Hard Brexit maths – walking away

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Macro Letter – No 77 – 19-05-2017

Hard Brexit maths – walking away

  • The UK’s NIESR estimate the bill for Hard Brexit to the UK at EUR 66bln
  • I guesstimate the cost of Hard Brexit to the EU at EUR 62bln
  • Legal experts for both sides suggest UK obligations cease on Brexit
  • A Free-trade deal with the EU may not begin until after March 2019

…How selfhood begins with a walking away…

C. Day-Lewis

It has been estimated that if the UK accedes to EU demands for a further EUR 100bln in order to begin the process of establishing a bi-lateral trade deal with the EU post-Brexit, it will cost the UK economy 4.4% of GDP. According to estimates from the NIESR, to revert to WTO Most Favored Nation terms (the Hard Brexit option) would only cost between -2.7% and -3.7% of GDP (EUR 61bln to EUR 84bln).

In January UK MP May stated:-

No deal is better than a bad deal.

It looks, on this basis, as though the UK may indeed walk away from its purported EU obligations.

A more considered analysis from, the politically influential Brussels based thin-tank Bruegel – Divorce settlement or leaving the club? A breakdown of the Brexit bill – suggests a more modest final bill:-

Depending on the scenario, the long-run net Brexit bill could range from €25.4 billion to €65.1 billion, possibly with a large upfront UK payment followed by significant EU reimbursements later.

This substantial price range is due to the way the UK’s share of liabilities is calculated. At 12% (the UK’s rebate-adjusted share of EU commitments) it is EUR 25.4bln. At 15.7% (the UK’s gross contributions without a rebate adjustment) it rises to EUR 65.1bln.

The House of Lords legal interpretation – Brexit and the EU budget:-

Article 50 provides for a ‘guillotine’ after two years if a withdrawal agreement is not reached unless all Member States, including the UK, agree to extend negotiations. Although there are competing interpretations, we conclude that if agreement is not reached, all EU law—including provisions concerning ongoing financial contributions and machinery for adjudication—will cease to apply, and the UK would be subject to no enforceable obligation to make any financial contribution at all.

This suggests all of the UK’s commitments to the EU are linked to membership. If that legal interpretation is correct, there would be no Brexit bill at the moment of departure. Apparently EU legal experts have arrived at similar conclusions. The Telegraph – €100bn Brexit bill is ‘legally impossible’ to enforce, European Commission’s own lawyers admit has more on this contentious subject.

Setting aside the legal obligations in favour of a diplomatic solution, what is the price range where a potential agreement may lie? The cost to the UK appears to be capped at EUR 84bln in a worst case scenario. One may argue that the ability of Sterling to decline, thus improving the UK’s terms of trade, makes this scenario unrealistically high, but as I discussed in – Uncharted British waters – the risk to growth, the opportunity to reform historic evidence doesn’t support the case very well at all:-

Another factor to consider, since the June vote, is whether the weakness of Sterling will have a positive impact on the UK’s chronic balance of payments deficit. This post from John Ashcroft – The Saturday Economist – The great devaluation myth suggests that, if history even so much as rhymes, it will not:-

If devaluation solved the problems of the British Economy, the UK would have one of the strongest trade balances in the global economy…. the depreciation of sterling in 2008 did not lead to a significant improvement in the balance of payments. There was no “re balancing effect”. We always argued this would be the case. History and empirical observation provides the evidence.

There was no improvement in trade as a result of the exit from the ERM and the subsequent devaluation of 1992, despite allusions of policy makers to the contrary. Check out our chart of the day and the more extensive slide deck below.

Seven reasons why devaluation doesn’t improve the UK balance of payments …

1 Exporters Price to Market…and price in Currency…there is limited pass through effect for major exporters

2 Exporters and importers adopt a balanced portfolio approach via synthetic or natural hedging to offset the currency risks over the long term

3 Traders adopt a medium term view on currency trends better to take the margin boost or hit in the short term….rather than price out the currency move

4  Price Elasticities for imports are lower than for exports…The Marshall Lerner conditions are not satisfied…The price elasticities are too limited to offset the “lost revenue” effect

5  Imports of food, beverages, commodities, energy, oil and semi manufactures are relatively inelastic with regard to price. The price co-efficients are much weaker and almost inelastic with regard to imports

6 Imports form a significant part of exports, either as raw materials, components or semi manufactures. Devaluation increases the costs of exports as a result of devaluation

7 There is limited substitution effect or potential domestic supply side boost

8 Demand co-efficients are dominant

 

But what is the economic impact on the EU? CIVITAS – Potential post-Brexit tariff costs for EU-UK trade postulates some estimates:-

Our analysis shows that if the UK leaves the EU without a trade deal UK exporters could face the potential impact of £5.2 billion in tariffs on goods being sold to the EU. However, EU exporters will also face £12.9 billion in tariffs on goods coming to the UK.

Exporters to the UK in 22 of the 27 remaining EU member states face higher tariffs costs when selling their goods than UK exporters face when selling goods to those countries.

German exporters would have to deal with the impact of £3.4 billion of tariffs on goods they export to the UK. UK exporters in return would face £0.9 billion of tariffs on goods going to Germany.

French exporters could face £1.4 billion in tariffs on their products compared to UK exporters facing £0.7 billion. A similar pattern exists for all the UK’s major EU trading partners.

The biggest impact will be on exports of goods relating to vehicles, with tariffs in the region of £1.3 billion being applied to UK car-related exports going to the EU. This compares to £3.9 billion for the EU, including £1.8 billion in tariffs being applied to German car-related exports.

The net Trade Effect of a Hard Brexit on the basis of these calculations is EUR 7.7bln in favour of the UK.

Then we must consider the UK contribution to the EU budget, which, if the House of Lords assessment is confirmed, will be zero after Brexit. This will cost the EU EUR7.8bln, based on the 2017 net EU budget of EUR 134bln, to which the UK is currently the second largest contributor at 5.8%.

Next there is the question of the impact on EU27 economic growth. These headwinds will be felt especially in the Netherlands, Ireland and Cyprus but the largest absolute cost will be borne by Germany.

According to a February 2016 study by DZ Bank, a Hard Brexit would be to reduce German economic growth by -0.5%, from 1.7% to 1.4% – EUR 18.5bln. Credit Agricole published a similar study of the impact on the French economy in June 2016. They estimated that French GDP would be reduced by -0.4% in the event of a free-trade agreement and -0.6% in the event of a Hard Brexit – EUR 13.2bln. The Netherlands Bureau for Economic Policy Analysis (CPB) estimated the cost to the Netherlands at -1.2% – EUR 8.2bln. Italian Government forecasters estimate the impact at -0.5 to -1% – taking the best case scenario – EUR 8.3bln. A leaked Spanish Government report from March 2017 (interestingly, the only estimate I have been able to uncover since the Brexit vote) indicates a cost of between -0.17% and -0.34% of GDP – again, taking the best case – EUR 2bln. Ireland, given its geographic position, shared language and border, has, perhaps the closest ties with the UK of any EU27 country. Back in 2016 the Irish ERSI estimated the impact on Ireland at only -1%, I suspect it might be greater but I will take them at their word – EUR 2.6bln.

In the paragraph above I have looked at just five out of the EU27. Added together the cost to just these five countries is EUR 52.8bln, but I believe it to be representative, they accounted for 84.74% of EU GDP in 2016. From this I arrive at an extrapolated cost to the EU of a Hard Brexit of EUR 62.3bln.

The European Commission has indicated that the cost for the UK to begin negotiating the terms of a new free-trade agreement with the EU may be as much as EUR 100bln. The cost to the UK, of simply walking away – Hard Brexit – is estimated at between EUR 61bln and EUR 84bln per annum. The cost of Hard Brexit to the EU is estimated (I should probably say guesstimated, since there are so many uncertainties ahead) at EUR 62bln. A simple cost benefit analysis suggests that both sides have relatively similar amounts to lose in the short term. And I hate to admit it, but looked at from a negative point of view, in the long run, the UK, with its structural current account and trade deficit, may have less to lose from simply walking away.

Conclusion and Investment Opportunities

Brexit negotiations are already and will remain deeply political. From a short-term economic perspective it makes sense for the UK to walk away and re-establish its relationships with its European trading partners in the longer run. Given the UK trade deficit with the EU it has the economic whip-hand. Working on the assumption that Jean Claude Junker is not Teresa May’s secret weapon (after all, suggesting ever higher costs for negotiating a free-trade deal makes it more likely that the UK refuses to play ball) one needs to step back from the economics of the situation. The politics of Brexit are already and will probably become even more venal. For the sake of the UK economy, and, for that matter the economies of the EU, I believe it is better for the UK to walk away To those of you who have read my previous articles about Brexit, I wish to make clear, this is a change of opinion, politics has trumped economic common sense.

