A New Year of Existential Moments

by Roy C. Smith

Dec. 31, 2014 

This is the time of year when resolutions and predictions are made. The resolutions are rarely achieved and the predictions, even short-term ones, are often wrong. Nevertheless, here are some for 2015, listed in terms of their existential urgency to the societies involved.

First, Russia.

This will be the year that Mr. Putin comes under the greatest amount of domestic political pressure since unexpectedly taking office on New Year’s Eve, 1999. There were a number of anti-war protests in Russia in 2014, adding to others that have occurred under Putin’s rule. In December, anti-government protests were staged in Manezh Square, and popular Kremlin critic Alexei Navalny was detained for attempting to participate. These sorts of demonstrations, however, have been harmless to Putin so far, but things may change in 2015 as acute economic pressures begin to eat into the economic gains middle class Muscovites have accrued over the past 15 years.  Russia’s GDP growth, never above 2% since 2008, has dropped to zero after the 50% collapse of oil prices and the ruble, but the added effects of US and European sanctions, soaring interest rates, a 44% drop in stock prices offer a bleak outlook for 2015 GDP growth of minus 4% to 5%.

Putin’s national approval ratings (reported by the government) may be high due to his machismo in the Ukraine, but do they resonate in Red Square? His political bullying and increasingly kleptocratic regime now resemble those of Viktor Yanukovych, the Putin supported, strong-armed President of the Ukraine who was suddenly deposed a year ago after protests in Maidan Square by thousands.  No one expected that: what goes around in public squares, can come around.

The pressure of all this presents Putin with an existential moment: He might avoid the worst by withdrawing forces from the Ukraine and acting in such a way as to get the sanctions, which are the only variable he can control in his current situation, removed. These sanctions, particularly those that restrict financial transactions and access to the Euromarket, have been very potent and may just be enough to tip the balance against Putin. As such, they may represent a new non-military tool that can be applied effectively by Western democracies when they can act together against aggressive or troublesome regimes. Better sanctions than armies.

China

Twenty-five years after Tiannamen Square, and after nearly that many years of soaring economic growth, China too may face an existential moment in 2015 as its growth rate continues to fall to around 7%, significantly below the 8% minimum that Chinese officials have thought to be necessary to prevent widespread social protests by the newly enfranchised middle class and the hundreds of millions of unregistered job seekers flocking to the cities. Communist Party General Secretary Xi Jinping, still largely unknown to the West as he maneuvers forcefully to secure his power and position in China, faces a dilemma. Flood the markets with cheap money and bank loans to reverse the economic decline, risking a financial bubble and collapse not unlike the Japanese in 1989, or tighten the belts and weather the economic adjustment but risk another Tiannamen Square event. So far it appears that the former path has been selected; increased liquidity has driven stock prices up by 36% just since March, despite an economic slowdown that will continue in 2015.

A market crash in China would reveal massive amounts of unreported bad loans to state-owned enterprises, municipalities, real estate developers and others and the shock effect could be enough to halt China’s twenty-year run of exceptional growth. Such an event also would surely awake the dragons of political protest.

Europe

Having survived (for now) a sovereign debt crisis, the Eurozone (EZ) was only able to stumble across the finish line in 2014 with growth of 0.8%. The EU was only a little better at 1.1%, nowhere near in either case what it needs to be to lower widespread unemployment or to support the enormous social safety net that still exists in Europe.  Growth forecasts for 2015 are slightly better, but unfolding events could actually make the European economic future worse. Coming up are elections in Greece that could produce a government mandated to improve the terms of the bailout or end the country’s participation in the EZ; an urgent need, according to the IMF, for labor market reforms in France, Italy and Spain that seem impossible to achieve; and a likely indefinite dependance on market-distorting “quantitative easing” by the ECB as a last ditch effort to secure minimal growth in the euro area. There is also a growth-killing EU financial transaction tax scheduled to begin on Jan 1, 2016.

Popular confidence in the EU/EZ system, its “single market” and “single currency” is fading fast. Never a Federal system like the US, at best European economic integration resembles the ineffective Confederation Period in US history (1781-1788) that was replaced out of necessity by a federal Constitution. Thus Europe too faces an existential moment when it will be required to choose between serious political integration along federal lines, or to give up and revert to the status quo pre-euro. Until it meets this moment, Europe’s slow growth and high unemployment condition is likely to remain in place.

Emerging Market Countries

There are a few Emerging Market countries that produced growth in 2014 above 5%, though all were in Asia (China, India, Indonesia, Malaysia, Philippines and Viet Nam).  In Latin America, Chile, Colombia and Mexico are showing the benefits of having invested in institutional infrastructure, but Brazil, with 2014 growth of 0.8%, Argentina 0.3%, and Venezuela (despite its oil) minus 2.8%, lag behind because they haven’t. 2015 promises an existential moment for Cuba, which will need to make significant domestic reforms to survive as an economically independent state. Now that Cuba and the US have announced a rapprochement of sorts, market and political forces will put a lot of pressure on Cuba to move things along faster than they want to.  

