Repairing the Global Plumbing
Mohamed A. El-Erian

NEWPORT BEACH – More than three years after the global financial crisis, the world still has a nasty plumbing problem. Credit pipes remain clogged, and only central banks are working to clear them. But their ability to do so is waning, posing yet another set of risks for Western economies blocked by too little growth, too much unemployment, deepening inequality, and debt in all the wrong places. Fortunately, it is not too late to build broader pipes that compliment and replace the damaged infrastructure.

The current situation embodies two narratives that seem contradictory, but are not. One speaks to the reality that most large companies with access to capital markets have no problem securing new funding. In fact, they have been remarkably successful in lengthening their debt maturities, accumulating cash, and lowering their future interest payments. In sum, they now havefortress balance sheets.

The other narrative speaks to an opposing, but equally valid reality. Too many small companies and households still find it difficult to borrow at reasonable terms. This includes those reliant on bank credit, as well as many mortgage holders with very high legacy interest rates and balances that exceed their homes’ market value.

From every angle, the extremity of this state of affairs – in which those with access to credit do not need it, and those who do cannot get it – is highly problematic. If left unattended, it leads to a gradual, and then accelerated, renewed deleveraging of the economic system, with the highest first-round costs – a longer unemployment and growth crisisborne disproportionately by those least able to suffer them. In the next round, as the system slowly implodes, even those with healthy balance sheets would be impacted, accelerating their disengagement from a deleveraging world economy.

All of this slows social mobility, tears already-stretched safety nets, worsens inequality, and accentuates genuine concerns about the functioning and sustainability of today’s global economic system. This is not just about socio-economic issues. There is also a political angle. With two competing, yet simultaneously valid narratives, ideological extremes harden. The result is even greater dysfunction in both process and content, ruling out any sustained policy attempt to make things better.

The problem has become acute in Europe, whose crisis has been belatedly recognized as reflecting something more than turmoil in the eurozone’s weakest countries. It also reflects broad-based contamination, resulting, most recently, in France’s loss of its vaunted AAA sovereign credit rating.

In the process, the efficacy of pan-European rescue mechanisms is being undermined. And, as fragilities increase – and as a financial wedge is driven into the eurozone’s core (Germany and France) – growth and employment prospects dim.

Central banks have recognized all of this for some time, prompting them to take enormous reputational and operational risks to slow the process. They have implemented a host of “unconventional policies” that previously would have been deemed unthinkable, even outrageous – and that can be seen in the enormous growth in their balance sheets.

In the last four years, the United States Federal Reserve’s balance sheet has more than tripled, from under $1 trillion to a mammoth $3 trillion. The growth relative to the size of the economy is even more stunning – from slightly more than 5% of GDP to 20%. The Bank of England’s balance sheet is also at 20% of GDP. And both seem to be itching to do even more.

The European Central Bank is often viewed as a laggard. No longer. Its balance sheet has now doubled, to a whopping 30% of GDP – and it, too, appears set to do even more. Mario Draghi, the ECB’s new president, recently said that he expects heavy take-up on the next three-year long-term refinancing operation, a powerful tool to pump cheap liquidity into the banks.

Unfortunately, the economic outcomes have come nowhere close to matching the intensity of these efforts. Effectively, the central banks have been unconventional bridges to nowhere, owing mainly to their imperfect tools and other government agencies’ inability or unwillingness to act. At some point – and we are nearing itbridges to nowhere become a standalone risk: they can topple over.

Rather than just pumping liquidity into clogged pipes, countries can and should do more to build a more effective network of compensating conduits. In doing so, their main objective (indeed, the test for effectiveness) would be the extent to which new private-sector investment is “crowded in.”
It is high time to move on five fronts, simultaneously:

· Countries such as Spain and the US need to be more forceful in unblocking the housing sector by making overdue decisions on burden sharing, refinancing, and conversion of idle and foreclosed housing stock.

· Countries with excessive debt, such as Greece and Portugal, need to impose sizeablehaircuts” on creditors in order to have a reasonable chance to restore medium-term debt sustainability and growth.

