Friday, 22 July 2016

Slovenia and the banks

I bet you've never heard of Slovenia. It's the northernmost Balkan state, squeezed between Austria, Italy and Croatia on the Adriatic coast. It's small, peaceful (by Balkan standards) and prosperous compared to the rest of the Balkans, though that isn't saying much. It is also stunningly beautiful, in a mountains-and-lakes sort of way. It is in many ways rather like Austria.

But at the moment, Slovenia is famous not for its lovely scenery, or its important history, or its rich culture. No, it is famous for its banks. And not in a good way. Slovenia's banking crisis is a long-running sore.

Slovenia's story is an all too familiar one. When it joined the EU in 2004, it entered the Exchange Rate Mechanism (ERM II) as a precursor to joining the Euro. EU membership requires free movement of capital across borders, and under ERM II its exchange rate was soft-pegged to the Euro. So it effectively lost control of monetary policy. The result, of course, was a mammoth inflow of foreign funds, a huge credit bubble, an enormous spike in real estate prices, and a massive current account deficit. This chart from a paper by the Bank of Slovenia on the causes of the banking crisis shows the buildup of credit from 2004 onwards, and in particular the strong spike in lending after Slovenia joined the Euro at the beginning of 2007:

Interestingly, in Slovenia the credit bubble seems to have affected corporations far more than households. And like most countries in Europe, the credit bubble burst at the end of 2007, not 2008.

You would think the bursting of the credit bubble would cause the greatest damage. But in Slovenia's case, the most harmful effects came from another source - the balance of payments. When you are locked into a currency union, a large and rising current account deficit is dangerous. All it takes is a shock somewhere else in the world for investors to refuse to finance it - and because you cannot devalue and you have no control of monetary policy, investor flight forces a wrenching adjustment to the balance of payments, usually accompanied by widespread distress in the real economy and a rapid fall in GDP. This is what we call a "sudden stop". And this is what happened to Slovenia in 2008 when the financial crisis hit.

Here is the Bank of Slovenia's lovely chart of Slovenia's sectoral balances. You can see how the external deficit (blue-green bars) rose from 2002 onwards and rapidly from 2007-08. When the financial crisis hit (box outlined in red) it abruptly switched from deficit to near-balance. At the same time, corporations rapidly deleveraged as the credit bubble burst (dark red bars). And the fiscal deficit (pale blue bars) surged from a perfectly reasonable 1.7% in 2008 to 6% in 2009. As a result of this, Slovenia was put into the EU's Excessive Deficit Procedure in November 2009.

The sharp-eyed among you will note that there is an even larger reversal between 2012-13. I shall return to this shortly. But for now, let's stick with 2008.

This table shows just how large the swings in investment and trade were between 2008-9 (outlined in red):

Note that the balance of payments adjustment involved sharp falls in both imports AND exports, both goods and services. This fed through into a steep drop in GDP.

And this is what the investment reversal looked like, charted:


The association between excessive bank lending, funded by cross-border investment flows, and Slovenia's sudden stop could hardly be clearer. But just in case anyone doesn't get it, the Bank of Slovenia spells it out:
The result of the fast growth of lending based on foreign borrowing by domestic banks and thus the increasing of the net debt of the Slovenian economy was increased vulnerability to financial shocks in the rest of the world, which materialised after the fall of Lehman Brothers in 2008.
I want this statement to be framed and hung on the wall of every economics department, Treasury department and central bank in the world. Oh, and business schools, too, since tax-adjusted Modigliani-Miller has done more damage than almost any other theory, encouraging as it does high leverage and a preference for debt financing over equity. High debt levels increase economic fragility and vulnerability to shocks. That applies to corporations, households and governments alike.

Slovenia's problem was not public sector debt, which even after the crisis was low by EU standards at about 30% of GDP. It was private sector debt, particularly corporations and - later - banks. And the 2008 "sudden stop" clobbered its economy. The GDP fall of 7.9% in 2009 was one of the worst in the EU.

However, as the table shows, it bounced back quickly. The economy started to grow again in 2010 and exports recovered, although investment continued to decline due to the legacy of the financial crisis elsewhere in Europe. Balkan countries suddenly weren't attractive investment prospects any more.

Nevertheless, by 2012 Slovenia looked as if it was on the road to recovery. Yet within a year, it was back in recession and its banks were collapsing. What went wrong?

In fact, the recovery was an illusion. Slovenia's economy was in deep trouble: its banks were weak and under-capitalised, its corporations were suffering due to the slump in demand, and to crown it all it was being expected to impose a yearly fiscal tightening of 0.75% of GDP.  Non-performing loans rocketed between 2008-12 as the weak economy took its toll on highly-indebted businesses:

Slovenian banks were already poorly capitalised, even by European standards. The rising NPLs ate the little capital they had, making an eventual state recapitalisation inevitable.

