Why central bankers may be hurting rather than helping lenders

Cutting rates below zero distorts the market for banks and for investors

Huw van Steenis

The European Central Bank in Frankfurt © EPA-EFE

As central bankers weigh up cutting interest rates deeper into negative territory, investors should consider when the risks of this trend will begin to outweigh its benefits.

With almost $17tn of negative-yielding debt already out there, I fear we have already hit the reversal rate — the point at which accommodative monetary policy “reverses” its intended effect and becomes contractionary for the economy.

Conventional macroeconomic models typically take banks and other intermediaries for granted. As a result, the overall benefits of cutting rates below zero may have been exaggerated.

Like steroids, unconventional policy can be highly effective in short dosages, but just as long-term usage of steroids weakens bones, so below-zero rates can weaken the financial system.

Negative rates erode banks’ margins and distort their incentives. They encourage lenders to seek out opportunities overseas rather than in their home markets. They also risk disrupting bank funding.

All these effects run counter to the central banks’ desire to ease credit conditions and support financial stability. How policymakers assess where and when the reversal rate kicks in will be pivotal to how investors should weigh up different policy packages from the European Central Bank and others.

Japanese banks, and more recently their European counterparts, have illustrated some of the problems caused by cutting rates. Japan’s regional banks have among the lowest returns on assets of any around the world.

Larger banks have fared somewhat better, in part by lending more overseas. Japanese banks bought about a third of the higher-rated tranches of US collateralised loan obligations — investment vehicles that buy leveraged loans — in the past few years.

Quantitative easing programmes have helped the global economy and enabled banks to repair their balance sheets. Low rates have improved the affordability of their loans, reduced bad debts and lifted the value of assets.

Japanese banks have relied upon capital gains from owning government bonds to offset pressures on profitability. But increased ownership of bonds can become a dangerous dynamic, a phenomenon known as a “doom loop”, magnifying the effects of swings in prices.

Lower profitability also reduces the ability of banks to upgrade their technology and enhance cyber defences, storing up future risks to financial stability.

Suppressing bad debts in the eurozone via QE has been useful for the banks, but this has largely come from indirect benefits, such as by reducing the difference in yield between German and, for example, Italian bonds. If central bankers really want to help increase the flow of credit, then buying the banks’ own debt as part of QE, which is still a taboo for the ECB, may be a better option than cutting rates further.

One counterargument is that the impact of negative rates appears to have been fairly benign in Sweden, Denmark and Switzerland, through the tiering of rates, where only part of banks’ reserves at the central bank are penalised. While these measures help, they are no panacea.

Banks have sought to offset negative rates by charging higher fees, repricing mortgage spreads and, in some cases, lending more aggressively. The longer the experiment lasts, the more Danish and Swiss banks are having to pass on negative rates to clients.

These tiering schemes were explicitly designed as foreign exchange policies, to deter inflows and protect banks. The spillover effects via the currency need to be weighed carefully. Should the ECB follow the Danish model, it may inadvertently exacerbate investors’ trade war concerns.

Pension funds’ asset allocations are increasingly being distorted by negative rates, too. One of the most striking consequences has been to encourage investors out of Japanese and more recently European markets and into US credit and equities instead. The thirst for yield has led to a self-reinforcing bid for longer-dated bonds.

As most savers target a particular level of retirement income, the lower rates go the more they will need to save to hit their targets, reducing their ability to spend today.

Investors are no longer sure how low rates might go in a range of countries. As long as this uncertainty remains, it is hard for banks to know whether the loans they are making are economically sensible or for investors to price the securities of financial institutions with confidence.

The assumption of a world without financial friction has been a fundamental weakness in much macroeconomic analysis. Where the reversal rate may be, and how long companies can endure these conditions, should be central to the policy debate. Otherwise, central bankers could end up doing more harm than good.

Huw van Steenis is senior adviser to the chief executive of UBS.

Professor Charles Goodhart of the London School of Economics also contributed to this article.

The Saudi oil crisis, volatile leaders and the risk of escalation

All sides have an interest in compromise — but that does not mean it will happen

Gideon Rachman

© FT montage/Getty

For decades, any list of global geopolitical risks will have had “attack on Saudi oil facilities” near the top. Now it has happened.

The good news is that the world is less vulnerable to an oil price shock than it was in the 1970s, when the Opec oil embargo created turmoil in the global economy. It is also true that all of the major powers involved — Saudi Arabia, Iran and the US — have strong incentives to avoid an all-out conflict.

The bad news, however, is that the key decision makers in this particular drama — Donald Trump, the US president, Mohammed bin Salman, the crown prince of Saudi Arabia, and the leadership of Iran — are all headstrong and prone to taking risks.

It is likely that, if the US sticks to its claim that Iran was behind the attack, it will stage a military response. If and when that happens, there are no guarantees that the conflict will not escalate further. Given that the weekend attacks have already caused a 20 per cent spike in the price of oil, the potential for further mayhem on the markets is clear.

The importance of Gulf oil to the wider world has been imprinted on the collective memory of the west ever since Opec imposed an embargo in 1973. It caused oil prices to quadruple, doing serious damage to markets and the world economy. The lesson learnt — that stability of Gulf oil supplies is crucial to the world economy — helped drive the west’s ferocious response to Iraq’s invasion of Kuwait in 1990.

Almost 30 years after the first Gulf war, western economies are considerably less vulnerable than they were to disruption of oil supplies from the region. The rise of shale-oil production in the US means that American oil imports from Saudi Arabia are now just one-third of the level they were in 2003.

But less vulnerable does not mean invulnerable. There is still a global price for oil; and Saudi Arabia remains the world’s leading oil exporter. So if Saudi supply is disrupted, consumers and industries across the world will quickly feel the impact.

The vulnerability of Saudi oil facilities to attack has also just been demonstrated. If the attack was carried out by drones, as first reported, it is a shocking insight into how open advanced industrial facilities are to assault by cheap and widely available new technologies. The Saudis also have cause to worry about the safety of their water supplies. The kingdom gets around half of its drinking water from desalination facilities, one of which was targeted in a rocket attack last June.

Awareness of their vulnerability to further attack should make the Saudis wary of escalating the conflict. The kingdom’s social and political stability is also a factor; the ruling family has long fretted about the threat of internal unrest from their large Shia minority.

Despite massive military spending, Saudi Arabia has also been unable to prevail in a brutal war in Yemen — which is a much less intimidating proposition than Iran. So while the Saudis have been ardent supporters of the Trump administration’s policy of “maximum pressure” on Iran, they have minimal interest in an actual war.

Iran also has a strong interest in avoiding an all-out conflict, which would expose the country to the firepower of their well-armed Gulf neighbours and, above all, to attack from the US. In recent months, the Iranians have staged an array of provocations including seizing western oil tankers in the Gulf and (probably) encouraging its Houthi allies in Yemen to hit soft targets in Saudi Arabia.

But this kind of Iranian brinkmanship has been interpreted by most western Iran-watchers as an effort to demonstrate that Tehran is not powerless in the face of sanctions. The Iranians were also seen as attempting to gain leverage ahead of a possible resumption of talks with the US.

As for Mr Trump, despite his bellicose rhetoric, the US president’s most recent actions have shown that he is keen to make a diplomatic breakthrough with Iran. One important reason that Mr Trump fired John Bolton last week is that his former national security adviser was too hawkish and opposed suggestions that American sanctions on Iran should be eased in the interests of getting talks started.

So all sides have economic and strategic interests to step back from the brink. Unfortunately, all sides have also shown themselves to be erratic, emotional and prone to miscalculation.

