Monetary to Fiscal Point of Inflection

October 2016 The Bulletin Vol. 7 Ed. 9

Monetary to fiscal Point of inflection

FOCUS on Frankfurt’s new path Charles Goodhart, Geoffrey Wood on QE risks Kingsley Chiedu Moghalu on African democracy Vicky Pryce on Germany and the G20 Ignazio Visco on the euro policy mix William White on zombie banks and companies Global Public Investor 2016 is the third annual report by OMFIF on public sector asset management and ownership. The increased detail and coverage builds on analysis in the 2015 and 2014 editions. GPI 2016 is focused on two fundamental developments on the world investment scene: the use of a rising number of currencies in world asset management; and the growth of low-carbon investment, part of a general upgrading of the importance of sustainable investment.

Selected media coverage

GPI 2014 GPI 2015 GPI 2016 The march of the Global state investors shift China’s central bank remains sovereigns into property world’s top public investor The Economist Financial Times China Daily 17 June 20 May 29 June Heimliche Strippenzieher Sovereign funds risk inflating Central banks lead fall in der Finanzwelt global property bubble GPI’s assets in 2015 Die Welt South China Morning Post The Business Times 27 June 21 May 29 June

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#OMFIFGPI2016 Contents - Vol. 7 Ed. 9 October 2016

COVER STORY: Monetary to fiscal October 2016

Frankfurt forges Monthly Review European path 6-7 Briefings – OMFIF meetings, Advisory Board International monetary policy 8 Limits of ‘low-for-long’ interest rates FRANKFURT Stijn Claessens, Nicholas Coleman, and Michael Donnelly 10 Merkel’s tasks for divided continent III Enhanced prowess and responsibilities Vicky Pryce Ben Robinson 11 Global liquidity under pressure V Formidable springboard for the future Ben Robinson FrankfurtRheinMain 12 Fed holds off amid election campaign Darrell Delamaide VI Promising real estate pipeline FrankfurtRheinMain 13 Quite erroneous policy Charles Goodhart and Geoffrey Wood VII Combining lifestyle and performance Stefan Bredt and Armin Winterhoff Sustainable investment 14 Market approach to climate change Flavia Micilotta Europe 7 15 A suboptimal policy mix Ignazio Visco 16 Italy’s ‘doomsday’ scenario Steve H. Hanke 17 Cyprus, Greece and ‘whatever it takes’ Panicos Demetriades 18 Costs for financial system Peter Warburton Emerging markets 19 Renminbi payments show limited gains Ben Robinson 20 Three headwinds for Brazil Danae Kyriakopoulou and Bhavin Patel 22 Directing policy to growth sectors Donald Mbaka 23 African democracy: work in progress Kingsley Chiedu Moghalu Book review 26 Best chancellor New Labour never had William Keegan OMFIF Advisory Board poll 27 ECB expected to extend QE to new asset classes 22

October | ©2016 omfif.org CONTENTS | 3 OMFIF Dialogue on world finance and economic policy Official Monetary and Financial Institutions Forum The Official Monetary and Financial Institutions Forum is an independent platformfor 30 Crown Place dialogue and research. It serves as a non-lobbying network for worldwide public-private sector London interaction in finance and economics. Members are private and public sector institutions EC2A 4EB globally. The aim is to promote exchanges of information and best practice in an atmosphere United Kingdom of mutual trust. OMFIF focuses on global policy and investment themes – particularly in asset management, capital markets and financial supervision/regulation – relating to central T: +44 (0)20 3008 5262 banks, sovereign funds, pension funds, regulators and treasuries. F: +44 (0)20 7965 4489 Analysis www.omfif.org OMFIF Analysis includes research and commentary. Contributors include in-house experts, @OMFIF Advisory Board members, and representatives of member institutions and academic and official bodies. To submit an article for consideration contact the editorial teamat [email protected] Board John Plender (Chairman) Meetings Jai Arya OMFIF Meetings take place within central banks and other official institutions and are held Jean-Claude Bastos de Morais under the OMFIF Rules, where the source of information shared is not reported. A full Pooma Kimis list of past and forthcoming meetings is available on www.omfif.org/meetings. For more Edward Longhurst-Pierce information contact [email protected] David Marsh John Nugée Membership Peter Wilkin OMFIF membership is comprised of public and private institutions, ranging from central banks, sovereign funds, multilateral institutions and pension plans, to asset managers, banks and professional services firms. Members play a prominent role in shaping the thematic Advisory Board agenda and participate in OMFIF Analysis and Meetings. For more information about OMFIF membership, advertising or subscriptions contact [email protected] Meghnad Desai, Chairman Phil Middleton, Deputy Chairman Louis de Montpellier, Deputy Chairman Frank Scheidig, Deputy Chairman Songzuo Xiang, Deputy Chairman Advisory Board

Mario Blejer, Senior Adviser The OMFIF 168-strong Advisory Board, chaired by Meghnad Desai, Aslihan Gedik, Senior Adviser is made up of experts from around the world representing a Norman Lamont, Senior Adviser range of sectors, including banking, capital markets, public Fabrizio Saccomanni, Senior Adviser policy and economics and research. They support the work of Ted Truman, Senior Adviser OMFIF in a variety of ways, including contributions to the monthly Bulletin, regular Commentaries, seminars and other OMFIF activities. Membership can change owing to rotation. Editorial Team

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September 2016 July-August 2016 June 2016 May 2016 Angela Willcox, Production Manager The Bulletin Vol. 7 Ed. 8 The Bulletin Vol. 7 Ed. 7 The Bulletin Vol. 7 Ed. 6 The Bulletin Vol. 7 Ed. 5 Julian Halliburton, Subeditor Official monetary and financial institutions ▪ Asset management ▪ Global money and credit Official monetary and financial institutions ▪ Asset management ▪ Global money and credit Official monetary and financial institutions ▪ Asset management ▪ Global money and credit Official monetary and financial institutions ▪ Asset management ▪ Global money and credit Modi and the market Storm-tossed currencies Fed and the election India passes a milestone Steering through volatility Ben Robinson, Economist Elusive American dream

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entral bankers responded to the global financial crisis with a mix of unconventional policies, including negative rates and asset purchases. CAddressing September’s OMFIF main meeting in Rome, Banca d’Italia Governor Ignazio Visco noted that such policies helped cushion the initial shock, and that both subsequent GDP growth and inflation would have been lower without them. But they have hardly provided a panacea. As Visco also noted, such policies have distorted markets and created risks for financial stability. Extraordinarily loose policies have not only failed to boost growth substantially, but have also created dangerous debt overhangs in many economies. There have been some collateral effects too, examined in this month’s Bulletin. Charles Goodhart and Geoffrey Wood argue that these measures have hurt bank profitability, while Stijn Claessens and Nicholas Coleman of the Federal Reserve Board of Governors, and Michael Donnelly of MIT, consider evidence on the effect on banks’ net interest margins. Ben Robinson presents the findings of an OMFIF report, produced with BNY Mellon, showing that unconventional policies have reduced the supply of liquid assets for collateral. Panicos Demetriades, former governor of the Central Bank of Cyprus, highlights the negative consequences for central banks’ credibility and the notion of their independence. The good news is there are signs that monetary policy is reaching an important inflection point. This might not be apparent at first sight. The US Federal Reserve defied expectations that it would raise rates at its September meeting. But as Darrell Delamaide argues, this was driven more by politics than economics – a December rate rise is now a virtual certainty. Meanwhile, the Bank of Japan’s decision to refrain from a rate cut and introduce yield curve controls in asset purchases confirms a shift to a more flexible approach. Some monetary alchemy will still be needed to help Japan exit its debt trap without pain – the subject of OMFIF’s latest report, published in September, by John Plender. The case of the Bank of England is more worrying, maintains Peter Warburton, who argues that even a shock as big as Brexit did not warrant the Bank’s August rate cut. Yet escaping from this unconventional quicksand dragging down central bankers will not be easy. As Luiz Pereira da Silva of the Bank for International Settlements told an OMFIF City Lecture in September, central bankers face a ‘singular dilemma’: continuing with such policies carries dangers in the long run, but exiting also risks market panic. One way to exit is to use more fiscal policy to ease the pain of tightening the monetary screws. With borrowing rates at historical lows, it is now time for governments to invest and they are not doing enough of it. This is not just a feature of developed markets: Donald Mbaka of the Central Bank of Nigeria echoes Visco’s warnings of a ‘suboptimal policy mix’. Despite these risks, the central bank that was the slowest to join the QE party may still find it hard to leave. A third of responses to our Advisory Board Poll expect the ECB to expand its QE programme into new asset classes instead of letting it expire in March 2017. This could bring the economics back into the spotlight, but for now Europe’s biggest headache remains its politics. As Vicky Pryce highlights, divisions across the euro area have risen and anti-euro movements are gaining ground in many countries. Steve Hanke alerts us to a doomsday scenario for Italian banks – even though the well-publicised problems of Deutsche Bank may provide Italy with a welcome distraction. There may be some silver linings for the European economy however, as Brexit creates an opportunity for financial centres on the continent. This month’s edition includes the second in OMFIF’s series of Focus reports, examining the case for Frankfurt. We round off with William Keegan’s review of an account of his time in politics by Ed Balls, the UK Labour party’s shadow chancellor who lost his parliamentary seat in the 2015 election. Perils of fiscal policy in disguise Zombie banks, zombie companies: the reckoning William White, Organisation for Economic Co-operation and Development nconventional monetary policies – as the bond-buying programmes by central banks in Japan, the US and continental Europe have been Ubaptised – are really fiscal policy in disguise. As a result of central banks’ transgression into the political sphere, the 40-year period of central banking independence is now effectively over. We will discover whether this puts the world on to a more or less stable footing. Current policies foster financial instability. By squeezing credit and term spreads, the business models of banks, insurance companies and pension funds are put at risk, as is their lending. The functioning of financial markets has changed dramatically, with many asset prices bid up dangerously high, threatening future growth. Resources misallocated before 2008 have been locked in through zombie banks supporting zombie companies. The insidious effects of persistently ‘easy money’ policies can be seen in the alarming slowdown in global growth. Two vicious circles are at work, with a wounded financial system contributing to both. On the demand side of the economy, accumulating debt creates headwinds that slow demand, leading to still more monetary expansion and yet more debt. On the supply side, misallocations slow growth, again leading to monetary easing, more misallocation and still less growth. There is a route out of the impasse – reliant on government action rather than that of central banks. We need to adopt precepts from both Keynes and Hayek. To please Keynes, governments should use whatever room they have for fiscal expansion, with an emphasis on infrastructure investment in concert with the private sector. Into the Hayekian category fall measures to address excessive debt through careful debt write-offs and restructuring; this might require recapitalisation or closure of those financial firms that made the bad loans. Structural reforms to raise growth potential and the capacity to service debt will pay longer-term dividends. A paradigm shift in thinking about how the economy and policy actually work is required – and then the political leadership to bring about well-balanced and judicious solutions. One way or another, the bill for accumulated debts will have to be met. If we do not marry the approaches of Keynes and Hayek, the bill will be paid by Greek taxi drivers and German taxpayers – in a fashion that would not only be profoundly unsatisfactory but also highly disorderly. I hope that this is not the path we end up taking.

William White is Chairman of the Economic and Development Review Committee at the OECD.

Professor Jenny Corbett is distinguished professor in the Crawford School of Public Policy at the Australia National University. She is reader in the Economy of Japan at the University of Oxford, a Research Fellow of the Centre for Economic Policy Research and a Research Associate of the Centre for Japanese Economy and Business at Columbia University. She was formerly the executive director of the Australia-Japan Research Centre. She has been a consultant to the Asian Development Bank, the Organisation for Economic Co-operation and Development, the World Bank and the European Commission. ‘Clouded outlook’ for Europe and euro he clouded outlook for Europe and the euro following the UK vote to leave the European TUnion, and the need for flexible and innovative fiscal and monetary policies to lift growth and employment, topped the agenda at an OMFIF Economists Meeting at the National Bank of Hungary on 29 September. There was a general discussion about the impact of the UK vote on faultlines in Europe, and agreement that this had caused great political uncertainty in all 28 member states, with UK doubts and questions about how to go forward compounding the problems. On a more optimistic view, the meeting heard, the UK would become associated with the EU through some form of ‘satellite relationship’ that would allow the City of London to maintain business through modified ‘passporting’ arrangements. On a more pessimistic reading, delegates discussed how the EU was heading towards a painful period of transition, with heightened tensions both within and between members and non-members of the euro. The meeting also heard how the National Bank of Hungary was adjusting to increased vulnerability and pressure on GDP growth with a new monetary policy approach using a more flexible set of instruments. This policy balanced financial and monetary stability with the bank’s inflation target and credit initiatives under ‘funding for lending’. Search for better policy mix in Rome he ever more urgent search for a better mix of European fiscal and monetary policies Twas a guiding theme at OMFIF’s Seventh Main Meeting in Europe at the Banca d’Italia on 22-23 September in Rome, against a background of slowing growth, high debt and political fragmentation in many countries. The overall mood was sombre, with a widespread perception that political risk – from the US presidential election to an upsurge of anti-European political parties – had increased. One well- known political speaker said Europe’s leaders were unable to resolve their difficulties because the continent’s time-honoured recipe of dealing with crises through emergency action forged in the heat of upheaval was no longer working. According to another top-line speaker, ‘Not even in the global financial crisis have the problems been more difficult… There has been an erosion of the mutual trust on which 2008 co-operation was based,’ he said, listing as the main European problems migration, Brexit, the rise of ‘nationalist and populist’ movements, financial and macroeconomic imbalances, and banking fragility. Several speakers underlined the need for innovative thinking on Europe, including the possibility of co-operation between blocs of countries, placing different degrees of emphasis on political and economic integration. There was a broad discussion throughout the meeting on the support for ‘populist’ polices in the US and Europe, with opinion divided about the validity and longer-term effects of this development. For Banca d’Italia Governor Ignazio Visco’s speech see p.15. Japan’s economy on ‘the edge of a shock’ apan’s monetary and financial system is living on the edge of a shock, with the potential to rock a global financial system still worryingly fragile in the aftermath of the global financial crisis, according to an OMFIF report by John J At the edge of the shock Plender, published in September. Japan’s problematic monetary future Almost four years after the launch of ‘Abenomics’ – Prime Minister Shinzo Abe’s three-pronged programme aimed at John Plender reviving Japan’s economy – Japan remains stuck in an atypical debt trap. The country’s aging demographic profile and history of excessive rates of corporate saving lie at the heart of an unsustainable build-up of debt that has necessitated increased public spending and caused the government to borrow as a substitute for tax receipts. Abenomics has failed to reverse this reality radically. Plender identifies three potential scenarios out of the debt trap, all of them problematic,

and concludes that all encompass significant risks of financial stability that could spill over to the rest of the world. For 21 September 2016 more details contact [email protected].

