A Champion Investment Bank Is the Wrong Solution for Europe

Even if Deutsche Bank and Commerzbank merge, they will still struggle with Europe’s flawed capital markets

By Paul J. Davies

The headquarters of Deutsche Bank and Commerzbank are seen in Frankfurt. Photo: Thomas Lohnes/Getty Images 

Newsflash for financial deal makers: Europe doesn’t need an investment banking champion.

If Deutsche Bank DB -1.57%▲ and Commerzbank CRZBY -1.08%▲ agree to a merger, their executives should remember this and it should govern where they make cuts and invest for the future. Investment banking and trading should be curbed dramatically, especially in the U.S. The priority should be corporate and transaction banking.

To be fair, all Europeans should be thinking this way, not just the two struggling Germans. This isn’t defeatism in the face of powerful U.S. competitors; it is about the lack of proper capital markets in Europe.

European capital markets just aren’t that big, and despite years of European Union-level negotiations and proposals, they aren’t developing either. In fact, European equities-trading revenue in 2018 was down by nearly 20% from 2011, according to data from Coalition, a research firm owned by S&P Global. In the U.S., it has grown nearly 50% over the same period.

In bond and currency trading, which has struggled almost everywhere, the European picture is even worse than other markets. In capital raising and deal making, revenue has held up better, but is still less than half U.S. levels.

Advisory and capital-raising work matters because it is what creates the securities for investors to trade. The big reason Europe is so far behind in this area is well known: It still relies much more heavily on bank financing than capital markets. Three-quarters of corporate debt in the U.S. comes from bond markets and the rest from banks, while in Europe only around one-fifth comes from bond markets.

European capital markets have struggled to develop partly because of national rivalries within the EU that help local banks dominate their domestic markets. National champions tend to lead league tables in each country, followed by big U.S. banks, with other Europeans bringing up the rear.

But there is also a problem with savings and investment habits: Europe has more pay-as-you-go pensions, by which current employees or taxpayers bear the cost of retirees, which means there are fewer pension funds to be invested.

Also, European households keep a greater share of savings in bank deposits rather than investing them in financial assets. Europeans keep about 30% of their funds in banks or cash savings, according to New Financial, a think tank, while Americans hold less than 14% this way.

This is a serious issue. It isn’t only bad for the bonus prospects of investment bankers, but it is bad for Europe’s ability to recover from financial or economic shocks. In capital markets, assets get revalued quickly, investors lose money and they move on. In banks, executives don’t want to take the losses so bad loans hang around, capital remains tied up in poorly performing assets and new loans and investments aren’t made.

Senior European officials know this, which is why they continue to push for reform to create the right sort of regulatory playing field. But as long as national politicians want to protect their local banks and Europeans prefer to keep savings in cash, none of those high-level reform efforts will do the trick.

Only in this old-fashioned world of national champions does a commercial-banking focused merger between Deutsche Bank and Commerzbank make sense. If Europe changes, a European investment-banking champion should emerge—but there is no point creating a vehicle for a road that hasn’t been built.


Fund Investors Believe That Cheap is Better. But That’s Not Always the Case

By Crystal Kim 

Fund Investors Believe That Cheap is Better. But That’s Not Always the Case
Photograph by Ken Cedeno/Bloomberg News          

It took some three decades and a financial crisis, but the evangelicals of index investing finally got their message across—low fees lead to better performance.

The past decade has seen unprecedented amounts of money going into index funds. And not just any index funds, but the very cheapest: More than 97% of flows into the $4 trillion exchange-traded fund industry last year went to ETFs that charge 0.2% or less, Bloomberg data shows.

Except some new research indicates that cheaper isn’t always better. That new message is coming from an unusual corner—noted Vanguard expert Dan Wiener, editor of the Independent Adviser for Vanguard Investors and chairman of financial advisory firm Adviser Investments.

“Vanguard’s late founder, Jack Bogle, had it wrong when he said that investors always ‘get what they don’t pay for.’ Sometimes they don’t,” he tells Barron’s. Of course, Bogle wasn’t referencing ETFs, but the performance of Vanguard’s mutual fund share classes versus their ETFs is illuminating, Wiener contends.

Vanguard’s funds require a bit of an explanation. The $5.3 trillion money manager has a unique exception, enabling it to launch an ETF as a share class of an existing mutual fund, so both have the exact same holdings and strategy. Other firms must introduce a whole new fund with an ever-so-slight difference in holdings. This makes performance comparisons difficult—whether you’re weighing an ETF against a similar, but not quite exact, mutual fund, or against another ETF with a similar, but not quite identical, index as its basis. The exception is the handful of BlackRock(ticker: BLK), Vanguard, State Street Global Advisors ,and soon JPMorgan Chase(JPM) ETFs that track big indexes, such as the S&P 500 or the Barclays Aggregate Bond Index.

“It is exceedingly rare to be able to compare ETFs, apples-to-apples. You can’t hold all else equal, which underscores the fee obsession,” says Ben Johnson, director of global ETF research at Morningstar.

Because of the quirk, however, the performance of the portfolios in Vanguard’s ETFs and mutual funds can be compared directly. The firm’s Institutional Plus share class, which has a buy-in of $100 million, has the lowest fee. Admiral shares used to be the next cheapest, but Vanguard’s latest annual report shows that the ETF prices below Admiral shares—though we’re talking about a difference of maybe 0.01%. The firm also lets Admiral share class investors exchange their holdings for an equivalent ETF.

One might think that the share classes advertised as having lower fees would produce better results if both had the same holdings. But that’s not always the case.

Consider the Vanguard Total Stock Market Index fund. In the 10 years through 2018, the Admiral shares (VTSAX) returned 13.25% annually; the ETF (VTI), 13.26%. The ultracheap Institutional shares (VSMPX) did even better, rising 13.31%. That’s to be expected. However, the ETF also returned more than the previously pricier Admiral shares net asset value over certain periods in those 10 years. All the differences were only a matter of basis points—each equal to 0.01%, or just a dollar for every $10,000 invested—but they still might puzzle some investors.