Saudi Arabia’s Prince Mohammed has demonstrated his own propensity for violent miscalculation through his conduct of the Yemen war and by apparently authorising the gruesome murder of the journalist, Jamal Khashoggi. As for the Iranians, if they did indeed authorise an attack on Saudi oil facilities they have taken an enormous risk, with consequences they cannot control.

Mr Trump’s volatility has been amply demonstrated. The US president’s willingness to rip up the Iran nuclear deal — but then sack his most hawkish adviser on Iran — also does not inspire confidence that he knows what he is doing. It also means that the White House is entering what could be the biggest security crisis of the Trump years, with no national security adviser in place.

Ever since Mr Trump’s election in 2016, nervous observers have wondered how the president would behave in a real foreign policy crisis. We are about to find out.

A Dollar for Argentina

Argentines prefer to hold greenbacks. Why not bury the peso?

By The Editorial Board

Argentina is back in the soup, as it so often is. The prospect that Peronists might retake power has Argentines fleeing the peso for dollars, and on Monday the center-right government of PresidentMauricio Macriimposed capital controls. Here’s a better idea: Replace the peso with the U.S. dollar as Argentina’s legal tender.

The actual election is in October but the August primary victory of left-wing populists—presidential candidateAlberto Fernándezand his running mate, former presidentCristina Kirchner —has triggered a monetary panic. The demand for dollars has soared, the peso has fallen some 20% against the dollar, and central bank reserves are declining.  

President Macri has done nothing to shore up confidence. After the primary vote foreshadowed a likely defeat in his bid for a second term, he announced a gasoline price freeze, a minimum-wage hike and new subsidies for special interests. This Peronism-lite did nothing to restore government credibility.

Last week Argentina failed to roll over its maturing dollar-denominated debt, and candidate Fernández, who is promoting the impression of chaos, said the country is in “virtual default.” The capital controls will limit access to dollars for businesses and individuals. Exporters will be required to bring their hard-currency earnings back to Argentina.

Argentina needs access to capital markets but its history of stiffing creditors makes it high risk. EconomistSteve Hankerecently wrote in Forbes that Argentina had “major peso collapses” in 1876, 1890, 1914, 1930, 1952, 1958, 1967, 1975, 1985, 1989, 2001 and 2018. Each time Argentines have had their savings, earnings and purchasing power diminished.

Now the government is telling investors that if they put their money in Argentina, they can’t be certain they can take it out. This is sure to be a drag on growth. The economy is expected to contract this year and next.

Dollarizers face resistance from the Peronist party, which relies on the inflation tax to fund its populism when revenues run low. Yet demand for dollars suggests that Mr. Macri would have popular backing for adopting the greenback as the national currency. Lawyers in Argentina differ about the legality of dollarization under the Argentine constitution, but our sources believe Mr. Macri could dollarize with the backing of a majority in Congress.

Panama has used the dollar as legal tender since 1904, and El Salvador and Ecuador dollarized in 2000. Ecuador did it to resolve a banking crisis and El Salvador did it to bring down interest rates. El Salvador and Panama now have the lowest domestic borrowing rates in Latin America and the longest maturities. Ecuador has price stability not seen in at least a half century.

One objection to dollarization is that Argentina would lose the profits a central bank earns by printing its own currency, known as seigniorage. But this is a political excuse disguised as economics. What is lost in seigniorage will be more than offset by ending peso crises.

Setting the right exchange rate also matters. Several Argentine economists propose converting short-term government paper to longer-term bonds to reduce the number of pesos that need to be exchanged for dollars in the short run. But the best rate is probably the black-market rate where the peso now trades.

Dollarization eliminates the moral hazard that central-bank rescues encourage in the banking system; international capital markets become the lender of last resort. Another benefit is that it would be nearly impossible to reverse, unlike Argentina’s one-to-one convertibility law with the dollar of the 1990s, which politicians violated when they were back in hock in the early 2000s. Argentines also ought to have the right to keep their dollars abroad if they choose. This would alleviate the worry that the government might “corral” bank accounts as it did in 2001.

A Macri decision to dollarize would break this ugly cycle by giving Argentines a store of value and a medium of exchange they can rely on. It might not save his Presidency, but it would ensure a legacy for Mr. Macri as the leader who dared to defend Argentine savings from a marauding future government.

Dousing the Sovereignty Wildfire

In time, the current spat between French President Emmanuel Macron and his Brazilian counterpart Jair Bolsonaro regarding the Amazon rainforest may become a mere footnote. But other rows between collective and national interests are sure to erupt, and the world needs to find a way to manage them.

Jean Pisani-Ferry

pisaniferry101_Brent StirtonGetty Images_fire

PARIS – On the eve of the recent G7 summit in Biarritz, French President Emmanuel Macron described the Amazon rainforest as “the lungs of our planet.” And because the rainforest’s preservation matters for the whole world, Macron added, Brazilian President Jair Bolsonaro cannot be allowed “to destroy everything.” In reply, Bolsonaro accused Macron of instrumentalizing an “internal” Brazilian issue, and said that for the G7 to discuss the matter without the countries of the Amazon region present was evidence of a “misplaced colonialist mindset.”

The dispute has since escalated further, with Macron now threatening to block the recently concluded trade deal between the European Union and Mercosur, unless Brazil – the largest member of the Latin American trade bloc – does more to protect the forest.

The Macron-Bolsonaro dispute highlights the tension between two big recent trends: the increasing need for global collective action and the growing demand for national sovereignty. Further clashes between these two forces are inevitable, and whether or not they can be reconciled will determine the fate of our world.

Global commons are nothing new. International cooperation to fight contagious diseases and protect public health dates back to the early nineteenth century. But global collective action did not gain worldwide prominence until the turn of the millennium. The concept of “global public goods,” popularized by World Bank economists, was then applied to a broad range of issues, from climate preservation and biodiversity to financial stability and Internet security.

In the post-Cold War context, internationalists believed that global solutions could be agreed upon and implemented to tackle global challenges. Binding global agreements, or international law, would be implemented and enforced with the help of strong international institutions. The future, it seemed, belonged to global governance.

This proved to be an illusion. The institutional architecture of globalization failed to develop as advocates of global governance had hoped. Although the World Trade Organization was established in 1995, no other significant global body has seen the light since then (and the WTO itself does not have much power beyond arbitrating disputes). Plans for global institutions to oversee investment, competition, or the environment were shelved. And even before US President Donald Trump started questioning multilateralism, regional arrangements began restructuring international trade and global financial safety nets.

Instead of the advent of global governance, the world is witnessing the rise of economic nationalism. As Monica de Bolle and Jeromin Zettelmeyer of the Peterson Institute found in a systematic analysis of the platforms of 55 major political parties from G20 countries, emphasis on national sovereignty and rejection of multilateralism are widespread. When John Bolton, the current US national security adviser, wrote in 2000 that global governance was a threat to “Americanism,” many regarded the idea as a joke. Few are laughing now.

True, nationalism hasn’t won the war. Despite Brexit and the rise of far-right parties in Italy and other countries, the European Parliament election in May did not produce the feared populist landslide. Growing segments of public opinion simply want policymakers to address problems in the most effective way, including at European or global level if needed.

Nowadays, however, international collective action cannot be based on further universal treaty-based obligations. The question, then, is which alternative mechanisms can address global challenges effectively while minimizing encroachments on national sovereignty.

Some models are already at work internationally. On trade, for example, burgeoning “variable-geometry” groupings are tackling new issues related to “behind-the-border” regulations such as technical standards, and the blurring of the distinction between goods and services. Corporate giants’ global abuse of market power is being confronted by the extraterritorial rulings of national competition authorities.