The implications for the UK financial markets over the next 22 months is uncertainty, although May’s decision to adopt a Hard Brexit starting point has mitigated a substantial part of these risks. Sterling is likely to act as the principle safety valve, however, a fall in the trade-weighted value of the currency will feed through to higher domestic inflation. Short term interest rates, and in their wake Gilt yields, are likely to rise in this scenario. Domestic stocks are also likely to be vulnerable to the negative impact of currency weakness and higher interest rates on economic growth. The FTSE 100, however, with 70% of its earnings derived from outside the UK, should remain relatively immune.

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Is there any value in the government bond markets?

Is there any value in the government bond markets?

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Macro Letter – Supplemental – No 4 – 12-5-2017

Is there any value in the government bond markets?

  • Since 2008 US 10yr T-bond yields have fallen from more than 5% to less than 2%
  • German 10yr Bunds yields have fallen even further from 4.5% to less than zero
  • With Central Bank inflation targets of 2% many bond markets offer little or no real return
  • In developed markets the inverse yield gap between dividend and bond has disappeared

Since the end of the great financial recession, bond yields in developed countries have fallen to historic lows. The bull market in stocks which began in March 2009, has been driven, more than any other factor, by the fall in the yield of government bonds.

With the Federal Reserve now increasing interest rates, investors are faced with a dilemma. If they own bonds already, should they continue to remain invested? Inflation is reasonable subdued and commodity prices have weakened recently as economic growth expectations have moderated once more. If investors own stocks they need to be watching the progress of the bond market: bonds drove stocks up, it is likely they will drive them back down as well.

The table below looks at the relative valuation between stocks and bonds in the major equity markets. The table (second item below) is ranked by the final column, DY-BY – Dividend Yield – Bond Yield, sometimes referred to as the yield gap. During most of the last fifty years the yield gap has been inverse, in other words dividend yields have been lower than bond yields, the chart directly below shows the pattern for the S&P500 and US 10yr government bonds going back to 1900:-

Chart-2-the-reverse-yield-gap-in-a-longer-term-con

Source: Newton Investment Management

Bonds_versus_Equities

Source: StarCapital, Investing.com, Trading Economics

The CAPE – Cyclically Adjusted Price Earnings Ratio and Dividend Yield Data is from the end of March, bond yields were taken on Monday morning 8th May, so these are not direct comparisons. The first thing to notice is that an inverse yield gap tends to be associated with countries which have higher inflation. This is logical, an equity investment ought to offer the investor an inflation hedge, a fixed income investor, by contrast, is naturally hedged against deflation.

Looking at the table in more detail, Turkey tops the list, with an excess return, for owning bonds rather than stocks, of more than 7%, yet with inflation running at a higher rate than the bond yield, the case for investment (based simple on this data) is not compelling – Turkish bonds offer a negative real yield. Brazil offers a more interesting prospect. The real bond yield is close to 6% whilst the Bovespa real dividend yield is negative.

Some weeks ago in Low cost manufacturing in Asia – The Mighty Five – MITI VI looked more closely at India and Indonesia. For the international bond investor it is important to remember currency risk:-

Currency_changes_MITI_V (1)

Source: Trading Economics, World Bank

If past performance is any guide to future returns, and all investment advisors disclaim this, then you should factor in between 2% and 4% per annum for a decline in the value of the capital invested in Indian and Indonesian bonds over the long run. This is not to suggest that there is no value in Indian or Indonesian bonds, merely that an investor must first decide about the currency risk. A 7% yield over ten years may appear attractive but if the value of the asset falls by a third, as has been the case in India during the past decade, this may not necessarily suffice.

Looking at the first table again, the relationship between bond yields in the Eurozone has been distorted by the actions of the ECB, nonetheless the real dividend yield for Finnish stocks at 3.2% is noteworthy, whilst Finnish bonds are not. Greek 10yr bonds are testing their lowest levels since August 2014 this week (5.61%) which is a long way from their highs of 2012 when yields briefly breached 40% during the Eurozone crisis. Emmanuel Macron’s election as France’s new President certainly helped but the German’s continue to baulk at issuing Eurobonds to bail out their profligate neighbours.

Conclusion and Investment Opportunity

Returning to the investor’s dilemma. Stocks and bonds are both historically expensive. They have been driven higher by a combination of monetary and quantitative easing by Central Banks and subdued inflation. For long-term investors such as pension funds, which need to invest in fixed income securities to match liabilities, the task is Herculean, precious few developed markets offer a real yield at all and none offer sufficient yield to match those pension liabilities.

During the bull-market these long-term investors actively increased the duration of their portfolios whilst at the same time the coupons on new issues fell steadily: new issues have a longer duration as well. It would seem sensible to shorten portfolio duration until one remembers that the Federal Reserve are scheduled to increase short term interest rates again in June. Short rates, in this scenario will rise faster than long-term rates. Where can the fixed income portfolio manager seek shelter?

Emerging market bonds offer limited liquidity since their markets are much smaller than those of the US and Europe. They offer the investor higher returns, but expose them to heady cocktail of currency risk, credit risk and the kind of geopolitical risk that ultra-long dated developed country bonds do not.

A workable solution is to consider credit and geopolitical risk at the outset and then actively manage the currency risk, or sub-contract this to an overlay manager. Sell long duration, low yielding developed country bonds and buy a diversified basket of emerging market bonds offering acceptable real return and, given that in many emerging markets corporate bonds offer lower credit risk than their respective government bond market, buy a carefully considered selection of liquid corporate names too. Sadly, many pension fund managers will not be permitted to make this type of investment for fiduciary reasons.

In answer to the original question in my title? Yes, I do believe there is still value in the government bond markets, but, given the absence of liquidity in many of the less developed markets – which are the ones offering identifiable value – the portfolio manager must be prepared to actively hedge using liquid markets to avoid a forced liquidation – currency hedging is one aspect of the strategy but the judicious use of interest rate swaps and options is a further refinement managers should consider.

This strategy shortens the duration of the bond portfolio because, not only purchase bonds with a shorter maturity, but also ones with a higher coupon. Actively managing currency risk (or delegating this role to a specialist currency overlay operator) whilst not entirely mitigating foreign exchange exposures, substantially reduces them.

Emerging market equities may well offer the best long run return, but a portfolio of emerging market bonds, with positive rather than negative real-yields, is far more compelling than continuously extending duration among the obligations of the governments of the developed world.

The Scotian experiment and European fragmentation

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Macro Letter – No 21 – 10-10-2014

The Scotian experiment and European fragmentation

  • Scotland voted to remain part of the Union but the devolution debate doesn’t end there
  • Further European integration risks breaking the European Union
  • Economic growth in the UK and Eurozone will be damaged by long-term uncertainty

The Scottish decision to remain part of the Union, by such a slim margin – 55% to 45% on an 85% turnout – caught me by surprise. On reflection it should not have been unexpected – it was as much about the “hearts” as the “minds” of the Scottish electorate. Now that the dust has settled, I wonder what this vote means for the United Kingdom and for other regions of Europe.

In this month’s issue of The World Today, Chatham House – A result that resolves little Malcolm Chambers – Research Director at the Royal United Services Institute (RUSI) made the following observations: –

The Scottish referendum was supposed to settle the UK’s constitutional uncertainties, but the result has raised more questions than it answers. How Britain addresses the devolution issue and the question mark over its commitment to Europe will shape perceptions of its ability to wield influence and hard power abroad for years to come.

Britain’s 2010 National Security Strategy, published shortly after the coalition government took office, was entitled ‘A Strong Britain in an Age of Uncertainty’. It made no mention of the two existential challenges – the possible secession of Scotland from the United Kingdom, and the risk of a British withdrawal from the European Union. Yet either event would be a fundamental transformation in the very nature of the British state, with profound impact on its foreign and security policy.

The article goes on to discuss the promises made to Scotland by Westminster’s political elite, from all the main parties, which may now create the conditions for eventual independence: –

Devolution max could have a similar effect, making the final step from ‘devo-max’ to ‘indy-light’ appear less traumatic, even as it still allows Westminster to be blamed for any ills that remain. If a further referendum is to be avoided five or ten years from now, it will not be enough to make constitutional changes.

Prime Minister Cameron took the opportunity to raise the issue of Scottish MPs voting on English issues; whilst this was politically expedient, it sows the seeds for regional calls for devolution of power to the poorer areas of Britain: –

Yet growing awareness of the constitutional imbalances created by devolution to Scotland – and, to a lesser extent, to Wales and Northern Ireland – is creating a series of shockwaves that will not dissipate easily. The UK, as a result, could now see a long period of constitutional experimentation and controversy, with profound effects on the governance of the country as a whole.

