OMFIFOMFIF BulletIn GlobalOfficial MonetaryInsight on and Official Monetary and Financial Institutions Financial Institutions Forum September 2012 Race against time for the euro Beyond ECB action, we need political will Frank Scheidig, Deputy Chairman, Advisory Board

e are still waiting for a cure recession-hit south, could over time for some kind of official financing for Wfor the woes of economic and lead to a calming of financial markets. Spain and conceivably, too, for Italy in monetary union (EMU). Necessary The problem is that, left to their own coming months. steps have been put into place by devices, the markets will take fright at European governments to improve the large volume of financing that still The fate of Greece can be expected to euro area decision-making. A start is has to be done for the under-performing dominate Europe’s political calendar, being made in healing the worst of the south in the next few months. but the real story focuses on the third intra-EMU economic imbalances. But and fourth economies of the euro area. this is a race against time. Given the scale of the current and The conditionality advanced by the capital account imbalances that still European Central Bank is useful and A rebalancing of European need to be financed, and the sharp necessary, but beyond that we need economies, with the relatively better- rise in bond market interest rates for political will to put taxpayers’ money performing northern economies losing the most heavily exposed countries, on the table to forestall excessive competitiveness against the necessarily Italy and Spain, there is no substitute behaviour. (continued on page 8 ...)

Conflicting signals from Berlin: ingenuous chaos meets ingenious ambiguity The ebb and flow of bad economic news has wreaked havoc on European yield curves, but the Anglo- American camp is more riled about conflicting signals from Germany and the lack of decisive steps to end the crisis, writes Michael Burda, Advisory Board, from Berlin. Chancellor Angela Merkel, in contrast, insists on petit pas and quid pro quos. (continued on page 8...)

ContentsContents ChallengesChallenges forfor centralcentral banksbanks PhilPhil MiddletonMiddleton 33 US politics rules BanksBanks andand thethe newnew environmentenvironment MichaelMichael LaffertyLafferty 55 Beijing may react LongLong shadowshadow ofof EuropeanEuropean crisiscrisis JamesJames BullardBullard 66 Kishore Mahbubani, Singapore Structural,Structural, social,social, greengreen AngelAngel GurríaGurría 99 CautiousCautious approachapproach onon growthgrowth StefanStefan BielmeierBielmeier 108 he decision by the New York State Department of Financial China’sChina's nextnext reformreform phasephase LindaLinda YuehYueh 1111 TServices to make public its strictures against the UK bank Standard Chartered could spark off similarly heavy-handed GuideGuide toto marketmarket sentimentsentiment AllanAllan LaneLane 1313 action by China. MonetaryMonetary lawlessnesslawlessness onon riserise BrendanBrendan BrownBrown 1515 DutchDutch SocialistsSocialists toto thethe forefore RoelRoel JanssenJanssen 1717 Benjamin Lawsky, the department’s superintendent, should EuroEuro moneymoney supplysupply boostboost neededneeded GabrielGabriel SteinStein 1919 have considered the possibility that his action may encourage Beijing to use its growing economic clout to take similar Debate on stimulus grows sharper Darrell Delamaide 24 Debate on stimulus grows sharper Darrell Delamaide 24 unilateral action against US banks. OMFIFOMFIF AdvisoryAdvisory BoardBoard 2626 MomentumMomentum dropsdrops worldwideworldwide StatisticalStatistical forecastforecast 2929 Lawsky’s decision to go after Standard Chartered appears to have been driven by domestic political considerations, not by TheThe shiftshift toto externalexternal lawyerslawyers PoomaPooma KimisKimis 3131 the merits of the case. In the US political climate, anyone who HighHigh stakesstakes inin euroeuro dramadrama MichaelMichael KaimakliotisKaimakliotis 3232 stands up to Iran is a hero. The superintendent has enhanced ArchiveArchive InsightInsight GermanGerman bondbond spreespree 3434 his reputation. Dow’sDow's lessonlesson ofof pastpast recessionsrecessions WilliamWilliam KeeganKeegan 3636 Additionally, he has undermined the move to create global co-operation among financial regulators. Finance is not ThisThis documentdocument mustmust notnot bebe copiedcopied a domestic industry. The only way to regulate it is through OMFIFOMFIF andand isis onlyonly toto bebe mademade availableavailable OfficialOfficial MonetaryMonetary andand FinancialFinancial InstitutionsInstitutions ForumForum toto OMFIFOMFIF members,members, prospectiveprospective global norms and processes. However, New York’s unilateral membersmembers andand partnerpartner organisationsorganisations decision has further undermined confidence in American judgments. (continued on page 8 ...)

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OMFIF 2012-09_08.indd 1 8/30/2012 10:02:06 AM OMFIF Official Monetary and Financial Institutions Forum letter from the chairman

Official Monetary and Financial Institutions Forum tensions in the air One Lyric Square London W6 0NB United Kingdom September – when things happen t: +44 (0)20 3008 8415 f: +44 (0)20 3008 5262 David Marsh, Chairman Advisory Board

Meghnad Desai entral bankers and market participants return from their holidays with a sense *Chairman, Advisory Board Cthat something is about to happen. The tensions in the air – whether over the euro debt crisis, the US presidential elections or the slowdown in the Chinese economy – are John Nugée Frank Scheidig palpable. September is often the time, on foreign exchange and capital markets as well Songzuo Xiang as in the wider political arena, when the ‘balloon goes up.’ ** Deputy Chairmen, Advisory Board (see p. 26-28 for more details) In this edition, coinciding with the annual DZ Bank-OMFIF central banking seminar, this Management Board time in Berlin, Frank Scheidig calls on his native Germany to take greater responsibility David Marsh for the euro area as a whole. Official financing is a necessity for peripheral countries Chairman under great strain from economic rebalancing. Michael Burda says Angela Merkel's [email protected] tactics remind him of a Grimm fairy-tale. Roel Janssen looks at prospects for a change of Michael Lafferty government and shift to the left in the Netherlands, the No. 2 creditor in the euro area Deputy Chairman [email protected] after Germany, and asks what this means for consensus on euro area economic reform.

Gabriel Stein Chief Economic Adviser Michael Kaimakliotis outlines the pressure on the Swiss authorities to hold the peg [email protected] against the euro in the face of massive upward foreign exchange pressure on the Swiss franc. Gabriel Stein analyses whether the European Central Bank is serious about Evelyn Hunter-Jordan [email protected] money, pointing to the disappointingly slugging growth in broad money since the worst of the financial crisis. Brendan Brown ponders on the implications of what he sees as a John Plender [email protected] rise in ‘monetary lawlessness’ in Europe and the US. Allan Lane explains how Exchange Traded Funds can offer a way out of uncertainty. OMFIF Secretariat Edward Longhust-Pierce Angel Gurría, secretary-general of the Organisation for Economic Cooperation and Dalin Hamilton Vikram Lopez Development, sets out the OECD’s plans to get economies moving again, including Nikolai Blackie through ‘green growth’. James Bullard of the Federal Reserve Bank of St Louis expounds [email protected] [email protected] on how the euro crisis has a deeper impact on the world economy and offers suggestions [email protected] for remedial action. We take an in-depth look at China. Linda Yueh points to the need [email protected] for a new phase of outward Chinese investment that will direct foreign technology Sanjay Ujoodia flows into the country, but says the authorities will take their time over renminbi Chief Financial Officer internationalisation. Stefan Bielmeier says the Chinese remain cautious on economic [email protected] +44 (0)20 3008 8421 stimulus measures and Beijing will not match the heady pace of recovery in 2009-10.

Darrell Delamaide US Editor Darrell Delamaide in his monthly round-up on the Fed surveys growing evidence that [email protected] the US will move into easing mode in coming weeks, with the public ‘hawks v. doves’ +1 (0)202 248 1561 debate between Federal Open Market Committee members sharpening in tone. Phil Sales Middleton gives details on a new report by Ernst & Young and OMFIF on the changing Pooma Kimis Christopher Goodwin shape of international central banks, due to be launched in coming weeks.

[email protected] On the vexed issue of banking and financial market irregularities, Kishore Mahbubani [email protected] says heavy-handed American action over Standard Chartered risks encouraging Thomas Heap China to take similar retaliatory action over US and other banks. Michael Lafferty Production Editor [email protected] warns emerging market economies with new outward-facing regimes against adopting western-style integrated banking systems. Pooma Kimis reports on how many banks and Strictly no photocopying is permitted. It is illegal to reproduce, store in a central retrieval system or transmit, financial firms are replacing in-house lawyers with external legal advisors, throwing electronically or otherwise, any of the content of this up important questions about checking and dealing with misconduct in the financial publication without the prior consent of the publisher. All OMFIF members are entitled to PDFs of the current issue industry. Our section on archives offers an intriguing look back at developments in and to an archive of past issues via the member area of 1975 when the Bundesbank indulged in little-known fondness for purchasing German the OMFIF website: www.omfif.org government bonds. While every care is taken to provide accurate information, the publisher cannot accept liability for any errors or In his monthly postscript, William Keegan casts a languid eye over the latest developments omissions. No responsibility will be accepted for any loss occurred by any individual due to acting or not acting as in UK coalition politics and in the race for the Bank of England governorship. I hope all a result of any content in this publication. On any specific this makes for thought-provoking reading. y matter reference should be made to an appropriate adviser.

