Friday, 27 April 2012

This made me angry

In the Telegraph yesterday, Colin Hines wrote a blog defending his "progressive protectionism" idea from what he called the "extreme Right", by which he means Tim Worstall. Well, Tim has some strange ideas, but I wouldn't call him "extreme right". But that's not what made me angry. 
Colin describes his idea of "protective protectionism" thus 
" protectionism rejects the incessant mantras of more open markets and the need to be internationally competitive. Acceptance of these edicts as inevitable invariably results in politicians being forced to drive down tax rates, constrain social and environmental improvements and preside over the eradication of countless local jobs and small business opportunities.... protectionism would not involve a return to the oxymoronic protectionism of the 30s. Then the goal was often for each protected industry or country to increase its economic strength by limiting imports, and then hoping to compete and export globally at the expense of others. Unsurprisingly, the more countries did this, the less trade there was between them. Today’s example of a self-defeating economic approach is the ludicrous fantasies of export fetishists. They whistle in the dark trying to keep up the nation’s economic spirits by promising hi-tech export-led growth. In an era of rising Asian dominance, this has to rate as the last colonial delusion. 
The alternative to this is a progressive protectionism which will allow countries to wean themselves off of present levels of export dependence. It would enable the rebuilding and re-diversification of domestic economies by limiting what goods states let in and what funds they allow to enter or leave the country. Having regained control of their economic future, countries can then set the levels of taxes and agree the regulations needed to fund and facilitate this transition. National competition laws would ensure that monopolies didn’t develop behind protective barriers. Finally, there is an internationally supportive approach to trade with poorer countries, ensuring that the gains from the remaining international trade would be targeted to help fund the move towards a localised economy that benefits the poor majority. In essence, this approach will make space for domestic funding and business to meet most of the needs of society worldwide."
Now, I agree this is not easy to understand. For example, what is the difference between "limiting imports" and "limiting what goods states let in?" So let me interpret this convoluted piece of writing as I see it. If you disagree with my interpretation, please do give your alternative in the comments.
Colin's objections to the current system of international trade - "globalisation", as he calls it - are the following:
1. Free markets are bad.
2. Low taxes are bad.
3. International trade is bad. 
4. Small domestic businesses are good.
So Colin's progressive protectionism basically involves ending most international trade. He doesn't say what international trade would be "allowed" to continue, but he implies that there wouldn't be very much. To achieve this he proposes that countries should:
- "wean themselves off export dependence" 
- "limit what goods they let in AND what funds they allow to enter or leave the country" (my emphasis)
Translation: Countries should have import controls, capital controls and export barriers. Now if you have neither imports nor exports, and you have capital controls, you have a closed economy. I should point out that Colin castigates the import controls of the 1930s because they weren't coupled with capital controls and export restriction, so resulted in global competition for exports, not because he thinks import controls are a bad thing. 
Colin's idea seems to be that if you create a closed economy you can "set the levels of taxes and agree the regulations needed.....". Yes, absolutely you can do what you like, because you have no relationship with the outside world. It seems he would like North Korea replicated worldwide - a global system of autarkic states. 
But if your economy is so closed that you control all trade and financial transactions, and you have seriously restricted imports, how are you going to create an "internationally supportive approach to trade with poorer countries"? For poorer countries to get richer they have to export to richer ones - that way they get the income they need to develop their domestic economies. Domestic economies don't get richer all by themselves: a closed economy may create the ILLUSION of prosperity, but real prosperity comes from the redistribution of global resources that arises from good international trade. I would be the first to castigate the practices that keep poor countries poor - trade tariffs imposed by richer countries to protect their domestic businesses from competition from lower-cost businesses in poorer countries, international investors that remove capital from the country at the drop of a hat, strings attached to international aid, protection of international lenders at the expense of the people of the country (now where are we seeing that at the moment?), corruption in domestic governments, and above all, war.....But Colin's solution to all of those is not to address the issue, but to close the doors . And this is what made me angry.
You see, Colin doesn't actually want poorer countries to trade with richer ones. He wants them to develop "a localised economy that benefits the poor majority".  But a localised economy in a poor country can only be poor people trading with each other in local markets - subsistence farmers, one-boat fishermen, small craftsmen. What a lovely romantic image! What a truly charming picture! As Splinter Sunrise put it on Twitter last night: 
"there's a lot of this stuff going around about how we should help Tanzanians to remain poor subsistence farmers". 
What right have people like Colin Hines - rich people in the rich developed world - got to deny people in poorer countries  the opportunity to become richer and have a better life through exporting to richer countries? And to do this in the name of environmental protection and "improving social conditions", as well. Oh yes, it will improve the environment in poorer countries because they won't be able to develop their natural resources - their countries will stay pristine and undeveloped, like a Constable painting. And it will improve social conditions - in the richer developed countries which are losing business to poorer countries. 
I am trying not to swear (though I'm afraid I did, on my comment on the Telegraph article!), but I have seldom read anything that made me so angry. Global inequality, set in stone. Let the poor remain poor so the rich can remain rich. Absolutely appalling.