· In several Western countries, public-private partnerships should be formed to finance urgently needed infrastructure investment.

· Regulators should stop bickering about the future configuration of key financial institutions, and instead set a clearer multi-year vision that is also consistent across borders.

· Finally, governments should inform their electorates explicitly and comprehensively that a few contracts written during the inadvisablegreat age” of leverage, debt, and credit entitlements cannot be met, and must be rewritten in a transparent way that strikes a balance between generations, labor and capital, and recipients and taxpayers.

Such policies would allow healthy balance sheets around the world, both public and private, to engage in a pro-growth and pro-jobs process. They require leadership, focus, and education. Absent that, plumbing problems will become more acute, and the repairs more complex and threatening to virtually everyone – including both the “one percenters” and those who worrisomely are struggling at the margins of society.

Mohamed A. El-Erian is CEO and co-CIO of PIMCO, and author of When Markets Collide.

China’s new challenge: less frugality

Yukon Huang

January 18, 2012

The slowdown in China’s economic growth last year has fostered mixed reactions. Some argue the recently-released 9.2 per cent annual rate exceeds expectations and is consistent with a soft landing. Others see the fall from 10.4 per cent in 2010 as an indication that a sharper drop is still to come.

Surprisingly, domestic consumption has held up well. However, this is partly due to the early arrival of Chinese New Year, which is likely to have shifted activity forward at the current year’s expense. Without actions to support growth, the pace may fall below eight per cent in 2012.

Beijing is likely to lower taxes and consider special incentives to spur consumption. But the real challenge is to encourage less frugality among the Chinese, especially among migrant workers.

Policies must be designed to deal directly with the exceptionally high rates of saving by people and corporations. This would have big implications for the trade balance, a contentious issue with the west.

Attention has focused on the rapid increase in China’s investment, which now exceeds 45 per cent of gross domestic product – the highest of any major economy. Less attention has been paid to the even faster rise in the savings rate, which exceeds 50 per cent of GDP. Since the trade balance is the difference between savings and investment, China has substantial trade surpluses that exceeded six per cent of GDP several years ago. Clearly, global imbalances would moderate and growth would be more robust if only the Chinese were less frugal.

Over the past decade, there has been a sharp increase in savings rates for all three major sectorshouseholds, enterprises and government. The trend has been nurtured by a combination of good and bad policies, and thus it is possible to reshape savings patterns to improve the quality and equity of China’s growth.

The greatest potential lies in moderating household saving rates, which have increased by ten percentage points as a share of disposable income in ten years. Although many factors have contributed, the impact of urbanisation has gone largely unnoticed. The urban population is now larger than the rural with persistent labour inflows. In the major coastal cities, savings rates of migrant workers are much higher than those of established residents. Without formal residency rights to public services, migrants have more incentive to save. And because they now account for the bulk of the labour force in many coastal cities, urban savings rates have soared.

The increase in corporate savings comes mainly from a surge in retained earnings. But because enterprises do not pay significant dividends, some of these surpluses have fuelled wasteful investments – including speculation in real estate. If China’s enterprises paid the same share of their retained earnings as dividends as companies in other countries, this could significantly increase consumption.

Government savings have also increased significantly over the past decade. Some of this has supported investment, but some has also been used to build up the social security system. Thus higher government consumption is unlikely unless revenues are increased.

Overall, providing migrants with more security and encouraging higher corporate dividends could increase consumption by some five percentage points of GDP. This could turn China’s current trade surplus into a deficit. These distinct and politically sensitive reforms would also lessen China’s alarmingly high income disparities. This strategy, with benefits for all, contrasts with that of pressuring China to strengthen the renminbi, perceived by Beijing as benefiting the US at China’s expense.

The writer is a senior associate at the Carnegie Endowment and a former World Bank country director for China

Southern Resilience
Paulo M. Levy


RIO DE JANEIRO – Latin America’s resilience in the aftermath of the 2008 financial crisis has been remarkable, especially when compared to the region’s performance in the 1980’s and 1990’s. But, as the world economy faces renewed uncertainty, the region must find new strategies to reduce the potential impact of volatile financial markets and protracted stagnation in the world’s richest economies.