Wiener, who shared with Barron’s how a real portfolio of Vanguard funds performed in his Roth IRA, noted that his return on the ETF shares differed from Vanguard’s stated return on market price—that at which you can buy or sell ETFs, which, in turn, differs from the NAV. Vanguard calculates the market price by taking the midpoint of the bid-ask spread for the trading cost of the ETF.

Why? Well, trading ETF shares involves more variables than buying and selling mutual fund shares. As a result, no ETF trade is done exactly at NAV and depending on when and how it’s executed, an investor could pay more or less than the next person.

A buy-and-hold investor like Wiener, who purchased the ETF at launch in 2008, never doing anything subsequently except reinvesting dividends, might find his real return differing by a few basis points from that reported on Vanguard’s website, because of the trading cost variable. In contrast, open-end mutual funds always change hands at NAV. Thus, gripes: “When you go to sell, how do you know you’ll get as much for your shares as someone who sells at NAV in an open-end mutual fund?”

Rich Powers, the head of ETF product management at Vanguard, says that the price differences “could be a function of penny rounding, which might present as such that one product has outperformed. “It’s a theoretical possibility.”

While the difference in performance is only a few basis points, Wiener says: “Isn’t the whole conversation around fees about basis points?” Indeed, as most investors know, a few basis points more can add nicely to the value of an investment held for many years.

BlackRock’s Fink says markets are poised for a ‘melt-up’

A dovish Fed and robust global economy will lure big investors back to equities

Robin Wigglesworth and Richard Henderson in New York and Owen Walker in London

BlackRock’s shares have lagged behind those of its rivals this year © Bloomberg

Global equity markets are poised for a “melt-up” as signs of healthier economic growth in the US and China reassure big investors that have largely stayed on the sidelines of the 2019 market recovery, according to BlackRock’s Larry Fink.

The chief executive of the world’s largest asset manager said he is optimistic that a “Goldilocks” scenario of improving economic data and more dovish central banks will compel institutional investors that have kept ditching stocks this year to reverse course.

Investment strategists have dubbed the 2019 stock market rally the “flowless recovery”, with equity funds continuing to suffer outflows even as the FTSE All-World index has climbed over 14 per cent — its best start to a year since 1998.

“There’s too much global pessimism,” Mr Fink said in an interview. “People are still very underinvested. There’s still a lot of money on the sidelines, and I think you’ll see investors put money back into equities.”

Bond funds have attracted $112bn of inflows already this year, but equity funds have suffered almost $90bn of investor withdrawals, according to EPFR, a data provider.

BlackRock cemented its position as the world’s biggest fund manager, growing its assets under management to $6.5tn in the first quarter, thanks to strong market returns and inflows of $65bn.

The impact of last year’s market tumult was apparent in the quarter, however. Year-on-year, base fees decreased 5 per cent, because it started the year with less than $6bn in assets. There was a 7 per cent decline in revenues to $3.3bn, which resulted in a 1 per cent fall in diluted earnings per share to $6.61.

However, this comfortably beat analyst expectations of $6.13, and the group saw technology revenue for the 12 months to March 31 increase 11 per cent, driven by its widely used Aladdin investment platform.

Listed investment groups saw their shares tumble almost 26 per cent on average last year — their worst performance since the financial crisis — as investors feared buoyant markets would no longer mask mounting fee pressures across the industry.

BlackRock has this year trimmed jobs and reshuffled its senior management ranks. Mr Fink took a 14 per cent pay cut.

“With fees coming down a lot of the big players are looking for new ways to generate revenues,” said Kyle Sanders, an analyst with Edward Jones. “For BlackRock it’s through software and Aladdin, which isn’t tired to moves in the market.”

The asset manager’s stock rose over 2 per cent on Tuesday to trade at its highest level since early October.

BlackRock is in a years-long battle with Vanguard to dominate the global fund management industry, with the latter catching up fast. However, BlackRock has claimed the top spot for exchange-traded fund global flows this year, which it said was driven by its fixed income products.

The iShares ETF business it acquired from Barclays almost a decade ago now manages almost $2tn, which alone would make it one of the world’s five biggest investment groups.

The average expense ratio of US equity funds have almost halved since 2000 to 0.55 per cent last year, and industry executives expect the trend to worsen. Morgan Stanley and Oliver Wyman’s latest annual study of the asset management industry predicted that revenues from traditional, actively-managed funds in developed markets will shrink 36 per cent by 2023.

BlackRock remains comfortably profitable, but to counteract these pressures it is doubling down on China. Mr Fink has told the FT that the company was in discussions with Chinese regulators over taking control of a local fund manager and ramping up its “alternatives” business.

The Morgan Stanley-Oliver Wyman report estimates that alternative asset classes such as private equity, direct lending and real estate will keep growing at a healthy clip and account for 40 per cent of all investment industry revenues by 2023.

The ravenous appetite for alternative investments has stirred concerns among some analysts and investors, and Mr Fink said that the sheer scale of the inflows should be watched.

“It’s something everyone should be focused on, as there are extraordinary flows going into an illiquid asset class,” he said. “But if you have a client base with longer-dated liabilities you can have a higher percentage of illiquid investments.”

Beware the Fed’s Feedback Loop in Emerging Markets

Many countries’ economies look healthier because of volatile investment flows, not real economic progress

By Jon Sindreu

The Federal Reserve’s shift away from raising interest rates has once again driven investors toward juicy returns in emerging markets. They need to be careful of a dangerous feedback loop: The very fact that money flows into these countries makes them look safer.

Fed Chairman Jerome Powell doubled down Wednesday on his new wait-and-see approach to monetary policy. This will prolong the good times for emerging markets, where stock markets have returned 2.8% over the past six months, compared with a 1.2% loss for all stocks globally, according to the respective MSCI indexes. Currencies in countries with high rates have also rallied more, pointing to speculative yield hunting.

Developing economies are looking impressively resilient, especially considering worries about a China-led global slowdown. Earnings expectations have stabilized and investors seem to have decided that the sharp selloff in emerging-market assets last summer had more to do with isolated problems in Turkey and Argentina than broader concerns.

A welder at a factory in Nantong, China.
A welder at a factory in Nantong, China. Photo: str/Agence France-Presse/Getty Images 

The problem is that investors’ confidence could be creating a deceptive sense of calm. This will suddenly reverse if the dollar appreciates or cash flows out.