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OMFIF 2012-09_08.indd 2 8/30/2012 10:02:10 AM OMFIF OMFIF Official Monetary and Official Monetary and Financial Institutions ForumWorldn financialews system Financial Institutions Forum Challenges for central banks Crisis progenitors hailed as potential saviours Phil Middleton, Advisory Board

s recently as five years ago, most central bank governors could walk down the main Having been forced Astreet of their country’s capital city unnoticed, their names and faces familiar only to centre stage as a avid readers of specialist journals. Today, in many countries, they are as well-known as the government leaders they serve, and their words and deeds are the subject of heated result of the financial debate in newspapers, bars and taxi cabs. crisis, central

In addition to their traditional monetary policy and governmental banking roles, central bankers may not banks have become national and global firemen with growing responsibility for the in future be able to resilience of economies, the stability of financial systems and individual financial institutions, escape the limelight. macro and microprudential regulation, and macroeconomic and arguably elements of quasi-fiscal policy.

They have gleaned far greater exposure to the media, politics and electorates. They have taken on a range of new strategic and operational tasks and become exposed to far greater financial, reputational and operational risks. As their responsibilities have grown, so have their balance sheets and the accompanying risks.

It seems timely to produce a review of the challenges facing central banks and an assessment of the future shape of central banking once the full force of the financial crisis abates. OMFIF in association with Ernst & Young will shortly publish a joint research report entitled 'Challenges for central banks – wider powers, greater restraints'. The report draws on extensive primary and secondary research with participation from current and former central bankers, politicians, academics, senior officials, members of OMFIF staff and advisory board, and contributors from Ernst & Young, to analyse the recent activities of central banks. The report comes to three major conclusions:

• The roles of central banks and central bankers have been fundamentally changed by the crisis and there will be no reversion to the status quo ante. Adjusting to an increasingly public and prominent position is a lasting legacy. The role of the central banker has become inherently more powerful, more complex, and more contentious.

• The price of the extension of the activities and powers of central banks is likely to be a trammelling of their hitherto sacrosanct independence. In many countries there will be a growing and vigorous debate about the transparency of the activities of central bankers and of accountability to government and the wider electorate.

• Many central banks are ill-prepared for the new set of policy and operational challenges. In a palette of disciplines ranging from overall strategy and governance, through risk management, and on to the core operational platform, there is much work to be done in attaining organisational fitness to manage significantly increased and more complex roles.

The report argues that the role of central bankers is changing and will continue to change fundamentally and irreversibly. There are multiple challenges, ranging from the grandly philosophical and strategic to more prosaic concerns.

Paradoxically, it may well be that expanded powers and responsibilities for central banks will come at the price of the surrender of all or part of the independence which has, particularly in the west, become their cherished hallmark. Having been forced centre stage, central bankers are unlikely in future to escape the limelight. y

'Challenges for central banks – wider powers, greater restraints' will be launched by Ernst & Young and OMFIF in coming weeks.

September 2012 3

OMFIF 2012-09_08.indd 3 8/30/2012 10:02:10 AM OMFIF 2012-09_08.indd 4 8/30/2012 10:02:11 AM OMFIF Official Monetary and Bankingnews structures Financial Institutions Forum Banks and the new environment How to adapt when countries ‘come in from cold’ Michael Lafferty, Deputy Chairman number of countries in Africa, Asia, the Middle East and Latin America have ‘come in Governments in Afrom the cold’ in recent years as a result of pent-up desire for political and societal renewal. A major issue for the new rulers running countries that are now much more open countries with new to the outside world is to consider how best to adapt banks and financial firms to systemic power structures political change. would do well to It is fair to say that putting banking and financial systems on to a new footing is probably not emulate 10 precepts the first priority for governments wishing to prevent war and hardship, assure populations if they wish to ensure of basic necessities and improve the overall quality of life. stability in the On the other hand, it should not be too far down the ranking list, either. financial as well as the political field. Here are 10 precepts that governments in such countries would do well to emulate if they wish to ensure stability and widen perspectives in the financial as well as the political field.

1. Avoid the Anglo-American universal banking model, combining retail banking and securities activities. It is now under attack in western Europe and North America and will probably be dismantled over the next few years.

2. In a similar way, do not allow banks and insurers to merge. Fundamentally, banking, securities and insurance are separate industries and should remain so.

3. Instead, introduce a system of specialist bank licences – some for retail banking, some for corporate banking and some for microfinance institutions. This has the advantage of simplicity and will be much easier to supervise. It should apply to domestic and foreign banks alike.

4. Do not permit a concentrated banking system, where perhaps a handful of giant banks dominate the market – as they do in many emerging economies. Competition is good for you!

5. Foster a mixed retail banking system – with many smaller privately-owned banks, mutual cooperatives/credit unions and a postal bank operating through the post office. Even small and medium-sized countries can aspire to have as many such community-based retail banks as possible. Economies of scale can be achieved in a different way given rapid advances in technology, the adoption of social networks and so on.

6. Require bank executives to be professionally qualified through approved and tested academic programmes.

7. Build a strong supervision system using best practice from many countries around the world.

8. Tackle potentially destabilising ‘cash mountains’ by introducing electronic payment card systems as soon as possible. In addition to internationally-accepted credit and debit cards you should give urgent priority to the introduction of prepaid card systems. These should be 'open loop' – with cards that can be used to make payments on a general basis.

9. Do everything possible to prevent a repeat of the Czech voucher scam, where millions of people lost their savings in the wake of the collapse of the Iron Curtain.

10. Establish a Consumer Financial Education Council and encourage it to work with the media, schools and employers to improve understanding of financial matters. y

September 2012 5

OMFIF 2012-09_08.indd 5 8/30/2012 10:02:12 AM OMFIF Official Monetary and Financial Institutions Forum Global analysis

long shadow of european crisis No easy solutions in store James Bullard, President, Federal Reserve Bank of St. Louis lobal investors are dividing Europe once again into member states, a sort of market- From the beginning Gbased disintegration of the continent. The US is growing, but at a sluggish pace. Recent data from China suggests a slower pace of growth than might have been expected of the sovereign earlier this year. Commodity prices have fallen to lower levels during recent months in part debt crisis, analysts, in response to the slowing global economy. policymakers, and Inflation readings have generally been lower. This constellation of data is causing financial market considerable unease. Much of this can be traced to realisation that the European sovereign participants have debt crisis may be more traumatising and intractable than previously understood. craved a simple, One of the principal issues facing policymakers inside Europe (and worrying those outside) sharp solution to is exit from Economic and Monetary Union (EMU). Exit is often portrayed as a crisis event, the problem. But as it would suggest the use of alternative and presumably much weaker currencies to pay back external debt. In this sense it would be a way partially to default, as is always the debt problems are case with surprise inflation and devaluation. Markets are reacting by pricing in some unlikely to find quick probability that such an event could occur, even though the official line is that it cannot. solutions. EMU was formed from a subset of EU countries, and some countries remain outside, the leading example being the UK. Since not all countries joined, it would seem that the experiment might have allowed exit from EMU, but it did not. In addition, some European nations use the euro even though they are not part of EMU. These arrangements give me pause concerning the meaning of exit. Some countries never joined and others have joined de facto.

The EMU can be viewed as a club, and members enjoy benefits that do not accrue to non-members. The value of being a member was originally to get German credibility on monetary policy. Countries choosing not to join calculated that they could run an equally effective monetary policy to the Germans. The value of club membership was highest for countries with the least monetary policy credibility. EMU’s initial success was stunning, driving yields on all EMU member debt essentially to German levels. This created a great environment for investment and stability within EMU.

The logic of exit suggests that, if the club is valuable, member countries will not want to leave. Survey evidence seems to indicate that these incentives to stay in the club remain strong today. Still, the common refrain that no country can ever be allowed to leave EMU is altering the incentives for nations to take the actions necessary to maintain membership. This is one of the main penalties that in principle should be enforcing the equilibrium behaviour among the members of the club.

The incentive effects for club membership are critical in another way. For countries that are already members, taking on country credit risk through mutualisation damages their incentives to remain in the club. They enjoy the benefits of membership, but the calculus could change if they see too many disadvantages from the policies undertaken to keep the union together. Countries can, in principle, remain on the outside and also do well, as Sweden has demonstrated. In short, my view is that the incentive effects for a member country to remain in EMU must be considered very carefully. Policies should be designed with an eye toward these incentives, and can no longer assume that the political processes will back EMU in all circumstances.

From the beginning of the sovereign debt crisis, analysts, policymakers, and financial market participants have craved a simple, sharp solution to the problem. But debt problems are unlikely to find quick solutions. We should expect a long, slow resolution process peppered with bouts of increased financial stress. Still, there is one possibility for a grand bargain that makes some sense and that has been increasingly discussed.

