Sunday, 30 August 2015

PQE, inflation and the problem of voter power

I have repeatedly said that I do not support Jeremy Corbyn's "People's QE". But there seems to be considerable confusion about what exactly I oppose. And that is for one simple reason: the deliberate conflation of government investment spending and QE by the architect of this scheme.

PQE is composed of two separate and distinct strands:

1. Government spending to finance investment in infrastructure, innovation, R&D and housing

2. Bank of England purchases of government bonds. 

Despite the insistence of the scheme's creator that one is impossible without the other, these two strands are actually not interdependent. In fact they are unconnected. As the UK is a member of the EU and a signatory of the Lisbon Treaty, it is not possible for Strand 1 to be directly financed with money from the Bank of England. But there is nothing to stop the government issuing "Corbyn bonds" to the UK private sector for Strand 1, either directly itself or via a National Investment Bank. It would therefore be entirely possible for Strand 1 to proceed on its own, and indeed many people - including me - think that it should. 

So why do we need Strand 2?

Strand 2 appears to be based upon the following assumptions:
  • there would be insufficient demand in the UK private sector for the bonds
  • the interest rate that would have to be paid to the private sector for the bonds is too high
  • the UK economy will soon need a QE programme
None of these assumptions are warranted. 

Firstly, very low market rates tell us that there is plenty of demand in the private sector for UK government bonds. I find it hard to believe that say 2bn of 30-year Corbyn bonds at 3% per annum (just above the current yield on 30-year gilts) would not sell.

Secondly, the cost argument is entirely spurious. Interest paid to the UK private sector is simply new money which will be spent into the economy either now or later. We can regard it as tax credits or a basic income. It is not in any normal sense a "cost" for the government: it should properly be regarded as another form of stimulus, akin to "helicopter money". The interest rate is therefore irrelevant. Personally I would offer bonds directly to small UK-resident savers at above-market interest rates. 

Finally, it really isn't possible to forecast either the timing or the depth of UK recessions. We do not know what effect, if any, the problems in China will have on the UK economy, but the Bank of England isn't predicting a downturn at the moment. I have argued that an austerity programme of the scale planned by the Conservative government would be likely to cause a recession: but the Chancellor's plans already envisage fiscal easing towards the end of the parliament, so it may be that the UK would be on its way out of any recession by the time of the election. If so, then waiting for the Bank of England to do QE before increasing investment expenditure would be like waiting for Godot

The truth is that there is no operational justification for Strand 2 at all. The "QE" part of PQE is wholly unnecessary. It is the investment spending that matters. 

Strand 2 would, however, mean that the debt incurred as a result of the new investment spending did not appear on the Government's balance sheet. The way this works is this. The Bank of England is wholly owned by the UK Government. Its balance sheet can therefore be consolidated into the Government balance sheet in the same way as a subsidiary is consolidated into a parent company. Indeed the Whole of Government Accounts do consolidate the Bank of England with the rest of government. 

When a subsidiary is consolidated with a parent, debt owed by the parent to the subsidiary or vice versa "disappears". After all, you can't owe a debt to yourself. So the Bank of England's holdings of gilts, which are government debt, simply vanish in the consolidation. As the Bank of England currently holds around 30% of gilts in issue, this has the effect of significantly reducing nominal debt on the Government's balance sheet. However, after consolidation the Bank of England's liabilities, which are base money (currency and bank reserves) remain in full on the Government balance sheet. The effect is therefore that government debt has been converted into money. We call this "debt monetisation".

Central banks around the world have monetised debt in this fashion ever since the financial crisis and in some cases (Japan) for far longer with no impact on inflation. It is therefore unlikely that monetisation of Corbyn bonds would cause inflation. What could cause inflation is the investment spending itself. But as Paddy implied in the now infamous "snake oil" post, a determined central bank with an inflation-targeting mandate would simply raise interest rates to counter any inflationary effect of government spending. It would do so even if compelled to buy the investment bonds. Indeed, it would be answerable to Corbyn's Chancellor if it failed to do so. 

Of course, inflation is well below target at the moment, so any inflationary effect from investment spending would be welcome. And the inflation target could be raised to say 4%, allowing more room for investment spending without monetary offset. The possibility of inflation is emphatically not a reason for failing to increase government investment spending. 

The author of the scheme says that the purpose of Strand 2 is to enable the Government to increase investment spending substantially without it appearing on the Government's books. Personally I regard this as underhand. I am disappointed that anti-austerity politicians and policy makers are too scared to confront the current hysteria around debt and deficits directly, so are resorting to smoke and mirrors to evade it. I would rather have openness, honesty and transparency. But perhaps more importantly, I don't think this will work as a political message. 

The principal drivers of the austerity agenda are older voters, who are terrified that high government debt and deficits will mean the loss of their wealth. But they lived through the last serious inflation in the UK. They are equally terrified that inflation will erode their wealth. Any proposal that fails to take inflation seriously is therefore unlikely to be welcomed.

But in order to justify the "QE" element of his scheme, the author has suggested (comments) that the Bank of England's inflation mandate should be ended and its operational independence eliminated:
So let’s get the rest clear. First, I would have thought it obvious if I did not believe in BoE independence that I did not also believe in the primacy of inflation as an economic target, but maybe I am guilty of not having spelt this out sufficiently: I would do so, and soon.
How this is supposed to encourage people to vote for Corbyn I don't know. The principal reason for the Bank of England's inflation target is the fact that an awful lot of people are very scared of inflation, and the principal reason for its operational independence is the fact that an awful lot of people don't trust government to keep inflation under control. 