Chambers then turns to investigate the “European Question”. Here he sees a parallel between the UKs relationship with the EU and the Scottish desire for independence: –

Britain’s relationship with the European Union is similar, in important respects, to Scotland’s position in the United Kingdom. It has a special financial arrangement, involving a rebate of most of its net contribution, that is not available to other member states. It retains its own currency and border controls, and has a permanent exemption from the common currency and passport-free travel to which other states have agreed. As in Scotland, there is strong political pressure for the UK to be allowed special treatment in further areas, such as immigration controls. In both cases, attempts to construct ‘variable geometry’ governance frameworks are made more difficult by the asymmetry in size between the opting-out nation and the political union as a whole.

From the Brussels’ perspective the issue of devolution is not just restricted to the “Sceptred Isle”: –

While the nature of the Britain’s constitutional crises is unique, they are part of a wider crisis of European politics. Over the past five years, the eurozone has faced successive crises as it has sought to find a way to reconcile vast differences in economic interest and viewpoint between its member states. Relations between Germany and the southern states have worsened as the former takes on a more openly hegemonic role.

Without further significant sharing of political sovereignty – for example through a banking union – the risk that one or more member states could leave the eurozone will remain very substantial. Yet further political integration could bring its own challenges, with powerful nationalistic parties in northern Europe already pushing against those who argue that all the answers must come from Brussels. One of the reasons that Britain’s European allies were so worried about the Scotland vote was precisely their concern as to the example that a Yes vote could have sent to separatist movements in Spain, Belgium, Italy or Bosnia. This concern will not have been entirely dissipated, both because of the precedent set by London’s willingness to hold the vote, and by the closeness of the margin.

In conclusion Chambers states: –

It is still far from likely that the United Kingdom will perish, or that it will abandon its commitment to the European Union. But the possibility of one or both of these separations taking place seems set to be a central part of British politics for a decade or more.

The impact on Sterling

Sterling is still some way below its longer-term average on a trade weighted basis as this chart of the Sterling Effective Exchange Rate (ERI) Index shows, however, it’s worth noting that the average between 1994 and 2013 is around 90: –

GBP Effective Exchange rate - BoE

Source: Bank of England

Uncertainty always undermines the stability of ones currency and the Scottish referendum was no different, although its impact proved relatively minor. In a recent speech, Bank of England – The economic impact of sterling’s recent moves: more than a midsummer night’s dream – Kristin Forbes – MPC member, downplayed what could have been a dramatic decline in the value of the GBP:-

There has been some volatility in sterling recently, especially around the time of the Scottish referendum, but sterling is currently only 1% weaker than its recent peak in July 2014.

In her conclusion she points to the appreciation of the GBP since the Great Recession and cautions those who fail to anticipate the negative inflationary consequences of a weaker exchange rate: –

Where sterling’s recent moves may have had the greatest economic impact is on prices and inflation. A “top down” analysis estimating the pass-through from exchange rate movements to prices suggests that the lagged effect of sterling’s appreciation during 2013 and early 2014 may have acted as a powerful dampening effect on inflation. Although model simulations may be overestimating the magnitude of the effect, sterling’s past moves have reduced the risk of inflation increasing sharply, despite the strong growth in employment and the overall economy.

This dampening effect of sterling’s past appreciation, however, will peak at the end of 2014 and then begin to fade. As a result, it is becoming increasingly important to monitor trends in domestically-generated inflation – and especially unit labour costs – so that monetary policy can be adjusted appropriately and also be allowed to work through the economy with its own set of lags. Unfortunately, understanding recent trends in the domestic component of inflation – especially the slow growth in wages – has been challenging. A “bottom up” analysis of inflation that focuses on current measures of domestically-generated inflation (which attempt to minimize the dampening effect of sterling’s moves) show price pressures that are well contained and little evidence of imminent inflationary risks.

These “bottom up” indicators present a very different story then the “top down” estimates of inflation after adjusting for sterling’s recent appreciation. Has sterling’s appreciation had less of a dampening effect on prices than has traditionally occurred – perhaps due to structural changes in the UK or global economy? Or are the measures of domestic inflation understating current inflationary risks – perhaps due to the long lags before timely data is available? To answer these questions, it is critically important to monitor measures of prospective inflation to determine the appropriate path for monetary policy.

If concern about political devolution of power to the regions, at the expense of the power-house of the UK’s South East, and expectation of rising Euro-scepticism, are destined to be the pre-eminent political issues for the next decade, then an appreciation in the value of Sterling is likely to be tempered. Since the UK economy is closely integrated to Europe this persistent undervaluation will be less obvious in the GBP/EUR exchange rate but hopes of the trade weighted value of GBP rising like the USD due to structurally stronger growth will be muted.

In the aftermath of the referendum RUSI – Never the Same Again – What the Referendum Means for the UK and the Worldobserved:-

Having, for the first time, looked at what a ‘yes’ vote might mean for them, private investors and businesses are now more sensitised than ever before to the risks that a further referendum could pose. If some of them were to begin to hedge their bets accordingly, there could be a risk of an extended period of underinvestment in Scotland, with serious consequences for its prosperity.

Better together?

The campaign slogan of the Westminster elite was “Better Together” but, setting aside the rhetoric of power hungry politicians, what are the pros and cons of devolution versus Union? Writing ahead of the referendum Adam Posen of the Peterson Institute – The Huge Costs of Scotland Getting Small made a valiant case for continued integration: –

When is it ever a good idea for a small nation to set up on its own? Leaving aside cases of colonization and outright oppression, there is little good reason ever to shrink on the world scene by leaving a larger unit. The internal politics of democracies always get better deals for regions within them than small sovereigns can elicit from identity-ignoring market forces. The few small nations that did gain in welfare by seceding from transnational entities are those that escaped failed autocratic systems. The Baltic countries escaping the former Soviet Union’s dominance can be seen in this light. But setting out on your own is only beneficial when the system left behind has directly constrained your nation’s human potential. Whatever else, that cannot be said of the current Scottish situation in the United Kingdom.

It is a fact of life in today’s world that a small economy on its own is always buffeted by the forces of the global economy more than a region within a larger union. Even well-run small states like Singapore and Estonia are subject to huge swings in their economy resulting from capricious capital flows in and out. These swings disrupt employment, investment, and competitiveness via real exchange rate fluctuations. More important, small economies are fundamentally undiversified because of their small scale, and they risk their specializations falling out of favor in world markets. Events beyond their control can overwhelm the small nation’s high value-added industries, no matter how good it is at those things, be they oil extraction or banking or whisky distilling. Scottish independence in form will instead mean increased vulnerability in fact, because, inherently, smaller means more exposure when the markets turn—and turn they will.

…The economic debate over independence has tended to focus on the one-time transfer costs: setting up a new government administration, apportioning the accumulated public debt, grabbing as much oil as possible. But these issues are of minimal importance, however one chooses to measure them, compared to the ongoing costs of permanently greater insecurity to households and businesses. Even if an independent Scotland were to start out with the Scottish National Party (SNP) fantasy of relatively low public debt and a relatively high share of remaining oil revenues, it would have to save more, pay higher interest rates, and keep more space in its budget for self-insurance, hampered by a narrow tax base, in order to cope with the vicissitudes of the global economy on its own.

When one looks at the economic austerity foisted on the population of Greece and at the hopeless prospects much of the unemployed youth of Europe I wonder whether there is an alternative to the “integrationist” approach.

Looking for an answer I went back to the forging of the United Kingdom. This is how John Lancaster describes the events which led to the Act of Union in 1707:-

During the 17th century, Scottish investors had noticed with envy the gigantic profits being made in trade with Asia and Africa by the English charter companies, especially the East India Company. They decided that they wanted a piece of the action and in 1694 set up the Company of Scotland, which in 1695 was granted a monopoly of Scottish trade with Africa, Asia and the Americas. The Company then bet its shirt on a new colony in Darien – that’s Panama to us – and lost. The resulting crash is estimated to have wiped out a quarter of the liquid assets in the country, and was a powerful force in impelling Scotland towards the 1707 Act of Union with its larger and better capitalised neighbour to the south. The Act of Union offered compensation to shareholders who had been cleaned out by the collapse of the Company; a body called the Equivalent Society was set up to look after their interests. It was the Equivalent Society, renamed the Equivalent Company, which a couple of decades later decided to move into banking, and was incorporated as the Royal Bank of Scotland. In other words, RBS had its origins in a failed speculation, a bail-out, and a financial crash so big it helped destroy Scotland’s status as a separate nation.”

The above passage, taken from Lancaster’s 2009 book It’s Finished, is quoted near the opening of a recent article by Tim Price – Let’s Stick Together in which he refers to Leopold Kohr – The Breakdown of Nations. The forward by Kirkpatrick Sale describes the problem of size when nation building: –

What matters in the affairs of a nation, just as in the affairs of a building, say, is the size of the unit. A building is too big when it can no longer provide its dwellers with the services they expect – running water, waste disposal, heat, electricity, elevators and the like – without these taking up so much room that there is not enough left over for living space, a phenomenon that actually begins to happen in a building over about ninety or a hundred floors. A nation becomes too big when it can no longer provide its citizens with the services they expect – defence, roads, post, health, coins, courts and the like – without amassing such complex institutions and bureaucracies that they actually end up preventing the very ends they are intending to achieve, a phenomenon that is now commonplace in the modern industrialized world. It is not the character of the building or the nation that matters, nor is it the virtue of the agents or leaders that matters, but rather the size of the unit: even saints asked to administer a building of 400 floors or a nation of 200 million people would find the job impossible.