Sunday, 22 April 2012

It doesn't work like that - TARGET2 edition

Today, Liam Halligan in the Sunday Telegraph wrote an excellent article castigating the Eurozone leadership for running cap in hand to emerging markets for help when they haven't reformed their banking system or resolved the structural problems with the single currency. Halligan's articles are always well worth reading and this one is no exception. But there is something wrong. About three quarters of the way down the article he says this:

"Obscure data shows that under so-called Target 2 operations, the ECB’s intra-eurozone payments system, the Bundesbank is owed a mighty €620bn by other member states. This stealth bail-out dwarfs German’s covert contributions to previous eurozone rescues, which themselves provoked bitter public criticism."

The TARGET2 system has been the subject of much debate recently. There have been repeated claims, of which Halligan's is just the latest, that the Bundesbank's deficit in TARGET2 represents a "stealth bailout" of indebted Eurozone countries. My friend Beate Reszat has written an excellent post explaining why this view is wrong and how TARGET2 really works.  Others - including FTAlphaville, which produced several rather technical blogs about this - have also had a go at sorting out fact from fiction. But to no avail, it seems. The Bundesbank itself even describes the imbalance as money "owing" to Germany. This is a serious misrepresentation of the truth. 

The Bundesbank's TARGET2 claim is an accounting representation of the trade imbalance between Germany and the rest of the Eurozone. Germany has a considerable current account surplus (excess of exports over imports), a large part of which is balanced by current account deficits in other Eurozone countries, as I have explained elsewhere.  There are therefore REAL inflows to the German private sector as money is received in payment for exports. These payments are made via the national central banks and the ECB using the TARGET2 system.  Beate's article (link above) is an excellent explanation of how the transfer mechanism works, but for those who want something more succinct, this article summarises it neatly and has a useful picture.  

But the story doesn't end there.  Once the money has reached the exporters, these payments eventually find their way back into commercial banks in the form of deposits. Banks that have excess deposits may lend them to other banks, or they may use them to reduce their need for funding either through the interbank market or from the central bank.  A proportion of the deposits arising from payments to German exporters through the TARGET2 system therefore end up back in the Bundesbank as commercial bank reserves, reducing the commercial banks' need for borrowing from the Bundesbank. As a loan from a central bank to a commercial bank is represented in accounting terms as a commercial bank liability and a central bank asset, if commercial banks reduce their central bank borrowings the central bank's asset base is reduced.  I hope this is clear.

The intra-Eurozone payments mechanism relies on base money creation and destruction (seigniorage) by central banks. When an importer in Greece buys a consignment of BMWs from Germany, no physical funds are transferred between the central banks: the Greek central bank reduces base money in Greece by the value of the import,  and the Bundesbank increases base money in Germany by the same amount. In each central bank, that takes place as a double-entry accounting entry: the increase in base money in the Bundesbank is balanced by an increase in its assets (its TARGET2 claim). Conversely, the decrease in base money in the Greek central bank (liability) is balanced by a decrease in its assets. The end result is that the Bundesbank appears to have lent money to the Greek national bank. But this is simply a representation of the trade flow between the two countries and a consequence of double-entry accounting. It is not, in any sense, a "debt".  And when you take into account the REDUCTION in the Bundesbank's asset base arising from export payments through TARGET2 eventually finding their way back into the Bundesbank in the form of commercial bank deposits, it is clear that the Bundesbank's assertion that its TARGET2 claim is money "owing" to Germany is incorrect. The increase in its asset base arising from its TARGET2 claim is at least partly offset by the reduction in its asset base arising from commercial bank deposits.

However, the Bundesbank's TARGET2 claim does mean that it has on its balance sheet assets that look like loans to other central banks.  And it is indeed correct to note, as many people have, that in the event of a country leaving the Eurozone, the Bundesbank's TARGET2 claim against that country would be likely to become worthless.  There has been considerable discussion in other places about whether or not central bank insolvency is a problem, mostly in relation to the unwinding of QE. It might be worth having a similar discussion in relation to the possible insolvency of Eurozone central banks if the Eurozone breaks up. 

The prevalent belief is that if Greece were to leave the Eurozone, the value of the Bundesbank's assets would be reduced, leaving it technically insolvent since its liabilities (base money in circulation, in this case) would exceed its assets. The effect of this would be a significant fiscal tightening caused by reducing base money in circulation (deflation) and/or increasing German taxes to recapitalise the Bundesbank. So Germans are understandably angry that they would end up picking the tab for Greece's exit.

Except that the Bundesbank's claim isn't against the central banks of other countries. It's against the ECB. It is the ECB that has a claim against Greece, not the Bundesbank. So in the event of Greece leaving the Eurozone, it would actually be the ECB that would be technically insolvent, not the Bundesbank.

The discussion we need to have regarding central bank insolvency in the event of Eurozone breakup therefore concerns the ECB, not the national central banks.  There are two possibilities:

- the Eurozone breaks up completely and the ECB is dissolved

- some countries leave the Eurozone, leaving the ECB insolvent, and the remaining countries recapitalise the ECB

The first of these I think is a pretty remote possibility, but if that were to happen then the central bank imbalances would become peer-to-peer with currency translation risk.  The Bundesbank would have direct cross-border balances with the central banks of its trading partners, and those balances would have to be revalued from time to time to represent movements in the exchange rate. Exactly what it currently does with its non-Eurozone trading partners, in fact. And I repeat - these balances are accounting representations of trade imbalances, not actual money that has to be paid. The exports have ALREADY BEEN PAID FOR. Controls on cross-border movements of capital therefore would make absolutely no difference.