6 | MONTHLY REVIEW omfif.org October | ©2016 Canuto: Structural reforms key Asia meetings taviano Canuto, executive director of the OMFIF Singapore office opening reception OWorld Bank and member of the OMFIF A reception to mark the opening of the Advisory Board, gave a City Lecture on 20 OMFIF office in Singapore in the presence September in London on global imbalances. of Lord (Meghnad) Desai, chairman, OMFIF These have recently re-emerged as an Advisory Board, Prof. Kishore Mahbubani, important topic for policy-makers, with current Dean, Lee Kuan Yew School of Public Policy account positions across economies diverging and Mr Ravi Menon, managing director of again after a narrowing of imbalances the Monetary Authority of Singapore. following the global financial crisis. A 16 November, Singapore rebalancing of internal and external objectives across countries would help support global Positioning Asia for growth in a challenging growth, but it is not a panacea: country-specific agendas of structural reforms are key to help global economic environment economies overcome ‘income traps’. Canuto also touched on the economic outlook of his The gathering brings together senior home country, Brazil. While he admitted that the economy is suffering from a double malaise representatives of official and private sector of productivity anaemia and ‘fiscal indigestion’, he argued that a reduction in the risk premium institutions from Singapore, the Asia Pacific for businesses, more competition in the private sector, and improved efficiency in the public region and beyond to discuss critical policy sector should all contribute to a stronger economy. and investment issues facing the region. Co-hosted by the Monetary Authority of Singapore. Rules ‘unevenly enforced’ 17 November, Singapore inancial globalisation provided ‘freedom’ for Financial stability in an uncertain global Fadvanced economies to run large current account environment deficits that amplified the effects of the crisis on The goal of the seminar is to have candid, emerging markets, Luiz Pereira da Silva, deputy general interactive discussions of the most significant manager of the Bank for International Settlements, current threats to financial stability, what told an OMFIF City Lecture on 19 September in London. needs to be done now to mitigate the most Pereira da Silva drew attention to challenges facing significant risks, what potential spillovers emerging markets such as the uneven enforcement might occur, and whether crisis management of rules in the international system. On advanced arrangements are sufficient. economies, he highlighted the ‘singular dilemma’ faced 23 November, Kuala Lumpur by international monetary policy-makers, between continuing with risky and decreasingly effective monetary policies and entering tightening that For details visit www.omfif.org/meetings. could cause market panic. Governments ‘should move on stimulus’ overnments globally must place greater emphasis on fiscal stimulus and systemic reform to Graise growth in view of low interest rates and diminishing effectiveness of monetary policy, Carolyn Wilkins, Bank of Canada first deputy governor, told an OMFIF City Lecture in London on 14 September. Wilkins outlined the dangers of slow growth, caused by structural factors such as weak demographics and decelerating productivity. The effects include threats to financial stability, as lower neutral rates raise the risks for indebted households and impede the effectiveness of monetary policy. To address these concerns, Wilkins argued for promoting a sound global financial system through greater use of macroprudential tools, and stressed the importance of pro-growth policies, particularly on the fiscal side.

Greater coordination needed in Beijing Election influence on Fed rate decision

On 3 October, the first day for markets following the renminbi’s Nick Verdi, senior foreign exchange strategist at Standard Chartered inclusion in the special drawing right, OMFIF held a telephone Bank, and Joseph Gagnon, senior fellow at the Peterson Institute for briefing which discussed the need for greater coordination between International Economics, told an OMFIF telephone briefing on 20 economic and financial reforms in Beijing. Ben Shenglin, September that the US Federal Reserve was unlikely executive director, Renmin University International to raise rates the following day, reflecting the Monetary Research Institute, moderated the influence of the electoral cycle. The discussion also call between Alain Raes, chief executive, EMEA covered the Bank of Japan, with speakers agreeing and Asia Pacific, SWIFT and Linda Yueh, fellow in that more monetary policy action was needed to Economics at St Edmund Hall, Oxford University. support growth in the Japanese economy.

hile overall bank profitability in banks are reluctant to lower interest rates. profitability, concluding that effects were Wadvanced economies, measured by As they must pass on lower rates on assets stronger at lower interest rates. return on assets, has recovered from the linked to contractual repricing terms (such as Evidence from the US supports this worst of the global financial crisis, it remains floating rate loans) to borrowers with other conclusion, though the direct effects of low. Many banks are facing profitability financing choices – and have an incentive low rates are relatively small. Analysis for challenges related to low net interest to do so – bank margins compress as rates Germany suggests normally small long-run margins, typically measured as net interest decline. effects of interest rate changes on NIMs, but income divided by interest earning assets, large effects in the recent, low-interest rate and weak loan and non-interest income environment. Evidence for other countries growth. Net interest margins has been more scarce. While NIMs across many banks in are lower when advanced economies have been trending New analysis: data and methodology downwards over the longer term, they have interest rates are low – Our new cross-country analysis confirms fallen more sharply since the financial crisis – banks must pass on lower and expands on these findings. A database in part, it appears, because of lower interest was assembled with 3,418 banks from 48 rates. rates on assets linked to countries for the period 2005-13. Countries In many ways, banks can benefit from “ were classified each year as being in either contractual repricing terms. low interest rates both directly (such as a low- or high-rate environment, based on through valuation gains on securities they whether the interest rate on their three- hold) and indirectly (for example, levels Analysing a sample of 108 relatively large month sovereign bond was below or above of non-performing loans will be lower as international banks, many from Europe and 1.25% (other cut-offs were also tested and borrowers’ debt service is less burdensome). Japan, and 16 from the US, Claudio Borio, yielded similar results). On the narrower question of the effects of Leonardo Gambacorta and Boris Hofmann, in Chart 1 shows the sample of countries low interest rates on banks’ NIMs, however, their 2015 paper ‘The influence of monetary covered and the range and median of the analytics and empirical findings suggest aﬀ that policy on bank profitability’ (BIS Working short-term yields in each country. The NIMs are lower when interest rates are low. Paper 514, October 2015), documented the variations in rates are large for a number of Low short-term interest rates can depress negative effects of low interest rates (and countries, with many both in the high- and bank margins. For many types of deposits, shallow yield curves) on banks’ NIMs and low-yield environment for some time (the

Chart 1: Advanced economies affected most by low yields Range and median of short-term yields, %, and low interest rate boundary

Source: Bloomberg, FRB staff calculations. Values used are yearly averages of the implied three-month rate published by Bloomberg.

NB alues used are yearly averages o the implied three month rate beteen 200 13 as published by Bloomberg

median provides a sense of how long each Chart 2: Negative impact when rates fall below 1.25% country has been in each environment). Net interest margins and return on assets, % Particularly advanced economies faced low yields after the global financial crisis – 19 such countries in 2009 as opposed to just two in 2005. These shifts help to estimate the differential impact of low rates on banks’ NIMs. Chart 2 shows that average NIMs are higher in the high-rate environment than in the low- rate environment. Profitability, measured by return on assets, is higher too in the high- rate environment. This is likely to reflect both higher NIMs and concurrent better overall economic and financial environments. To isolate effects, we regressed the NIMs for all banks for each year on the average level of the three-month sovereign rate in that year (a common proxy for banks’ marginal funding costs) – controlling for the bank’s own lagged NIM, other time-varying bank characteristics, and a bank fixed effect, as well as GDP growth and the spread between the three-month Source: Bankscope, Federal Reserve staff analysis and 10-year sovereign rates. The sample was

then split into banks in low- and high-interest We also analysed separately the effects around 0.20 percentage points for the ratio rate environments. of movement in interest rates on changes in of interest expense to liabilities. Source: Bankscope, Federal eserve staﬀ analysis The results show that a decrease in the interest expenses and interest income. In other words, at low rates, banks have short-term interest rate lowers NIMs in The more pronounced effects on NIMs in greater difficulty reducing their funding rates. both low- and high-rate rate environments, the low-rate environment are largely driven Moreover, they still largely have to pass the with effects symmetric for an interest rate by the greater pass-through of low rates lower rates on to their borrowers. increase. But, all other things being equal, on interest income rather than on interest This is likely to be due to greater effects are statistically greater in a low-rate expenses. competition, including from non-bank environment. Specifically, a one percentage point lenders, and lower demand for loans. Chart 3 summarises the regression results. decrease in the short-term rate is associated Economic activity is lower in times of low For a representative bank, a one percentage with a 0.63 percentage point decrease in the interest rates, causing NIMs to decline more. point decrease in the short-term rate is ratio of interest income to earning assets associated with a 0.09 percentage point in the low-rate environment, and only a Overall effects and conclusions decrease in NIM in the high-rate environment 0.35 percentage point decrease in the high- While there are caveats, our findings strongly versus a 0.17 percentage point decrease in rate environment, a 0.28 percentage point suggest that NIMs are low when interest the low-rate environment. difference. The equivalent difference is rates are low.

Chart 3: Shortterm rates drive bank returns An important issue then is how banks can adjust their activities and cost structures to Chart Estimated3: Short-term impact on bankrates margins drive in low bankand high returnsinterest rate environments (bps) offset adverse effects on profitability and Estimated impact on bank margins in low- and high-interest rate environments (bps) capital. Although institutions are making adjustments, such efforts take time, with

limited immediate pay-offs when facing weak cyclical conditions and deleveraging pressures. This poses a challenge for banking systems in many low-interest rate countries. Until lost income can be offset through other actions, lower profitability will reduce financial institutions’ ability to build and attract capital.

This increases their vulnerability to shocks and declines in market confidence, undermines their ability to support the real economy, and potentially weakens the transmission channel of monetary policy. ▪ Stijn Claessens and Nicholas Coleman are Economists at Net interest margin Interest income margin Interest expense margins the Board of Governors of the Federal Reserve System.

Michael Donnelly is a Masters student at MIT. The views Low-interest rate environment High-interest rate environment expressed are those of the authors and should not be attributed to the Board of Governors of the Federal Source: Federal Reserve staff analysis Reserve System. staﬀ analysis October | ©2016 omfif.org INTERNATIONAL MONETARY POLICY | 9 Merkel’s tasks for divided continent Taking responsibility for unachievable G20 pledges Vicky Pryce, Advisory Board he G20 leaders’ communiqué on 5 TSeptember following their summit in Hangzhou, China, was the last before Germany takes over the G20 leadership on 1 December. It was, as would be expected, a positive one, full of good intentions – geopolitical stability, solving the refugee crisis, containing environmental damage, fighting terrorism, and so on. On the economic front, the leaders acknowledged that although the world recovery was ‘progressing’, this was not happening fast enough. Investment and trade remain sluggish, unemployment is still too high in many countries, and volatility in commodity and financial markets provides a Angela Merkel, Chancellor of Germany threat to stability. The threat of protectionism emerges when economies do less well. At times the threat rejected European refugee-sharing proposals, surplus of some 7% of GDP. The current is realised, backed by populist movements, although turnout was below the threshold account surplus this year is expected to be before unravelling over time. But the damage for validity. even more, 9% of GDP can be significant. Southern Europeans are increasingly The popularity of Angela Merkel, the The G20 leaders called for protectionist united and vocal about the unfairness, as German chancellor, is falling following last trends to be curtailed and restated their well as the negative economic and social year’s significant influx of refugees. This led commitment to reducing trade barriers impact, of policies often perceived as being to her suffering setbacks in recent regional further, setting themselves firmly against imposed by supranational European policy- elections. competitive devaluations. The fear of makers. This creates the strong impression of In Italy a constitutional referendum on protectionism and its negative impact on a divided Europe. 4 December could result in Prime Minister world trade were also highlighted by the One of the G20 leaders’ main pledges International Monetary Fund in its latest clearly is not being met, namely the need for World Economic Outlook published in early well-designed and coordinated monetary and The threat of October. fiscal policies to achieve ‘strong, sustainable, protectionism emerges balanced and inclusive growth’. A tide of nationalist fervour when economies do less But this is hard to achieve against a tide Rhetoric and reality well. At times the threat of increased nationalist fervour, in both The European Central Bank is doing what it can economics and politics. Despite the rhetoric, on the monetary front, but this alone will not is realised, backed by a World Trade Organisation report on G20 guarantee balanced growth. That requires “ populist movements, before trade restrictions, published in June, found other policy elements, including fiscal. that around 70% of restrictive measures were The G20 sets down a high standard: ‘We unravelling over time. But the instigated by G20 economies. are using fiscal policy flexibly and making tax damage can be significant. The campaign slogan ‘Taking back control’ policy and public expenditure more growth- was instrumental in convincing the majority friendly, including by prioritising high-quality of British voters to support ‘Brexit’ on 23 June. investment, while enhancing resilience and Matteo Renzi’s downfall, though Renzi has Donald Trump’s presidential campaign in the ensuring debt as a share of GDP is on a stated that his government will remain in US has protectionism, even isolationism, as sustainable path.’ place irrespective of the result. its core message. The reality is somewhat different. Spain There is still no firm government in Spain Europe, severely shaken by the British and Portugal narrowly escaped being fined after two elections – a third is expected vote to leave the European Union, has yet to for missing their deficit targets. Southern in December – and increasing talk of new decide in a cohesive way how to respond – European countries’ debt to GDP ratios elections in Greece. something that the divisions evident at the remain unsustainable – not only Greece’s Merkel must be wishing that another conclusion of the EU’s Bratislava summit on 188% but Italy’s 137%, Portugal’s 130%, and country could head the G20 from 1 December. 16 September made very clear. Spain’s now nearly 100%. Taking responsibility for unachievable G20 Meanwhile, nationalist parties are gaining At the opposite extreme, Germany has pledges adds one more task to her list of ground in France, Italy, the Netherlands, ignored bodies including the Organisation unenviable challenges. Austria and Germany. Countries such as for Economic Co-operation and Development, ▪ Poland, Hungary, and Slovakia protest that the European Commission and the Vicky Pryce is a Board Member at the Centre for their voices are not being heard. Hungary’s International Monetary Fund by running Economics and Business Research and a former Joint 2 October referendum overwhelmingly a budget surplus and a current account Head of the UK Government Economic Service.

