Fiddling at the Fire

Nouriel Roubini

13 September 2012


PARISFinancial markets have rallied since July on the hope that the global economic and geopolitical outlook will not worsen, or, if it does, that central banks stand ready to backstop economies and markets with additional rounds of liquidity provision and quantitative easing. So, not only has good – or better-than-expected – economic news boosted the markets, but even bad news has been good news, because it increases the probability that central-banking firefighters like US Federal Reserve Chairman Ben Bernanke and European Central Bank President Mario Draghi will douse the markets with buckets of cash.
But markets that rise on both good and bad news are not stable markets. Risk-offepisodes, in which investor sentiment sours, are likely to return if economic news worsens and confidence in policymakers’ effectiveness drops.
In the eurozone, euphoria followed the ECB’s decision to provide support with potentially unlimited purchases of distressed countries’ bonds. But the move is not a game changer; it only buys time for policymakers to implement the tough measures needed to resolve the crisis. And the policy challenges are daunting: the eurozone’s recession is deepening as front-loaded fiscal consolidation and severe credit rationing continues. And, as eurozone banks and public-debt markets become increasingly balkanized, establishing a banking union, a fiscal union, and an economic union while pursuing macroeconomic policies that restore growth, external balance, and competitiveness will be extremely difficult.
Even the ECB’s support is not obvious. Monetary hawks – the Bundesbank and several other core central banks – who were worried about a new open-ended ECB mandate pushed successfully for strict and effective conditionality for countries benefiting from the bond purchases. As a result, they can pull the plug on the program if its stringent criteria are not met.
Moreover, Greece could exit the eurozone in 2013, before Spain and Italy are successfully ring-fenced; Spain – like Greece – is spiraling into depression, and may need a full-scale bailout by the “troika” (the ECB, the European Commission, and the International Monetary Fund). Meanwhile, austerity fatigue in the eurozone periphery is increasingly clashing with bailout fatigue in the core.
Small wonder, then, that Germany, politically unable to vote on more bailout resources, has outsourced that job to the ECB, the only institution that can bypass democratically elected parliaments. But, again, liquidity provision alonewithout policies to restore growth soon – would merely delay, not prevent, the breakup of the monetary union, ultimately taking down the economic/trade union and leading to the destruction of the single market.
In the United States, the latest economic data – including a weak labor marketconfirm that growth is anemic, with output in the second half of 2012 unlikely to be significantly stronger than the 1.6% annual gain recorded in January-June. And, given America’s political polarization and policy gridlock, we can expect more fights on the budget and the debt ceiling, another rating downgrade, and no agreement on a path toward medium-term fiscal consolidation and sustainabilityregardless of whether President Barack Obama is reelected in November. On the contrary, we should expect agreement only on the path of least political resistance: avoidance of tough fiscal choices until the bond vigilantes eventually wake up, spike long rates, and force fiscal adjustment on the political system.
In China, a hard economic landing looks increasingly likely as the investment bubble deflates and net exports shrink. Meanwhile, the reforms necessary to reduce savings and increase private consumption are being delayed. As in Europe and the US, the worst will be avoided in 2012 only by kicking the can down the road with more monetary, fiscal, and credit stimulus.
But a hard landing becomes more likely in 2013, as the stimulus fades, non-performing loans rise, the investment bust accelerates, and the problem of rolling over the debts of provincial governments and their special investment vehicles can no longer be papered over. And, given a new leadership’s caution as it establishes its power, reforms will occur at a snail’s pace, making social and political unrest more likely.
Meanwhile, Brazil, India, Russia, and other emerging economies are playing the same game. Many have not adjusted as advanced economies’ weakness reduces the room for export-led growth; and many delayed structural reforms needed to boost private-sector development and productivity growth, while embracing a model of state capitalism that will soon reveal its limits. So the recent slowdown of growth in emerging markets is not just cyclical, owing to weak growth or outright recession in advanced economies; it is also structural.
Similar dithering is apparent at the geopolitical level as well. The major global powers are still trying negotiations and sanctions to induce Iran to abandon its efforts to develop nuclear weapons. But Iran is playing for time and hoping to reach a zone of immunity. By 2013, an Israel that – rightly or wrongly perceives Iran’s nuclear program to be an existential threat, and/or the US, which has rejected containment of a nuclear Iran, may decide to strike, leading to a war and a massive spike in oil prices.
Ineffective governments with weak leadership are at the root of the problem. In democracies, repeated elections lead to short-term policy choices. In autocracies like China and Russia, leaders resist the radical reforms that would reduce the power of entrenched lobbies and interests, thereby fueling social unrest as resentment against corruption and rent-seeking boils over into protest.
But, as everyone kicks the can down the road, the can is getting heavier and, in the major emerging markets and advanced economies alike, is approaching a brick wall. Policymakers can either crash into that wall, or they can show the leadership and vision needed to dismantle it safely.