And their funding situation was dire. They had been unable to fund themselves since the 2008 sudden stop when their foreign funding inflows dried up, and had became completely dependent on the sovereign for funding. It worked like this: the Slovenian government issued bonds, which were bought by its banks, who then pledged them to the Bank of Slovenia for Euro funding. It kept the banks alive, but the toxic embrace between the sovereign and the banks threatened the stability and solvency of both. The inevitable sovereign credit downgrades followed in 2012 and 2013.  

In December 2013, the ECB's stress test results revealed a total capital shortfall in the Slovenian banking sector of 4.8bn Euros (about 10% of GDP). The three largest banks failed the tests. On 18 December, the European Commission approved Slovenia's plan to inject 3.2bn Euros of new capital into its banks and transfer non-performing loans into a new "bad bank", the Bank Asset Management Company (BAMC), Junior bondholders were forced to take a haircut of an estimated 600m Euros, and shareholders were wiped.

The junior bondholders - and even the shareholders - fought this bail-in tooth and nail. The Slovenia Times reports that the Slovenia Constitutional Court "admitted several applications" by subordinated bondholders to have the bail-in overturned. The Constitutional Court referred the matter to the European Court of Justice. This week, the ECJ gave its judgment. And the judgment has resolved - well, absolutely nothing.

The case hung on the interpretation of a Communication from the European Commission in 2013 which established the ground rules for the granting of state aid for banks in the financial crisis. This is known as the Banking Communication. The ECJ decided that the Banking Communication "must be interpreted as meaning that it is not binding on the Member States."

Bondholder representatives were delighted:
We are very satisfied with the ruling," said Mr. Kristjan Verbic, President of VZMD. "VZMD and Better Finance - The European Federation of Investors and Financial Services Users consider this decision to be a victory for investors. The European Court of Justice ruled that 'expropriations of and encroachment upon shares and bonds of Slovenian banks were neither necessary nor unavoidable for the restructuring of the banking system and allocation of state aid.' VZMD has maintained this was the correct analysis since the very beginning."
No doubt they will now go back to the Slovenia Constitutional Court and petition for the bail-in to be overturned, with the backup of an appeal to the European Court of Human Rights if the Constitutional Courts slaps them down.

But I fear they are wrong. The Banking Communication does not impose a requirement on Slovenia to bail in subordinated creditors and shareholders, but it doesn't prevent it from doing so, provided that the bail-in doesn't exceed what is necessary to overcome the banks' capital shortfall and doesn't leave creditors in a worse position than they would have been in had the bank failed. Indeed, as the judgment goes out of its way to emphasise that the Banking Communication provides for shareholders and subordinated debt holders to share in the losses from a failing bank, it is hard to see any reason for the bondholders to rejoice. Unless they can show that bail-in was either unnecessary or discriminatory, they still have no case.

And Slovenia can't possibly afford the cost of overturning the bail-in, anyway. Three years on, Slovenia is still in a mess. The bank bailout raised the government deficit to 15% and public debt/GDP to 71%, and Slovenia additionally suffered a brutal recession: even now, GDP growth remains well below 1% and unemployment is above 11%. Fiscal consolidation under the Excessive Deficit Procedure has brought its fiscal deficit down below 3%, but at the end of 2015, Slovenia's debt/GDP was 83% of GDP.

The IMF has just completed its latest Article IV consultation, and the principal findings are worrying. It appears that, expensive though it was, the bank restructuring was insufficient to restore normal credit conditions. Non-performing loans remain high, and bank lending is still contracting despite falling interest rates and loosening credit conditions. Partly, this is due to low credit demand, especially among smaller companies, many of which are still highly indebted and struggling to meet their obligations. The truth is that Slovenia's supply side has taken a terrible hit, and recovery is proving very slow and painful.

So what lessons should we draw from this?

Firstly, that relinquishing control of monetary policy by opening the capital account and fixing the exchange rate carries a terrible price. The Bank of Slovenia lays the responsibility for the 2004-8 credit bubble primarily at the door of the ECB, whose interest rate policy was too loose for Slovenia at that time. But the ECB had to consider the Eurozone as a whole, and Germany at that time was in the doldrums. Interest rates were inevitably lower than the overheating Slovenia needed. Slovenia is by no means the only Eurozone country with this problem. It may be that in the future, movement of capital in the Eurozone will have to be moderated to prevent the large destabilising capital flows that have caused so much damage over the last decade.

And secondly, that banks MATTER. Unless fiscal finances are very stretched, as in Greece, repairing banks should be a far higher priority than repairing fiscal finances. Repairing the banks early reduces the damage to the economy that a wrecked banking sector causes, and the return of bank lending brings recovery, as Latvia's remarkable performance has shown. This can help restore fiscal finances without the need for years of painful consolidation.