Kohr grew up in a small village which may have helped him to recognise one of the intrinsic weaknesses of democracy: that it works best on a small scale.

Taking this theme further and applying it to an independent Scotland, John Butler – From bravery to prosperity: A six-year plan to make Scotland the wealthiest Anglosphere region of all makes the case for a smaller more flexible approach. Here is an abbreviated version of his six point plan:-

Debt Repayment

The Scots’ legendary bravery is equalled by legendary parsimony, the first essential element of success. There is no growth without investment and no sustainable investment without savings. It stands to reason that you aren’t a parsimonious society if you carry around a massive, accumulating national debt. Debt service is also a drag on future growth. Thus if the Scots want to prosper long-term, they are going to need to pay down their share of the UK national debt.

Tax Reduction

There are several policies that would quickly create an investment boom. Most important, Scotland should do better than celtic rival Ireland, with a low corporate tax rate, and abolish the corporate income tax altogether. Yes, you read that right: The effective corporate income tax in many countries now approaches zero anyway, due to all manner of creative cross-border accounting.

Human Capital

Developing human capital, at which the Scots excelled in the 19th century, is the third element. Consider which industries are most likely to relocate to Scotland: Those requiring neither natural resources nor extensive industrial infrastructure, that is, those comprised primarily of human capital. Although financial services comes to mind, there is tremendous overcapacity in this area in England and Ireland, including in unproductive yet risky activities, so that is better left to the English and Irish for now. Better would be to concentrate on health care, for example, an industry faced with soaring costs and stifling regulation in much of the world.

Scotland could, inside of six years, become the world’s premier desination for so-called ‘healthcare tourism’. Scotland lies directly under some of the world’s busiest airline routes, an ideal location.

Sound Banking

A fourth essential element to success is to implement Scottish Enlightenment principles for sound banking. This is of utmost importance due to the potential monetary and financial instability of the UK and much of the broader Anglosphere.

As a first step, Scotland should forbid any bank from conducting business in Scotland if they receive any direct financial assistance from the Bank of England or from the UK government. In turn, Scotland should make clear to Westminster that Scottish residents will not contribute to any taxpayer bail out of any UK financial institution. No ‘lender of last resort’ function will exist for financial activities in Scotland, unless such action, if formally requested by a bank, is approved by the Scots in a referendum. (Taxpayers are always on the hook for bailouts one way or the other; why not make this explicit?)

Self-Reliance

The fifth element reaches particularly deep into Scottish history: Self-Reliance. Peoples that inhabit relatively inhospitable or infertile lands tend to establish cultures with self-reliance at the core. No, this does not make them culturally backward, but it does tend to contribute to a distrust of foreign or central authority. The Scots, while brave, were frequently disunited in their opposition to English rule, something that had unfortunate consequences for many, not just William Wallace.

Scottish Presbyterianism

Finally, there is the sixth element: the collective cultural traditions of Scottish Presbyterianism. There are few religions in the world that hold not only faith, but hard work, thrift and charity in such high regard as that of traditional Presbyterianism. Yes, as with most all Europeans, the Scots have become more secular in recent decades. But the same could be said of the Germans, who nevertheless cling to their own, solid Protestant work ethic and associated legal and moral anti-corruption traditions.

To be fair to Adam Posen of the Peterson Institute, none of the arguments for a non-integrated Scotland solve the problems of vulnerability to external shocks. The crux of the issue is whether a larger, more integrated unit, is more effective than a smaller more flexible one.

The Politics of Empires

“Power tends to corrupt, and absolute power corrupts absolutely. Great men are almost always bad men.”  Lord Acton – 1834-1902.

Throughout history successful nations have grown through expansion and integration. The process is cyclical, however, and success sows the seeds of its own demise. Europe emerged from the dark ages to conquer much of the known world. Since then it has imploded during two world wars and may now be embarking on a further wave of integration. Or, perhaps, this is the last attempt to assimilate a multitude of disparate cultures before the “long withdrawing breath” into smaller, more dynamic, self-reliant units.

In the opening chapter of Edward Gibbon’s “Decline and Fall of the Roman Empire” he says:-

…but it was reserved for Augustus (who became Caesar in BC 44) to relinquish the ambitious design of subduing the whole earth and to introduce a spirit of moderation into the public councils.

However, I believe the seeds of destruction, which eventually created the conditions for the establishment of A NEW Europe, stem from Diocletian’s introduction of the Tetrarchy in AD 284. It divided the Roman Empire in four regions.

Diocletian’s son, Constantine attempted to slow this fragmentation by adopting Christianity as the official religion of the empire, however, his decision to move the seat of government from Rome to Byzantium in AD 324 set the stage for the final schism into the Eastern and Western Empires which occurred in AD395 on the demise of Theodosius.

The Western Empire sustained continuous assaults from Vandals, Alans, Suebis and Visigoths leading to the second sack of Rome in AD 410 by Alaric. The Western Empire finally collapsed in AD 476 when the Germanic Roman general Odoacer deposed the last emperor, Romulus . Europe had descended into a “dark age” of constant wars between rival tribes. The sole pan-European administrative organization after the fall of the Western Empire was the Catholic Church, which adopted the remnants of its infrastructure.

The creation of the Europe we recognise today began with the conversion to Christianity of Clovis – King of the Franks – in AD 498, but it was not until the re-uniting of the Frankish kingdoms in AD 751 under Pepin The Short and the subsequent appointment of his son Charlemagne as Holy Roman Emperor in AD 800 that the idea of a Christian “Western Europe” began to emerge. When viewed from this long historical perspective the current development of the EU is still in its infancy.

In the East, Constantinople remained the administrative center of the Byzantine Empire. Under Emperor Justinian in AD 526 the Empire expanded. Challenges from the Lombards in AD 568 saw the loss of Northern Italy, but the rise of Islam after AD 623 proved a more terminal event. Although Byzantium went into decline, due to many assailants – not least the Western Empire – it limped on until 1453 when it to finally succumbed to the Ottoman Turks.

Why the history lesson? The spark of the industrial revolution was kindled in Europe. It developed out of the chaotic collapse of the Western Roman Empire, the warring between a plethora of tribes and the rise of independent city states. It was built on the fragmented polity of petty fiefdoms and the desire to trade despite national borders and political restrictions on the movement of labour and goods. The renaissance began in Italy where the competition between small city states stimulated “animal spirits”. The flowering of art and culture that this democratisation of prosperity set in motion goes some way to support the idea that “small is beautiful”.

During the dark ages the concept of “Nationhood” was fluid, as exemplified by the Dukes of Normandy’s fealty after 1066 to the King of France, but only in respect of their French domains. As nation states began to coalesce international trade developed further. Nations waxed and waned, alliances were made and broken but no single nation succeeded in dominating the whole region. Demographic growth encouraged voyages of discovery. Colonisation followed, and finally the conditions were propitious for the birth of the industrial revolution from which we continue to benefit today.

These processes were gradual, running their course over many generations. I believe Europe is now fragmenting once more; painful for our own time but filled with promise for future generations. Calls for self-government from many regions within the EU will increase. The more Brussels attempts to make its citizens feel European the more its citizens will yearn for self-determination.

This trend will be driven by a number of factors aside from the declining effectiveness of central government. Bruegal – The Economics of big cities articulates one of these economic paradoxes, how globalisation has made the world more local: –

Local economies in the age of globalization

Enrico Moretti writes that the growing divergence between cities with a well-educated labor force and innovative employers and the rest of world points to one of the most intriguing paradoxes of our age: our global economy is becoming increasingly local. At the same time that goods and information travel at faster and faster speeds to all corners of the globe, we are witnessing an inverse gravitational pull toward certain key urban centers. We live in a world where economic success depends more than ever on location. Despite all the hype about exploding connectivity and the death of distance, economic research shows that cities are not just a collection of individuals but are complex, interrelated environments that foster the generation of new ideas and new ways of doing business.

Enrico Moretti writes that, historically, there have always been prosperous communities and struggling communities. But the difference was small until the 1980’s. The sheer size of the geographical differences within a country is now staggering, often exceeding the differences between countries. The mounting economic divide between American communities – arguably one of the most important developments in the history of the United States of the past half a century – is not an accident, but reflects a structural change in the American economy. Sixty years ago, the best predictor of a community’s economic success was physical capital. With the shift from traditional manufacturing to innovation and knowledge, the best predictor of a community’s economic success is human capital.