Two papers recently released by the Basel-based Bank for International Settlements highlight new evidence of this effect. First, by looking at a database of nonfinancial firms in Mexico, the BIS found that corporations tend to do the same as international investors when the U.S. dollar is weak: They borrow in greenbacks at low rates to lend in pesos at higher yields, and pocket the difference.

Their aim isn’t usually to speculate, but to extend trade credit to partners with less access to global capital. Still, the need to preserve these business relationships means that, when the dollar strengthens again, companies tend to offset losses by slashing investment rather than closing the credit taps, researchers found. This means that bouts of currency volatility—like last summer’s—likely damage these countries’ long-term productivity growth.
The research flies in the face of the economic-textbook idea that weaker currencies improve poorer countries’ chances because their exports get cheaper.

A second piece of BIS research, released this week, found that sovereign-debt investors in emerging markets tend to demand less compensation when the dollar is weak, even when buying bonds in local currency.

This is shortsighted: A weak dollar boosts credit to emerging markets, making them look stronger than they are. Investors often don’t give enough weight to this, mistakenly attributing both economic improvements and crises to local political developments rather than the ebb and flow of global capital.

Right now, investors are happy to clip their coupons, lulled by the Fed’s dovish mood music.

But they should be less blasé about the risks of a weaker-than-expected global economy and the return of a stronger dollar.

George Soros famously dubbed “reflexivity” the phenomenon whereby markets are subject to feedback loops between sentiment and reality. Volatile exchange rates make emerging markets particularly extreme examples.

German Defense Spending Is Falling Even Shorter. The U.S. Isn’t Happy.

By Katrin Bennhold

The NATO secretary general, Jens Stoltenberg, with German soldiers last October in Norway.CreditCreditJonathan Nackstrand/Agence France-Presse — Getty Images

BERLIN — Germany, which had already announced that it will fall significantly short of NATO’s defense spending goals, annoying the United States, risks provoking Washington further by failing to reach even its own slimmed-down target.

Chancellor Angela Merkel’s government had a falling-out with the Trump administration last year when it said that, despite signing a commitment to work toward spending 2 percent of gross domestic product on defense by 2024, its target would instead be 1.5 percent.

Now, projected spending levels are expected to fall below even that lower path in a three-year budget plan due to be announced on Wednesday, portending another confrontation with Washington.

The timing could not be worse, with NATO preparing to celebrate its 70th anniversary in Washington in April.

Mr. Trump’s resentment toward European allies he perceives to be coasting on America’s security guarantee is well known, and recent reports that Washington is considering billing allies for hosting American troops has further shaken the alliance.

Even in Europe, some diplomats in neighboring countries privately complain that Germany’s failure to meet its commitments is putting not just its own relationship with Washington on the line, but that of the whole Continent.

Ms. Merkel insisted on Tuesday that her government could still hit the 1.5 percent target in budgets down the road. But few still believe her — least of all Mr. Trump’s ambassador in Berlin.

“NATO members clearly pledged to move toward, not away, from 2 percent by 2024,” Richard Grenell, the American ambassador to Germany, told reporters on Monday after budget numbers were first floated. “That the German government would even be considering reducing its already unacceptable commitments to military readiness is a worrisome signal to Germany’s 28 NATO allies.”

With Mr. Trump calling the European Union a “foe” and NATO “obsolete,” trans-Atlantic relations have been badly strained for some time.

But in recent months, the tone has become openly hostile, especially between the United States and Germany, Europe’s largest economy.

Mr. Grenell has demanded that Berlin scrap Nord Stream 2, a planned gas pipeline from Russia, or risk possible sanctions for the companies involved; stop German companies from doing business in Iran, or risk restrictions on doing business in the United States; and ban a Chinese company from building a new communications network, or risk losing access to some intelligence sharing.

The threats have not gone down well in Berlin, with one German politician this week even demanding Mr. Grenell’s immediate expulsion for interfering in Germany’s sovereign affairs, although that is unlikely to happen.

“Any U.S. diplomat who acts like a high commissioner of an occupying power must learn that our tolerance also knows its limits,” said Wolfgang Kubicki, deputy chairman of the opposition Free Democrats.

The Social Democrats, Ms. Merkel’s center-left coalition partner, have put Mr. Trump’s scowling oversize face on a campaign poster ahead of European parliamentary elections with the caption: “Trump? Europe is the answer.”

Mr. Stoltenberg with the German chancellor, Angela Merkel.CreditAndreas Gebert/Reuters

But even some of Mr. Trump’s fiercest critics say that Germany’s failure to live up to its NATO spending commitments has given a hollow ring to the country’s vocal defense of the international order.

“You can’t have it both ways,” said Julianne Smith, a former adviser to the Obama administration who is currently in Berlin as a senior fellow at the Robert Bosch Academy.

“You can’t at every turn stress the importance of multilateralism and keep it as the foundation of German foreign policy,” Ms. Smith said, “and then renege on the commitments you’ve made to multilateral institutions like the NATO alliance.”

“I appreciate that Donald Trump has made it more difficult,” she added. “It’s become a liability to stand shoulder to shoulder with this guy.”

But she and others point out that Germany had committed to moving toward the 2 percent target long before Mr. Trump’s election — most memorably in 2014, shortly after Russia annexed part of Ukraine.

“Any German who frames this as bending to Trump’s wishes is missing the broader point,” Ms. Smith said of NATO’s 2 percent target.

German officials point out that in absolute terms, German military spending has increased for five straight years, up 36 percent, and that Germany is NATO’s second-biggest contributor of funds and troops. They say that a fair measurement of a country’s contribution to NATO should take account of wider factors, including foreign aid spending and the rate of economic growth.

Given the size of Germany’s economy and years of consistently high economic growth, 2 percent of G.D.P., some also argue, was a fast-moving target — and one hard to meet in a short period of time.

But many security experts have questioned that argument.

“We are just not credible anymore,” said Jan Techau, director of the Europe Program at the German Marshall Fund in Berlin. “First we said 2 percent, but we didn’t really mean it. Then we said 1.5 percent, and it turns out we didn’t really mean that either.”

Defense spending is still on course to increase next year, rising from 1.35 percent of G.D.P. this year to 1.37 percent next year, finance ministry officials said. But by 2023, according to the latest budget figures, it is expected to be back at 1.25 percent.