When researching this piece, I was struck by how little attention was paid to the state of the banking sector until it was far too late. The Bank of Slovenia comments that the Slovenian government did not take action to recapitalise its banks in 2008-11 when it should have done. But the IMF conducted two Article IV reviews during that time. And Slovenia was in the Excessive Deficit Procedure throughout, under regular supervision from the European Commission. The primary focus of both the IMF and the EC was on fiscal finances, and the IMF additionally did a "special issues" report in May 2009 that focused on inflation - yes, inflation, in a country which was in deep recession. Throughout all of this, the looming implosion of the banks appears to have gone almost unnoticed. If these august institutions don't take any notice of banks and their crucial role in making or breaking an economy, why on earth should we expect governments to?

Related reading:

Property, inequality and financial crises
How do you say "dead cat" in Latvian?
A Finnish cautionary tale
Black Thursday

Image from

Wednesday, 20 July 2016

Grieving for a lost empire

There has been a huge amount of analysis about the reasons why British people voted to leave the EU. Some of it is very good: some of it less so, saying more about the biases of the writers than it does about the motivations of the British (no, I won't link any of those posts here!). I confess, I have added to the literature myself. I leave it to you to judge into which of these categories my contributions fall.

But in all the vast verbiage written on this topic, there appears to be a no-go area - a taboo, if you like. And it is not immigration, nor even racism and xenophobia. Nor is it the loss of Britain's manufacturing and the seizure of its fisheries. Nor the divide between London and other areas, the old-young split, the fact that people with degrees tended to vote to Remain. Plenty has been written on all of these. No, the taboo subject is the legacy of World War II and the loss of the British Empire.

I grew up in the shadow of war. My parents were children during World War II. My mother was evacuated, which from the little she has told me was an unbelievably traumatic experience, even though (unlike many evacuees) she was sent to stay with relatives. And my father lived through the Blitz. The war scarred both of them for life, and their experiences as children in turn coloured my own childhood. Even though the war was long over, we dug for victory, growing large amounts of our own food. My parents told us stories about the war: I remember my father describing the sky lit up with fire the night the London docks were bombed, and my mother (who returned to London towards the end of the war) talking about collecting shrapnel. And my grandparents told us stories not just about the second World War, but the first one too. They had lived through both.

In my childhood, popular reading material of the time - even for children - was unashamedly triumphalist. Boys' comics, in particular, were full of stories about heroic British (sometimes Americans too) defeating the "Jerries". Films at that time were also dominated by war stories. But we also lived with the threat of a new war. So we had Soviet spy stories too. This was the age of James Bond, uncomfortably juxtaposed with the Dam Busters and "Where Eagles Dare". War was a constant risk. But we knew we could win. After all, we had won two world wars.

But - had we, really? The cracks in the British Empire were already showing by the time the First World War ended, with the secession of Ireland in 1921 and the creation of the Commonwealth in 1931. And much more of it peeled away after the second World War. India, the "jewel in the crown" of the British Empire, became independent in 1947. The Suez crisis of 1956 exposed Britain's political and economic weakness: rapid decolonisation of the Middle East and Africa followed, as Britain, struggling with high debts, rising inflation and a stagnant economy at home, was forced to relinquish the colonies it could no longer support. The British Empire effectively ended in 1997, when Hong Kong was returned to China.

So although Britain won the wars (with a lot of help from its friends), it lost its status as the premier global power. For those who grew up in the post-World War II era of British triumphalism, this was bad enough. But worse was to come.

Britain was not a founder member of the European project. Indeed, its application to join the nascent European Community was twice vetoed by French President De Gaulle. And even when it finally joined in 1972, its membership was half-hearted: a referendum in 1975 confirmed that it would stay, but subsequent governments repeatedly fought against the terms of membership. Something in the British psyche just didn't like being drawn into a European project in which it was not the leader.

The further the European project moved towards integration, the more uncomfortable the British became. The creation of the Euro in 1999 - which Britain refused to join - created a "core" of which it was not part. Gordon Brown's decision not to join the Euro probably protected Britain from a major collapse in the 2008 financial crisis, but it meant Britain could not be at the heart of the EU. And David Cameron's famous "walkout", in which he refused to sign the fiscal compact that would draw the Eurozone countries into an austere embrace, left Britain sidelined. Britain had not only lost an empire, it was becoming a peripheral state in what was looking more and more like a new empire. And the Greek crisis showed all too clearly that the new empire was increasingly dominated by an old enemy.

I have been at a loss to explain the almost visceral hatred of the EU that I have experienced from people I have spoken to and from pieces I have read, particularly in tabloid newspapers. But I think I now understand.

Yesterday, my next door neighbour told me why she (and her family) voted to leave. "It was my mother," she said. "She reminded me that we fought two wars in order not to be run by the Germans. Now they are telling us what to do." And she continued: "That, for me, was the clincher."

My next door neighbour is a similar age to me - in her 50s. She has lived in this area all her life and is solidly working class (she and her husband run their own car respraying business). Like me, she grew up in the era of post-war British triumphalism. And for her, Britain becoming a vassal state in a new European empire run by Germany was a bridge too far.