Likewise, the effective strengthening of bank capital ratios resulted not from any international law, but from the voluntary adoption of common, non-binding standards. And although the world is lagging on climate-change mitigation, the 2015 Paris climate agreement has prompted several countries to act, including by mobilizing regional and city governments, and triggering private investment in clean technologies.

But because not all global problems are alike, such mechanisms will provide a suitable template for collective action only in certain cases. When the various players are willing to act, a modicum of transparency and trust-building is sufficient to ensure cooperation. In other cases, however, the temptation to free-ride or abstain can be countered only by powerful incentives or even sanctions.

That brings us back to the Amazon fires. The interests of Brazil and the international community are not aligned. For Brazil’s small farmers and big agri-food corporations, the economic value of the land matters considerably. But the rest of the world is mainly concerned with the rainforest’s ecological and biodiversity value.

Time horizons also differ: unsurprisingly, the wealthy in the Global North value the future more than the poor in the Global South do. Even if large segments of Brazilian society value the preservation of the rainforest, it is wishful thinking to believe that moral suasion and nudges alone will resolve differences between Brazil and its external partners.

In the case of the Amazon, the only hard instruments available are money and sanctions. Through the transfer of more than $1 billion to the Amazon Fund since 2008, Norway already subsidizes the preservation of the environmental service that the rainforest provides to the world (it interrupted transfers last month in protest against Bolsonaro’s policies). Macron’s alternative is to coerce Brazil into valuing the environment by making trade deals and other international agreements conditional upon the country managing its natural resources sustainably.

Both options are problematic. Payments open an enormous Pandora’s box, and reaching a significant scale requires an agreement on who will actually bear the burden: the annual social value of carbon capture by the Amazon rainforest is hundreds of times larger than the Norwegian transfers. Coercion is also tricky, because there is only an oblique logical relationship between deforestation and trade. But because there are no other options, solutions will probably have to involve some combination of the two.

In time, the Macron-Bolsonaro spat may become a mere footnote. But other disputes pitting global concerns against national sovereignty are sure to erupt, and the world needs to find a way to manage them.

Jean Pisani-Ferry, a professor at the Hertie School of Governance (Berlin) and Sciences Po (Paris), holds the Tommaso Padoa-Schioppa chair at the European University Institute and is a senior fellow at Bruegel, a Brussels-based think tank.

Jeremy Corbyn’s plan to rewrite the rules of the UK economy

The Labour leader’s proposals represent a fundamental redistribution of income and power in the UK

Jim Pickard and Robert Shrimsley

“They looked like they were meeting the Gremlins”, is how one of Labour’s Treasury team remembers a meeting with senior UK civil servants ahead of the 2017 election. Jeremy Corbyn’s party was yet to surge in the polls and expected to take a thorough beating. For the officials, required to meet the opposition ahead of an election, this was a matter of going through the motions.

Two years on with UK politics scrambled by Brexit, the landscape is unrecognisable. A Corbyn government is no longer a remote prospect.

Yet John McDonnell, Labour’s shadow chancellor and the man driving its economic strategy, has not forgotten the experience. It confirmed what he always assumed, that much of the civil service, like the rest of the British establishment, is instinctively inimical to the party’s agenda.

Treasury officials, he says, will be forced to learn “a wider range of economic theories”. If Mr Corbyn does indeed lead his party to power, they are not the only ones in for a lesson.

A Corbyn government promises a genuine revolution in the British economy. Labour’s leadership intends to pursue not only a fundamental change in ownership and tax but a systemic effort to embed reform in a way that future parties will struggle to unpick.

“We have to do what Thatcher did in reverse,” says Jon Lansman, founder of the Corbyn support group Momentum. “We have to take decisive steps to both achieve a significant redistribution and create a constituency of an awful lot of people with an obvious stake in a continuing Labour government.”

LONDON, ENGLAND - OCTOBER 11: Trains arrive at and depart from Clapham Junction Station during the morning rush hour on October 11, 2018 in London, England. The Office of Road and Rail released its annual report on UK rail finance today. Net government support of the rail industry totalled £6.4billion in 2017-18 (not including Network Rail loans). This was £601million higher than 2016-17. The government received a net contribution from the train operating companies of £223million compared with £776million in the previous 12 months. (Photo by Jack Taylor/Getty Images)
Labour has announced plans to nationalise rail, water, mail and electricity distribution companies, in addition to higher taxes on the rich © Getty

At the heart of everything is one word: redistribution. Redistribution of income, assets, ownership and power. The mission is to shift power from capital to labour, wresting control from shareholders, landlords and other vested interests and putting it in the hands of workers, consumers and tenants. “We have to rewrite the rules of our economy,” says Mr McDonnell. “Change is coming.”

David Willetts, a former Conservative cabinet minister who now chairs the Resolution Foundation think-tank, says Brexit has made it harder to paint Labour’s plans as risky. “Brexit is so radical and such a massive gamble, breaking a 40-year trading arrangement, that it’s hard for Tories to say to people ‘don’t gamble on Labour’,” says Lord Willetts. “They just think: ‘who’s the gambler?’”

Over the next week, the FT will be examining the impact of a prospective Corbyn government on the UK economy, exploring the intellectual underpinnings of Corbynism and examining the feasibility and price tag of the planned reforms.

Understandably, those who are doing well out of the existing arrangements are nervous. Matthew Fell, the CBI’s chief UK policy director, says: “The question on the lips of any international investor looking at the UK, is ‘what would a Labour government mean for the economy?’ From company ownership to taxation, they want to know that their investments will be safe.”
BIRMINGHAM, ENGLAND - NOVEMBER 23: An array of To Let signs adorn properties to rent in the Selly Oak area of Birmingham on November 23, 2016 in Birmingham, England. Chancellor of the Exchequer, Philip Hammond is due to deliver his autumn statement to MPs later today. It is expected that he will ban lettings agents in England from charging fees to tenants. Philip Hammond will say that shifting the cost to landlords will save 4.3 million households hundreds of pounds. (Photo by Christopher Furlong/Getty Images)
The shadow chancellor has set out plans to build 1m social homes and sharply increase the minimum wage © Getty

Mr McDonnell, the architect of the economic agenda, has been careful to avoid causing too many controversies. But even the plans already announced are breathtaking in scope: the nationalisation of rail, water, mail and electricity distribution companies; significantly higher taxes on the rich; the enforced transfer of 10 per cent of shares in every big company to workers; sweeping reform of tenant rights; and huge borrowing to fund public investment.

But this may be just the start. The leadership is also studying an array of even more radical ideas, including a four-day week, pay caps on executives, an end to City bonuses, a universal basic income, a “right to buy” for private tenants and a shake-up in the way that land is taxed to penalise wealthy landlords.

To supporters this is about fairness; about reorienting an economy that works for those at the top but not for the young, the unemployed or those struggling on zero-hours contracts.

To his opponents and those likely to be at the sharp end of such a programme — high-earners, business owners, investors and landlords, it is alarming. “Whenever we hold events I always ask, ‘what are you more worried about, a Corbyn government or a no-deal Brexit?’” says one business lobbyist. “Now the universal answer is Corbyn.” Terry Scuoler, former head of Make UK, the manufacturers’ organisation, has described the prospect of a Labour government as “nightmarish”.
The Labour Party's shadow Chancellor of the Exchequer John McDonnell speaks to party leader Jeremy Corbyn at the party's conference in Liverpool, Britain, September 24, 2018. REUTERS/Phil Noble - RC17CDB30800
Jeremy Corbyn, head of the Labour party, with John McDonnell, the shadow chancellor and man driving the party's economic strategy, © Reuters

It is not hard to understand their fears. Influential figures within the leadership now include former members drawn from various Trotskyite factions. The trade union Unite has a dominant role in the Labour leader’s inner circle. Mr Corbyn’s past opposition to Nato and the Trident nuclear deterrent and his onetime support for the Venezuelan regime continue to cause concern.