The latest trans-Atlantic conflict is in part rooted in Germany’s domestic politics.

The finance minister, Olaf Scholz, who drafted the new budget plan, is a member of the Social Democrats, the center-left coalition partner of Ms. Merkel’s Conservatives. Ahead of a string of European and regional elections this year, the Social Democrats, whose poll ratings have plummeted in recent years, are eager to distinguish themselves by giving priority to social spending over defense.

Some political leaders like Michael Grosse-Brömer, the conservative caucus whip, said that Parliament was expected to approve a continuation of its current military missions in Afghanistan, Mali, South Sudan and the Mediterranean, and that Germany still intended to uphold its spending commitments to its NATO partners. But he, too, conceded that “the current plan looks somewhat different.”

One wild card is economic growth, which is set to slow in coming years, making it easier to increase defense spending as a percentage of G.D.P. The German Council of Economic Experts scaled down its growth forecast for the current and coming years to 0.8 percent and 1.7 percent, respectively, saying that “the boom years are over.”

But it is time for Germany to look beyond electoral horizons and consider defense spending in a longer-term, strategic framework, said Ms. Smith, the former Obama adviser.

“Imagine Trump left NATO tomorrow,” she said. “Imagine the investment Germany would have to make in its own and Europe’s security then.”

“This is the cheap version,” she said of the current NATO spending targets.

Christopher F. Schuetze contributed reporting.

SEC to examine competition among US asset managers

Regulator fears that industry consolidation will hit investor choice

Chris Flood

Dalia Blass said the SEC would look at whether technologies such as blockchain could improve access to fund distribution for small and midsized managers (Capital Insights)

The US financial regulator is set to examine whether investors’ choice of asset management companies will be damaged by competitive pressures that threaten to destroy smaller players.

The fight for survival in the fund industry is driving merger and acquisition activity, with many small and midsized managers seeking to forge alliances.

This situation is of concern to the Securities and Exchange Commission, which will begin an investigation this year.

The SEC wants to see if any barriers exist that make it harder for small and midsized companies and whether these can be addressed without sacrificing investor protection.

“I am concerned about what it will mean for investors, particularly main street investors, if the variety and choice offered by small and midsized asset managers becomes lost in a wave of consolidation and fee compression,” said Dalia Blass, director of the division of investment management at the SEC.

Ms Blass was speaking on Monday in San Diego, California, at a conference hosted by the Investment Company Institute, the trade association.

As many as a third of managers could disappear over the next five years, according to Marty Flanagan, chief executive of Invesco, the Atlanta-based asset manager. “The strong are getting stronger and the big are going to get bigger,” said Mr Flanagan in a recent interview with the Financial Times.

A price war raging among US asset managers has led to the cheapest mutual funds winning an increasing share of new business.

BlackRock and Vanguard, the largest asset managers, have spearheaded price cuts with their low-cost index-tracking funds attracting record inflows. Last year, the big two together grabbed more than half of global net new inflows into long-term mutual funds.

Fees have been driven down as a result of competition for the business of institutional clients and the bargaining power of large distributors selling funds to retail investors.

Many distributors have culled funds from their platforms as investors shifted to low-cost index trackers.

Five of the eight leading US distributors have rationalised shelf space by dropping 4,900 funds in the past two years, according to Deloitte, the financial services provider.

Ms Blass said the SEC would look at whether technologies such as blockchain could improve access to fund distribution for small and midsized managers.

The SEC may also set up an advisory committee to take a broad view of asset management issues. This could look at the effect of indexing on markets, common ownership, the consequences of the scale of investment management companies and the participation of funds in markets historically associated with banks and brokers.

Ms Blass said that while an advisory committee could not answer every question it would lend “transparency, engagement and rigour” to industry debates.

Her speech highlighted other priorities for the SEC in 2019. The finalising of new rules for both exchange traded funds and fund of funds has a “high priority” for the SEC. It will also seek public comments on proposals for the reform of business development companies and closed-end fund offerings.

Ms Blass said the SEC anticipated that it would publish proposals for modernising the advertising and solicitation rules for investment advisers as well as a proposal on the use of derivatives by investment companies.

Why further financial crises are inevitable

As time passes, regulation degrades and risks rise

Martin Wolf

We learnt this month that the US Federal Reserve had decided not to raise the countercyclical capital buffer required of banks above its current level of zero, even though the US economy is at a cyclical peak. It also removed “qualitative” grades from its stress tests for American banks, though not for foreign ones. Finally, the Financial Stability Oversight Council, led by Steven Mnuchin, US Treasury secretary, removed the last insurer from its list of “too big to fail” institutions.

These decisions may not endanger the stability of the financial system. But they show that financial regulation is procyclical: it is loosened when it should be tightened and tightened when it should be loosened. We do, in fact, learn from history — and then we forget.

Regulation of banks has tightened since the financial crises of 2007-12. Capital and liquidity requirements are stricter, the “stress test” regime is quite demanding, and efforts have been made to end “too big to fail” by developing the idea of orderly “resolution” of large and complex financial institutions. Daniel Tarullo, the Fed governor in charge of financial regulation until early 2017, recently noted that “the aggregate risk-weighted common equity ratio of the largest US banks increased from about 7 per cent in the years preceding the financial crisis to about 13 per cent as of the end of 2017”.

Yet complacency is unjustified. Banks remain highly leveraged institutions. The public expects them to be safe. But, with average ratios of assets to core capital of around 17 to one, their loss-bearing capacity remains limited. The argument for this is that these institutions promote growth. As Stanford’s Anat Admati insists, this is a doubtful argument. But, politically, it works.

Furthermore, as Jihad Dagher of the International Monetary Fund, shows in a recent paper, history demonstrates the procyclicality of regulation. Again and again, regulation is relaxed during a boom: indeed, the deregulation often fuels that boom. Then, when the damage has been done and disillusionment sets in, it is tightened again. This cycle can be seen in the UK’s South Sea Bubble of the early 18th century and, three centuries later, in the run-up to — and aftermath of — recent financial crises. Plenty of examples can be seen in between.

We can see four reasons why this tends to happen: economic, ideological, political and merely human.