The US

 Despite years of talk about losing its grip, the US has been the economy to beat going into 2015.  Third quarter growth of 5%, low inflation and interest rates and a strong dollar suggests that the US has finally pulled itself out of the ditch it has been in since 2008. The US private sector, the world’s largest by far, is less affected by government action than other economies, but it has still suffered from over-regulation, aggressive government litigation and a generally anti-business administration. Corporate America, however, has adapted to these pressures, improved productivity and profitability, and is in good shape for the future. The American public sector, on the other hand, suffers from financial distress in the States and large cities, and in their pension funds, but elected officials are beginning to deal with them. Recent elections may resolve some of the gridlock problems in 2015.

The last few years have reminded Americans of two important lessons ingrained in the country’s economic history: without free-market capitalism there cannot be enough economic growth to provide the social system the people want, and free-market capitalism  can only operate a democracy with the consent of the people. Perhaps these are grounds for compromise between Democrats and Republicans. Lets hope so.

Happy New Year

A Sobering Anniversary

By Roy C. Smith

Amid the holiday bubbly, some will recall that 25 years ago, on December 29, the Nikkei index stood at 38,916, its all-time high. What happened next has sobering lessons for China. The bubble burst in a most non-festive fashion – and it had been inflated by government efforts to stave off exactly the problem that besets China today.

The Japanese babaru keizai, or “bubble economy”, of the 1980s resulted from efforts to sustain the “miracle growth” that began in the 1950s and won Japan its reputation as an economic superpower. After two decades of export-fueled growth, in the middle of the 1970s, Japan had started slowing towards a world average growth rate. Japanese officials sought to counter the trend with large amounts of easy money.

The ensuing “excess liquidity”, which reached 5.5% of GDP in 1986 and 1987, did not pass into goods and services as inflation but into rising prices of stocks and real estate. At the market’s peak, stocks in the Nikkei index traded at an average of 70 times earnings. Japanese institutions, corporations and households (and many foreign investors) all bought these assets, very often with borrowed money, because of their belief in the limitless sustainability of Japanese economic success. The Nikkei index rose six-fold in the 1980s, compared with a three-fold increase in the US stock market.

Then came the crash. As the Nikkei dropped 63% to a low of 14,309 in 1992, it sucked the value out of all other financial assets and collapsed the financial system that had taken the assets as collateral. The Nikkei continued to slide for 17 years, reaching a low of 7,055 in 2009.

Though the bursting of the Japanese bubble was nastier than most, bubbles do come and go. What is most frightening about the Japanese experience is the extent to which the confidence of the Japanese people in their economy was destroyed. Despite 25 years of Keynesian stimulus programs (that have pushed Japan’s government debt to GDP ratio from 50% in 1989 to 250%, the highest in the world), and a decade of zero-interest rate monetary policy, Japan’s average annual growth rate since 1990 has been scarcely above zero.

China is the “miracle economy” of today. It has much in common with the centralized, export-led economy of Japan before 1990. And it is vulnerable to similar sorts of asset bubbles that can devastate its economic momentum and progress.

Indeed, China was just getting started when the Japanese market blew up. Though China’s slow but steady opening up to Western markets was set back for a couple of years by the Tiananmen Square massacre – seven months before the 1989 Nikkei crash – Deng Xiaoping’s persistence in discarding Communism for “socialism with Chinese characteristics” led to 20 years of growth at an average rate of 9.5%

China’s basic economic strategy was the same as Japan’s: use a tightly controlled banking system to leverage the country’s high savings rate to finance plants and equipment that can manufacture high-quality, low-cost goods to be sold abroad for foreign exchange. Force overseas companies wanting access to the Chinese market to provide foreign direct investment and the latest technology, and gradually move manufactured products up the technology curve. Open and liberalize stock markets, privatize state-owned companies and let the world buy into the show as China breaks through (as it has) to become the world’s largest economy based on purchase-power parity.

The Shanghai Stock Exchange Index rose gradually after reopening in 1990 from 1,000 to 2,000 in 2001, after which, reflecting world equity markets, it slumped to about 1,500 in 2004. Then it jumped four-fold to 6,000 in 2007, only to be brought back to the 2,000 level after 2008. The index has not grown much since – losses may have driven away early believers, deflecting speculative demand into real estate. China’s stock market still lacks a broad institutional base of pension funds, insurance companies and mutual funds. As these develop, the demand for stocks will increase substantially. Today, China’s combined stockmarket capitalisation is about the same as Japan’s.