Although Latin America’s growth corresponds to global trends, there is a good chance that, in 2012, the region’s economies will outperform industrial countries once again. Contraction of world trade and reduced financial flows will likely slow growth somewhat, but the annual pace should remain close to the region’s 2000-2008 average of 4%.

One reason for this prediction is that abundant liquidity in international markets and continuing high demand from China and India may prevent commodity prices – especially for agricultural products – from falling as much as they did during the 2008-2009 crisis. Gains in terms of trade have been crucial for growth in Latin America, given the region’s low domestic saving rates, because they encourage investment but have relatively little negative impact on current-account balances.

Strong capital inflows, especially of foreign direct investment, and terms-of-trade recovery since 2009 have made the region less vulnerable to external shocks – that is, to recurrence of the abrupt capital-flow reversal that occurred in late 2008 and early 2009. More importantly, most Latin American countries now have in place counter-cyclical measures to mitigate any negative external impact.

For example, many countries that were tightening their monetary policy when the first signs of turbulence emerged have either put interest-rate hikes on hold, or, like Brazil, have already started to reduce rates. Most Latin American countries’ recent adjustments, moreover, have prevented their budget positions and current-account deficits from becoming sources of vulnerability.

This appears to be the case, for example, in Peru, where sound fiscal policies have kept deficits and inflation under control. It is also true in Colombia, where strong budget revenues could allow for a temporary spending boost to counter external risks. Noteworthy exceptions are Argentina and Venezuela, where macroeconomic tensions have reduced the scope for counter-cyclical action, and Mexico, whose fate is bound by extensive trade links to that of the United States.

Brazil, the region’s largest country, and one of its most prosperous, reflects several economic trends in Latin America. After the global financial crisis erupted in the last quarter of 2008, interest rates in Brazil fell sharply, credit expanded quickly, and fiscal policy shifted from neutral to strongly expansionary. The Brazilian treasury’s massive funding of the National Development Bank also acted as a buffer against declining investment.

This policy stimulus led to strong growth, in both consumption and investment, and economic activity recovered quickly. While the appreciation of the real’s exchange rate kept a lid on prices for tradable goods, non-tradable goods, especially services, remained a source of inflationary pressure. To fight accelerating price growth, the authorities adopted measures at the end of 2010 to cool overheating domestic demand, first through credit restrictions and higher reserve requirements for banksso-calledmacroprudentialmeasures – and later through the resumption of interest-rate hikes.

But the sudden deterioration of external financial conditions, and the prospect of protracted stagnation in Europe and the US, prompted Brazil to reverse its policy last August. The central bank has already cut its benchmark interest rate by 150 basis points, to 11%, and the downward trend is expected to take real rates to record lows in the post-crisis period.

But the price for this might well be that annual inflation remains significantly above the 4.5% target. Indeed, more recently, the credit restrictions that were implemented at the end of 2010 have been loosened in order to stimulate consumer demand.

Moreover, Brazilian fiscal policy is likely to switch from restrictive to neutral or slightly expansionary this year. The government has promised to make the move more gently than in 2009-2010, thereby allowing the flexibility to bring down interest rates over the long term.

In 2012, it plans to increase the minimum wage by 14% according to the current adjustment rule, with a strong impact on social-security benefits, and the public-investment outlays that were repressed last year are also likely to resume. These measures, plus a reduction in tax revenues, should reduce the primary surplus and contribute to reviving demand.

Latin America has achieved substantial progress in its macroeconomic policy framework, giving its authorities increased room for maneuver in softening the impact of external shocks. But demand management is only part of the job when it comes to fostering long-term economic growth. Having successfully steered their countries through the crisis, Latin America’s authorities should devote greater attention to resuming reform efforts aimed at improving competitiveness and ensuring the sustainability of high growth rates.

