March 27, 2012 8:21 pm

European finance: A leaning tower of perils


By piling on funds to save banks, the monetary authorities may initiate a renewal of the euro crisis


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A drug. A pyramid scheme. Strikingly for an initiative that is credited with saving the eurozone and financial markets from disaster, those are just two of the undignified epithets that some in the financial markets now hurl at the European Central Bank’s provision of cheap three-year loans to eurozone commercial banking groups.


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The ECB’s “longer-term refinancing operation” has sparked a big rally in global equities and has lowered borrowing costs for Italy and Spain, viewed as the countries whose fortunes will determine whether the crisis in the 17-nation single currency area intensifies again.

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The €1tn-plus, two-stage action by the Frankfurt-based monetary authority – taken in December and late February as the first big policy move by Mario Draghi, its new president – has demonstrably eased fears of an imminent collapse either of a European bank or even of the euro itself.



But there is a dark side to the LTRO. Critics are increasingly concerned that by helping to save banks and governments now, the ECB may unwittingly be sowing the seeds for the next escalation of the crisis. That would shatter the calm in global markets of the past few months and cause renewed soul-searching about the continent’s single-currency project.



Financial markets have certainly been impressed. But this isn’t really solving anything and in some respects it is actually worsening the intricate and nepotistic relationship between banks and sovereigns,” says George Magnus, senior adviser to UBS, the Swiss bank. He describes claims by some European politicians that the crisis is over as “myopic”.


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Concerns over the LTRO are several, ranging from the question of banks becoming dependent on artificially cheap funding to fears about the structure of their balance sheets. But one of the main charges is that the sheer cheapness of the funds has prompted banks to go on another credit-fuelled binge, similar to what preceded the global financial crisis but this time snapping up the debt of their own governments.


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Their bond buying has brought bond yields down for the likes of Italy and Spain but it has also caused the fates of banks and countries to become even more inextricably linked. “There is a risk it’s like tying two drowning people together in the hope they will float,” says Benedict James of Linklaters, the law firm.


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In total, UBS analysts think Italian banks have taken about €260bn from not just the LTRO but other liquidity schemes from eurozone central banks. Spanish banks in turn took €250bn, well ahead of the next biggest users, French banks, with €150bn.


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While banks have used the money for a variety of purposes including refinancing their debt, they have also clearly stocked up on state paper. Spanish banks, for example, increased their holdings of Madrid’s state bonds by 29 per cent in December and January combined, the last two months for which data are available, to reach €230bn. Italian banks boosted their domestic purchases by 13 per cent over the same period to €280bn.


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The effect on government bond yields has been dramatic, particularly in short-dated maturities, which have tumbled. Conversely, this demand has strengthened bond prices, which move inversely to yields. Under the so-called carry trade, banks get the money at 1 per cent from the ECB and invest in higher-yielding securities. Two-year yields for Italy have fallen from 4.6 per cent to 2.5 per cent and for Spain from 3.4 per cent to 2.5 per cent so far this year.



Debt auctions have also gone well for the two Mediterranean countries. Spain has raised 44 per cent of its target while Italy is more than a fifth of the way to its 2012 goal, according to UBS credit analysts. But the buying in auctions and secondary markets has been overwhelmingly by domestic buyers, with international investors largely staying on the sidelines. One senior European investment banker, with perhaps only a little exaggeration, says some auctions have drawn buyers of which 95 per cent were domestic.



Describing it as a “Ponzi scheme”, Marc Chandler, currency strategist at Brown Brothers Harriman in New York, says simply: “Weak banks are buying weak sovereigns.”



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Concern is focused more on Spain than on Italy, largely because the former’s banking system is viewed as more fragile. Unlike Italy, Spain experienced an enormous housing bubble and many investors fret that the cleaning up of Spanish banks’ balance sheets has only just begun.


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As government bond yields fell, and correspondingly bond prices rose, banks were making a tidy paper profit on the carry trade. But in recent weeks Spanish, and to a lesser extent Italian, market interest rates have started rising again. Spain’s benchmark yields had risen 48 basis points from their lows earlier this year to 5.35 per cent by Tuesday.