10 | EUROPE omfif.org October | ©2016 Global liquidity under pressure OMFIF report highlights role of Global Public Investors Ben Robinson lobal liquidity – a vital ingredient in risks to the fore, as many emerging economies Reforms to market infrastructure Gthe factors driving markets and growth are highly leveraged, many mutual funds offer and practices can offset some of these worldwide – has been under severe strain in open-ended daily redemptions, and large challenges, including via better collateral the eight years since the financial crisis. This amounts of post-crisis debt issuance remain valuation rules and margining policies, as is underlined by periodic disruption in even outstanding. Future US rate hikes risk asset well as increased counterparty risk the most liquid market of sovereign bonds, price deflation, a decline in new issuance and management. The tri-party repo reform in as well as limits on some fund redemptions an increase in short positions. the US, and the European Markets and less frequent trades and lower turnover In this context, compensating for the lack Infrastructure Regulation which places a for some assets. As an OMFIF report of liquidity-enhancing but balance sheet- central clearing counterparty between published on 11 October demonstrates, intensive activities of banks, stabilising traders, have helped to tackle some of global public investment institutions have markets to prevent investor runs, and these concerns. They have, however, raised contributed to this situation, but sovereigns ensuring access to wholesale market funding costs and increased demand for high quality show a growing willingness to play a role in are vital to avoiding a liquidity shock. As collateral. This raises the importance of mitigating the challenges. underlined by an OMFIF survey of sovereign collateral management and reuse facilities Low interest rates from central banks led institutions with $4.74tn in assets under from custody banks. to an expansion of high-yield and ‘junk’ bond issuance, while large public purchases of safe Scope for sovereign involvement and liquid assets reduced yields for investors, Compensating for The desirable level of sovereign institutions’ pushing them towards these riskier assets. involvement in capital markets is contested, A second cause of lower liquidity – the the lack of liquidity- with some survey respondents arguing that it tightening of banking regulations which have enhancing but balance is not the role of official institutions to price raised the cost of balance sheet-intensive sheet-intensive activities of risk or make markets, and should instead act activities such as market-making – has meant as asset managers with a long-term view. banks have become less able and less willing banks, stabilising markets However more than 40% of institutions to stabilise markets. In the past, banks and “ believe there is an increased capital markets to prevent investor runs, securities firms helped smooth the market role for sovereigns as a result of bank when an immediate buyer or seller could and ensuring access to disintermediation. not be found, by using their balance sheet wholesale market funding The potential benefits are significant: to become the counterparty to trades. are vital to avoiding a not just an increase in market liquidity and However since 2008 they have lowered resilience to destabilising shocks, but also their inventories by over 80%, reducing their liquidity shock. the rewards of higher yields to offset the ability to play a stabilising role. disbenefits of low or negative interest rates on high-quality liquid assets. Substantial dangers management, sovereigns are willing to meet The result is a large growth in primary market these challenges, particularly via increased Ben Robinson is Economist at OMFIF. This is an issuance despite a lack of secondary market capital markets activities such as securities edited version of ‘Mastering flows, strengthening depth, making assets vulnerable to rapid lending and direct funding of less-liquid asset markets: how sovereign institutions can enhance price corrections when monetary policy or classes including private debt and equity. global liquidity‘. For a copy of the report, please market sentiment changes. The speed with Among other palliatives, sovereign contact [email protected]. which this may happen has increased as investors suggest widening collateral eligibility market participants have changed, including for repo transactions, increasing sovereign the growth of ‘shadow banking’ institutions, participation in wholesale funding markets, mutual funds and high-frequency traders, ‘renting’ their balance sheets, and directly adding to complexity over counterparty risks funding some assets and projects to offset and trade strategies. some of the issues of bank disintermediation. The dangers are substantial. If liquidity in Mastering flows financial markets and the ability of corporate Obstacles to overcome Strengthening markets and sovereign bond issuers to raise funds at Obstacles need to be overcome, however, How sovereign institutions can enhance global liquidity affordable prices are reduced, second round including regulations on banks and dealers, a effects could emerge which set off a series of lack of coordination between regulators and bankruptcies and insolvencies. sovereigns, and a lack of coordination among As seen after the financial crisis, when sovereigns themselves. trust in financial markets evaporates, along Some GPIs need to overcome internal with confidence in the quality of assets and rules that prevent them from pursuing a the ready availability of funds on which more active role in securities lending or repo liquidity depends, the reverberations can be markets. They need to manage the implied deep and long-lasting. counterparty, credit, collateral and cash In association with The prospect of divergent monetary policy collateral reinvestment risk involved in these between different central banks brings these expanded activities.

October | ©2016 omfif.org INTERNATIONAL MONETARY POLICY | 11 Fed holds off amid election campaign December rate hike likely after 8 November vote Darrell Delamaide, US editor espite the protests to the contrary, it was only to take the heat off the other Fed policy- Dnever likely that the US Federal Reserve makers. would raise interest rates in September, just That may sound somewhat far-fetched, weeks before the presidential election. Even but it indicates that the Fed cannot help less so in November, just days before the but be drawn into the political quicksand of vote. this bizarre election. It does not necessarily Fed chair Janet Yellen sought to emphasise mean, however, that the Fed’s explanation for at the press conference following the late leaving rates unchanged in September is just September meeting of the Federal Open so much window-dressing. Market Committee that the US central bank is ‘The Committee judges that the case not political in any way, shape or form. for an increase in the federal funds rate ‘I can say, emphatically, that partisan has strengthened but decided, for the politics plays no role in our decisions about Esther George, President, Kansas City Fed the appropriate stance of monetary policy,’ she said in response to a question. ‘We do not Some Fed officials discuss politics at our meetings and we do not could provoke a negative market reaction take politics into account in our decisions.’ have voiced concerns that would give the Fed pause.) But that affirmation means it could not about asset bubbles forming In a widely noted speech the week before take any action with uncertain consequences after the long period of low the FOMC meeting, Fed governor Lael so close to an election. Brainard signalled decisively that the Fed Raising rates could have a negative impact interest rates. would wait on action. She said in Chicago that on stock prices. Making the move just as the “ ‘the costs to the economy of greater than last voters are making up their minds would expected strength in demand are likely to be bring a barrage of criticism from the staff of time being, to wait for further evidence of lower than the costs of significant unexpected Hillary Clinton, who is campaigning on the continued progress toward its objectives,’ weakness.’ steadiness of the economy under her fellow the consensus statement read. ‘The stance Brainard, who many think could become Democrat, Barack Obama. of monetary policy remains accommodative, Treasury secretary if Clinton wins, concluded: thereby supporting further improvement in ‘This asymmetry in risk management in ‘Fed doing political things’ labour market conditions and a return to 2% today's new normal counsels prudence in the Of course, not taking action can also be inflation.’ removal of policy accommodation.’ interpreted as political, and Donald Trump did not hesitate to level this charge in the first Dissent among the FOMC Restless regional bank chiefs presidential debate. However, there was an unusually high level But the regional bank chiefs are restless. In ‘We are in a big, fat, ugly bubble,’ Trump of dissent. Three of the five regional bank an unusual move, Rosengren, usually a dove, said, commenting on the US economy. ‘And heads who are voting members – Esther issued a statement defending his dissenting we better be awfully careful. And we have a George of Kansas City, Loretta Mester of vote: ‘The economic progress since the last Fed that’s doing political things. This Janet Philadelphia, and Eric Rosengren of Boston – tightening in December might, by itself, be Yellen of the Fed. The Fed is doing political – said they would prefer to raise the target rate sufficient to justify a further increase in the by keeping the interest rates at this level.’ for federal funds a quarter point to 0.75% rate target. However, it is in considering The controversial candidate continued in right now. Only James Bullard of St. Louis and the implications of current policy for the his colourful, stream-of-consciousness way: William Dudley of New York supported Yellen sustainability of the expansion that the case ‘And believe me: The day Obama goes off, and the other four in the Washington-based for raising rates has now become even more and he leaves, and goes out to the golf course board of governors. compelling.’ for the rest of his life to play golf, when they Could a decision come in November, she Another dove, San Francisco Fed chief raise interest rates, you’re going to see some was asked at the press conference. ‘Every John Williams, indicated that the dissenting very bad things happen, because the Fed is meeting is live, and we will again assess as we voters have support for their arguments from not doing their job. The Fed is being more always do incoming evidence in November the seven regional bank heads who currently political than secretary Clinton.’ and decide whether or not a move is do not have a vote. Some Fed officials themselves have voiced warranted.’ Don’t hold your breath. ‘It is getting harder and harder to justify concerns about asset bubbles forming after But Yellen also said that ‘most participants interest rates being so incredibly low given the long period of low interest rates, so do expect that one increase in the federal where the US economy is and where it Trump’s critique is not outlandish. funds rate will be appropriate this year, and I is going,’ he told Reuters in an interview. But his personalising the criticism and would expect to see that if we continue on the ‘I would support an interest rate increase. directing it at Yellen puts her in an awkward current course of labour market improvement I think that the economy can handle that. I position if Trump wins the election – which and there are no major new risks that develop don’t think that would stall, slow or derail the cannot be ruled out. Some analysts have and we simply stay on the current course.’ economic expansion. gone so far as to suggest that Yellen would This seems to make a rate hike in December ▪ step down in the event of a Trump victory, a virtual certainty, barring any unexpected Darrell Delamaide is a writer and editor based in even before the December FOMC meeting, if bad news. (A Trump victory, for instance, Washington.

12 | INTERNATIONAL MONETARY POLICY omfif.org October | ©2016 Quite erroneous policy Bond-buying has little impact on real economy Charles Goodhart and Geoffrey Wood t a time when interest rates, throughout If liquidity needs are satiated in this way – bankers who perpetrated, or failed to prevent, Athe yield curve, are at an all-time low, at a time when debt ratios have been climbing the misdeeds) are not conducive to greater it could be argued that the public sector, at a rate hitherto unparalleled in peacetime – profitability. Profitability is procyclical. the biggest debtor, should be trying to why are there still claims that interest rates Has policy been actively damaging bank lock in such rates by shifting to ever longer are being held down by excessive demand for profitability and hence growth of money maturities and duration. and credit? In most academic studies of However, if one adjusts for central the efficacy of monetary policy, all that bank swaps, under which central banks Negative interest rates, appears to matter is the direct link between effectively buy longer-dated government riskless official short-term rates, and future debt in exchange for sight deposits, the a flat yield curve, and expectations thereof, and the real economy. overall maturity of public sector debt in most substantial fines on the In David Reifschneider’s 2016 Federal countries practising quantitative easing has banking institutions are Reserve Board paper, ‘Gauging the ability of been going down, not up. the FOMC to respond to future recessions’, We are told that such central bank deposits hardly conducive to greater the words ‘bank’, ‘money supply’ and ‘credit’ need not, indeed should not, ever get repaid. “ do not appear. The same official insouciance profitability. That they are, or should be, the equivalent of about the profitability of financial Consols (a type of British government bond intermediation goes wider than just banks. redeemable at the option of the government) ‘safe’ assets? Is this claim consistent with the Insurance companies and pension funds are – quasi-permanent debt. narrowed risk premia now being observed? pressured to hold matching assets against Jeremy C. Stein, professor of economics Furthermore, if the demand for liquidity, their liabilities. Policy then serves to reduce at Harvard University, argues that satisfying and reserves, by banks is to remain satisfied, the availability and yield of such assets. liquidity needs enhances financial stability what then constrains, and determines, the If the effect of monetary policy has been and that monetary policy can continue by aggregate money stock, mostly consisting of to weaken the profitability of financial varying the interest paid on central bank commercial bank deposits, and bank lending intermediation, might this help to explain why deposits. to the private sector? The answer, we would the massive monetary expansion measures He adds that enlarged central bank presume, is the availability of bank (equity) undertaken by central banks have had so balance sheets should remain a permanent capital. But capital will be made available little impact on the real economy? Perhaps feature. But as such reserve deposits are now only if the business is sufficiently profitable to QE has now become ‘Quite Erroneous’. interest-bearing, the huge volume of central earn a competitive return (unless the public ▪ bank deposits increases the public sector sector injects the capital itself). Charles Goodhart is Professor Emeritus at the London interest rate roll-over risk just as much as if In the banking sector, negative interest School of Economics and Political Science. Geoffrey Wood the Treasury had issued a similar amount of rates, a flat yield curve, and substantial fines is Professor Emeritus of Economics at the Cass Business Treasury bills. on the banking institutions (rather than the School.

ﬂti Despite QE, inflation remains subduedﬂati Annual consumer price inflation, %

Source: US Bureau of Labor, ONS, Eurostat, OMFIF analysis

Market approach to climate change Necessary transition to more sustainable economies Flavia Micilotta, Eurosif he 21st UN Climate Change ‘Conference the way towards more sustainable patterns In the last six months, it has launched two Tof the Parties’, held in Paris in December of investment. key consultations. These have examined how 2015, ended with the milestone agreement The Paris agreement also led a number of companies can increase their transparency, for countries to reduce their greenhouse gas investors to reconsider their investments in following up on the new directive on non- emissions sufficiently to keep the increase oil. Mark Carney, the governor of the Bank financial reporting, and how investors can in global temperatures well below 2°C this of England, declared in September 2015 that improve their standards in respect of long- century. investors faced potentially significant losses term and sustainable investments. The agreement established a system for as a result of climate change action. Following Both pieces of the same puzzle, the measuring individual countries’ commitments this, even investors who did not think of consultations have sent a strong message and contribution every five years. A progress about the importance of those ‘intangible’ assessment is set for 2018. criteria, most often referred to as economic, Although it is too early to determine Asking investors to social and governance criteria. whether the agreement has been drafted sensibly or whether it will deliver on its disclose how they factor Looking to the long term commitments, it sets the tone for policies environmental, social and Embedding these criteria into investment and businesses. governance criteria, as well analysis and portfolio construction across Investors now have a number of options a range of asset classes is the underlying to contribute to the transition to a more as carbon-related aspects, principle of sustainable and responsible sustainable economy. In this context, the “ investment. According to Eurosif’s definition, into their investment policies, best-case scenario is a race to the top for socially responsible investment ‘is a long- both investors and companies to take part in points the way towards more term orientated investment approach which the fight against climate change. sustainable patterns of integrates ESG factors in the research, investment. analysis and selection process of securities Policy push within an investment portfolio. It combines The strongest policy push following the fundamental analysis and engagement with Paris conference came from France, where themselves as particularly ‘pro-environment’ an evaluation of ESG factors in order to better the government encouraged the financial began to reconsider the viability of investing capture long-term returns for investors, community to adopt Article 173 of France’s in oil companies. Now they are pondering and to benefit society by influencing the law on energy transition and green growth. the real costs of the carbon bubble. behaviour of companies.’ By asking investors to disclose how they The European Commission demonstrated factor environmental, social and governance an understanding of the various issues of ESG incorporation criteria, as well as carbon-related aspects, relevance to different stakeholders, as well In ESG incorporation, investment institutions into their investment policies, the law points as strong willingness to support this change. complement traditional quantitative analysis of financial risks and returns with qualitative and quantitative analyses of ESG policies, ESG market indices outperform market counterparts performance, practices and impacts. Growth of S&P 500 and ESG variant of index, % Asset managers and asset owners can incorporate ESG issues into the investment process in a variety of ways. Some may actively seek to include companies that have stronger ESG policies and practices in their portfolios, or to exclude or avoid companies with poor ESG track records. Others may incorporate ESG factors to benchmark corporations to peers or to identify ‘best in class’ investment opportunities based on ESG issues. Still other responsible investors integrate ESG factors into the investment process as part of a wider evaluation of risk and return. Regulators have come a long way in pushing the socially responsible investment industry forward. But much can still be done to help SRI become a significant factor in the transition to more sustainable economies. ▪ Flavia Micilotta is Executive Director of Eurosif, the Source: S&P 500 ESG Index European Sustainable Investment Forum.

