Successful central banks focus on greater purchasing power

Interest rates are not a solution for the Japanese and eurozone economies, writes John Greenwood
A pedestrian walks past the Bank of Japan (BOJ) headquarters in Tokyo, Japan, on Tuesday, March 15, 2016. The BOJ refrained from bolstering its record monetary stimulus as policy makers gauge the impact of the negative interest-rate strategy they adopted in January. Photographer: Kiyoshi Ota/Bloomberg©Bloomberg
Bank of Japan
The Bank of Japan has now been conducting quantitative easing — the buying of financial assets by a central bank — for just over three years, while the European Central Bank has been doing QE for a little more than a year. In neither case have the results been satisfactory — despite interest rates in both Europe and Japan being driven down into negative territory.
Why have these two central banks achieved far less success than either the US Federal Reserve or the Bank of England? Fundamentally, the reason is that interest rates are not a solution to the problems of the Japanese and eurozone economies.
Among the major developed economies — the US, the eurozone, Japan and the UK — two different types of QE have been deployed in recent years. The QE operations conducted by the Fed and the BoE have largely been successful for three reasons. First, because they were targeted at the purchase of securities from non-banks. Second, because they therefore increased the stock of money or purchasing power held by firms and households directly. And third because they were consistent with a reduction in private sector leverage.
By contrast, the brand of QE implemented by the BoJ and the ECB has had much less success. Again, there are three main reasons for this. First, the operations of both central banks were targeted largely at the purchase of securities from banks. As a result, they have not materially increased the stock of money or purchasing power held by firms and households. Nor have they helped to reduce private sector leverage.
To restore economic growth and raise inflation closer to the target of 2 per cent in both Japan and the eurozone, policymakers need to achieve two sets of results. They need to encourage the repair of private sector balance sheets since spending will not resume normal or potential growth rates unless excess leverage is eliminated.

Additionally, liquidity needs to be reinjected into these economies. Or else they should be provided with additional purchasing power, but without adding to leverage.

There are two rules for central banks to follow when designing a QE programme. The first is that the central bank should only buy securities from non-banks. The reason is that the primary purpose of doing QE is — or should be — to expand purchasing power. If the central bank buys securities from banks, there can be no assurance that the money supply will increase. However, if it buys securities from non-banks, this guarantees that new deposits will be created, expanding the money supply.

Of course, if firms or households are deleveraging — repaying debt — the central bank may need to conduct even larger scale asset purchases to counter any reduction of deposits due to the debt repayments.

The second rule is that the central bank should buy only long-term securities. This ensures that the central bank’s portfolio is not rapidly eroded by allowing a high proportion of its securities to mature too soon. As a result the volume of funds injected into the economy can remain stable for a long period of time.

The BoJ has repeatedly broken both these rules, while the ECB has mostly violated the first rule.

Under QE1 and QE2 the Fed purchased treasury securities with maturities as short as two years instead of solely longer-term debt and, consequently, from September 2011 it had to conduct $667bn of what was called “Operation Twist” to unwind this mistake. By contrast, when the Bank of England announced its QE programme in February 2009, it said explicitly that it would buy gilts with longer maturities (5-25 years) precisely so that these purchases would be from non-banks. In doing so it guaranteed the success of its programme.

The fundamental problem is that the ECB and the BoJ are trying to implement QE through the normal credit creation channels of the banking system. But the traditional transmission channels are broken — either because banks are risk-averse and do not wish to lend, or because households and firms are still significantly leveraged and do not want to borrow.

In these circumstances, the policy of relying on ever lower interest rates cannot be assured of success, even if rates are negative. Given that the standard transmission system for monetary policy through the banking system is broken, central banks need to circumvent the banks if they are to create new purchasing power, restore normal economic growth and return to 2 per cent inflation and normal interest rates.

The writer is chief economist at Invesco and a member of the BoE’s shadow Monetary Policy Committee

Reigniting Emerging-Economy Growth

Michael Spence

Indian day laborers around fire

HONG KONG – It is no secret that emerging economies are facing serious challenges, which have undermined their once-explosive growth and weakened their development prospects. Whether they return to the path of convergence with the advanced economies will largely depend on how they approach an increasingly complex economic environment.