If the views of voters on government debt are too entrenched to be challenged, then surely the views of voters on inflation are too. This scheme tries to assuage popular fears about high government debt by adopting a technique that is popularly associated with high inflation, while removing the principal obstacle to high inflation. I fail to see how this can be a vote winner.

Related reading:

Green QE and the Juncker Plan

Image: "Waiting for Godot" at The Albany, courtesy of

Friday, 28 August 2015

Monetary Snake Oil

Guest post by Paddy Carter.

Jeremy Corbyn’s People’s QE offers the alluring prospect of spending more without borrowing more. Which is just the ticket, if you want to replace austerity with largesse, and cut the deficit to boot. Sadly, this appealing miracle cure is pure snake oil (although there is, perhaps, a version of the idea which might be helpful, if substantially less miraculous).

The basic idea behind People’s QE is to finance public spending by printing money. This is actually something that happens all the time, and it is by understanding how, and why, that we shall see why People’s QE, as sold, is an empty promise.

As the real economy grows, the money supply has to keep up. Suppose we wanted zero inflation then, as a first approximation, we would expect the money supply to grow at the same rate as the real economy. If the economy grows at 2 per cent a year and base money (reserves and bank notes) grows at the same rate as the broad money supply (debit accounts etc.) then the newly printed money implied by expanding base money at 2 per cent is government revenue. The word for this is seignorage and for PQE to enable spending without borrowing, it must increase the long-run rate of seignorage.  

Over the short run, the base money supply ebbs and flows as the Bank of England (BoE) goes about its business. The BoE does not directly target the money supply, instead it sets the interest rate and lets the money supply do whatever is needed to meet demand at that rate. The process is rather convoluted and involves banks setting targets for the amount of money on reserve over a certain period. There is not a neat relationship between the interest rate and money supply growth, so you cannot say that when the interest rate is low the money supply is expanding, and vice versa. But you would not go far wrong to think that when the interest rate is stimulating the economy, the rate of seignorage grows, and shrinks when monetary policy is tightened (potentially becoming negative).

And here’s why People’s QE (PQE) is snake oil. So long as the BoE is still targeting inflation, it will still be pushing and pulling money in and out of the system, as required to meet demand for money at the interest rate it has set. If the BoE is still targeting inflation, then whatever money PQE puts into the economy on one hand, the BoE is going to be taking out with the other. Or, if the BoE happens not to take the money out, that implies it would have been putting it in, anyway. And that means that over the long run the rate of seignorage, or the extent to which the government is able to spend without borrowing, is not affected by PQE.

But why would the BoE want to remove whatever money PQE puts in? After all, we just put £375bn of freshly printed money into the economy, without causing inflation. Conventional QE is an entirely different animal from PQE. Conventional QE merely swapped one asset (bonds) for another (cash). This did not much affect banks’ ability to lend nor the demand for borrowing, so that cash has merely accumulated on reserve. Conventional QE works by changing - only by a little - the returns on assets so that they become a little less attractive and spending relatively more so. This probably only had a modest impact on the economy. PQE, in contrast, is there to directly finance spending, pay wages, purchase goods. The whole point is to boost aggregate demand. For PQE inflation is a feature, not a bug. Now it’s true that there may be some slack in the economy and some of the things the envisaged PQE-financed National Development Bank would do might raise productive capacity, so there might be some scope to raise demand without inflationary pressure. But step beyond that and either the BoE would neutralise it, or, if prevented from doing so, we’d get inflation. Judging by campaign rhetoric, I think we can expect a Corbyn administration would err on the side of too much spending.

It is not clear exactly how PQE would be implemented. The most important question is whether it would be a countercyclical tool in the hands of the BoE, or something the government uses whenever it wants to finance expenditure. Richard Murphy has suggested the Bank governor would be fired if he tried to block the policy. If, somehow, the flow of money fed into the system is forced above whatever is consistent with the BoE setting its interest rate to hit its inflation target, then we can expect inflation to rise above target. The government could spend without borrowing, if it decided to abandon the current arrangements for inflation targeting. In the extreme, if a Corbyn administration opened the monetary taps every time it thought unemployment was too high and investment too low (i.e. all the time), and neutered the BoE’s ability to offset, then warnings about inflation might start to look warranted.

None of this says we currently have the best possible system. The failure to exploit low interest rates to finance infrastructure investment during the great depression has been particularly egregious. Perhaps a version of PQE could have a role, as a countercyclical tool in the hands of the BoE, in solving that problem and combating deflationary pressure. In theory PQE is entirely unnecessary and governments can finance investment during downturns by borrowing when rates are low. In practice, some short-run seigniorage earmarked for public investments might help the system overcome its reluctance to do so and deliver countercyclical fiscal policy via a monetary backdoor. But that’s not what Corbyn is selling.

Paddy Carter is really a development economist but has been brainwashed by years of teaching undergraduate macroeconomics and absorbing more by osmosis, briefly having had an office down the hall from Tony Yates. A long time ago he was a journalist. His academic research can be found here:

Thursday, 27 August 2015

Europe's Shame

I am temporarily departing from my usual finance & economics slant to write about something that I consider utterly shameful: the response of European countries, including my own, to the refugee crisis on their borders.

This photo was taken on the Macedonian border today:

Herbert Mayrhofr tweeted this with a comment, "This is not the Europe that I want to live in".

