Tuesday, 21 February 2017

UK inflation and the oil price

Inflation is back.

Here is the change in the consumer price index (CPI) for January 2017, according to ONS:

Well, this doesn't look too serious. CPI is barely reaching the Bank of England's target of 2%. It has been much higher for most of the last decade, and yet the Bank of England has kept interest rates at historic lows.

But consumer price inflation - the prices that people pay for goods in the shops - is only one side of the equation. On the other side is producer price inflation (PPI), the prices that companies pay for the materials and energy they need to produce goods and services. The picture here is entirely different, as this table from ONS's January 2017 producer price inflation report shows:

Annualised producer price inflation has risen dramatically in the last six months. It reached double digits in October 2016 and currently stands at an astonishing 20.5%. Most of that is due to sharply rising import prices, of which by far the most important is crude oil, the price of which has risen by 82% in the last year. The dominance of oil imports in producer price inflation figures is evident from this chart:

Rising oil prices in the last year have added 9% to producer prices.

But inflation is a rate-of-change measure: it tells you how fast prices are rising, but not where they started from. Just over a year ago, we were looking at this chart:

In October 2015, ONS reported an entire year of double-digit deflation in producer prices, due to a 40% fall in the oil price and significant price falls in other imports:

So we could regard imports as simply returning to a more normal price level after the unwinding of the oil and commodities bubble. But what is a "normal price level"?

It turns out that import prices and the oil price are joined at the hip. So there is no such thing as a "normal price level" that ignores movements in oil prices. This chart shows producer price inflation since 2002:

And this chart shows the price of Brent crude since 2002:

Even just eyeballing these, the correlation is evident. For the whole of this century, the oil price has been the single biggest driver of producer price inflation in the UK. And judging by the CPI chart at the head of this post, it appears to be a significant driver of consumer price inflation too.

The other major driver of producer price inflation in the last 6 months has been the falling sterling exchange rate. Sterling is down by 13% against the US dollar. This explains the apparent divergence between the rate at which the oil price is rising and the rate at which inflation (PPI and CPI) is rising. Brent is quoted in US dollars per barrel, so its price in sterling is rising faster than its dollar price.

However, the rising oil price is evidently not being significantly passed through to consumer prices. A producer price rise of 20% is resulting in CPI of less than 2%. In fact the chart above shows that none of the swings in producer price inflation this century have been fully passed through to consumer prices - including the extraordinary speculative oil price spike just prior to the financial crisis and the QE-driven oil and commodity price bubble of 2010-14. Clearly, businesses have chosen to absorb the costs rather than passing them on to consumers. So where have the effects of these price rises been felt?

This is part of it:

Note the inflection point in 2007. For the next seven years, real wages fell, and they are still barely growing. Producer price inflation was not passed on to consumers - it was passed on to workers, in the form of wage growth that failed to keep up with consumer price rises.

Producer price inflation was also passed on in the form of poor productivity. Rising energy costs are particularly destructive to productivity, since rising productivity by definition increases energy usage. The picture is one of businesses trying to avoid passing costs on to consumers by restricting both wage growth and energy use. We would expect this to show up as lower output. And indeed, this is what we find:

 (source: ONS Gross Domestic Product time series January 2017)

UK output fell off a cliff in 2007, then tried to recover in 2009-10 but was clobbered by rising oil and commodity prices. I have previously observed that the UK in 2010-12 suffered double-digit inflation in energy prices, which in my view was the principal reason why the UK economy flatlined. If the QE-driven oil and commodity price bubble was the principal cause of the failure of the UK's recovery, then the prolonged use of QE by the US to restore its own economy has had terrible consequences for the UK. QE spillovers are known to be inflationary for emerging markets, but it seems that there was also an indirect inflationary effect in oil-dependent developed countries, which showed itself as stagnant output, poor productivity and flat wage growth.

If this is correct, then the falling oil price of the last two years has been the single biggest reason for the UK's improving output and wage growth. But now the oil price is rising and sterling is falling (which amplifies the depressing effect of the rising oil price on the UK economy). The little boom is over. If the oil price continues to rise, I expect wage growth to stall and output to flatline again. And if businesses do start to pass on these costs to consumers, then the Bank of England will additionally come under pressure to raise interest rates. This does not look promising to me.