Of course, these economies’ development path was never simple or smooth. But for most of the post-World War II period, until as recently as ten years ago, it was relatively clear-cut.

Countries needed to open their economies at a sensible pace; leverage global technology and demand; specialize in tradable sectors; pursue a lot of investment (some 30% of GDP); and promote foreign direct investment, with appropriate provisions for knowledge transfer.

Throughout this process, the emerging economies recognized the importance of allowing market mechanisms to work, guaranteeing property rights, and safeguarding macroeconomic and financial stability. Perhaps most important, they knew that they had to focus on generating employment, particularly in urban areas and modernizing sectors, and on inclusiveness more broadly.

As they pursued this agenda, emerging economies experienced stuttering starts and numerous crises, often associated with excessive debt, currency traps, and high inflation. And, upon reaching middle-income levels, countries confronted the policy and structural pitfalls that accompany the transition to high-income status. Nonetheless, in an increasingly open global environment, characterized by strong growth (and demand) in the advanced economies, the emerging economies managed to make huge and rapid progress.

That all changed after the 2008 global financial crisis. To be sure, the core of the development agenda remains the same. But it is vastly more complicated.

One set of complications arises from external global imbalances, distortions, and heightened volatility in capital flows, exchange rates, and relative prices. Given that such challenges are essentially new, there is no proven roadmap for overcoming them. After all, the developed economies have not previously engaged in the kind of unconventional monetary policy seen in recent years – a period characterized by ultra-low interest rates and ultra-fast cross-border capital flows.

For the emerging economies, with their relatively illiquid financial markets, such trends encourage over-dependence on low-cost external capital, which can be withdrawn in a heartbeat. Rock-bottom borrowing costs also spur excessive reliance on leverage, weakening the will to undertake reforms needed to boost potential growth – and further exacerbating the economy’s vulnerability to a shift in interest rates or investor sentiment.

Making matters worse for the resource-rich emerging economies, commodity prices have plummeted since 2014. After a prolonged period of accelerating demand growth, notably from China, governments came to regard high commodity prices as semi-permanent – an assumption that caused them to overestimate their future revenues. Now that prices have dropped, these countries are facing huge imbalances and fiscal strain. And governments are not alone; the private sector, too, relied on rosy assumptions to justify imprudently high levels of leverage.

Slower growth in the advanced economies has also weakened trade flows, adding to the headwinds. As Mohamed El-Erian has observed, in the global economy, your neighborhood – the economies to which you have economic or financial links – matters. That is all the more true for the emerging economies, which have become highly dependent on their neighbors.

In short, emerging economies have been challenged by externally generated macroeconomic shifts, unconventional monetary policies, widespread volatility, and slow growth in developed markets. Without much of a playbook to guide them, it is unsurprising that their ability to cope with these challenges has varied considerably.

Generally, those that have fared better, such as India, have combined sound growth fundamentals and reforms with pragmatic and activist measures to counter the external sources of volatility. India has also, of course, benefited from lower oil prices.

Commodity exporters like Brazil have struggled more, but not just because of falling natural-resource prices. In fact, the decline in prices, together with the reversal of capital flows, exposed weaknesses in the underlying growth patterns that had previously been masked by favorable conditions.

Now there is yet another challenge, which is becoming larger by the year. Whichever path emerging economies choose for addressing these challenges must also account for the fundamental shift driven by digital capital-intensive technologies. While digital technologies have created new kinds of jobs in high-tech sectors and the sharing economy, among others, they have been reducing and dis-intermediating “routine” white- and blue-collar jobs.

Here, rapid advances in robotics are particularly relevant, as increasingly sophisticated machines threaten to supplant low-cost labor in a variety of sectors. The high fixed and low variable costs of these technologies mean that once robots become more cost-effective than human labor, the trend will not reverse, especially given that automated assembly can be located close to markets, rather than where labor is cheapest.

Jobs in electronics assembly, which plays a huge role in global trade and has helped to drive growth in many emerging economies – notably, China – are particularly vulnerable. While trades involving sewing – textiles, apparel, shoes – are not yet being automated much, it is probably only a matter of time before they are.