If yields continue upwards, some analysts worry that banks may have been pushed into buying the bonds at exactly the wrong time. “You are encouraging banks to buy at potentially the peak. Banks are going to have to mark to market and post more collateral if bond prices decline meaningfully,” says Graham Secker, equity strategist at Morgan Stanley. He describes Spanish and Italian banks’ approach as in some respects “the proverbial all-in at poker”.



Policy makers are not oblivious to the dangers. ECB officials insist the LTRO was necessary to relieve market tensions, especially about the possibility that one or more eurozone banks could collapse because of funding difficulties.


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But they also acknowledge that there are risks to the scheme. Jens Weidmann, the president of Germany’s Bundesbank, has gone further, warning in a speech in February that “too generous a provision of liquidity will open up business possibilities for banks that could lead to greater risks for the banks” and thus jeopardise financial and price stability. The German central bank did not try to block the LTRO, unlike its resistance to other recent ECB policies, but it would have preferred less-favourable terms to have been set.



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A second big problem that many see is that the LTRO lessens the pressure on both banks and sovereign borrowers to reform. In essence, the ECB loans have bought three years for banks to reform themselves and for the southern countries in Europe to rekindle economic growth.



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But some wonder whether enough will be done now the immediate heat has been turned down.


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“There’s a fine balance to be struck between providing the market with a sufficient level of optimism and at the same time keeping a certain level of fear so that progress is genuinely delivered,” says Richard Ryan, a senior credit fund manager at M&G Investments.



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Alastair Ryan, banking analyst at UBS, argues that banks should be looking different from how they did before the financial crisis, both in terms of capital and the size of their balance sheets. But while UK banks have been forced to alter their structure – by boosting capital heavily, selling assets, raising liquidity and reducing their reliance on wholesale funding – “if you look at French, Spanish and some Italian banks not very much has changed at all”.


LTRO-chart-small
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He frets that the Spanish banks are now “chronically dependent on the ECB” and the sector no longer has an incentive to carry out reforms. Weak funding and capital positions in turn limit the ability of banks to lend to the real economy, hurting the country’s growth prospects.


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It is a widely feared addiction. “Like any drug, there will be side effects. It is just we don’t know what they are at the moment,” says Nick Gartside of JPMorgan Asset Management. Europe still has too many banks 460 from Germany alone tapped the second LTRO – and the loans could lessen incentives to consolidate as well as to change broken business models.



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Of worry to many is what happens in three years when all this bank debt comes due at the same time. The hope is that economic growth will have picked up by then, giving banks a healthy backdrop against which to issue debt on their own.




But plenty of people in the market believe institutions in some of the “peripheralcountries in southern Europe at least are likely to struggle for longer than three years, raising the prospect of their becoming zombie banks”. Peter Sands, chief executive of Standard Chartered, the UK-based emerging markets lender, says the amount of liquidity pumped in by central banks riskslaying the seeds for the next crisis”. He adds: “It is not clear what the exit strategy is. What happens in three years time when it needs to be refinanced?”



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Within the ECB’s 23-strong governing council there is also widespread concern that by relieving financial market tension and helping subdue bond yields in what some have dubbedbackdoor quantitative easing”, pressure on governments for fiscal and structural reforms has lessened. Some in Frankfurt have already been alarmed by Spain’s defiance over its fiscal targets this year after dramatically breaching them in 2011.



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LTRO critics reject suggestions they are being churlish, given that markets have undergone a remarkable stabilisation this year compared with the dark days at the end of 2011. Concerns that the next few months could have been highly tricky for banks in terms of funding have dissipated, they agree, as has the “tail risk” – marketspeak for an event that could disrupt markets’ central muddling-along scenario – of a lender going bust.

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But many remain worried about just what the LTRO will end up achieving. Banks remain under pressure to shrink their balance sheets, a process known as deleveraging, even if the LTRO has eased the strain somewhat. As UBS’s Mr Ryan asks: “What is LTRO? Is it a useful tool to manage deleveraging, quantitative easing via the back door, or a convenient way to avoid restructuring?”


