Deutsche Bank and UBS Explored European Banking Alliance

Deal talks in June never coalesced but show how far European lenders are willing to go to address a punishing banking environment

By Jenny Strasburg


UBS CEO Sergio Ermotti and Chairman Axel Weber at the company's shareholder meeting in May. Photo: arnd wiegmann/Reuters


Deutsche Bank AG DB -2.79%▲ and UBS UBS -1.41%▲ Group AG this year explored ways to combine their businesses, including talks as recently as mid-June to form an unusual alliance of investment-banking operations, according to people familiar with the discussions.

The talks between Germany and Switzerland’s biggest lenders show how far European lenders are willing to go to address a punishing banking environment. Hammered by negative interest rates and slowing economic growth, European banks are struggling to compete globally and fend off encroachments from bigger U.S. rivals on their home turf.



A deal never coalesced, as the two sides failed to sort out thorny issues, including how to structure and allocate capital to any joint operations, the people said. Deutsche Bank and UBS for years have contemplated exploring a merger, the people said. One person who has been involved in multiple deliberations said the talks have been on and off but never fully off the table.

Inside Deutsche Bank, a tie-up was seen as a way to save Germany’s biggest bank from the painful cuts now in motion, the people said. The banks discussed a full-blown merger earlier in the year, a move that would have created a European banking behemoth more able to compete with Wall Street’s most dominant players, such as JPMorgan Chase& Co. and Goldman Sachs Group Inc. Bloomberg reported in May that the two banks briefly explored a merger. The June talks haven’t been previously reported.

UBS has suffered from volatile performance in its investment bank, and shares currently trade near their lowest point since it restructured its business in 2012. Deutsche Bank’s shares trade just above their all-time low hit this month.

The mid-June discussions, held near Milan, included the finance chiefs of both banks, senior investment-banking executives and advisers, some of the people said. The executives discussed ways to swap some operations and intertwine parts of their investment banks but keep the parent companies separate, according to the people familiar with the talks.

The people said a concept behind an alliance was to play to the strengths of both lenders, as Deutsche Bank, which remains a big player in its fixed-income trading and structuring business, would get referrals from UBS, which pulled back from some of those business lines several years ago. Deutsche Bank would feed business into UBS’s more successful equities franchise, the people said. UBS was interested in some of Deutsche Bank’s deal-advisory teams in the U.S., a person briefed on the discussions said.

Such a venture was seen by some involved as a possible test case, some of the people familiar with the talks said. It might have allowed the German and Swiss banks—and regulators, governments and investors—to gauge whether a merger might make sense, without committing to a new headquarters, regulatory regime or full restructuring, the people said.

Deutsche Bank’s then-investment-banking chief Garth Ritchie was at the meeting in Italy, along with Alexander von zur Muehlen, who is Chief Executive Christian Sewing’s top internal adviser on strategy. So was UBS’s Robert Karofsky, co-president of the investment bank, people familiar with the meeting said.


Deutsche Bank CEO Christian Sewing, right, speaks with Chairman Paul Achleitner at the bank’s annual meeting in May. Photo: Alex Kraus/Bloomberg News


UBS Finance Chief Kirt Gardner attended, and Deutsche Bank’s CFO,James von Moltke, dialed in, people familiar with the talks said. Tadhg Flood, a partner with deal advisory firm Centerview Partners, was advising the German bank, the people said. He previously served inside Deutsche Bank and remains a confidant of Mr. Sewing. On the UBS side was Jonathan Wills, the people said, another Deutsche Bank alum who worked this year for consulting firm Oliver Wyman. In June, Mr. Wills joined UBS as head of investment-bank strategy.

Earlier in the year, when Deutsche Bank was in talks to merge with crosstown rival Commerzbank AG, Deutsche Bank had parallel discussions with UBS to combine their asset management arms, The Wall Street Journal and others reported in April.

UBS Chairman Axel Weber earlier this year discussed with German officials the potential merits of a UBS-Deutsche Bank deal, and UBS Chief Executive Sergio Ermottiwas also open to exploring the idea, some of the people said.



The full merger talks went on for weeks, but by May they bogged down over regulation of the investment bank and the location of a combined bank’s headquarters—Zurich, Frankfurt, a third location where neither bank is located, or some combination of the three, according to people familiar with the talks.

By June, Deutsche Bank was running out of time. While talking with UBS, the German bank was planning cuts and discussing with other banks selling off stock-trading technology and pieces of its prime-brokerage franchise, which serves hedge funds. French bank BNP Paribas eventually struck a deal for some of those businesses.

The alliance discussions with UBS were short-lived; UBS walked away after the Milan meeting, some people familiar with the negotiations said. Deep cooperation short of a merger is rare in the banking world. People involved in the talks said the two sides decided they couldn’t quickly sort out how to structure the operation or share capital between the entities. One of the people said the idea was a long shot.

On June 21, Mr. Sewing emailed business heads demanding additional details for executives preparing the “equity story” for a major restructuring, people familiar with the internal communications said.

Some inside the bank said the crunch of hurried decision-making left executives little time to finalize senior management and cost-cutting decisions. They say the impact is still felt, with confusion about what services the bank will keep and how much capital those businesses need.

On the first Sunday in July, Messrs. Sewing and von Moltke laid out a reorganization that included the departure of three management-board members, including Mr. Ritchie, and 18,000 job cuts. There will also be a major pullback from the bank’s Wall Street presence, with an exit from most of its equities business and more investment in its strongest fixed-income and advisory businesses.

Central banks have lost much of their clout

Monetary policy is no longer enough to keep the economy on track

Adair Turner


© Jonathan McHugh


As leading central bankers meet this week in Jackson Hole, Wyoming, financial markets and media anxiously await indications of future policy direction. This year’s topic is Challenges for Monetary Policy and, amid slowing global growth, the talk is of interest rate cuts and clearer forward guidance.

In September, the European Central Bank may commit to keeping rates below zero beyond 2020. Some economists think the Bank of England’s Monetary Policy Committee should make explicit interest rate forecasts, mirroring the US Federal Reserve practice.