Already, the shadow chancellor has set out plans for £49bn of new taxes and extra spending a year, borrow £250bn to fund a National Investment Bank, nationalise a swath of utilities, rip up labour laws to help workers, build 1m social homes and sharply increase the minimum wage.

A central ambition for both the Labour leadership and its union backers is tilting the balance of power away from employers and back towards the workforce.

Where former prime minister Tony Blair accepted the Thatcherite consensus on union reform, the next Labour government would make it easier for unions to go on strike and extend full employee rights to all workers in the gig economy — such as sick pay, parental leave and protection against unfair dismissal. There are plans for workers on boards, and even staff votes for leaders of some companies. There would be a 20:1 executive pay cap for companies with government contracts.
LONDON, ENGLAND - APRIL 03: Former head of the Home Civil Service Lord Bob Kerslake speaks at a 'People's Vote' press conference on April 3, 2019 in London, England. Prime Minister Theresa May is due to meet Labour leader Jeremy Corbyn today in an attempt to agree a plan on Britain's future relationship with the EU and the withdrawal agreement. (Photo by Dan Kitwood/Getty Images)
Bob Kerslake believes Labour's manifesto pledges are 'radical' but can be delivered © Getty

Mr Corbyn has dropped plans for a “people’s QE” — printing money to pay for infrastructure — at least for now. But he would move the Bank of England from London to Birmingham and parts of the Treasury to Manchester.

There would be a host of tax rises, including higher income tax for those earning over £80,000, a new “excessive pay levy”, a £5bn-a-year financial transactions tax and a jump in corporation tax from 19p to 26p in the pound.

A recent report commissioned by the leadership, Land For The Many, suggested that the current exemption from capital gains tax enjoyed by millions of homeowners could be scrapped.

A man speaks on his phone as he walks past The Gherkin and other office buildings in the City of London, Britain November 13, 2018. REUTERS/Toby Melville - RC144545D070
Some Labour figures accuse the leader's team of not caring about the interests of the City of London © Reuters

Mr Corbyn’s Labour is a far cry from Mr Blair’s “New Labour” of 1997, which sought to convince voters of its moderation. “Back then people wanted to be reassured about things not changing too much,” says one close ally. “This time people do want change.”

The financial crisis created the opportunity the Corbynites were waiting for. Its aftermath reinforced the sense of a rigged system, establishing a direct link between the excesses of the financial services industry and the economic travails of ordinary citizens. The Labour leadership further believes the decade of low interest rates since the financial crisis has been to the benefit of speculators rather than ordinary workers.

Many executives have been pleasantly surprised by a series of meetings held with the besuited Mr McDonnell, who pledges to listen to their concerns. Labour has also benefited from the Brexit chaos, which has caused many businesspeople to re-evaluate the Conservative party’s reputation as the party of economic stability.

Yet some political analysts argue that the deceptively gentle demeanour of a longstanding Marxist should not be misinterpreted. “Change doesn’t come from people having tea at the Ritz. It comes from people storming the Ritz,” he said a few years ago.

For Labour, Brexit is also an opportunity. In his speech to the 2018 Labour conference: Mr McDonnell noted: “The greater the mess we inherit, the more radical we have to be.”

Cherie Blair looks on as her husband, Tony Blair, addresses the nation for the first time as Prime Minister in Downing Street. Labour ousted the Tories from 18 years of government with a landslide general election victory.
Tony Blair with wife Cherie. Mr Corbyn’s Labour is a far cry from Mr Blair’s 'New Labour' of 1997 © PA Archive/PA Images

It was at that same conference that Labour unveiled its most daring initiative to date: a plan to seize 10 per cent of the shares in every large company in the country — whether public, private or foreign-owned — and hand them to employees. In reality the workers would not entirely own the shares but would simply be eligible for up to £500 a year each in dividends, while the remainder would be taken by the exchequer.

Calculations by the FT and Clifford Chance can today reveal that the policy, called the “Inclusive Ownership Fund”, amounts to a £300bn raid on shareholders, albeit gradually over 10 years. “It’s the biggest stealth tax in history,” says one former member of Corbyn’s office.

Mr Corbyn and Mr McDonnell are also studying an array of other initiatives including: the break-up of the Big Four auditors; a ban on all share options and golden handshakes; curbs on the voting rights of short-term shareholders; and the public naming of all workers on over £150,000 a year. Companies that fail to meet environmental criteria could be delisted from the London Stock Exchange.
LONDON, ENGLAND - AUGUST 28: Pro-EU supporters protest on outside Downing Street on August 28, 2019 in London, England. British Prime Minister Boris Johnson has written to Cabinet colleagues telling them that his government has requested the Queen suspend parliament for longer than the usual conference season. Parliament will return for a new session with a Queen's Speech on 14 October 2019. Some Remain supporting MPs believe this move to be a ploy to hinder legislation preventing a No Deal Brexit. (Photo by Peter Summers/Getty Images)(Photo by Peter Summers/Getty Images)
Pro-EU supporters outside Downing Street recently. Labour's economic plans have been pout into perspective by the Tories' 'gamble' on Brexit © Getty

Mr McDonnell has dabbled with the idea of a universal basic income but so far has promised only a pilot scheme. He is more excited about the idea of a four-day working week, and has asked Robert Skidelsky, the economist and Keynes biographer, to produce a report: “Until the first world war people thought it entirely normal to have a one-day weekend, but when it changed to two days the sky didn’t cave in,” says one ally.

Labour would also take an unconventional approach to trade. John Hilary, who is acting international liaison for Labour, has called trade deals a “new form of imperialism” and a type of “plunder”. At one event he said that “we reject the whole principle of free trade”.

By conventional yardsticks, the Labour leader’s political views would keep him from Number 10. His personal ratings are among the lowest ever seen for an opposition leader, while the public remains sceptical about Labour’s economic credibility.

Polling data show that voters currently evince little enthusiasm for a Corbyn government. And yet the existential shock of Brexit, combined with his appeal to younger voters and families fatigued by nearly a decade of austerity, could still deliver the unexpected.

Chart showing UK parties poll

For all the current woes Labour is still the party most likely to benefit from a decline in support for the Tories. But there are questions about how much of the Corbyn-McDonnell policy platform can be carried out in a single term, especially if Labour failed to win a majority.

“There must be a reasonably high prospect that they are a minority government,” says Bob Kerslake, former head of the civil service, who is helping Labour to prepare for government. “They will have to think about the implications of that for the delivery of their manifesto.”

While some in the business community have welcomed Labour’s plans for greater investment in infrastructure projects and for a more muscular industrial strategy, executives in a multitude of industries are now growing uneasy as they pay closer attention to the potential impact of a Labour government in terms of regulation, tax and red tape.

“I would be worried about Jeremy Corbyn, John McDonnell and Seumas Milne, they don’t give a fuck about the City of London,” says one senior Labour figure. “I think a lot of money would be shifted out on day one. There are a lot of people who are worried about the future financial security of the City.”

