US banks wake up to an easy money hangover

Balance sheets are strong, but business is going to become tougher

The editorial board


Citigroup trades below the value of the tangible equity on its balance sheet © Bloomberg


Each bad market is bad in its own way. The characteristic feature of the rout that ended 2018 was the cruelty it visited on US bank stocks. This is striking, as the US economy is steady, the big US financial institutions are well capitalised and, for the most part, nicely profitable. Shares in US banks were down over 18 per cent in the fourth quarter, far worse than the wider market.

Bank shares have bounced back this year — the first big bank to report fourth-quarter earnings this week, Citigroup, rose nicely on mixed results— but investors remain jumpy. Citi and Goldman Sachs still trade below the value of the tangible equity on their balance sheets.

The simplest explanation is that we are late in the business cycle, when economically sensitive banks perform poorly. After all, the other sectors that have been hit hardest — autos, energy, materials — are also highly cyclical.

It cannot be quite so simple, though. Other than the fact that it has been an unusually long time since we have had a recession, evidence that one is on the way is thin on the ground. US output is growing nicely. Unemployment remains low, consumer sentiment and spending is strong and — crucially for banks — credit defaults and delinquency remain rare.

All of this fits with the Federal Reserve’s unanimous decision to raise rates a quarter point last month, saying that “economic activity has been growing at a strong rate”. Yes, the Fed has also signalled flexibility on future rate rises and sees growth moderating in the months to come. But this is a long way from predicting a 2019 recession, as bank shares seem to be doing.

What can the bank rout be telling us, then? That the process of normalising crisis-era monetary policy will be neither simple nor painless. As the Fed raises rates and quantitative easing has shifted into reverse, short-term credit costs are rising. Long-term loan rates have not risen as much, resulting in tighter profit margins for lenders. But the increases have been enough to raise the costs of auto and home loans, which has made those two sectors perhaps the weakest in the otherwise healthy US economy, while damping loan growth for banks.

While the Fed kept rates low, companies took advantage and borrowed as much as they could on the longest terms they could find, often in yield-starved capital markets rather than at banks. For now, as a result, demand for more debt is subdued (the Trump administration’s corporate tax cut, by allowing many corporations to bring home cash trapped abroad, has further damped demand).

And then there is the return of volatility to markets and, more to the point, the decline in asset valuations. All the big US banks have advisory, capital markets and asset management businesses, and in the days of quantitative easing and steadily rising asset prices, business was good. Mergers and acquisitions and refinancings boomed, keeping bankers happy. Assets under management rose, doing the same for financial advisers. Business looks like it is going to get a lot tougher now.

Banks have little to complain about. The policies that are unwinding to banks’ detriment now saved many of them from bankruptcy a decade ago, and helped them get back on their feet in the intervening years. But those policies were not magic. They worked, in large part, by stimulating demand and inflating asset prices. Those effects were always going to reverse, to a greater or a lesser degree. A reversal must inevitably work itself out in the markets where banks make their money. In sum, US banks are strong, but they do face a testing 2019.


How US Monetary Policy Has Tamed China

In any emerging economy, there is an important connection between the health of the capital account and that of the domestic economy. A fragile capital account, and the economic self-doubt it can create, are hardly strong foundations for aggressive Chinese foreign policy.

David Lubin

us dollars and yuan


LONDON – Chinese leaders do like their slogans, and where foreign policy is concerned, two have reflected Beijing’s thinking in recent times. The first is the cautious principle of tao guang yang hui, usually rendered in English as “hide your light and bide your time,” which guided Chinese policy for decades after Deng Xiaoping established it in the 1980s. In late 2013, though, President Xi Jinping coined a new slogan to define a more assertive, muscular approach: fen fa you wei, or “strive for achievement.”

The drift toward a more assertive foreign policy under Xi has been evident everywhere, from China’s declaration of an air defense identification zone over the East China Sea in late 2013, to the creation of “facts on the ground” in the South China Sea, to the development of the Belt and Road Initiative.

But recently there have been signs that China might be having second thoughts about its ability to keep striving for achievement. Xi’s government seems clearly to have entered concession-making mode in its relations with the United States, and some prominent Chinese academics have begun questioning whether China has been guilty of strategic overstretch. For example, Yan Xuetong, a doyen of Chinese foreign-policy scholarship, has recently argued that Xi has gone too far, and that China should limit its ambitions to a narrower, regional sphere. Another Beijing-based expert, Shi Yinhong, calls for “strategic retrenchment” in Chinese foreign policy.