But, after 25 years, China’s growth rate is slowing and creating political headaches for its new government. Much of the slowdown reflects low growth in China’s exports but some is because of rising wages and operating costs in China, where economic and social expectations have risen. Disappointment in these expectations, or with local or regional political factors, may have been behind the 180,000 incidents of social unrest in 2010, estimated by The Economist.

China’s existential problem is that if economic growth drops below 7% or 8%, factory closings, unemployment and social demands could threaten Party control. Growth is likely to be 7.4% or less this year (down from 12% in 2010), so the government is trying hard to reverse the trend.

It has engaged in stimulus programs and lowered interest rates to spur growth. While the government is pumping money into banks to increase lending to state-owned enterprises and local governments, bank regulators are concerned about non-performing loans and leverage. Excess liquidity is rising, especially in the under-regulated non-bank sector, but inflation remains low. A Japanese-style asset bubble may not be far away. Bubbles are hard to predict, partly because they can be hard to distinguish from what others view as “trends,” and partly because it is hard to tell when and where the first chinks in the dam will appear.

Total debt in China (largely undertaken by opaque state-owned enterprises and local and regional governments) now equals 250% of GDP, up from 130% in 2008. But, like Japan in 1989, China’s banking system is fragile. Non-performing loans are disguised, and under-reported. Relative to the rapid expansion in non-government loans outstanding, the banks report a very unlikely decline in bad debts.

A serious setback in Chinese stocks and real estate could, as it did in Japan, force the realisation of losses that could severely affect the 300 million mostly urban “middle class” that have mortgages and own stocks. According to a recent report in The Financial Times, 90% of Chinese households own at least one home, and 76% of the assets or urban householders are in real estate.

China has a sufficient pile of foreign exchange reserves and other resources to bail out its banking system if need be. Japan did too.

But if a series of financial shocks hit the middle class, it may be difficult for the government to retain the confidence of the people in the country’s economic prospects, particularly if exports remain tied to sluggish Western growth rates. If that confidence is lost, China’s superpower status and the longevity of the Party may be in doubt.

From: Financial News, Dec 8, 2014

Bank Cultures Rely On Effective Controls

By Roy C. Smith and Ingo Walter                                                                     

 

Of all the financial markets that should be resistant to manipulation, the foreign exchange (FX) market surely tops the list. With $5.3 trillion traded daily by thousands of buyers and sellers across the world, this should be a hyper-efficient market.

Foreign exchange is traded in a self-regulated broker-dealer market dominated by large, responsible banks and other intermediaries serving financial and non-financial clients worldwide. It has run seamlessly for decades, including during the global financial crisis of 2008-2010.

The FX playing field is a design masterpiece, blending efficiency, innovation stability and robustness. Equals are treated equally and unequals treated unequally in a transparent, competitive framework that extends from massive dealing banks at the center to nonfinancial firms making wire transfers or hedging currency exposures.

FX traders’ live in a fishbowl where gains and losses are taken as they come and there are no rocks or weeds to hide under. As befits such a business, traders must be as tightly controlled as a Pit Bull on a leash – alternately extending or tightening trading limits with changing market conditions and traders’ skills – controlled by experienced supervisory managers who have been there and done that.

So how could six traders in the FX business -- Citigroup, JP Morgan, HSBC, Royal Bank of Scotland,UBS and Bank of America - agree to a $4.3 billion “settlement” to dismiss charges of FX market misconduct by US, UK and Swiss authorities after a year-long investigation? This is the largest group settlement ever, and the first to target the FX business. The specific charges involved failure of the banks to prevent traders’ efforts to manipulate the FX market - irrespective of whether they succeeded, which quite likely they did not.

To many, the settlement seemed just and appropriate, coming on the heels of similar scandals in the Libor, mortgage-backed securities, commodities and retirement savings markets. Years after the 2008 financial crisis, these same banks, and a few others yet to be dealt with, seem still to be out of control and need to be forced to do their jobs properly. This is a sad commentary on the effectiveness of market discipline.

But to others, the settlement seemed to be an example of bullying and over-reaching by regulators to extract disproportionately large payments from banks to settle charges that a few apparently poorly supervised FX traders misbehaved. Instead of punishing the miscreants, their direct supervisors and, in turn, their senior managers, it is the shareholders of the banks who are stuck with the bill – billions that could have been returned as taxable income to shareholders or used to increase bank capital.

The New Normal

Indeed, the FX settlement is the latest in a long line of massive legal actions against banks as corporate “persons” responsible for the actions of those whom they employ. In this connection, prosecutorial efforts to make shareholders liable for problems caused by employees has been aimed at forcing boards of directors to reform their banking cultures to make them more responsible to the public interest, upon which their banking charters are ultimately predicated.  