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Capital structures: Relegation of the bondholders



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For an investor, holding bonds in banks or governments used to be fairly straightforward. Your place in the capital structure was clear, meaning that if any entity went bust you knew where you stood in terms of payment.



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The financial and sovereign debt crises have changed that. Bondholders are now much more subordinated to other creditors. This is perhaps starkest among holders of eurozone bank bonds. In 2007 they typically accounted for more than 80 per cent of a bank’s capital structure, research by Citigroup shows. Now it is about 10 per cent, with a swath of other interests ranked ahead, among them deposits, covered bonds and arrangements with the European Central Bank.



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There has also been a marked change in government bonds as the Greek debt restructuring showed. Private sector bondholders suddenly found that they were ranked lower in payment termsnot just, as expected, to the International Monetary Fund but also, for political reasons, the ECB and the European Investment Bank.



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Citigroup reckons the subordination could be worse in other bail-outs. After expected refinancings in Portugal and Ireland, private holders would respectively represent just 40 per cent and one-third of total debt.


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At the similar stage in Greece before its restructuring this month, they held about two-thirds.One of the lessons of the financial crisis is that there has not been enough focus on the capital structure,” says Andreas Utermann of Allianz Global Investors. “It is becoming very political.”


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The worry is acute for banks where the ECB’s longer-term refinancing operation is adding to worries about institutions tying up assets to raise money. This results in so-called balance sheet encumbrance as banks pledge their assets either to obtain cheap ECB money or to use in transactions, such as covered bonds.


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Some argue that this leaves banks with less collateral. It would also make the cost of funding for unsecured debt – that not backed by assetsless attractive, prompting banks to cut lending and shrink. Alberto Gallo of RBS says the LTRO has helped banks to refinance debt. “But we believe the price for liquidity today is bondholder subordination tomorrow.”

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Additional reporting by Ralph Atkins


Copyright The Financial Times Limited 2012


Whither Europe?
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26 March 2012 .
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Michael Boskin

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BEIJING – With the likelihood of a contagious sovereign-debt implosion and European bank failures greatly reduced by the Greek debt deal and the European Central Bank’s lending program, it is time to look ahead. Where do the European Union, the eurozone, and the EU’s highly indebted countries go from here? Will Europe be able to roll back its welfare states’ biggest excesses without economic distress and social unrest toppling governments and, in the peripheral countries, undermining already-tenuous agreements with creditors?



Some good news globally will have an impact on how these questions are resolved. The United States’ economy is gradually reviving, albeit slowly by the standards of recovery from a deep recession.


China, Brazil, and India have not decoupled from their customers in Europe and North America, and so are slowing, though a relatively soft landing is likely if Europe’s recession is as short and mild as predicted.



The EU’s economic output and population are larger than that of the US, so the fate of the 27 EU countries is everyone’s business, from New York to New Delhi, São Paulo to Shanghai. Formed originally as a free-trade area, the eurozone comprises 17 of the countries. Knitting together 17 disparate economies, cultures, and institutions was a monumental undertaking, fraught with risk.



The Lisbon Treaty emphasizes unanimity in decision-making. With some members inside of the eurozone, and others remaining outside of it, and with disparate economic interests and monetary and fiscal traditions even within the eurozone, agreement is difficult. That sets the stage for three broad scenarios, each with implications for the European and global economy, the financial and banking system, and relations between the member states and EU institutions.



In the first scenario, a more united and homogeneous Europe emerges from the crisis, enforcing greater restrictions on member states’ budgets to reduce apparent risk. Accompanied by a strong, broad eurozone, risk of a future currency crisis remains.




In the second scenario, a two- or three-tiered Europe includes a two-tiered euro, with the weaker countries using a separateeuro-Bcurrency that can float against the stronger economies’euro-A.” This arrangement would hold out the promise to fiscally stressed economies that, if they get their act together, they could rejoin euro-A – and do so more readily than they could from their own currency.