Human Capital may be defined as “the skills, knowledge, and experience possessed by an individual or population”. In the internet age this resource can be located almost anywhere and need not be isolated due to email, telephone or video conference technology, however, the advantages of physical proximity and social interaction favour cities.

Another, and related, issue is the increasingly disruptive effect of technology on employment. Bruegal – 54% of EU jobs at risk of computerisationhighlights one of the greatest economic challenges to the social fabric of the EU, but this is a global phenomenon: –

Based on a European application of Frey & Osborne (2013)’s data on the probability of job automation across occupations, the proportion of the EU work force predicted to be impacted significantly by advances in technology over the coming decades ranges from the mid-40% range (similar to the US) up to well over 60%.

Those authors expect that key technological advances – particular in machine learning, artificial intelligence, and mobile robotics – will impact primarily upon low-wage, low-skill sectors traditionally immune from automation. As such, based on our application it is unsurprising that wealthy, northern EU countries are projected to be less affected than their peripheral neighbours.

European governments are caught between the competing needs of an aging population and a younger generation who have little prospect of finding gainful full-time employment. Meanwhile city workers are paying for the regions where unemployment is highest. The tension between “wealth makers” and “wealth takers” are destined to increase.

Conclusion

Scotland voted to remain part of the Union. The Independence campaign was ill prepared failing to consider such issues as what currency they would use or how they would avoid a run on their banking system. The next time the Scots vote – and there will be a next time – I believe they will leave the Union because these questions will have been addressed. Other regions around the UK and Europe have taken note – the spirit of devolution is abroad. Prosperous regions, such as Catalunya and Northern Italy – Padania as it is sometimes called – crave independence from their poorer neighbours. Poorer regions resent the straight jacket of a single currency – be it the GBP for regions like the North East of England or the EUR for Greece and Portugal. To the poorer regions, the flexibility of a floating exchange rate is beguiling; as the EU stumbles through an era of debt laden low growth devolution pressures will increase.

For the GBP and EUR the Scottish “No” vote will fail to diminish the potential for social and political tension. The value of these currencies will reflect that uncertainty. Longer-term foreign direct investment will be lower. This will place an additional burden on EU budgets. A larger percentage of central government spending will be directed to regions where calls for devolution are highest rather than to economically productive projects in more prosperous areas.

European and UK equities are likely to under-perform in this environment whilst the increased indebtedness of EU governments is likely to increase their real borrowing costs.

Will this happen soon and will it be possible to measure? I think it is already happening but, given the very long-term nature of the fragmentation of nations, it will be difficult to measure except during constitutional crises. The shorter-term business cycles will still exist. Trading and investment opportunities will continue to arise. For the investor, however, it is essential to be aware of the risks and rewards which this fragmentation process will present.

European Markets and Unification

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Macro Letter – No 3 – 17 -01-2014

European Markets and Unification

During 2013 developed market equities were the top performing major asset class. The US and UK had justification for rising since the effects of quantitative easing appear to have stimulated some economic activity. Europe, however, has less reason for strength since ECB policies have been less accommodative. The performance of the German mid-cap index aside, European equity market performance in 2013 was largely due to receding fears of the break-up of European currency union. This has been a major contributor to the decline in peripheral bond yields as the chart below shows.

European Bond Yields - 2005 - 2014 - Bloomberg.

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Source: Bloomberg

Banking Union and the ECB

In 2014 the focus will be on deepening unification, commencing with a European Banking Union. Der Spiegel reports: –

Not Fit for the Next Crisis: Europe’s Brittle Banking Union – 19th December 2013

http://www.spiegel.de/international/business/weak-eu-banking-union-could-have-dangerous-side-effects-a-940065.html

When German Finance Minister Wolfgang Schäuble, a trained lawyer, announced an agreement on Wednesday night in Brussels on the long negotiated EU banking union, observers might have been left thinking that he is precisely this type of lawyer.

On paper, Schäuble and his negotiators are right about very many points. They succeeded in ensuring that in 2016, the Single Resolution Mechanism will go into effect alongside the European Union banking supervisory authority. The provision will mean that failing banks inside the euro zone can be liquidated in the future without requiring German taxpayers to cover the costs of mountains of debt built up by Italian or Spanish institutes.

They also backed the European Commission, which wanted to become the top decision-maker when it comes to liquidating banks. The Commission will now be allowed to make formal decisions, but only in close coordination with national ministers from the member states.

But it goes even farther. Negotiators from Berlin have also created an intergovernmental treaty, to be negotiated by the start of 2014, that they believe will protect Germany from any challenges at its Constitutional Court that might arise out of the banking union.

They also established a very strict “liability cascade” that will require bank shareholders, bond holders and depositors with assets of over €100,000 ($137,000) to cover the costs of a bank’s liquidation before any other aid kicks in. The banks are also required to pay around €55 billion into an emergency fund over the next 10 years. Until that fund has been filled, in addition to national safeguards, the permanent euro bailout fund, the European Stability Mechanism, will also be available for aid. However, any funds would have to be borrowed by a national government on behalf of banks, and that country would also be liable for the loan. This provision is expected to be in place at least until 2026.

The government in Berlin put a strong emphasis on preventing the ESM, with its billions in funding, from being used to recapitalize debt-ridden European banks. Schäuble was alone with this position during negotiations, completely isolating himself from the other 16 finance ministers from euro-zone countries. Brussels insiders report that it was “extremely unusual because normally at least a few countries share Germany’s position.”

The article goes on to highlight some of the weaknesses with this agreement: –

  1. 1.       It’s too complex – The Financial Times stated, “In total, the process could involve nine committees and up to 143 votes cast.”
  2. It’s underfunded – The Single Resolution Mechanism, at Euro 55bln by 2026, is a drop in the ocean.
  3. It’s primarily a domestic affair, the union will be subject to national borders
  4. It will probably take at least five years to establish joint European liability.

Bruegel – Ending uncertainty: recapitalisation under European Central Bank Supervision – takes up the subject:-

http://www.bruegel.org/publications/publication-detail/publication/806-ending-uncertainty-recapitalisation-under-european-central-bank-supervision/

• Estimates of the recapitalisation needs of the euro-area banking system vary between €50 and €600 billion. The range shows the considerable uncertainty about the quality of banks’ balance sheets and about the parameters of the forthcoming European Central Bank stress tests, including the treatment of sovereign debt and systemic risk. Uncertainty also prevails about the rules and discretion that will apply to bank recapitalisation, bank restructuring and bank resolution in 2014 and beyond.

• The ECB should communicate the relevant parameters of its exercise early and in detail to give time to the private sector to find solutions. The ECB should establish itself as a tough supervisor and force non-viable banks into restructuring. This could lead to short-term financial volatility, but it should be weighed against the cost of a durably weak banking system and the credibility risk to the ECB. The ECB may need to provide large amounts of liquidity to the financial system.

• Governments should support the ECB, accept cross-border bank mergers and substantial creditor involvement under clear bail-in rules and should be prepared to recapitalise banks. Governments should agree on the eventual creation of a single resolution mechanism with efficient and fast decision-making procedures, and which can exercise discretion where necessary. A resolution fund, even when fully built-up, needs to have a common fiscal backstop to be credible.

The initial Asset Quality Review (AQR) of European Banks carried out in 2011 by the European Banking Authority proved to be a political embarrassment since almost every bank was found to be in relatively rude financial health: shortly before bailouts were required.

Breaking Views – Still time to undo EU bank stress test fiasco – November 2011 – sums up the problems with the previous stress tests eloquently: –

http://www.breakingviews.com/still-time-to-undo-eu-bank-test-fiasco/1616988.article

The test, which was blessed by last month’s ill-fated European summit, had two problems. First, it wasn’t stringent enough: the European Banking Authority concluded that Europe’s lenders needed an additional 106 billion euros, when the International Monetary Fund thought about twice as much was needed. The test has done little to restore confidence in the blighted sector. Banks are still unable to issue long-term unsecured debt, and have been increasingly thrown back on short-term support from the European Central Bank.

Second, the test encouraged deleveraging by expressing the capital requirement as a ratio and giving lenders eight months to get there. Given depressed share prices, many banks are anxious to avoid issuing equity. Instead they are trying to boost capital ratios by shrinking their balance sheets. This will almost certainly have the unfortunate side-effect of further suffocating the European economy, which is already on the edge of recession.

The current iteration of the AQR will, undoubtedly, have more “teeth” but these are shark infested waters where an ECB “health warning” might precipitate an ugly banking crisis.

The Peterson Institute – The European Central Banks Big Moment – December 2013 –  elaborates:-

http://www.piie.com/publications/opeds/oped.cfm?ResearchID=2527

Europe’s banking union project has had many doubters since it started to be widely discussed in the spring of 2012. What is not in doubt, however, is its transformative nature. In June 2012, EU leaders chose—in a galloping hurry, as usual—to move towards the centralization of bank supervision across euro area countries, with this authority entrusted to the European Central Bank (ECB). The consequences have only gradually become apparent to most and represent both an opportunity and a risk.