Many hope that the Fed’s recent 0.25 per cent rate cut will be the first of many. Governor Haruhiko Kuroda of the Bank of Japan faces calls for action to counter stubbornly low inflation. More quantitative easing is possible.

Given the uncertainty, this year in particular the precise words spoken at Jackson Hole will be scrutinised with great care. But, in reality, what central banks can do alone is no longer very important.

It has been clear since the 2008 global financial crisis that when short and long-term interest rates are already very low, further cuts make little difference to real economic activity. If the BoE now cuts its rate from 0.75 per cent to 0.5 per cent the impact on consumption will be trivial.

Because big German companies can already borrow 10-year money at less than 0.5 per cent, using quantitative easing to reduce that to, say, 0.4 per cent will make almost no difference to their investment plans. Pushing policy rates too far into negative territory could instead reduce growth by limiting bank profitability and lending.

Central banks’ attempts to manage expectations are also ineffective. When German bond yields show that investors expect negative ECB rates for a decade, promising they will not rise until 2021 cannot have more than trivial impact.

Despite all this, a mountain of economic commentary is still devoted to predicting minor shifts in central bank policy, and central bankers still obsess over the effectiveness of their communications. Two factors explain this disconnect between economic importance and the focus of economic debate.

The first is that while minor rate changes matter little to consumers and businesses, correctly anticipating them matters a lot to many asset managers, macro hedge funds, investment banks and their investor clients. Central bank-watching is, therefore, a preoccupation for many professional economists. Central bank announcements, with their ability to move markets and the drama of expectations confirmed or disappointed, also create a media buzz.

For financial investors “mixed messages” from central bank governors can turn potential speculative gains into embarrassing losses. When a member of the UK House of Commons Treasury select committee accused BoE governor Mark Carney of being like an “unreliable boyfriend”, it made for good headlines. But, in an era of structurally low interest rates, uncertainty about the timing of small future changes is just not that important.

Monetary easing can have a significant stimulative effect if interest rate changes drive currency depreciation. But that is a zero-sum game. US president Donald Trump wants a weak dollar, while China is allowing the renminbi to depreciate to offset the impact of his tariffs. No exchange rate policy can stimulate both economies.

The second factor is the fear of what follows if monetary policy has become powerless; for either we can then do nothing to offset potential recessions or fiscal policy must take the strain.

But higher fiscal deficits mean rising public debt, unless they are financed with central bank money, and the latter seems to threaten central bank independence. So, for fear of finding something worse, central bankers cling to the hope that some sophisticated wrinkle of monetary policy will at last be effective.

However, large fiscal deficits and forms of monetary finance are already major drivers of global growth. In the spring of 2016, there were fears that central banks were “out of ammunition”. But, triggered by the Trump administration’s 2017 tax cuts, the US fiscal deficit has risen to today’s 4.5 per cent of gross domestic product.

China’s fiscal deficit has grown from 2.8 per cent of GDP in 2015 to 6 per cent in 2019, with some of this financed by People’s Bank of China lending to state-owned banks to buy public bonds. Japan has run large deficits for a decade, fully matched by Bank of Japan purchases of government bonds, which will never be sold back to the private sector. And while Germany has stuck to the path of fiscal rectitude, its growth has relied on exports to these profligate rule breakers.

It is the eurozone that now faces the greatest danger. The Fed’s funds rate is now at 2-2.25 per cent, so the US can still cut by enough to make some difference — and if the economy continues to slow, the Trump administration will unleash increased spending or further tax cuts.

Meanwhile, China and Japan will continue to run large fiscal deficits indirectly financed by their central banks. For the UK, as a smaller economy, exchange rate depreciation is a more powerful option than elsewhere.

But if global demand and eurozone exports remain subdued — and hardliners continue to block a European version of fiscal relaxation lubricated by central bank government bond purchases — there is no feasible action the ECB can take that will make more than a trivial difference to eurozone growth.

The truth is that, acting alone, central bankers are no longer that important.


The writer is a former head of the UK Financial Services Authority


What a Recession Would Mean for Brazil

The country’s recent economic figures aren’t inspiring much hope that it will return to high growth rates.

By Allison Fedirka

 
It’s easy to see why the estimates are so pessimistic; the country’s economic activity index – seen as an indicator of growth – declined by 0.13 percent in the second quarter, and the economy contracted by 0.2 percent in the first. Another consecutive quarter of contraction would put the country in a technical recession.
Either way, the Brazilian economy is clearly struggling, and the government appears to be preparing for the worst, introducing stimulus measures to try to boost growth.
 
Slow and Painful
Brazil’s modest recovery from its two-year recession has been slow and painful. Since 2017, the government has adhered to budget spending caps and has slashed spending on social programs. Unemployment reached 12.7 percent in the first quarter of this year, and though it has since fallen to 12 percent, it remains well above pre-recession levels, and an additional 28.5 million Brazilians (25 percent of the working-age population) are considered underemployed.
Productivity has dropped as more people settle for informal work or leave the workforce altogether. Research from the Brazilian Institute of Economics found that labor productivity fell 1.1 percent in the first quarter of this year, led by declines in the manufacturing and services sectors.
The deceleration is even more stark when compared to the 2.8 percent increase in productivity in the last quarter of 2018. Real income has also declined throughout the year. In May, the average household monthly real income was 2,280 reals ($560), down 1.5 percent from the previous quarter.

To address these issues, the government of President Jair Bolsonaro has made structural reforms a top priority. The cornerstone of the reforms has been changes to the pension system – including an increase in the retirement age – through which the government hopes to save $800 billion to $900 billion over the next 10 years.
According to the Bolsonaro administration, spending on social security and other social assistance programs in Brazil ranks among the highest in the world, and it’s becoming a bigger burden as the Brazilian population ages and its growth rate declines.
 
 
The government’s structural reforms also include privatization efforts to reduce support of unprofitable companies and public sector presence in the economy. In agriculture, the government has moved away from subsidizing production in favor of new and larger lines of credit for farmers. There are also proposals for modifying labor laws to generate more jobs. It’s hoped that deregulation will make it easier for companies to do business in the country and, therefore, attract more private investment at a time when the government’s own ability to stimulate the economy through spending is limited. To that end, the government has introduced the Direct Investment Ombudsman, whose purpose it is to support foreign investors with general inquiries and questions over legislation and administrative procedures related to investing in Brazil.