I don't agree with her view. I don't see Germany in that way: I know how much soul-searching the German people have gone through since the end of World War II. I do believe that Germany does not wish to become an imperial power again. But in defiance of the post-war consensus - that Germany should never again be allowed to build an empire - the world is egging on Germany to take control.

For this, we must blame those who designed the European Union. The idea that European nations can simply put behind them their bloodstained past and cooperate with each other to create a greater whole was a lovely dream. And for a while, it appeared to work. But when the crises came, the nations fragmented, exposing the leadership vacuum inherent in the EU's design. Inevitably, the world looked to the strongest nation in the bloc to show leadership. And that nation was not the semi-detached Britain. It was the largest nation at the heart of the EU. Germany.

Whether or not Germany wishes to be an imperial power is beside the point. In the eyes of many older British people, today's EU is the German empire that they thought they had destroyed, rising like the Phoenix from the ashes of the financial crisis. No wonder they voted to leave. They did not wish to be part of such a monstrosity. And they further hoped that by leaving, they would destroy it. It has been very clear that a fair few Brexit supporters believe that the EU will not survive Britain's departure - and gleefully anticipate its unravelling.

I fully accept that this is by no means the only reason why people voted to leave the EU. But in my view it is a significant one. And I believe it goes some way towards explaining why it is older people, particularly, who voted to leave.

I know that what I have said here will raise hackles. I expect to get shouted down, to be told that I have written jingoistic nonsense and no-one in Britain really thinks like this. But I have one parting shot in defence of my case.

A few months ago, in the early days of the referendum campaign, I was invited to attend a book launch in London. I turned up not really knowing what to expect: the book itself sounded interesting and not obviously pro- or anti-EU. But as speaker after speaker presented an anti-EU case, I realised that I had walked into a Brexit meeting. As a committed Remainer ever since the Rochester & Strood by-election in 2014, in which I refused to vote for UKIP, I felt increasingly uncomfortable. But what made me uncomfortable was not the fact that they were as committed to Leave as I was to Remain. No, it was who they were - and the reasons they gave to justify Brexit.

The room was full of white men. Most were quite a bit older than me. They had all had senior careers, many of them in merchant banking, stockbroking and the law: some had been officers in the armed forces. They were not the "white working class" that we are told voted Leave to administer a massive kick to the elite that had failed them. No, they WERE the elite - in their day. But their day was gone. And they thought that leaving the EU would restore it.

One after another, they talked about restoring British "sovereignty" - which was a thinly disguised metaphor for "empire". They talked about Britain becoming a new global power at the head of a renascent Commonwealth. They discussed Britain becoming China's principal trading partner, ahead of the US and the hated EU. They seemed to believe that Britain could simply walk into any corner of the world and set up trading relationships on its own terms. It did not apparently occur to them that the Commonwealth might not be too keen on Britain trying to lead them once again, China might have other ambitions, and other countries might not wish to accept Britain's terms. For them, once Britain was out of the EU, the glory days would return.

I felt incredibly sad for them. And I still do. For leaving the EU will not bring back Britain's lost empire. It will not enable it to establish itself as the leader of the Commonwealth. It is unlikely to encourage China to treat it as the trading gateway to the world. It will not restore Britain's influence in the world. It might even reduce it.

For sure, even after leaving the EU, Britain will have an important role: it is still one of the world's largest economies, and it has powerful advantages in location, law, language and culture. But the glory days are gone forever. Far from bringing them back, the vote to leave the EU has ensured that they will never return.

Related reading:

Looking behind the Brexit anger - Flipchart Fairy Tales
Currency Wars and the Fall of Empires - Pieria
Gazing into the distance

Image from

Monday, 18 July 2016

The silent gender divide

Last week, I went to my son's graduation ceremony. He has just completed a B.Sc in sound & light echnology at Derby University. So he is one of the STEM (Science, Technology, Engineering and Mathematics) graduates that we are told this country so badly needs.

As I watched the graduates from the College of Engineering and Technology walking past the dignitaries on the stage, I became aware of a huge gender gap. The vast majority of the young people filing on to that stage were boys. I calculated that only about 16% were girls, and they were concentrated in architecture, computer animation and - above all - mathematics. A number of disciplines, notably civil engineering, electrical engineering and most branches of computer science, had no girls at all.

I asked my son about this. He doesn't have an answer. But he commented that even in his own discipline (sound & light engineering), of 34 people who started the course, only five were girls. However, all five girls graduated, three of them with first-class degrees: one was a prize winner. In contrast, nearly half the boys did not graduate.

I don't know what the drop-out rate was in other disciplines. But it was apparent from the listings that girls punched well above their weight. Girls were disproportionately recipients of first-class degrees, relative to their numbers: and nearly half the College's prizewinners were girls.