The second is rather more complex - and much more likely. Any decision to recapitalise the ECB would hit Germany hardest because of its dominance in the Eurozone.  German taxpayers would be footing a large part of the bill for partial breakup of the Eurozone. Personally I don't think this is anything like as big a problem as the LTRO unwind in three years' time will be, or the problem that the ECB already has with valuation of junk sovereign and other bonds it has accepted as collateral. But it is the prospect of having to recapitalise the ECB that German taxpayers should be worrying about, not whether the Bundesbank's claims will be met. There is ZERO chance of the Bundesbank being left insolvent. The ECB can if necessary meet the Bundesbank's claim through seigniorage - though this would seriously upset the Bundesbank, with its inflation phobia and horror of money creation.  Sometimes I think Bundesbank officials think the Bundesbank and the ECB are the same thing.....

The long-term solution to the TARGET2 imbalances, obviously, is to eradicate trade imbalances between Eurozone countries. I have to say that current economic policy in the EU seems to be heading in the wrong direction at the moment, and in particular, Germany's determination to hang on to its current account surplus is making it virtually impossible to undertake the necessary rebalancing.  But in the meantime, the Eurozone should create a sterilisation mechanism for central bank TARGET2 balances, to get them off central bank balance sheets and onto commercial bank balance sheets where they should be. An example of a sterilisation mechanism might be the following:

- The German government would instruct the Bundesbank to issue bonds to the value of its TARGET2 claim and force commercial banks to buy those bonds. 

- on the other side, countries with trade deficits would instruct their central banks to transfer TARGET2 liabilities to commercial banks by lending them money at very cheap rates or even (shock, horror) by directly crediting commercial bank reserve accounts. 

This would amount to the Club Med national banks doing QE to counter the deflationary effect of the reduction in the money supply arising from their net import payments via TARGET2, and the Bundesbank doing reverse QE (selling assets) to counteract the inflationary effect of the expansion of the German money supply arising from its net export receipts. (Note that both figures must be net of offsetting export receipts in Club Med and import payments in Germany.)  This might be a bit of a problem - I don't think there's any doubt that the Club Med economies could desperately use some QE, given the appalling economic contraction they are experiencing, but are the inflationary pressures in Germany sufficient to justify monetary tightening at the moment? 

In practice Eurozone central banks do informally sterilise part of their TARGET2 balances, the Bundesbank by encouraging commercial banks to reduce their borrowings and the Greek national bank by lending to cash-strapped Greek banks. But no formal sterilisation mechanism exists, and I imagine significant enhancement of the TARGET2 system would be required to create it.  The trouble is, such a mechanism would bring to light the full horror of German banks' reckless lending to fund Germany's trade surplus.  I suspect the German government would have to bail them out, something it has been systematically avoiding by claiming that other countries "owe it money" in various ways.  

It really isn't helpful to regard the TARGET2 imbalances as a "debt" problem or as Germany doing some kind of bailout. The problem arises from the inadequate setup of the single currency. Nobody ever imagined that such trade imbalances would build up, and so nobody put in place any formal mechanism to sterilise central bank operations and keep the trade imbalances in the private sector where they belong. By allowing the imbalances to reside on central bank balance sheets, the Eurozone has been able to pretend for too long that trade imbalances are not an issue. If they were forcibly transferred to the private sector, the Eurozone leadership would have to admit that trade imbalances are not only an issue, they are the major cause of the insolvency of the Eurozone banking system and the instability of the currency union.  And then we can perhaps stop blaming countries for their debt problems and point the finger at the real culprits - the banks that have lent so recklessly, the governments that have protected them, and the politicians who have created the deformed and dysfunctional single currency.

Friday, 20 April 2012

Circular easing

The Government has a new scheme. It's called Credit Easing and it's designed to improve the availability and lower the price of bank loans to small and medium-size businesses (SMEs).

There has been continual moaning from the SME sector about lack of finance. "Banks aren't lending", they moan. When the banks respond that SME's aren't borrowing, SME representatives bewail the cost of bank loans. Far too high, especially for risky enterprises.

Well, when I was doing corporate finance we regarded it as normal for banks to charge higher interest and fees on loans to higher-risk enterprises. And the SME sector generally is high-risk. They have few "hard" assets that can be used as collateral, and securing the loan by means of a charge over the company's assets is only as good as the value of those assets, which in the case of insolvency may be not very much. At a time when banks are supposed to be de-risking their own balance sheets and returning to more prudent forms of lending so as to reduce the risk of serious losses requiring taxpayer bailout, increasing high-risk lending to SME's doesn't look like a particularly intelligent strategy. The Government's Project Merlin has forced banks at least to offer finance to businesses that otherwise they might turn down, but it doesn't say they have to make it affordable. So bank finance is available, but often at a very high cost and with prohibitive conditions which many SMEs simply cannot or will not accept. The result is a near-freeze on SME lending.