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OMFIF 2012-09_08.indd 6 8/30/2012 10:02:12 AM OMFIF Official Monetary and Financial Institutions Forum

This is the notion that Europe has reached a ‘Hamilton moment’. Alexander Hamilton was In the medium term, a proponent of a more powerful national government for the member states, then bound together by the Articles of Confederation. The states had considerable debts. In a famous it may be possible to compromise, the new and stronger national government assumed the states’ debts under undertake structural certain conditions. Could something similar happen in today’s Europe? Certainly there are reforms in the US many calling for greater fiscal and political union. and in Europe and A common refrain is that, while some EMU countries have considerable debt problems, improve growth Europe as a whole has sufficient resources to contain the situation. The debt-GDP ratio for EMU is 87%, arguably better than the US, depending on how US obligations are counted. prospects. However, A stronger ‘national’ government for Europe could hold and service that level of debt. the results would of Member states could transfer today’s debts to the European level, probably in exchange for course feed through balanced budget amendments or similar binding restrictions on future borrowing. only over time. Such a deal seems remote at present. But the basic building blocks of a deal are in place as they were in Hamilton’s time. Much of the manoeuvering in Europe has elements of this type of bargain: in particular, the discussion of a fiscal compact and ideas concerning debt mutualisation. This makes me put some probability on a sunnier outcome. On the downside, however, I do not have the sense that there is sufficient political support for a ceding of sovereign authority. This is making me keep my baseline case as one of a slow paydown of debt in an environment of slow growth.

More rapid economic growth would help solve a lot of problems. My reading of the literature is that growth depends on innovation, improvements in technology, human capital, and other long-run factors. It is not really a matter of government spending in the abstract, or of monetary policy. I am worried that a growth agenda interpreted as a government spending agenda, instead of a focus on the factors actually driving economic growth, will not succeed and may make problems worse.

I have been disappointed by the debate concerning fiscal stabilisation policy in the US over the past several years. We have a leading theory of how fiscal stabilisation policy could work in some circumstances, a theory that respects what is known and has been learned over the last several decades. There is a mismatch between what the theory suggests might be reasonable policy and what is generally proposed in policy discussions.

Critically, the theory suggests that the stance and efficacy of monetary policy is a key feature in determining the success of a fiscal expansion, a topic addressed only in the rarest of macroeconomic quarters. According to the leading theory, a certain type of fiscal expansion can substitute for a missing monetary policy (missing because of the zero lower bound), and is not a complement to monetary policy. The policy discussion almost always treats the two as complements, perhaps in the spirit of ‘throwing everything at the problem.’

One very concrete version of this would proceed as follows. If you think, as I do, that monetary policy can be effective even with the policy rate at the zero lower bound, then one should not talk about fiscal supplements to that policy because according to the theory that would not make sense. Further, if monetary policy is appropriately calibrated given the current macroeconomic situation, as I believe it is in the US, then we have the counter- cyclical policy we need in place.

For those who think, on the other hand, that monetary policy is not effective once the zero lower bound is encountered, the focus should be exclusively on fiscal stabilisation policy, and supplements from monetary policy would be a distraction. However, the basic fiscal intervention required is a tax-financed increase in expenditure, not a deficit-financed one. Even this will have the intended effects only if implemented in a relatively precise way.

While more rapid economic growth is a desirable outcome, I am doubtful it can be achieved through traditional fiscal expansion. In the medium term, it may be possible to undertake structural reforms in the US and in Europe and improve growth prospects. That would be a favourable outcome, although the results would of course feed through only over time.y

This article is based on a speech to OMFIF in London on 10 July

September 2012 7

OMFIF 2012-09_08.indd 7 8/30/2012 10:02:12 AM OMFIF Official Monetary and Financial Institutions Forum news

Race against time on eMu (... continued from page 1) The EFSF rescue fund and its permanent rate savings as a result of the new- euro economies borrow at very high successor ESM require extra money found ‘haven’ status of German interest rates compared with German and additional powers, so that the government bonds. According to the opposite numbers – a huge competitive unpopular burden of supporting Institut für Weltwirtschaft in Kiel, the advantage for German companies government bonds through intervention German state has saved €68bn in doing business in these countries. purchases can be taken away from the interest costs in the past 3-1/2 years’ ECB, which should be reduced to a borrowing, compared with the total Third, German exports to the euro area subsidiary role only. that would have resulted from average may have suffered from recessionary interest rates in 1999-2008. forces unleashed by the periphery’s Germany must give a lead. German problems. But latest data show exports politics is focused on the costs of Second, low interest rates have are holding up well; Germany’s trade shoring up the euro area, but German worked their way more generally into surplus in the first half of 2012 was up politicians need to point out the producing relatively buoyant German 18% compared with the same period considerable advantages that have economic conditions. As a result in 2011. These benefits are not given accrued to the biggest economy in of the fragmentation of European sufficient hearing in Berlin. Germany the euro area. First, the Berlin finance banking caused by the sovereign has to take more responsibility for the ministry has made enormous interest debt crisis, companies in peripheral euro area as a whole. y Conflicting signals from Berlin (... continued from page 1)

On TV last Sunday Merkel openly never had a chance to vote on it). Until then, the Germans will create an supported Greece's remaining in the The lessons of the 1992-3 crisis in the image of a slightly irrational German euro while holding it to its budgetary European exchange rate mechanism shepherd which has delegated control and reform promises, which appears are that a) clear roadmaps with explicit of the situation to an unwitting Troika less realistic and more cruel than a commitment to sustaining exchange (read: IMF). Grimm fairy tale. rates or interest rates are ‘one-way bets’ which will not work because markets This form of delegation has strategic A key Bavarian politician all but with their billions will challenge them advantages. Beyond that, the nuclear endorsed Grexit, replete with a and b) the parties involved have to option for Germany (Teutoexit) is still on pro-Hellenic Marshall Plan, while agree on fundamental objectives. the table, especially if the constitutional the top brass of the Bavarian CSU court or electoral pressures take control conservatives pay lip-service to the The Greek drama is a game of chicken. of the process. The chaos may be just Merkel government position. The Greeks want cash to service their what the doctor ordered. bloated debt and the Germans want to Add to this the recent Spiegel see that money again. Neither side has The grandstanding and brinksmanship interview with Bundesbank president an interest in Grexit, and both know it. remind me of another episode from the Weidmann’s careful but unambiguous mid-1990s, when the Fed put its foot objections to European Central Bank To extract maximal reform from present down and refused to cut rates until debt purchases for the peripheral and future Greeks, the Germans will Congress and President Bill Clinton states, and you have chaos. play the good-cop-bad-cop game, agreed to a more sustainable fiscal yielding on monetary policy and path, which lasted until 11 September Yet it would be surprising to expect any quantitative easing, when Club Med 2001. Possibly, the ECB has become democracy to speak with a single voice, starts investing in sustainable growth the last guarantor of structural reforms especially on something as weighty as by cutting oversized public sectors, in the southern countries, even if they the future of the monetary union. (The privatising family jewels and liberalising don’t say it publicly. y Germans have not forgotten that they product and labour markets. uS politics rules (... continued from page 1)

The third reason why the decision In purchasing power parity, China’s My suggestion is this: at the next G20 was flawed was that it seems it did gross national product could outstrip finance ministers meeting in 2013, not even occur to Lawsky to ask: the US’s by 2016. How will America Britain should bring up the Lawsky would another regulatory authority react when China begins to behave as action for candid discussion. If that someday similarly retaliate against unilaterally as New York has done? happened, I would make a bet that an American bank? It is obvious why not a single other G20 member, apart this question did not occur to him: Already many Americans have from the US, would support New York. American power appears, to him at condemned China for unilaterally least, to be unassailable. curtailing rare earth mineral exports. Such action, and an appropriate Does the US want to encourage single outcome, would add weight to the Yet the US may become No 2 in the standards or double standards in the view that, in this case, Lawsky has world economy sooner than expected. global order? behaved as a rogue regulator. y

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OMFIF 2012-09_08.indd 8 8/30/2012 10:02:12 AM OMFIF Official Monetary and World economy Financial Institutions Forum Structural, social, green Three-pronged initiative to get growth going Angel Gurría, OECD Secretary-General

e are now into the fifth year of the greatest economic crisis of our lifetimes. In May A shift is needed Wwe projected 2012 GDP growth across OECD countries at 1.6%. Some 48m are still from ‘lifetime unemployed – 14m jobs would need to be created to bring the employment ratio back to pre-crisis levels. jobs’ to ‘lifetime employability’. This We have recently seen clear signs of further deterioration. Those countries that still have room for manoeuvre should coordinate and implement additional fiscal and monetary means investing in measures to support demand and boost job creation. We need a satisfactory resolution of skills throughout the the euro banking and sovereign debt crisis. Recent meetings of euro leaders provided some life cycle. welcome developments towards a banking union, the recapitalisation of Spanish banks, and support for Cyprus. But much more needs to be done. This is not just about Europe. Policy-makers around the world face unwanted legacies: low growth, rising unemployment and inequality, high budget deficits and debt, destabilising markets and public confidence. We must resolve these issues while also addressing longer-term challenges. Wealth is shifting. The climate is changing. Populations are growing in emerging and developing countries, while ageing in developed economies. As those at the top grow wealthier, so does the gap between the rich and the poor.

We advise governments to move forward in three parallel tracks. ‘Go Structural, Go Social and Go Green.’

Structural reforms are a pivotal rung on the ladder to prosperity. They can encourage entrepreneurship by making it easier for new and existing businesses to bring fresh ideas to fruition. They can induce competition; promote innovation and research and development. Education measures can help put people back to work as more productive, skilled employees. Structural reforms don’t take generations to materialise. Well-targeted structural reforms can deliver results faster and more efficiently than generally expected. And reforms are not necessarily painful. Short-term pain can be minimised by exploiting synergies amongst complementary policies. Structural reforms can also tackle the rising social costs of this crisis, particularly for countries with high long-term and youth unemployment.