In recent weeks it has become clear to investors in water companies, the National Grid, projects funded by the private finance initiative, and the Royal Mail that a Labour government would not pay them the market price of their shares when nationalisation takes place.John Allan, president of the CBI, urged Labour in May to drop its “ideological positioning”, warning that the nationalisation plans are being watched by investors around the world. “People are now asking: is my money, my savings, my income at risk?” he asked. Mr McDonnell accused the CBI of ignoring the public clamour for change and “continuing to put shareholders first”. 
Rumours have been swirling for months about other potential candidates for nationalisation — for example, airports or BT — which have been denied by the party. Mr Corbyn, meanwhile, openly advocates the nationalisation of parts of the struggling steel industry. Senior Labour officials believe there is a huge public appetite for state ownership of industries: one points to a recent survey by the Legatum Institute suggesting that one in four people want nationalised travel agents.“Of course they can add to their manifesto commitments . . . but I’m not aware of some huge hidden list,” says Lord Kerslake.  
P23WBW The Troxy, 490 Commercial Road, London, July 6th 2016. Jon Lansman, a close Corbyn ally and founder of the Momentum campaign group, delivers a speech
John Lansman of the Corbyn support group Momentum: 'We have to do what Thatcher did in reverse' © Lee Thomas / Alamy

Mr McDonnell has tried to play down the idea that Labour would have to impose capital controls if it came to power. The issue emerged in late 2017 when the shadow chancellor said he had hired an academic to plan for various post-election crisis scenarios including a run on the pound. “I want to make it explicit that we will not introduce capital controls,” he told the FT in January.

But a 2012 pamphlet with contributions from current senior Labour figures — “Building an Economy For the People” — set out plans for capital controls. With contributions from Andrew Murray and Seumas Milne, two of Mr Corbyn’s most senior advisers, the booklet offers a range of measures to “control the flow of capital”.

“It’s a radical manifesto and it will take some delivering in one term, I think, but they will want to make significant progress on it in a first term,” says Lord Kerslake.

For the hard left, this feels like a once-in-a-lifetime opportunity. There is no appetite for timidity. “The last time that an established leading economy tried to go for a proper socialist government was [François] Mitterrand in the 1980s,” says one of Mr Corbyn’s advisers. “He said in economics there are two solutions: ‘Either you are a Leninist. Or you won’t change anything’. We want something in between, you could — to coin a phrase — call it a Third Way.”

The repo markets mystery reminds us that we are flying blind

Quantitative easing means there is a greater chance of the global financial machine misfiring

Gillian Tett

NEW YORK, NEW YORK - SEPTEMBER 18: Traders work on the floor of the New York Stock Exchange (NYSE) on September 18, 2019 in New York City. As concerns about a global economic slowdown mount, the Federal Reserve on Wednesday cut interest rates by a quarter percentage point for the second time since July. (Photo by Spencer Platt/Getty Images)
The dramatic gyrations of repo rates this week triggered by a 'temporary' cash squeeze suggests neither the Fed or investors completely understand how the modern financial machine operates © Spencer Platt/Getty Images

What the heck happened? That is a question many market participants are asking about events this week at the US Federal Reserve.

But the confusion is not due to the issue that was supposed to grab headlines — namely Wednesday’s announcement on interest rates. That storyline is clear (ish): although the Fed cut its core policy rate by 25 basis points, officials also signalled their reluctance to cut rates again too soon while growth is strong. That is sensible, predictable and readily understandable.

Instead the development that is sowing shock and confusion is related to the normally arcane matter of financial plumbing. At the start of the week, overnight borrowing rates in the repurchase or repo market, where traders do short-term deals to swap treasuries for cash, suddenly spiked to 10 per cent, up from their normal levels of 2-2.5 per cent.

Repo rates declined after the New York branch of the Fed pumped $75bn into the markets for three days running. But conditions remain jittery. After all, the last time we experienced this scale of gyrations in repo rates was the 2008 financial crisis.

So should investors worry? Yes — and no. One piece of good news about this week’s events is that the movements were not sparked by the same issues in the 2008 panic, namely a fear of financial collapse. Instead, the trigger appears to be due to “temporary mismatches in the demand for funding and availability of cash”, as JPMorgan explained to its clients in a note.

More specifically, American companies typically need around $100bn of cash to pay tax bills on September 15, which prompts big withdrawals from the money market funds that are an increasingly crucial pillar of the repo markets. This year, this outflow coincided with Monday’s $54bn settlement of treasury coupons, creating more demand for cash. The resulting squeeze may have been exacerbated by an additional dash for funding among players hit by the unexpected surge in oil prices due to the drone strike in Saudi Arabia.

The other bit of good news is that Fed officials seem ready to offset these temporary problems by employing “flexibility when needed”, as Simon Potter, then a senior official at the New York Fed, noted last year. This nimble and creative approach is another contrast to 2008 — and very welcome.

But here is the bad news: the fact that a “temporary” cash squeeze created so much drama shows that neither the Fed nor investors completely understand how the cogs of the modern financial machine mesh. That is partly because “money markets have been and are now changing quickly in response to regulatory, technology and business model incentives”, as Mr Potter put it.

A decade of extraordinary monetary policy experiments has left the system badly distorted. Thus the Fed is now like a pilot flying a plane with an engine that has been stealthily remodelled. Neither the passengers nor the pilot knows how the engine’s shifting cogs might affect the controls during a wave of turbulence, because there is little historical precedent.

Take the matter of bank reserves. Quantitative easing earlier this decade caused an explosion in the level of reserves that private banks place on deposit with the Fed, hitting a peak of $2.9tn in 2014. Since the Fed started rolling back QE a couple of years ago, those reserves have shrunk to $1.3tn as of this summer. Until recently, Fed officials thought that was enough cash to keep the system running smoothly. Although $1tn in reserves are tied up by regulatory and liquidity requirements, the remaining $300bn “buffer” was presumed to be sufficient to absorb unexpected market shocks.

This calculation was always a guess, not scientific projection, since the Fed has never before unleashed QE — or tried to unwind it. And, as Lorie Logan of the New York Fed said in 2017, you only truly know that a reserve buffer has run out when rates spike.

The best guess now is that $300bn is not big enough. “The Fed is learning as it goes,” explains BMO Capital Markets. Although Fed officials will probably introduce new tools to create additional safety buffers, JPMorgan fears that “this sort of volatility will only persist” given all the structural changes under way.

This is unnerving. But the bigger point that investors need to understand is this: the more that QE (and its partial reversal) reshapes global finance, the greater the risk that the cogs in the machine unexpectedly misfire. That is no reason to panic. But central bank pilots — like investors — are learning on the job. Better hope they stay completely alert.

Hitting the ceiling

Why the Fed was forced to intervene in short-term money markets

The repo rate spiked in an alarming echo of the financial crisis

THE FEDERAL RESERVE had plenty to fret about as it prepared to discuss policy interest rates on September 17th and 18th. Trade tensions and wilting global growth have led businesses to cut back investment in the second quarter of the year. 

In manufacturing, production and capacity utilisation have been falling since the end of 2018. 

Though the Fed has described jobs growth as “solid”, some analysts worry that the labour market is wobbling. As expected, these concerns prompted the central bank to lower rates for the second time this year, by 0.25 percentage points, to a target of 1.75-2%. But the meeting was overshadowed by turmoil in money markets.

On September 17th, for the first time in a decade, the Fed injected cash into the short-term money market. The intervention was needed after the federal funds rate, at which banks can borrow from each other, climbed above the level targeted by the Fed. It rose as the “repo” rate—the price at which high-quality securities such as American government bonds can be temporarily swapped for cash—hit an intra-day peak of over 10%.

On September 17th the Fed offered $75bn-worth of overnight funding, of which banks took up $53bn. The following day it again offered $75bn-worth. The amount demanded by banks rose to $80bn.