ed ti October 2016

Frankfurt forges European path FRANKFURT FOCUS A growing centre with European and global reach

his second report in the OMFIF series on European financial centres after the UK European Frankfurt and its TUnion vote goes beyond the issue of financial innovation and capital markets discussed in September’s Luxembourg analysis. hinterland provide We focus on the crucial juxtaposition of the real economy and Europe’s financial sector, giving the crucible for fast- Frankfurt and the surrounding Rhine-Main area – known as the FrankfurtRheinMain region – a pivotal place in the overall European economy. developing financial As the heart of European manufacturing, Germany provides traditional emphasis on financing technology companies, larger and smaller businesses, including the legendary Mittelstand category of smaller, often family- “ owned firms that form the country’s economic backbone. Frankfurt is a nexus for this interplay as well as expanding between finance and industry, as well as an important regulatory, financial and monetary policy- foreign investment and making centre. The city is home to the European Central Bank and the Deutsche Bundesbank, the trade. ECB’s most important and often most vocal shareholder. Frankfurt and its hinterland provide the crucible for fast-developing financial technology companies, as well as expanding foreign investment and trade that have been one of the mainsprings of German growth since the 19th century. Benefiting from roots in German industry, Frankfurt has GFCI financial centre ranking table global reach, seen in the international activities of Deutsche Börse Top 10 EU performers and the growing role of renminbi clearing and settlement, as well as the city’s experience in connecting start-up companies to European EU Financial GFCI 19 and international investors. ranking centre ranking The potential for interlinked EU projects such as the Commission’s strategic investment plan and capital markets union points to 1 London 1 further possible extension of Frankfurt’s role in raising funds and 2 Luxembourg 14 mobilising capital. Brexit vicissitudes provide opportunities for Frankfurt expansion, not least its ability to attract international 3 Frankfurt 18 financial institutions and regulatory bodies, including those which 4 Munich 27 may move from London. This is not a zero sum game; there is plenty of room for growth- and revenue-generating co-operation between 5 Paris 32 Frankfurt and London, as the planned merger of Deutsche Börse 6 Amsterdam 34 and the London Stock Exchange (whatever the post-UK-referendum uncertainties) demonstrates. 7 Stockholm 37 Germany and the Frankfurt region have a vital position bridging 8 Dublin 39 the needs of European households and businesses and the exigencies of dynamic banking and financial markets. In the new 9 Vienna 40 structures emerging after the UK vote, Frankfurt looks set to forge a still more important European path. 10 Warsaw 48

Source: Global Financial Centres Index 19 (March 2016), examining financial centres’ global competitiveness, based on CONTENTS profiles, ratings and rankings for 86 centres. II A growing centre with global reach

III Enhanced prowess and responsibilities Ben Robinson

V Formidable springboard for the future FrankfurtRheinMain

VI Promising real estate pipeline FrankfurtRheinMain

VII Combining lifestyle and performance Stephan Bredt and Armin Winterhoff

‘Frankfurt Focus’ forms part of the OMFIF Bulletin for October 2016. It is not to be distributed separately without permission of OMFIF. The same disclaimer applies as on p.4 of the Bulletin.

ermany is Europe’s largest economy, leading exporter, biggest creditor and the base for euro Euro clearing and Garea financial, regulatory and monetary policy-making institutions. Frankfurt is at the heart of this activity, as Germany's largest financial centre and a pivotal location for European capital settlement activities, markets. the majority of which take As the home of the European Central Bank and the Bundesbank, Frankfurt is a key location for non-EU companies and banks, particularly from China, seeking access to European policy-makers place in London, may and regulators as well as financial market operators across many sectors. This role has become still move within the euro area, more significant since 2014 when the ECB assumed supervisory responsibility for banks operating “ in the euro area, under the Single Supervisory Mechanism. Frankfurt is home to the European again potentially providing Systemic Risk Board, responsible for macroprudential regulation. The European Insurance and a boost to Frankfurt. Occupational Pensions Authority is based in the city, as is the European Banking Federation, the main body for the European banking sector. Post-Brexit this concentration of institutions, prowess and responsibilities could be strengthened further. The European Banking Authority, which regulates the European banking sector, is based in London. After the UK voted to leave the EU the EBA argued that this can no longer continue, placing the institution in search of a new home within the EU. Though Frankfurt faces competition from Paris, the city’s powerful presence in housing other EU supervisory and regulatory bodies puts it in a strong position. Euro clearing and settlement activities, the majority of which take place in London, may move within the euro area, again potentially providing a boost to Frankfurt. In 2015 the ECB lost a court case seeking to move euro clearing within the euro area and away from London, on the basis that it would discriminate against an EU member. London may now be vulnerable to a second attempt. Some industry observers however say that no other EU centre will gain the clearing business, maintaining that the only financial metropolis with sufficient economies of scale to play this role lies outside the EU – in New York. Whether or not various Frankfurt overtures are successful, the uncertainty surrounding the UK’s access to the single market and to ECB liquidity once it leaves the EU means banks may pre-emptively move at least some of their operations to the euro area. As unquestionably the euro area’s central banking hub, Frankfurt is well positioned to attract this business.

A European base for Chinese banks Among the financial institutions that have been attracted to Frankfurt are Chinese banks, including the People’s Bank of China, which maintains its euro area base in the city, along with the five largest Chinese commercial banks, which have used the city as a focal point for expanding their European activities. In 2014 Frankfurt was chosen as the location for the first renminbi clearing and settlement centre outside Asia, following the establishment of a currency swap agreement between the ECB and the PBoC in 2013, and the granting of Renminbi Qualified Foreign Institutional Investor status to Germany in 2014. Access to renminbi Frankfurt offers a wide range of renminbi products and services to liquidity facilitates companies based in the euro area, so long as their bank maintains an account trade between Chinese at the Bank of China in Frankfurt. These include renminbi trading and hedging; opening and processing letters of credit; issuing bank guarantees; processing and euro area companies capital transfers in China; and active currency management, via onshore by removing currency renminbi hedging and offshore currency swaps. “ Access to renminbi liquidity facilitates trade between Chinese and euro risks, time delays and area companies by offsetting currency risks, time delays and exchange rate exchange rate costs. costs. The share of euro area-China trade denominated in renminbi, currently around 20%, is expected to double within the next few years, putting Frankfurt at the centre of an important financial development.

Market infrastructure and new technologies Frankfurt has expanded its role beyond Europe, becoming an important player in global capital markets. It is home to Eurex, the third-largest derivatives exchange in the world (by contract volume), and the largest futures and options market in Europe. It has been investing in market infrastructure and new technologies, resulting in it winning many awards for excellence in European exchange and clearing house performance. Frankfurt-based Deutsche Börse, one of the leading global stock exchanges, has increased its activities, purchasing important index providers and trading platforms, including the 360T currency trading platform, contributing to expanded trading and investment on the Frankfurt exchange. In response to the opportunities and disruptive repercussions of digitisation sweeping global banking and finance, Deutsche Börse has invested heavily in fintech. Between 2013 and 2015 German investment in fintech companies increased more than fivefold, to €580m. This is far ahead of France but still slightly below the UK, the biggest fintech investment centre in Europe with just over €700m in 2015.

October 16 | © 2016 FOCUS: FRANKFURT | III Vital outcome of Deutsche Börse negotiations Frankfurt is establishing an incubator for fintech and other financial start-up companies, centred The shape of the on the cluster of Goethe University, the Technical School of Darmstadt and the Frankfurt School planned merger of Finance and Management. The stock exchange has established the ‘Venture Network’ platform between the Frankfurt and to increase interaction between investors and start-ups, as well as providing free space to start-up companies around the business district, to enhance the city’s role in fintech innovation. London stock exchanges The shape of the planned merger between the Frankfurt and London stock exchanges has not has not been completely been completely clarified following the Brexit vote. The structure of the new group, assuming the “ merger goes ahead, is still under discussion. Deutsche Börse wants it formed as a joint holding clarified following the company, rather than a London-based holding company as was initially planned. This would see Brexit vote. the legal domicile of the company based in London, with the exchange itself remaining in Frankfurt. The outcome of these negotiations is vital, as losing its globally important stock exchange would strip Frankfurt of an important string to its financial bow.

Areas for potential growth outside Europe Frankfurt has diversified its activities and focus over the last few years and some of the main areas for its potential growth lie outside Europe. In 2015 it opened the China Europe International Exchange, in partnership with the Shanghai Stock Exchange and China Financial Futures Exchange. CEINEX was the first platform for authorised renminbi-denominated trading As part of a broader outside mainland China, helping to establish Frankfurt as a major centre for European investors and traders seeking to access Chinese markets. It allows strategy by Beijing international investors to buy shares in exchange-traded funds that hold to internationalise the renminbi-denominated assets, providing access to the Chinese economy that was previously subject to restrictions imposed by the Chinese authorities. renminbi and improve As part of a broader strategy by Beijing to internationalise the renminbi and access to international improve access to international investors, Frankfurt benefits from potential “ for further product development and service offerings, providing significant investors, Frankfurt growth in renminbi bonds, ETFs and derivatives. benefits from potential for While both Eurex and CEINEX are either owned or partly owned by Deutsche further renminbi product Börse, both have told OMFIF that, even if the planned Deutsche Börse-London Stock Exchange merger goes ahead, all activities will remain in Frankfurt. development. The challenges of benefiting from Brexit Attracting activities necessary to make Frankfurt a beneficiary of Brexit presents challenges. It has a less well-established tradition of financial innovation than other locations, and it has been less active in marketing its services than Paris, Luxembourg or Dublin. Competition with other financial centres requires substantial investment in new capabilities, infrastructure and skills to maintain Frankfurt’s edge. The question marks over the EU’s future are weighing on business and investment sentiment across Europe. So too are, in a specific Frankfurt setting, the difficulties burdening Deutsche Bank and (to a less severe extent) Commerzbank, the county’s premier two banks. However, many of the causes – including global banking regulations, low and negative interest rates, worries over excessive debt, and the sluggish euro area economy – are exacting a toll on Germany’s rivals too.

Väth: ‘Frankfurt cannot and does not want to replace London’ The exact role Frankfurt plays as a financial centre may be limited by factors outside its control. Yet the city prides itself on its solid foundations, its efficiency and technological development, as These two diverse well as its linkages with Europe’s strongest real economy. As Hubertus Väth, managing director of yet complementary Frankfurt Main Finance, has said, Frankfurt cannot and does not want to replace London. Instead it hopes to play to its strengths and improve its position in core areas. cities play interlocking As the global financial system evolves, Frankfurt is gaining over other European financial centres roles in wholesale in its commitment to fintech and improving financial market infrastructure. While it is unlikely banking and trading, to replace London as ‘the central financial centre’, Frankfurt could become an important bridge “ linking London, China and other fast-growing economies to the euro area. All of these developing international asset and country partners will in time become platforms for capital market activities on both the asset and wealth management and liability side of western firms’ and asset managers’ balance sheets. Against this changing international background, with the gravitational centre of world finance corporate deal-making. moving gradually yet inexorably toward Asia, there is abundant potential for beneficial linkages between London and Frankfurt. These two diverse yet complementary cities play interlocking roles in wholesale banking and trading, international asset and wealth management and corporate deal-making. There is no reason why these twin metropoles – a Continental financial nucleus embedded in the real economy and a globally connected, multivalent money centre close to, yet outside, the EU – cannot co-exist on highly favourable terms for all involved. ▪ Ben Robinson is Economist at OMFIF.

he UK’s vote to leave the European Union has prompted much discussion of possible Even without Talternatives to London. Some companies and banks with a presence in the City, and Britain more broadly, may be required to extend their European footprint. Some may decide to leave concrete indications the UK altogether to protect their European market share. of Brexit’s eventual shape, Frankfurt is taking a different approach to many of its European and global competitors for foreign direct investment. The city and the surrounding region are not aiming to convince companies in both the businesses to leave the UK. Rather, FrankfurtRheinMain is positioning itself as a powerful and UK and Germany are dynamic alternative for companies that are required for any reason to seek a continental solution “ for future growth. drawing up scenarios and Frankfurt’s financial sector and international airport – comparable in size to London’s contingency plans. Heathrow or Charles de Gaulle in Paris – are well known. The mutually reinforcing benefits of the FrankfurtRheinMain region are less immediately evident, but all the more relevant for businesses taking a longer-term view. Large numbers of foreign businesspeople visit Frankfurt each year to participate in international trade fairs. This benefits both the city and the surrounding region, which has a centuries-old record of welcoming, accommodating and integrating travellers to this traditional European hub for carry out trade, finance and commerce. FrankfurtRheinMain hosts more than 100 foreign consulates, as well as the headquarters of around 20% of the largest foreign companies in Germany. It is home to more than 1,000 US companies and the largest Korean business community in Europe. There is a growing contingent of Japanese, Chinese and Indian companies.

A combination of a service and industry-driven economy Frankfurt is home to the largest concentration of banks and financial service providers in Germany. But there is much more than finance: FrankfurtRheinMain contributes around 10% of German manufacturing output. Major life science, ICT and automotive clusters provide an attractive combination of a service economy mixed with forward-looking 21st century industry. Part of the appeal lies in plentiful opportunities for a desirable life-work balance. The region has more than30 international schools. Around 40% of FrankfurtRheinMain is unspoiled, often gently undulating countryside threaded by rivers and studded with alluring towns and villages. Frankfurt’s compact size and modern transport system allow easy access to airports and other cities as well as recreational and cultural highlights, often no more than half an hour away by car, train or tram. Depending on the outcome of Brexit negotiations, FrankfurtRheinMain is well equipped to absorb a substantial influx of foreign professionals. While quality office space is readily available, newcomers seeking apartments and houses for rental or purchase may – as in other buoyant German cities – face pockets of rising residential property prices, requiring additional forward planning for those seeking a base in the conurbation. FrankfurtRheinMain has always been open to international business and trade. The region is reacting with relish to the challenges of Brexit; whatever happens, the UK will remain one of Germany’s largest trading partners. Companies in the UK and Germany are drawing up contingency plans to secure best possible outcomes from the UK’s withdrawal negotiations. By providing sensible and efficient options for corporate relocation and expansion, Frankfurt and the FrankfurtRheinMain region offer a formidable springboard for the future. ▪ For more details contact Iassen Boutachkov, Director Europe, on +44 (0) 20 3769 0741 or [email protected].