I wondered whether there was an element of self-selection going on here. The few girls who do engineering and technology are very good. Perhaps less able female candidates simply don't do engineering and technology. What do they do instead?

A possible answer lay in the second half of the ceremony, where graduates of the College of Health & Social Care received their awards. Here, the gender gap was reversed - and it was even wider. The graduates were overwhelmingly female. Of 182 graduates, only 20 were boys - less than 11% of the total. Unlike engineering, where girls seemed to gravitate towards certain disciplines, the few boys were scattered evenly across all disciplines.

Again, I wondered whether there was an element of self-selection going on. Do "average" boys tend to gravitate towards engineering, while "average" girls tend to graduate towards the caring professions? If so, then we would expect boys in Health & Social Care to be disproportionately able compared to girls.

Sadly, that is not the case. The boys in Health and Social Care were no better than the girls - in fact if anything, they were worse. Only four boys achieved first class degrees, and of seven prizes, only one went to a boy. It seems likely that there are other factors discouraging boys from going into nursing, social work and various forms of therapy. I suspect there are social factors at play. For example, even now, nursing is seen as a woman's job. A very able boy would be subtly pushed towards medicine rather than nursing. Similarly, boys who might make exceptional therapists could be pushed towards psychiatry. This might explain why the boys in this college did not demonstrate the exceptional performances of the girls in the Engineering college. And it might also explain why there were so few of them.

Now, of course this is only one university, and Health & Social Care is not the only non-STEM discipline that could attract young people of both sexes. But what I want to draw from this is our asymmetric and irrational social expectation of boys and girls.

We hear much about under-representation of girls in STEM. But there is an even greater under-representation of boys in Health & Social care. In an ageing population, nursing, social work and therapies are disciplines of growing importance. And there are already significant skills shortages. We need more people to work in these disciplines.

STEM subjects are by no means the sum total of our skills needs. Increasingly, in the future, we will need people whose job it is to care, skilfully and professionally. So why do we talk endlessly about the need to encourage girls to study STEM subjects, but never, ever, encourage boys to work in health and social care? Why do we still assume that caring is a woman's job?

Photo taken by me shortly before the start of Derby University's graduation ceremony in the Derby Velodrome. 

Wednesday, 13 July 2016

Reshoring is hype

This chart has been doing the rounds on Twitter (h/t @dbcurren). It shows manufacturing employment in the USA. 

See that huge drop? That's the drain of manufacturing jobs to South East Asia.

And see that uptick since 2010, that appears to be tailing off? That's the return of manufacturing jobs to the USA. What they call "reshoring".

Reshoring is hype, isn't it?

Related reading

U.S. reshoring: over before it began? - ATKearney (pdf)

Tuesday, 12 July 2016

Gazing into the distance

The result of the EU referendum was a considerable shock - not just to the UK, but to the EU and indeed to the whole world. Just how big a shock it was is evident from the fact that the OECD has suspended its forecasts until September. It usually only does this for "significant unforeseen or unexpected events", such as a major earthquake or a tsunami. Brexit is a shock to the global economy of a similar order. And it has permanently changed the world. Whatever the future holds, we can be pretty sure that it will be very different from the dominant paradigm of the last forty years.

The vote was highly disruptive. It created chaos in the UK, anger and confusion in the EU, and puzzlement and concern further afield. But as the fog clears, markets return to some kind of normality and a new UK government takes the reins, we can perhaps begin to discern what the future might hold.

To everyone's relief, the UK's banking sector appears resilient: bank share prices have fallen, but there have been no bank runs, market freezes or liquidity crises, and banks are continuing to lend. If only the same could be said of the European banks. The Brexit shock highlighted the weakness of Italian banks in particular, but the truth is that the entire European banking sector is under-capitalised, highly risky and stuffed with bad assets. On the day of the EU referendum, Deutsche Bank failed the Federal Reserve's stress tests for a second time, and the Spanish bank Santander for the third time. The EU's abject failure to deal adequately with its banks was brought into sharp focus. By comparison, the UK's banks looked - and still look - rather good.

However, the UK's property market does not look so good. Open-ended property funds suffered severe liquidity crises and were forced to cease redemptions: additionally, both open-ended and closed property funds slashed their valuations. Construction has already suffered a sharp downturn and it seems likely there will be more pain to come. We should expect a price correction in commercial real estate and high-end residential property, especially in London: it is possible that price falls may trickle down to ordinary residential property too. Falling property prices nearly always presage a recession. 

There is also growing evidence of a significant hit to the real economy. Businesses are delaying or cancelling investment decisions, cutting production and in some cases considering moving headquarters and/or operations elsewhere. Of course, this might be a response to the chaos of the last couple of weeks. But if these effects are sustained, we should expect there to be negative consequences for wages and employment. 