That sent shivers down spines. A spiking repo rate was an early warning sign before the financial crisis. In 2007, as market participants began to doubt the quality of collateral backed by mortgage lending, repo rates jumped as lenders hoarded cash.
The latest jump was unlikely to have been caused by such doubts. Most collateral is now high-quality American Treasury bonds or bills. Even so, there are reasons to worry. 

America’s banks and companies seem to be short of cash. And during the turmoil the repo rate stopped tracking the federal funds rate. This link is the main way monetary policy influences the economy. A gap opening between the two deprives the Fed of its most important policy tool.

Fortunately, the Fed’s interventions seemed to work. The repo rate has returned to its usual level, close to the federal funds rate, which in turn is within the range targeted by the Fed.

Even so, the turmoil raised questions about how the Fed plans to handle future cash shortages. 

The mere prospect marks an important shift for America’s financial system. Before the financial crisis the Fed controlled the federal funds rate using a “corridor”, with a ceiling and a floor. Banks with too little cash could borrow at the ceiling rate.

But there was no compensation for extra cash held at the Fed (the floor interest rate was zero).

To keep interest rates precisely on target the Fed used “open market operations”, swapping Treasuries and cash to control liquidity in the banking system.

Six years of quantitative easing changed this paradigm.

To push down long-term interest rates, the Fed bought vast quantities of long-dated Treasury bonds. Its balance-sheet ballooned to $4.5trn. The holders—mainly banks—ended up with mountains of cash. To keep market interest rates at or above the policy rate, the Fed was authorised by Congress to raise the floor from zero, compensating banks for their cash that it held. The ceiling became redundant, as did open market operations. Only the floor mattered.

But banks’ cash piles have dwindled of late. Since late 2017 the Fed has been reducing its balance-sheet by not reinvesting all the proceeds when its assets mature. The balance-sheet shrank from $4.5trn in 2017 to $3.8trn in June this year. Moreover, a wider budget deficit means the Treasury has had to issue more bills and bonds.

So far this year it has issued an average of $63.9bn-worth of bills and bonds per month, net of repayments.

During the same period in 2017 the monthly figure was just $19.6bn.

As banks buy Treasuries, their cash piles fall.

The surplus reserves banks hold in their deposit accounts at the Fed fell from $2.2trn in 2017 to $1.4trn now.

No one knows how much surplus cash banks need to feel comfortable. That depends partly on regulations, which have increased the amount of cash banks must hold as a buffer, but also on business sentiment. Banks’ near-death experience in 2008-09 has left them with a strong desire to hold plenty of extra cash. Economists have attempted to estimate the level at which banks would start to squirm, most coming up with estimates of $1.2trn-1.5trn.

Usually banks have at least this much on hand. But they may not have had on September 16th, for relatively benign reasons. That was the deadline for quarterly corporate-tax payments, meaning companies asked banks for more cash than usual. The Treasury had issued $77bn-worth of bills in the previous week. The buyers, mostly banks, also had to pay on September 16th.

The Fed anticipated these events, said Jerome Powell, its chairman, but did not expect such an extreme reaction. As banks’ cash piles shrank, they grew reluctant to lend to companies and other counterparties. The repo rate spiked. Some banks stepped in, lending to companies at elevated rates. But then those banks tried to borrow from other banks in the federal funds market, pushing up the rate. This prompted the Fed to intervene.

Cash would have become scarce sooner or later, says Bill English of Yale University. In a growing economy—especially one with a rising government deficit—the demand for bank cash increases over time.

The Fed now faces a choice. It could return to conducting frequent open market operations to pin down interest rates, as before the crisis. Or it could keep the current system and avert future cash shortages by expanding its balance-sheet enough to keep the banking system permanently saturated with liquidity, even as demand for cash grows over time.

On September 18th Mr Powell suggested that the Fed would opt for the latter, saying it wanted reserves to be ample enough to avoid operations of the sort carried out in recent days. He also announced technical tweaks that will mean banks are compensated a little less handsomely for cash deposited at the Fed, which might encourage them to lend a little more in the repo market instead.

It is unclear how quickly balance-sheet expansion might be resumed.

This week’s events suggest it may be soon. As Mr Powell said after the Fed’s meeting, “I think we’ll learn quite a lot in the next six weeks.”

US Military Options in Iran

By George Friedman

The United States has openly accused Iran of being behind the drone and cruise missile attacks on Saudi Arabia’s largest oil refinery. Now the question is what the United States will do in response.

The U.S. is in a difficult position. The attacks did not directly affect the U.S., save for the spike in oil prices, which actually helps the American oil industry. There is a temptation to let the attacks slip into history.

But the United States has formed an anti-Iran alliance in which Saudi Arabia is a key (though weak) player. Saudi Arabia is under internal pressure from members of the royal family who oppose Crown Prince Mohammed bin Salman, and low oil prices have undermined the kingdom’s political cohesion. Doing nothing would call the U.S.-sponsored coalition into question.

Saudi Arabia is an important player in the Sunni Arab world – and that world is the main threat to Iranian expansion. Failing to respond to an Iranian attack on a vital Saudi facility could help Iran increase its power throughout the region. During Donald Trump’s presidency, the United States’ inclination has been to avoid initiating direct military action in favor of applying economic pressure instead. He has maneuvered to minimize and halt active military engagement. Military action against Iran, therefore, would both endanger the alliance structure and cut against U.S. strategy.

An alternative option would be to introduce new sanctions, but there are two problems with this move. First, sanctions do not have the psychological impact military action does. The psychological impact would be on both Iran and the Sunni world, and the logic of the situation requires it. Second, the U.S. has already imposed painful sanctions on Iran’s economy. Any further sanctions would have limited effect and insufficient heft.

There is one military option that would have a severe economic shock but would also limit U.S. exposure: imposing a blockade on Iranian ports, with a selective closure of the Strait of Hormuz. This strategy has three weaknesses. First, a large naval force of multiple carrier battle groups would have to be deployed for a potentially unlimited time.

Second, the fleet could come under attack from Iranian missiles, and while we would assume that U.S. naval vessels have effective anti-missile capabilities, any mistake could cost the U.S. a major vessel. To counter this, anti-missile air attacks as well as defensive measures would be needed, creating a second potentially costly dimension to this operation. Finally, such a blockade is by definition without a terminal point. If Iran does not fold under the pressure, the blockade could continue indefinitely, since ending it without a successful outcome would be seen as a defeat.

Another possible response would be to launch strikes against Iranian targets. The most appropriate target would be the factories producing drones and cruise missiles, along with storage facilities and so on. Here, the problem is getting accurate intelligence. The U.S. has undoubtedly been cataloging such things, but acting on poor information could result in an Iranian strike on U.S. forces or another sensitive site under informal American protection. This would only compound the problem of the Iranian attacks on the Saudi refinery.

The difficult question the U.S. faces is whether it should take an action so painful that it will block any further actions from Iran. If a blockade doesn’t shatter Iran’s economy, then escalation to eliminate its offensive air capability is needed. As for an air campaign, history has shown that they tend to take much longer than expected and sometimes fail altogether, providing the adversary an opportunity to take offensive action on its own. A U.S. attempt to eliminate Iran’s strike capability can be costly, and hidden Iranian missiles can attack regional targets. As with a blockade, an air campaign can go on indefinitely. Small-scale retaliatory strikes open the door to Iranian countermoves and could escalate into an extended operation.

As for sending in ground troops, not only does that not quickly solve the problem of Iranian air power, but it also returns the U.S. to a posture it has been in since 2001: occupation warfare.