Several factors, however, have complicated these reform efforts. Passing social security changes is challenging in any country, but it is especially so in a country as diverse and divided as Brazil. Brazil’s lower house has approved the pension reform bill, but the Senate has yet to vote on it. And as economic growth has stalled, the government has had to repeatedly cut back spending to meet the self-imposed spending cap. It froze $2.2 billion in spending in late May and another $2.3 billion in late July. Despite these cutbacks, the government is at risk of exceeding its budget deficit target of 139 billion reals for the year because of lower-than-expected revenue. It has worked with state-level governments, which are also struggling financially, to harmonize national and state plans and avoid state bankruptcies.
 
 
The U.S.-China trade war is also partly to blame. Exporters and major industries across Brazil delayed or reduced (by hundreds of millions of dollars) investment plans because of the trade war, and there’s growing concern that, as the war escalates, Brazil’s window of opportunity for recovery will narrow.

Meanwhile, the country’s third-largest trade partner – Argentina – is in the middle of a recession, which has naturally hurt bilateral trade. Argentine purchases of Brazilian products fell 41.7 percent to $5.3 billion in the first half of 2019. This has significantly affected Brazil’s automotive industry, and it’s a major reason that Brazil’s manufacturing sector has struggled over the past two years.
 
Introducing Stimulus
The government has therefore introduced some economic stimulus measures. Though it initially wanted to hold off on a major stimulus package until after the reforms were implemented, the government believed it could no longer wait to try to encourage spending. In July, the government loosened rules over when and how workers can access their FGTS retirement accounts. (Previously, these funds could be accessed only in case of retirement, severe illness or to purchase a home.)

The measure is expected to inject up to 42 billion reals into the economy by 2020. Another 21 billion reals were made available through another social welfare fund, but only 2 billion reals are expected to be redeemed. This month, the government also announced plans to reduce the financing rate by as much as half for home buyers. For its part, the central bank said that, for the first time in 10 years, it would sell dollars on the spot currency market because of increased demand for liquidity – a move previous administrations were very reluctant to allow for fear of draining its foreign reserves.
 
 
The government has tried to encourage trade to supplement weak domestic demand. In the past, domestic demand has been a major driver of the Brazilian economy, while exports have accounted for only 15 percent of GDP. But after two years of recession and a weak recovery, domestic demand has slipped, and there’s an increasing need to look to foreign consumers.

But Brazil’s top three export destinations – China (27.6 percent), the U.S. (13.4 percent) and Argentina (4.7 percent) – are all showing signs of downturn. This explains in part why Brazil has worked to loosen trade restrictions within Mercosur – the South American trade bloc consisting of Brazil, Argentina, Uruguay and Paraguay – and why, after 20 years of negotiations, Brazil helped push through a free trade agreement between the European Union and Mercosur. The agreement hasn’t been ratified yet, but Brazil is already pursuing free trade agreements with other partners, including the United States and South Korea, and it reached a trade deal with Mexico on light vehicles, subject to a 40 percent regional content requirement, after six years of talks.

The government introduced several measures to try to recover from its last recession – measures that are now being used to stave off another downturn. It finds itself in the same position as many other major economies trying to avoid recessions of their own. More changes – including another possible stimulus package – may be on the way, and with an interest rate at 6 percent, there’s room for maneuver on monetary policy, too. 

But whether these steps are successful in preventing another major downturn remains to be seen.

The Biggest Migration Since the Barbarian Invasions of Rome

by Doug Casey



International Man: Former Libyan leader Muammar Ghaddafi once warned that "Europe runs the risk of turning black from illegal immigration… it could turn into Africa."

Since the United States and NATO helped overthrow Ghaddafi in 2011, millions of migrants from Africa and the Middle East have poured into Europe. Many transited from Libya.

This is all well known, and all signs point to this trend accelerating. What’s your take on where this is going?

Doug Casey: First, it’s a pity Ghaddafi was taken out. Another disastrous US policy decision.

Not that he was a nice guy—no one running an artificially constructed nation-state can be. But it was at least a stable situation. Now it’s been replaced by a bloody and costly war. And it’s complete chaos. Nice work Hillary and Obama. But let’s talk about Africa at large.

Africa, or at least migration in and out of Africa, is going to be the epicenter of what’s happening in the world for the rest of this century.

Africa has gone from being just an empty space on the map in the 19th century, to a bunch of backwater colonies in the 20th century, to a bunch of chaotic failed states that most people are only vaguely aware of today. Soon, however, it will be continuing front-page news. This is because Chinese are moving to Africa in record numbers while Africans are leaving as fast as they can.

What we’re looking at is actually the biggest migration since the barbarian invasions of the Roman Empire. There will be tens of millions—scores of millions—of Africans trying to get into Europe. I don’t know how the Europeans will keep them out. I used to say Europe was going to be a petting zoo for the Chinese, but it may be more of a squatter’s camp for the Africans.

Africa is the only part of the world where the population is still growing and growing rapidly.

Africa south of the Sahara was about 6% of the world’s population in the ’50s, now it’s about 16%. But by the turn of the century, it’s going to be 45%. Assuming there isn’t some kind of catastrophe. It’s not clear that the Africans can grow enough food for billions more people.

In fact, if the West stops supporting the continent with capital and technology, it could be in for very tough times. Wakanda, the country in "Black Panther", doesn’t exist. On the contrary, the continent is full of Gondwana lookalikes. Gondwana is where most of the action takes place in Speculator, the novel John Hunt and I wrote. It’s the first of seven in the High Ground series.

Few people realize how fast the population is growing, and things are changing in Africa. I ask knowledgeable people what they think the biggest cities in the world will be at the turn of the next century. They all guess cities in China or India.

But that’s not true. Eighty years from now, Lagos, Nigeria, will be the largest city in the world.