The big economic reason is that over time the financial system evolves. There is a tendency for risk to migrate out of the best regulated parts of the system to less well regulated parts. Even if regulators have the power and will to keep up, the financial innovation that so often accompanies this makes it hard to do so. The global financial system is complex and adaptable. It is also run by highly motivated people. It is hard for regulators to catch up with the evolution of what we now call “shadow banking”?

The ideological reason is the tendency to view this complex system through a simplistic lens. The more powerful the ideology of free markets, the more the authority and power of regulators will tend to erode. Naturally, public confidence in this ideology tends to be strong in booms and weak in busts.

Politics are also important. One reason is that the financial system has control of vast resources and can exert huge influence. In the 2018 US electoral cycle, according to the Center for Responsive Politics, finance, insurance and real estate (three intertwined sectors) were the largest contributors, covering one-seventh of the total cost. This is a superb example of Mancur Olson’s Logic of Collective Action: concentrated interests override the general one. This is much less true in times of crisis, when the public is enraged and wants to punish bankers. But it is true, again, in normal times.

Borderline or even blatant corruption also emerges: politicians may even demand a share in the wealth created in booms. Since politicians ultimately control regulators, the consequences for the latter, even if they are honest and diligent, are evident. If necessary, they can be removed. JK Galbraith invented the “bezzle” — the wealth people think they have, before theft is revealed. Bubbles create vast legal bezzles. Everybody hates officials who try to stop them getting a share of these spoils.

A significant aspect of the politics is closely linked to regulatory arbitrage: international competition. One jurisdiction tries to attract financial business via “light-touch” regulation; others then follow. This is frequently because their own financiers and financial centres complain bitterly. It is hard to resist the argument that foreigners are cheating.

Then there is the human tendency to dismiss long-ago events as irrelevant, to believe This Time is Different and ignore what is not under one’s nose. Much of this can be summarised as “disaster myopia”. The public gives irresponsible policymakers the benefit of the doubt and enjoys the boom. Over time, regulation degrades, as the forces against it strengthen and those in its favour corrode. The bigger the disaster, the longer stiff regulation is likely to last. But it will go in the end. The very fact that the policy response to the last crisis successfully prevented another depression increases the chances of an earlier repetition. That the private sector remains heavily indebted makes this outcome more likely.

The advent of Donald Trump’s administration should be viewed as a part of this cycle. It is possible that parts of the regulations and tough supervision it dislikes are unnecessary, or even damaging. But the cumulative effect of its efforts is quite clear: regulation will erode and that erosion will be exported. This has happened before and will do so again. This time, too, is not different.


How to be a rock-star bond investor

Bill Gross, Rolling Stone

ONE NIGHT in 1965, Keith Richards woke up with a riff going around inside his head. He reached for his guitar, played the bare bones of a song into a cassette recorder and promptly fell asleep. Mick Jagger was soon scribbling lyrics by the swimming pool. Four days later, the Rolling Stones recorded “(I Can’t Get No) Satisfaction”.

Hit records are not made like that any more, according to John Seabrook’s book, “The Song Machine”. Instead they are assembled from sounds honed on computers. It can take months. A specialist in electronic percussion does the beats. Another comes up with hooks, the short catchy bits. A third writes the melody. Everything is calibrated against what worked well on previous hits.

This brings us to Bill Gross, who founded PIMCO, the world’s biggest bond firm, and ran its market-beating Total Returns fund from 1987 until 2014. Mr Gross, who retired last month, is often called a rock-star fund manager. A new paper by Aaron Brown of New York University and Richard Dewey of Royal Bridge Capital, a hedge fund, gives him the “Song Machine” treatment, breaking his performance into constituent parts. It finds that even if you could simulate his strategy, a human factor would remain that algorithms cannot match. A Stones fan might call it inspiration. In finance, it is known as alpha.

What were Mr Gross’s trademark beats and hooks? He spoke of three. He took on more credit risk, buying bonds from issuers who might default, than would a bond manager tracking a benchmark index. He similarly loaded his portfolio with mortgage-backed bonds. His third signature trade relied on the shape of the yield curve. A five-year bond will usually have a higher yield (and lower price) than a four-year bond. Bonds therefore become more valuable as time passes. As a five-year bond yielding, say, 6% becomes a four-year bond yielding 5%, its price goes up. Mr Gross’s trick was to isolate the sweet spot where this “roll-down” is strongest—around the five-year mark—and hold more of those bonds. He offset this by holding fewer 30-year bonds, where roll-down is weak.

Messrs Brown and Dewey compiled simple trading rules to mimic these elements. They then undertook a statistical exercise to gauge how far they explain Mr Gross’s excess return. Even when you allow for these factors, they find he still beats the index. He had the magic alpha.

The template for this kind of analysis is “Buffett’s Alpha”, a paper in 2013 by Andrea Frazzini, David Kabiller and Lasse Pederson. It found that the market-beating performance of Warren Buffett, the Beatles to Mr Gross’s Stones, could have been matched by an investor following a well-defined strategy, a core part of which was buying “value” stocks (ie, those with low prices relative to the worth of a firm’s assets). Their conclusion is a tad reductive for some tastes—like saying anyone with an Apple Mac could come up with “Satisfaction”. Mr Buffett was able to identify a winning strategy and to stick with it, which is not easy. But the main goal of these exercises is to show that systematic investing can work well.

It appears, though, that Mr Gross did something that could not easily be replicated. Whatever his edge, it was just as well he had it, argue Messrs Brown and Dewey. When you think you have a market-beating strategy, it is wise to ask, “If I am to win, who loses?” A value investor of the Buffett stamp wins because of other investors’ tendency to extrapolate the initial success of “growth” stocks and overpay for them. Similarly, Mr Gross’s roll-down trade may work because excess demand for long-dated bonds from certain kinds of investors with long-term liabilities leaves that end of the yield curve rather flat.

Profiting from the errors of others is what skilful investors do. But two of Mr Gross’s strategies involved taking on extra risks that a lot of bond investors would prefer not to bear. Credit securities and mortgage bonds give a little extra return compared to safe government bonds. But from time to time they inflict big losses. An investor who makes better returns by taking on such risks is not demonstrating skill, say the authors.