The U.S. military fully deployed can defeat the Iranian military and take terrain, but to hold it against a hostile militia would create interminable conflict with casualties that cannot be sustained. Iran is a big and rugged country, with a population of 82 million people, more than twice as large as Iraq or Afghanistan. And the idea that U.S. troops would be greeted as liberators is mere fantasy.

Apart from an air attack on Iran designed not to achieve a significant goal but rather to give the Saudis confidence in the U.S., the options for a direct attack are not promising. But there is another way to think about this problem. The United States has been concerned about Iran’s expanding political influence. But this creates potential targets that are of high value to Iran – and hitting these targets would be less daunting than an attack on Iran itself. Iran has its own or proxy forces in Iraq, Syria, Lebanon and Yemen. It has invested a great deal of time, resources and risk in creating these forces that are now holding territory in these countries.

Consider Lebanon, a place where Iran has been highly active since the 1980s through its proxy Hezbollah. If Hezbollah could be crippled, the political structure of Lebanon would shift out of Iran’s control, and Iran’s anchor on the Mediterranean would be gone. Such an operation could not be left to the Israelis partly because their force is much smaller than what the U.S. could bring to bear, and also because collaboration between U.S. and Israeli forces would put the U.S.’ Sunni allies in a difficult position. Such a response would directly hurt Iran’s interests but could be carried out at lower risk and at higher cost than other options.

Indeed, the very threat of an attack on Hezbollah might cause the Iranians to change their strategy. Of course, an attack there might also unleash a torrent of missile strikes from Iran, and that is the downside of this and all the other strategies. But the advantage is that where other strategies would likely fail to achieve their goals, an attack on Hezbollah might well succeed. It would be something Iran would not want to see and would be carried out by secure U.S. forces. Alternatively, the U.S. could attack Iranian forces in Syria, but that would have a lower impact.

This is a theoretical exercise; answering Iran’s attacks with an air campaign on a proxy power is unlikely. The Saudis would have trouble portraying it as U.S. commitment to Saudi security.

Attacks in Syria, Iraq and Yemen would all suffer from a lack of clarity and from the fact that Iran itself would not be hit. There is the possibility that the Saudi air force could retaliate, but its ability to sustain losses and conduct an extended air campaign is doubtful. The Saudis could fire missiles at Iran, but that would begin an open-ended exchange, and the U.S. strategy has to be to hurt Iran in a mission with closure.

The Iranians know the dilemma they have posed the United States. They have bet that the risks are too high for the United States to respond. But the problem in Iran’s thinking is it can’t be sure the degree to which the U.S. sees Iranian expansion as a threat to U.S. long-term interests in the region. So the Iranians are asking the U.S.: Are you feeling lucky?

There would appear to be no good military options. Doing nothing could well destroy the anti-Iran bloc the U.S. has worked hard to create. The likely but not certain answer to this problem will be a symbolic retaliation. The problem with retaliations, however, is that they get out of hand.

A Better Way to Solve China’s Debt Problem

By Nathaniel Taplin

China tweaked its dysfunctional interest-rate system in late August, but held off on the deeper reforms needed to solve its bad-debt problem. Investors hoping for more radical change could be in for a long wait.

One reason is that fundamental reforms risk seriously damaging already-shaky bank balance sheets—and at a point when Beijing’s drive to replenish bank capital in the markets is under threat.

August’s rate “reform” was mostly an acknowledgment of changes that have already taken place. China’s central bank is phasing out its old benchmark lending rate, which banks were supposed to use as a basis price for loans, and replacing it with a “loan prime rate” derived from bank quotes. But the old benchmark had in effect been abandoned already. The People’s Bank of China hasn’t adjusted it since 2015, and banks are free to lend far above it. Weighted average lending rates midyear were 5.66%, compared with a benchmark of 4.35%.

To conduct monetary policy since 2015, the central bank has instead relied primarily on tweaks to banks’ reserve-requirement ratios and on special lending facilities. Loan prime rate quotes are now supposed to be based on the most important of these: the PBOC’s medium-term lending facility, which sported an outstanding balance of 3.4 trillion yuan ($476 billion) in August, up from zero in mid-2014. That huge balance means banks’ funding costs, and the rates at which they lend, already depend significantly on MLF rates. The new prime rate simply formalizes this.

The real problem for China isn’t bank lending rates, which have been more or less liberalized for years, but deposit rates. Banks can’t freely raise these to compete for deposits without running afoul of central bank guidance. That means regional banks that dominate small business lending struggle to attract funds, because retail depositors perceive them as less safe than bigger peers.

Banks are free to lend at interest rates far above the PBOC’s old benchmark. Photo: jason lee/Reuters

Cheap deposit funding instead flows to bigger banks, giving them little incentive to lend to private-sector borrowers. They can earn nearly risk-free money by funneling funds to inefficient state-owned companies. These can’t afford higher rates but are also highly unlikely to go bust.

Fully freeing up deposit rates would help solve both problems. Private enterprise would get a boost, and so would small banks that otherwise have to rely for funding on risky high-interest wealth-management products, “structured deposits” or other dubious workarounds.

Unfortunately, this reform would also mean that a lot of infrastructure and other state-owned loans made at too-low rates couldn’t be refinanced and would have to be written down, damaging bank capital. And banks might struggle to recapitalize themselves by selling equity-like perpetual and convertible bonds, as Beijing would like, because of problems at small lenders like Bank of Jinzhouand Baoshang Bank.

Uncertainty regarding creditor payouts after Baoshang Bank’s takeover by regulators this summer caused a brief panic in China’s money markets in June. On Sunday, Bank of Jinzhou announced it was withholding a year’s worth of interest payments on “contingent convertible” dollar bonds. Future buyers of such bonds may require significantly higher rates, if they are interested at all.

China needs deeper interest-rate reforms to win its continuing battle against bad debt and wasteful investment, but it also needs a lot more bank capital. Until the state steps in more forcefully to deal with the problem, aggressive—and much-needed—reforms to the way banks lend will probably remain on hold.

Brexit Purgatory and the German Economy

Endless Brexit delays are taking a toll on the European Union’s largest economy.

By Ryan Bridges


Brexit was widely projected to be catastrophic for the U.K.’s economy. For a while after the 2016 referendum, it did not appear to have anywhere near the effects feared. But that might finally be changing. The economy contracted by 0.1 percent in the previous quarter, and the latest surveys show business confidence falling sharply. Yet what the forecasts didn’t fully appreciate was the damage that would be done to the economies across the channel, most importantly Germany’s, and what that could do to the European Union’s negotiating position on Brexit.
The Question of Trade
The ongoing trade war between the U.S. and China, the world’s two largest economies, has shaken confidence everywhere, but it hasn’t been disastrous for export-dependent countries like Germany. To be sure, German exports to both markets (especially China) aren’t increasing as quickly as they were, but in general Germany has benefited from trade diversion. There have, however, been much greater fluctuations in Germany’s trade with the United Kingdom. In the second quarter of 2019, German exports to the U.K. – its fifth-largest export destination last year – were down nearly 15 percent compared to the same quarter in 2018. Not coincidentally, German gross domestic product also contracted in the second quarter by 0.1 percent. Exports contributed minus 0.7 percent to quarterly GDP.


Data from the past year is similarly enlightening. In the third quarter of 2018, exports to the U.K. were down 6.9 percent year over year, and German GDP followed, shrinking by 0.1 percent. Conversely, in the first quarter of this year, when U.K. businesses were hurriedly stockpiling in anticipation of Brexit, German exports to the country rose by nearly 6 percent year over year, and the economy as a whole grew by 0.4 percent, tying its best quarterly growth number since 2017. To be sure, there are other factors at play, but for an economy as dependent on exports as Germany’s (net exports accounted for about 6.7 percent of German GDP in 2018) trade fluctuations with a major partner matter. In fact, a repeat of Brexit stockpiling over the next few months could be the thing that keeps Germany from slipping into a technical recession this quarter.