It’s on track to have a population of more than 90 million. The world’s second biggest city will be Kinshasa in the Congo with about 80 million people. Dar es Salaam, Tanzania, will be the world’s third biggest city with a population of roughly 75 million people. It’s quite amazing.

When I first visited Dar in the early ’80s, it was a quiet, exotic seaport with old tramp steamers in the harbor.

Now all those people have cell phones, and they’re well aware of the fact that the standard of living is vastly higher in Europe and every other part of the world than in Africa. And they’re well aware of the fact that there are welfare benefits of all types if they can get to Europe.

There are hundreds of NGOs encouraging Africans to come across the Mediterranean to Europe. Or for that matter, flying them to the US. Exactly who paid the airfare and legal and living expenses of the 200,000 penniless Somalis who were transplanted to Minnesota?

It’s a growing tidal wave. With the European population diminishing and the African population growing, you’re going to see Europe basically taken over by Africa in the next several generations.

International Man: What we don’t hear as much about is the massive migration of the Chinese to Africa that’s taking place.

Doug, you’ve spent a lot of time in Africa. What’s going on with all this?

Doug Casey: We’re seeing a veritable recolonization of Africa. Each time I visit Africa, there are more Chinese. It doesn’t matter which country; they’re everywhere.

Rich Chinese are smart to diversify to developed Western countries. Poor Chinese go to backward countries to try to become wealthy. Africa is the prime recipient.

It’s supposed to be official Chinese policy to migrate about 300 million Chinese to Africa in the years to come. They’re employed in building roads, railroads, ports, mines, and other infrastructure. It’s partially driven by their Belt and Road Initiative.

The Chinese are lending billions to African governments. African governments are, by an order of magnitude, the most corrupt in the world. And the people who run these African governments are being well compensated for making deals with the Chinese. And in effect, selling out their countrymen. All these governments are full of people trying to be "Mister 10%."

The worst case for them is to retire as centimillionaires, to live high off the hog in France or Switzerland. So, they’ve got nothing to lose. It’s a fairly unstoppable trend at this point.

Regardless of how much is stolen, however, I expect the Chinese are going to want the money they loaned to the Africans back, with interest.

If bribing or intimidating political leaders proves ineffective in getting it back, it’s possible that they’ll put soldiers’ boots on the ground. They could send in the People’s Liberation Army (PLA) to defend their assets. Or send in assassins to take out recalcitrant African politicians.

I wouldn’t be surprised to find the PLA in Africa in the years to come, physically collecting on those debts. And to make it easier for them, they’re going to be greeted by lots of Chinese already there.

It will be interesting to see what happens when a couple hundred million Chinese are living with a radically expanding native African population.

If the Africans were unhappy with European colonization, I think they’re going to be very, very unhappy with the Chinese colonization. The Chinese will not be "inclusive" and PC like today’s Westerners. It has the makings of a race war a generation or so in the future.

International Man: What about Africa piques the interests of the Chinese?

Doug Casey: It’s important to remember that Africa doesn’t produce anything besides raw materials—and people. There’s close to zero manufacturing—like 1% of the world’s total—in sub-Saharan Africa. And almost all of that is in South Africa.

The Chinese see Africans as no more than a cheap and dispensable labor source. That’s at best. Other than that, they’re viewed as a complete nuisance. Basically an obstacle—a cost—standing in the way of efficient use of the resources of the continent itself.

What do the Chinese people think of Africans? They don’t hold them in high regard. Of course, you’ve got to remember that China has viewed itself as the center of the world since Day One.

They see all non-Han people as barbarians, as inferiors.

That was absolutely true when the British sent an ambassador, Macartney, to open relations at the very end of the 18th century. He was treated with borderline contempt—pretty much the way Europeans and Americans have treated primitive peoples since the days of Columbus.

It’s actually the normal human attitude when an advanced culture encounters a backward culture. The Chinese see their culture as superior to even that of the West and believe—probably correctly—that they’ll soon be economically and technologically superior as well.

International Man: If China comes to dominate Africa and its resources, what does that mean for its rivalry with the US?

Doug Casey: Well, the US government is basically bankrupt at this point. The only thing that the US exports in quantity is US dollars. And sometime soon, the Chinese, the Russians, the Malaysians, the Iranians, and the Indians, among others, won’t need or want US dollars. They don’t want to accept them now, because it’s an asset of their adversary or even their enemy.

They’re unhappy about having to settle accounts in dollars that all have to clear through New York.

So, they’re going to come up with their own alternative. And I suspect they’re going to use gold.

Why? Because they don’t trust each other’s paper currencies. And why should they?

How’s the United States going to react to that?

It’s going to be left out in the cold. No one needs or wants their dollars—they want and need real goods, not the paper obligations of a hostile, unpredictable, bankrupt government. Also, the US isn’t in a position to export people, except for some unwelcome soldiers. The Chinese are in an excellent position to export a couple hundred million spare people. The bottom line is that the Chinese are going to take over Africa financially, and they’re going to take it over demographically as well.

International Man: What kind of speculative opportunities do you think this trend will create?

Doug Casey: Well, I’ve often said that if I were 30 years old today and wanted to make my fortune, I would definitely go to Africa. The reason for that is that you don’t want to be on a level playing field. You want to be on a field tilted in your direction as much as possible.

If a young Westerner goes to Africa and travels around, he’ll find it quite easy to move with the top levels of society. Because he’s unusual. And people are interested in things that are unusual.

The fact that you’re a Westerner means that you’ve probably associated with people who have much more money, much more sophistication, much more knowledge than any of the locals do.

You have unique advantages in Africa. If a young Westerner stays at home, however, he has no marginal advantages.

It’s very hard to vault yourself to the top in a Western society, because there are tens of millions of people just like you with the same education, background, and abilities.

But in Africa, you’re automatically on the top of the heap. And you’re noticeable. So, it’s a great place to go for entrepreneurial reasons.

At the same time, I don’t think Africa is a place to invest unless you’ve got the PLA standing behind you. It’s a place for a hit-and-run type of entrepreneurialism. Or perhaps political entrepreneurialism.

As corrupt as Africa is, the way almost everybody makes money is by getting hooked up with the government. And that’s possible to do. You could go to any number of African countries, hang out there for a month, and be sitting down with the president.