So the Government is stepping in. It is making cheap funds available to banks to lend out under the credit easing scheme. The condition of accepting this funding is that SME loans must then be offered at a reduction of one percentage point on the rate that would otherwise have been offered. This assumes of course that the borrowing would be offered at all. Implicitly, the Treasury is assuming that banks are passive agents - that if they have more funding at lower rates, they will of course make more loans.

Frankly, this assumption displays a lamentable lack of understanding of how bank lending actually works, and has been shown to be false again and again over the last few years. The decision whether or not to lend is a commercial decision based upon the expected return versus the risk. I've explained in other posts how lending works in practice, but basically banks make lending decisions in the absence of funding and seek the funds to settle the loan when it is drawn. The Government providing funds to banks ahead of their lending may improve their liquidity but it won't necessarily make any difference at all to their decision whether or not to lend. If a bank regards some kinds of SMEs, such as startups, as unacceptably high risk, it will not lend to them however much money the Government throws at it. It will simply sit on the funds - park them at the Bank of England, or lend them to another creditworthy institution.

I can't see much point in this measure unless it is accompanied by other measures to reduce the perceived risk of SME lending. The most obvious would be a Treasury guarantee for SME loans. When the Government announced what it called the "National Loan Guarantee Scheme", I assumed that's what it meant.  I was wrong. What the Government means by this is guaranteed loans TO BANKS so they can lend to SMEs.  And I could forgive people for being confused by this. "Credit easing" and "National Loan Guarantee Scheme" seem to mean the same thing and could be more accurately termed "Bank funding easing" or "liquidity enhancement". How this is supposed to flow through to SMEs is a mystery to me.

Anyway, the provision of cheap guaranteed funds to banks is supposed to be the funding "push" that encourages banks to lend to SMEs. But at the other end, there is a proposal for a "pull" mechanism as well.  The idea is that the Government should create an agency to buy up SME loans from banks, package them into asset-backed securities and sell them on into the international capital markets. Once a capital market for securities backed by SME loans is established, the thinking goes, demand for these products would drive lending to SME's.

Demand for asset-backed securities in capital markets can indeed drive expansion of lending. Gillian Tett, in her book Fool's Gold, remarks that by the time of the financial crisis, there was so much demand for mortgage-backed securities in the capital markets that mortgage originators took higher and higher lending risks in order to meet the demand. I'm not sure such a demand-driven lending spree is entirely what we want - after all, we know what happened to the American mortgage market, don't we? But I'm not at all convinced that there would be such demand for SME loan-backed securities.

One of the major reasons why mortgage-backed securities were so popular lies in the word "mortgage". Residential mortgages have traditionally been seen as "safe" investments because they are secured on property which generally is worth at least as much as the loan value and often much more, and because most homeowners will go to the ends of the earth to protect their homes from repossession, so default risk even on sub-prime mortgages in normal times is probably not that high. Compare this with SME finance: the MAJORITY of startups fail, and default risk can be fairly high even in established businesses. And as I noted above, available security can be pretty dodgy. Yet the market for mortgage-backed securities crashed in 2008 and now barely exists at all.  It is fair to say that markets for other asset-backed securities - including some for unsecured personal lending - have performed better. But at the moment you really wouldn't say that asset-backed finance was a growth industry. So why on earth would there be any appetite for new SME loan-backed securities?

There is a solution, of course, which was obliquely mentioned by the Chancellor in his speech to the Conservative Party Conference last Autumn. The Bank Of England purchases government securities (gilts) in return for new money under the Quantitative Easing programme. But it also has authority to purchase corporate bonds, though it has done very little of this. It has been suggested that the way to ensure that there is a market for SME loan-backed securities would be for the Bank of England to purchase them under its Asset Purchase Facility. There is a slight snag: the Bank of England cannot participate in a primary auction, so the SME loan-backed securities would have to be offered to private investors first, heavily underwritten by the issuing agency or some other tame institution. The Bank of England could then step in and buy any that remained unsold (which would probably be most of them).

Now, just to remind you - the Bank of England is wholly owned by the Treasury. So anything it purchases actually belongs to the Government. In effect, the Government would buy up SME loan-backed securities issued by a Government-sponsored agency that bought loans from banks that were funded by cheap loans from the Government.....

And so the circle is complete.

What I can't understand is why on earth we need to create a complex circular flow of funds from Government, through banks and capital markets and back to Government again, just to provide SMEs with the finance they need to expand. Wouldn't it be simpler for the Government to lend the money directly to SMEs?

Oh no, wait. Government isn't supposed to be in the business of banking, is it? So we need this ridiculous circularity just to avoid any suggestion that Government is lending to SMEs. And to think I have been castigating the idiotic complexity of Eurozone financing, which is entirely designed to avoid giving the impression that the ECB is funding Eurozone governments. It seems the UK can do its own version of fudge.