I wholeheartedly agree. What kind of society is it that will threaten toddlers with police batons?

Many argue that Europe cannot afford to accommodate the number of "migrants" currently streaming in. But the countries of the EU are by-and-large rich countries. They can always find resources for the things that are politically important. My own country found the resources to fight wars in Libya and Afghanistan - but apparently is now so poor that it must repel with razor wire and tear gas the refugees from the war zones it has created. What appallingly skewed priorities.

Others say that the volume of migrants is so large that it "threatens their way of life". They point to books like this in support of their argument. But this report from the Guardian gives  the lie to their scaremongering. The number of migrants that have arrived in the EU this year is 0.027% of the  EU population. Please don't tell me the EU can't accommodate this, and indeed far more than this.

Still others say that these are just "welfare tourists" who come to sponge off generous European benefits systems. This view is particularly prevalent in France and the UK. But there is absolutely no evidence to support it. Firstly, 60-70% of these people are refugees fleeing war zones. They endure extraordinary hardships in the hope of getting to a country where they can be safe. And secondly, even economic migrants are mainly young skilled people who expect to work for their living. Those who bring older people and children with them expect to work to support those dependents.

European rules say that refugees should apply for asylum in the first safe country they travel to. But the countries nearest the conflict zones - such as Lebanon, Turkey, Egypt - are already bursting at the seams. Greece is struggling with a major fiscal crisis. And Italy's economy is flatlining. Where is the financial support that these countries will need if they are to accommodate large numbers of refugees? There is none. It is hardly surprising therefore that they help migrants to move on to richer countries. For the richer countries to turn refugees away on the grounds that they should have applied for asylum in the poorer countries, while denying those poorer countries the resources needed to resettle refugees, is an utter disgrace.

There are in reality only two reasons why EU countries say they can't accept migrants. They have tied themselves in a fiscal noose which prevents them from releasing the resources needed to resettle migrants, and they have convinced themselves that migrants are someone else's problem. Neither explanation is remotely credible, and both show a shocking disregard for the human rights of migrants. I suppose we should be thankful that we are not now leaving migrants to drown "pour encourager les autres" - though many still are dying en route to Europe. But denying them the basic means to live is no better.

The UN High Commission for Human Rights has now weighed in. Its Special Rapporteur on the rights of migrants has castigated the EU's inadequate response: "Let's not pretend Europe's reponse is working", he says. And he calls on the European Union to establish a human rights-based, coherent and comprehensive migration policy which makes mobility its central asset, saying that this is the only way in which the EU can reclaim its border, effectively combat smuggling and empower migrants. 

The Special Rapporteur emphasises the utter futility of harsh methods aimed at deterring migration:“Building fences, using tear gas and other forms of violence against migrants and asylum seekers, detention, withholding access to basics such as shelter, food or water and using threatening language or hateful speech will not stop migrants from coming or trying to come to Europe,” he says. And he criticises remarks from politicians and media, including the UK's Prime Minister David Cameron: 
“Talking about ‘flows’, ‘marauders’, and ‘swarms’ is an unsubtle way of dismissing the legitimacy of the asylum seekers and migrants’ claim to human rights, by creating images linking them to toxic waste or natural disasters. We are talking about men, women, children and even babies, who have faced traumatic experiences. These are people just like you and me, and none of us have the moral high ground to say that we would never do the same if we were in their shoes.”
In treating our fellow human beings with such inhumanity, we make ourselves less than human. I am ashamed of my country's leaders.

But the inhumanity shown to these refugees has its origin in the inhumanity displayed to citizens of European countries. Unemployment in the EU is over 10% despite low rates in countries such as Germany and the UK. Youth unemployment is more than double that. These migrants are predominantly young, skilled people, many with children. Accommodating them could go some way towards solving Europe's demographic problems - falling birth rates and a growing proportion of elderly. But because EU policies prioritise balancing government budgets ahead of ending the scourge of unemployment, European countries - with the notable exceptions of Germany and Sweden - dare not accept migrants for fear of making the unemployment problem worse. We are not only behaving inhumanely towards people both outside and inside the EU, we are squandering the human capital on which our future prosperity depends. This is utter insanity.

Let's stop this now. Relax the destructive fiscal tightness that is wrecking economies all over Europe. Prioritise full employment over budgetary discipline. And let the wellbeing of people - including those who come to our countries as refugees and migrants - become our primary concern.

Monday, 24 August 2015

Making the case for public investment

Jeremy Corbyn’s “People’s QE” scheme has been extensively discussed in the media. In fact it has caused something of a storm. The FT’s Chris Giles did an excellent balanced analysis of it, and there have also been useful contributions from – among others - Oxford University’s Simon Wren-Lewis, The Economist’s Buttonwood and FT Alphaville’s Matt Klein. The extent of discussion is far more, in my view, than the scheme deserves.

The scheme envisages that the Government, via a public investment bank, would issue bonds for infrastructure development, which would then by bought by the Bank of England as part of a QE programme. The architect of the scheme, Richard Murphy, suggests that to avoid accusations of monetary financing of government – which is a breach of the UK’s obligations under the Lisbon Treaty – the bonds would be issued to the private sector initially at a price set by the Bank of England, which would then hoover them up in (presumably compulsory) secondary purchases. I find it hard to see how this complies with the spirit of Article 123, but I’ll let that pass. My real objection 
to this scheme lies elsewhere.