That’s not going to happen if you try to do the same thing in North America or Europe or for that matter even South America or Asia.

International Man: If you were 30 years old and looking for opportunity in Africa, what countries in particular would you be most interested in?

Doug Casey: Well, I wouldn’t jump off the deep end at first. Don’t go to a place like Nigeria to start. Nor is South Africa ideal for this purpose. It’s too developed, and there are too many people of European descent—although that’s changing. White people are making what the Rhodesians called "the chicken run" and for the same reasons. There’s too much anti-white racism in South Africa, and besides, the economy is going into reverse.

I would go to a country like Namibia, which is large, empty, and pretty mellow. I would definitely look at Mozambique. Or Mauritania—a huge country, where nobody goes. São Tomé and Príncipe, an obscure island country off the west coast. If you’re adventurous, the Central African Republic, which is probably the most backward country in Africa.

International Man: Thank you for your insights Doug.

The Real Cost of Trump’s Trade Wars

Economic analysis suggests that bilateral trade wars are unwinnable in an interconnected world. By firing his latest tariff salvo against China, US President Donald Trump has further raised the stakes in an increasingly damaging dispute – and America is likely to emerge as the bigger loser.

Daniel Gros

gros125_GettyImages_yuanoverlayingdollar


BRUSSELS – For a while at least, trade tensions between the United States and China seemed to have settled into a “new normal.” After both countries imposed high tariffs on a substantial proportion of each other’s goods, US President Donald Trump refrained from further escalation. But, following another inconclusive round of bilateral trade talks in Shanghai last week, Trump announced that the US will impose 10% tariffs on a further $300 billion worth of Chinese goods, effective September.

Should this new measure take effect, almost all US imports from China will be subject to tariffs. (The US already levies 25% tariffs on $250 billion worth of Chinese imports.) Although the US has also imposed non-tariff barriers in its trade war with China, reciprocal tariffs are the most visible component of the dispute – and are likely to hurt America more than China.

One way to compare the restrictiveness of countries’ trade policies is to look at their average tariff rates. For the US, this seems to paint a fairly reassuring picture. Before Trump took office, the average US tariff rate on industrial imports was about 2%, somewhat lower than that of China.

Even under Trump, this figure has (so far) not increased that much. Imports from China account for about one-quarter of all US imports, and the 25% tariff affects about one-half of imported Chinese goods. This implies that the average US import tariff has increased by about three percentage points, to 5% or so, which does not appear excessive.

But the average tariff is a misleading indicator. Economic theory suggests that tariffs have disproportionately negative effects on the welfare of consumers and producers. A doubling of a tariff, for example, will lead to more than double the welfare loss. A 25% tariff on a limited share of trade is thus much more serious than an average tariff of 3%.

Many countries have high import tariffs on a certain number of specific products, with a rate above 15% usually considered to be a “tariff peak.” But whereas these peaks apply to less than 1% of total imports for most industrialized countries, they cover a far larger share of US imports.

Moreover, Trump’s tariffs discriminate against China: the 25% tariff is paid only by Chinese producers, not by their European, Latin American, or Asian competitors. Such a country-specific tariff is equivalent to levying a general tariff on all imports while providing a production subsidy for competing producers outside China – with this subsidy paid by US consumers in the form of higher prices.

Because non-Chinese producers can raise their prices by up to 25% and still remain competitive in the US, prices for American consumers are likely to increase on a wide range of goods. The indirect effect of Trump’s China tariffs on consumer prices is therefore likely to be much greater than the recent estimate of a direct impact of only 0.1%. These indirect harmful consequences of country-specific tariffs are the main reason why the “most favored nation” principle has long been a cornerstone of the global trading system.

Moreover, preliminary studies suggest that Chinese producers have not significantly lowered their prices as a result of Trump’s tariffs. And even if they did, the small gain to US consumers from lower Chinese prices would likely be far outweighed by higher prices on competing imports diverted to the US market by Trump’s country-specific tariffs.

Although China previously imposed a reciprocal 25% tariff on many of its imports from the US, the negative impact on the Chinese economy is likely to be limited because US goods account for less than one-tenth of China’s overall imports. Chinese retaliatory tariffs thus have a small impact on the Chinese economy. And China has actually lowered tariffs on its imports from the rest of the world.

Moreover, a large share of China’s imports from the US consists of agricultural commodities such as soybeans, which the country could easily import at a similar price from Brazil if necessary. The US would then presumably export more soybeans to markets formerly served by Brazilian producers, including in Europe. (This would reduce America’s trade deficit with Europe and might ease US pressure on the European Union in that regard.)

The US has also ratcheted up non-tariff barriers as part of its aggressive trade policy toward China. Most notably, Trump has put Chinese tech giant Huawei on the list of entities to which US firms are forbidden to sell American products. True, Trump has also said that for the time being, US suppliers should obtain the necessary licenses to continue to supply Huawei. But from now on, US technology companies will clearly think twice before entering long-term contracts with Huawei or other prominent Chinese firms that might be at risk of being included on the “entities list.”

In parallel, China’s government and businesses will redouble their efforts to become independent from the US in sourcing key technological components. The mere threat of the entities list will henceforth act as a significant hidden barrier to US-China trade. And because this barrier is also discriminatory (directed only at China), it will have the same high costs as country-specific tariffs.

Economic analysis suggests that bilateral trade wars are unwinnable in an interconnected world. By firing his latest tariff salvo against China, Trump has further raised the stakes in an increasingly damaging dispute. And America is likely to emerge as the bigger loser.


Daniel Gros is Director of the Centre for European Policy Studies.


Mark It Zero

by: The Heisenberg


Summary
 
- Friday was a wild ride, and it continued after the closing bell on Wall Street.

- Investors are now left to ponder both the short- and longer-term consequences of the latest Fed and trade drama.

- Here are some thoughts on what happens next both for markets and for policy.
 

After the closing bell sounded on the fourth consecutive week of losses for the S&P, President Trump responded to China's retaliatory tariffs.
 