Even the most talented rock stars take risks. Keith Richards took enough illicit drugs to fell a herd of bison. He lived to tell the tale. Mr Gross’s riskier bets also paid off. But as Messrs Brown and Dewey argue, the risk of catastrophic loss that comes with these strategies is hard to gauge upfront. Things might have gone differently. As Mr Richards has noted, a lot of rock stars don’t survive.

Package deal

China’s current-account surplus has vanished

A deficit could remake the financial system, if the government lets it

IN A CONTROL room at the headquarters of Ctrip, China’s largest online travel agency, dozens of fluorescent lines flash every second across a big digital map of the world. Each line represents an international flight sold on Ctrip’s platform. The top destinations on the morning of March 11th, when your correspondent visited, were Seoul, Bangkok and Manila. A live ranking for hotel reservations put Liverpool in first place among European cities, Merseyside’s rough-hewn charms briefly trumping Venice and Barcelona (and apparently benefiting from a special offer).

In this century’s first decade Chinese citizens averaged fewer than 30m trips abroad annually. Last year they made 150m, roughly one-quarter of which were booked via Ctrip. That is not just a boon for hotels and gift shops the world over. It is a factor behind a profound shift in the global financial system: the disappearance of China’s current-account surplus.

As recently as 2007 that surplus equalled 10% of China’s GDP, far above what economists normally regard as healthy. It epitomised what Ben Bernanke, then chairman of the Federal Reserve, called a “global saving glut”, in which export powerhouses such as China earned cash from other countries and then did not spend it. China’s giant surplus was the mirror image of America’s deficit. It was the symbol of a world economy out of kilter.

No longer. Last year China’s current-account surplus was just 0.4% of GDP. Analysts at Morgan Stanley predict that China could be in deficit in 2019—which would be the first annual gap since 1993—and for years to come. Others, such as the International Monetary Fund, forecast that China will maintain a surplus, though only by the slimmest of margins. Either way, it would be a sign that the global economy is better balanced than a decade ago. It could also be an impetus for China to modernise its financial system.

The basic explanation for the change is that China is buying much more from abroad just as its exporters run into resistance (see chart). Its share of global exports peaked at 14% in 2015 and has since inched down. The trade war with America adds to the headwinds. At the same time, imports have soared. China’s surplus in goods trade in 2018 was the lowest for five years.

The tale of trade in services, especially tourism, is even more striking. When Beijing hosted the Olympic games in 2008, foreign visitors splashed out a little more in China than Chinese did abroad. Since then the number of foreign arrivals in China has stagnated, while Chinese outbound trips have surged. Not only that: Chinese travellers have proved to be big spenders, as anyone who has queued for a VAT refund at London’s Heathrow airport knows only too well. In 2018 China ran a $240bn deficit in tourism, its biggest yet.

Some of the current-account fluctuations are cyclical. Chen Long of Gavekal Dragonomics, a research firm, notes that the price of oil and semiconductors, two of China’s biggest imports, was high last year. If they come down, a current-account surplus could swell up again.

Yet deeper forces are also at work. At bottom, a country’s current-account balance is simply the gap between its savings and its investment. China’s investment rate has stayed at a lofty 40% or so of GDP. But its savings rate has fallen to about the same, from 50% of GDP a decade ago, as its people have learned to love opening their wallets (or rather, tapping their mobile payment apps). An ageing population should lead to a further drawdown of savings, because fewer workers will be supporting more retirees. The disappearance of the surplus is, in this sense, a reflection of China growing richer and older.

There is, nevertheless, some concern about the implications. In emerging markets big current-account deficits can be a warning sign of financial instability, indicating that countries are living beyond their means and relying on fickle foreign investors to fund their spending. But China is in no such danger. Any deficit is expected to be small, as a fraction of GDP, in the coming years. What is more, the government still has a fat buffer of $3trn in foreign-exchange reserves. That should buy it time.

The crucial question is how China uses this time. By definition any country that runs a current-account deficit needs to finance it with cash from abroad. In an economy with a wide-open capital account and a freely floating currency, inflows and outflows balance without the central bank giving it much thought. But in China the government keeps a tight grip on both its capital account and its exchange rate.

So now that it is facing the prospect of current-account deficits, it has little choice but to relax its grip, in order to bring in more foreign funding. It is moving in that direction. China has long controlled access to its capital markets by issuing strict quotas to foreign investors, with a preference for institutions such as pension funds. But in recent years it has opened more channels, notably through carefully managed links to the Hong Kong stock exchange.

These moves, though incremental, have been enough in aggregate to persuade compilers of leading stock and bond indices, important benchmarks for global investors, to bring Chinese assets into their fold. Last month MSCI said it would more than quadruple the weight of mainland-listed shares in its emerging-markets stocks index to 3.3%. Next month China will enter the Bloomberg Barclays bond index, which could fuel roughly $100bn of inflows into Chinese bonds within two years.

In a new book on China’s bond market, the IMF argues that this could foster a virtuous cycle. More active investing in bonds would support the government’s goal of using interest rates as a bigger weapon in its monetary-policy arsenal (instead of old-fashioned administrative guidance). With a more flexible exchange rate to boot, China would end up with a more modern, efficient financial system—proof that a current-account deficit can, handled well, be a welcome development.

But there are clear limits to how far China is willing to go. Efforts to lure in foreign investors have not been matched by moves to make it easier for its citizens to invest abroad. Yi Gang, the newish governor of the central bank, has repeatedly vowed to maintain the “basic stability” of the yuan. Louis Kuijs of Oxford Economics thinks the constraint is ultimately philosophical. The Chinese government is wary about ceding too much control to the market. “It implies a relatively slow opening up,” he says.

Another element of China’s approach to managing a deficit is therefore to stop it from getting too big in the first place. Guan Tao, a former central-bank official, says that China has to improve its competitiveness in services. With a better tourism industry, better universities and better hospitals, China would, he believes, attract more foreigners and keep more of its own spending at home.

Think of it as the second act for the Great Wall. It never much worked as a fortification for China: over the course of its two-plus millennia in existence, barbarian invaders repeatedly breached it. But now its role is to lure in tourist hordes. In this battle it has a better chance of success.