UPDATE - Following a Twitter discussion, another nasty possibility has emerged (thanks to Graeme Pietersz for raising this). The difference between cheap loans to banks ostensibly so they can lend more to SMEs at cheaper rates, and cheap loans to banks for any other purpose, is vanishingly small. The last time banks were offered cheap loans was in the ECB's LTRO operations in December 2011 and February 2012. These were thinly-disguised bailouts of weak illiquid (and possibly insolvent) banks and, indirectly, highly indebted sovereigns. Given that we KNOW that throwing cheap money at banks doesn't make them lend, maybe enhancing SME lending isn't the real intention. Maybe SME lending is just a smokescreen for the real objective, which is to provide more government support to weak UK banks. They certainly need it, but overt financial support is politically unacceptable at the moment. It is very telling that the strongest UK bank, HSBC, does not plan to participate in the National Loan Guarantee Scheme, and the bank that intends to use it the most is the UK's weakest bank, RBS.

Saturday, 14 April 2012

The charity tax grab

In the last few days, there has been a growing furore over the Government's plans to cap the amount of money an individual can give to charity free of tax. The amount of misinformation and misunderstanding around this is extraordinary and there have been some very silly comments from both supporters and opponents of the proposal.

I am no expert on tax, so for those who want to know how tax relief on charitable giving works, here is an excellent explanation by Andrew Brooks of SB Consulting. But let's be clear about what the Government's proposal is NOT.

Despite what is promoted and widely believed, it is NOT an additional tax on the rich. It is a tax on charities, particularly those that receive large single donations. Universities and the arts are particularly dependent on this form of philanthropic support, and there is a lot of concern from people in these sectors that funding will diminish as donations are taxed and government will not plug the gap.  Let me explain how it will work.

The proposed cap limits the proportion of annual income that an individual can give to charity to 25% or £50,000, whichever is larger. Below this limit donations can be made tax-free. This effectively means that the donor is "relieved" of their tax liability on donations made to charity. The Government's proposals DO NOT change this.

Above 25% or £50,000, ALL tax relief is withdrawn. This in effect means that charitable donations in excess of the cap will incur income tax at the donor's highest rate, probably 45p (or 50p in the current tax year).

To give an example: suppose an individual who earns £4m wants to give £2m to charity. At present he can give all of that £2m to the charity, declare the donation on his tax return and receive tax relief at his highest rate on that donation. In effect he has reduced his taxable income from £4m to £2m.

Once the cap is in place, the individual will still receive tax relief on £1m of the donation. But the remaining £1m will be taxed at his highest rate. Now, it is possible that our philanthropic donor will still give £2m even though half of that is taxed at 45p in the £. But it is much more likely that our donor will reduce the amount given to charity by £0.45m, to accommodate the tax that he will have to pay on that donation and leave him paying the same amount overall.

So the effect is that income to charities from single large donations will be partly subject to top-rate income tax. In effect, for the first time charities are being taxed - and at a pretty steep rate, too.

Not everyone is opposed to this. In a letter in the Guardian today supporting the proposed cap, representatives of the Tax Justice Network (TJN) and Jubilee Debt Campaign (JDC) make this statement:

"A decent society should not have to depend on the largesse of the super-rich for its public services, cultural life or anti-poverty drive."

And they go on to say:

"Tax exemptions for the super-rich have helped foster inequality. The removal of such exemptions must form a small part of a wider quest for tax justice which would allow governments everywhere to provide public and cultural goods accountable to their societies." 

It would seem that our TJN & JDC friends don't really want people to give to charity at all. They want all giving to go to the state and all services to be provided by the state. Well, they are entitled to their opinions, but this looks a bit extreme to me - and perhaps more importantly, is completely at variance with the will of Parliament over a long time now, which has sought to encourage charitable giving by means of a system of tax reliefs. 

But quite apart from their extreme statist views, our TJN & JDC friends also don't seem to understand basic maths. The proposed cap aims to raise additional tax revenues to pay for EXISTING government spending - not for Government to take over the provision of services currently provided by charities. If Government were to take over the provision of those services because charities no longer had the income to provide them, the money raised through the taxation of donations would still go into the provision of the SAME services - just provided by the public sector instead of the not-for-profit sector. There would be no net financial benefit to the Government at all, no more money for existing spending commitments. So the assumption must be that if taxation of charitable donations means that charities are no longer able to provide services that they do at the moment, those services will NOT be provided by Government - they will simply disappear, and society will be the poorer for their absence. Interestingly, a member of the governing council of the Royal College of Music (my alma mater) makes exactly that point in another letter on the same page in the Guardian.

The nastiest part of this whole shambles, to my mind, is the public depiction of large-donation givers as "tax avoiders". I find this really quite unpleasant. Firstly, these people are GIVING MONEY AWAY. Yes, they don't pay tax on the money they give away. But does that mean they are giving the money away simply in order to avoid tax? That really doesn't seem very likely. If the donation is to a bona fide charity, they do not benefit from that money at all - even the tax relief doesn't benefit them, since it simply allows more of their donation to go to the charity. Secondly, the tax relief on charitable donations was DELIBERATELY CREATED by Parliament to encourage charitable giving. If someone uses a relief for the purpose for which it is intended, it is NOT tax avoidance - it is tax compliance. So, if our philanthropic donor gives £2m to a bona fide charity free of tax, he is not "avoiding tax": the relief that he claims is designed for that purpose. Parliament has the right to remove the relief, of course, but for politicians to describe as "tax avoiders" people who use reliefs for the purpose for which they were intended is wrong, unfair and looks very much like playing to the gallery. Tax avoidance by the rich is a VERY fashionable subject at the moment. 