The tariff rate on the $250 billion in Chinese goods which were taxed at 10% from September 24, 2018, and from 25% after the White House abandoned the Buenos Aires truce in May, will be taxed at 30% starting on October 1. Additionally, the tariff rate on the $300 billion in Chinese goods which were set to be taxed from September 1 and December 15 (Trump delayed duties on some items in an effort to avoid hurting US consumers ahead of the holiday shopping season) will be 15% instead of 10%.
 
Delaying the announcement until after the close on Wall Street was clearly an effort to avoid triggering further losses. The S&P fell more than 2.5% on the final day of the week.
 
The worst, second-worst and third-worst days of 2019 for US equities have all come in August.
 
Here's an updated version of the annotated August chart which documents all of the relevant twists and turns.
 
(Heisenberg)
 
 
If you, like everyone else, are wondering what comes next, the first thing you'll want to watch in the new week is the yuan. China on Saturday "strongly objected" to Trump's Friday afternoon tariff hike, and the yuan was already on the back foot following the President's tweets.
 
You can expect the offshore yuan to test its all-time low of 7.14. The daily fix will be scrutinized for signs that Beijing is either trying to calm things down, or send another message Washington's way.
(Heisenberg)
 
 
Obviously, any indication that Beijing is willing to let the currency absorb more of the tariff pressure would ostensibly be bearish for risk assets, but it's worth noting that last week brought the first ever revamped loan prime rate print (the "new" LPR), which marked the culmination of China's efforts to reform their two-track interest rate system.
 
Long story short, on the 20th of each month, China will publish the rate (there's a one-year tenor and five-year), which is set based on submissions from banks, which quote the new LPR in basis points on top of the medium-term lending facility ("MLF" for short). So, mathematically, cutting MLF rates will bring down LPR, all else equal. The point: Beijing may well cut open market operation rates soon thereby tipping a lower LPR in late September, and that option could substitute for weaker yuan fixes.
 
From a bigger picture perspective, what happened on Friday increases the odds that the Fed will ultimately cut rates to zero (or close).
 
As documented here, Jerome Powell's Jackson Hole speech was replete with references to the darkening global growth outlook and to geopolitical turmoil. On top of that, Powell alluded to the flatter Phillips curve, a nod to the purported safety of running the labor market (and the economy more generally) hot without risking a dangerous spike in inflation. The Fed chair also said, quote, "a lower r* combined with low inflation means that interest rates will run, on average, significantly closer to their effective lower bound." That's pretty explicit in terms of validating bets for a lower short-rate.
 
What you want to keep in mind here is that the longer the US economy holds up in the face of a deteriorating global backdrop, the bigger the risk of importing disinflation due to a persistently stronger dollar. I've talked about this in these pages before, but it's even more relevant after Friday.

One of the reasons the market is pricing in sharply lower rates in the US is arguably that some believe the Fed will have to cut aggressively even if there's not a recession, because if they don't, the imported disinflation from a strong dollar will eventually cause a downturn anyway. The whole thing has a certain deterministic feel to it, which President Trump seems to have picked up on.
 
The trade war is exacerbating the situation by imperiling the global growth outlook, thereby compelling foreign central banks to cut rates and lean ever more dovish. Meanwhile, the US economy is still hanging in there, having run out ahead in 2018 thanks in part to the tax cuts and fiscal stimulus. It's hard for the Fed to justify aggressive rate cuts when the US consumer is still spending, the labor market is still healthy and the jury is still out on whether the manufacturing sector is going to roll over in earnest or not. So, you're left with both an economic and a monetary policy divergence, with the former feeding into the latter and the trade war exacerbating both.
 
Clearly, the trade tensions have now worsened, which sets the stage for more lackluster data abroad, more accommodation from foreign central banks and, all else equal, a stronger dollar, which risks imported disinflation.
 
So, why did the dollar dip on Friday? Well, because President Trump's tweets were seen as materially raising the odds of outright, active FX intervention by Steve Mnuchin's Treasury. To be clear, Treasury doesn't have very much ammunition in that regard. The Exchange Stabilization Fund is small in absolute terms and tiny compared to the FX market. Here are the technical details of how Mnuchin can effectively marshal the entire $94 billion in the ESF (from a Barclays note):

 
The ESF’s actual intervention power is often understated, but even at its maximum extent, it remains tiny relative to the ‘very, very large, liquid markets’ of FX, in the words of Mr. Mnuchin.

While the ESF’s dollar holdings total only $22.6 billion, it has the ability to issue ‘SDR Certificates’ equal in value to its SDR allocations to the Federal Reserve in exchange for USD.

Additionally, it can ‘warehouse’ its euro and yen holdings with the Fed through an FX swap, but requires Fed FOMC authorization to do so. The outstanding FOMC authorization for warehousing currently stands at $5 billion, but in the past the FOMC has authorized as much as $20 billion. However, even assuming warehousing of all the ESF’s euro and yen assets, its $94.6 billion in total assets would represent just 2% of average daily FX transactions involving USD.

The Fed would be compelled to match that. In other words, the Fed, in keeping with historical precedent, would likely double Mnuchin's firepower to roughly $180 billion. Some on the FOMC would doubtlessly dissent against any such move. After all, there were two dissents last month on a 25 bps rate cut, so one can only imagine what the reaction would be if Powell came to his colleagues with a tacit mandate from Mnuchin to conjure up $90 billion for the purposes of helping the White House drive down the dollar. But, in theory anyway, Powell has unlimited ammunition. Here's Barclays one more time:
Were the FOMC fully on board with an effort to depress the exchange value of the dollar, because the Fed has the ability to create dollars by fiat, it could sell unlimited quantities. This would almost certainly require complete politicization of the Fed — a rising concern of market participants following the nominations of Stephen Moore and Herman Cain as Governors — but even then would not be the most likely outcome. As noted before, President Trump appears to see too-tight Fed policy as the primary source of excess USD strength, hence easing monetary policy would be a more straightforward action from a politicized Fed (and one that would attract less Congressional scrutiny).
The point in all of this isn't to suggest that unilateral intervention would be successful. It almost surely wouldn't. Historically, interventions were coordinated affairs, but nobody is going to coordinate with Trump in an effort to undercut their own exports by helping push down the dollar in the face of tariffs. Rather, the point is to say that on days like Friday when the President's pronouncements come across as particularly irritated and thereby foreboding, it stokes concerns about the volatility which would invariably accompany an intervention, and those concerns manifested themselves in the dollar falling against G-10 peers.
 