The need that this scheme ostensibly addresses is the desperate need for investment in infrastructure, R&D, skills and social housing. Few, I think, would disagree with this. Private and public sector investment in Britain have both been well below levels in most other developed countries for a long time. The Coalition government not only reversed the modest investment spending increases of the previous Labour government, it made deep cuts: halving the deficit between 2010 and 2015 was achieved in part by halving investment spending. Despite interest rates at unprecedentedly low levels, government investment in the future of the economy is now at its lowest for over a decade (ONS, 2014):

Not only is investment desperately needed, safe assets are too. Savers suffer from cripplingly low returns on their savings in part because the supply of government debt – which makes up a substantial part of pension investments - has been restricted by QE, raising its price and hence depressing its yield. The Bank of England currently owns about 30% of the UK’s stock of gilts. Of course, the loss in yield is offset by the gain in price. But for those who live on the returns on their pensions, this is cold comfort. The last few years have been grim, and there is no end in sight: interest rates remain on the floor and the Bank of England shows no signs of unwinding its QE purchases. The Coalition government offered some relief to pensioners with its Pensioner Bonds, which enabled retirees with liquid savings to buy government bonds at above market rates. But this is a drop in the ocean.

The fact is that there is plenty of demand among UK residents for UK government debt, including longer maturities, and plenty of potential public sector investment projects that could be funded by long-term government debt. Government debt is the safest form of saving available to UK residents, as well as an important anchor in the financial system. There is absolutely no reason from an investment point of view to restrict its supply.

But a toxic narrative has grown up around government debt. Because of events in the Eurozone and some unhelpful academic research, we have learned to regard it as something bad to be eliminated – a burden on future generations, a drag on growth, a source of fiscal vulnerability. At very high interest rates, this would be true. But at today’s very low interest rates, the return on the vast majority of investments would far exceed the cost, even if bonds were issued at a premium to market rates as the Pensioner Bonds were. Tomorrow’s pensioners would be supported by the returns on their investment today, while their children and grandchildren benefited from modern infrastructure, better education and a higher standard of housing. And importantly, businesses of the future would benefit from investment in R&D and innovation. We need to stop regarding government debt as something malign, and start regarding it as a social good. It is the investment of today’s citizens in their own future and the future of those they love.

How the Government should organise the financing of public sector investment projects is a matter of some debate. Richard Murphy envisages a public investment bank, capitalised by the government, which would issue bonds to fund itself and lend funds to suitable projects. But the government is already its own bank: it could simply issue bonds directly to the public to fund specific projects. The UK has historically funded wars by issuing War Bonds directly to the public. Why should it not finance infrastructure projects, R&D, education and social housing construction by issuing Development Bonds?

An alternative would be a leveraged Sovereign Wealth Fund, which would fund itself by issuing bonds which it would use to purchase assets. This could include taking equity stakes in housing, infrastructure developments and - possibly – innovative start-ups.  Clearly such a fund would take risks, but importantly these risks would not be passed on to the people whose life savings would be funding it. Government can eat losses much better than small savers. Anyway, there is no particular reason why a leveraged sovereign wealth fund should lose money overall if it is properly managed, even with a scatter of project failures.  

The arguments of those who object to public sector investment on the grounds of inefficiency usually rest on the belief that government does not evaluate projects properly or manage them effectively. They ask how “malinvestment” would be prevented. There are, of course, examples of project failure in the public sector, some of which have caused major losses. But this is to ignore the many projects that do deliver on time, to budget and deliver the required returns, particularly in local authorities. 

Professional project evaluation and management is as necessary in the public sector as it is in the private sector. Potential projects should be subject to rigorous cost/benefit evaluation with sensible hurdle rates of return. Of course it can be difficult to establish tangible benefits for social projects, but not even to attempt to do so is lazy. Government projects should aim to deliver real returns just as private sector ones do. And they should be properly managed. The mistakes that led to the cancellation of the NHS project - and other expensive failures - were elementary project management errors. These are as common in the private sector as the public sector: but private sector project failures are swept under the carpet, whereas public sector ones make headline news. The possibility of failure should not deter investment in the public sector any more than it does in the private sector.  

Of course, borrowing for investment does have limits. When governments are very highly indebted, investors start to get worried and bond yields start to spike. But we are nowhere near that limit. Japan currently has debt of over 200% of GDP. For much of the last century, the UK’s public debt was well in excess of 100% of national income, as indeed it was for much of the previous century too (Ritschl, 1996):

Neither Japan nor the UK has ever defaulted on public debt. Indeed, Japanese government bonds and UK gilts are regarded as among the safest investments in the world. Even quite a sizeable increase in public debt for investment purposes would be unlikely to change this, especially if investors knew the Bank of England stood ready to buy bonds if necessary to stabilise yields. Having a trusted and effective central bank guarding your back makes a huge difference to sovereign creditworthiness. It is this that the Eurozone lacks, and it is for this reason that comparisons with say Greece are invidious.

But there is an additional problem. The UK is still running a fiscal deficit of 5.5% of GDP. How can a substantial investment programme be undertaken without vastly increasing this deficit?

I don’t wish to dismiss the deficit as unimportant. But it is not relevant to the discussion of investment spending. The present situation is that what we might call the “day-to-day” spending of the government exceeds its revenues. I am personally of the opinion that trying to reduce this directly has untoward effects and it would be better to focus on measures to improve productivity and wages, but I recognise that to many people a persistent deficit spells disaster. But judicious investment spending can be expected to raise national income and therefore both increase government revenue and reduce its spending. For example, investment that results in higher productivity feeding through into higher wages means more tax revenue for government AND lower welfare bills. Investment spending has long-term benefits on both sides of the public balance sheet. Indeed, that is its purpose! 