There is widespread public perception that many of the charitable donations that will be subject to this tax are to "spurious charities". The Prime Minister claimed, as justification for the proposed cap, that many charities "didn't do much charitable work". But this claim has yet to be substantiated in fact and has come in for serious criticism from the Charity Commission and HMRC, who have stated that they are not aware of any such cases. And the head of the National Council for Voluntary Organisations (NCVO), Sir Stephen Bubb, has publicly called for the Government to provide evidence of such behaviour so that the charities concerned can be closed down. There has also been criticism of large donations to overseas (especially European) charities: but we are part of the European Union and charities based anywhere in the EU can legally operate here and receive tax-free donations from UK residents. 

So in short, this is a Government raid on charities dressed up as an attack on tax avoiders. It's slimy, underhand - and completely counterproductive. Attacking charities is NOT a clever strategy for a Tory government. Because many of the people who make large donations to charity are Conservative party supporters, and many of the charities receiving those donations are run by Conservative party supporters. Encouraging private (including charitable) provision of services instead of state provision has been a hallmark of Tory party policy for a very long time. By targeting charities, the Government is upsetting its supporters and undermining its own party policy.  

Personally I do think that tax relief on charity donations needs to be rationalised. The present situation is that under gift aid, charities can claim back from Government the basic rate tax deemed to have been paid on the donation, which gives them an additional 20% on top of each donation. If the donor is a higher-rate payer, though, and declares the donation on his tax return, he receives tax relief at his highest rate even though the charity can only claim basic rate. If charities can only claim basic rate tax under gift aid, then in my view tax relief should also be restricted to basic rate for gift aid donations. And there could be a case for restricting all tax relief on charitable donations to basic rate, or even for eliminating tax relief completely - no doubt our TJN friends would like that.  But leaving higher-rate relief in place then abruptly withdrawing ALL tax relief at £50,000 or 25% of income strikes me as folly. My example above assumed that my donor didn't change his giving behaviour as a result of this bear trap, but people don't like traps - they generally avoid them. I would therefore expect there to be significant changes in donor behaviour, such as keeping donations just below the tax level and perhaps finding other, more tax-efficient ways of using their money. The income loss to charities could turn out to be far more than the tax actually suffered. 

And this is not the only charity tax grab. In the first letter on that page in the Guardian, the Chief Executive of the Arvon Foundation points out that the Government plans to remove the VAT exemption for alterations to listed buildings. Charities that renovate and maintain listed buildings, therefore, will now suffer tax on their work - even if it is funded by Government grants. This seems idiotic. Really the Government hasn't thought this through at all.

It looks to me as if the Government has no real strategy for increasing tax take and reforming taxation, but is simply snatching at straws - schemes it thinks will be popular with voters and give the impression that they are doing something significant. The Chief Executive of the Arvon Trust, in the letter to the Guardian that I have already quoted, bewails the lack of "joined-up thinking" in the Government's tax policies. She is absolutely correct - it is piecemeal, inconsistent and unfair. Osborne is the most "political" Chancellor we have had for a long time, and in my previous post on the budget I suggested that the driving force behind other tax changes was the 2015 election. But if that was his intention with the charity tax grab, I fear he has lost his political marbles.  

Thursday, 12 April 2012

Corporate finance and daft ideas

On 16th March, an Independent Taskforce instigated by the Department for Business, Innovation and Skills produced a report into non-bank lending. The BIS press release regarding this report can be found here and the entire report (pdf) can be downloaded from this link.

The purpose of the Taskforce and its summary findings are as follows:
The Taskforce, chaired by Tim Breedon, CEO of Legal & General plc, was commissioned by the Government to examine a range of alternative and sustainable finance sources, particularly for small and medium-sized enterprises (SMEs).
Bank lending is by far the largest source of external finance currently used by businesses, but the Taskforce believes there is significant potential to develop both the demand and supply of non-bank lending to match the financial landscape of countries like the US. 
The main recommendations from the Taskforce’s report to Business Secretary Vince Cable are:
  • Increase awareness of alternative financing by creating a single brand and a single business support agency to deliver the Government's range of SME finance programmes, drawing on international examples such as Germany's KfW.
  • Industry to establish a Business Finance Advice network, comprising the main accountancy bodies.
  • Open up access to capital markets financing for smaller companies through the creation of a body to bundle and securitise SME loans.
  • Consider the potential for the Government's Business Finance Partnership to invest in innovative products such as mezzanine loan funds and peer to peer lending.
  • Encourage large businesses to support smaller companies by reinforcing prompt payment practices, supporting greater use of invoice discounting and utilising supply chain financing to invest in smaller suppliers.
  • Government and industry to review the impact of international prudential regulation such as bank and insurance capital rules on the supply of SME finance.
  • Increase the UK retail investor appetite for corporate bonds.