How the Trade War Won’t End

Washington wants to cut a deal now, but Beijing is playing the long game.

By Phillip Orchard


The U.S. and China are circling ever closer to a trade deal. They just need to agree on how to make it mean something a year or two from now. In the weeks since U.S. President Donald Trump agreed to postpone the March 1 spike in tariffs on $200 billion in Chinese goods, enough progress has apparently been made that both sides are eyeing a “signing summit” between Trump and Chinese President Xi Jinping by June. This cautious optimism is fueled by several factors, from Beijing’s offer to nudge down the trade deficit by binging on U.S. energy and agriculture products, to new laws set to be approved this week that include expanded protections for foreign investors. Trump’s barely concealed urgency to give markets a boost by calling off the dogs is probably furthering hopes in Beijing.
But “ending” the trade war still appears to mean something quite different to each side. China, naturally, wants to put this whole unpleasantness behind it and to turn its full focus to its staggering domestic headaches, and is reportedly demanding that all tariffs be lifted immediately. The U.S., naturally, is wary of China’s history of backsliding on rigorously negotiated deals, and presumably aware that it would take Beijing years to implement some of the structural reforms Washington is demanding. Washington needs to hold on to at least some leverage to ensure that the Chinese follow through. As a result, the U.S. is reportedly offering only to lift tariffs incrementally (while Chinese counter-tariffs would be lifted immediately). What’s more, the U.S also wants snapback mechanisms in place to further discourage Beijing from backsliding.
In other words, the focus of the talks has evidently moved to the thorny issues of implementation and enforcement. This speaks to a core problem bedeviling U.S. aims in the matter: Given that U.S. tariffs are only one of many problems weighing on Beijing, can the U.S.-China trade dispute really be negotiated away?
Keeping to a Deal
Whether the U.S. has any real urgency beyond political interests to wrap up a deal depends on whether it believes its broader strategic aims merit the costs of the trade war. The U.S. economy is at the peak of the business cycle and will eventually come back to earth. And the diminishing returns of a tool as blunt as tariffs for forcing China to make systemic changes are starting to become clear. Already, according to the Institute of International Finance, Chinese counter-tariffs are costing U.S. exporters more than $3 billion per month. The higher cost of imports is falling primarily on U.S. consumers, with losses expected to approach $70 billion this year, according to two new authoritative studies. None of this is devastating to the U.S., but Washington can’t ignore the ghost of the Smoot-Hawley Tariff – which raised duties on 20,000 imported items and contributed to the severe economic deterioration of the Great Depression. Meanwhile, there’s no evidence suggesting Beijing is preparing to make the sweeping structural changes demanded by the U.S. To get everything it wants from Beijing, the U.S. would have to keep up the pressure for years – likely well into an economic downturn, and certainly during a key election year. Moreover, even if annual Chinese growth plummets to 3-4 percent, it will still be adding hundreds of billions of dollars in new consumption. The opportunity cost to U.S. exporters is steep.
If the U.S. deems the costs necessary to stunt China’s rise, then no deal is imminent. Otherwise, the U.S. has an interest in settling for quite a bit less up front. By agreeing to a limited deal, pairing relief from specific tariffs with implementation of select concessions by Beijing, Washington can gradually ease the burden on the U.S. entities hurting most – exporters, firms with supply chains routed through China, firms dependent on lower-cost Chinese inputs, and consumers. And it will still have other tools like export controls, investment restrictions and the embattled but still potent World Trade Organization dispute settlement courts with which to protect U.S. firms and target Chinese practices that pose the biggest long-term threat, particularly in the race for technological supremacy. Whether or not the current negotiations produce a substantive deal, U.S. pressure in these areas isn’t going away.
But to trade hawks in the Trump administration, the sense of urgency to get a deal risks undermining efforts to address the very real problem of post-deal implementation – and giving Beijing incentive to try to run out the clock on what it sees as an impatient president. (Beijing would be foolish to think the next U.S. administration will be fundamentally more dovish, but it’s reasonable to think political and economic complications in the coming years will weaken U.S. appetite for a sustained offensive.) China has a mixed history, at best, of implementing deals. If it had fulfilled all of its WTO obligations, after all, it wouldn’t be in this position in the first place.
Beijing is trapped between oft-conflicting imperatives: economic dynamism and social stability. Under Xi, it has routinely prioritized the latter, deepening state domination of the economy in ways that have provoked the U.S., but that also helped maintain steady employment and manage China’s immense internal financial risks. Tariffs are a far smaller problem for China than internal dysfunction. But the duties are making Beijing’s tightrope walk of internal reform ever more precarious. In all likelihood, China will agree to whatever it deems necessary to make the tariffs go away. But if keeping order necessitates cheating on its commitments and risking a backlash, Beijing won’t hesitate.
What the U.S. Can Do
U.S. Trade Representative Robert Lighthizer is trying to make it harder for Beijing to backslide in a couple ways. The U.S. is insisting that concessions from Beijing be as explicit and quantifiable as possible. (Lighthizer says the agreement will exceed 110 pages.) The easier it is to identify cheating, the greater the reputational costs for Beijing and the easier it will be for Washington to make the case to the U.S. public and allies that pressure be revived. There are two main problems here: One, the Chinese system is exceedingly opaque, especially given the dominance of state-owned enterprises. Two, implementation progress on the biggest issues – forced technological transfers and cyber theft, for example – can’t easily be quantified or monitored. Thus, the U.S. is also demanding the right to independently assess whether China is living up to what it considers the spirit of the deal – and to unilaterally reimpose tariffs, without retaliation, if it concludes Beijing is falling short.
Still, these sorts of measures can do only so much. Trade deals, like most international agreements, last only as long as each side is willing to comply, which is why they tend to work only when they are truly in both sides’ interests. Either way, it’s really hard to make them binding. There won’t be any trade cops to make arrests when there’s a violation. The U.S. isn’t going to threaten war to enforce this sort of deal. Nor can the U.S. really take too much reassurance from measures like China’s new foreign ownership law, which would ostensibly help address the issue of forced technology transfersThe new law is vague, and Beijing has only so much ability and interest to enforce it at a granular level. (Trade lawyers say tech transfer typically happens willingly, often by foreign firms that are desperate for funding or that simply failed to adequately protect themselves under existing Chinese laws.) And when it comes to core technologies Beijing deems critical for initiatives like next-generation military applications, all bets are off. Law in China is applied only to the extent that it serves the Communist Party’s interests.
This isn’t to say China won’t have reasons beyond the lure of tariff relief to continue to comply. A lot of what Beijing will likely concede is fairly low-hanging fruit. For example, it’s expected to pledge to refrain from artificially weakening its currency (currently, it’s trying to keep the yuan from collapsing) and to buy more U.S. goods (items it needs to import anyway). Its measures to improve intellectual property protections, meanwhile, are needed to reassure spooked foreign investors, ease discontent among domestic private firms fed up with their state-owned counterparts, and further erode the U.S. business community’s support for the trade war. Countries often use trade agreements to bring recalcitrant domestic players obstructing needed reforms into line. And Beijing has a real need to repair its image abroad. The trade war has triggered a slow-motion stampede to the exits by foreign firms in the country, while also intensifying the spotlight on internal practices, deterring new investment. It’ll be dealing with the fallout of this for years and has ample reason to let the U.S. lose interest.
But structural reforms like ending industrial subsidies and scaling back the state’s role in the economy would be an order of magnitude trickier for Beijing to implement. These issues also happen to be at the heart of U.S. grievances. Even if the U.S. can pressure China into including concessions in these areas in the deal, it will be an exceedingly wobbly deal, however many pages it runs.