Frankfurt - The Financial Centre €3.5tn €1.7tn 62,700 market capitalisation the ﬁnancial sector

196 100+ 155 research institutions

Source: Frankfurt Main Finance

usinesses and banks should be aware of the substantial merits of FrankfurtRheinMain in The promising Boffering attractive and competitively priced office accommodation and commercial real estate. Particularly compared with other European regions with major international airport real estate hubs, the area provides significant location benefits. This is borne out by a positive environment pipeline will strengthen for investment projects and a string of real estate initiatives that could well be further enhanced by the impact of the UK’s EU vote. FrankfurtRheinMain’s The promising real estate pipeline will strengthen FrankfurtRheinMain’s position in the global position in the global market – a self-feeding development promoting and sustaining the area’s drawing power. For“ discerning pursuers of real estate opportunities, there is no shortage of availability. With 12.4m market – a self-feeding square metres (sq.m) of total office space, Frankfurt has a vacancy rate of around 11%, or roughly development promoting 1m sq.m. Monthly rents for prime properties have increased slightly over the past year to €38.5 per sq.m and sustaining the area’s and are expected to remain stable in the near term. Average rents of €15.5 per sq.m have also drawing power. risen slightly. But there is substantial office space in central and other attractive locations at much lower prices. For warehouse and logistics space in the greater Frankfurt area, building completions have shown the best results for years, reaching 350,000sq.m last year. Monthly prime rents for 5,000 sq.m warehouse and logistics space around Frankfurt airport are unchanged at about €6 per sq.m. For less extensive spaces, under 5,000sq.m, rents can be more than €7 per sq.m. Compared with the previous year, rents for warehouse and logistics space have stabilised. A combination of an impeccable status quo and an enticing pipeline makes FrankfurtRheinMain a hub of real estate opportunities for companies building a continental base. ▪ For more details contact Iassen Boutachkov, Director Europe, on +44 (0) 20 3769 0741 or [email protected]. ©Fraport AG ©Fraport

Luxembourg Sep 2016

A series of specialist monthly reports examining the Frankfurt Oct 2016 post-Brexit opportunities for European financial centres To discuss marketing opportunities contact Wendy Gallagher +44 (0) 20 3008 5262 or [email protected]

mid considerable uncertainty over the economic, financial and political implications of Europe, its Athe UK vote to leave the European Union, one thing is clear: Europe, its economy, and the financial services sector in particular require a reliable and stable framework toremain economy, and the competitive internationally. London’s role as a provider of financial services to the EU is unlikely financial services sector to persist. Frankfurt is prepared to strengthen its role as a pivotal partner for global financial market operators, in the best interests of the European economy and European development. in particular, require Banks, insurance companies and other global financial services providers have a presence in a reliable and stable London and Frankfurt. The major German banks and 155 foreign banks are present in Frankfurt, “ where a broad set of other financial services is offered, including by leading capital market service framework to remain providers, Deutsche Börse and Eurex Deutschland. competitive internationally. Many other business services – legal, consulting, analytical – are readily available. Frankfurt will remain an attractive environment for financial technology enterprises, providing an environment that facilitates start-ups and new developments while encouraging established businesses to maintain a long-term presence. Frankfurt is the EU’s leading internet hub. Relatively low costs for companies and employees make it a magnet for other businesses, particularly associated with financial services. Frankfurt is home to financial regulators, including: the European Central Bank, the Single Supervisory Mechanism, the European Systemic Risk Board, the European Insurance and Occupational Pensions Authority, Deutsche Bundesbank, Bundesanstalt für Finanzdienstleistungsaufsicht, Bundesanstalt für Finanzmarktregulierung and the Global Legal Entity Identifier Foundation. Following the UK vote, Hessen is applying for the European Banking Authority to be located in Frankfurt.

Flexible and effective German labour law German labour law, an important factor in business location, is flexible and effective: 66% of disputes are resolved within three months, while redundancy payments are regulated by law. In practice, payments of between 50% and 200% of annual salaries are the norm. A study by the Federal Statistical Office found the number of actions filed involving labour law in 2011 (three years after the financial crisis) was only 60% of the 1995 level. Overall tax levels in Germany are much lower than often presumed. With a corporate tax rate of 15% and a business tax rate of 10-16%, financial companies in Frankfurt pay generally a total marginal tax rate of 25-31%. The German economy offers business growth opportunities and political stability. Compared with other prominent euro area countries, Germany – taking up 15th position – is the highest-ranked country in the World Bank’s ‘ease of doing business’ index (ahead of Ireland at 17, France at 27, and the Netherlands at 28). Frankfurt is part of the FrankfurtRheinMain region, with 5.6m inhabitants and GDP of €216bn, profiting from steady and sustainable growth. The region is second-ranked in the EU in terms of GDP per capita. The city provides high-quality lifestyles, with the population benefiting from an excellent work-life balance, efficient public transport, and a lively cultural scene. According to the Mercer 2016 ‘quality of living’ survey, helping governments and companies with employees on international assignments, Frankfurt ranks as No.7 internationally, compared with rankings of Amsterdam at 11, Dublin at 33, Paris at 37 and London at 39. Frankfurt’s international workforce and well- integrated expatriate community testify to its global appeal. All these ingredients make Frankfurt well placed to become the EU's leading international financial centre following Britain’s withdrawal. ▪ Dr. Stephan Bredt is Director General Economic Sector, Financial Services, Exchanges at the Ministry of Economics, Energy, Transport and Regional Development of the State of Hessen ([email protected]). Armin Winterhoff is Head of Financial Centre Frankfurt at the Ministry ([email protected]).

Official financial institutions based in Frankfurt Six regulators located in Germany’s financial hub

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CEINEX is the dedicated trading venue for China and RMB related financial products. We bridge the Chinese and international capital markets with innovative products and services, offering easier access to cross-border investments; serving as an international market and cooperation platform for your company. Experience new opportunities: www.ceinex.com A suboptimal policy mix Why Europe needs fiscal measures and growth reforms Ignazio Visco, Banca d’Italia ery low inflation and the persistent risk of Domestic factors operate both via macroeconomic outlook and the persistence Va de-anchoring of inflation expectations expectations and via economic activity. In of exceptionally low inflation. continue to dominate the economic both respects conditions in the euro area The ECB will continue to monitor outlook for the euro area. The policy mix is differ from those in other main advanced economic and financial market developments suboptimal: there is no common fiscal policy economies. very closely and, if warranted, act again by and many countries lack sufficient room for Since the end of 2014, the risk of a using all the instruments available within manoeuvre. de-anchoring has increased notably in the its mandate. The purchase programme is Bank profitability remains weak and euro area, where expectations have fallen intended to run until the governing council several intermediaries may need to sees a sustained adjustment in the path strengthen their balance sheets against a of inflation consistent with its inflation background of subdued economic prospects Nominal rates that objective. The relevant committees have and continuing regulatory reform. been tasked with evaluating the options for The governing council of the European are low or negative ensuring its smooth implementation. Central Bank has acted boldly to encourage a for too long may hurt But monetary policy cannot pursue return to price stability. Official interest rates the profitability of some a return to price stability and a more have been reduced repeatedly, bringing the sustained growth rate in isolation. It must be deposit facility rate to negative levels. New institutions. But a less accompanied by fiscal policies consistent with longer-term refinancing operations have “ cyclical conditions, and by reforms designed accommodative monetary been introduced, with conditions rewarding to achieve a permanent return to higher rates banks which provide more credit to the policy in the current of growth potential and job creation. economy. The Asset Purchase Programme circumstances would harm The fear of continued weak demographics has been progressively expanded. everyone. and modest productivity growth is the likely real cause of very low real interest rates. Effective action Central bank action has been effective. further than in other advanced economies. In Structural reforms Without these measures, economic addition, there is evidence of a stronger link Important structural reforms have been conditions would have been much worse, between low inflation and economic slack. adopted in several euro area countries and possibly leading to a deflationary spiral. In Italy, France and Spain, nominal wages these efforts must continue. Their benefits Credit supply conditions, particularly tight became more reactive to unemployment are beginning to be felt, but it will take time in 2011-12, have loosened gradually. The after the crisis. to exploit their full potential. Each country cost of credit to the economy has fallen and has its own problems, and solutions are financial fragmentation in the euro area has Low interest rates difficult to standardise. eased. The weak credit dynamics still being The ECB is conscious of the potential for Reforms imply short-term costs, both observed in the euro area mainly reflect negative collateral effects from a long period economic and political, and we should guard subdued demand. of very low interest rates. against the risk of unintentionally introducing The measures have fostered a decline In the euro area as a whole there is obstacles. For example, excluding some in yields and bolstered the prices of a wide currently no evidence of risks to financial countries from advances in fiscal and political range of financial assets. This has had a stability related to an excessive increase union until they have achieved sufficient positive impact on consumption, through in the prices of shares, corporate bonds or convergence would make their reform efforts wealth effects, and on investment, through houses. more difficult. a fall in the cost of capital. Business and Growth in lending relative to the cyclical Reducing uncertainty is one of the most household confidence have been buoyed. position of the economy is moderate. pressing challenges facing European policy- According to ECB estimates, without the Risks that may arise in specific sectors makers. It not only requires adequate wide range of monetary policy measures can be addressed with carefully targeted institutions and policy tools, but above all true introduced between mid-2014 and the first macroprudential instruments, as has already leadership capable of restoring a common part of this year, annual inflation and GDP happened in some countries, without sense of purpose and defining a clear vision growth would be more than half a percentage interfering with the monetary policy stance. for the future of the European project. point lower in the euro area in 2015-17. Nominal rates that are low or negative This is the only possible response to rising This highly expansionary monetary policy for too long may hurt the profitability of populism and the risks it poses to the future stance is the result of well thought-out some institutions. But a less accommodative well-being of European citizens. decisions and a response to the weakness of monetary policy in the current circumstances There are many short-term challenges. the economy and the risk of deflation. would harm everyone. But we must continue to emphasise the need Low inflation is undoubtedly in part a Strengthening the economy is key to for a longer-term perspective. global phenomenon. It reflects developments ensuring a return to price stability, as well ▪ in oil prices; deflationary pressures from as mitigating risks to financial stability. In Ignazio Visco is Governor of the Banca d’Italia. This is an the Chinese economy; and possibly also the current cyclical conditions, the main edited extract of a speech given to OMFIF’s Seventh Main technological change. But it depends too on risks to financial stability, the profitability Meeting in Europe on 22-23 September. A full summary of domestic developments that should not be of banks and firms, and even to household proceedings and other details of the Rome meeting can be underestimated. income, continue to stem from the uncertain viewed at www.omfif.org/analysis/reports/.

October | ©2016 omfif.org EUROPE | 15 Italy’s ‘doomsday’ scenario Storm clouds on horizon for banking sector By Steve H. Hanke, Advisory Board n 23 June UK voters gave a collective €5bn. Questions remain too over the ability of broad money and nominal GDP are closely Othumbs-down to continued membership to raise new bank capital in Italy, where linked. Italy’s money supply (M3) growth rate of the European Union, shocking the banks are loaded with non-performing loans since 2010 has been well below its trend rate establishment and temporarily unsettling (around €200bn) and bank shares are trading (6.53%) for most of the period (see Chart). the markets. The outcome increased the below book value. If new private capital for Unsurprisingly, nominal GDP growth rate in possibility of an Italian – as well as a euro Monte dei Paschi is not raised, and raised 2010-15 was only 0.4% per year. area – ‘doomsday scenario’. quickly, Italy and the EU will butt heads, and The results of stress tests for European therein lies the potential storm. banks, published on 29 July, showed that Without new capital, Monte dei Paschi Monte dei Paschi is Italy’s Banca Monte dei Paschi di Siena was bondholders will be forced to take losses the only European bank out of the 51 tested (a bail-in) before any government bail-out not the only problem whose capital was wiped out in the stress test money could be deployed under EU rules. child of the Italian banking scenario. However, a bail-in would be politically highly system: all the country’s big The bank subsequently announced that it problematic for Prime Minister Matteo Renzi would raise capital by issuing stock, while the as retail investors, making up a powerful banks could benefit from Italian treasury indicated that there would portion of the electorate, hold a big chunk of “ some additional capital. not be a bail-out of Italian banks. Fabrizio Italian bank debt (bonds). Viola, Monte dei Paschi’s chief executive, was Suffering losses from a bail-in, bondholders dismissed and replaced by Marco Morelli, would be likely to vote against Renzi’s Breaking down the contribution to the setting the stage for the bank to raise €5bn in proposed changes to Italy’s constitution in money supply growth, state money produced new capital and dispose of around €30bn in December, though this will not prompt a by the European Central Bank accounts for non-performing loans. change of government – Renzi has said his only 17% of Italy’s M3. The remaining 83% is administration will remain in place regardless bank money produced by commercial banks New capital of the referendum result. through deposit creation. As such, Italy’s Nevertheless, storm clouds remain on the The monetary approach posits that banks are an important contributor to the horizon. Monte dei Paschi has used up €12bn changes in money supply, broadly determined, money supply and the economy. of capital raised since 2008, and there are cause changes in nominal national income However, banks have been struggling and no guarantees it would not use up a further and the price level. Sure enough, the growth any contraction of their loan books – which would cause the money supply and credit to the private sector to slow – would produce Growth in Italian money supply hit by bank weaknesses another recession. Money supply (M3) and credit to private sector, annual % change State rescue Monte dei Paschi is not the only problem child of the Italian banking system: all the country’s big banks could benefit from some additional capital. But issuing new shares is unattractive because bank stock is trading below book value (at the time of writing, Intesa Sanpaolo’s price-to-book ratio was 0.77; that of UniCredit 0.27; UBI Banca 0.24; Banco Popolare 0.22; and Monte Paschi 0.07). Without new private capital, an Italian state rescue is the most attractive source for

the recapitalisation. Otherwise, the banks will be bailed-in by the bondholders, Renzi’s constitutional changes will go down in flames and the government will collapse. With that, the populist Five Star Movement is most likely to form a government, raising the threat of a serious initiative to leave the euro. If the EU does not bend and allow one of the loopholes in its rules to be used, it risks setting in motion an Italian and euro area ‘doomsday’ machine. ▪ Steve H. Hanke is Professor of Applied Economics at Johns Source: ECB, ONB, calculations by Steve H. Hanke Hopkins University.