Rising inequality is one reason to ‘Go Social’. Addressing this issue not only improves well-being, it can also restore balance, competitiveness and productivity. Tax, health, social security, and other policies are needed. But it is particularly important that countries focus on education and skills – the global currency of the 21st century. Without adequate investment in skills, people languish on the margins of society. There are plenty of unemployed graduates on the streets, while employers search in vain for people with the skills they need. This tells us that skills do not automatically translate into better economic and social outcomes. A shift is needed from ‘lifetime jobs’ to ‘lifetime employability’. This means investing in skills throughout the life cycle; from early childhood, through compulsory education, to the transition into the workforce and beyond.

As well as going social, we need to ‘Go Green’. The costs and consequences of environmental inaction could be colossal. Without immediate action, by 2050 we will see a 50% increase in greenhouse gas emissions, with a disastrous impact on the quality of life worldwide; a doubling of premature deaths from exposure to particulate air pollution; 2.3bn more people living in severely water-stressed areas, bringing the total to about 40% of the world’s population; and a further 10% decline in global terrestrial biodiversity.

We will not overcome these huge environmental challenges in isolation. They must be managed in the context of other global issues, such as food and energy security, poverty alleviation and our wider growth agenda. Well-designed policies to tackle one environmental problem could also help alleviate others, and can contribute to growth. y This article is based on a speech to OMFIF in London on 24 July. See http://bit.ly/NyxDGk for full text.

September 2012 9

OMFIF 2012-09_08.indd 9 8/30/2012 10:02:12 AM OMFIF Official Monetary and Financial Institutions Forum China & the world Cautious approach on growth China will not match pace of 2009-10 recovery Stefan Bielmeier, Advisory Board

hina’s GDP growth has eased markedly for more than two years now from nearly 12% There is an Cyear-on-year in early 2010 to 7.6% in the second quarter of 2012. The slowdown was inevitable to cool the housing bubble. And this has worked: the house prices surge has increasing risk that come to an end, producing a sharp fall in real estate investment which contributes more GDP growth will be than 10% to GDP. But with the European debt crisis deteriorating, export growth has come even weaker than under serious pressure. Total merchandise exports are up only 1% year-over-year, with sales to the European Union falling more than 16%. 8% this year. For the time being, at Latest provisional figures for August indicate that the slowdown has accentuated, with weak manufacturing data based on poor foreign shipments suggesting that China is being badly least, the Chinese affected by a global slowdown. These setbacks have prompted Beijing to take counter- economic engine will measures. But, unlike in 2008, China has acted cautiously to avoid unwanted side effects. not be able to match Monetary policy has been loosened and some infrastructure projects have been brought the heady pace of forward, especially in the railway sector, for a total of more than Rmb400bn, nearly 1% of recovery in 2009- GDP. Public investment has started to pick up again slightly, as has loan growth. Aggregate new loans are up nearly 15 % year-on-year, compared to a slight contraction last year. 10.

However, so far there are virtually no signs of a trend reversal in ‘hard’ data. Already, economic indicators for July were largely disappointing. Particularly in the industrial sector, which contributes almost half of output, growth fell far short of expectations, falling to 9.2%, in single digits for the fourth month in a row. As a rule of thumb, industrial production needs to grow by more than 10% to enable economic output growth to top 8% year-on- year. Unless industrial activity picks up soon, China will find it difficult to surpass the 8% growth threshold.

There are however some signs of greater momentum. Manufacturing sentiment has improved, indicating a slight revival. Infrastructure measures initiated in the spring are likely to work through to industrial output in the next few months, particularly now volumes have been increased. Furthermore, inflation has now fallen to only 1.8%, a more rapid slowdown than expected. This will give the People's Bank of China more scope for monetary relaxation, as has already been reiterated by some government officials. Cuts in minimum reserves, probably accompanied by another interest rate cut, can be expected in the weeks ahead.

Additionally, the Chinese government has again started to focus on exchange rate policy, given the sluggish trend in exports. The renminbi stopped appreciating against the dollar at the beginning of the year, and recently it has declined. This formerly ‘hidden’ change of course seems to have become an official feature of exchange rate policy, giving exports some support in coming months.

This exposes the leadership to the risk of renewed political conflict with the US, right at the end of the presidential election campaign. Beijing, however, is preparing for an imminent change in leadership, too. In October, the successors to President Hu and Prime Minister Wen will be appointed, ahead of taking office in March. China will make strenuous efforts to avoid economic problems and tensions in this interim period.

Beijing’s cautious approach on stimulus has not resulted in notable success so far. Now the Chinese leadership feels the need to raise the tempo somewhat. This is likely to benefit the Chinese economy in the rest of the year. We expect GDP growth to pick up slightly in the second half of the year, but, at just over 8% for 2012 as a whole, output will still grow at the slowest pace for more than a decade. And there is also an increasing risk that GDP growth will be even weaker than 8% this year. For the time being, at least, the Chinese economic engine will not be able to match the heady pace of recovery in 2009-10. y

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OMFIF 2012-09_08.indd 10 8/30/2012 10:02:13 AM OMFIF OMFIF Official Monetary and Official Monetary and Financial Institutions Forum ?????????? Financial Institutions Forum China’s next reform phase Making haste slowly on renminbi Linda Yueh, Advisory Board hina’s second 30 years after the reforms of the 1970s will centre on global integration, The authorities are Coutward investment and the internationalisation of the renminbi. Beijing has successfully used inward foreign direct investment (FDI) to catch up in growth by developing aware of the risk is manufacturing and export capacity. that the renminbi becomes, like the The next phase requires technological progress and thus will involve outward FDI, including a ‘going global’ policy by Chinese companies which is combined with bringing in foreign yen, a very liquid technology and knowhow. A key part of China’s future growth will depend on its ability currency, yet not to foster globally competitive corporations that will help China move up the value chain, sustain development and overcome the ‘middle income country trap’. This refers to how held widely in countries slow down after reaching about a GDP of $14,000 per capita – the level that reserves. The key China is forecast to reach by 2020. is to ensure the The change brings macroeconomic benefits. China will slow down accumulation of foreign renminbi becomes reserves, which have grown to more than $3tn, since the country will move to buy more real an international store assets abroad instead of government bonds. China had already begun to worry over the value of its western holdings in the West in the aftermath of the 2008 global financial crisis. of value. This was one of the reasons, too, for China’s launching of renminbi internationalisation.

Shifting towards domestic demand means boosting consumption. China needs to address high precautionary savings by households, particularly in rural areas. Additionally, state and non-state companies increased savings during the 2000s, rivalling those of households – partly reflecting China’s distorted financial system. The ‘going out’ strategy of state- owned enterprises and private firms is part of China’s efforts to compete better on global markets. China aims to become more than a generic producer of low-end manufacturing goods, branded under the moniker of western firms.

Outward FDI has grown rapidly since the mid-2000s when the first commercial investment by a Chinese firm was permitted in 2004. With outward FDI close to overtaking inward FDI, China is trying to show how its industrial capacity is a function not just of foreign firms producing its exports, but of a more widespread upgrading.

The exchange rate should become more flexible with greater capital account liberalisation, since future transactions will involve greater use of the renminbi. The exchange rate and interest rate reforms should produce a better balance between China’s internal (savings/ investment) and external (balance of payment) positions. Capital flows have grown steadily since WTO accession in December 2001 with the introduction of the Qualified Domestic Institutional Investors (QDII) scheme, increasing outward flows. In April, the China Securities Regulatory Commission (CSRC) increased the quotas under the 2002 Qualified Financial Institutional Investors (QFII) scheme to $80bn from $30bn. It has also increased the amount that can be invested under the RQFII (RMB QFII) scheme that permits offshore investors to invest renminbi into China.

How far to open the capital account is yet undecided as China worries about the potentially destabilising effects of hot money flows seen in the Asian financial crisis. The preferred policy is to create offshore renminbi centres, first established in Hong Kong in July 2010, and with further hubs in London and Singapore. Increasing the renminbi’s prominence is designed to allow it eventually to become a global reserve currency with attendant benefits, such as lower borrowing costs.

The authorities are aware of the risk is that the renminbi becomes, like the yen, a very liquid currency, yet not held widely in reserves. The key is to ensure the renminbi becomes an international store of value. That needs a substantial deepening of China’s financial markets – another reason why, over internationalisation, China will take its time. y

September 2012 11

OMFIF 2012-09_08.indd 11 8/30/2012 10:02:13 AM OMFIF 2012-09_08.indd 12 8/30/2012 10:02:14 AM OMFIF Official Monetary and Assetnews management Financial Institutions Forum

Guide to market sentiment ETF flows provide guide to financial trends Allan Lane, Twenty20 Investments

ith more than $1.5tn in assets under management in Exchange Traded Funds (ETFs), A $44bn increase Wflows in and out of ETFs are a good proxy for overall risk appetite in financial in AUM equity ETFs markets. If we look at the chief changes affecting the so-called ETF Titans – ETFs with AUM above $1bn – in the first seven months of the year, a number of different themes emerge. has not been at the expense of fixed Overall, a $44bn increase in AUM equity ETFs has not been at the expense of fixed income ETFs, which have grown in size by a net $33bn. Partly reflecting the fall in the gold income ETFs, which price, the net flow of capital into commodities as an asset class is much lower than it has have grown by a net been during the last three or four years (Chart 1). $33bn. If demand Chart 1: Net new asset flows for the ETF Titans, Jan-July 2012 ($bn) for ETFs has been muted in Europe, this has not been the case in the US.