Alan García, Ex-President of Peru, Is Dead After Shooting Himself During Arrest

Former President Alan García of Peru in Lima last year.

By Andrea Zarate and Nicholas Casey

Former President Alan García of Peru in Lima last year.CreditCreditErnesto Arias/EPA, via Shutterstock

LIMA, Peru — A former president of Peru died on Wednesday after shooting himself in the head when the authorities tried to arrest him in connection with one of the biggest corruption scandals in Latin American history.

When the authorities arrived at the home of the former president, Alan García, with an arrest warrant, he locked himself into his bedroom, shot himself and was rushed to a hospital, his personal secretary told reporters.

The charges relate to Odebrecht, a Brazilian construction giant, which last year admitted to $800 million in payoffs in exchange for lucrative contracts for projects including roads, dams and bridges. The company was a main builder across Latin America, where it profited from a commodities boom that led to a huge spike in infrastructure construction.

The revelation that Odebrecht had secured contracts through graft set off a flurry of investigations by prosecutors and lawmakers, principally in Latin America, as they sought to learn who was on the receiving end of the payments.

Mr. García, 69, a rare two-term president who had become a larger-than-life figure in Peru, and whose legacy straddled periods of both growth and economic collapse, knew that he was under investigation. Last year, he fled to the Uruguayan Embassy in Lima, the capital, where he asked for asylum. The request was denied, and Mr. García returned home.

On Wednesday morning, the Peruvian authorities ordered an initial 10-day detention of Mr. García on accusations of money laundering, influence peddling and collusion. The measure allows officials to hold suspects before charges are formally presented.

That afternoon, mourners from his political party gathered outside the hospital as news came that the former president was dead.

Writing on Twitter, Peru’s current president, Martín Vizcarra, said that he was “dismayed” by the death of Mr. García, who served one term from 1985 to 1990 and another from 2006 to 2011. Mr. Vizcarra joined many Latin American leaders in expressing their condolences to Mr. García’s family.

The kickback scandals in which Mr. García had been implicated have touched off a surge of arrests throughout the region.

In Brazil, former President Luiz Inácio Lula da Silva was sentenced to 12 years in prison last year for corruption and money laundering, and is accused of taking bribes from Odebrecht.

In Ecuador, a former vice president was given a six-year sentence for pocketing millions from the company.

Police officers outside the hospital where Mr. García was treated on Wednesday.CreditGuadalupe Pardo/Reuters

And in Colombia, protesters have called for the resignation of the attorney general, who is investigating Odebrecht despite having worked as an adviser to one of its partners.

But of all the countries affected by the prosecutions, none has been more shaken than Peru, where the scandals reached a number of ex-presidents.

Last week, prosecutors detained Pedro Pablo Kuczynski, Mr. Vizcarra’s predecessor, in an investigation related to the case. They have asked that he be held up to three years as they gather evidence.

Alejandro Toledo, who was president in the early 2000s, is wanted for extradition from the United States and has refused to return to Peru; Ollanta Humala, president from 2011 to 2016, was detained as well, but eventually released. 
Odebrecht, which began work in Peru in 1979, had risen to be one of the country’s chief constructors of roads, bridges, dams and highways.

The company built a $4.5 billion road that connected the Pacific to the Amazon basin and an electric train in Lima. It was behind a $1.9 billion irrigation project called Chavimochic that irrigated a section of desert on Peru’s northern coast and paved the way for the export of asparagus and strawberries.

But it also left Peru in the lurch of one of its most toxic political crises in years.

In late 2017, after Mr. Kuczynski, then the president, was linked to a $782,000 payment from Odebrecht, and his rivals in Congress moved to impeach him. He avoided being ousted at the time, but resigned last March, and was detained this month. He has maintained his innocence, and chosen to fight in court.

The authorities appeared to have been closing in on Mr. García as well, bringing a corruption case that could have ended his decades-long career in Peruvian politics.

At the time he took office in 1985, he was Latin America’s youngest president, at 36. But the country soon entered a disastrous economic collapse in which hyperinflation reached an estimated 2 million percent. The period was also marred by deadly conflict with the Peruvian rebel group Shining Path, which Mr. García seemed unable to control.

Mr. García was succeeded by Alberto Fujimori, a populist who suspended the Constitution and ran the country as a dictator for a decade, citing the unrest.

Peru’s democracy was eventually restored, and Mr. García returned to power in an election in 2006. With the Shining Path largely defeated, Mr. García turned his attention to foreign investment, particularly in mining, and the country’s economy grew at rates well above 5 percent.

But Mr. García’s popularity, even after his second term, never recovered. He was known by many critics in Peru as “crazy horse,” for what they called his tendency to make rash decisions and behave in an unstable way.

His second term became a point of investigation for prosecutors, who examined whether campaign contributions for Mr. García’s party were tied to the Odebrecht scandal.