The opportunity is to reestablish trust in European banks, reboot the pan-European interbank market, end dysfunctional credit allocation, and start reversing the vicious circle between bank and sovereign credit. In an optimistic scenario, the ECB’s 12-month process of “comprehensive assessment,” including an asset quality review (AQR) and stress tests of about 130 credit institutions covering 85 percent of the euro area’s banking assets, will trigger the triage, recapitalization, and restructuring that history suggests is a prerequisite for systemic crisis resolution.

The risk is that, if the assessment fails to be consistent and rigorous, the ECB may find its reputation so damaged that the credibility of its monetary policy—and the perception of Europe’s ability to get anything done—could be affected. After all, this exercise is unprecedented in scale and scope, which means the ECB has little prior experience. At the same time, the political fallout is potentially poisonous to most of the states concerned.

Thus, much is at stake in the balance sheet review, and the scene is set for an escalating confrontation between the ECB and member states in the months ahead. The ECB has pointedly made clear that it will form an independent judgment on the capital strength of the banks examined, without necessarily following the views of national supervisors.

A successful AQR and establishment of the Single Supervisory Mechanism (SSM)—EU jargon for the handover of supervisory authority to the ECB—would have structural consequences. Europe’s national and local governments often use their leverage over the publicly-regulated banking industry for industrial policy purposes or to facilitate their own financing, a dynamic known to economists as financial repression.

Bruegel – Supervisory transparency in the European banking union – January 2014  – looks, in more detail, at the issues surrounding European bank regulation by the  ECB, they acknowledge the need for greater transparency and highlight the dangers of a half-baked approach to a banking union: –

http://www.bruegel.org/publications/publication-detail/publication/807-supervisory-transparency-in-the-european-banking-union/

• Bank supervisors should provide publicly accessible, timely and consistent data on the banks under their jurisdiction. Such transparency increases democratic accountability and leads to greater market efficiency.

• There is greater supervisory transparency in the United States compared to the member states of the European Union. The US supervisors publish data quarterly and update fairly detailed information on bank balance sheets within a week. By contrast, based on an attempt to locate similar data in every EU country, in only 11 member states is this data at least partially available from supervisors, and in no member state is the level of transparency as high as in the US.

• Current and planned European Union requirements on bank transparency are either insufficient or could be easily sidestepped by supervisors. A banking union in Europe needs to include requirements for greater supervisory transparency.

I always find Bruegel comments useful , not only in terms of what should be done to move the “European Project” forward, but also as a guide to what the institutional response is likely to be should an EU proposal fail to be adopted. They conclude: –

Finding agreement on an EU legal change that requires the ECB and member-state supervisors to open their books to greater scrutiny will surely be a difficult task given the current diversity of practices and interests – eg banks, national supervisors – that benefit from this diversity.

But greater supervisory transparency will facilitate more efficient distribution of capital and increase market discipline. It will increase the legitimacy of actions that the regulator takes against banks. The European Union receives justified flak that there is a great distance between European citizens and the institutions that make decisions on their behalf. There is real suspicion of the financial sector and distrust that public money goes only to help out political friends. Transparency in terms of the data the supervisors themselves use to make decisions would allow the public, and more realistically the various interest groups one finds in civil society, to judge whether regulators did choose actions consistent with protecting the public interest. Such ‘fire alarms’ therefore represent one small step towards addressing the democratic deficit that most citizens think exists in Europe.

If such transparency is not possible, for purposes of increasing ‘output legitimacy’ more work should be done to strengthen the role of parliaments. For the European Parliament, the autumn 2013 interinstitutional agreement with the European Central Bank represents a good start. Under all current proposals, national regulators will continue to play an important role especially for any bank resolution. As discussed earlier, the German Bundestag gains the ability in 2014 to investigate specific banks as part of the national implementation of Basel III. Such parliamentary powers should become standard in all European Union member states. Moreover, such a procedure should be not only a theoretical power, but also one that is used.

Nationalist Backlash

In a more recent post this month – Peterson Institute – Calm Seas in Europe in 2014? – Jacob Funk Kirkegaard predicts that whilst 2013 was a year of relative calm for the Eurozone, 2014 may be a very different matter. As usual the driving force behind any change in sentiment will be political: –

http://www.piie.com/blogs/realtime/?p=4195

No major EU elections are scheduled in 2014. In Italy, a new electoral law is unlikely to be agreed upon before it takes over the rotating EU presidency in the second half of 2014. By tradition, countries in that position refrain from holding national elections. Rather, European Parliament elections in May will be the political highlight of 2014. As discussed earlier, there is a risk that angry voters will turn out and elect some colorful non-mainstream members to that body. Still, there seems little risk that the European Parliament will become a “Weimar Parliament” with a majority of anti-EU members. Instead the established European parties seem likely to prevail with a smaller majority, ensuring that Europe remains governable.

With their increased representation, the question of what the anti-EU parties want (aside from their daily parliamentary allowances) will arise. Much has been written about the alliance between Marine Le Pen, leader of the French National Front, and the leader of the Dutch Freedom Party Geert Wilders. But theirs is little more than a photo-op coalition, posing limited political risks. There are inherent limitations on the ability of nationalist parties to collaborate across borders.

The European Parliament elections, though, may also indirectly influence the choice of the next president of the European Commission. In an attempt to broaden the democratic appeal of the European Union, the European political parties have suggested that they each propose a pan-European spitzen-kandidat for the post and then let the European voters decide. Of course, this is a naked—if well-intended—power grab by the European Parliament, as the right to select the Commission president resides with the EU member states according to the EU Treaty. And they are unlikely to surrender this right. At the same time, it will be very difficult for the EU member states to ignore the winning side in the European Parliament election. The heads of states will hence likely be compelled to at least choose a new European President from the side of the political aisle that won the most votes in the election. Their selection power will thus be constrained…

Economically, the biggest event in 2014 will be the rollout of the ECB’s asset quality review (AQR) and stress tests of the euro area banking system, representing the opportunity to finally restore the soundness of Europe’s bank balance sheet. Failure to carry out a convincing review will threaten the region with Japanese-style prolonged stagnation and undermine the credibility of the ECB. The AQR/stress test is more important than the hotly debated single resolution mechanism (SRM) designed to close down or consolidate failing banks, finally agreed by the EU finance ministers in late December [pdf]. Only a successful AQR/stress test can avert the continuing fragmentation of credit markets and reduce the high interest spreads between the core and periphery. Assuming that the SRM can fix financial fragmentation is erroneous, and much of the related criticism of the complex SRM compromise is misplaced. Even an optimally designed SRM would not make euro area banks suddenly lend to each other again.

A more pertinent question is whether the SRM compromise makes it more or less likely that the AQR succeeds in 2014. For sure the envisioned SRM is far from perfect. It has an excessively complex structure, including a 10-year phase-in, and a multistage resolution process involving a resolution board, the European Commission, and the EU finance ministers in the ECOFIN (finance ministers’) Council. Parts of it are grounded in EU law and parts are to be embodied by a new intergovernmental treaty. Hopefully some of these kinks will be corrected in the ongoing final reconciliation negotiations on the SRM between the member states and the European Parliament. But writing off the SRM as unworkable just because it is complex is a mistake. The European Union of 28 member states works every day, despite breathtaking complexity. Moreover, in emergencies the European bureaucracy can be circumvented and a decision forced through in 24 hours.

The European political landscape may become more polarised in 2014 with right wing parties gaining ground in the European parliament.

The Economist – Europe’s Tea Parties – 4th January 2014 – looks at the rise of nationalist parties in Europe, making comparison with the US Tea Party Republican group, there are some similarities but the differences are more pronounced: –

There are big differences between the Tea Party and the European insurgents. Whereas the Tea Party’s factions operate within one of America’s mainstream parties, and have roots in a venerable tradition of small-government conservatism, their counterparts in Europe are small, rebellious outfits, some from the far right. The Europeans are even more diverse than the Americans. Norway’s Progress Party is a world away from Hungary’s thuggish Jobbik. Nigel Farage and the saloon-bar bores of the United Kingdom Independence Party (UKIP) look askance at Marine Le Pen and her Front National (FN) across the Channel. But there are common threads linking the European insurgents and the Tea Party. They are angry people, harking back to simpler times. They worry about immigration. They spring from the squeezed middle—people who feel that the elite at the top and the scroungers at the bottom are prospering at the expense of ordinary working people. And they believe the centre of power—Washington or Brussels—is bulging with bureaucrats hatching schemes to run people’s lives.

The minority parties might seem largely irrelevant but voter apathy towards voting at European Elections gives European “Tea Parties” an opportunity to punch above their weight: –

Ultimately, though, the choice falls to voters themselves. The Tea Party thrived in America partly because a small minority of voters dominate primary races especially for gerrymandered seats. In elections to the European Parliament many voters simply do not bother to take part. That is a gift to the insurgents. If Europeans do not want them to triumph, they need to get out to the polls.