The list of ETFs which have seen AUM declines include those featuring shorter-dated US and German Treasury bonds which seem overpriced to many investors (see Chart 2). European ETFs demonstrate considerable divergence. While some providers such as iShares, Source and Amundi show continued strength, others such as Lyxor, db x-trackers and Comstage have seen outflows. This is partly due to heightened media coverage of the risks in swap-based ETFs. Plainly, there are too many providers offering an ETF that tracks the Euro Stoxx 50 Index. Lyxor’s product features among the top 10 AUM declines.

Market Vectors’ Gold Miners ETF, which attracted much interest when it was launched, has been a casualty of reduced buoyancy in the gold market. It has attracted inflows this year, but the lower net asset value has produced a fall in AUM become negative.

If demand for ETFs has been muted in Europe, this has not been the case in the US. State Street’s S&P 500 SPRD – with AUM up by $2.8bn – underlines that an equity revival may well be in the making. Despite Facebook’s problems, the 20%-plus performance shown by Nasdaq indicates a revival in technology stocks, demonstrated by Powershares’ performance. Yields for investment-grade bonds range from 2% to 5%. They are at an even more appealing level of around 6% to 7% for high yield bonds. Perhaps the asset class that represents the best hope for a return to ‘normality’ is Vanguard’s ETF which tracks the MSCI REIT benchmark. This has seen some of the largest inflows so far this year, about $2.7bn, which provides some room for modest optimism on the US housing market. y Chart 2: Top 10 AUM increases and decreases

Exchange Asse t Amount Exchange Asse t Amount Top Ten ETF AUM Increases Top Ten ETF AUM Decreases Code Cla ss ($bn) Code Cla ss ($bn) SPDR S&P 500 US Equity 12.6 iShares MSCI EAFE US Equity 2.1 Vanguard MSCI Emerging Markets US Equity 10.7 iShares MSCI Brazil US Equity 2.0 PowerShares QQQ Nasdaq 100 US Equity 7.2 iShares Barclays 1-3 Year Treasury Bond US Debt 1.8 iShares iBoxx $ Inv Grade Corporate Bond US Debt 6.6 Amundi MSCI Japan SW Equity 1.2 iShares iBoxx $ High Yield Corporate Bond US Debt 5.3 iShares FTSE China 25 US Equity 1.2 iShares S&P 500 US Equity 4.6 SPDR Utilities Select Sector US Equity 1.0 Vanguard MSCI REIT US Equity 4.6 IShares EBREXX Govt 1.5-2.5 GR Debt 0.9 Vanguard Total Bond Market US Debt 3.1 Market Vectors Gold Miners US Equity 0.8 SPDR Barclays Capital High Yield Bond US Debt 2.7 Lyxor Euro Stoxx 50 FP Equity 0.8 iShares S&P Prefered Stock US Debt 2.6 Powershares DB US Dollar Bullish Fund US Currency 0.7

September 2012 13

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OMFIF Official Monetary and the future of eMu Financial Institutions Forum Monetary lawlessness on rise Bundesbank failings reduce EMU influence Brendan Brown, Head of Economic Research, Mitsubishi UFJ Securities

onetary lawlessness is now prevalent. The US Federal Reserve has scrapped all Today’s Bundesbank Mremnants of monetary orthodoxy in the most blatant attempt to manipulate long- term interest rates since the 1940s. The European Central Bank (ECB) appears to have occupies the same found its way around the barriers in the Maastricht Treaty against the monetary financing building as the of governments. institution Otmar The Bundesbank’s huffing and puffing is of no avail. Chancellor Angela Merkel is counting Emminger built up on her fellow citizens not to realise that massive back-door lending by the ECB to insolvent in the 1960s and governments will cost them as much eventually as front-door lending via the EFSF or ESM rescue funds. What will be consequences of monetary lawlessness? In the US there could be 1970s, but the the good news first (for investors) of another episode of asset price inflation, concentrated spirit of monetarist on the US equity market. In Europe we could see several months or even quarters during conviction departed which the sovereign debt crisis goes into remission and export industries gain some relief in the form of a weaker currency. long ago.

ECB president Mario Draghi repeats the justification of ‘strengthening the monetary transmission mechanism’ for expanding bad bank-style operations. Yet a monetary union without political union or a central taxing authority is coherent only if market forces are allowed to discipline member countries. Otherwise, they should be forced to leave. That is how the Gold Standard worked. Have we learnt something new since then? No!

And so we can expect an agreement under which the EFSF/ESM and the ECB will buy Spanish government debt, operating, respectively, for long-term paper in the primary market and for shorter maturities in the secondary market. Where will the ECB get the funds to finance these purchases? Most likely, some combination of further non-monetary liabilities (repos, special certificates of deposits) and of monetary liabilities (reserves and excess reserves), where interest rates are virtually zero.

We will see more emergency liquidity assistance (ELA) to crisis-hit central banks, which will lend the funds on to their banks against problematic collateral. This expansion is funded by the central banks in the financially stronger countries foregoing seigniorage. When eventually interest rates start to normalise, and the ECB’s creditors expect their returns to rise in step, the ECB will have to print money to do this. The ECB will probably try to delay normalising rates so as not to find itself in this situation – adding to the longer term risks of monetary instability.

Before this, foreign depositors with German banks might fear that in an eventual EMU break-up (perhaps when Germans say No to inflation) their funds would not be converted into a new D-Mark-like currency. Yet the anticipation of possible break-up could already have driven German interest rates to very negative levels. So the foreign depositors would pull funds out of the German banks and simply hold euro banknotes in their vaults. Present excess reserves with the ECB would mutate into banknote issuance. Some investors would decide in favour of spending those banknotes rather than wait for the final EMU crisis.

Jens Weidmann, the Bundesbank president, is aware of these dangers. But the past quarter century of weakness and error has lost the Bundesbank the special affection it enjoyed among German citizens.

The Bundesbank failed to ensure that the Maastricht monetary constitution was sufficiently strict to prevent backdoor government financing. The Bundesbank’s Otmar Issing failed to build an ECB monetary pillar to prevent a huge credit bubble. The Bundesbank orchestrated the fateful launch of ECB emergency liquidity operations in summer 2007. Today’s Bundesbank occupies the same building as the institution Otmar Emminger built up in the 1960s and 1970s, but the spirit of monetarist conviction departed long ago. y

September 2012 15

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OMFIF 2012-09_08.indd 16 8/30/2012 10:02:17 AM OMFIF Official Monetary and the netherlands & the world Financial Institutions Forum Dutch Socialists to the fore No.2 euro creditor faces new government Roel Janssen, Advisory Board

he teddy bear-like figure of Emile Roemer, a congenial former school teacher who has Asked what he Tbeen handing out free ice cream in Amsterdam as part of his election campaign, looks likely to become the next prime minister of the Netherlands. Roemer, 50, leads the Socialist would do as party, which benefits from a clear opinion poll advance in the run up to the parliamentary prime minister elections on 12 September. if the European Roemer heads a formerly Maoist party which opposes greater austerity for European Commission countries and takes a nationalistic ‘Netherlands-first’ approach on key economic issues. subsequently fined He looks set to become the latest government leader few have ever heard of to play a significant role in tackling the euro crisis. the Netherlands, Roemer stated: ‘I will The election challenge for economic and monetary union (EMU) comes on the day that not pay the fines.’ the German constitutional court issues its judgment on the legality of the ESM rescue mechanism. Several weeks of Dutch political uncertainty lie in store. Even if the Socialists emerge as the undisputed winner, Roemer – who is fighting the VVD conservative party run by prime minister Mark Rutte – will probably face great difficulties in forming a new government A broad coalition of centre parties may be the outcome, representing the coalition of parties that achieved a €30bn budget deal in April, with the addition of the Social Democratic party.

A convincing political majority has been absent in the Netherlands for the past decade. The country is split by crucial issues like welfare reforms, Europe and the euro, immigration and globalisation. One of the main surplus countries in Europe, and the No.2 creditor after Germany, faces a period of possible political perturbation where left- and right-wing nationalism is on the rise. The current conservative-Christian Democrats government was formed after the 2010 elections. With a minority in parliament, it had to rely on the support of the Freedom party led by Geert Wilders, anti-immigration, anti-Islam and, more recently, anti-euro maverick. He has exercised extraordinary influence, but after the April budget deal, his stock has been falling, while that of Roemer and the Socialists has been rising.

Like in Germany, the general attitude in the Netherlands is that the euro crisis has been caused by profligate spending in southern countries which need first to adjust before receiving emergency funds. Parliament was reluctant to approve the subsequent rescue packages and is sceptical on proposals to increase Brussels’ budgetary powers.

Prime minister Rutte abandoned the Netherlands’ traditionally constructive attitude on the euro and opted for even harsher positions than Germany towards the debtor countries. Nevertheless, ultimately the Netherlands agreed rescue packages to Greece, Ireland, Portugal and Spain. Though Wilders and Roemer are at the opposite extremes of the political spectrum, they share a nationalistic outlook. On social and European issues their positions are similar.