This is the real lesson for bank shareholders, and, fair or not, this is the “new normal.” The legal power to sue banks for infractions, supervisory failure and associated cultural dysfunction is undisputed and here to stay. And the system is stacked against the banks. Prosecutors almost never have to prove their cases in court because bank boards fear the reputational damage of a public jury trial and that a “guilty” verdict would open a floodgate of civil litigation. So, they settle on the best terms they can get

The current FX case also demonstrates how US-style litigation has spread to Europe, where the UK’s Financial Conduct Authority (FCA) and the Swiss Financial Market Authority (Finma) have teamed up with US banking authorities. In all three countries, it is possible that criminal charges against individuals may follow.

Holder Factors In

Charging corporations as persons responsible for the conduct of their employees was unusual until 1999, when Eric Holder, at that time US Deputy Attorney General, wrote a memo to federal prosecutors outlining the criteria for bringing such charges. His memo - which has been superseded by a series of others - set standards that the Government followed in suits against Enron, WorldCom and other corporations caught in scandals during the early 2000s.

The basic idea of the Holder memo was that corporations are expected to provide a culture of good citizenship and appropriate business practices which fully comply with the law. It contained several “factors” to be considered by prosecutors in bringing charges against corporations – these included pervasiveness of wrongdoing within the company, a history of misconduct, timely and voluntary self-disclosure of wrongdoing to regulators, cooperation in the ensuing investigations, and the existence and adequacy of compliance programs, including management efforts to prevent, identify and discipline wrongdoing (italics added).

The test for whether a corporation meets these tough standards is not entirely clear, but the burden of demonstrating that it has in fact done so rests with the corporation itself.

Some of the banks involved in the FX settlements - particularly those with a history of employee misconduct in other markets - may have been uncomfortable demonstrating the ability of their management organizations to spot and prevent trouble. No doubt there have been cases of FX trading desks being pressured to boost their profitability using aggressive tactics, failing to examine new “trading strategies” for compliance shortcomings, or failing to listen to whistleblowers.

A New Standard

Given the Holder factors, it is increasingly hard for banks to plead ignorance or incompetence. No longer will it do to say “we have procedures in place, but we cannot be expected to keep track of everything every employee does.”

The proliferation of settlements across different financial markets makes it clear that banks increasingly will have to show they made credible and persistent efforts to keep their people in line. They must now be able to demonstrate that they have organized themselves into proactively watchful, compliant organizations by training, motivating and rewarding thousands of middle managers for spotting and fixing trouble before it happens. Such a functional approach to controlling behavior is the essence of the missing “cultural” issue in banks. It does however beg the question of how to reward these people appropriately for things that didn’t happen as opposed to things that did.  

Even with the best of intensions and commitment of resources things can still go wrong. But if a bank can show it has in good faith done all that any responsible organization could have done to prevent, detect and halt employee misconduct, then it can expect to avoid the kind of litigation that has damages shareholders and undermines its reputation and performance.

Bank boards of directors are beginning to get the message. They appreciate that getting these Holder-type issues wrong can be hugely expensive, and can lead to even worse consequences if their cultures are perceived to be tolerant of misconduct.

The good news is that banks can turn things around. This requires pruning the FX ranks of chat-room miscreants and re-training those who remain. People selected for middle management must be inculcated with the idea that they can and will be be rewarded for how well they play “defense” as well as “offense.” Internal whistleblowers need to be encouraged, not marginalized – itself not an easy thing to do. Department ad hoc committees at the operating unit level need to be able to thrash-out and resolve conflicts-of-interest and compliance issues on the spot as they arise.

This will require a major reworking of middle management responsibilities and accountability for a large segment of a bank’s managerial structure – maybe one in every ten or fifteen employees. But it can be done, and done effectively, if the necessary will and resources are applied.

The latest series of FX settlements  make it very clear that the banks have no choice but to do all this, and do it quickly.

Breaking Up the Banks

By Roy C. Smith 

from Financial News, Nov. 10, 2014

Last month, William Dudley, president of the NY Federal Reserve hosted a “Workshop on Reforming Culture and Behavior in the Financial Services Industry” for about 90 invited senior bank executives, regulators, prosecutors, and academics. This was the concluding paragraph in a lengthy and thoughtful analysis of the dangers of sharp-edged, aggressive “trading cultures” at banks

… if those of you here today as stewards of … large financial institutions do not do your part in pushing forcefully for change across the industry, then bad behavior will undoubtedly persist.  If that were to occur, the inevitable conclusion will be reached that your firms are too big and complex to manage effectively.  In that case, financial stability concerns would dictate that your firms need to be dramatically downsized and simplified so they can be managed effectively (emphasis added)… The consequences of inaction seem obvious to me—they are both fully appropriate and unattractive—compared to the alternative of improving the culture at the large financial firms and the behavior that stems from it.  So let’s get on with it.  

In other words, if the banks did not change their cultures to prevent “bad behavior”, Dudley warned, they would leave their regulators, alas, no choice but to break them up. 