Paulo M. Levy is an economic researcher at IPEA, the applied economic research institute of the Brazilian government.

Copyright: Project Syndicate, 2012.

January 18, 2012 5:43 pm

Central banks curb their appetite for Treasuries

Anxious investors are buying, so is the Federal Reserve. But many of the world’s central banks are doing the oppositeoffloading US Treasury bonds, and at a record pace.

A closely watched gauge of foreign appetite for US sovereign debt – the Treasury International Capital or Tic flow report, which includes private and official flows – on Wednesday showed solid demand for Treasuries in November.

Click to enlarge

This was hardly a surprise. Demand for US debt has been robust, despite last year’s downgrade of the US triple A credit rating by Standard & Poor’s, largely because of the financial turmoil caused by the eurozone debt crisis. That strong demand has extended into the new year as illustrated by last week’s sale of 10-year notes at a record low yield of 1.90 per cent.

Yields on benchmark Treasury debt in the secondary market have fallen from about 2.4 per cent in October to a low of 1.84 per cent as of Wednesday. Last year was the best for long-dated US debt since 1995.

But the retreat by foreign central banks is a warning that not all players in the bond market are happy with such meagre returns on offer, particularly with annualised core US inflation running at more than 2 per cent.

Of the $10tn in outstanding US Treasuries, foreign holders account for some 48 per cent of the market, with official investors such as central banks a significant presence. Since late August these investors have cut their Treasury holdings by $95bn, with $68bn sold in the past six weeks as the dollar has strengthened and emerging market economies have experienced outflows. A fall in the value of emerging market currencies against the US dollar has reduced the need for their central banks to recycle foreign exchange reserves back into US bonds.

“The decline in custody holdings with the concurrent rise in the dollar suggests the composition of flows into the US may have changed,” says Marc Chandler, head of currency strategy at Brown Brothers Harriman.

The fall in so-called custody holdings was temporarily offset in November by Japan buying $60bn in Treasuries as it recycled dollars acquired in its currency intervention in October, the latest Tic data show. By contrast, China’s Treasury holdings at $1.13tn extended a decline from their peak of $1.17tn in July and are at their lowest since August 2010.

China’s selling is expected to accelerate in the coming months as the country recently reported its first quarterly decline in foreign exchange reserves since 1998 during the last three months of 2011.

But not all of the selling has come from China. Hong Kong and Russia have been reducing their holdings over the past year.
Switzerland, for its part, while up on the year, has been selling Treasuries since September after setting a currency peg versus the euro.

“It would appear that other nations besides China have been reducing their holdings of Treasuries at the Fed,” says Lou Crandall, economist at Wrightson Icap. “Still, the turnaround in the growth rate of China’s currency reserves since the summer helps explain the change in the trajectory of the custody accounts.”

Since August the US dollar has rallied nearly 10 per cent on a trade-weighted basis, while custody holdings of Treasuries have fallen from a peak of $2.76tn to $2.6tn as of last week.

“It is no surprise to see this type of liquidation by official accounts as the dollar is stronger and a sub 2 per cent 10-year doesn’t work the charm,” says William O’Donnell, strategist at RBS Securities.

Sales by foreign central banks, though, have been overshadowed by the Fed’s buying under its “quantitative easingprogramme, the eurozone crisis propelling investors to the relative safety of US sovereign debt and proposed capital rules pushing US banks to own more government bonds.

“There is little doubt that the Fed’sOperation Twist is keeping yields down,” says Gerald Lucas, senior investment adviser at Deutsche Bank. “When the Fed is buying, you don’t fight them.”

High-profile investors such as Bill Gross at Pimco also advocate owning Treasuries. His bond fund increased the proportion allocated to Treasuries to 30 per cent in December, the most in more than a year. There is a strong chance that, even when the Twist ends in June, the Fed will continue to support US government bond prices via another round of quantitative easing.