The Socialists oppose Dutch emergency support for southern euro countries, on the grounds that this benefits the banks that lent money to these countries in the first place. Ordinary Dutch tax payers should not bail out greedy bankers, they say, arguing for less harsh conditionality on the debtor countries and less draconian economic reforms.

The Socialists want the Netherlands to stay in the euro and endorse the 3% ceiling for fiscal deficits, but only in the long run. They reject fast fiscal consolidation, arguing that adjustments worsen the economic crisis, increase unemployment and hurt people dependent on social security. In government, Roemer’s party would reject the budget deal for 2013 that has been presented to Brussels. Asked during the election campaign what he would do as prime minister if the European Commission subsequently fined the Netherlands, Roemer bluntly stated: ‘I will not pay the fines.’ y

September 2012 17

OMFIF 2012-09_08.indd 17 8/30/2012 10:02:19 AM OMFIF Official Monetary and Financial Institutions Forum the future of eMu Euro money supply boost needed Why ECB should live up to its monetarist creed Gabriel Stein, Chief Economic Adviser

he discussion over the European Central Bank’s possible bond buying programme Tprovides an apt opportunity to study what the ECB has and has not done since the financial crisis broke out in August 2007. Beyond the attention given to the question of sovereign bond purchases and the confusion generated by ECB’s various statements over the past month, a more central issue needs to be raised. It is this: For an avowedly monetarist central bank, the ECB seems curiously blind to the demonstrable need to boost the euro area money supply.

Each month, the ECB president solemnly reviews monetary developments at his press conference. But, in some ways, this has become a meaningless ritual, as the conclusions of money (and credit) data seldom seem to translate into action. Raising the money supply through buying assets from the non-bank private sector holds out the hope of some form of speedier recovery across the countries of economic and monetary union (EMU). Only by output growth can euro members solve both the private sector and the public sector debt problems. Under these circumstances, and bearing in mind that the ECB’s actions so far have shown only lukewarm success, tackling money supply head-on is worth trying.

The ECB has certainly not been inactive. Since mid-2008 the Governing Council has made 23 formal decisions over 49 months, of which nine can be said to refer to ‘unconventional’ measures. Not all of these were helpful. Only Jean-Claude Trichet, ECB president before Mario Draghi took over on 1 November last year, is nowadays likely to claim that raising interest rates in July 2008 and in April and July 2011 was the right thing to do.

The ECB operates, of course, under a number of restrictions. Some are due to the peculiarities of EMU, under which there is no political/fiscal counterpart to the ECB. The ECB has only limited means to deal with the EMU debt and deficit crisis. Fiscal reforms must be undertaken by governments in the countries concerned. Dealing with excess private sector debt requires a combination of monetary policy, fiscal policy and deleveraging.

Some of the ECB’s restraints are self-imposed; for example, its unwillingness to do anything that could be perceived to threaten the bank’s concentration on its price stability target, even at the risk of financial instability. It is difficult to argue that the ECB’s actions have been successful beyond the short term. The bank has cut interest rates broadly speaking as low as possible. While the main refinancing rate could be cut from 0.75% to 0.25% or even less, the marginal effect of that is likely to be limited.

Chart 1: Euro area 'money gap' under alternative assumptions

Source: ECB and ECB calculations.

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OMFIF 2012-09_08.indd 18 8/30/2012 10:02:20 AM OMFIF OMFIF Official Monetary and Official Monetary and Financial Institutions Forum ?????????? Financial Institutions Forum

The full allotment refinancing operations – weekly, three-monthly and the exceptional ones over six, 12 and 36 months – have helped to unfreeze the interbank market. But this has come at a price, notably increasing banks’ dependence on central bank financing and – above all in the case of Spain and Italy – banks taking on increased risk by buying government bonds. Moreover, the impact of each successive measure has diminished, as it has become clear that the underlying problems remain.

This is one of the reasons why there are widespread expectations that the ECB will do more on the bond-buying front, even though Draghi’s statement on 26 July that ‘within our mandate, the ECB is ready to do whatever it takes to preserve the euro’ was followed not by action but ‘guidance’ at the next ECB Council meeting on 2 August.

Within its own boundaries, the ECB has done neither too badly nor too well. Partly, this reflects the facts of EMU. If the central bank restricts itself to buying government bonds from the banking system, on what basis should it do so? Buying bonds of the countries where yield spreads have widened the most would be perceived to reward bad behaviour and so give rise to moral hazard. In fact, this is what happened in August 2011, when the ECB started buying Italian bonds, which led the then government (under Silvio Berlusconi) almost immediately to renege on reform promises. Similarly, pro rata buying of bonds based on debt outstanding also rewards the ‘miscreants’; while GDP-weighted buying across the euro area would not be enough to bring down yields where they are too high and would in fact spur the flight to safety.

But the ECB may have restricted itself too much. It should start by looking more carefully at the money and credit data. The ECB has a medium-term reference value for M3 growth of 4.5%. This was set in 1998 set on the basis of 2% inflation, a 2-2.5% real GDP trend growth rate and a 0.5-1% trend decline in the velocity of money. The number has since been reviewed, but not changed. However, there are reasons to believe that it is too low. Banque de France research implies that the reference value should be closer to 7.5%, which takes into account a lower trend growth rate but a faster decline in the velocity of money.

This is not just an arcane debate. The ECB has in the past made reference to what it calls the ‘money gap’. This is the difference between the actual stock of real M3 and the stock that would have been if it had grown at its reference value and if inflation had been on the 2% target since EMU began.

A different picture of excess or insufficient money supply emerges, depending on whether one uses the ECB’s or the Banque de France assumptions. Using the ECB’s 4.5% value, the money gap has been positive since EMU began, implying that there is excess liquidity across euro members as a whole (Chart 1, p.18). Even now, after more than three years of slowing broad money growth, the money gap remains a sizeable 23%.

Chart 2: Euro area M3, 12-month change, %

Source: ECB and ECB calculations

September 2012 19

OMFIF 2012-09_08.indd 19 8/30/2012 10:02:20 AM OMFIF Official Monetary and Financial Institutions Forum the future of eMu

By contrast, using the Banque de France’s 7.5% value, the stock of broad money was essentially on target until 2009, following which a sizeable negative money gap opened up, currently at 17%. It may well be that the Banque de France measure is by now too high – EMU trend growth is probably around 1-1.5% – but the view that the euro area as a whole has suffered a lack of liquidity is certainly plausible. This view is strengthened if we look at what has actually happened to money supply. Until April 2009, euro area M3 consistently grew faster than then 4.5% reference value. Since then, it has consistently grown more slowly, even contracting for a period from November 2009 to May 2010 (Chart 2, p.19).

Overall euro area broad money growth grew by 3.8% in the year to July. By recent standards, that is good. By more long-term standards and particularly compared with previous recoveries, when broad money typically would grow by 8 to 10%, it is far too low. This weak money supply expansion is not sufficient to compensate for sharp divergences across the euro area. The excesses in individual countries are particularly marked as the result of earlier sharp rises in money supply in the Mediterranean states when real interest rates in these countries were too low, and low growth in the northern states, where real interest rates were too high. This has now been reversed (Chart 3 below).

Even though the ECB may believe that is that there is still excess liquidity, a case can be made to attempt to boost the growth of broad money. Some may argue that, through its interest rate cuts and direct lending to the banks, the ECB has already done enough to boost credit growth. According to this argument, credit and broad money growth are mirror images of each other, credit being the main assets of the banking system and money (in the form of bank deposits) the main liability. But the two can grow independently; and the difference between broad money and credit is that, whereas the growth of credit is a one-off, the growth of money is (almost always) permanent. Given that EMU’s problems emanate mainly from excess debt, boosting credit growth is unlikely to be a solution.

The monetary contraction in the Mediterranean problem countries is clear. This is seen by the overall change in bank deposits since end-2009 (Chart 4, p.21), when the Greek sovereign debt crisis erupted, and by the growth of each country’s contribution to euro area M3 (in other words, ‘national’ broad money growth, Chart 3). Yes, some countries have seen deposits rise; but at least part of the rise in German or French deposits is due to deposit flight from countries like Greece and Spain, which has boosted German and French M3 growth. It can be argued that ‘national’ broad money numbers no longer have any relevance in a monetary union. However, leaving the validity of that point aside, they remain very important pointers to activity within the countries concerned. As the overall euro area monetary data show, faster broad money growth in Germany or France is not enough to compensate for the collapse of Italian or Spanish M3 growth – let alone Greek.

Chart 3: National contributions to euro area M3 growth, 12-month change, %

Source: ECB and ECB calculations

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OMFIF 2012-09_08.indd 20 8/30/2012 10:02:20 AM OMFIF OMFIF Official Monetary and Official Monetary and Financial Institutions Forum ?????????? Financial Institutions Forum

The ECB’s peculiar inability to react to monetary issues has been indicated on a number of occasions. In April 2009, Lorenzo Bini Smaghi, then on the ECB executive board, analysed the different aspects of conventional and unconventional monetary policy. Significantly, Bini Smaghi only discussed measures aimed at improving the cost and availability of external finance to banks, households and non-financial companies. He noted that, in normal times, central banks do not conduct debt market operations. This is a puzzling statement for a central banker, particularly from a monetarist bank.

Bini Smaghi was responsible for the ECB’s international operations, not for the economics. For that, we must go to Jürgen Stark, who was then on the ECB executive board. Far from advocating a policy aimed at boosting M3 growth, Stark – in common with the rest of the ECB executive – seemed fixated on the exit strategy from non-standard measures.