16 | EUROPE omfif.org October | ©2016 Cyprus, Greece and ‘whatever it takes’ Political threats to central bank independence Panicos Demetriades, University of Leicester hen Mario Draghi, president of the indefinitely or euro exit, political leaders September’s programme review remains WEuropean Central Bank, declared in in both countries came to their senses – incomplete, with a number of key reform July 2012 that the ECB would do ‘whatever temporarily at least. deliverables outstanding. The Greek it takes’ to save the euro, financial markets In Cyprus, politicians protested about government has submitted a bill with reforms reacted positively. The intention was fleshed the ECB’s ‘blackmail’. In his testimony to to parliament that will need to be passed for out in the Outright Monetary Transactions a judicial inquiry, Nicos Anastasiades, the the next tranche of bail-out funds, amounting programme, which had as its declared Cypriot president, said the ECB had ‘put a to €2.8bn, to be released by the creditors. aim to eliminate what the ECB viewed as gun to his head’, otherwise he would never It includes reforms to Greece’s electricity ‘unacceptable re-denomination risk’ in have accepted the write-down on bank market, measures to speed up privatisations Italian and Spanish bonds. deposits. That gun, he explained, was the and cuts to state pensions. OMT was never used, though its supply of emergency liquidity assistance. Prime Minister Alexis Tsipras’ slim majority announcement achieved those objectives The ECB of course was alluding to its own in parliament may be sufficient to pass the bill at the time. However, the programme on its legal constraints. If the Cypriot government this time. However, government officials are own could never have addressed the weakest became bankrupt, it could not continue to pledging to resist labour reforms that could links in the chain: Greece and Cyprus. supply Cypriot banks with euros. lead to further wage cuts and job losses. Significant steps were taken subsequently While such political uncertainty persists, towards establishing a banking union, Taxpayers could not bail out banks the risk of ‘Grexit’, which has subsided since including the creation in November 2014 of The agreement with Cyprus involved the heights of 2015, could resurface in the the single supervisory mechanism, better imposing losses on bondholders and near future, even if macro downside risks do placed than national supervisors to tame depositors because, as the International not materialise. excessive risk-taking by big banks. This is Monetary Fund’s debt sustainability analysis The return of bank deposits – a key a problem of particular relevance to small showed, Cypriot taxpayers could not bear the barometer of confidence in ‘Gremain’ – has countries, as I quickly discovered when I burden of bailing out the big banks. been virtually non-existent. Capital controls became governor of the Central Bank of The much criticised bail-in that was finally remain in place and Greek banks continue to Cyprus in May 2012. agreed (after parliament turned down the be largely funded by the ECB. broad-based levy on insured and uninsured Too big to fail deposits proposed by the government and A risky strategy Cyprus’s crisis was very much a tale of two agreed by the Eurogroup) affected only 4% When it came to the crunch, the ECB may banks becoming too big to fail, too big to of uninsured depositors, and reduced the have helped to keep the euro intact. But save, and too big to regulate. Between 2005 total bail-out bill by around 33% of GDP. And can the same be said of its key institutional and 2011, the domestic banking sector it spared Cyprus from Greek-style austerity, foundation – central bank independence? doubled in size to 9.5 times GDP, while risks which goes some way towards explaining the Since 2012 attacks on euro area central were largely ignored. economy’s recovery. banks and their governors have become The two largest banks had assets Other upfront banking reforms, including common. Some appear to follow actions that equivalent to 400% of GDP. Parliament rarely restructuring credit co-operatives and ring- involve imposing losses on bank creditors. asked the national supervisor, CBC, to explain fencing the Cypriot banking system from Others have been politically motivated. how these rapidly growing banking risks, Greece, were instrumental in restoring There have been legal challenges to the which represented a contingent liability for confidence and allowing capital controls to be ECB (as well as associated political attacks) the taxpayer, were being managed. lifted early. However, the reforms resulted in over its unconventional policies from within Important steps have been taken in fiscal considerable toxic fallout for the central bank. Germany. They have focused primarily on policy coordination that should help prevent Political attacks were soon followed by the Bundesbank’s allegedly unlawful role in a Greek-style build-up of public debt in future. legislative changes to the Central Bank of the ECB’s outright monetary transactions and Both the Cypriot and Greek crises could have Cyprus governance. These not only eroded quantitative easing programmes. been prevented had all these improvements the bank’s independence but undermined These developments have shown that been in place before 2012. its decision-making processes – much as ‘whatever it takes’ is a risky strategy, not At the time, addressing legacy problems predicted by an ECB legal opinion published just for Eurosystem institutions but for in banks and public finances remained n in June 2013 (which legislators ignored). individuals taking critical actions for the the hands of political leaders. The ECB could euro’s survival. But if EMU is to survive the do little to influence bail-out negotiations, Greece: not on track storm that appears to be brewing – involving other than to warn that, in the absence of In Greece, public debt is expected to reach Brexit, Italian banks, geopolitical risks and the agreement at the political level, it would be 185% of GDP this year, notwithstanding slowdown in China – the ECB can ill afford to forced to cut off or freeze liquidity support. seven years of austerity (and the private relax its guard. Doing ‘whatever it takes’ will Since 2012 those warnings have been sector involvement of 2011), compared with remain on the agenda. made openly twice: in Cyprus in March 127% at the outset of the crisis in 2009. No ▪ 2013 and in Greece in June 2015. In both wonder programme legitimacy remains Panicos Demetriades is Professor of Financial Economics cases bail-out negotiations had come to a a huge concern. The long-awaited first at the University of Leicester and Fellow of the Academy of standstill, and the ECB’s actions resulted in review of the Greek programme suggests Social Sciences. During 2012-14 he served as Governor of banks shutting down for several days. Faced that it remains ‘broadly on track’, but that the Central Bank of Cyprus and Member of the Governing with the prospect of banks remaining closed ‘significant implementation risks’ remain. Council of the ECB.

October | ©2016 omfif.org EUROPE | 17 Costs for financial system When lowering interest rates does more harm than good Peter Warburton, Economic Perspectives t is hard to imagine the possible benefits of There comes a point at which borrowing yield curve makes it harder for insurance Ithe August cut in the UK bank rate. rates are no longer a material obstacle companies to deliver promised returns to If lower interest rates impart stimulus to to borrowers. They may fail to qualify for policy-holders, and threatens the solvency of the UK economy, is it the case that the lower loans based on their disposable income, the weaker companies. the rate, the greater the stimulus? And if credit score, postcode or other criteria, lower positive interest rates boost aggregate but the rate is immaterial. Consumer debt Pension fund injections demand, would negative rates have an even is motoring along at growth of 10% per Actuarial adjustments based on lowered more pronounced effect? bond yields have a profound effect on Analytically, it is possible to assert that pension deficits. a lower discount rate will bring forward The wider impact of With 80% of company-sponsored funds household consumption, that a lower cost of falling returns in a in deficit, many businesses will be required capital will boost fixed capital formation, and to inject funds into their schemes at the that higher property and financial asset prices complex, leveraged, financial expense of investment spending. Defined will inflate the net worth of households and system could easily overturn contribution pensions will project lower businesses, inducing them to save less and the expectation of a net retirement incomes. spend more. “ There is a generalised cost to the financial But when interest rates are extremely, economic stimulus when system when liquidity is hoarded within abnormally and persistently low, other rates are abnormally low. financial institutions and large corporations, possibilities must be considered. rather than pooled for the benefit of all. A zero interest rate equates to zero The risk of concussion annum and in no obvious need of assistance. incentive to offer surplus liquidity into the When interest rates fall out of bed, there is Older savers, on the other hand, are market. The wider impact of falling returns a risk of concussion. Concussion is difficult perplexed by the persistence of low rates. in a complex, leveraged, financial system to incorporate into analytical models, but no Fearing penury in their latter years, senior could easily overturn the expectation of less of a reality. citizens are prone to save more of their a net economic stimulus when rates are The flip side of very low borrowing rates non-interest income to top up their abnormally low. – for example, the 4.1% personal loan rate capital. and the 2.3% lifetime tracker mortgage rate Banks typically suffer a squeeze of their net Capital spending – is extraordinarily low saving rates. These interest margins as interest rates approach Business investment in structures, plant and are exemplified by instant access deposit zero, occasionally leading them to raise equipment has been a serial disappointment rates (less than 0.05%) and fixed rate bond borrowing rates to restore profitability. The to policy-makers over the past seven years deposits of 0.85%. systematic compression of the government and, if anything, the trends are worsening. This raises a number of questions. Has the capital spending decision been soured by Interest rates trend persistently lower ultra-easy money and quantitative easing? Selected UK household interest rates, % Are decision-makers unsettled by the fresh doubts cast by policy easing on the economic outlook? As policy uncertainty increases, perhaps the option value of cash rises to offset its lower return? Other questions include whether large- scale asset purchases crowded investors into the securities of cash-rich companies, persuading them to distribute income rather than commit to fixed investment. And while bond yields may be lower, has the hurdle rate for business capital expenditure risen? There are ample grounds to suspect that the effectiveness of lower rates as a policy stimulus has been overtaken and overwhelmed by other considerations. In the Bank of England and the Treasury, as well as further afield, it is time to rethink monetary policy. ▪ Sterling unsecured personal £10k loan rate (left scale) Sterling ﬁxed rate bond deposit rate Lifetime tracker mortgage rate Peter Warburton is Director of Economic Perspectives and a Member of the Institute of Economic Affairs Shadow Source: Bank of England Monetary Policy Committee. 18 | EUROPE omfif.org October | ©2016 Renminbi payments show limited gains Challenges for reserve status after SDR inclusion Ben Robinson he renminbi was the world’s fifth largest By contrast, the Americas accounted for China is seeking to move beyond a trade role Tpayments currency by value at the end 23% of all trade with China, of which only for its currency towards a more sophisticated of August, according to latest data from 3% was denominated in renminbi. Even use in international investments. Beijing has international interbank telecommunications within the two largest renminbi payment opened up the domestic market, albeit in provider SWIFT. This accounts for 1.86% of regions, just two centres – Hong Kong and a limited form, to foreign investors. Strong world payments. However, while this is a the UK – are responsible for the majority of economic growth, an appreciating renminbi, significant improvement from ninth position, these transactions, indicating a relatively and low yields and weak growth elsewhere which the currency held in August 2013, the limited uptake. Other centres are catching have contributed to international demand for internationalisation of the renminbi remains up, however – the Middle East is the fastest renminbi-denominated A-shares and Chinese limited. growing region for renminbi payments. corporate and sovereign bonds. With the currency still protected by However as an investment currency the capital controls, a managed peg to the Substantial gains renminbi faces challenges: stock market dollar saw the renminbi appreciate by more Despite these caveats, the currency has volatility in mid-2015 and at the start of 2016 than 33% in real terms against China’s made substantial gains in recent years. This have reduced confidence in Chinese shares. trade partners between January 2010 and partly reflects China’s dominant presence in Fears over a bond market bubble, as well as November 2015, a leading factor behind its international trade. As the largest import and concerns about the economy, are growing, as improved ranking in payments value. Over export partner for many countries, the logic indicated by rising yields. the same period the yen fell by more than of converting local currencies into dollars and While higher risks and a growing number 26% and the Canadian dollar by 17%. The then into renminbi has weakened, while the of bond market defaults may partly reflect Hong Kong and New Zealand dollars rose, costs, exchange rate risks and time delays of a natural rebalancing of the market, the but not as much as the renminbi. These doing so have grown. country’s growing debt over the last few figures have however narrowed this year, To facilitate renminbi payments China has years raises concerns over a ‘hard landing’. reducing the renminbi’s lead and causing it to rapidly expanded the presence of clearing fall back behind the yen after its August 2015 banks in global financial centres, including Reserve status challenges devaluation. Hong Kong, Singapore, Frankfurt, London, In addition to becoming a global trade and While the renminbi’s share of global Paris, Luxembourg, Doha, Toronto, Buenos investment currency, a long-term goal of the payments has grown, it has been uneven, Aires and Zurich. Chinese authorities is for the renminbi to led predominantly by the Asia Pacific region. The PBoC also has a growing number become a global reserve currency. Despite Between January and end-August 2016, Asia of currency swap agreements, with more its inclusion in the International Monetary Pacific was responsible for 47% of all trade than 30 countries, to facilitate smooth Fund’s special drawing right reserve currency with China, of which 45% was denominated transactions, lower costs and ensure access basket, this status remains a long way off. in renminbi, followed by Europe with 31%. to renminbi liquidity. China’s SDR share is 10.92%. While countries can sell SDRs to access renminbi liquidity if needed, especially if they are RenminbiValue of overtakes global payments four by currency, currencies index ﬁgures by payment value since 2013 facing balance of payments pressures with Value of global payments by currency, index figures China, the relatively low share of overall trade conducted in renminbi, as highlighted by the SWIFT data, suggests this will be only a minor consideration. Boosting the currency’s role as a reserve asset first requires a larger use in trade and investment, for which greater confidence in the Chinese economy, more market- based pricing, clearer risk signals, and less intervention are all prerequisites. The SDR move, meanwhile, raises questions for the IMF on the acceptable spread between the onshore and offshore rate, on the risk of large movements in the renminbi’s value, and on how the Fund will monitor the currency’s move towards a more market-based rate. Now that the renminbi has entered the SDR, observers will be paying close attention to gauge its further progress towards internationalisation and reserve currency status. ▪ Source: SWIFT Ben Robinson is Economist at OMFIF.

October | ©2016 omfif.org EMERGING MARKETS | 19 Three headwinds for Brazil Potential shock for economy after investor flurry Danae Kyriakopoulou and Bhavin Patel look at the fundamentals suggests that the retirement age have proved popular with by the country’s central bank is here to stay. ABrazil’s recent investor rally has been investors, they have been much less so with Rising interest rates in turn will put further overdone. The country faces a rising stock the broader electorate. pressure on the cost of servicing an already of debt, which will become increasingly Brazil’s population has enjoyed a high debt pile, raising further questions over expensive to service as monetary policy substantial boost in living standards over the debt sustainability. remains on a tightening track. Global macro past decade, with GDP per capita between This situation cannot be maintained in the risks, such as the slowdown in China and the 2006 and 2016 rising by 11%, the biggest long run, but implementing policies that will commodities market, are creating further increase in Latin America. This was partly put Brazil on a more sustainable fiscal path vulnerability exacerbated by domestic financed by the commodities boom, but requires huge levels of political capital. While political uncertainties. After years of Temer remains popular among the public, partying culminating in the Rio Olympics, this could change. Brazil is now suffering a hangover. History may repeat itself. Rousseff enjoyed Brazil’s financial markets have seen a Brazil’s pension similar approval ratings during her presidency flurry of inflows in 2016 as investors bet spending is among before corruption charges saw her officially on economic recovery. The Bovespa equity the highest in emerging impeached. Temer is also being investigated index has risen by 34% this year, the best over corruption allegations in connection performance of equities globally. markets, second only to with the Petrobras scandal. He could quickly The real has appreciated by more than Turkey: at 8% of GDP, it is lose cross-party support, putting current 22% since January, making it the highest “ political stability at risk. performing major currency in 2016. Brazil’s higher even than that of finance ministry projects GDP growth of 2% Sweden, an economy with Running out of steam in 2017 against an expected 3% contraction External conditions are adding to Brazil’s in 2016. a much older demographic headache. Growing trade and investment profile. links with China served the country well Messy politics, bullish investors during the boom years – China is Brazil’s Political change has driven investor largest trading partner, according to the momentum. Markets have anticipated an also by credit expansion, mainly through the latest data from 2015, in contrast to the economic turnaround, bullishly tracking the highly leveraged public sector. majority of economies in the region which impeachment of Dilma Rousseff, unseated as Continued credit-fuelled growth is are more connected to the US. Foreign direct president by the senate in August. unsustainable. For example, Brazil’s pension investment from China into Brazil soared Michel Temer, who has taken over, has spending is among the highest in emerging between 2005 and 2015, from around $8m pledged to restore market confidence by markets, second only to Turkey: at 8% of to $232m. reining in fiscal spending, spurring job GDP, it is higher even than that of Sweden, But China’s economy is slowing. From creation, in a bid to stabilise debt levels and an economy with a much older demographic double-digit growth in 2005-10, annual re-establish Brazil’s credit rating. profile. Sharp rises in borrowing tend to result GDP growth has now eased to just over However, while the previous vice in an inefficient allocation of investments. 6%, according to the latest official data. president’s policies of limiting budget Brazil’s high inflationary stance implies Alternative measures of the strength of the increases in line with inflation and raising that the monetary tightening course pursued economy estimate growth at 3%-4%. More important for Brazil, though, is not Chart 1: Brazil’s growth tracks commodity markets that China’s economy is slowing, but rather Annual S&P commodity index return, %, and Brazil’s real GDP. annual % change the nature of the slowdown. The fact that China’s previously rapid expansion is running out of steam is not a surprise. Beijing is rebalancing its economy away from exports and manufacturing to focus on domestic consumption and the services sector. Demand for industry-heavy commodities such as iron ore and steel has collapsed, but commodities such as sugar or petrol have brighter prospects as China’s middle class develops a greater appetite for richer foodstuffs and car ownership. Although this creates important opportunities for Brazil (vegetable products and other foodstuffs make up around 30%

of the country’s exports), the downturn in Commodities the commodity price cycle acts as a third Source: S&P, Brazilian Institute of Geography and Statistics, OMFIF and final headwind to the Brazilian economy Insti titi

Nowhere has the recent investor flurry into Brazil been To assess the fundamentals-implied exchange rate, economists more pronounced than in the performance of the real. After usually rely on the ‘law of one price’ – the principle that exchange depreciating by 33% in 2015, the currency has recouped 47% of rates correct so that any product should cost the same wherever last year’s losses and is the best-performing currency in 2016. it is purchased.