(Heisenberg)
 
As alluded to in the latter passage from Barclays, the far more likely scenario when it comes to the dollar "problem" is that the Fed ultimately cuts rates to the effective lower bound.
 
Powell's speech provided a series of justifications for starting down that road, although clearly, President Trump did not read between the lines or bother trying to decipher the nuance.
 
Deutsche Bank's Stuart Sparks summed the situation up in a note out Friday afternoon. Here is a brief passage from the executive summary:
Powell enumerated slower global growth, trade policy uncertainty, and muted inflation as key risk factors for the policy formation process, noted the effects of a flat Phillips curve, and reiterated previous Fed comments that “a lower r* combined with low inflation means that interest rates will run, on average, significantly closer to their effective lower bound”. Taken together, these can be seen as validating market pricing for aggressive further Fed easing. China's announcement of additional tariffs on US imports, and President Trump’s response, have provided a catalyst for still more aggressive Fed pricing, and Powell’s statement can be seen as establishing the basis for an ultimate move to zero policy rates.
 
Assuming the dollar doesn't suddenly roll over and sustain a drop (unlikely barring an abrupt deterioration in the US economic data or concrete signs that Mnuchin is set to intervene), the Fed will find itself forced to cut rates further and faster, or risk a disinflationary FX shock that would further undermine the central bank's ability to fulfill its price mandate.
 
Of course, the Fed can wait and hope that the environment shifts. A sudden inflection for the better in the data abroad, a series of dour data points on the home front or, potentially, a lasting trade truce that helps stabilize the global growth outlook thereby removing some of the pressure for the FOMC's counterparts abroad to ease, could potentially take some of the pressure off when it comes to dollar strength.

But waiting around risks falling even further behind and having to catch up by rapidly cutting rates, something Deutsche's Sparks underscores in his exposition on the subject.
 
Ultimately, it's hard to see how the Fed doesn't end up back near zero one way or another.
 
The worry is that all of this competitive easing (i.e., the "race to the bottom") will come to naught, as the tit-for-tat rate cuts and monetary accommodation offset each other in the FX space, while further distorting fixed income markets along the way, leaving everyone with negative rates and no ammunition to deploy in the event of another acute economic crisis.
 
And with that, I'll leave you with one final chart (this one from BofA) which shows that, to quote the bank, "a quarter of the world, in GDP terms, is now subject to negative central bank rates and a fifth of the world is now living with negative 10-year yields."
 

(BofA)

The euro must prepare for future shocks

Monetary policy is not enough on its own — fiscal co-ordination is essential

Laurence Boone


Eurozone finance ministers at the Eurogroup Finance Ministers' meeting in Brussels last December © EPA


For the past year, the OECD has been warning about the accumulation of risks and uncertainty that undermines investment and the world economic outlook. Its 2019 global growth projections fell from 3.7 per cent in September 2018 to 3.2 per cent in the latest forecast in May, well below the growth rates seen over the past three decades.

The summer is providing little respite amid heightened trade tensions, the possibility of a no-deal Brexit and renewed market volatility. Brexit alone illustrates the magnitude of these risks: if the UK were to start trading with the EU on World Trade Organization rules, gross domestic product in the remaining EU27 area would contract by around three-quarters of 1 per cent over a few years, with steeper declines in some countries and individual sectors.

In such a challenging environment, Europe will be in a stronger position if further progress is made on economic management across the bloc.

Speakers at the European Central Bank’s annual conference earlier this summer reviewed the first 20 years of the euro, judging it against benchmarks for outcomes, institutions and policymaking. The consensus view was that outcomes, in terms of the convergence of living standards, have been uneven. However, the eurozone has been strengthening its institutions and policy toolbox. Looking back in this way can help disentangle policy mistakes from institutional constraints. And it will make it easier to build political support for joint action across the eurozone in the future.

On the monetary side, the ECB has been impressive and continues to fight stubbornly low inflation. It was instrumental in lifting the eurozone out of the financial and sovereign debt crises, and fulfilled its role of lender of last resort, providing liquidity to banks.

Yet the central bank was not as quick to react to the slowdown in activity at the same time. It did not initiate quantitative easing, on top of larger liquidity support and negative interest rates, until March 2015. Why did it take so long for the ECB to start quantitative easing when growth was anaemic, inflation falling and other central banks had already increased their balance sheets? The US Federal Reserve, for example, started QE on a large scale five years earlier.

There were institutional reasons for the delay. It took time to forge a consensus amid legal uncertainty. And there were entrenched opposing views in the ECB’s governing council. There were also concerns about the asymmetry of the central bank’s mandate to ensure price stability.

Mario Draghi, the president of the ECB, addressed the question of asymmetry at a press conference in July, insisting that there was “no question” of accepting permanently lower inflation rates. But a firmer consensus on the governing council and policy support from the eurogroup of EU finance ministers, while respecting the independence of the ECB, would permit a swifter response to new developments.

It is on fiscal policy that support from the eurogroup will be most crucial. After a large synchronised stimulus in 2009, the fiscal stance reversed quickly. Tightening started much too early, while the output gap in the eurozone was still widening.

Adjustment measures were decided at the country level, ignoring cross-border spillovers. Since then, rules have been reformed but the lack of co-ordination remains.

Fiscal co-ordination is challenging and spillovers are difficult to measure. But there is little doubt that cross-border fiscal effects are significant in an integrated currency area such as the eurozone. In addition, political incentives are weak. Some member countries have been reluctant to respect the fiscal rules, while others have neglected the EU’s macroeconomic imbalance procedure. The combined effect has been to undermine incentives to co-ordinate policy.

However, looming threats to growth in the eurozone should encourage member states to put their differences aside and formalise greater fiscal co-ordination. This would boost confidence in the ability of the eurozone to deal with shocks and assume some of the burden currently borne by monetary policy.