As the classic sources of early comparative advantage dwindle, countries – particularly earlier-stage developing countries – will need to implement policies that feature services (including tradable services) more prominently; they will also need to adjust their investment in human capital. Whether this amounts to removing the bottom rungs on the ladder of development remains to be seen. The relatively unconventional growth pattern in India, with its early emphasis on services, may hold important lessons.

In any case, the developing countries – and especially the emerging economies – clearly have a lot on their plates. As these economies add items – protecting themselves from volatility, countering unfavorable external conditions, and adapting to powerful technological trends – to their core structural growth agendas, they will invariably make mistakes, and even stumble.

This will produce high variance in performance across countries and probably reduce the average pace of convergence. But it will not, in my estimation, derail convergence completely.

The Soup Kitchens of Athens


Greek pensioners demonstrating against pension cuts in front of the the Greek Parliament in Athens. Credit Angelos Tzortzinis for The New York Times        
ATHENS — After last summer, when the clash between Greece’s Syriza government and the insolvent state’s creditors ended, the world’s media moved on. Greece’s rebellion against the austerity measures imposed on it was snuffed out in July 2015 when Prime Minister Alexis Tsipras folded.
Greece’s disappearance from the financial headlines since then has been seen as a sign that its economy has stabilized. Sadly, it has not.
Lest we forget, Greece had by 2015 already endured years of austerity. By 2013, more than a third of Greeks were living below the poverty line. By 2014, government wages and pensions had been cut 12 times in four years.
In comparative terms, by the proportion of national income diverted to reducing budget deficits, Greece had absorbed austerity measures almost nine times the magnitude of those imposed in Italy and about three times Portugal’s. The result? Between 2009 and 2014, Italy’s economy grew by a paltry 2 percent and Portugal’s contracted by 1 percent; in the same period, Greece’s national income dwindled by a catastrophic 26.6 percent — about the same as for America in the depths of the Great Depression. The result was a humanitarian disaster only a 21st-century John Steinbeck could adequately describe.
Against this background, Greek voters elected my then party, Syriza, in January 2015 to negotiate an end to self-defeating austerity in exchange for serious reforms. With the state now living within its means, I strove, as the country’s new finance minister, to convince our European and institutional lenders that their interest and ours would best be served by reducing tax rates and avoiding further cuts to already much reduced pensions. As a compromise, I even promised a “deficit brake” — automatic tax hikes that would kick in if government revenues did not pick up within an agreed period.
My pleas fell on deaf ears, and I resigned. Greece’s creditors insisted instead on even higher sales taxes, as well as new cuts in pensions and wages. The Greek government’s capitulation to the creditors even involved a preposterous obligation that all Greek companies should pay, immediately and in full, their estimated tax for the next year. The cruel screw of austerity turned again.
Once the new measures were implemented, incomes in Greece, which had picked up slightly while we put austerity on hold, began to fall again. The bank closures that were forced by Greece’s creditors to make our government yield, and the new austerity that followed, revived the recession. This increased the number of nonperforming loans on banks’ balance sheets — an astounding 45 percent of all loans — with the effect of denying credit to potentially profitable export-oriented firms. In 2014, close to half of Greek families had no adult in employment, while the cuts in public spending mean that for the past two years less than 10 percent of the jobless receive any unemployment benefit.
Behind the grim numbers, an ugly reality looms, one that gets uglier by the day. Small businesses have been crushed by punitive taxes, and a wave of home foreclosures is on the horizon. Greece’s hospitals are running out of basic necessities, while our universities cannot even afford to provide toilet paper in their restrooms. In Athens these days, only the soup kitchens are flourishing.
Amid this endless suffering, have any lessons been learned? It seems not.
Greece’s economic misery seemed set to provoke a new standoff recently — except that, this time, it was between the International Monetary Fund and the European Union’s Brussels-Berlin nexus.
Chancellor Angela Merkel of Germany is reluctant to confess to the Bundestag that Greece’s bailout loans were always unsustainable. To maintain the fantasy that they will be repaid as planned under the terms of last year’s deal, Berlin has insisted on setting a ludicrous target for Greece’s budget surplus. (That target is 3.5 percent of gross domestic product every year starting in 2018 — roughly equivalent, as a percentage of G.D.P., to America’s military budget, but in Greece’s case, purely to service its foreign debt.)
The German condition amounts to imposing permanently escalating austerity on Greece. The I.M.F. protested, correctly, that there was no level of austerity that could achieve this target.
In past weeks, there were indications that the fund was ready to insist on debt relief for Greece, allowing a lower budget surplus target and therefore less austerity. Unfortunately, last week’s meeting of the so-called Eurogroup — an informal body of eurozone finance ministers together with officials from the European Central Bank and the I.M.F. — dashed these hopes. With the I.M.F.’s managing director, Christine Lagarde, notably absent, her stand-in capitulated to the Brussels-Berlin axis, postponing any debt relief until 2018 at the earliest.
Earlier this month, Athens had obediently introduced a fresh round of tax increases and pension cuts — the sales tax in Greece now stands at 24 percent. The I.M.F.’s view is that these measures will fail to attain the impossible surplus target. The fund is right about that, but the new solution it has condoned is as bizarre as it is counterproductive.
Instead of reducing the surplus target, the I.M.F.’s representative at the Eurogroup meeting, Poul M. Thomsen, consented to the extraordinary decision to retrieve from the trash basket of last year’s negotiations the deficit brake that I had proposed in exchange for an end to austerity. The idea is that if the 3.5 percent surplus target is missed — and it will be — then new tax increases and spending cuts will kick in automatically. So, the very instrument that I had proposed as a substitute for austerity will now become its supplement. The mechanism will merely intensify Greece’s austerity-driven recession.
Reason demands an end to this loop of doom. What Greece needs is a realistic restructuring of its debt and a primary surplus target of no more than 1.5 percent of national income. The government should also continue with reforms that target oligopolies in areas of the economy like supermarkets and the energy sector, as well as inefficiency and corruption in public administration.