This volatility, driven by market sentiment related to political As a result, changes in inflation tend to drive changes in the developments, obscures the fundamental drivers of the currency’s exchange rate. This seems to be supported by the data for the valuation. With a floating currency such as the real, the exchange real/dollar exchange rate (see Chart 2). rate will be determined by the economy’s links to international The inflation differential between Brazil and the US looks set markets through international trade and capital flows. to widen: the Federal Reserve has hesitated to raise interest rates Trade plays an exceptionally small role in Brazil’s economy. once again, and any rate rise will be very modest. Meanwhile, Yet with commodities making up roughly half of Brazil’s exports, the Central Bank of Brazil remains on a tightening schedule to investors in the foreign exchange market tend to associate Brazil’s combat high inflation. The fundamentals point to depreciation of performance with that of commodities. the real over the long term.

in the short term. As Chart 1 shows, Brazil’s Sudan, Afghanistan, Burundi, and Kiribati with the real also performing as a commodity economic performance traditionally has have a lower contribution of exports to GDP. currency (see Chart 3). been closely tied to the commodities market. To put this further into context, the The recovery in commodities and the exports to GDP ratio can be well above 100%, possibility of a Chinese soft-landing has seen Dependence paradox as is the case in city states such as Hong Kong Brazil benefit. Investment has flowed into At first sight, this strong dependence appears and Singapore, or even countries such as the region, and the outlook for a Brazilian paradoxical. Commodities play a relatively Ireland. Even emerging markets of a similar recovery appears positive. small role in Brazil’s economy: rents from size to Brazil such as India, Russia, or Mexico The question now is how long the positive natural resources comprise around 5% of tend to have a substantially higher share of trend will last. Brazil’s financial market GDP, close to the global average. In the boom exports in their economies. recovery could be generating bubbles – years this figure was higher, peaking at 8% in recovery of fundamentals have lagged 2007. Commodity currency behind the growth in assets. If the Fed raises While they have greater weight in exports Brazil’s economic fortunes may be so tied interest rates more quickly than expected, (agricultural and mineral products alone to the commodities market because of the market sentiment could change abruptly, make up around half of Brazil’s exports), close association in investors’ minds between capital inflows could turn into outflows – and exports on the whole play a very small role Brazil and commodities – resulting in capital Brazilian investors could be in for a shock. in Brazil’s economy, accounting for less than outflows and a bearish attitude each time the ▪ 15% of GDP – the fifth lowest ratio in the commodities market turns down. This seems Danae Kyriakopoulou is Head of Research and Bhavin world, according to the World Bank. Only to be supported by the data to an extent, Patel is Research Assistant at OMFIF. commodities index Chart 2: Brazil’s exchange rate driven by inflation Chart 3: Brazil’s ‘commodity currency’ challenge Brazil-US inflation rate differential, %, and real per dollar S&P commodities index total return, $, and dollar per real

Commodity index total return (RHS) Source: Central Bank of Brazil, US Bureau of Labor, Brazilian Institute of Geography and Statistics, OMFIF analysis Source: S&P, Central Bank of Brazil, OMFIF analysis October | ©2016 omfif.org EMERGING MARKETS | 21

Directing policy to growth sectors Nigeria seeks better monetary-fiscal coordination Donald Mbaka, Central Bank of Nigeria n its quest to keep price increases within economy, as was the case in several other preoccupation, domestic economic factors Idefined limits, the Central Bank of Nigeria jurisdictions where unconventional monetary have necessitated some ingenuity on the part has consistently ensured that Nigeria’s policies were implemented. The underlying of monetary authorities. banking system – the key platform for goal was to precipitate real sector activity The Bank of Japan has committed to transmitting monetary policy impulses – and generate domestic economic activity to increasing the monetary base annually by remains sound and stable, with low threats support local capacity and reduce imports. a given amount to pull the country out of from systemic risks. Several intervention funds were prolonged recession. However, the central bank has grappled established to provide low-income financing The US Federal Reserve, the Bank of with the effects of low levels of domestic to economic sectors with the potential to England and the European Central Bank economic activity, particularly their impact galvanise an economic revival – key sectors have adopted the purchase of financial on the exchange rate. This can be attributed include micro, small and medium-sized instruments (including government bonds). largely to widespread dependence on These jurisdictions have well-organised receipts from crude oil sales, resulting in and vibrant economies, and financial markets the neglect and stifling of other economic While there is no doubt provide the only feasible avenue for non- sectors. that the design and standard measures. It has not always been this way. Nigeria implementation of monetary The same may not necessarily apply to was noted in past decades for the large-scale a less developed country like Nigeria. Here, production of high-value agricultural exports policy should always be the financial system is thriving but still such as cocoa, groundnuts and palm produce, the central bank’s primary developing, while economic activity remains among others. These generated substantial “ far below potential. foreign exchange resources and formed the preoccupation, domestic Monetary interventions should target bedrock of the country’s economic growth in economic factors have points likely to produce greater impact. the early years after independence in 1960. The CBN has directed its unconventional But while the discovery and commercial necessitated some ingenuity monetary policy towards sectors that are exploitation of crude oil continues to yield on the part of monetary more likely to boost domestic economic additional and significant inflows of foreign authorities. activity and enhance productivity. exchange, which account for around 75% of government revenues, this has yielded worse Price stability than expected outcomes. enterprises, agriculture, and power. Leverage Such concerns are nevertheless valid. for this venture hinged on powers granted to Central banks should focus on achieving Large-scale imports the Bank to facilitate development functions, and maintaining price stability, to create a Nigeria’s domestic resources – both human as enshrined in its enabling statutes. macroeconomic environment conducive and natural – have not been adequately The funds undoubtedly have opened to sustainable economic growth. Keeping exploited. This has resulted in large-scale up newer channels to satisfy the financial inflation within specified targets should be imports to meet numerous domestic and resource requirements of various business their primary goal. industrial requirements, large outflows of ventures as against prohibitive bank loans. In this regard, the CBN – which follows a foreign exchange to pay for these imports, However, adopting such an unconventional monetary targeting strategy and has adopted and resulting problems with exchange rate monetary policy tailored to development the corridor system for implementation management. financing has inevitably prompted concerns in of monetary policy – may need to isolate As the warehouse for official crude oil Nigeria over the design and implementation the various unconventional measures receipts – which account for around 90% of of monetary policy – the prime responsibility while providing adequate guidance and foreign exchange inflows – the CBN by default of central banking. supervision, and re-focus on price stability. is the major supplier of foreign exchange to Fiscal authorities, on the other hand, satisfy in-country demand. It does this at Monetary interventions should provide the direction and incentives the expense of its stock of foreign exchange These interventions were quasi-fiscal in for structural efficiency. Economic growth reserves, which has been consistently nature and increased money supply to the and development are within this jurisdiction. depleted over time. economy. This naturally translated into an Monetary policy cannot succeed when The global financial crisis, coupled with upside risk for inflation where a single-digit the economy is comatose, and fiscal policy the subsequent collapse in crude oil prices, rate had been targeted. cannot push through with economic growth highlighted the need for adequate domestic As a result, and in addition to other fiscal measures while other significant monetary capacity to cushion the effects of negative measures with implications for prices, the (and macroeconomic) indicators perform external developments. inflation rate has significantly breached the poorly. In particular, widespread dependence on single-digit target. There have also been Healthy coordination between monetary imported products accounted for a major claims that the Bank has gone beyond its and fiscal policy can produce beneficial proportion of the consumer price index, and monetary policy remit and ventured into results. This must be the aim for Nigeria’s was a significant contributor to domestic broader economic policy. policy-makers. inflation. While there is no doubt that the design ▪ Given these challenges, the CBN decided and implementation of monetary policy Donald Mbaka is Economist at the Central Bank of to provide monetary stimulus to the should always be the central bank’s primary Nigeria.

22 | EMERGING MARKETS omfif.org October | ©2016 African democracy: work in progress Moving to better governance and inclusive growth Kingsley Chiedu Moghalu, Advisory Board bserving the presidential election Ocampaign in the US, a more than 200-year-old democracy, provides a reminder of the need for some perspective when assessing the progress of democracy in Africa. That a vast majority of Africa’s 54 nations are now democracies is a good thing. This represents a radical shift away from the military dictatorships that dominated the continent just a quarter of a century ago. The shift has come about partly in response to the innate urge for individual human freedom and free societies, and partly in response to the hegemonic forces of globalisation as the cold war ended in the late 1980s and the struggle between Muhammadu Buhari, President of Nigeria the Soviet and US superpowers ended on American terms. Moreover – as a result of this – it has also Nkurunziza sought to extend his hold on ‘licence’ conferred by winning elections to come about in part in response to the felt power by removing constitutional term limits. quash the voices of opposition. need in African nations to meet the evolving In Rwanda, the country’s parliament in Additionally, democracy in Africa needs minimum requirement for legitimacy in a 2015 voted to remove term limits to the to be organised around ideas that can lead global order increasingly based on democratic to real progress. Such ideas incorporate norms (even if the main international inclusive economic growth that will make institution that spread these norms, the UN, It is clear that the the popular notion of ‘Africa rising’ more is not fully democratic). real than the media- or investor-led hype Democracy has been broadly good for rituals of democracy that has soured of late, even as the continent Africa, but not because the dictatorships it such as voting by themselves remains a business destination of today and replaced could not have created progress. do not constitute the sum tomorrow. Those military regimes failed largely because Too often, elections are still contests they were self-serving, and lacked a world of real democracy. More for control of power and patronage view of economic transformation. “ resources by ethnic and religious identities. important – and needed in Zambia’s presidential elections in August Mixed election outcomes Africa – is a deepening of point to a regression towards these Elections in Africa in 2015-16 have pointed the democratic ethos. motivating forces. These atomistic definitions to progress and challenges, as well as the of self-interest have blocked the emergence evolving maturity of pluralistic political of more unifying national visions that create spaces. leadership of Paul Kagame. In some ways real progress. In Nigeria, an opposition party led by reminiscent of Singapore’s Lee Kwan Yew, Third, an important lesson of Africa’s Muhammadu Buhari, a former military Kagame has led his country from an age of democratic trajectory is that, to create leader, defeated Goodluck Jonathan, genocide in 1994 to a new era of development real wealth for Africa’s nations, democratic the incumbent president, in a national and undeniable economic progress, even as contests will require the participation of presidential election in 2015. Even more western governments question his human technocrats skilled in the art and science remarkably, Jonathan conceded defeat and rights record. of leadership, economics, public policy and oversaw a peaceful transfer of power to the management, engineering, and innovation. new government. Democratic ethos This trend is already taking root in a few In South Africa, the majority African It is clear that the rituals of democracy such countries such as Ghana. In many other National Congress’ hold on political power has as voting by themselves do not constitute countries, the old guard of ‘chartered slipped significantly this year as opposition the sum of real democracy. More important politicians’ still holds sway, conflating the party candidates make significant inroads in – and needed in Africa – is a deepening of the longevity of their political careers with their mayoral races in important urban centres. democratic ethos. perceived ability to take their citizens into the In east and central Africa, Tanzania held Acquiring power through the ballot box future in a competitive world. Africa’s citizens successful presidential elections in 2015. needs to be accompanied by a sense of the and voters must be educated to recognise However, polls in Uganda were marred by limitations imposed by the real meaning the difference. controversies over allegations of political of democratic governance, including the ▪ repression by Yoweri Museveni, president for strengthening of independent institutions Kingsley Chiedu Moghalu is Professor of International the past three decades. Burundi descended and the tolerance of dissent. There is a need Business at The Fletcher School at Tufts University and a into civil conflict in 2015 as President Pierre to guard against ‘democratic despotism’ – a former Deputy Governor of the Central Bank of Nigeria.