An easy explanation for this Chinese shift toward retrenchment is US President Donald Trump, who has applied his own brand of assertiveness to the US-China relationship, with the apparent support of the entire American political class and much of Europe’s, too. Confronted by pushback from the West, China is unsurprisingly warier of pushing forward.

But China’s current caution also owes much to the fragility of its economic performance. As anyone who has recently traveled to Beijing will tell you, the sense of economic pessimism there has rarely been as tangible as it is now.

To a degree, sagging Chinese growth is a self-induced problem. Since Xi’s declaration in 2017 that financial stability is a national-security concern, risk-taking by local governments and the financial sector has generally been frowned upon. Because these actors have been the two main engines of China’s growth in the past ten years, risk-aversion among provincial officials and financiers has naturally sapped energy from the economy.

Yet there is another, under-noticed, source of China’s economic fragility: the capital account of its balance of payments. Since 2014, when China’s foreign reserves began to fall from their $4 trillion peak (to $3 trillion level today), the authorities have been nervous about the damage excessive capital outflows might inflict on China’s economic self-confidence and global role.

In any emerging economy, there is an important connection between the health of the capital account and that of the domestic economy. If money is voting with its feet, how can anyone expect domestic confidence to be strong?

Furthermore, the most important single driver of capital flows in and out of any emerging economy is the state of US monetary conditions. Loose US monetary policy in the aftermath of the 2008 financial crisis pushed capital toward China and other developing countries. That’s what helped reserves grow to $4 trillion in the first place: the US Federal Reserve’s “quantitative easing” made it profitable for Chinese firms to borrow dollars and sent investors on a global quest for yield, so money flowed to China.

Conversely, the progressive tightening of US monetary conditions over the past five years has undeniably helped to suck dollars away from China, causing the country to lose reserves and self-confidence. This is partly because Chinese companies tend to repay debt when the dollar is strengthening and the cost of servicing dollar liabilities goes up. In addition, foreign portfolio investors are less willing to buy Chinese government bonds when the China-US interest differential narrows, as it has in recent months.

The main reason why reserves haven’t fallen below $3 trillion, which would make Chinese policymakers even more nervous, is the network of controls on capital outflows introduced in late 2016 and early 2017. But the controls may not be completely watertight: the history of capital flows tells us that when money wants to leave a country, it will.

A fragile capital account, and the economic self-doubt it can create, are hardly strong foundations for aggressive Chinese foreign policy. The next time Trump feels like excoriating Fed Chairman Jerome Powell for tightening monetary policy too quickly, he might pause to consider the role that higher US rates and a stronger dollar have played in taming China’s self-confidence. A dovish Fed is a gift to Beijing.


David Lubin is Head of Emerging Markets Economics at Citi and an associate fellow at Chatham House. His book Dance of the Trillions: Developing Countries and Global Finance was listed by the Financial Times as one of the best economics books of 2018.


The Trump Administration’s Farewell to Aims

Whereas previous US political leaders used speeches in Cairo to explain America's broad objectives in the Middle East, Secretary of State Mike Pompeo recently opted for a different approach. Rather than articulate a strategy to bring peace and reform to the region, he promised only further confrontation.

Carl Bildt

mike pompeo speech cairo

STOCKHOLM – Every now and then, a US political leader descends on Cairo to deliver an address outlining America’s policy objectives in the ever-challenging Middle East. For example, in June 2005, then-Secretary of State Condoleezza Rice made waves with a speech that firmly put the promotion of freedom and democracy on the agenda.

“For 60 years,” Rice observed, “the United States pursued stability at the expense of democracy in this region … and we achieved neither. Now, we are taking a different course. We are supporting the democratic aspirations of all people.” And to those who would accuse the US of imposing democracy on the region, she responded, “In fact, the opposite is true. Democracy is never imposed. It is tyranny that must be imposed.”

Needless to say, a number of regional leaders were distinctly uncomfortable with the speech, given that it came just two years after the US invasion of Iraq. But Rice was also following up on the 2002 Arab Human Development Report, which had highlighted the region’s miserable conditions, and made a clear case for long-term structural reforms.

Four years later, it was a newly elected President Barack Obama’s turn to head to Cairo. In his speech, Obama downplayed the promotion of democracy and emphasized the need for a more harmonious relationship between the US and the entire Muslim world, while also calling for a resolution to regional conflicts.