For an historical perspective on how the Eurozone might move towards closer unification the New York Fed – The Mississippi Bubble of 1720 and the European Debt Crisis – 10th January 2014 – offers some interesting observations. This is part of a series of articles called the “Crisis Chronicles” from Liberty Street Economics: –

http://libertystreeteconomics.newyorkfed.org/2014/01/crisis-chronicles-the-mississippi-bubble-of-1720-and-the-european-debt-crisis.html

Austerity and Debt Restructuring

From summer 2012 through 2013 European equities performed well, with peripheral markets such as Greece and Ireland benefitting from the reduced risk of a Greek exit and single currency area breakup. Bond markets exhibited a similar response with higher yielding peripheral markets outperforming the core – see first chart above.  2014 may see these convergence patterns reverse as this article from the Council for Foreign Relations – Beware of Greeks Bearing Primary Budget Surpluses – points out: –

http://blogs.cfr.org/geographics/2013/12/04/greeksurpluses

Sovereign Debt Default and Primary Balances - Source IMF.

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Source: IMF

Things are looking up in Greece – that’s what Greek ministers have been telling the world of late, pointing to the substantial and rapidly improving primary budget surplus the country is generating.  Yet the country’s creditors should beware of Greeks bearing surpluses.

A primary budget surplus is a surplus of revenue over expenditure which ignores interest payments due on outstanding debt.  Its relevance is that the government can fund the country’s ongoing expenditure without needing to borrow more money; the need for borrowing arises only from the need to pay interest to holders of existing debt.  But the Greek government (as we have pointed out in previous posts) has far less incentive to pay, and far more negotiating leverage with, its creditors once it no longer needs to borrow from them to keep the country running.

This makes it more likely, rather than less, that Greece will default sometime next year.  As today’s Geo-Graphic shows, countries that have been in similar positions have done precisely this – defaulted just as their primary balance turned positive.

The upshot is that 2014 is shaping up to be a contentious one for Greece and its official-sector lenders, who are now Greece’s primary creditors.  If so, yields on other stressed Eurozone country bonds (Portugal, Cyprus, Spain, and Italy) will bear the brunt of the collateral damage.

European debt restructuring meanwhile still has far to go but many EZ countries seem to think that being “developed” precludes the need to restructure and reform. Carmen Reinhart and Kenneth Rogoff produced a working paper for the IMF –  Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten – December 2013 – which takes a global look at this subject in detail: –

http://www.imf.org/external/pubs/ft/wp/2013/wp13266.pdf

Here’s the abstract: –

Even after one of the most severe multi-year crises on record in the advanced economies, the received wisdom in policy circles clings to the notion that high-income countries are completely different from their emerging market counterparts. The current phase of the official policy approach is predicated on the assumption that debt sustainability can be achieved through a mix of austerity, forbearance and growth. The claim is that advanced countries do not need to resort to the standard toolkit of emerging markets, including debt restructurings and conversions, higher inflation, capital controls and other forms of financial repression. As we document, this claim is at odds with the historical track record of most advanced economies, where debt restructuring or conversions, financial repression, and a tolerance for higher inflation, or a combination of these were an integral part of the resolution of significant past debt overhangs.

The paper follows on from research they have undertaken over the last couple of years including their seminal work – Growth in a time debt – NBER – January 2010 – which achieved considerable notoriety when an economics student discovered statistical errors in the paper – a short version is available here: –

http://www.nber.org/digest/apr10/w15639.html

Their new paper concludes: –

Of course, if policymakers are fortunate, economic growth will provide a soft exit, reducing or eliminating the need for painful restructuring, repression, or inflation. But the evidence on debt overhangs is not heartening. Looking just at the public debt overhang, and not taking into account old-age support programs, the picture is not encouraging. Reinhart, Reinhart, and Rogoff (2012) consider 26 episodes in which advanced country debt exceeded 90 percent of GDP, encompassing most or all of the episodes since World War II. (They tabulate the small number of cases in which the debt overhang lasted less than five years, but do not include these in their overhang calculations.) They find that debt overhang episodes averaged 1.2 percent lower growth than individual country averages for non-overhang periods. Moreover, the average duration of the overhang episodes is 23 years. Of course, there are many other factors that determine longer-term GDP growth, including especially the rate of productivity growth. But given that official public debt is only one piece of the larger debt overhang issue, it is clear that governments should be careful in their assumption that growth alone will be able to end the crisis. Instead, today’s advanced country governments may have to look increasingly to the approaches that have long been associated with emerging markets, and that advanced countries themselves once practiced not so long ago.

Germany’s slowing growth and potential banking crisis

Meanwhile, Germany, which has benefitted economically from the painful Hartz reforms of the early 2000’s may be losing momentum.

Peterson Institute –  Making Labor Market Reforms Work for Everyone: Lessons from Germany – sets the scene, highlighting how labour reform in Germany has given the country a significant competitive edge: –

http://www.piie.com/publications/pb/pb14-1.pdf

…First, Germany has the best functioning labor market among large economies in Europe and the United States. Second, German wage restraint is of a relatively limited magnitude compared with most euro area countries and hence fails to explain the uniformly large intra–euro area unit labor cost divergences between Germany and other members after 1999. Third, total German labor costs per worker continue to exceed costs in other major EU countries and the United States. Fourth, Germany’s recent labor market revival has not come about through the expansion of predominantly low wage jobs. Fifth, the expansion of mini-jobs in Germany since 2003 has overwhelmingly taken place as second jobs. And sixth, the successful reliance on kurzarbeit programs in 2009 was not an innovation but rather another instance of labor input adjustment in favor of “insider workers” in Germany.

I’m indebted to Quartz.com for the table below which shows German exports and imports by region. Within the Eurozone the two components are fairly balanced but this disguises country specific imbalances, for example, for the first 10 months of 2013, Germany ran a surplus with France of Euro 30bln but a deficit with the Netherlands of Euro 15bln.

German exports and imports by region - source Quartz.

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Source: Quartz.com

The Economist – Die grosse stagnation – 30th November 2013 – paints a rather different picture of the risks ahead for Germany – once again these risks are political in nature, but their principal concern is that the recent coalition deal looks set to reverse a number of these successful reforms: –

http://www.economist.com/news/leaders/21590903-germanys-proposed-new-government-set-turn-motor-europe-slowcoach-die-grosse

…That is because Germany’s economy has been living off past glory—especially “Agenda 2010”, a series of reforms launched in 2003 by Gerhard Schröder, Mrs Merkel’s predecessor. But it is running out of puff. Labour productivity has grown less than half as fast as Spain’s over the past ten years; and its overall rate of public and private investment, at 17% of GDP, has fallen by more than a fifth since the euro was introduced. No European country has carried out fewer reforms than Germany since the euro crisis began.

… The coalition’s 185-page “treaty” was a chance to launch a new reform agenda. Instead, its proposals are a mixture of the irrelevant—charging foreigners to use German motorways—and the harmful.

…The coalition’s pension policy seems even more retrogressive. These days, most advanced economies are expecting longer-living people to be longer-working, too. But the coalition wants the pension age, raised to 67 in the previous grand coalition, to be moved back down again for specific groups, in some cases to 63. France’s president, François Hollande, was rightly mocked, not least by Mrs Merkel, for a similar ploy. Now the woman who has lectured the rest of Europe about the unsustainability of its welfare spending will follow down the same spendthrift road.

…The impact on this coalition on the rest of Europe would not be all bad. One bonus is that, for all its primitive economic policies, the SPD seems keener to support some basic reforms such as the creation of a banking union. But that will count for little if Germany, the motor of Europe’s economy, stalls. And, in the light of the coalition agreement, that is a real danger.

After a strong performance by European Equities and peripheral government bonds in 2013, the prospects for 2014 may be less sanguine, though I’m not bearish at this stage. The principal market risk is likely to emanate from the European banking sector. One example of this, concerns shipping. The chart below shows the Baltic Dry Freight Index month end values from 1985 to end December 2013 – it’s worth noting that the BDI has plummeted this month leading many commentators to predict a global economic downturn.

Baltic Dry index 29 yrs.

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Source: Bloomberg

Over the past ten years the price of “Dry” cargoes has soared and plummeted. During this cycle European banks, German ones in particular – abetted by favourable German government tax treatment – moved aggressively into the shipping finance sector; it is estimated that German banks are currently the financiers behind more than 40% of the world container shipping fleet. These shipping loans were often repackaged and sold on to high net worth investors but, rumour has it, the majority of these investments carried a “principal guarantee”. The ships, meanwhile, are no longer competitive due to improvements in fuel efficiency since the mid 2000’s. The banks are effectively left long “scrap metal”.