There is no doubt that in the last decade almost all the major US and European capital market banks were involved in instances of shabby and sometimes illegal business practices, gamed the system to evade the rules and, in the high spirit of the trading culture, did what they could to “rip out the eyeballs” of their “counterparties.” 

Such actions are not to be excused, but the perception of cultural decay and rampant misconduct truly exceeds the reality.  The crash occurred after decades of industry deregulation, consolidation and innovation encouraged by regulators that were inspired by Alan Greenspan to believe that increased competition in financial markets would lower the cost of capital to market users, and that the markets themselves would constrain banks behavior. Consequently, the markets became enormous – the value of securities outstanding in 2007 reached an extraordinary $200 trillion – and liquidity events arising from sudden shifts in such a large market could be overwhelming, as we discovered in 2008.

After 2008, however, it didn't take long for governments everywhere to blame the financial crisis, and the many troubles that ensued from it, on the greedy and reckless cultures of the banks. 

But, how bad was it really, when prosecutors could find no evidence of illegal actions by any senior bank officers, despite extensive investigations. Indeed, most observers of the period now recognize that the banks, notwithstanding their turbo-charging of the mortgage business, were not alone in bringing about the crisis. Regulators and other government officials contributed significantly to the financial meltdown, before, during and after the crisis.

Six years after the event the cultures of the large banks have changed, as Mr. Dudley surely knows. They may not have been fully brought to heel, but certainly they have been defanged. 

Almost all of them have changed top management, purged their ranks of securitisers and others associated with the mortgage business, reduced trading activities, modified their compensation systems, and have tried to persuade shareholders, rating agencies and creditors that they are now better managed, less risky and fully reformed.  

The banks have also had to adapt to the greatest regulatory onslaught since the 1930. One recent report showed that the six largest US banks had already spent $70 billion in complying with all the new rules that affect them, But, unlike the 1930s, banks have also had to cough up $150 billion of shareholders’ capital to settle government lawsuits..

Despite their efforts at reform, most of the large capital market banks’ shares still trade at or below book value and their returns on equity capital remain below its cost.  Such a condition does not bode well for their economic viability or competitiveness  

Indeed, Mr. Dudley really should be more worried about the long-term viability of these banks, which are crucial to the financial system, than the nature of their cultures after all the changes already imposed. 

Further, it is hard to see how the financial system would benefit by converting bank  cultures into ones that are residually risk averse and afraid of getting into trouble.  

When Dodd-Frank was passed, it was criticised for many things, but praised for one – it did not arbitrarily force all large banks to chop themselves up or reintroduce Glass-Steagall to force all of them to leave the securities business.

Its authors understood that the burden of compliance would be high, and may change the industry considerably, but how any individual bank would respond to the new rules was to be left to the bank itself. 

Undoubtedly, some said, the new regulations would result in banks breaking themselves up into more flexible and economically viable units.  One such option was to spin off highly capital-intensive investment banking units, tailoring what remained into a basic, national commercial bank, like Wells Fargo.

So far this hasn't happened. Some banks have pulled back from capital markets, but none have gone so far as to break themselves up.

Knowing this, maybe Mr. Dudley is sending a message that ultimately the banks are going to have to do what the Fed wants them to, which for some of the largest and more complex, is to act more quickly and radically to simplify their basic business models. 

Dodd-Frank has given the Fed a lot of power over banks, and much of it is now being applied on a discretionary basis. It conducts annual stress tests that include qualitative factors that must be met in order to pay dividends and repurchase stock. The Fed also must approve banks incentive compensation plans and their “living wills” for banks to be in good standing (it recently rejected the living wills of 11 major banks, forcing them to resubmit them). 
Now, after Mr. Dudley’s remarks, it appears that the Fed can use any instance of “bad behavior” to determine that a bank is not well managed, “dictating” that the Fed force the bank to “dramatically downsize and simply” itself. With numerous investigations of post-crisis conduct still ongoing (LIBOR, FX), the possibility of more bad behavior surfacing is not insignificant. Such behavior does not have to be proven, or recent, for Mr. Dudley to act.

Though Dudley’s threat was forcefully made, it would be momentous and unprecedented for the Fed openly to force a bank to break up. But the power to do so under Dodd-Frank is certainly there, though the process is complex and can be appealed. 

Mr. Dudley’s cultural workshop may actually be less about culture and more a subtle warning to those banks the Fed considers to be moving too slowly in transforming themselves into the well-managed entities it wants.  Those banks know who they are.  As Mr. Dudley says, they need to “get on with it.”

Will Modi Reset India’s Emerging Market Economy?

By Roy C. Smith and Ingo Walter[

The forthcoming visit to Washington by Narendra Modi, his first since becoming India’s Prime Minister last April, is likely to have little impact.

Yes, it will attract the usual ceremonies and displays of goodwill, but it comes at a time of disillusionment with the BRICS, and suspicion about Mr. Modi’s real political objectives. So it is not likely to change much of anything.