QE3 is a sign of the Fed’s policy purgatory

Mohamed El-Erian

  September 13, 2012

Through both its actions and what it refrained from doing, the Federal Reserve confirmed on Thursday that it is operating in policy purgatory: incapable of delivering the good economic outcomes it desires, yet unable to exit from an experimental policy stance that risks a widening array of collateral damage and unintended consequences.
To grasp the Fed’s policy dilemma, we must first discuss the why and what of additional unconventional Fed measures.

Three realities anchor the case for additional measures, notwithstanding the fact that the results of prior policy interventions actions have consistently fallen short of policymakers’ own expectations.

First, the FOMC reiterated concerns about the country’s economic prospects, and rightly so. It echoed Chairman Ben Bernanke’s speech at Jackson Hole on August 31. There he cited America’sdaunting economic challenges,” including the “grave concern” of a stagnant labour market where high unemployment – even if predominantly cyclical in nature as Mr Bernanke believes – would get embedded in the structure of the economy were it to persist for long.

Such worries were accentuated in the last week by the disappointing August employment report, as well as the more recent high frequency jobless claim data released earlier on Thursday. Both confirm weak job dynamics. They come at a time when long-term and youth unemployment is way too high, Americans are dropping out of the labour force, poverty is on the rise, and income inequality is widening.
Second, the Fed is not helped by the fact that it is the only entity properly engaged in addressing America’s challenges. Others, including those paralysed by deep congressional splits, are standing on the sidelines even though they have better suited policy instruments.

Then there are the unusualtail risks” facing the economy and additional policy insurance they appear to warrant – from the threat of the European debt crisis to the self-inflicted fiscal cliff in the US and mounting political risks in the Middle East. If even one were to materialise, America would soon find itself again in a recession which would accentuate economic, financial, political and social fragilities.

With this in mind, Fed officials decided to experiment even more. They extended forward guidance, stating that policy rates are expected to stay exceptionally lowat least through mid-2015”.

Importantly, they also committed to additional, open-ended purchases of mortgage-backed securities (what will likely be labeled “QE3”).

History and detailed analyses of the problems underpinning America’s prolonged economic malaise suggest that these well-intentioned measures will again fail to secure a much better economic situation. This is also behind the widening gap between economists urging the Fed to do even more and those favouring less.

In refraining from going beyond forward guidance and QE3, the Fed is seeking to balance these two competing views. It thus refused to cut the interest it pays on excess reserves (IOER) despite some arguing that this would induce banks to lend more to the real economy and thus encourage greater economic activity. It also declined to move from an intermediate policy target (boosting asset prices) and time commitment (mid 2015) to specific economic targets (including nominal GDP).

With both options having been discussed by Fed officials, their revealed preference speaks to important considerations that will grow in the months ahead.

They signaled growing recognition of the “costs and risks” of unconventional policies – from undermining the functioning of certain market mechanisms to hampering entire segments that provide financial services to citizens (such as money market accounts, life insurance products and pension coverage). For example, a cut in the IOER would have dealt an even bigger blow to the money market industry. They also reinforced Mr. Bernanke’s earlier view that “monetary policy cannot by itself [deliver] what a broader and more balanced set of economic policies might achieve.”

Like the ECB, its Frankfurt-based European counterpart, the Fed cannot by itself secure the results that so many desire high growth, robust job creation and financial stability. At best, it can keep buying time in the hope that other government entities will get their act together. Until this happens, the Fed will remain in policy purgatory.

viernes, septiembre 14, 2012



Investment banking

Dream turns to nightmare

Investment banking once delivered juicy profits. No longer

Sep 15th 2012

“THE best countercyclical indicator of the health of capital markets is when investment banks cut staff,” says a senior banker at a large American investment bank. “We always cut just before the cycle turns.” But what if the cycle doesn’t turn? An industry that once seemed to offer banks the opportunity to earn juicy returns and expand internationally is now in retreat almost everywhere.