Moody’s gave an estimate last month for German banks impairment due to shipping loans of US$22bln for 2014, they went on to state: –

Germany’s eight major ship financiers have lent a total of 105 billion euros to the sector, a fifth of which are categorized as non-performing…

We expect the extended downward shipping cycle to cause rising problem loans in the shipping sector during 2013-14, requiring German banks to increase their loan-loss provisions. This will challenge their earnings power.

Here is the Reuters article for further detail: –

http://www.reuters.com/article/2013/12/10/moodys-shippingbanks-idUSL6N0JP2CV20131210

I wonder whether the ECB’s AQR will uncover the extent of this problem. Last Autumn S&P estimated European banks had a funding gap of Euro 1.3trln as at the end of 2012. My guess is that this is understated: shipping is just one sector, the “quest for yield” is industry wide.

EZ Money supply growth and rising peripheral debt

Another headwind facing Europe is the weakness in money supply growth. In 2012 EZ M3 was growing at above 3%, it dipped below 3% in H1 2013 and below 2% in H2 2013.

Eurozone M3 - ECB.

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Source: ECB

The ECB CPI target of 2% is roughly consistent with M3 growth of 4-6%.

The Telegraph – Eurozone M3 plunge flashes deflation alert – Novemebr 28th 2013

takes up the theme of potential deflation:-

http://www.telegraph.co.uk/finance/economics/10481773/Eurozone-M3-money-plunge-flashes-deflation-alert-for-2014.html

The European Central Bank said M3 money growth fell to 1.4pc from a year earlier, lower than expected and far below the bank’s own 4.5pc target deemed necessary to keep the economy on an even keel.

A rather more extreme view is expressed by Andrew Cullen – Europeans Looking To Inflate Their Debts Away – Mises Institute – 12th November 2013

http://mises.org/daily/6581/Europeans-Looking-To-Inflate-Their-Debts-Away

How does a reduction in consumer price inflation become “deflation”? How does a minor improvement in the purchasing power of consumers become a problem for liquidity in the financial markets? Austrian-economic thinking, which understands that new money is never neutral in its effects, offers insight:

[T]he crux of deflation is that it does not hide the redistribution going hand in hand with changes in the quantity of money …[4]

European politicians and central bank policy-makers are concerned not about consumer price reductions but about real reductions in the money supply as such reductions would force governments to abandon permanent budget deficit monetization. That is why they maintain a monopoly over the power to create money and they like to control where money enters the economy. Politicians use these advantages in two ways.

First, they are all, with the sole exception of the Bundesbank, “inflationists” when it comes to monetary policy. Inflation (that is, an increase in the money supply) steadily reduces the purchasing power of a fiat money and, in parallel, eases the burden of debt repayments over time as nominal sums become progressively of less relative value.

Such price inflation benefits debtors at the expense of creditors. Hence, for highly indebted Eurozone governments, price inflation is the perceived “get out of jail” card, permitting them to meet their debt obligations with a falling share of government expenditures.

Second, at least amongst the political elites in the “PIIGS” (Portugal, Italy, Ireland, Greece, Spain) and in France, they espouse “reflation” plans using the ECB’s money-creation powers which would ratchet up to another degree inflation of the money supply, monetization of government debt, and increases in total government debts; and thereby protect and enhance the economic power and privileges of governments and the state.[5]

Yet growth of PIIGS governments’ debts as a proportion of GDP (Table 1) have now crossed above the critical 90 percent ratio advised by Rogoff and Reinhart as being the threshold above which growth rates irrevocably decline.[6]

Table 1. Gross Government Debt as Per cent of GDP 2008-14 for the Eurozone and selected member countries (Adapted from: IMF Fiscal Monitor: Taxing Times, p16. October 2013)

                                2008       2010       2012       2014 (forecast)

Eurozone                70.3        85.7        93.0        96.1

Spain                      40.2        61.7        85.9        99.1

Italy                        106.1      119.1      127.0      133.1

Portugal                 71.7        94.0        123.8      125.3

Ireland                    44.2        91.2        117.4      121.0

There is another potential problem: European commercial banks may be too fragile to fulfil their allotted role. ECB President Mario Draghi himself has initiated another round of stress testing of European banks’ balance sheets against external shocks, a sign that the ECB itself has doubts about systemic stability in the banking sector. But this testing has hardly begun. Here are four risk factors in play:

First, there has been large-scale flight of deposits from banks operating within the PIIGS’ toward banks of other Eurozone countries,[7] as well as outside the Eurozone entirely. This phenomenon is caused by elevated risk of seizures, consequent upon the forced losses on bondholders at Greek banks and the recent “bail-in” of depositors at the Bank of Cyprus.

Second, many PIIGS’ domestic banks still hold on their books bad loans arising from the boom years (2000-2007). Failure to deleverage and liquidate losses is prolonging the banks’ adjustment process.

Third, they already hold huge quantities of sovereign debt (treasury bonds) from Eurozone governments from previous rounds of buying. Banks have had to increase their risk weightings on such debt holdings as Ratings Agencies have downgraded these investments to comply with Basel II. This constrains their forward capacity for lending to these governments.

Fourth, there is concern for rising interest rates. Since the famous “Draghi put” in July 2012, real rates remain low and yields on PIIGS’ sovereign bonds fell back closer to German bunds. But this summer yields on US Treasury bonds with long maturities started to rise on Fed taper talk.[8] Negative surprises knock confidence in the international bond markets. The risk of massive losses should bond prices drop is one that the European-based banks cannot afford given their still low capital reserves and boom phase legacy of over-leveraging.

Implementation impediments aside, a new phase of aggressive easy money policy from the ECB is both probable and imminent.

[4] J.G. Hülsmann, Deflation & Liberty (2008), p. 27.

You might also enjoy Andrew’s blogsite where he also speculates about large scale asset purchases from the ECB: –

http://www.thecantillonobserver.com

European equity and bond market prospects for 2014

This brings me neatly to what you may consider a rather contrarian view of European equities and bonds. So far this article has focussed on the negative headwinds which many commentators expect to undermine confidence in financial markets, however, I’m reminded of some sage words from the “Sage of Omaha” – the quote below comes from an interview/speech which Warren Buffet gave in July 2000 at the Allen & Co, Sun Valley corporate gathering, reported here by Fortune/CNN: –

http://money.cnn.com/magazines/fortune/fortune_archive/2001/12/10/314691/

In economics, interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset. You see that clearly with the fluctuating prices of bonds. But the rule applies as well to farmland, oil reserves, stocks, and every other financial asset. And the effects can be huge on values. If interest rates are, say, 13%, the present value of a dollar that you’re going to receive in the future from an investment is not nearly as high as the present value of a dollar if rates are 4%.

So here’s the record on interest rates at key dates in our 34-year span. They moved dramatically up–that was bad for investors–in the first half of that period and dramatically down–a boon for investors–in the second half.

Since short term rates are close to zero and central bank buying of government bonds has flattened yield curves in most major markets, surely the risk has to be that government bond yields have an asymmetric upside risk? Well, yes, but only if investors lose all confidence in those “risk-free” government obligations. Added to which – what is the correct size for a central bank balance sheet – $4trln or $400trln? When measured in balance sheet expansion terms the ECB is far behind the curve; they have availed themselves of the aggressive quantitative easing of other central banks to exert internal pressure on profligate EZ countries, cajoling them to structurally reform. I believe this austerity has largely run its course, but, as the AQR, is likely to show, it has left the EZ financial system in a weak position.

European bond convergence between the core and periphery continues as the table below (15/1/2014) from Bloomberg shows : –

Europe Yield

1 Day

1 Month

1 Year

Germany 1.82% +1 -1 +24
Britain 2.86% +3 -4 +84
France 2.47% +1 +4 +34
Italy 3.88% +1 -21 -33
Spain 3.82% +1 -28 -120
Netherlands 2.13% +1 -1 +43
Portugal 5.25% 0 -77 -104
Greece 7.67% 0 -95 -388
Switzerland 1.18% +1 +22 +56

European stock markets are making new highs – although EuroStoxx 50 is still some way below its 2008 peak, unlike the S&P. EUR/USD continues to regain composure after the fears of an EZ break-up in the summer of 2012. In this environment I see no reason to liquidate long positions in European equities and higher yielding peripheral bond markets. If US Equities turn bearish and US bond yields rise abruptly, as they did in 2013, then I would expect the ECB to provide their long overdue support. However, a precipitous decline in EUR/USD is cause for concern as this may herald the beginning of another Eurozone crisis – whilst I anticipate some of the above issues will surface during 2014, the “Draghi put” still offers significant protection, whilst the Peterson Institute – Why the European Central Bank Will Likely Shrink from Quantitive Easing – January 15th 2014 – makes a strong case for the ECBs hands being tied: –

http://blogs.piie.com/realtime/?p=4208

I still believe European markets represent a “hedged” exposure to the continued bullish trends in major market equities and higher yielding bonds – the market always prefers to travel than to arrive.