So this report is all about financing small and medium size enterprises (SMEs) by means other than traditional bank loans. Well, this certainly seems to be an area that needs expansion. Bank lending to SMEs is pitiful and expensive, and although the Government has managed to enforce Project Merlin lending targets, just about, it is nowhere near enough to enable the UK's smaller businesses to develop domestic and export markets, employ lots of people and get the economy growing again. Which, most people agree, is what they should be doing.

There are some sensible proposals here which would be relatively simple to implement and probably quite effective in the short term.
  • Integrating the various Government finance schemes under a single brand name and delivering them through a single agency would certainly help to target finance where it is needed and reduce the (considerable) confusion that exists around what financing is available and to whom it applies.
  • Creating a Business Finance Advice network sounds like a good idea and could work well in practice if it is delivered through the professional bodies ICAEW, ACCA and ICAS. The network should cascade effectively down not only through the big accountancy firms but through much smaller accountancy suppliers, which would mean that for the first time businesses would be able to rely on their accountants to provide much-needed business advice. But there is a big hole in this proposal. Your average high street accountant has no more idea than his clients regarding some of the fancier forms of financing discussed in this report, and the report doesn't come up with any other ideas whatsoever for helping SME directors navigate the complex and difficult seas of corporate finance.
  • It is manifestly sensible to apply Government pressure to large companies to get them to treat their smaller suppliers better, and to set a good example by treating small suppliers to the public sector better (personal gripe here - state schools please note, that includes you). Squeezing of small suppliers is a reprehensible practice which should have been stamped on long ago. Personally I'd do a lot more than "encourage" large companies to behave better. Legislation and enforcement is the right way to go, in my view. 
All good so far. But from here on, sanity disappears from this report. I should have known, really. The moment anyone says they want our financial system to look more like the US my heart sinks and I wonder what planet they are on. 

Here's daft idea no. 1:

"Open up access to capital markets financing for smaller companies through the creation of a body to bundle and securitise SME loans".

Translation: The Government should create a State agency which will buy from banks the loans they have made to SMEs, bundle these loans up into packages of larger value and create from them asset-backed securities for sale to capital markets investors.

What this means is that the Government should create an American-style "Government-Sponsored Enterprise" (GSE) for SME loans. The purpose of GSEs is to enhance availability and reduce cost of credit to targeted sectors. America has GSEs in three sectors - home finance (mortgages), agricultural finance and education. Of these home finance is by far the largest and the most controversial. The two giant GSEs, "Fannie Mae" and "Freddie Mac", bailed out in the 2008 financial crisis at a cost to the US Treasury of $200 billion, are currently in "conservatorship", which is nationalisation under another name. The jury is still out on what contribution these enterprises made to the failure of the American mortgage market and the consequent near-collapse of international investment banking and capital markets. Note that the US does not have an SME GSE. This would be a UK innovation.

Anyway, ignoring the chequered history of GSEs in the US, just suppose that the UK were to create a Government agency to buy up SME loans, bundle them together and create asset-backed securities. Who would buy these securities? By any standard they are high risk. Unlike mortgages, which are secured on property, SME loans are at best secured on the assets of the company. If an SME goes bust, these assets will be sold at firesale prices - or they may be worthless. And SME failure rate is much higher than the default rate on residential mortgages, especially for startups. So given that the capital markets are still wary of mortgage-backed securities after the thrashing they received in 2008, why on earth would anyone invest in bundles of much higher-risk SME loans? Well, actually, someone would - if the price was right. But because of the risk, the right price would likely to be low, and the yield, high - rather pointless if the intention is to reduce the cost of borrowing for SMEs. They could tranche the securities, of course (structure them like CDOs). That way, even though the default risk would still be high, the most senior tranches might make it to investment grade. But I can't see that there would be much of a market for these securities.

In fact the report completely undermines the whole idea anyway in section 8.1, where it notes that the present direction of financial regulation (Basel III, Solvency II and UCITS) will actually make it more difficult for institutional investors to participate in SME loan securitisations and that there is currently little international appetite for relaxing regulations to accommodate the higher-risk financing needs of smaller businesses. The best it can do by way of constructive suggestions to solve this problem is to recommend that "UK authorities and business representative bodies should produce an evidence-based perspective of the impact of international regulatory measures on the provision of bank and non-bank finance to UK SME's and to update their findings on an annual basis". In other words, produce a report which will get filed.

The regulatory problem is a showstopper. There is no way a liquid market for SME loan securitisations can be created from nothing in the teeth of regulation that is designed to reduce the risk in investor portfolios, unless the risk of the underlying loans can be significantly reduced and the pump primed by Government intervention. This implies that the Government will have to guarantee SME loans directly (rather than the bank funding for those loans), and probably purchase the securities as well, perhaps through the Bank of England's corporate asset purchase scheme. Without such direct action by the Government I see little prospect of SME loan securitisation getting off the ground at all in the present financial climate. But if the Government has to intervene so directly to create such a market, why bother with it at all - why not just create a State Investment Bank and lend to SME's directly?

And now for daft idea no. 2.

"Improving access for mid-size businesses to the Private Placement market".

