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May’13 Newsletter: The End of Austerity? Not Quite

The May Newsletter explains the austerity concerns heralded during April, the European Banking Union issue, the coming implementation of the Tobin Tax and the fact that there was no major banking fatalities during the month.

EU countries: Austerity is relaxed in favour of Structural Reforms

Since the average Eurozone nation’s debt to GDP ratio now stands at over 90% (it should be below 60%, according to the Maastricht Treaty), it is clear that those countries who claim to have been cutting budgets have done so only modestly. An additional concern is that, in countries such as Italy, “austerity” has been interpreted more as a justification to increase taxes, rather than to cut spending.

April heralded two new “austerity” concerns; firstly the downgrading of its importance in favour of promises of future structural reforms and secondly a furious debate, based on an academic study, about whether countries should be cutting spending at all.

The first concern was triggered mid month by EC President Barroso, who observed that deficit reduction policies must ‘have the minimum of political and social support’. Since such support is highly questionable, a number of countries, struggling to sell austerity to their electors, interpreted these comments as an invitation to switch the focus to less unpopular policy-making, whatever that might mean.

Spain proposed to the EC a package of ‘structural reforms’, of state pensions, labour laws and fiscal management, as a trade off against a reduction in deficit targets for the next three years. The timing coincided with Spain reporting its 2012 budget deficit at 10.6% of GDP.

France took the opportunity to emphasise that its structural reforms are on track, and easily managed to keep attention away from March’s disappointing news about its 2013 deficit expectations.

Italy’s newly appointed leader, Enrico Letta, adopted the same approach in his inaugural Parliamentary address: “fiscal rigour alone will kill us”.

Germany’s leaders immediately appreciated the likely future consequences of such a change in policy and Mrs Merkel repeated her call for central approval of national budgets. The Bundesbank applauded and encouraged the efforts made by several other countries to balance their budgets.

But this switch in policy, away from external duress imposed by European Commission staff in countries such as Greece, to the more measured approach of self-managed structural reforms, raises obvious questions. Will the reforms be implemented and will they achieve their stated objectives, or is this just another case of kicking the can further down the road? One must also ask why such policies were not proposed in the first place and wonder if the PIGS have simply been guinea PIGS?

The second significant ‘austerity concern’ was the focus in April on a study by Harvard academics, Reinhart and Rogoff, which concluded that a government debt to GDP ratio of over 90% is a significant drag on growth. Keynesians took to the airwaves en masse, attempting to debunk this conclusion on the grounds of an inadvertent statistical error and the exclusion of some 1950s New Zealand data. They drew the (incorrect) conclusion that the case for austerity was discredited.

Most policy makers welcomed this academic furore, which gives them an excuse to avoid the medicine they would rather not take. As long as this rather distorted way of thinking continues it is hard to see any progress.

Meanwhile, the EU’s polling organisation, Eurobarometer, published figures showing that public confidence in the EU, particularly among the most pro-EU countries such as Germany, Italy and Spain, is in precipitous decline. In Spain, 72% of those recently polled do not trust the EU, compared with 23% in 2007. Rank and file voters throughout Europe are clearly losing confidence in Europe’s leaders and perhaps its institutions as well.

Institutions

a) Banking Union

On April 13, EU economics ministers, at a meeting in Dublin, approved centralized bank monitoring. The new single bank supervisor will be established in 2014 and report to Mario Draghi, President of the ECB.

The following day, however, Germany’s finance minister raised eyebrows by changing the timetable for banking union with a few words about legalities. At the same Dublin meeting he declared that the EU’s treaties must be changed to permit the creation of a single banking authority with the power to shut down failing financial institutions. There is no point having a toothless supervisor without such an empowered institution working alongside it, he argued.

Herr Schäuble would have known for certain that the more eurosceptic countries would seize on such comments to inflame debates about repatriation of powers and in/out referendum dates. But German politicians know just how tired their voters are of the endless stream of Germany-backed rescues. Germany is growing in confidence and can be expected to be even louder in laying down terms, rules and timetables for institutional developments.

b) Tobin Tax

Although initially presented as a matter concerning only the eleven countries subscribing to the new tax on the value of the transactions (0.1% on securities, 0.01% on derivatives), the Commission’s detailed legislative proposal shows that it will in practice impact every investor globally.

There are several reasons for this. First, a financial institution is to be deemed ‘established’ in one of the eleven countries if its counterparty is located in any one of them. Second, any security ‘issued’ by an entity located in any of the eleven nations come within the remit of the tax. Third, both buyers and sellers of relevant instruments are to be jointly and severally liable for this tax, and so double taxation fears arise.

In the context of the practical operation of deeply entrenched international mutual tax collection conventions, the Commission’s proposal will impose obligations and liabilities even on governments who refuse to sign up to the Tobin tax. The UK is in this category, and it has instigated a legal challenge to the Commission’s proposal based on these points.

Banking

There were no major banking fatalities during the month. Indeed the major banking centres such as London increasingly have a pre-crisis feel, with prices now of the types of complex structured products that were blamed for the 2008 collapse reaching very high levels, as investors’ chase yield around all markets.

Energised by the feelgood factor, the two major UK failed banks (RBS and Lloyds) appear to have pulled off a remarkable lobbying coup by objecting to government proposals for auditor rotation every 15 years. The arguments in favour of auditor rotation are very strong. Investor groups led by the University Superannuation Scheme (USS) have even appealed directly to Commissioner Barnier. These investors argue that independence of audit scrutiny is just as important as reform of IFRS accounting standards, whose effectiveness is now under formal review by the European Commission.

Yet the power of the banking lobby is strong. It appears that rotation will be enforced in the UK only every 25 years (the present average is 48) and bank chiefs are happy, some boasting that they have a longer relationship with their auditors than with their wives.

RBS (82% government owned) attracted strong criticism for its announcement in early May that it will recapitalise using a modern hybrid form of equity rather than launch a traditional ‘rights issue’. Instead of shares, it will issue bonds that automatically convert into shares if a capital minimal trigger is breached.

The bank claims that the hybrid route is necessary because the UK Government refuses to inject any more capital. This point is fallacious. Rights issues are priced at a significant discount to the pre-rights market share price, so any investor wishing not to pay in any more capital can sell their rights for cash on advantageous terms. Indeed, institutional investor groups have calculated that a rights issue would have generated cash receipts to the UK Government of £3 – 5 billion.

Why then would RBS management choose hybrid capital over a rights issue? A clue to their thinking may be the news of a £4billion lawsuit filed in April against the 2008 Board based on allegations of false statements in the rights issue prospectus. If proven, the Board will be personally liable for the claim. The 2008 Board were given an indemnity when the bank was bailed out. The present Board have no such indemnity, but unlike rights prospecti, bond prospecti do not expose board members to personal liability.

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