Why China’s Banks Need a New Source of Funding

China’s banks are looking to less reliable debt markets as deposit growth is drying up

By Anjani Trivedi

When the river starts running dry, start looking for water elsewhere.

That’s what China’s largest banks have done lately. With their traditional funding base of deposits slowing to a crawl, they have raised more than $70 billion in debt markets so far this year. That’s the most since at least 1995 over the same period; and already 40% of last year’s record issuance, according to Dealogic.

With deposit growth slowing faster than loan growth, Chinese banks’ loan-to-deposit ratios, a measure of their reliance on borrowed funds, have started to inch up. The door was opened to this when China scrapped a 75% cap on loan-to-deposit ratios last year. Across China’s largest banks, this ratio rose to 72% at end of last year, from 69% the year before.

To make up for slowing deposits, China’s financial institutions are turning to market-based funding, which also means greater swings in costs. Especially, as yields in China’s interbank bond market have spiked in recent weeks and international capital markets remain volatile.

Funding from deposits costs approximately 1%, while that from the onshore interbank bond market is closer to 2.5% and international capital markets is more like 3%. The trouble is all this hits banks’ net interest margins further, already shrinking under the pressure of lower interest rates and rising credit costs.

Looking for new funding sources may prove to be a painful adjustment for China’s banks. Already, there are signs that investors are less willing to fund China’s banks than they once were. Last week, for instance, investors pulled cash off the table because policy lender China Development Bank’s bonds didn’t compensate them enough.

Capital markets aside, there are other maneuvers to keep funding intact. Banks could start locking in deposits for longer to secure funding while lending out shorter-term loans to deal with deteriorating asset quality. That too however, would erode their net interest margins.

All this of course, only takes into consideration what’s actually on banks’ balance sheets. With net-interest margins shrinking, banks of late have been significant issuers of off-balance sheet investment-linked wealth management products, in which short-term funds are raised from consumers and invested in bonds, stocks and other assets. The funding risks here are arguably even more acute.

With banks getting their funding from less secure sources, it will serve China’s banks to know the worth of wáter.