Some of this withdrawal has been going on since the crisis—the fees paid to banks for trading in capital markets as well as for advising on takeovers and sales of shares and bonds have been falling for a few years now. But lately retreat has turned to rout. Early this month Nomura, which had made a gutsy bet on expansion when it bought the European and Asian businesses of Lehman Brothers in 2008, in effect pulled the plug on its global investment-banking business. Peers express little surprise. “Nomura was dead before it started,” says the boss of one large bank. “It was a totally ill-conceived foreign expansion.”
Yet other banks are pulling back hard, too. Deutsche Bank, Germany’s banking champion, plans deep cuts to its investment bank, a part of the business responsible for much of its growth. Barclays is said to be considering slimming its investment bank by as much as a fifth, reversing a decade-long expansion of a business that contributes more than half of total profit. Both Barclays and Deutsche are lowering their targets for returns on equity, in Deutsche’s case to just 12% after tax, well down on the 25% pre-tax target it once aimed for.

There are two main reasons for the sharp falls in profitability at investment banks everywhere. The first is that their clients are simply doing a lot less business with them. Income from trading bonds, currencies and commodities (an area of activity known in the industry as FICC) has fallen as slowing economies and turmoil in Europe have discouraged institutional investors from trading and companies from buying one another or issuing shares.

Equity issuance worldwide dropped by about 30% in the first seven months of this year from a year earlier; in debt markets, bond issuance has fallen by about 8%, according to analysts at Mediobanca, an Italian bank. Number-crunchers at Deutsche Bank reckon that revenue from investment banking around the world will total some $240 billion this year, down by almost a third from 2009 (see chart).



The second reason is that regulations on capital and liquidity are starting to bite. These are reducing returns earned by banks as well as forcing them to shrink their balance-sheets and cut back on trading. Many banks are also starting to position themselves for proposed rules that are not yet in force, such as America’s Volcker rule, which aims to stop banks trading for their own account, and regulations that will shove over-the-counter derivatives, which command fat margins, onto clearing-houses and exchanges.

Not everyone is gloomy: J.P. Morgan reportedly says investment banking has never been stronger. But most other banks seem to have lost their mojo. The most visible consequence of this is in headcount. London’s financial industry will have lost about 100,000 jobs by the end of this year from a peak of 354,000 in 2007, according to CEBR, an economics consultancy. New York’s financial comptroller reckons Wall Street employs almost 20,000 fewer people than before the crisis.

Slashing variable costs is only half the story, however. The industry is reshaping itself in other ways, too. First, there is the decline of stand-alone investment banks, and the concomitant resurgence of universal banks, which combine investment banking with the simpler commercial- and retail-banking sort. Diversified, deposit-taking universal banks can maintain higher credit ratings and can borrow more cheaply than specialist investment banks such as Morgan Stanley or Goldman Sachs. As credit has become scarce, moreover, universal banks have been able to demand a larger share of lucrative investment-banking business from their clients in return for offering loans.

In response, investment banks such as Goldman Sachs and Morgan Stanley are trying to expand into corporate lending, private banking and retail stockbroking. This week Morgan Stanley reached a deal to buy out Citigroup’s 49% stake in their Smith Barney retail-broking joint venture.

The second shift in the investment-banking landscape is a hollowing-out of the midsized banks as the very biggest in the industry grab a greater share of trading revenues. This is partly because the titans can afford the best trading systems, but also because a bank with a large share of trading has the liquidity that further increases its attractiveness as a trading counterparty. Analysts at Deutsche Bank reckon that the five leading banks in FICC won 40% of the market’s revenue in 2011, up from 36% in 2007. Smaller banks that once aspired to be global are expanding in markets closer to home instead.

The more open question is whether the industry’s geographical centre of gravity will also move, away from London and towards Wall Street and Asia. London’s natural advantages of time zone, law and language are not easily bettered.

But Asian and American banks have big deposit bases to call on to finance expansion; European banks generally do not. And London’s reputation has been sullied by recent regulatory failures over issues such as the rigging of LIBOR interest rates, as well as the political backlash against investment banking that arose as a result. “London hit Ctrl-Alt-Delete in terms of wanting to be a centre of global finance,” says the boss of one large universal bank. “Singapore and New York will be the new hubs of global finance and you can’t open enough coal mines to make up for that.”

09/12/2012 10:30 AM

Green Light for ESM

German High Court OKs Permanent Bailout Fund with Reservations

Germany and Europe can both breathe a sigh of relief on Wednesday: The Federal Constitutional Court has rejected a petition to stop the ratification of the permanent euro rescue fund, the European Stability Mechanism. The decision clears the way for the ESM to go into effect.

In a historically significant signal for the euro rescue, the German Federal Constitutional Court on Wednesday ruled there are no grounds to stop the country from ratifying the European Stability Mechanism, the permanent euro bailout fund, and the fiscal pact aimed at bringing economic governance to countries in the euro zone. The decision bolstered stock markets in Europe and around the world and also strengthened the euro. However, the justices at the Karslruhe-based court also expressed some reservations.