October | ©2016 omfif.org EMERGING MARKETS | 23 ECONOMIC & INDUSTRY EDUCATION & RESEARCH PUBLIC POLICY CAPITAL MARKETS & INVESTMENT BANKING EDITORIAL & COMMENTARY Meghnad Desai Meghnad Desai Chairman 24 | ADVISORY BOARD Deputy Chairman Deputy Philip Middleton

Louis de Montpellier Deputy Chairman Deputy Deputy Chairman Deputy Frank Scheidig Deputy Chairman Deputy Songzuo Xiang omfif.org Senior Adviser Mario Blejer Senior Adviser Aslihan Gedik Robert Johnson Robert Senior Adviser October Norman Lamont Senior Adviser | ©2016 OMFIF ADVISORY BOARD Kingsley Moghalu Fabrizio Saccomanni Niels Thygesen Ted Truman Senior Adviser Senior Adviser Senior Adviser Senior Adviser

EDITORIAL & COMMENTARY BANKING 1. Peter Bruce, Business Day 1. John Adams, China Financial Services 2. Reginald Dale, Center for Strategic and International Studies 2. Yaseen Anwar, Industrial & Commercial Bank of China 3. Darrell Delamaide, Market Watch 3. Marek Belka, formerly National Bank of Poland 4. Jonathan Fenby, China Research, Trusted Sources 4. Consuelo Brooke, Alliance Trust & BlackRock 5. Stewart Fleming, University of Oxford 5. Moorad Choudhry, formerly Royal Bank of Scotland 6. Harold James, Princeton University 6. John Chown, Institute for Fiscal Studies 7. Roel Janssen, NRC Handelsblad 7. Michael Cole-Fontayn, BNY Mellon 8. William Keegan, The Observer 8. Christian Gärtner, DZ BANK 9. Joel Kibazo, formerly African Development Bank 9. José Manuel González-Páramo, BBVA 10. Thomas Kielinger, Die Welt 10. Akinari Horii, formerly Bank of Japan 11. Jürgen Krönig, Die Zeit 11. Korkmaz Ilkorur, Business & Industry Advisory Committee to OECD 12. Willem Middelkoop, Commodity Discovery Fund 12. Philippe Lagayette, Fondation de France 13. Brian Reading, independent economist 13. Andrew Large, formerly Bank of England 14. Janusz Reiter, former Polish Ambassador to US 14. Oscar Lewisohn, Soditic 15. Anthony Robinson, formerly Financial Times 15. Wilhelm Nölling, formerly Deutsche Bundesbank 16. David Smith, formerly United Nations 16. Athanasios Orphanides, formerly Central Bank of Cyprus 17. Michael Stürmer, WELT-Gruppe 17. Francesco Papadia, formerly European Central Bank 18. David Tonge, IBS Research & Consultancy 18. Philippe Sachs, formerly Standard Chartered Bank 19. Nasser Saidi, formerly Bank of Lebanon 20. Fabio Scacciavillani, Oman Investment Fund 21. Miroslav Singer, formerly Czech National Bank 22. José Alberto Tavares Moreira, formerly Banco de Portugal 23. Jens Thomsen, formerly Danmarks Nationalbank 24. Pasquale Urselli, formerly Crédit Agricole 25. Makoto Utsumi, Japan Credit Rating Agency 26. Tarisa Watanagase, formerly Bank of Thailand 27. Ernst Welteke, formerly Deutsche Bundesbank CAPITAL MARKETS & INVESTMENT PUBLIC POLICY 1. Andrew Adonis, National Infrastructure Commission 1. Antonio Armellini, former Ambassador, OSCE 2. Bahar Alsharif, formerly International Finance Corporation 2. Franco Bassanini, formerly Cassa Depositi e Prestiti 3. David Badham, World Platinum Investment Council 3. Frits Bolkestein, formerly European Commission 4. Stefan Bielmeier, DZ BANK 4. Laurens Jan Brinkhorst, University of Leiden 5. Mark Burgess, formerly Future Fund 5. Colin Budd, formerly UK Diplomatic Service 6. Caroline Butler, Walcot Partners 6. Otaviano Canuto, World Bank Group 7. John Campbell, Campbell Lutyens 7. Desmond Cecil, Areva UK 8. Stefano Carcascio, formerly Banca d’Italia 8. Natalie Dempster, World Gold Council 9. Hon Cheung, State Street Global Advisors 9. Hans Eichel, former German Minister of Finance 10. Peter Gray, Berkeley Capital 10. Jonathan Grant, Policy Institute at King’s 11. Trevor Greetham, Royal London Asset Management 11. François Heisbourg, Fondation pour la Recherche Stratégique 12. George Hoguet, CFA Research Foundation 12. Karl Kaiser, Harvard Kennedy School 13. Frederick Hopson, formerly Hessische Landesbank 13. John Kornblum, former US Ambassador to Germany 14. Matthew Hurn, Mubadala Development Company 14. Ben Knapen, Dutch Senate 15. Paul Judge, Schroder Income Growth Fund 15. Ruud Lubbers, former Dutch Prime Minister 16. Mumtaz Khan, Middle East & Asia Capital Partners 16. Bo Lundgren, formerly Swedish National Debt Office 17. Celeste Cecilia Lo Turco, Italian Ministry of Foreign Affairs 17. Denis MacShane, former British Minister for Europe 18. George Milling-Stanley, formerly World Gold Council 18. Kishore Mahbubani, Lee Kuan Yew School of Public Policy 19. Paul Newton, London & Oxford Capital Markets 19. Boyd McCleary, former HM Diplomatic Service 20. Saker Nusseibeh, Hermes Fund Managers 20. Luiz Eduardo Melin, formerly Brazilian Development Bank 21. Robin Poynder, formerly Thomson Reuters 21. Célestin Monga, African Development Bank 22. Colin Robertson, formerly Aon Hewitt 22. Murade Miguigy Murargy, CPLP 23. Olivier Rousseau, Fonds de réserve pour les retraites 23. David Owen, House of Lords 24. Marina Shargorodska, formerly Quantum Global Group 24. Jukka Pihlman, Standard Chartered Bank 25. Gary Smith, Baring Asset Management 25. Poul Nyrup Rasmussen, former Danish Prime Minister 26. Soh Kian Tiong, DBS Bank 26. Paul van Seters, Tilburg University 27. Marsha Vande Berg, formerly Pacific Pension Institute 27. Christopher Tugendhat, House of Lords 28. Jack Wigglesworth, formerly LIFFE 28. John West, Asian Century Institute 29. Paul Wilson, formerly De La Rue EDUCATION & RESEARCH ECONOMICS & INDUSTRY 1. Iain Begg, London School of Economics 1. Irena Asmundson, California Department of Finance 2. Harald Benink, Tilburg University 2. Robert Bischof, German-British Chamber of Industry & Commerce 3. Gottfried von Bismarck, Körber Stiftung 3. Eduardo Borensztein, Inter-American Development Bank 4. Michael Burda, Humboldt University, Berlin 4. Albert Bressand, European Commission 5. Nick Butler, King’s College, London 5. Shiyin Cai, Business Adviser 6. David Cameron, Yale University 6. Efraim Chalamish, New York University 7. Forrest Capie, CASS Business School 7. Vladimir Dlouhy, former Czech Industry Minister 8. Jenny Corbett, Australia National University 8. Brigitte Granville, Queen Mary, University of London 9. Mark Crosby, Melbourne Business School 9. Graham Hacche, National Institute of Economic and Social Research 10. Jeffry Frieden, Harvard University 10. Hans-Olaf Henkel, University of Mannheim 11. Haihong Gao, Institute of World Economics and Politics 11. Hemraz Jankee, formerly Central Bank of Mauritius 12. Hans Genberg, SEACEN 12. David Kihangire, formerly Bank of Uganda 13. Steve Hanke, Johns Hopkins University 13. Pawel Kowalewski, National Bank of Poland 14. Elliot Hentov, State Street Global Advisors 14. Gerard Lyons, Greater London Authority 15. Ludger Kühnhardt, Center for European Integration Studies 15. Stuart Mackintosh, Group of Thirty 16. Mariela Mendez, Escuela Superior Politecnica del Litoral 16. Winston Moore, Moore Asociados 17. Rakesh Mohan, International Monetary Fund 17. Vicky Pryce, formerly UK Department for Business 18. José Roberto Novaes de Almeida, University of Brasilia 18. Edoardo Reviglio, Cassa Depositi e Prestiti 19. Michael Oliver, ESC Rennes School of Business 19. Pedro Schwartz, CEU San Pablo University 20. Danny Quah, London School of Economics 20. Vilem Semerak, Charles University, Prague 21. Richard Roberts, King’s College, London 21. Song Shanshan, SDIC CGOG Futures 22. Paola Subacchi, Royal Institute for International Affairs 22. Gabriel Stein, Oxford Economics 23. Shumpei Takemori, Keio University 23. Takuji Tanaka, Innovation Network Corporation of Japan 24. Maria Antonieta Del Tedesco Lins, University of São Paulo 24. Jorge Vasconcelos, New Energy Solutions 25. Daniel Titelman, ECLAC 25. Obindah Gershon nee Wagbara, Georgetown University 26. Linda Yueh, BBC 26. Volker Wieland, German Council of Economic Experts

October | ©2016 omfif.org ADVISORY BOARD | 25 Best chancellor New Labour never had Back to hinterland for political retiree William Keegan, Advisory Board d Balls is one of the most interesting Balls’ role and influence was crucial in all EBritish politicians of modern times. But three of these key decisions. This was when at the age of 49 he is no longer a member he was a Treasury adviser, before embarking of parliament and his political career is over on his political career by winning a seat in the – or is it? 2005 general election. It certainly looks like it. In the general Balls is best known for his economic election of 2015, Balls not only witnessed his expertise, and confesses in the book that he party’s defeat but lost his own parliamentary now regrets never having been chancellor. seat. He has not put his name down for The possibility of moving to the Treasury another constituency and would be unlikely arose on several occasions during Brown’s to be selected to stand in another seat. One of the messages that comes across from this engaging memoir, Speaking Out: Lessons in The possibility of Life and Politics, is that he has no appetite for moving to the Treasury another five years of opposition politics. The great British political commentator arose on several more Alan Watkins was fond of saying, ‘Politics is a occasions during Brown’s rough old trade.’ The fact that a man of Balls’ calibre should have been propelled from premiership, but something the scene so unceremoniously is a classic “ always got in the way. illustration of the Watkins dictum. It is a crying shame. Balls played a major live in a market economy and it is electorally role on behalf of his mentor Gordon Brown in 2007-10 premiership, but something always dangerous to come across as anti-business. fashioning ‘New’ Labour’s economic policies, got in the way. Balls was the best chancellor The book is beautifully written, in an achievement for which he has not received New Labour never had. conversational style, and divided into themes the recognition he deserves. In addition to taking up a fellowship at such as ‘Decisions’, ‘Ambition’, ‘Mistakes’. The Conservatives under David Cameron Harvard University and becoming a visiting Balls is an admirer of the great Labour and George Osborne in 2010 managed to professor at King’s College, London, Balls politician Denis Healey, whom he met shortly persuade more gullible voters that Labour has produced this book just over a year after before Healey died. had been responsible for the global financial losing office. Healey made a great thing about how crisis, and perpetuated the myth throughout politicians should always have a cultural the 2010-15 parliament. Slogans like ‘Labour ‘A trying relationship’ ‘hinterland’ to shield them from the slings cannot be trusted with the nation’s finances’ He admits that, although he was as close and arrows of political life. were still a factor in the 2015 election. to Brown as anyone, it could be a trying Balls certainly has one. He is happily The fact that Labour was not responsible relationship. married to the politician Yvette Cooper; he for what went wrong in the US or the euro One revelation is Balls’ firm assertion is an enthusiastic footballer and marathon area was neither here nor there. Enough that, although the press was always replete runner; plays the piano; and has become a British voters were convinced that Labour’s with stories about disagreements between national figure through popular television public spending plans had caused the crisis. Tony Blair and Brown, the two were much programme Strictly Come Dancing. However, there has been widespread closer on policy than most people were led Political career over? He concludes: ‘I’ve acknowledgement that Labour was right to to believe. had my chance in politics and – while you make the Bank of England independent and On the other hand, having worked happily should never say never – I don’t expect keep the UK out of the euro. with Ed Miliband at a more junior level, Balls that chance to come again.’ Alas, given the And although the state of the National found himself more or less isolated when potentially terminal state of the Labour party, Health Service is once again a source of Miliband became Labour leader. he may well be right. concern, a determined effort to save the This did not help Labour’s election ▪ service in one of Brown’s early budgets as chances in 2015, when Miliband abandoned William Keegan is Senior Economics Commentator for The chancellor received broad support. a fundamental New Labour insight – that we Observer.

his month’s poll focused on the outlook for the European Central Bank’s quantitative easing programme and euro area inflation. Members Tof the Advisory Board were asked two questions. First, ‘What changes, if any, do you expect the ECB to make to its quantitative easing programme before it expires in March 2017?’ with five possible options (respondents were invited to select as many or few as appropriate) – expand into new asset classes; lower or abolish the minimum yield requirement; change the capital key governing ECB QE purchases; raise the issue limit on bonds; and no change – let the programme expire. The second question asked members for their prediction for the euro area annual inflation rate, on the ECB’s measurement, in 2017 and 2018. Of the responses received, 32% expected the bank to expand the QE programme into new asset classes. A further 20% each subscribed to options three, four and five – that the bank would change the capital key governing QE purchases, the ECB raising the issue limits on bonds, and ‘no change – let the programme expire’, while 8% expected the bank either to lower or abolish the minimum yield requirement. Estimates for euro area inflation in 2017 and 2018 were wide-ranging – at the lower end for 2017, 0.6%, with an upper estimate of 2%. Respondents broadly expected inflation to be higher in 2018. Estimates ranged from 0.6% to an upper estimate of 2.5%.

Opti ‘While I don’t expect the ECB to change the capital ECB expected to expand into new asset classes key that governs QE purchases in its current ordinary Percentage of responses programme, it could if one or several countries ask for activation of the ESM. But one could imagine a redesigned programme with some sort of yield targeting whereby the ECB purchases fewer expensive bonds and more higher-return bonds. This would drive German and French yields higher and could be welcomed by the Bundesbank and the German government, as it would reduce the rate of saver pauperisation so dreaded by future retirees.’ Olivier Rousseau, Fondation de reserves pour les retraites ‘Market-based inflation expectations in the euro area have recently hovered around lows and have been trending down more markedly after the Brexit vote. Until the ECB sees a sustained adjustment in the path of inflation consistent with its aim, the most likely scenario is that it will extend its QE beyond March 2017. However, QE’s technical restrictions will become an What changes, if any, do you expect the ECB to make to its issue, with each option having its share of drawbacks. quantitative easing programme before it expires in March 2017? There are also risks of re-opening rifts within the ECB with QE extension, with Germany sceptical of moves to prolong asset purchases.’ Wide-ranging inflation expectations Hemraz Jankee, formerly Central Bank of Mauritius Estimates for euro area inflation, OMFIF Advisory Board

‘QE is now more contentious as the negative impact 2017 2018 has become more evident. A fall in risk assets, leading to hits to Central Bank balance sheets, would further Lowest estimate 0.6% 0.6% damage support for this policy.’ Colin Robertson, independent asset allocation Median 1.0% 1.4% consultant Highest estimate 2.0% 2.5% These additional statements were received as part of the September poll, conducted between 9 and 24 September. It calculates the results as What is your prediction for the euro area annual inflation rate, a percentage from a total of 25 responses coming from 17 respondents. on the ECB’s measurement, in 2017 and 2018? A respondent can choose more than one option to the question. November’s question Will China’s economy experience a hard landing or recession over the coming five years?

Will the renminbi's inclusion in the IMF’s SDR basket make an essential difference for the international monetary system, or is it largely a ceremonial seal of approval?

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