Currently, the indications are that the UK will suffer possibly quite a nasty downturn. The gilt yield curve is inverted at the 2-year point, which suggests that markets are expecting a recession within the next two years:

Because of this, the Bank of England has already relieved banks of the requirement to build up countercyclical buffers, and is widely expected to cut interest rates and perhaps do more QE to support the economy. But as this is primarily a supply-side shock, monetary policy won't be enough. Indeed, in the absence of fiscal support, the unfortunate distributional consequences of unconventional monetary policy could even make matters worse. In the aftermath of a vote driven to a considerable extent by anger against what is perceived as a rich metropolitan elite, the last thing the UK needs is a policy response that increases inequality. 

I am relieved that key government figures have already indicated that tough fiscal targets will no longer apply. Trying to close the deficit now would be folly. Quite apart from the fact that tax revenues are likely to disappoint and benefits bills to rise, the economy will need fiscal support. A cut in VAT would be sensible to support demand, coupled with a substantial programme of investment spending. There is no reason to be shy about this. The new Chancellor, whoever it is, will no longer have the European Commission breathing down his or her neck. Gilt yields are low and falling. And the Bank of England can be relied upon to support gilt prices. This is a heaven-sent opportunity to invest in infrastructure, R&D, innovation, education and housing. 

Once the path and timetable for Brexit are clear, changes are likely to intensify in the run-up to leaving the EU. Those who no longer see their future in the UK will leave: but we may see others arriving, perhaps attracted by the UK's global outlook. It depends how we play it, of course: if we make life very hard for immigrants or foreign businesses, new ventures may be slow to appear. The new government will need to think about what businesses it wishes to attract for the future, and how to attract them.

To me, the present situation looks a lot like the preparation for the handover of Hong Kong to China in 1997. In 1996, while working for a major global bank, I was involved in a project to transfer trading books from Hong Kong to London. Like many international businesses, we feared that Hong Kong would lose access to international markets once it returned to China, so we wanted to get our business out of there. We were by no means the only business planning to leave. Many people, too, did their best to leave: those with British passports came to the UK, while others went to Singapore. There was a general atmosphere of worry during the five years between the terms of the handover being agreed and the actual return of Hong Kong to China. And it had a dampening effect on Hong Kong's economy.  

But we were wrong. Leaving the UK did not end Hong Kong's access to international markets. Nor did it result in the imposition of a repressive Chinese regime, as many feared. In fact, Hong Kong has become both the gateway to the largest market in the world and one of the world's great financial centres in its own right. It remains a lively, cosmopolitan, multi-cultural place. And many of those who left out of fear before 1997 have returned, attracted by Hong Kong's vibrant economy and its key role in the South East Asian marketplace. 

Of course, the UK is very different from Hong Kong, and it is leaving rather than joining a major trading bloc. It all could go horribly wrong: the UK could lose large parts of its financial services industry and be unable to develop other industries to compensate. Rather than a vibrant future, it could face years of stagnation and decline. There are no guarantees. But it is entirely possible that, like Hong Kong, once the UK has completely cut the ties, investment could return and the economy start to grow again. 

Whatever happens, though, the UK will change fundamentally. I do not know what the UK will look like in thirty years' time. But I am certain it will be little like today. Those who voted for Brexit in the hope of preserving their idea of Britain, preventing "their" culture from being diluted by foreign influences, are in my view doomed to be disappointed. When the UK leaves the EU and faces the world, it will place itself at the mercy of the world, and the world will make of it whatever it chooses. Short of imposing North Korea-style autarky, UK will have little control over this process. "Take back control" is in fact relinquishing control and stepping into the unknown. 

Not for a long time has the future been so uncertain. In the short-term, there will be pain. But in the longer-term, the future could be exciting. I did not vote for this, but this is what my compatriots chose, and I accept their decision. So this is what we - collectively - have chosen. Now we must embrace it, fully. For only by committing to our post-Brexit world can we have any hope of making it work. While we hanker after the past, and try to find ways of hanging on to it, we remain condemned to a stagnant future. Risk is life. Let's take some risk. 

Related reading:

Friday, 8 July 2016

The untold story of the UK's productivity slump

The ONS has produced a fascinating discussion of the UK's productivity puzzle, with some great charts. This one shows just how much the UK's productivity has slumped:

Notice when productivity started to slump. It was much earlier than 2008. In fact the data (which ONS have helpfully provided in Excel) show that output per hour started to fall in Q4 2006. The productivity slump, therefore, cannot be caused by the financial crisis. I suspect we have a "third variable" problem here. It seems likely that the financial crisis and the productivity slump are both symptoms of an underlying shock. But what was that shock?

To shed some light on this, here is another great ONS chart from the same publication:

In the middle of this we had the biggest financial crash since the 1930s, so the productivity drop for financial services is not surprising. What is surprising is that it is by no means the biggest productivity drop. There has been a catastrophic productivity collapse in extractive industries and utilities.

This chart comes from Tomas Hirst:

That big red bubble is North Sea Oil.  The UK's massive productivity growth from 1990-2006 was due to oil, not financial services. Even energy utilities downstream from North Sea Oil had a greater productivity rise than financial services. And both oil and utilities suffered a massive collapse. 

