Home » March’14 Newsletter: A Questionable Recovery

March’14 Newsletter: A Questionable Recovery


The quality of the recovery remains questionable. In the meanwhile, banks must deal with new regulation and investors look for higher yields.

Money: too cheap for the Ukraine, never cheap enough for the West.

Ukraine’s economic woes are connected to the Euro-American cheap money policy more than the weak trade links would suggest. Ukraine then returns the volley to European policy-makers through a spike in oil and foodstuff prices.

Economic implications of the strained Ukraine-Russia relations on the Eurozone were downplayed by the ECB at the start of March on the grounds that direct economic links between Ukraine and the Eurozone are modest. Few have disagreed with that sentiment, expressed as it is in purely economic terms. However, thinking more broadly, underlying links between the geopolitics of the Ukrainian crisis and the Eurozone economy have quickly become apparent.

Ultra-loose western monetary policies have probably contributed to stoking this particular fire. In 2010, Ukraine agreed a financing package with the IMF, which involved politically unpopular policy choices. But as the Federal Reserve opened the QE taps and investors ventured further afield in search of yield, markets provided funding on terms so attractive that Ukraine quietly pulled out of the constraining IMF arrangement. In April 2013, Ukraine was able to issue ten-year capital market debt at a cost of only 7.5%, with none of the policy adjustments desired by the IMF. Had Ukraine’s leaders taken funds from the IMF, agreed to structural adjustments and/or intensified negotiations with Western counterparts, Kyiv would have been closer to the umbrella of “western” protection.

Perversely, the modest spike in the price of oil and staple foodstuffs resulting from the Ukrainian fallout may have pleased Eurozone policymakers who are now deeply worried about deflation. Official Eurostat Eurozone (EA18) inflation for February was unchanged at 0.8%. It is worth re-emphasising that policymakers consider achieving positive GDP growth and consumer price inflation closer to 2% as critical to sustain their credibility. The ECB chose not to cut interest rates on March 7th, citing modest 4th quarter GDP uptick of 0.3% and some upbeat forecasts. We fear that such forecasts may signal only an unsustainable build up of inventories, which as we noted last month accounted for the majority of the pick up in 2013 US growth. Such concerns are confirmed by producer price data which showed that the prices of goods leaving factories fell in January at the fastest level since 2009, down 1.4% for the year (again, for EA18); and by other data showing bank lending to the economy (as opposed to other banks) fell again slightly in January, after a 3% contraction in 2013. Briefly put, we are still seeking hard evidence of any Europe-wide recovery.

For now, therefore, policymakers remain co-ordinated in action and goals even if less confident of their chances of success. Co-ordination is perhaps the most successful policy achievement to emerge post-crisis, it has worked well since July 2012. The question now arises as to how long such a consensus will be maintained if economic stagnation persists.

Central Banking and Bank Regulation

A new financial regulation that aims to equalize the rules for foreign and domestic banks in the US has put the Fed between a rock of the SEC and a hard place of the EU’s own idea of a level playing field.

With US 4th quarter growth reported at +2.4%, and official unemployment down to 6.6%, the US continues to look in better shape than Europe, but recent data have disappointed. Industrial production data are not as strong as has been hoped and the New York Federal Reserve’s index of General Business Conditions fell in February to just under 5% from 12% a month previously. Across the US, housing starts were down sharply, although some of this is probably due to extreme weather conditions. Fed Chair Janet Yellen has sought to reassure that current Fed policy on further tapering reduction is for now unchanged.

Meanwhile, Ms Yellen’s colleagues at the Federal Reserve’s regulatory arm caused a little storm of their own by announcing specific capital and liquidity rules for foreign banks doing business in the US. Foreign banks with assets of more than $50 billion will, from July 2016, be required to consolidate all US activities into one reporting subsidiary and meet the same standards that apply to domestic US banks. The capital rule is a simple capital-to-assets test (leverage ratio), rather than a risk-weighted approach such as the traditional Basel rule. Some 17 foreign banks such as Deutsche and Barclays are expected to be affected: the effectiveness of these tests remains questionable, and the administrative costs they entail are substantial.

The news has provoked sharp responses not only from the European Commission but also other US regulators. In Europe, commissioner Barnier hinted at retaliation on the grounds that the US decision may undermine the ‘global level playing field’. In some sense, though, the Fed’s decision can be justified as levelling the playing field for banks operating in the US, which some believe previously favoured foreign banks. Another reason for the regulation is to protect US taxpayers from potential bailout liabilities for foreign banks, especially in light of the glacial progress of European negotiations concerning bank resolution mechanisms and funding thereof.

The announcement also provoked a reaction from the US Securities and Exchange Commission, the principal regulator of broker dealers and investment banks. The SEC is worried that the wide definition of foreign banks’ “activity” will include broking activities, so that the Fed will encroach upon the SEC’s own territory. SEC officials stopped just short of questioning the Fed’s competence in this area, but openly voiced the importance of preventing the creation of “duplicative or counterproductive” regulations. The SEC specifically disputed the appropriateness of Leverage Ratio tests for the businesses of broker dealers: they need relatively large quantities of liquidity, which under this new rule will require more capital.

Whilst we would expect domestic disagreements as to the aims of different US regulators to be resolved without too much difficulty, the imposition of US specific firewalls represents a fairly significant breach of the international post-crisis regulatory consensus that has prevailed so far. The UK is considering following America’s lead, and the European Commission has hinted at “retaliation”.

Banking and Investment

New financial instruments have sprung up, with repayment explicitly linked to the issuer’s financial health. Will these Cocos pour milk into banks, or will the coco-nut prove hard to crack?

The European Banking Authority reported that European banks raised $80 billion in capital in 2013. How much more do banks need? As the stress tests on European banks get underway, some commentators have pointed out that if the Swiss and US regulatory preference for a Leverage Ratio of 6% rather than the present 3% were applied, Europe’s banks would need another $500 billion of capital. And that assumes that the asset quality review produces no bad news at all.

Established professional fund managers such as PIMCO have demonstrated their confidence in certain banks’ turnaround stories by subscribing for a type of hybrid capital instrument called Contingent Capital instruments (Cocos). Cocos are high yielding bonds, and are distinguished from ordinary bonds by diminished recovery if the issuing bank’s capital level falls below an explicit, pre-defined trigger. Reduced investor recovery can take the form of coupon deferral, conversion to ordinary equity, or even a full write down. This feature means that the bonds display genuine ‘loss absorption’ features, and therefore they count as capital for purposes of either the Basel regulatory capital or leverage ratio requirements. This feature differentiates Cocos from other instruments such as the so-called plain-vanilla subordinated debt which may absorb losses but which contain no actual “bail-in” trigger.

The Coco market has grown to just under $40 billion after a slow start in 2009. One reason for the pickup in growth has been tax deductibility which, currently granted by the UK, France and Spain. Another reason is investors’ quest for yield in a market of very low interest rates. With Cocos yielding 6-9% annually, it seems likely that major bond funds have developed an interest. The big question, of course, is whether banks will somehow survive future market turbulence. Will the 2013 stock-market rally run out of momentum, given that the Eurozone periphery’s banking system will have to deal with possibly $2 trillion of non-performing loans? And will policymakers be able to generate the nominal GDP growth of 3 – 5% needed for Euro zone countries to get their still-growing debts under control?

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