For the past 15 years, the BRICS have been seen as the world’s best hope for sustainable growth. These five countries, representing 40 per cent of the world’s population and 25 per cent of its GDP in 2013, recorded growth rates 4 to 5 times greater than those of the US, Europe and Japan, and threatened to displace them as the world’s most important economic powers in another 20 years or so.

Today, this seems much less likely – China is struggling to achieve a 7 per cent growth rate this year and avoid a banking crisis caused by excessively easy credit.

India’s growth has fallen to less than half the rate of its best years.

Russia, struggling with the crisis in Ukraine and President Vladimir Putin’s approach to foreign investment, will be lucky to report any growth at all.

And a humbled Brazil expects a growth rate of only 0.9 per cent at best, while South Africa’s is even worse.

Weathering economic shocks

True believers in “emerging markets” maintain that new growth has to come from internal economic reforms that permit market forces to set prices and allocate capital and labor.

It is the expectation of market-driven development in these countries that attracts the capital, which in turn underwrites higher rates of growth. The BRICS, the largest countries in the “developing” world, all set out to follow this template, even though some (Russia and China) were starting out on the journey well behind the others.

Even ardent supporters of the BRICS understand that there are obstacles to face along the way, primarily economic shocks (like the financial crisis of 2008) and domestic politics.

Over time, these obstacles slow growth performance, but the power of the internal reforms and the sheer size of the future markets for goods and services at “normal” per-capita consumption rates still made a good case for the BRICS.

India re-energized

Mr. Modi is thought by many in India to be just the sort of bold, charismatic leader needed to re-energize India’s effort to free up market forces.

The Rupee is up 3 per cent against the dollar, and the Indian stock market has gone up 14 per cent in value in the last year.

He may well be just such a person, but India’s recent political paralysis and economic slump that helped elect Mr. Modi, only confirms the skeptic’s view that the country’s burdensome political, bureaucratic and legal systems are just too much for any leader to shift long enough to transform the country into a market-driven economy to complement its democratic political structure.

These concerns now include Modi’s surprise decision in July to block an important WTO trade facilitation agreement because it lacked provisions to enhance government food subsidies.

While in the US, Mr. Modi will have many opportunities to discuss US-Indian trade, investment and bilateral cooperation. Mr. Obama will surely look for India's support for US policies in Asia, especially regarding relations with China and Pakistan; Mr. Modi - a newcomer to such issues - is likely to be cautious and non-committal.

Still, the meeting between the US and Indian heads of state is important. It helps clarify what each expects of the other, and what the costs and benefits of helping each other might be.

More importantly, however, is what Mr. Modi does back in India to advance the case for becoming a viable market economy. Progress in this direction can have an enormous payoff in terms on increasing India’s power and influence, including its influence in Washington.

Mr. Modi has political capital to spend in India, and he ought to use some of it to winnow government subsidies, reduce protection of certain economic sectors, and to do all he can to increase basic competition in goods and services.

Infrastructure and education are important too, but these take a long time to improve. The most immediate need is to get the growth rate back to a 9-10 per cent level.

Keeping doors open

The success of the BRICS has taught us that the prospect of change from low growth to high growth triggers all kinds of private sector energies seeking to engage in the opportunity the shift presents.

Vast amounts of inward foreign direct investment can be attracted, along with technology and managerial skills.

These resources are premised on the willingness of such countries to keep doors open and to treat investment capital fairly. Equally, however, they can be reversed if these conditions change.

Mr. Modi has to convince the world’s investors that he means to restart India’s efforts at becoming an emerged marketplace, despite inevitable setbacks.

If he achieves this, his next visit to Washington will be very different.

Vladimir Putin, Sanctions and the Ukraine

Roy C. Smith and Ingo Walter
 

Vladimir Putin, a martial arts enthusiast, must be an admirer of Muhammad Ali, master of the famed “rope-a-dope” strategy in boxing. Putin’s antics are a mirror image of Ali’s in-and-out style, but in a different arena. Annexation of territory, soldiers losing their way on somebody else’s property, cross-border artillery barrages, anti-aircraft missiles that aren’t there but leave 297 passengers blown out of the sky, solemn agreements unremembered after lunch.

Many observers think Putin’s strategy is working. The Obama Administration’s reliance on sanctions and world opinion seem too weak to derail Putin’s aggression - which suggests a tougher, military alternative that would fall largely on the US. But supplying and supporting the Ukrainians militarily in Russia’s back yard could easily lead to escalation.

Reliance on military involvement may well be unnecessary. In the long run, Putin’s actions are self-destructive on several important economic fronts that are likely to be powerful enough to moderate them sooner rather than later. Each relies on the disciplining force of economics and markets.

Despite Putin’s periodic interventions, Russia’s economy has become highly linked to the global economic and financial system - to the great benefit of the Russian people. Exports (mainly oil and gas) account for 43% of its GDP and more than 50 percent of its fiscal revenues. Rising oil prices and increasing global involvement enabled Russia to achieve an average annual GDP growth rate of 7.1% from 2004 to 2008 and attain prominence as an emerging market economy - something that was unthinkable a couple of decades ago. While Russia’s growth rate declined after the global financial crisis, like most other countries, it was still able to attract $94 billion in foreign direct investment in 2013. At the beginning of 2014, Russia even broke into Bloomberg’s list of the top 50 countries for doing business.

Putin’s bellicose initiatives have resulted in modest sanctions which, limited and recent as they are, have already had a significant effect on markets. Russian GDP growth in 2013 dropped to 1.3%, down from 4.8% in 2012, and is expected to be zero or less for 2014. The ruble and stock prices are down around 15% for the year, the 10-year Russian government bond, reflecting an increase in inflation to 7.5%, now yields 9.7%. Capital outflows exceeded $100 billion in the last year. Access to foreign financial markets, from which Russian banks have obtained the majority of their funding, has been denied and inward investment has effectively been brought to a halt. Oligarchs are getting their money out as best they can while Russian banks and industrial groups are repatriating theirs to avoid future sanctions.

New sanctions now being considered by the EU at America’s urging could limit non-contractual oil and gas sales and the use of the dollar and euro payments systems, as well as blocking access to funds held externally by Russians. In combination, these would substantially constrict the Russian economy and most likely drive it into recession.

Today’s financial reporting requirements and payments tracking technology make it very difficult to evade sanctions, and their enforcement by determined regulators is relatively simple - as was demonstrated in the recent $9 billion BNP Paribas settlement with the US government. Sanctions take time, but they can work.

Putin’s actions have frightened Russia’s most important customers. Already the EU is accelerating efforts to find alternative suppliers and sources of energy – Europeans may restart nuclear reactors, invest more in conservation or in fracturing, recommit to wind or solar sources, or import LNG from the US. Technology has increased their choice of practical alternatives, certainly over the longer term, and Putin has provided an excellent reason to move ahead with greater urgency.

Russia’s European customer base formed a steady, safe, lucrative and growing market for its energy exports. Now it will increasingly have to replace these customers with less dependable and less profitable markets elsewhere. Russia’s recent 30-year ($400 billion) deal with China is an example, but it will take years before shipments flow and much can change in the relationship between Russia and China over the life of the contract.

The Ukraine conflict began a year ago with a domestically popular effort by Kiev to link more closely to the EU in order to expand economic opportunity. It was halted by Ukrainian President Viktor Yanukovych apparently at the behest of Vladimir Putin, who did not want to “lose” the Ukraine to the West. Demonstrations on Maidan Square ended with Yanukovych’s forced departure and the formation of a new, much more westward leaning government that was soon opposed by Russian-backed separatists in the East.

When forced to choose between the kind of prosperity common in Poland and other Eastern European countries and reverting to political and economic subservience to Russia, it is not surprising that the majority of the Ukrainians selected Europe. Their willingness to endure hardship and violence to move in that direction may be surprising, but their actions did not go unnoticed by others in the Russian Federation, or within Russia itself.

Putin’s rope-a-dope tactics aimed at preserving the Russian sphere of influence appear to be popular in Russia, where national pride and honor have been revived. Russians have long suffered economic hardship in the past, but, having tasted prosperity, will they tolerate losing it? Could the next Ukrainian-style demonstrations happen in Red Square?

Over time, Putin’s actions threatens to isolate Russia from the world free-market economy, which operates on the basis of maximizing growth and opportunity. A retreat into a Soviet-style shell will have consequences he may not be able to endure for long. He needs a political solution that creates an effective “reset.”

Mr. Obama’s job is to keep his eye on the long-term prize – turning things around with Putin to get him back on-message in the global economy. Global economic pressures -- workable new tools of the 21^st Century that are preferable to Cold War saber rattling -- can be very powerful in helping to shape national behavior.

Blueprint Needed to Rebuild Structured Finance

By Roy C. Smith

While the corporate side of global finance is recovering well, another side that suffered in the crisis is still ailing so badly it is a drag on the US economic recovery as a whole. Mortgage-backed securities may have got a bad name in 2007-2008, but some way to revive the structured finance market must be devised to get the housing market out of the doldrums.

Corporations around the world issued $2.1 trillion dollars of new bonds in the first half of this year, according to Dealogic, setting a record.  The issues included corporate investment grade, high yield and financial industry bonds. Corporate new issues of stock (including a big increase in IPOs) also increased over the first half of 2013, to $489 billion, a 20% improvement.  So global capital markets are on track to provide about $5 trillion of corporate finance in 2014.

Banks also provide global syndicated loan facilities (including bridge and other leveraged loans, and refinancing) to corporate clients. For the first half, the volume of all such loans was $1.7 trillion, up 8% on 2013 and the highest since 2007. 

The main difference in capital market activity since the crisis, however, has been the plunge in global “structured finance” (securitised debt). In 2006, $2.8 trillion of global structured finance issues were sold.  By 2013, volume had dropped 70% from its peak, to $790 billion, and at a pace of $356 billion in the first half of 2014, it appears to be drifting even lower. Most of the decline in structured finance has been in mortgage-backed securities, especially those issued without US federal agency guarantees.

In the US, banks make mortgage loans based on credit scores, then sell the loans to federal housing finance agencies (the Federal National Mortgage Association, Fannie Mae, or the  or Federal Home Loan Mortgage Corporation, Freddie Mac) that guarantee the loans and package them into mortgage-backed securities to be sold to the market.  The banks recover their investment and repeat the process, providing a continuous, relatively low-cost flow-through mortgage finance system that greatly aids the real estate industry.

A Serious Structural Problem

The collapse of the mortgage finance system has left a serious structural problem. The system is now being squeezed at all its vital points.

The federal mortgage agencies are not playing the flow-through role they were. Before the crisis they were aggressive, overleveraged and devoted to expanding home ownership by lending to weaker credits. But  since being taken into federal “conservatorship” in 2008, they have deleveraged, become more cautious and been made to run a tight ship.

Under conservatorship (which lasts indefinitely) the agencies have had to rebuild their balance sheets, repay the government the $187 billion of bailout funds they received, and distribute all free cash flow to the government, not to investors. In the process, the agencies have cut back their purchases and securitisation of mortgages from pre-crisis levels; in 2013 these were 13% less than the year before,  and down a little more in the first half of 2014.

Non-agency credit sources have disappeared; the agencies now guarantee nine of ten US residential mortgages.

Banks, addressing their own balance sheet problems, have pulled back on loans to borrowers with lower credit scores. But the pace of the pull-back has accelerated. In the first half of 2014, total mortgage lending declined by 53% from 2013 levels, according to Inside Mortgage Finance, and non-bank mortgage lenders among the top 30 originators accounted for 23% of the market, up from 11% in 2012.

Partly this decline is because the largest US mortgage lending banks (Wells Fargo, Bank of America, JP Morgan and Citigroup) are wary of doing business with the federal agencies. The banks have complained of the massive government lawsuits over technical breaches and failures that occurred long after the loans were made, but felt they had to settle rather than face the risk of losing at trial. 

Fed chair Janet Yellen said in June that this concern by the banks has substantially dampened the recovery of the US housing market. Sales of existing homes in July  were 4% below the 5.4 million-unit level of July 2013 and sales to first-time buyers remain historically low, according the National Association of Realtors. House sales are still about 25% below what they were in 2006.

Restoring housing activity is a key, but still missing, component of the broad economic recovery that the government says it is seeking.  A drying up of mortgage credit has continued to be a drag on the housing market.  It may get worse before it gets better.

In August, John Stumpf and Jamie Dimon, chief executives of Wells Fargo and JP Morgan, respectively, warned (separately) that unless the government offered a “safe harbour” from such litigation, based on clearly defined rules for handling the business, they would hold back from making new loans to the millions of people with lesser credit scores that are looking for mortgages.

Resuscitate the private sector

The Treasury tried to get out in front of the housing finance problem in February 2011 when it announced a plan to wind down the housing finance agencies over time to be replaced by private capital that would be appropriately disciplined by Dodd-Frank’s enhanced regulatory umbrella.

The Treasury has done little since then to support the plan or to explain how it might happen. A bi-partisan effort in the Senate was made this year to bring a bill to restructure the housing agencies. This much anticipated bill, which endeavored to get rid of the federal agencies but preserve the government guarantee of mortgage loans and a commitment to “affordable housing” ,disappointed just about everyone when it was revealed in March, and is now permanently stalled in committee.  

The best hope for restoring mortgage finance activity is to rethink ways to get the private, non-government guaranteed portion of structured finance market restarted. Surely a new set of more conservative and transparent mortgage backed securities that would appeal to institutional investors (especially in this low interest rate environment) can be created, but it will take a combined effort of the banking industry, credit rating firms and public regulators to make it work. They will have to cooperate to establish a new set of standards for what goes into the securities, how they are to be analysed and rated, and how regulatory safe harbour rules will work to enable the issues to be underwritten.

This is really a job for old-fashioned investment bankers to take on, one that requires a lengthy series of patient negotiations with the various parties involved to produce a workable prototype for a whole new market to develop. Sigmund Warburg and his partners created the first Eurobond through such a process in 1963.

A similar effort is now essential to redesign the global structured finance market.

From Financial News, 8 Sept., 2014