The court ordered that ratification can only be completed if it is ensured under international law that Germany's current maximum liability of €190 billion ($245 billion) can only be increased with the approval of the German representative in the ESM board, court President Andreas Vosskuhle said. "(No) provision of this treaty may be interpreted in a way that establishes higher payment obligations for the Federal Republic of Germany without the agreement of the German representative," the court states.

This also means that Germany's federal parliament, the Bundestag, must play the leading role in important decisions. Under a German law accompanying the ratification of the ESM treaty, the German parliament must first vote on the positions taken by the German representative in the ESM board before they can act on them. However, it is still unclear at this point whether decisions will require a vote of the full parliament or the significantly smaller budget committee.

In another significant condition, the court ruled that Germany must ensure that the treaty is implemented in a way that ensures that representatives of the Bundestag, and the Bundesrat, the upper legislative chamber that represents the federal states, are comprehensively informed of the bailout fund's activities despite the professional secrecy that ESM employees are required to adhere to.

Vosskuhle also noted that the decision on the permanent rescue fund is provisional and that full proceedings would follow.

Germany is the only euro-zone member state that has not yet ratified the treaty establishing the ESM. Without the participation of the EU's largest member state, the bailout fund has not been able to begin its work yet.

'Good for Germany, Good for Europe'

German Chancellor Angela Merkel praised the ruling. "This is a good day for Germany, a good day for Europe," she said during a special session of the German parliament. "We haven't yet overcome the crisis, but we have achieved our first steps." She said Germany had sent a "strong message to Europe and beyond." The court has cleared the way for the ESM and the fiscal pact while at the same time strengthening the rights of parliament. This, she said, would provide certainty for everyone -- not only members of the Bundestag but also taxpayers.

Foreign Minister Guido Westerwelle of the business-friendly Free Democratic Party (FDP), which is the junior coalition partner in Merkel's government, also greeted the ruling. "It was a smart decision reflecting the pro-European spirit of our constitution," he said, adding that the conditions imposed by the court had been necessary and that Germany could not be allowed to become overburdened. "The Federal Constitutional Court has affirmed the policies of the federal government and declared them to be constitutional. That's good for Germany and good for Europe."

The group Mehr Demokratie ("More Democracy"), together with 37,000 German citizens, had sued at the country's highest court to halt the ESM's ratification. The group alleged that Germany was entering into "unlimited and irreversible liability risks." Peter Gauweiler, a politician with the conservative Christian Social Union who is a prominent critic of the German government's euro rescue policies, and the Left Party had claimed that accepting the new liabilities would be irresponsible.

There are also critical voices within Merkel's conservative Christian Democratic Union party, which has largely stood behind her policies in rescuing the euro, but is also home to some of her greatest adversaries in the crisis. Wolfgang Bosbach, a notorious critic of the euro rescue, expressed skepticism about the court's ruling. Despite the conditions imposed by the court, he said, Germany still carried enormous liabilities. "I have mixed feelings about the ruling," he said. On the one hand, it has strengthened parliament's hand in Berlin. But he also warned that it only created the appearance that the upper ceiling on Germany's liability would be limited to €190 billion. He argued that if the European Central Bank purchases government bonds in an unlimited manner, as the bank has said it may do, that would also increase Germany's potential liability.

German President Free To Sign Treaty

Following Wednesday's ruling, German President Joachim Gauck is now free to sign the ESM treaty, which was already approved by Germany's parliament, the Bundestag, in June. The ESM can only go into effect with his signature.

The permanent euro bailout fund will operate in parallel with its predecessor, the European Financial Stability Facility (EFSF), for a period, completely replacing it by mid-2013. The ESM will be equipped with €700 billion in capital but will only be able to lend a maximum of €500 billion.

In accordance with its share capital in the European Central Bank (ECB), Germany is providing guarantees for 27 percent of the ESM's funds. Germany is required to provide €22 billion in cash to the fund as well as guarantees totaling close to €170 billion. But critics fear that Germany will have to provide far more cash and guarantees in the end.

Despite firm words of warning in the past, the court has never ruled against the ratification of a major EU treaty and most politicians in Berlin, including Chancellor Angela Merkel, expected that the constitutional guardian in Karlsruhe would give its blessing to the ESM.

Stock markets across Europe showed gains following the Karlsruhe ruling. Eurostoxx, an index of blue chip European companies, rose briefly by 1.2 percent -- to close to 2,580 points. Spain's leading index, Ibex, also rose for a time by over 1 percent exceeding 8,000 points. Meanwhile, Italy's FSTE rose by more than 1 percent, bringing it to a total of almost 200 points.

The euro also rose on the news to $1.2906, its highest level since mid-May.