Failing to invest in projects which have clear positive returns on the grounds that it would increase the current deficit is a false economy. So investment spending should not be counted as part of the “current” deficit at all. This is the strongest argument in favour of a public investment bank or sovereign wealth fund rather than direct public investment. It makes the distinction between current and investment spending crystal clear and forces the real returns from investment spending and asset acquisition to be recognised in public accounts.

The UK needs investment spending. Restricting investment spending while interest rates are so low is not “responsible management” of the economy. Unfortunately, none of the candidates for Labour leadership have so far pointed this out. All of them – including Mr. Corbyn – have tacitly accepted that eliminating the deficit is top priority and government debt serves no useful purpose. I find this depressing. And I find it even more depressing that Mr. Corbyn, who at least acknowledges the need for investment spending, fails to address this poisonous narrative head on, preferring to propose a form of financial engineering that would deny Britain’s savers the opportunity to invest in their future for better returns than they currently get. In this respect, “People’s QE” it is not.

It would of course be perfectly acceptable for the Bank of England to buy “Development Bonds” as part of a QE programme in a future recession. Richard Murphy believes that in 2020 there will be a recession. If he is right, then a Jeremy Corbyn-led government could indeed do “People’s QE” as he outlines it. But I fail to see why investing in the future of the economy should be dependent on there being a recession. And I fail to see why it has to wait for 2020, either. Her Majesty’s Opposition should get its act together and make the case for investment NOW. 

A shorter version of this post was published in the FT on 24th August 2015.

Related reading:

Image from The Independent.

Saturday, 22 August 2015

The Co-Op Bank: too high a mountain?

The Co-Op Bank has revealed its 2015 half-year results. And they are not pleasant reading. It has made a statutory loss before taxation of £204m, considerably worse than the £77m loss reported in the 2014 half-year accounts. And the Board advises that the bank will not return to profit for another couple of years.

The background to this horrible report is the Bank of England's stress tests last autumn. I didn't bother to look at the results at the time, since it was always obvious that the Co-Op Bank was not going to pass the tests. They came too soon for it to have made serious improvements to its balance sheet after its near-collapse and traumatic recapitalisation in 2013. But I should have looked. The stress test failure was far worse than I had realised:

The table shows that the adverse stress scenario, which modelled a severe property market crash, completely wiped out the Co-Op Bank's capital, leaving it insolvent. This is a major failure. Really, the Co-Op Bank should have been closed down. It is only still alive because the PRA agreed to its capital-raising plan:
The PRA Board’s expectation of The Co-operative Bank’s capital buffer is being re-set to take into account the additional assessment provided by the stress test. In light of that, the PRA Board has required The Co-operative Bank to submit a revised capital plan, which has been accepted by the PRA Board. That plan envisages a reduction in the risk profile and size of the bank’s balance sheet, as a means of reducing its capital requirements. If executed, the plan will deliver a level of resilience commensurate with a bank of its future size and business model. The PRA Board will continue to monitor The Co-operative Bank’s progress against the plan.  
The Co-Op Bank is now a ward of the PRA. Its continued existence depends on successful completion of the plan agreed with the PRA. This is why the PRA recently decided not to impose a richly-deserved penalty of £121m. The Co-Op Bank is already hanging on by its fingernails. Imposing that penalty would amount to stamping on its fingers.

The principal components of the £204m loss just reported arise from the scale and pace of the capital plan.  The Co-Op Bank has taken £38.2m losses on Non-Core asset sales, of which a significant proportion comes from the recent securitisation of £1.5bn of Optimum mortgage assets. The Co-Op is trying to dispose of its Optimum portfolio of subprime residential mortgage loans as quickly as possible, since it significantly adds to balance sheet risk and eats capital. But although it has reduced the Co-Op Bank's risk-weighted assets and therefore improved its capital position, the securitisation was not entirely successful, since the bank has had to retain 65% of the senior tranches. Hanging on to senior tranches of subprime securitisations is not the wisest move for a distressed bank, so I assume this was because of lack of buyers. These Class A notes are now held as "available for sale". Anyone fancy a flutter?

Unwinding over-optimistic fair value adjustments from the Britannia Building Society acquisition in 2010 cost the bank another £54m, The remainder of the loss arose from increased expenditure on restructuring, including IT system replacement: this suggests cost over-runs, but it may simply be due to the PRA's insistence on a faster pace of change.

The counterpart to the loss is the capital gain. Largely because of the securitisation, the Co-Op's Core Equity Tier 1 capital ratio (CET1) has improved to 14.9%. But this is only temporary. Because there are further losses to come, the CET1 ratio is set to fall again, and remain below the PRA's required level for the Co-Op Bank (its "individual capital guidance" level) for some time to come. In other words, the Co-Op Bank is still in regulatory insolvency, two years after its initial collapse and restructuring, though admittedly this is principally because the regulator has moved the goal posts. Unsurprisingly, the report focuses far more on the measures the bank is taking to improve its capital than on the headline losses.

But the fact is that the Co-Op Bank has a simply enormous mountain to climb. It is still haemorrhaging depositors, though at a much slower rate. Its credit rating remains on the floor, making its cost of funding uncompetitive compared to other banks. Its costs are far too high, despite recent rationalisation of its branch network. And its balance sheet is highly risky. For example. 26% of core retail secured lending and the majority of the Optimum portfolio is interest-only (though this is less than in 2014):

Most of the core retail interest-only lending is buy-to-let, of course. But the high proportion of interest-only lending makes the bank vulnerable to housing market downturns - hence the stress test failure.