External shocks could be caused by a no-deal Brexit (the likelihood of which is growing), or escalating trade and currency tensions. They would call for a co-ordinated fiscal response, parallel with monetary accommodation. The OECD’s estimates of the impact of these shocks show that individual countries will struggle to absorb them without such a package.

Over its first two decades, the euro has proved to be impressively resilient. The next few years will bring further tests. But they will also be an opportunity to improve the single currency’s governance structures, allowing the eurozone to make a more positive contribution to global economic and financial stability.


The writer is chief economist at the OECD

Locating Equality

For years, wealth and income inequalities have been rising within industrialized countries, kicking off a broader debate about technology and globalization. But at the heart of the issue is a fundamental good that has been driving social and economic inequality for centuries: real estate.

Harold James

james158_GettyImages_dollarcoinhousechimney


MUNICH – Inequality is the leading political and economic issue of the current era, yet debates about it have long suffered from a degree of imprecision. For example, the standard measure of inequality, the Gini coefficient, reduces a country’s entire income distribution to a single number between zero and one, and is thus highly abstract.

Similarly, while inequality is rising in many parts of the world, there is no simple correlation between that trend and social discontent or unrest. France is much less unequal than the United States, and yet it has similar or even greater levels of social polarization.

Today’s inequality debate effectively began in 2013 with the publication of French economist Thomas Piketty’s Capital in the Twenty-First Century, which found that the rate of return on capital tends to outpace the rate of growth, thereby causing inequality to increase over time. Specifically, appreciating real-estate values seem to be a fundamental driver of rising inequality. But here, too, one encounters a degree of imprecision. Real estate, after all, is not a homogenous good, because its value famously depends on “location, location, location.” There are elegant castles and palaces that now cost less than small apartments in major cities.

Wealth stirs the most controversy where it is most tangible, such as when physical spaces become status goods: the corner office is desirable precisely because others cannot have it. More broadly, as major cities have become magnets for a global elite, they have become increasingly unaffordable for office workers, policemen, teachers, nurses, and the like. While the latter must endure long, tiresome commutes, elites use global cities as they see fit, often hopping around from place to place. Large swaths of Paris and London are eerily shuttered at night. Manhattan now has nearly a quarter-million vacant apartments.

Whenever violence and revolution have consumed unequal societies, real estate has been a focus of discontent. In the later years of the Western Roman Empire, vast estates catered solely to an aristocratic elite. In a famous homily from this period, St. Ambrose of Milan, reflecting on the Old Testament story of Naboth’s vineyard, decries elites for making “every effort to drive the poor person out from his little plot and turn the needy out from the boundaries of his ancestral fields.”

Likewise, the French social historian Marc Ferro has demonstrated that many urban Russians were driven to the Bolsheviks in 1917 not out of ideological zeal, but because the old regime and the new constitutional parties had proved incapable of providing food and housing. Over the course of World War I, Petrograd had developed an enormous munitions industry, manned by peasant labor conscripted in the countryside and brought to the newly expanded factories. But production planners had neglected the question of where these workers would be housed, and in 1917, the worker committees (soviets) offered an answer: apartments would be confiscated from the aristocrats and bourgeoisie.

A similar pattern played out in other cities where rapid, unplanned wartime industrialization had occurred (Budapest, Munich, Turin). Today’s equivalents are the centers of the new economy, such as Silicon Valley and its high-tech imitators in Europe and Asia. These cities have produced many jobs, but they have utterly failed to accommodate the people who actually live there. As a result, even middle-class professionals are living in cars, vans, and trailers.

And this malaise is not limited to the global cities themselves. Support for Brexit in southeastern England owes something to the perception that London and its immediate surroundings have become unaffordable as a result of too much immigration, international financial activity, and tourism – in short, globalization.

Needless to say, the political response to the real-estate problem has so far been inadequate, even counterproductive. Some large European cities are introducing rent controls, despite the poor track record of such policies. When New York tried similar measures in the twentieth century, the open market dried up, and property was hoarded or traded at a premium on the black market. When the UK rolled out a fiscal subsidy for first-time homebuyers, home prices rose accordingly, offsetting any potential benefit.

Removing tax privileges – as the US did recently by imposing a $10,000 cap on the state- and local-tax deduction – is a slightly better approach. But it will not solve the fundamental problem of supply. Not surprisingly radical, even Bolshevik-style, proposals are making a reappearance. A popular initiative in Berlin, for example, would socialize the holdings of large-scale real-estate owners (those managing more than 3,000 apartments).

The obvious solution to the supply problem, of course, is to build more housing. But new construction can conflict with environmental protections and a city’s architectural heritage, and is often opposed by existing property owners, who do not want the value of their own property to fall.

Sometimes, new construction can create alternative urban magnets, such as when the Spanish city of Bilbao was transformed by the addition of a Frank Gehry-designed Guggenheim Museum. But many declining industrial cities have already tried this solution, and only a few have succeeded. Those that have failed are still run down, and now have the added burden of maintaining new arts infrastructure.

Eventually, the cities and urban areas that are driving the bulk of new wealth creation will provoke a counter-movement. If they price out or otherwise exclude those who earn less, they will have sacrificed the openness that made them attractive in the first place. So, if they want to survive and thrive in today’s egalitarian political climate, they will need to come up with bold solutions.

During a previous period of urban-based dynamism, in the early sixteenth century, rich merchant families built low-rent housing that was then allocated to the poor. One such project, the Fuggerei complex in Augsburg, Germany, still provides low-rent social housing to this day.

If enough such housing cannot be supplied, might a lottery allocation of public accommodation help to stem the encroaching homogeneity of today’s global cities? It is certainly worth a try.


Harold James is Professor of History and International Affairs at Princeton University and a senior fellow at the Center for International Governance Innovation. A specialist on German economic history and on globalization, he is a co-author of the new book The Euro and The Battle of Ideas, and the author of The Creation and Destruction of Value: The Globalization Cycle, Krupp: A History of the Legendary German Firm, and Making the European Monetary Union.