On the Israel-Palestine question, whereas Rice’s speech had embraced a “vision of two democratic states living side by side in peace and security,” Obama went further, describing the Palestinians’ situation as “intolerable” and harshly criticizing Israel’s settlement activities.

In Obama’s view, the unresolved Israeli-Palestinian conflict posed the second-largest danger to the region, after “violent extremism.” Then came Iran’s nuclear program and the threat of a regional arms race, followed by the absence of democracy, the lack of religious freedom, and economic underdevelopment. He envisioned “a world where Israelis and Palestinians are each secure in a state of their own … and the rights of all God’s children are respected.”

But it wasn’t to be. Despite intense diplomatic efforts by US Secretary of State John Kerry during Obama’s second term, a peace settlement could not be reached. In his farewell address in December 2016, Kerry put the blame squarely on Israeli Prime Minister Binyamin Netanyahu.

One can debate whether Rice or Obama’s words played any role in the 2011 Arab Spring, which began in Tunisia and found a symbolic home in Cairo’s Tahrir Square. But it is clear that those who took to the streets to demand democracy and representative government were genuinely hopeful for the future. Again, it wasn’t to be. In almost all of the countries where people mobilized to demand political and economic reform, the result was counterrevolution, repression, and, in Syria’s case, civil war.

Obama failed to avert the disaster in Syria. But, pursuing his previously stated priorities, he did help to prevent a devastating region-wide war by concluding the 2015 nuclear agreement with Iran. That, in turn, opened the door for further engagement with Iran on all other issues of concern, including human rights.

This month, the current US secretary of state, Mike Pompeo, traveled to Cairo to deliver his own speech. And he made clear that the Trump administration’s approach to the region represents a stark departure from that of its predecessors.

Pompeo started by attacking Obama for having based his strategy on “fundamental misunderstandings” of history. He then declared that US policy would henceforth focus solely on destroying the two evils of the Middle East: “radical Islam” and “Iran’s wave of regional destruction and global campaigns of terror.”

Gone was any talk about democracy and reform. On the question of peace between Israel and Palestine, Pompeo limited himself to mentioning Trump’s counterproductive decision to move the US embassy to Jerusalem. The speech made no mention of overcoming divisions, building bridges, and opening up the region for economic development, but it did offer plenty of implicit praise for dictators who have managed to deliver stability. In effect, America’s approach to the region has come full circle: Pompeo espoused precisely the failed policy that Rice had repudiated in 2005.

On the key issue of Iran, the speech revealed the administration’s policy to be a barren one of confrontation for its own sake. Iran, in Pompeo’s telling, is the source of every problem in the region. Without profound political change there, he declared, “The nations of the Middle East will never enjoy security, achieve economic stability, or advance their dreams.”

This is nonsense. The Iranian regime has nothing to do with the brutal repression in Egypt, the severe structural issues in Saudi Arabia, or the Israel-Palestine deadlock. Moreover, Iran is a sworn enemy of the Islamic State (ISIS), and has committed resources to that fight.

All told, the Pompeo Doctrine seems to amount to unlimited confrontation with Iran, strong support for stable authoritarian regimes, neglect of the Palestinian issue, and a complete disinterest in representative governance and reform. The Trump administration is not just ignoring the current escalation of tensions throughout the region; it is actively supporting it.

From a European perspective, this is profoundly worrying. Conflicts in the Middle East have far-reaching implications for our own security and stability. In the absence of US leadership, Europe needs its own policy for preserving the Iran nuclear deal and promoting a two-state solution of the Israel-Palestine conflict. The European Union has been both vocal and clear on these two points. But it must translate these priorities into a comprehensive vision of reform and reconciliation for the entire region.

Unlike the speeches by Rice and Obama, Pompeo’s address is unlikely to inspire anyone outside a small circle of regional authoritarians. With the US having abandoned moral leadership, it is up to Europe to show those yearning for democracy and reform that they are not alone.


Carl Bildt was Sweden’s foreign minister from 2006 to October 2014 and Prime Minister from 1991 to 1994, when he negotiated Sweden’s EU accession. A renowned international diplomat, he served as EU Special Envoy to the Former Yugoslavia, High Representative for Bosnia and Herzegovina, UN Special Envoy to the Balkans, and Co-Chairman of the Dayton Peace Conference. He is Chair of the Global Commission on Internet Governance and a member of the World Economic Forum’s Global Agenda Council on Europe.