Not only does the bank have business risks, it has operational ones too. The report notes:
across the Bank's IT infrastructure there are varying levels of resilience and recoverability and whilst a basic level of resilience to technical component failure is in place, the Bank does not have a proven end-to-end capability to recover from a significant and prolonged data centre outage.
The FCA has formally notified the Co-Op Bank that this is a breach of its Threshold Conditions - which means the bank does not have adequate resources to be in the business of banking. This is further justification for closing it down, since lack of IT resilience is even more risky for customers than lack of capital. But once again, the Co-Op Bank has been reprieved. The IT systems are being replaced, though this is a high-risk project which will take some time to complete.

I am wondering how many more reprieves the Co-Op Bank will be given. The regulators are astonishingly generous to it, considering the scale and nature of its problems. It is the most damaged bank in Britain by a long way. I suspect that, were it not for an exceptionally loyal customer base - which it does not deserve - and a crucial role as clearing bank for a significant proportion of the UK's small building societies and credit unions, it would have been wound up long ago.

But the whole capital project is high risk. The bank admits that it is not at all sure the plan will work:
The Bank’s plan to focus on becoming a smaller Core Bank is unproven and is in the early stages of implementation. The Bank does not have a track record in successful execution of the large scale change necessary.
 And it identifies the following  specific risks (my emphasis):
  • Worsening economic and market conditions and/or increasing interest rates and/or a fall in house prices could result in the Core and Non-core assets suffering from more than expected impairments which would adversely impact on the Bank’s operating results and retained earnings; 
  • The Bank needs the ongoing acceptance of the PRA regarding projected ICG deficit in moving forwards with its plan. To the extent this is not forthcoming or to the extent that the Bank does not perform in line with its plan, additional capital may be required over and above that included in the plan in order for the Bank to remain a Going Concern. This could also be the case if there are increases in regulatory capital requirements as a result of changes to international regulations or other changes to legislation or other market wide regulatory requirements or a change in regulatory risk appetite. The plan assumes additional non-CET1 capital will be raised within the plan period; 
  • The inability of the Bank to deleverage its Non-core assets in a controlled and capital efficient manner may have a negative impact on the Bank’s operating results and financial position and its regulatory capital position. In addition, any greater than expected costs or delays in deleveraging the Non-core assets may divert funding from and adversely impact the longer term development and growth of the Core business;
  •  Inability of the Bank for whatever reason to execute on its plan.
The Risk Management section tries to explain what the bank is doing to manage them. But some risks just are not manageable. Point 2 bluntly states that the Co-Op Bank might not remain in business. The plan faces considerable headwinds and slippage seems distinctly likely. If, as a result of this, PRA orders the bank to raise more capital and it is unable to do so, it is dead.

This has been noticed by the bank's auditors:

Oh dear. The last time there was a statement from the auditors that cast doubt on the Bank's ability to remain in business was in the 2013 interim results. And we all know what happened next.

So what is the way forward? Well, the Co-Op has raised £250m of additional capital. And there is talk of the Co-Op Group selling its remaining 20% stake: this might be a welcome relief to the Co-Op Group, which is itself still in intensive care after a major restructuring. There seems little doubt that selling is the Co-Op Group's eventual intention, since it has for the last two years listed the Co-Op Bank under "discontinued operations" in its annual reports. But the question is the timing, and the implications. The Co-Op Group is not going to get a good price for its stake at present, given the uncertain future of the bank. And once the Co-Op Group no longer had any interest in the bank, how much longer would the Secretary of State allow the bank to keep its name?

An IPO has also been discussed. But despite the cautious optimism expressed by its Chief Executive Niall Booker, I can't see how Co-Op Bank can have a future as a small independent retail bank. The extent of change is just too great and the risks too high. I suspect that the real purpose of the capital plan is to dress it up for sale. Indeed the FT reports that Booker has already mentioned the possibility of merger with another bank:
The chief executive added the bank could take part in the consolidation of smaller banks through a potential merger. “We’ve always said that we think there will be some consolidation in the challenger market. We talk to people from time to time,” he said.
In a particularly poignant twist, this would place the Co-Op Bank on the same footing as TSB, the Lloyds Bank carve-out it had hoped to buy, which has just been sold to Banc Sabadell.

But sale to another bank would mean the ignominious end of a venerable institution, and the demise of the hopes of those who wanted to return it to cooperative ownership.

La commedia è finita.

Monday, 17 August 2015

Never mind Greece, look at Venezuela

Via Business Insider comes this colourful map and chart of CDS spreads worldwide:

Those who thought Greek bonds would be the most expensive to insure, since everyone knows it can't pay its debts, need to think again. Venezuela is the most expensive, by a long way. 

Related to that is this:

The yield curve has been deeply inverted all year, but yields at all maturities are now rising:

When even the yield on long-dated bonds is heading for 30%, the public finances are completely unsustainable. 

Venezuela, of course, is monetarily sovereign, since it issues its own currency. Well, in theory. In practice it is burning through reserves at a shocking rate to support its absurd managed exchange rate system:

Don't be fooled by the uptick in June. That is because China lent it some dollars. It'll get through those in short order if it continues on its present path. To be sure, Venezuela is still earning FX due to its trade surplus, but its current account is deteriorating. 