The collapse of North Sea Oil productivity started in 2004. And as this chart shows, that is when the price of Brent crude started to rise - astronomically:

Since this is a global price, to what extent the price rise is linked with the productivity fall is unclear. But it does speak of a supply/demand imbalance, to which falling productivity in the North Sea must have contributed. 

The collapse of NSO productivity was followed by a productivity collapse in downstream utilities, probably due to input price rises. Tom's chart shows that this was partly offset by a rise in financial services output per hour - though the gigantic falls in NSO and utilities output per hour dwarf the increasing productivity of financial services. 

We now know that the financial services rise was due to a credit bubble which disastrously burst in 2008. But just have a look at that oil price chart. Why is no-one talking about the mammoth oil price spike from 2004 to the first half of 2008 and its relationship to the financial crisis? 

Anyway, the UK's productivity puzzle is perhaps not such a puzzle after all. It seems to be mainly a story of the rise and fall of North Sea Oil. The financial bubble maintained productivity growth for a while as NSO declined. But as the bubble was itself driven by oil price dynamics*, it was doomed. It burst disastrously in September 2008, though the warning signs were there from 2007 onwards.

This suggests that, far from representing some kind of slump, the present productivity trend could actually be normal. We thought the productivity growth of the NSO period was normal, but it is in fact abnormal - and will never return. That does not bode well for future wage growth. Though of course technology might still save us.....

But somehow I doubt it. 

UPDATE: Richard Jones of SPERI has reached similar conclusions, though he says the oil productivity slump is not the whole story. He says the UK economy is suffering from Dutch disease, and desperately needs to diversify and invest in R&D and innovation. I can only concur.  

Here's Richard's fascinating paper on UK productivity (pdf). Do read it. 

Related reading

* Yes, I know this is a controversial view. Everyone thinks the credit bubble was about property. But in my view this was itself symptomatic of an underlying unsustainable oil price dynamic. I shall write about this in another blogpost, as it is global rather than UK-specific.

Wednesday, 6 July 2016

Short-run effects of the Brexit shock

The Governor of the Bank of England's opening remarks at the release of today's Financial Stability Report were stark:
At its March meeting, the FPC judged that “the risks around the referendum [were] the most significant near-term domestic risks to financial stability.” Some of those risks have begun to crystallise.
The Governor was admirably calm and balanced in his press conference. But nevertheless there was a degree of schadenfreude about his remarks. Prior to the referendum, the Bank of England was severely criticised by the Leave campaign for scaremongering. It was accused of overstating the economic risk in order to support the Remain campaign. But it is already clear that the Bank's analysis was accurate, as least as far as the near-term risks are concerned.

The principal risks identified by the Bank of England are threefold. Firstly, the financing of the UK's current account deficit is coming under pressure as inward investment flows slow down or reverse. Secondly, the UK's commercial real estate market - already overstretched and far too reliant on external funding - is suffering severe outflows and sharp valuation adjustments. And thirdly, over-indebtedness in the household sector raises the possibility of an aggregate demand shock and pressure on the housing market. Yippee.

The most obvious indication of the pressure on the current account is the fall in sterling. Sterling fell sharply on the night of the referendum results, as the Bank of England's chart shows:

Sterling has fallen further since, though not so sharply. It is now at its lowest level since 1985. Though it is worth putting this fall in context:

Maybe it is a little too soon to panic about the falling value of the pound.

But worries about the UK's current account deficit are legitimate. It is historically large, as can be seen from this chart:

We often talk as if the current account deficit is caused by Britain's inability to produce enough goods for export. This is true to some extent: there is a structural trade deficit (blue bars), though this has reduced somewhat since the financial crisis. But the largest component of the current account deficit is primary income. The Bank of England notes that this is made up of compensation of employees (Brits working abroad cost us more than we receive for foreigners working here, despite what UKIP may think) and net investment income, which is the difference between the amount that Brits earn on their investments abroad and the amount that foreigners earn on their investments in Britain.

Primary income switched from surplus to deficit as the Eurozone crisis started, and has gone deeper into deficit since. The ONS notes that although both receipts and payments have fallen, receipts have fallen by considerably more than payments - hence the primary income deficit. The reason is the falling rates of return on overseas investments:
The decline in credits over this period largely reflects continuing deteriorations in rates of return, which have fallen from a peak of 7.7% in 2011 to 5.0% in 2014, and have fallen further in 2015 to 4.8%. Annualised rates of return for Quarter 1 2016 indicate a further decline in the rate of return, having fallen to an estimated 3.0%.
So the large deficit on primary income is due to poor investment performance elsewhere in the world - in particular, in Europe. Foreigners receive better rates of return in Britain than Brits do abroad. This is actually a sign of success. Our economy is doing better than theirs, so rates of return are higher - and that attracts inward investment. FDI and portfolio investment flows are very important to the UK.

