance sheets must be provisioned and recapitalisation must take place wherever needed. Continue reading »

With the US presidential race heating up, the candidates are increasingly prone to make sweeping promises. They say they will do this or that in their first day in office – balance the budget, close the prison at Guantánamo, abolish the Federal Reserve, whatever – and their supporters all cheer that one of their cherished goals will be achieved instantly if only their man gets to sit in the Oval Office.

This is, of course, rank nonsense. And it has nothing to do with the relative absurdity of the promises being made. It has to do with the nature of US government, which is something even Americans often forget.

In the US system, the president is far weaker than the chief executive in most other countries. The reason is that it was baked in the cake by the framers of the constitution who were deeply sceptical about monarchism. They wanted a leader who was subservient to the legislature, not its overlord.

Thus we can safely ignore sweeping promises from all the presidential candidates if they require the enactment of legislation. This is especially so regarding the federal budget. Continue reading »

With the €530bn lent to banks through its latest three-year longer-term refinancing operation, the size of the European Central Bank’s balance sheet has increased to unprecedented levels, raising a number of concerns. Not all are justified.

The main concern is that sooner or later the increase in central bank money will lead to inflation. However, there is no empirical evidence – across countries and over time – that the size of the central bank balance sheet in advanced economies is related to inflation. Even though inflation is ultimately a monetary phenomenon, the quantity of money circulating in the economy also depends on the motives underlying the demand for money by the private sector, in particular by the banking system. If the increase in central bank money helps commercial banks to finance additional private or public consumption and investment, over and above the economy’s productive potential, it may indeed fuel inflation. If, instead, the demand for central bank money reflects a change in the composition of financial market participants’ portfolios, towards less-risky assets, the increase in central bank money is not inflationary. It contributes instead to preventing deflation.

With the LTRO, the ECB has helped to reduce systemic risk and avoided a credit crunch. To minimise the inefficiencies and perverse incentives that may result from the increase in its balance sheet, and to reduce counter-party risk, the ECB should be given a greater role in co-ordinating and overseeing supervision of the eurozone banking system. The euro area needs a supervisory and regulatory compact, as much as – if not more than – a fiscal compact. Continue reading »