Floating the currency is not really an option. The black market exchange rate is approaching 700 VEF to 1 USD. Inflation in Venezuela is officially nearly 70%, but almost certainly much more, since the central bank has provided no updates since December: some estimates put it over 100%. Whatever it is, it is undoubtedly rising fast despite the pegged exchange rate. The bolivar is currently pegged at 6.30 to the USD, though hardly anyone uses that rate: most goods are priced at one of Venezuela's secondary exchange rates. Even those substantially overvalue the bolivar. 

Because of Venezuela's unsustainable public finances, the central bank is monetising the public deficit, which in January was 11.5% of GDP and is probably now much higher. This is the growth in base money in the last year:

Again, don't be fooled by the tapering-off in March. The central bank, like the government, is no longer providing reliable figures. 

Unpegging the bolivar would almost certainly trigger hyperinflation. But unless the bolivar is allowed to float, Venezuela faces a FX crisis despite its trade surplus. Either way, default appears a near-certainty. Hence the astronomically expensive CDS and the wildly inverted yield curve. Dollarising the economy - which would mean surrendering control of monetary policy to the Fed - has been ruled out by President Maduro. 

That's the financial story. But underlying it is a political crisis. It is hard to obtain neutral reports on the political situation: captive media claims that Maduro is set to win the December elections with a landslide are not remotely credible. But reports in American press that Maduro's personal popularity has fallen to 25% and his Socialist party would fail to gain a majority are also suspect, given the Maduro administration's claim that the country's economic problems have been engineered by the US government to bring down the regime - though the fact that Maduro is now ruling by decree with the support of the military does suggest that he doesn't have much in the way of a democratic mandate. Personally, I think it is unlikely that the Maduro government would survive disorderly default, hyperinflation and economic collapse, which seem likely to be Venezuela's fate within the next couple of years. But what would replace it?

There are no good answers. The history of Latin America suggests that a military coup is likely, though not inevitable. Years of political chaos is a second possibility. And a third is the election of a much more radical government, right or left, which opts for near-autarky and a highly authoritarian command economy. All of these have been experienced by countries in Latin America over the last half century. All have proved disastrous. US hegemony, Colombia-style, is a fourth option which might prove more successful, though opponents of course claim that this is the US's plan, driven by desire to gain effective control of Venezuela's rich natural resources. 

Whatever. The real issue here is the human tragedy. Venezuela faces a humanitarian disaster. Even under a new regime, it would need aid as well as restructuring and reform. And without a viable government, it would not qualify for the IMF programme it will almost certainly need. Not that the IMF is exactly up to speed on Venezuela, given that the Article IV consultation has been delayed by 110 months. Only Somalia is further adrift. 

But I warned in my previous CC piece about Venezuela that the genesis of disastrous populist governments lies in the wrenching fiscal adjustments typically imposed on defaulting countries by the IMF under the Washington Consensus. People facing the ruin not only of their own lives, but those of their children and grandchildren, do not long tolerate unyielding fiscal austerity. Too many mistakes have been made by the Bretton Woods institutions, both in Latin America and elsewhere. Most recently, the IMF is significantly to blame for the situation in Greece. 

There must be no more mistakes. The IMF's primary concern must in future be the wellbeing of people and the restoration of social and economic prosperity, not the repayment of creditors. 

Related reading:
The IMF's Big Greek Mistake - Ashoka Mody, Bloomberg View

Friday, 14 August 2015

A Finnish cautionary tale

Eurozone growth figures came out today. And they are horribly disappointing. Everyone undershot, apart from Spain which turned in a remarkable 1% quarter's growth, and Greece which somehow managed an even more incredible 0.8% (yes, I will write about this, but not in this post). France  didn't grow at all, Italy all but stagnated at 0.2%, and even the mighty Germany only managed 0.4%. Despite low oil prices, falling commodity prices, weak Euro and the ECB's QE programme, Eurozone quarterly growth is a miserable 0.3%. Maybe it's just me, but I can't help thinking that something just isn't working in the Eurozone.

Among the most disappointing performances was Finland's. Back in May, the European Commission confidently predicted that growth would return in 2015:

But what is actually happening is this (this chart includes today's figures):

Finland has been in recession for most of the last three years. True, towards the end of 2014 it did look as if it was beginning to recover. But that was a damp squib. Today's figures show that the economy contracted by 1% in the second quarter of 2015. 

So what on earth went wrong? It doesn't appear to have been the financial crisis. Finland did get clobbered, yes - it suffered a deep recession in 2009, as the chart shows - but it bounced back quickly and in 2010-11 was growing at a highly respectable 5%. Then it collapsed. It would be easy to blame that on the Greeks, wouldn't it? Or maybe the oil price rises at that time?

No. This is not a story of Eurozone macroeconomic imbalances and oil price shocks. Rather, it is the sad tale of a country that allowed itself to become dependent not just on one industry, but on one company. 

Some years ago, I went for an interview at Pfizer's plant in Sandwich, Kent. As I drove through the town, I was struck by how dependent the local economy had become on Pfizer, its only significant employer. I found myself wondering what would happen if it ever left. And in February 2011, it did. Three thousand people lost their jobs when Pfizer left. But more importantly, the entire local economy collapsed. Everything from hotels to bookshops, from the summer festival to Christmas parties, was clobbered by Pfizer's decision. Four years later, Sandwich still has not recovered. When the heart has been ripped out of an economy, recovery takes a long time. 