Legalising marijuana in the US: the economic highs (and lows)

Wall Street is rushing into a field already worth an estimated $10bn

Gillian Tett





This week, William Barr, Trump’s nominee for attorney-general, has endured the ritualistic Washington grilling that is a confirmation hearing. Predictably, topics that grabbed the headlines were those linked to the Mueller investigation into Donald Trump and other matters of constitutional law. But to my mind there was another telling moment – one that concerned the debate about marijuana. When Barr was asked whether he wanted to legalise the drug, he said that while he did not want to make pot legal in the US, he did not plan to halt the fast-growing business of selling the drug, since “investments have been made”.

Confused? We ought to be. For if you want to see how contradictory American policy making can sometimes be, marijuana is a potent case in point. In theory, as Barr said, the use of the drug is still illegal from a federal perspective. Thus banks and credit card companies will not touch the industry; it is illegal to move pot across state borders; and the nation’s prisons are crammed with people, disproportionately black, convicted for past marijuana “offences”.

Yet, earlier this decade, states such as California and Colorado legalised the drug for recreational use, and acceptance of it in some places is so widespread that you can order weed to be delivered to your house as easily as pizza. Other states are following suit: this week Andrew Cuomo, New York state governor, laid out plans to legalise the drug for recreational use. Indeed, a quarter of the US now has access to legal recreational pot, and as many as two-thirds can access the drug for medical purposes.

Unsurprisingly, this has sparked an investment boom, as Wall Street rushes into a field already worth an estimated $10bn. But since the business is not legal on a federal basis, retail purchases are conducted almost entirely in cash. And if you ask mainstream asset management groups about their marijuana strategies, most will not discuss it in public. The sensation of cognitive dissonance, in other words, hangs confusingly in the air – not just in the pot world but in Washington DC too.

Is this situation likely to change? Marijuana evangelists argue that it will – for cultural reasons, as much as anything. After all, the topic of weed, like gay marriage, has become a case study in just how fast public opinion can change. According to the Pew Research Center, in 2010 the proportion of voters who supported legalising weed was 40 per cent; today it is nearer to 60 per cent.

While it is these cultural issues that grab the headlines, there is another crucial factor that receives less attention: economics. Benjamin Hansen, Keaton Miller and Caroline Weber, a group of economists, have done fascinating research in this area recently. They looked at weed sales in the neighbouring states of Washington and Oregon, where stores had been legally selling recreational marijuana since July 2014 and October 2015 respectively.

Before Oregon passed this law, sales in Washington were booming, particularly near the border, indicating a massive cross-border smuggling operation. But after Oregon legalised selling in stores for recreational use in 2015, sales along the Washington border immediately fell 36 per cent. What is even more notable is that the economists have extrapolated backwards to calculate that by taxing legal weed, Washington “has earned between $64m and $100m in tax revenue from cross-border shoppers to date”.

Furthermore, the economists concluded that when you multiply this across the country, the result is that “cross-border incentives may create a ‘race to legalise’”. Cuomo’s announcement came at around the same time as New Jersey politicians made a similar pledge: politicians on both sides of the Hudson know that if they do not act, they risk losing potential tax revenues to each other.

This will cheer the hearts of libertarians, who have long supported full decriminalisation; after all, decades of patrolling the Mexican border has not stopped heroin flooding in. Indeed, if you want to see the power of economic incentives in action, consider that marijuana investors believe weed is now flowing freely across the Mexican border, but from north to south – not the other way around – because of the increased supply in the US.

Of course, this situation will also horrify the many who are opposed to the drug on religious or moral grounds. It may worry some doctors too. There is some evidence that marijuana can have medical benefits for many users but there is also evidence that over-use among teenagers can be harmful for brain development.

Many like me will also worry that the peculiar half-legal framework means labelling is still partly self-regulated. Thus pot stores can sell products that look exactly like kids’ candy, without any clear indication of the dosage.

I hope that in the coming years the US starts to talk more openly about this strange situation and act – ideally, by embracing federal legalisation but with proper regulation (and product labelling). Barr wants more clarity too. “If we want to have a federal approach, then let’s get there and let’s get there the right way,” he said. Don’t bet on this happening soon, not least while the Republicans are so dependent on the evangelical vote. For the moment, this confusing fog suits all sides; never mind that it might make heads spin.