However, the point of this post is not to remind everyone that my middle name is Cassandra. It is to highlight the critical dependence of the UK economy on the oil price, and to a lesser extent on imported commodities. The Bank of England's monetary policy is fairly effective at discouraging businesses from passing on import price rises to consumers. But we pay for this through inadequate wage growth, low productivity and poor output. Would it be better if businesses passed the costs on? Would significantly higher inflation in the medium-term be a reasonable price to pay for improved output and wage growth? Those who argue for a higher central bank inflation target are in effect saying that it would.

Of course, there are other moving parts in the productivity-wages-output puzzle. For example, I have not in this post discussed the effects of public sector wage freezes and the entry to the workforce of previously economically inactive people such as single mothers, sick & disabled and older women. And I have completely omitted the effect of damaged banks cutting back productive lending in order to repair their balance sheets. But the impact of the oil price on the economy is widely ignored, not least because the focus is entirely on consumer price inflation. Yes, a central bank can dampen the effect of oil price rises on consumer price inflation. But it cannot protect businesses from rising costs due to oil and commodity price rises. Perhaps, in future, we should pay far more attention to the direct effects of imported inflation on the supply side, rather than obsessing about consumer prices. After all, it is the supply side that ultimately drives economic growth and prosperity.

Related reading:

What derailed the UK recovery?
Inflation, deflation and QE
Inflation report, February 2017 - Bank of England

Monday, 13 February 2017

The end of the road for the Co-Op Bank

The Co-Op bank is putting itself up for sale. It announced today that it will offer all of its shares for sale, including the Co-Op Group's 20% stake and the shares currently owned by a consortium of American hedge funds, institutional investors and small investors. The decision follows on from last month's disclosure that it was facing a full-year loss for the third year running and would fail to meet capital requirements set by the Prudential Regulatory Authority (PRA) for some years to come. It has almost certainly been made under pressure from the PRA.

The decision to offer the bank for sale was undoubtedly very painful for the Board. But it has been obvious for some time that the Co-Op Bank's recovery plan was heading for the rocks. Both the 2014 and the 2015 reports contained warnings from the directors, endorsed by  the auditors, that the bank may not be able to continue as a going concern. There is little doubt that the forthcoming 2016 report, due at the end of March, will contain a similar warning.

In fact the Co-Op Bank has been living on borrowed time ever since it ignominiously failed the Bank of England's stress tests in 2015. The capital plan it agreed with the PRA was high risk from the start, relying on very favourable trading conditions and no major shocks. Unfortunately, the reality has been difficult trading conditions and a series of nasty shocks, culminating in the Brexit vote last June. Low interest rates were already squeezing its profits, making it hard to rebuild capital: in August 2016, when the Bank of England cut interest rates still further, the Co-Op Bank warned that uncertainty following the Brexit vote posed a serious risk to its recovery. 

But low interest rates and uncertainty are not the only reason for the failure of the Co-Op Bank's recovery plan. Speaking on BBC News, the new Chief Executive, Liam Coleman, admitted to two other reasons.

The first is the sheer scale of the repair work needed, which he said was much larger than had been expected. The bank has done a lot of work to clean up its balance sheet, cut its costs and improve the quality of its IT systems. But it still has unacceptably high levels of non-core assets and is struggling either to dispose of them or build the capital to support them. Despite a major cost-cutting and integration drive, its cost/income ratio remains unsustainable at over 100%. And although it has now migrated some of its IT systems to a more robust technical platform, it is still a long way from implementing the resilient, efficient and user-friendly IT infrastructure needed to deliver a strategy based upon a major move to online and mobile banking. 

 And secondly, the burden of fines, litigation costs and compensation for past misconduct. Relative to its size, its PPI mis-selling bill is nearly as large as that of Lloyds Bank, and it is the only bank to be censured by the FCA for breaking the Consumer Credit Act in relation to mortgages. In 2015 it was censured by the PRA for serious failings in risk management. And in 2015, its former Chief Executive, Barry Tootell, was personally fined by the PRA and banned from working in financial services, along with the former head of Corporate Banking, Keith Alderson. Tootell, an accountant who had acted as CFO as well as CEO, was subsequently barred from membership of the Financial Reporting Council as well.

The level of misconduct at the Co-Op Bank may surprise some people. But the truth is that the so-called "ethical bank" has been anything but ethical. Quite why its customers have been so loyal to it is a mystery. The bank systematically ripped them off for years.

The proposed sale amounts to an admission that the Co-Op Bank cannot grow out of its problems. It needs to find more capital, and it seems that its existing owners are not able or willing to provide it. The question is whether an external buyer would be willing to provide it. Frankly, this is a tall order. The market for distressed banks is decidedly thin at the moment, and there are arguably more promising candidates than the Co-Op Bank for anyone wanting to attempt a turnaround. Europe is littered with failing banks, many of which are in better shape than the Co-Op despite their problems. The Co-Op, after all, has already had one private sector rescue.

There have been suggestions that the TSB might be prepared to take it on - for the right price. The TSB's management probably know better than any other potential buyer just what a mess the Co-Op Bank is in: after all, it was the failure of the Co-Op Bank's attempt to buy the nascent TSB that exposed the awful state of the Co-Op Bank's own balance sheet. They will drive a hard bargain. The sale price of the Co-Op Bank is likely to be extremely low.

There could be some poetic justice in the TSB taking over the bank that tried to buy it - though of course the TSB itself is no longer an independent entity, having been taken over by Spain's Banco Sabadell not longer after its flotation. But it would need to be extremely careful. There have been too many cases of sound banks taking over distressed banks, only to end up in serious trouble themselves: the TSB will no doubt be mindful of the fate of its former parent Lloyds Banking Group, and indeed of the history of the Co-Op Bank itself. Taking on a distressed bank is not to be undertaken lightly. The TSB would no doubt like the Co-Op's customers (if it can keep them) and whatever good quality assets exist on its balance sheet, but it won't be nearly so keen on its costs and its debts. Even at a fire sale price, the Co-Op Bank may be too rotten a morsel to swallow.

If sale of the bank as a going concern fails - as seems distinctly possible, given the scale of the risks for any potential buyer - then it could be broken up. Currently, this seems more likely than an outright sale. The FT reports that challenger banks (including the TSB) and private equity firms are expressing an interest in buying parts of the Co-Op Bank's portfolio.

Breaking up the bank would leave a rump business with its reputation shot to pieces and little in the way of decent assets. It might be better capitalised, but from a business perspective it would have an even bigger mountain to climb than it had before. It would be unlikely to survive for long as an independent entity. However, it would probably be easier for the stripped-down and recapitalised bank to find a buyer.

The FT suggests that the Board might also try to restructure the Co-Op Bank's balance sheet by swapping debt for equity and raising additional capital from new and existing investors. I don't believe it. If that were a viable alternative they would have tried it before putting the business up for sale. I suspect they have already sounded out major shareholders about a rights issue and been firmly told "No". And without a rights issue, a debt for equity swap would still leave the bank desperately short of capital. It is not a solution.

As a last resort, the Co-Op Bank could be wound up by the PRA. In my view this outcome is only likely if a buyer for the whole business still cannot be found after a fire sale of assets.

Whatever the outcome for the bank as a business, the Co-Op Bank brand is likely to disappear. There are a number of reasons for this. Once the Co-Op Group no longer has a stake, it may object to the bank continuing to use its brand name. And if the bank ends up entirely in private sector ownership, the Secretary of State may revoke the bank’s right to describe itself as “cooperative”. If  the bank is broken up, the assets will be absorbed into the buyers' own brands: the rump business may retain the Co-Op Bank brand name, but unless by some miracle it manages to rebuild a distinctive franchise with a solid reputation, a future buyer would be unlikely to be interested in paying goodwill for what is by any standards a badly tarnished brand.

This 144-year-old institution seems set to disappear from Britain’s high streets. Many will mourn its passing. But there is a silver lining. The continued existence of a bank that is cooperative in name but not in nature has severely hampered the Cooperative Movement's efforts to promote cooperative banking. Once this albatross has been cast overboard (and regulatory obstacles overcome), they will be free to create new, vibrant cooperative banks. The death of the Co-Op Bank could, perversely, become the source of new life in cooperative banking.

Related reading:

The Co-Op Bank: too high a mountain?
Co-Op Bank Interim Financial Report 2016
The "ethical" Co-Op
A tale of two banks|

Image: "Wheatfield with Crows", Vincent Van Gogh. Courtesy of the Vincent Van Gogh Museum.  

Sunday, 12 February 2017

France's shame

Today, the Guardian has a report on conditions in the refugee camp at Dunkirk, just up the French coast from the infamous "jungle" at Calais that was cleared at the end of 2016. "Women and children 'endure rape, beatings and abuse' inside Dunkirk's refugee camp" proclaims the headline. This is of course the shiny new refugee camp, supposedly built to international standards, that was opened less than a year ago.

It makes harrowing reading. Here is an excerpt:
The witness statement from another volunteer, who could speak Arabic, describes how a 14-year-old from Morocco appeared to have been raped and could not sit down and kept repeating that he felt so “ashamed”. 
Their account stated: “He didn’t want anything, he was only crying and asking for his mum. He had been badly beaten."
The worker also described how a young child had been sexually assaulted on site, leaving her mother so shocked she had been rendered mute. “We have also seen in the past a woman holding a seven or eight-year-old girl by her arm next to GSF [the charity Gynaecology sans Frontières has a unit on site] and apparently this child had been raped just before, and the woman was afraid to report it to police. She was there, standing silent refusing to report it.”
But hang on. Let's just look at the last two sentences in that excerpt again, shall we?

"....the woman was afraid to report it to police. She was there, standing silent refusing to report it."

This is in France, remember. Women and children in a refugee camp in a supposedly civilised Western country are afraid to report serious crimes to the police. Rape of a minor is a criminal offence in France, as it is in the UK. It carries a long prison sentence. But if the camps are so poorly policed that sexual assault of children goes unreported because of fear, the perpetrators will never be brought to justice. They will continue to abuse vulnerable people with impunity.

Does the Guardian lead on the failure of the French authorities to ensure that women and children in the camp are protected from abuse? No. It blames the UK.

"The fate of those stranded by the UK’s decision to limit taking child refugees from France," says its sub-headline.

No doubt some of these children have been affected by the Home Secretary's decision to end the Dubs programme after resettling only 350 children instead of the 3,000 originally planned. There may well be a case for reinstating the Dubs programme: I for one think the Home Secretary's decision was appalling and would like to see it reversed. I wish those pursuing a legal challenge every success.*

But the stories in this article do not have anything to do with the UK's responsibility for resettling child refugees. They are about the fact that France treats its refugee camps as if they are not part of France. Policing is completely inadequate, and the residents of the camps are effectively deprived of the normal protections afforded by French law. The UK is not in any way responsible for the determination of the French authorities to make life extremely difficult for refugees in the hope that they will go away.

If this story were about the camps in Libya where torture, rape and execution is an everyday occurrence, I might think that it would be right to lead on the UK's responsibility to resettle children from the camps. Libya is ravaged by war and has no effective government. But this is a story about a camp in France. France, a rich Western country with a stable democracy. France, a signatory to the Geneva Convention on Refugees and the European Convention on Human Rights.

To my mind, it would have been a lot more useful for the Guardian to shout about the fact that neither the UK government nor the EU authorities have been able to force the French government to improve its treatment of refugees. The UK government was instrumental in getting the Calais "jungle" closed down: but this was to stop illegal immigration to the UK, not to ensure the welfare of refugees. After the "jungle" was closed down, humanitarian organisations expressed concern about the fate of unaccompanied minors evicted from the camp.

The Dunkirk camp is also under threat of closure, along with other camps throughout Northern France. But closing down refugee camps is not an adequate solution. In October 2016, Médecins Sans Frontières warned that dismantling camps simply condemned refugees to living as vagrants. It called on French authorities to put on hold all plans to evict camp residents and close down camps until suitable alternative arrangements could be made. It is hard not to conclude that "suitable alternative arrangements" are the last thing the French authorities want to provide. They want refugees to leave, not take up residence.

 If the Geneva Convention on Refugees (pdf) means anything at all any more - which is looking increasingly doubtful - the international community must pressure the French government to improve policing and conditions in its camps and detention centres. Denying refugee women and children the protection of the law flouts both the letter and the spirit of the Geneva Convention. France's treatment of refugees who have sought safety inside its borders is a national disgrace.

Related reading:

When the world turns dark
In the bleak midwinter
Europe's shame
Horror story
What have we learned from history?

* Legal challenge to the Dubs decision on behalf of the refugee children of Dunkirk is being crowdfunded. You can find out more and make a donation at CrowdJustice here.

The handy map at the top of this post comes from the Daily Mail. It dates from January 2016.