And when this happens to an entire country, the consequences are disastrous. From the EC's country report, here is Nokia's contribution to Finnish GDP:

And here is Nokia's share of Finnish exports:

The crowding-out of other export industries by Nokia's dominance is painfully evident. 

The appalling effect of Nokia's dominance on the Finnish economy is spelled out by the European Commission (their emphasis) and illustrated in the charts below - though it wasn't the only Finnish export industry to shrink in the aftermath of the financial crisis:
Similarly to its decisive role in the boom period, the collapse of Finnish mobile handset exports accounts, in itself, for around half of the total decrease in the Finnish export market share of goods. The share of mobile handsets in the Finnish goods export declined from 13 % in 2000 to 1 % in 2013. This also reduced the share of high-tech products in Finnish exports from around 20 % at the beginning of the 2000s to around 5 % in 2013. Filtering out the impact of the trade in mobile handsets, the accumulated market share decline would have been close to 20 % between 2008 and 2013, i.e. still the largest in the EU-28. It illustrates that the loss in export market shares also concerned other goods and reflected an adverse change in the international demand structure from a Finnish point of view.

In short, Finland is Sandwich, on a simply gigantic scale. No wonder it has struggled to recover.

But wait. Nokia's collapse occurred at the time of the financial crisis. Yet Finland did recover, albeit briefly. At the time of the deepest trade deficit, Finland's GDP was growing at 5% per annum. Why was this?

In a word, imports. The European Commission explains (their emphasis):
The second main driver of the deteriorating current account and trade balance is the growth in imports for domestic demand purposes, although this factor is often overlooked. Import growth was boosted by the increasing consumption of households, in particular after 2008 (Graph 2.2.17) and by the growing import intensity of domestic demand from 23 % in 2000 to 26 % in 2011. Between 2000 and 2008, the increasing consumption ratio has reflected growing real consumption. Although real consumption of households declined in 2009, it quickly recovered in 2010 and 2011 and broadly stabilised afterwards. This, in parallel with a GDP that is still below its pre-crisis level, resulted in an increasing import ratio.
Imports rose sharply as exports collapsed, because household consumption continued to increase: (note that on the RH chart net exports are shown inverted, i.e. rising line indicates falling net exports):

But how did households maintain their consumption? Here's how (my emphasis):
After 2009, consumption was supported by improving real gross disposable income, which increased until 2011 and stabilised afterwards in light of the slow labour market adjustment (in both wages and employment) to deteriorating growth developments and due to enhanced current transfers to households. In short, despite the decline in national income, households could maintain their real consumption without decreasing their saving ratio.  
Keynesian countercyclical fiscal stimulus, in other words. This is what it did to the government budget deficit:

In 2009-10, Finland's budget balance switched abruptly from a surplus of nearly 6% of GDP to a deficit of nearly 4% of GDP. That accounts for nearly all of the 10% fall in GDP that Finland suffered in 2009. 

Putting this together, we can see that Finland's recovery from the financial crisis was driven almost entirely by a large rise in government spending to support households. Interestingly, tax revenues don't seem to have fallen relative to GDP - the budget deficit seems to have been entirely caused by spending increases.

And we also now know why Finland's GDP collapsed from 2011. The government reduced its budget deficit, forcing households to cut back spending. Only when the budget deficit started to rise again in 2012 did GDP start to improve. 

So where are we now? Finland's budget deficit is currently 3.2% of GDP - twenty basis points above the Maastricht limit - and is expected to rise further. And Finland's debt/GDP, which is currently just above the Maastricht limit of 60% of GDP, will also rise, not only because of its fiscal deficit but also because of falling GDP. 

This chart shows that a high proportion of the fiscal deficit is considered structural. Admittedly, this forecast assumes return to growth in 2015. But what this shows is the supply-side damage done by the loss of Nokia. Considerable structural redevelopment will be needed to repair it. 

Sadly, the European Commission gives little weight to this. It makes some sensible recommendations about product market reforms, and rightly highlights the importance of entrepreneurship and innovation. But there are no significant recommendations for measures to support innovative start-ups and SMEs, and there is no discussion whatsoever of Finland's need to attract FDI. 

Instead, there is an unhealthy focus on fiscal finances that totally fails to acknowledge the need for continuing fiscal support, probably for a long period of time. In the European Semester review recommendations in May 2015, top priority is given to reducing the deficit:
Ensure that the excessive deficit is brought below 3% of GDP in a timely and durable manner by [XX] in line with Finland's obligations under Article 126 TFEU. Continue efforts to reduce the fiscal sustainability gap and strengthen conditions for growth. 
Fiscal tightening now is clearly inappropriate. The economy is not strong enough to cope with it. Even had it returned to growth as the European Commission predicted, unemployment in Finland is nearly 10% and youth unemployment is double that. There is little investment activity by corporations and not much in the way of FDI. Exports are stagnant and the current account is negative in relation to GDP: the recent improvement in the balance of payments is entirely due to improving terms of trade, probably due to falling oil prices. Tightening now, when there has not been sufficient supply-side development to plug the gap left by Nokia, will drive the economy deeper into recession and set back the development of new industries, which Finland desperately needs. 

But even with fiscal support, it will take Finland a long time to recover from the damage done to its productive capacity not just by the loss of Nokia, but by the over-dependence on Nokia in previous years. 

And the moral of the story is this. If you are a small country, never, ever allow yourself to become the home of a large multinational. 

Related reading: