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Friday, September 26, 2014

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.

Thursday, September 11, 2014

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 21st Century that are preferable to Cold War saber rattling -- can be very powerful in helping to shape national behavior.

Monday, September 8, 2014

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

Thursday, September 4, 2014

Can Black Political Empowerment Help Save Ferguson?

Can Black Political Empowerment Help Save Ferguson?

Ingo Walter

Looking ahead at the future of Ferguson, Missouri after the events of recent weeks, it seems certain that the overwhelming African-American majority will press for empowerment in municipal affairs. This transition needs to come with a parallel effort to strengthen the municipal economy, drawing on any and all local and external resources to prevent a “politics of scarcity” that can end badly for the town and its residents.
Drive a short distance west of “ground zero” in Ferguson toward Lambert St. Louis International Airport, and you will find the overgrown lots, blocked streets and crumbling building foundations of Kinloch, once an all-black town of about 10,000 residents – one of nine such cities in the US back in the 1960s.  Kinloch at the time was a politically autonomous black community, created in 1948 by residents of an unincorporated area of St. Louis County – then a blank space on the map of mainly middle-class white towns that had incorporated in the region over the years.
Some residents had migrated to Kinloch from the South in the 19th and early 20th Centuries. Others settled as returning soldiers after World War I, and some moved from Illinois after East St Louis race riots in 1917. After World War II, new residents often sought refuge from poor living and housing conditions facing African-Americans in the City of St. Louis, particularly in the “projects.”
By incorporating, Kinloch residents were fully empowered at the municipal level, and were free to plan and conduct their own affairs by whatever means they chose to try improving their conditions of life. Indeed, the town was established on the premise that, through a substantial measure of self-determination, African-Americans could gain for themselves what they were denied in superordinate white-dominated political structures. The town formed a circumscribed and identifiable political unit, and its well-marked borders formed social as well as political boundaries. For advocates of separatist-style Black Power in those years, Kinloch might have provided an ideal beta-test for the independent development of black-led institutions and separatism.
But in a social and economic study of Kinloch at a time of serious US racial tensions in the late 1960s, John E. Kramer – then a sociologist at the University of Missouri - St. Louis – and I concluded that the overall effect of political autonomy on Kinloch’s economy was primarily adverse. For all of its political autonomy, Kinloch appeared to be a strikingly depressed and stagnant zone of economic deprivation even at its peak, in the midst of a rapidly growing region during the prosperous years of the 1960s. The social and physical contrasts between it and its immediate neighbors like Ferguson were remarkable and obvious.  

Making sustainable economic progress proved to be a tough slog for Kinloch. There were new street lights at street corners, a new fire engine and some other gains, but such progress may well have materialized anyway if the community had remained an unincorporated area of St. Louis County. A large 1965 federal grant for sewer con­struction might not have been forthcoming had Kinloch remained unincorporated, but the grant seemed less a consequence of political autonomy and the develop­ment of strong indigenous political institutions than the result of one individual's personal initiative. Most importantly, the Kinloch schools remained a hopeless exercise in economic hardship, even as social ties centered on the town’s churches were impressive and serious leaders emerged from time to time to try and make a difference.

Meantime local taxes were much higher than they would have been if the municipality had not been formed. The tax base was just too small. So Kinloch residents had lower disposable incomes under home rule and public revenue was woefully deficient. The sadly inferior schools the town was able to maintain had an evident and predictably deleterious effect on the academic and vocational skill levels of its work force at a time of plentiful jobs in the St. Louis region. Perhaps the most discouraging single image during our research was a large pile of books, donated by other St. Louis County school districts, piled in the library basement under a foot or two of water.

In the end, we concluded that the residents of Kinloch had gained little in a material sense from political independence, and may have lost a good deal more – we could find no identifiable connection between political autonomy and improvement of economic welfare. The economic “air supply” was absent, and there was nothing on the horizon back fifty years ago that might have given give substance to hope - the critical sequencing of economic development and political empowerment suggested in Jason Riley’s new book Please Stop Helping Us (2014) in the case of Kinloch was in effect reversed.

There is also the irony of attempting a separate-but-equal approach to civil and political organization even though that same approach had been ruled unconstitutional and inherently unequal in the educational sphere more than a decade earlier.

In the 1980s much of Kinloch’s land was taken over in an Airport noise abatement project and the most recent data (2010 Census) records a mere 299 residents. So it’s not possible to assess how Kinloch would have fared during the late 20th and early 21st centuries.
In today’s coverage of Ferguson, few media reports mention neighboring Kinloch, and when they do it’s about unruly kids crossing the town line and vandalizing local homes. Going forward, developments in Ferguson are uncertain. However, in Kinloch we have a valuable, nearby warning that empowerment, desirable as it may be, is limited in its ability to foster development. In the end, people want to improve their lives. Period. And that involves going back to the basics of creating marketable labor skills, attracting capital investment and providing well-funded public services. If the new Ferguson wants to succeed, an object lesson is right next door. Political empowerment by itself won’t cut it.