In the final scenario, what emerges is a more decentralized Europe, with less top-down agreement in areas beyond trade and a smaller, more homogeneous eurozone composed of the EU’s core economies. Such a construct would be far more popular with citizens who are unhappy with the accretion of EU power in Brussels and the loss of traditional sovereignty. Some current euro membersGreece (and perhaps others) – would revert to national currencies.



None of these options is easy; each entails serious difficulties and great risks. Episodic muddling through may be the best that can be hoped for.



For example, how would Greece (or any country) exit the euro in order to cushion the extreme downward wage adjustment required to regain competitiveness, and to avoid the severe social unrest that could result from reining in debt too rapidly? As soon as word got out that Greece was seriously considering such a move well before it could even generate a new drachma currencyeuro bank deposits would flee Greece.



As a result, Greece would be forced to impose capital controls. Some contracts denominated in euros would be subject to Greek law, some to European law, and others – for example, derivatives contracts – to British or US law. Legal chaos would result. Yet sticking to the euro and forcing all of the adjustments in wages risks greater unrest; indeed, it might merely postpone the inevitable.



Governments and the bond market will test the seriousness of the newly agreed fiscal guidelines (if they are ratified). While talk is tough now, the history of such agreements does not inspire optimism. Before the financial crisis, even Germany violated the EU Stability and Growth Pact’s (SGP) deficit limits. In the US, the 1980’s deficit limits set by the Gramm-Rudman-Hollings law were not met, and, like the SGP, were revised and extended. Agreements with, and access to, the International Monetary Fund and Europe’s new bailout fund provide (soft) constraints.



Regardless of how these governance and fiscal issues are resolved, or muddled through, Europe’s banks remain a thorny issue. With the time afforded by the ECB’s three-year cheap loans, they have some breathing room to rebuild their capital and clean up their balance sheets. But, while doing so, they are not likely to be expanding private-sector lending to support economic growth. European banks are far more thinly capitalized, and account for a much larger share of credit extended, than banks in the US, where much more lending originates in capital markets.



Most large US banksCiti is an exceptionpassed US Federal Reserve stress tests recently, with enough capital to withstand a hypothetical deep recession (13% unemployment, a 21% further fall in home prices, and a 50% stock-market decline). Europe’s stress tests have been much weaker. Some sort of Brady bond to reduce and extend excessive sovereign debt will be necessary.



We can expect further European turmoil – from banks, sovereign debt, and social unrest in response to even modest welfare-state rollbacks – and clashing visions, within and among countries, concerning the desirability of deeper European integration. Europe has come a long way from the days when its leaders prophesied that the euro would quickly rival the dollar as a global reserve currency.



Yet no one should write off Europe. It still has great strengths, and, with sensible reforms, the EU can survive and eventually return to greater prosperity and stability. But Europe remains closer to the beginning of that process of renewal than to the end.


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Michael Boskin is Professor of Economics at Stanford University and Senior Fellow at the Hoover Institution. He was Chairman of George H.W. Bush’s Council of Economic Advisers from 1989-93, and headed the so-called Boskin Commission, a congressional advisory body that highlighted errors in official US inflation estimates.

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March 27, 2012 7:29 pm
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Prepare for a new era of oil shocks

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Ingram Pinn illustration



Oil prices are up. Barack Obama is to blame. Drilling in the US is the solution. This is the mantra from the president’s opponents.


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All presidents tend to get the blame for high fuel prices. But with the price of gasoline nearing $4 a gallon, Mr Obama is getting it by the barrel load.


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This may be good politics. But it is absurd. Oil, unlike natural gas, is a globally traded commodity, whose price is set in world markets. In 2010, the US produced 7.8m barrels a day, 9 per cent of the world’s supply. Unlike Saudi Arabia, the US lacks spare capacity: it is a price taker. Responding to his critics, Mr Obama said: “We are drilling more.


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We are producing more. But the fact is, producing more oil at home isn’t enough to bring gas prices down overnight.” These remarks are correct, except for the last word. Producing more oil would have next to no effect on oil prices.
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To enlarge click here

 

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Moreover, if there is a specific cause for the rise in oil prices, it is the tightening of sanctions on Iran, which Republicans support. If, as many desire, military action is taken, the impact on oil prices and the world economy will be far greater.