If the U.K. were to leave the EU on Oct. 31 without a transition agreement that would effectively keep the current trade relationship in place for a brief period, the German economy would be on the front line of those hit hardest by new tariffs and supply chain disruptions. The Halle Institute for Economic Research predicted that a no-deal Brexit would cost 100,000 German jobs. Manufacturing centers in southern Germany could be particularly affected. The International Monetary Fund estimated last year that Germany’s GDP would be 0.5 percent smaller by 2030 if the U.K. left without a deal than if Brexit didn’t happen.

These assessments don’t account for the damage caused by prolonged uncertainty and the consequent dampening effect on investment. The managing director of the Federation of German Industries, or BDI, the country’s powerful industrial lobby, said in January before the first Brexit extension that German businesses had mixed feelings about a delay, and before the second extension in April, the BDI said, “The negative effects of each new extension are coming dangerously close to the potential damage of a disorderly Brexit.”

Given the German economy’s exposure to the U.K., its ongoing manufacturing sector slump and the increasing agony of being stuck in Brexit purgatory, one might expect Berlin to be turning up the pressure on Brussels to strike a viable transition deal with London, whatever the cost. This would entail a significant softening of the Irish backstop or possibly its removal from the withdrawal agreement. Germany is indeed among the more dovish member states when it comes to Brexit. But there are four significant obstacles to a major policy reversal by the Germans.
Why Germany Is Holding Fast
First, a volte-face would devastate European unity at a critical moment. The most pessimistic forecasts in the immediate aftermath of the Brexit vote saw the U.K. as the first domino in the dissolution of the European bloc. (Michel Barnier, the bloc’s chief Brexit negotiator, has recounted how Brexiteer Nigel Farage told him at one point that “after Brexit, the EU will no longer exist.”) Instead, the member states rallied together and, for the most part, have stayed united in the face of what is perceived as an assault on the entire integration project.

For Germany to lead a change of course, it would have to get several other member states on board, most importantly France and Ireland. Convincing Paris would be a monumental challenge given French strategic interests, but moving Dublin without a very public bullying campaign would be impossible. The backstop is an existential concern for the Republic of Ireland; acceptance of a border on the island would undo the significant progress Dublin has made, after centuries of struggle, toward its strategic imperative of full control of the island with the 1998 Good Friday Agreement. Were the Germans to steamroll a member state on such an important strategic matter, they would shatter EU unity and confidence in the benefits of membership.

Second, Germany depends on the frictionless trade of the EU’s single market as much as any member state. Its exporters’ supply chains span the Continent and extend into the U.K. Leaving open the single market’s external border in Ireland risks undermining the integrity of the whole project. Other countries that have trade agreements with the EU, such as Turkey or Ukraine, would demand the same treatment. What’s worse, other, more euroskeptic member states like Italy could be emboldened to join the U.K. in heading for the exit with the expectation that they, too, would not lose their single market access.

Moreover, the European Union and Germany worry about the long-term effect of giving the U.K. seamless market access without forcing it to play by the same rules as EU economies. It’s an imperfect parallel, but an unpublished European Commission analysis, for example, concluded last year that EU GDP would be as much as 9 percent lower after 15 years (compared to the status quo) if the U.K. aligned with EU rules on goods but diverged on services. Such an outcome would enable the U.K. to gain a competitive advantage and undercut European producers in a variety of sectors. Compare this to the damage of a no-deal Brexit, which the IMF gauged to be about 1.5 percent of GDP for the EU by 2030.

Third, the EU negotiating position is popular in Germany. A survey in January by German public broadcaster ZDF found that 73 percent of Germans opposed any further concessions by the EU, with only 20 percent in support. Similarly, after the second extension of Brexit talks in April, 60 percent of Germans told ZDF that the delay was a bad thing – suggesting that a majority believed no deal would have been preferable to more uncertainty – versus 32 percent who supported it. The BDI’s public statements indicate that business shares this sentiment. Essentially, the German government is not under significant domestic pressure to back down, despite the potential costs.

The final obstacle to a German push for concessions on Brexit has to do with British domestic politics. There is no confidence that removing the backstop would be enough to win support for the withdrawal agreement in Parliament. The last time the EU softened the backstop at the request of the British government, which promised the compromise would help it push the deal over the line in the House of Commons, it accomplished nothing. (In fact, it was probably counterproductive, leading to charges that the EU was plotting to trap the entire U.K. in a customs union to kill off the “global Britain” vision.) In addition, the most hard-line Brexiteers in the ruling Conservative Party have vowed to vote against the withdrawal agreement even if the backstop is dropped. And the European Commission said on Tuesday that the U.K. government had recently demanded other changes to the terms of the agreement. Given this uncertainty and the damage to the EU associated with the first and second obstacles, there’s no incentive for Berlin or Brussels to cave.
The Political Calculus
Germany’s economy is wobbling on the edge of recession. An orderly resolution to the extended dispute with its fifth-largest export destination would go a long way toward resuming growth. But just as calculations in the U.K. are not only about economics, the same is true in Germany.

Germany may be the most powerful country in Europe, but it’s surrounded by other strong states and not powerful enough to dominate all of them. Above all else, it must prevent the formation of European coalitions against it. In this sense, the European integration project has been one of the most successful foreign policy accomplishments in German history. Germany has achieved unprecedented peace and prosperity, along with a semi-hegemonic role in Europe, all without turning its neighbors against it. It would take much more than what Germans expect would be the sharp but short-lived shock of no deal to convince Berlin to risk a strategy in Europe that has succeeded for almost 70 years.

But neither is the U.K. in a position to back down, first and foremost because it’s in no position to agree on anything. A significant part of the problem is that large segments of the populations of Scotland and, to a lesser extent, Northern Ireland appreciate the ways in which EU membership dilutes England’s dominion over them and are unenthused by the prospect of total English supremacy after Brexit. On its own, however, this cannot fully explain why Parliament has been unable to pass a withdrawal agreement, seeing as large numbers of English Conservative lawmakers and Northern Ireland’s Democratic Unionist Party (which, until Tuesday’s rebellion, gave the Tories their parliamentary majority) have voted repeatedly against the existing deal.

The more fundamental issue is that the Brexit vote was indicative of the fact that roughly half the population, and more than half in England and Wales, favored some level of detachment from the Continent. But each attempt to define the degree of detachment costs the Brexit movement one or more of its factions that prefer a closer or looser relationship. A no-deal scenario might come closest to achieving consensus, but that is mostly based on the misconception that it would settle the question (it wouldn’t; it’s untenable over the medium term for the U.K. not to have some sort of economic relationship with the Continent) or that it would somehow give the U.K. greater leverage over the EU.

With both sides stuck, the obvious solution is another election in the U.K., as is being discussed – except there’s little reason to think another vote would propel any of the factions in Parliament to a majority capable of pushing through a deal. What it might do is garner enough support for no deal, though again this solves none of the problems. Alternatively, the moment may be approaching – not next month but in the near future – when the grinding cost of endless uncertainty for business and for policymakers convinces the European Union to refuse another delay. This remains a distant possibility, in no small part because of what it could mean for the Irish border and because of the danger of alienating even pro-Europe Britons. But it isn’t as unthinkable as it once was, and that in itself is significant.