What should the ECB do now? Bearing in mind that, at least in some countries, the debt problem is focused as much on the private as on the public sector, and that the euro area is facing recession, the ECB should concentrate on boosting money supply growth. It can do this by buying assets held by the non-bank private sector, boosting deposits of households and non-financial companies beyond the limit to which they are normally willing to hold money. If private sector agents hold more money than they wish to, they will attempt to adjust their money balances. They can only do so by buying goods or services (which boosts output growth) or assets (which boosts asset prices); or by destroying money by paying down debt (which speeds up the deleveraging process). But, crucially, with the exception of the fourth method, what one household/company can do cannot be done by society as a whole. Does this follow? The monetary injection is therefore (almost) permanent, and everyone trying to adjust their money holdings creates activity – i.e. growth.

This means that the ECB should concentrate on buying assets held by non-bank private sector, as opposed to government bonds held by the banking system (which has no effect on money supply). Of course, buying private sector assets has the central bank interacting directly with the private sector, thereby stepping into the realm of credit risk. But buying government paper is not risk-free either. Purchasing non-bank private sector assets risks distorting the market for private sector securities; but, again, for the ECB this is not much difficult from the problems relating to purchases of government bonds.

The ECB has proved adept at short-term fire-fighting, but less so at long-term solutions. True, monetary policy cannot solve the euro area fiscal crises; but it can ameliorate them. Focusing on broad money could be a powerful instrument. Under its first chief economist, Otmar Issing, it is unlikely that the ECB would have ignored broad money the way his successor Jürgen Stark did. Maybe the new member of the board responsible for economics, Peter Praet of Belgium (although born in Germany), will restore the ECB’s standing as a bank that not only talks about money but actually does something with it as well.

Chart 4: Change in bank deposits held by other general government/other EA residents, % change since December 2009

Source: ECB and ECB calculations

September 2012 21

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OMFIF 2012-09_08.indd 22 8/30/2012 10:02:21 AM OMFIF Official Monetary and tnheews future of eMu Financial Institutions Forum

ECB main actions since summer 2008

3 July 2008, raises rates 25bps to 4.25% 8 October 2008, cuts rates 50bps to 3.75%. Decides that weekly repos will be fixed rate full allotment 15 October 2008, increases list of assets eligible as collateral 6 November 2008, cuts rates by 50bps to 3.25% 4 December 2008, cuts rates by 75bps to 2.5% 18 December 2008, extends full allotment to the end of March 2009, reintroduces 200bps standing facility corridor 17 January 2009, cuts rates by 50bps to 2% 5 March 2009, cuts rates by 50bps to 1.5%, extends full allotment fixed-rate tenders to as long as is needed 2 April 2009, cuts rates by 25bps to 1.25% 7 May 2009, cuts rates by 25bps to 1%, introduces 1 year fixed rate full allotment LTRO and buys covered bonds 4 June 2009 decides how to buy covered bonds 4 March 2010 decides to return to variable rate tender for 3-month repos from 28 April 10 May 2010 decides on the Securities Markets Programme, goes back to fixed-rate full allotment on 3-months 10 June 2010 decides to extend fixed rate full allotment to Q3 2 September 2010 decides to extend fixed-rate full allotment to end-year – later extended further 7 April 2011 raises rates by 25bps to 1.25% 7 July 2011 raises rates to 1.5% 4 August 2011 decides on full allotment supplementary six-month LTRO 6 October 2011 decides on two one-year LTROs, fixed rate full allotment 3 November 20 11 cuts rates by 25bps to 1.25% 8 December 2011 cuts rates by 25bps to 1%; also introduces 2 three-year LTROs, increased availability of collateral 9 February 2012 further ‘temporarily’ eases collateral rules 5 July 2012 cuts rates by 25bps to 0.75% Notes on contributors Quantum Global Wealth Management is the leading independent provider of asset management services to Central Banks and Sovereign Wealth Funds. Our services include the development of customized Stefan Bielmeier is Chief Economist and Head of Research at DZ Bank investment programs, access to global investment opportunities, direct James Bullard is President of the Federal Reserve Bank of St. Louis investments and training. Brendan Brown is Director and Head of Economic Research at Mitsubishi UFJ Securities We see our clients as our partners and we design bespoke investment solutions to suit the specific needs of each individual client. Michael Burda is Professor of Macro- and Labour economics at Humboldt University, Berlin. His latest book (with Charles Wyplosz) is Macroeconomics: A European Text , 6th edition, Oxford University Press (November 2012)

Find out more at : www.quantumglobalwealth.com Darrell Delamaide is a Member of the OMFIF Advisory Board and sits on the Board of Contributing Editors

Angel Gurría is Secretary-General of the OECD

Roel Janssen is a Member of the OMFIF Advisory Board

Michael Kaimakliotis is Head of Investments, Quantum Global Wealth Management

Pooma Kimis is Sales Manager at OMFIF

Allan Lane is Managing Partner, Twenty20 Investments

Kishore Mahbubani is Professor in the Practice of Public Policy at the Lee Kuan Yew School of Public Policy, National University of Singapore

Philip Middleton is the Partner who leads the EMEIA Central Banking team at Ernst & Young

Gabriel Stein is Chief Economic Adviser to OMFIF

Linda Yueh is the Director of the China Growth Centre at the University of Oxford. Her latest book is China’s Growth: The Making of an Economic Superpower, Oxford University Press. See http://ukcatalogue.oup.com/ product/9780199205783.do

September 2012 23

OMFIF 2012-09_08.indd 23 8/30/2012 10:02:21 AM OMFIF Official Monetary and Financial Institutions Forum Banknotes - the Fed Debate on stimulus grows sharper Officials air conflict in media Darrell Delamaide, Board of Contributing Editors

he Federal Open Market Committee significantly shifted its stance in its last meeting on 31 July and 1 August, according Tto the minutes released three weeks later. The monetary policy panel went from being ready to act if economic indicators showed a worsening situation to anticipating the need for further easing unless there was a substantial upturn.

'Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery,' the minutes said. Despite their concerns over the sluggish recovery, the committee postponed any action until its September meeting at the earliest. In the meantime, the public debate between FOMC members sharpened in tone, with doves and hawks taking to the media to air the disagreements that normally take place behind closed doors.

Eric Rosengren, president of the Boston Federal Reserve Bank and a non-voter this year, let his frustration show in a media blitz of interviews in leading newspapers and on a widely watched business news cable channel. Rosengren urged a new open-ended program of substantial asset purchases as he complained that the US economy is ‘only treading water.’ ‘If you are treading water, even if you are a good swimmer, at some point you need to get to land,’ Rosengren said on CNBC. Rosengren went so far, in response to a question from a Boston Globe reporter, as to say that the committee should ignore any considerations about the presidential campaign in deciding to boost the economy. Eric Rosengren In public at least, Fed officials like to pretend that politics plays no role in the timing or tenor of monetary policy decisions. But when the economy is a major issue in a tight race, it can hardly be ignored that any decision to boost the economy may aid the incumbent President Barack Obama at the expense of his Republican challenger Mitt Romney. According to the Globe, Rosengren said the Fed should not worry if a move to ease monetary policy is seen as influencing the presidential election. ‘We don’t get to pick the timing of a global slowdown,’ Rosengren told the newspaper. ‘If there’s a slowdown and you have an independent central bank, the appropriate response is to act. I think that’s exactly what we should do.’

Presumptive Republican nominee Romney exerted some of that political pressure himself when he told CNN earlier in August that he didn’t think the Fed should engage in a new round of quantitative easing, or QE3, on top of two earlier rounds.

‘I think the Fed’s first action in quantitative easing was effective, to a certain degree. But I believe that QE2, the second round of easing, I don’t think it had the impact they were hoping for,’ he said. ‘I don’t think a massive new QE3 is going to help this economy.’

Fisher not in favour of further easing

Romney’s remarks echoed those by some FOMC members who opposed any new asset purchases. Dallas Fed chief Richard Fisher (non-voter), who is about as far on the hawkish scale as Rosengren is on the dovish ranking, quickly countered his Boston colleague by saying that the Fed has done what it can that further monetary easing would have little impact. ‘I believe we have done our job,’ Fisher said on Bloomberg television. ‘We have done enough. It does not solve the problem.’ Richard Fisher Fisher insisted again that any further aid to the economy needs to come from Congress, by removing fiscal and regulatory uncertainty. He warned that any Fed action in September would be perceived as politically motivated, even though that would be incorrect.

‘The closer we get to an election, the more I think the perception, incorrectly, will be that we have become too politically pliant,’ Fisher said. The time to avoid that perception is past, he said. If the Fed did need to act to boost the economy, ‘we should have done it [earlier],’ he said. The Dallas Fed chief reiterated his message a week later on CNBC, calling again for ‘fiscal clarity’ and asserting that uncertainty about fiscal measures was the main dampener on economic recovery.

‘There's no uncertainty about one thing,’ Fisher told the network. ‘There's plenty of cheap high-octane fuel which we the Fed have provided. What good would it do to put still more out there since what we’ve already put out there is not having much effect on employment?’ Fisher said it is now up to members of Congress. ‘They are the only game in town,’ he said. ‘They have to do something.’