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In the longer run, a big reduction in US demand, still 20 per cent of the world’s total, might make an appreciable difference to prices. Moreover, the relative wastefulness of US oil use, compared with other high-income countries, would make such a reduction quite easy to achieve.

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The best way to make this happen would be to raise prices, via higher taxation. But that policy is deemed un-American. It is a policy fit only for European wimps.


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Yet, despite the absurd politicking, we should be concerned about the economic impact of high oil prices: a rise of $10 in the price of oil shifts $320bn a year from higher-spending consumers to lower-spending producers, within and across countries. The 15 per cent rise since December 2011 would shift close to $500bn. The real price of oil is also very high, by historical standards (see chart). Further rises would take the world into uncharted territory.



In short, higher oil prices are a threat. So what is going to happen?


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In a recent note, Goldman Sachs argues that a 10 per cent rise in oil prices tends to lower US gross domestic product by 0.2 percentage points after one year and by 0.4 percentage points after two. In the European Union, the impact is smaller: a reduction of 0.2 percentage points in the first year, but no further reduction thereafter.



Since the actual rise has been 15 per cent since December, the impact on US and EU GDP would be a reduction of 0.3 percentage points over the first yearappreciable, but not calamitous. Such a price rise would lower US household incomes by about 0.5 per cent. Moreover, crossing the threshold of $4 a gallon might be significant when confidence is fragile, as it is now.

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Goldman also suggests the factors that would determine the size of any adverse impact.


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The first is whether the rise in prices is caused by demand or a shock to supply, with the latter being more disruptive. The answer, it suggests, is that demand is now the principal cause of higher prices, though the tightening of sanctions on Iran would be more important. The Paris-based International Energy Agency, in its latest monthly report, even qualifies this view. It agrees that “there may be no actual physical supply disruption at present deriving from the Iranian issue’. But there are ongoing non-OPEC outages totalling around 750,000 barrels a day”.



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The second factor is how much spare capacity exists. The answer: not much. Inventories in high-income oil markets are low (see chart). Saudi Arabian production is now at 30-year highs, which suggests limited spare capacity.


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Moreover, the growth of world oil supply has been persistently slow, at just below 1 per cent a year over the past decade, despite generally high oil prices. Thus, capacity is structurally tight. That explains the level and the volatility of prices over the past decade. With potential global economic growth at 4 per cent a year, oil supply growing at 1 per cent and the lack of easy alternatives to oil as a transport fuel, supply is likely to become tighter.



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A third factor is what is happening in other commodity markets. Here the news is good: natural gas prices have been falling, while agricultural prices have not been so much of a problem this year. This should limit the inflationary impact.


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A final consideration is the monetary response. Here the news remains favourable. Central banks are likely to ignore movements in commodity prices, particularly ones whose impact is contractionary, provided they see no pass-through into wages. They are right to do so.


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In all, Goldman concludes, the price increase is a “brake”, not a “break”, in growth. But Fatih Birol, the IEA’s chief economist, warns against too much complacency. He notes that the EU’s net imports of oil will cost 2.8 per cent of GDP at present prices, against an average of 1.7 per cent between 2000 and 2010. Given the frailties of the EU economy, the dangers are evident.


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Furthermore, in this stressed oil market, further spikes in prices are quite possible. A war with Iran may be the most frightening possibility. But danger is always present, given the political instabilities in places where oil is produced. Moreover, the world is going to remain stuck in this danger zone, given the soaring demand for oil from rapidly growing emerging countries. The IEA suggests that Chinese sales of private light-duty vehicles will reach 50m a year by 2035, even under an energy-efficient scenario. The implications of such growth in vehicle fleets are quite obvious.



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The world will be vulnerable to high oil prices and repeated shocks, so long as supply is stagnant, demand buoyant and unrest likelyin short, so long as it remains as it now is. For the US, the best response would be to lower the oil-intensity of its economy, to reduce vulnerability to these shocks. Higher prices would help deliver this. But why does it let all the revenue go to foreigners? It makes far more sense to tax imports and keep some of it, instead.



Copyright The Financial Times Limited 2012.