Keeping yields low remains a priority for policymakers as long as the US economic recovery is lacklustre. As a result, many in the bond market expect a third round of quantitative easing, or QE, in the spring or early summer. A new round of QE that replaces the Twist could in turn stoke a “risk-on rally” that boosts emerging markets and results in renewed accumulation of dollar reserves by their central banks, and more purchases of Treasuries.

QE 3 will happen, you are going to see growth roll over from 3 per cent to averaging under 2 per cent for the first half of 2011,“ says Eric Green, economist at TD Securities. “The Fed has a high tolerance for inflation but not for sub-par growth and QE is likely by April.“

Daniel Katzive, foreign exchange strategist at Credit Suisse, says: “QE has generally been negative for the dollar and a boost for risk appetite, which is a good recipe for emerging market outperformance. More flows into EM will mean more reserve accumulation and buying of Treasuries.”

Copyright The Financial Times Limited 2012.

January 19, 2012 7:28 pm

Too Big to Fail undermines the free market faith


Observers saw capitalism triumphing over communism, free markets over central planning, democracy over dictatorship, Hayek over Marx. Francis Fukuyama even proclaimed the end of historymankind had supposedly reached an optimum state, with no feasible alternative.

From the outset, this was a false doctrine. Whereas “real socialismended in disaster wherever it was tried, history teaches that the idea of a socialist society promising equality will never fade, whatever empirical evidence shows. Moreover, there was hardly a country in the world where capitalism had become established in a way that was satisfying in every respect. Historical determinism was the most absurd aspect of Fukuyama’s notion. No liberal philosopher would have embraced the idea of history being predetermined.


Competition between different ways of organising societies has continued since the end of the cold war. Socialism still suffers from the fatal blow dealt by its past collapse. As a consequence it is seen mainly in grassroots protests such as the Occupy movement. How this might be achieved remains totally unclear – the movement encompasses a variety of issues with one dominant element: an attack on the finance industry.

Looking at the evolution of the financial market crisis, the only surprise is that it took so long before a serious movement materialised. The crisis has provided strong arguments for opponents of the financial system.

Interventions to avoid its collapse have severely undermined not only confidence in financial markets but also in the market economy as a whole. Once a financial institution has become so big or interconnected that its insolvency threatens the stability of the system, politicians must intervene. The problem of “too big to fail” has made societymore precisely, the taxpayerhostage to the survival of individual financial institutions.

As a result, the basis of free markets has been shaken. A market economy rests on the principle that individuals are free to act within boundaries set by a legal system. Individuals are invited to exploit opportunities and to assess risk. No other system can release the same amount of potential locked inside individuals. As Hayek explained, the market is the best discovery process.

The rules of the game should be clear. Those who succeed are free to take the profits (after taxation); those who make losses have to bear the consequences, with bankruptcy the ultimate sanction. Thus, “too big to failnot only undermines a fundamental principle of market economies but also a principle of societies in which individuals are responsible for their actions.

The taxpayers’ billions committed to rescue supposedly systemic institutions has dealt a big blow
to confidence in the free market system – and has in turn become a threat to free societies.
The threat has been aggravated by people expecting more from governments than politicians can actually deliver – while at the same time trust in politicians, it seems, has fallen almost everywhere to its lowest ever levels.

Meanwhile, the financial industry still fails to give a convincing
to fundamental questions: to what extent do its activities contribute to the welfare of society and are they indispensable for a dynamic economy?

It would probably be too much to expect the financial sector to respond by saying that, in fact, some parts of its businesses are superfluous or even dangerous. So, governments are confronted with the challenge of creating a convincing system of regulation and supervision that enables the financial industry to deliver services considered indispensable but, as far as possible, prevents it pursuing activities deemed detrimental to society.

Notwithstanding a number of encouraging improvements, such as higher capital requirements and greater transparency, this task is anything but completed. The challenge of strengthening the fundamentals of market economies and free societies continues. History never endsexcept in the minds of those who believe in the inevitability of the Mayan calendar, which predicts the end of the world in December 2012.

The writer is president of the Center for Financial Studies and a former member of the European Central Bank’s executive board

Copyright The Financial Times Limited 2012.