At first sight, this doesn't seem to be too bad an idea. For institutional investors to buy bonds directly from medium-size corporates, bypassing the capital markets, seems eminently sensible. Except when you start looking at the difficulties. The report identifies several major stumbling blocks:

- lack of tools to establish credit worthiness
- maturity mismatches (investors want to lend for 10-15 years, corporates want to borrow for 3-10 years)
- regulatory barriers, notably liquidity requirements
- price: illiquidity premium may make this an expensive way of raising finance.
- issuance costs

As with the SME loan securitisations, I really wonder whether the Government intervention that would be required to get round this lot would be justified. Yes, pressure could be applied to the industry to lower barriers and reduce costs. But how do you deal with the fact that the maturity needs of institutional investors and corporates are fundamentally different? And what appetite is there to reduce regulatory requirements to allow institutional investors to accept more private placements? The world is going in the opposite direction at the moment. And unless there is significant investment in tools to assess credit worthiness, investors would have to do full due diligence for every placement, which would be expensive, time-consuming and invasive. Would they really want to do this - or would they prefer to buy rated bonds in the open market?

Moving swiftly on, here's daft idea no. 3.

"Increasing UK retail investor appetite for corporate bonds"

To start with I thought this was quite a good idea. Retail investors can already invest in corporate bonds and equities, but it is fair to say that most people are a bit nervous about investing in these things and prefer to put their money in building society accounts and National Savings. Encouraging people to invest directly in companies is a good way of raising corporate finance.

But then they suggested this: "Launching electronic retail-dedicated gilt products available through registered stock exchanges". GILTS? Gilts are government bonds. The idea seems to be that if everyone's grannies got used to buying gilts instead of putting their money in National Savings, they would become more willing to invest in corporate bonds. Now, I can quite imagine that a naive granny might be happy to buy some gilts instead of National Savings certificates - as the report implicitly notes, they're the same thing really - but to assume that therefore she would be equally happy to buy corporate bonds, especially in smaller companies that she's never heard of and with no Government guarantee, seems to me to be stretching credibility to its limits. Why on earth would familiarity with gilt purchases motivate grannies to move from "safe" Government investments to much riskier corporate investments?

And it gets better. Even stupider is the suggestion that the ISA scheme should be expanded to encourage investment in riskier SMEs. I have no problem with explicit tax breaks to encourage SME investment by people who know what they're doing, but ISAs are intended as a safe tax-efficient investment for your average naive granny. No way should grannies be investing in risky SMEs. They'd lose their chemises and we'd never hear the last of it.

And finally - daft idea no. 4. This is probably the silliest of the lot.

"Government should explore the potential for the Business Finance Partnership to make commercially attractive investments in the following:
- Online Receivables Exchanges;
- Mezzanine Loan Funds; and
- Peer-to-peer lending platforms"

Wonderful. The shadow bank network in the US was created not by Government, but by the private sector seeking to avoid Government regulation that raised costs and restricted commercial activities. Here we have the same sort of thing developing: non-bank, technologically sophisticated commercial platforms facilitating trade flows; loan funds made up of complex financial instruments that have characteristics of both debt and equity; non-bank financial intermediaries for higher-risk forms of lending . So what do they recommend? The Government should take this over and CREATE a shadow bank network in the UK. You really couldn't make it up, could you?

I don't have a problem with any of these innovations, although I think the lack of financial understanding in SME's generally limits their use - though this could be addressed through the business advice network that the report also advocates. But why on earth does Government need to get involved? They are developing quite nicely on their own. Government involvement would simply raise the costs, restrict the activities and annoy the independent commercial players who are already developing these innovative products. It's like bringing up children - they have to be allowed to take risks and do things on their own. The best thing Government could do in my opinion is to provide a supportive regulatory environment (which the report notes it already does), then turn a blind eye and be ready with sticking-plasters.

So a good half of the report is taken up with daft ideas - plus section 8.1, of course, which is entirely dedicated to moaning about the fact that changes to regulatory requirements designed to make financial institutions safer places for grannies to put their money have the unfortunate effect of making it harder for SMEs to borrow money, especially for trade finance. And then there's section 8.2, which suggests that bank should provide credit information to non-bank suppliers of finance (i.e. their competitors) and that HMRC should provide additional information to assist finance suppliers in the assessment of credit worthiness. Yup, that's really going to encourage SME directors to be open about their financial affairs, isn't it?

But what the report DOESN'T address is the lack of equity financing for SMEs, and the preferential tax treatment of debt financing that ensures that companies will always prefer to borrow money rather than issue shares. The Executive Summary (paragraph 4) notes that equity is significantly under-used by smaller companies and that in the early stages of company development equity is often a more appropriate form of financing than debt. Then it de-scopes equity from the review and it is never mentioned again.

The Treasury has already responded to this report. Apart from slapping down the report's ridiculous suggestion that the ISA scheme should be extended to riskier SME investments, and giving a distinctly lukewarm response to ideas for enhancing gilt sales to retail investors and watering down regulatory changes, the Treasury's response is noncommittal. The word "welcome" these days generally seems to mean "more work needed", and it was possibly the most frequently used word in the document. So, the Treasury thinks more work is needed. Can it PLEASE include equity financing and improvements to corporate taxation - and get rid of daft ideas?