But they are also a risk factor. If foreigners suddenly withdrew their investments, there would be a sharp correction to the current account - what we know as a "sudden stop". As the UK issues its own floating currency, this would cause sudden sharp devaluation, with (since the UK is an import-dependent economy) obvious implications for inflation. Since the UK runs a sizeable government deficit, which (in the absence of a domestic private sector surplus) is financed by those inward investment flows, it would also cause a fiscal crisis. And it would additionally cause a private sector debt crisis, since the flows also finance corporate investments, notably in commercial real estate. In short, the UK is terribly dependent on external capital flows for its economic and financial stability. Hence the watchful eye on sterling and the worry about the current account.

There is no sign as yet of anything as disastrous as a "sudden stop". In fact the fall in sterling experienced so far should be helpful to exporters (I have to declare an interest here - much of my income is in US dollars, so I have effectively had a pay rise!). But the absence of crisis does not make the shifting pattern of investment flows caused by the Brexit shock "beneficial". Closing a current account deficit by ruining the attractiveness of the economy to investors is not clever.

The commercial real estate market has been showing signs of strain since the beginning of the year. As the Bank of England's chart shows, foreign inflows of capital fell by almost 50% in the first quarter of 2016:
How much of this can realistically be put down to Brexit fears is unclear. The chart shows bubble-like growth which might have corrected anyway. But this chart does suggest that the UK economy was already slowing long before the Brexit vote. There is clear evidence of significant capital outflow, which would eventually feed through into lower growth. So basically we have smacked an already cooling economy in the face. Someone please tell me why this is a good idea?

But the vote itself has had a dramatic effect. Share prices of investment funds have fallen sharply. Closed funds simply have to weather the storm, though they might close their doors to new investors. But open-ended funds face damaging runs and the possibility of fire sales. Yesterday, Standard Life announced it was suspending trading in its open-ended CRE fund. And today, M&G and Aviva followed suit.

Open-ended CRE funds are highly illiquid (it is not easy to sell office blocks and shopping centres at short notice), yet they offer redemption on demand to investors. This is maturity transformation on an even more extreme scale than banks, and these funds are consequently vulnerable to severe liquidity crises. Yet they do not have any form of liquidity support. Trade suspension is thus a necessary circuit breaker, and it is built into the terms and conditions of the funds. It is roughly the equivalent of a bank closing its doors to stop a bank run.  

There is clearly going to be a severe correction in CRE prices. How damaging this will be to the economy depends on the impact on banks. Worryingly, it appears that UK banks - particularly smaller ones - are significantly exposed to CRE. But the Bank of England insists that it has covered all bases in its stress tests, so the banks should be able to absorb CRE losses without falling over. We shall see.

The third risk is one that I have persistently warned about. There is already evidence that the Brexit shock is causing people to delay spending and investment decisions. If this continues, then we can expect a significant economic slowdown, leading to real wage cuts and rising unemployment. Under such circumstances, high household indebtedness is a serious economic risk. And the UK's households have not significantly deleveraged since 2008. They still have far too much debt:

The Bank of England observes that highly-indebted households tend to cut back spending very hard when their incomes fall, preferring to honour their debts at the expense of their lifestyles. This can seriously reduce aggregate demand. And buy-to-let investors faced with interest rate rises may choose to sell out, causing house prices to fall and worsening the position of marginal borrowers. There is a risk of a self-reinforcing debt deflationary spiral developing, though tighter lending restrictions imposed in recent years may help to dampen these procyclical effects.

The market is already pricing in interest rate cuts, though the Governor refused to be drawn on what form these would take: he dislikes negative rates, not least because of the risk they pose to building societies, so maybe the preferred instrument will be some form of QE. And the Bank of England has relaxed countercyclical capital buffer requirements for banks to encourage them to keep lending - though the Governor admitted that demand for loans would probably fall.

But realistically the Bank cannot entirely protect the economy from the toxic combination of over-indebtedness and the Brexit shock. As the Governor said, all the indicators are that the UK faces a significant downturn. We are seeing falling stock prices on the FTSE 250 (though not the globally-focused FTSE 100), downwards pressure on gilt yields and a flattening yield curve. These are leading indicators of recession. To be sure, the UK might have been facing a slowdown anyway. But if so, the Brexit vote will make it much worse.

However, recessions don't last forever, and it is entirely possible that once the UK is completely disentangled from the EU, investment will return and the UK will come "roaring back". But how long this will take is impossible to tell. The patient won't die, but it could be decades before it is fully recovered.

In the long run, Britain may once again become a vibrant, world-beating economy. But as Keynes said, in the long run we are all dead. Particularly those who voted for this wholly unnecessary surgery, who are by and large the old. They will die: but the young will bear the scars.

Related reading:

The snake oil sellers
Who is really to blame for Brexit?

Image courtesy of The Telegraph.