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OMFIF 2012-09_08.indd 24 8/30/2012 10:02:22 AM OMFIF Official Monetary and Financial Institutions Forum

‘Is there anyone not Debate on stimulus grows sharper Hawks opposed to further monetary easing borrowing today or Richmond Fed chief Jeffrey Lacker (voter) chimed in with support for his purchasing a house fellow hawk and agreed that further monetary action could do little to because interest boost employment. ‘There are a lot of people overestimating the extent to which monetary policy is capable of having any sustained effect on rates aren’t low growth or labour markets,’ Lacker told The Associated Press. enough?’ George Jeffrey Lacker rhetorically asked a Esther George (non-voter), the head of the Kansas City Fed who is the newest regional chief on the FOMC, also expressed scepticism about any impact in further monetary easing. local business group.

‘Is there anyone not borrowing today or purchasing a house because interest rates aren’t low enough?’ George rhetorically asked a local business group. ‘Do we expect that businesses will hire if their long-term rates are lower?’

George, who is seen as leaning hawkish, went on to caution about the challenge the Fed already faces in unwinding its asset purchases when the economy picks up.

‘It’s always easy to buy,’ she said, according to the Kansas City Star. ‘We’ve never had to go back into the market to sell this quantity of assets.’ Further asset purchases would only exacerbate that problem, she suggested.

Doves hold advantage in the voting

Dovish-leaning John Williams (voter), who took over the San Francisco Fed last year, set a counterpoint to this scepticism. Williams, who was not in favour of further action earlier this year, now sees the need for the Fed to do something.

John Williams ‘It seems like if we have the tools to move us faster toward our goals, we should use them,’ he said in an interview with the San Francisco Chronicle. ‘When you weigh the costs and benefits,’ he said, ‘it’s at the point where it is definitely tilting toward taking further action.’

Ultimately, it will be Chairman Ben Bernanke’s call whether he wants to push for action at the meeting in mid-September.

With the exception of Lacker, the regional hawks don’t have a vote this year. Eleven of the regional chiefs rotate as voting members, with only four voting in any given year, along with the seven members of the Board of Governors and the head of the New York Fed.

New York Fed chief William Dudley (voter) is a confirmed dove and the board members generally follow Bernanke’s lead. Three of the regional voters – Dennis Lockhart of Atlanta, Sandra Pianalto of Cleveland, and Williams – are squarely in the dovish camp.

So if Bernanke chose to put it to a vote, there’s little doubt about what the outcome would be. But the non-voters also take part in the debate, William Dudley and, given the political sensitivity of the issue just weeks before the presidential election, the Fed chairman would probably want to seek the widest possible consensus.

Plus, the economic picture remains unclear. Even though the headline unemployment rate remains high at 8.3%, there have been some positive notes in hiring and housing prices. The need to do something is not so urgent as to give Bernanke a clear-cut case for moving ahead.

The Fed chairman’s mantra is that the Fed has tools and will use them when it deems necessary. y

September 2012 25

OMFIF 2012-09_08.indd 25 8/30/2012 10:02:23 AM OMFIF Official Monetary and Financial Institutions Forum NewsOMFIF Advisory Board

Meghnad Desai John Nugée Frank Scheidig Songzuo Xiang Gabriel Stein

ADVISORY BOARD ADVISORY Chairman Deputy Chairman Deputy Chairman Deputy Chairman Chief Economic Adviser

John Adams Mario Blejer Consuelo Brooke YY Chin Aslihan Gedik Dick Harryvan BANKING

Carl Holsters David Kihangire Philippe Lagayette Andrew Large Oscar Lewisohn Wilhelm Nölling

Frank Scheidig** Jens Thomsen Ernst Welteke Derek Wong

Hon Cheung John Cummins Trevor Greetham Frederick Hopson Matthew Hurn Mumtaz Khan ARKETS M

APITAL George Milling-Stanley Paul Newton Saker Nusseibeh Bruce Packard Marina Shargorodska Hendrik du Toit C

Jack Wigglesworth Sushil Wadhwani

26 www.omfif.org

OMFIF 2012-09_08.indd 26 8/30/2012 10:02:46 AM OMFIF Official Monetary and Financial Institutions Forum

OMFIF welcomes new members to the Advisory Board Three new members have joined the OMFIF Advisory Board. They are: Michael Burda, Professor of Macro- and Labour Economics at the Humboldt University of Berlin; Hans-Olaf Henkel, former President of the Federation of German Industry (BDI); and Sir Peter Heap, former UK Ambassador to Brazil.

They take the total number of Advisory Board members to 104. The OMFIF Advisory Board, covering the global economic system, includes people who contribute to OMFIF's output in many ways, who are also available to carry out advisory work and other services for OMFIF members.

Paul Betts Nick Bray Peter Bruce Darrell Delamaide Jonathan Fenby Stewart Fleming OMMENTARY & C

Haihong Gao Trevor Greetham Harold James Roel Janssen William Keegan Joel Kibazo DITORIAL E

Peter Norman Ila Patnaik John Plender Robin Poynder Michael Stürmer David White

Michael Burda Nick Butler Jon Davis Meghnad Desai* Steve Hanke John Hughes EDUCATION Ashley Eva Millar Rakesh Mohan Danny Quah Abdul Rahman Richard Roberts Paul van Seters

Niels Thygesen Makoto Utsumi Shumpei Takemori Linda Yueh

September 2012 27

OMFIF 2012-09_08.indd 27 8/30/2012 10:03:14 AM OMFIF Official Monetary and Financial Institutions Forum OMFIF Advisory Board

Frits Bolkestein Laurens Jan Brinkhorst Shiyin Cai Neil Courtis Natalie Dempster Vladimir Dlouhy

Willem van Hasselt Peter Heap Paul Judge John Kornblum Norman Lamont Thomas Laryea POLICY

PUBLIC

Ruud Lubbers Denis MacShane Luiz Eduardo Melin Phil Middleton John Nugée** David Owen

Poul Nyrup Rasmussen Martin Raven Janusz Reiter Akinari Horii Christopher Tugendhat Jorge Vasconcelos

Katinka Barysch Paul Boyle Albert Bressand Stephane Deo Hans-Olaf Henkel Pawel Kowalewski ECOMOMICS &

Gerard Lyons Mariela Mendez Isabel Miranda Michael Oliver Vilem Semerak Paola Subacchi RESEARCH

David Tonge Peter Walton John West Songzuo Xiang

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OMFIF 2012-09_08.indd 28 8/30/2012 10:03:37 AM OMFIF Official Monetary and Statisticalnews forecastS Financial Institutions Forum Momentum drops worldwide Euro area weakness spills over to Germany DZ Bank Economic Forecast Table usiness sentiment has continued to worsen in the major GDP growth BEuropean Union countries, suggesting that the recession in Europe will probably persist until the end of this year. 2 011 2012 2013 Even in the first few quarters after that, we expect GDP US 1.8 2.0 2.0 growth rates to remain mired around zero. Japan -0.7 2.3 1.4 China 9.2 8.2 8.8 The chief causes of this deterioration are additional fiscal consolidation measures, most notably in Spain but also in Euro area 1.5 -0.4 0.0 France and the Netherlands. To make matters worse, the Germany 3.0 1.2 0.8 German economy, which had previously seemed largely France 1.7 0.2 0.4 impervious to the debt crisis, is beginning to struggle in the face of falling demand from the rest of Europe. Italy 0.5 -2.5 -0.9 Spain 0.7 -1.6 -2.2 Consumers in the single currency area are particularly UK 0.8 -0.3 0.5 negative about the general economic outlook for the next 12 months. As a result, fear of unemployment has increased again. The DZ Bank euro indicator fell yet again in June and Addendum is now languishing at its lowest level for almost three years. Asia excl. Japan 7. 3 6.7 7. 4 World 3.6 3.3 3.5 Whatever the overall perspectives, the growth outlook for euro member states presents a highly mixed picture. Even with its economy slowing, Germany remains an engine Consumer prices (% y/y) of growth, whereas the French and Dutch economies will US 3.1 2.4 2.8 probably scarcely expand at all. Because of its additional deficit reduction measures, Spain will remain mired in deep Japan -0.3 0.2 0.2 recession in 2013, while Italian economic output is likely to China 5.4 2.9 3.4 shrink for the second year in succession. Euro area 2.7 2.4 2.5 For the euro area we expect to see only a gradual, hesitant Germany 2.5 2.0 2.1 recovery from the second half of 2013. Aggregate euro area France 2.3 2.3 2.4 unemployment is likely to register a fifth successive annual Italy 2.9 2.9 2.4 increase to 11.7%. Spain 3.1 2.5 3.6 Nor has there been any improvement in the outlook outside UK 4.5 2.5 2.3 the euro area over the past month. In the UK, for instance, economic output slumped in the second quarter of 2012, Current account balance (% of GDP) which means that the country is stuck in recession. In the US GDP growth was slower in the second quarter than in the US -3.1 -3.3 -3.1 first, mainly because of weaker consumer spending. Japan 2.1 1.7 2.2 China 4.1 3.2 3.4 In China, too, GDP growth was down: the figure of 7.6% for the second quarter was the lowest for three years. Although Euro area 0.0 0.1 -0.1 the Chinese government and central bank have introduced Germany 5.7 5.2 4.3 stimulus measures to prevent any further deceleration of France -2.2 -2.3 -2.2 business activity, these will take a while to work through. Italy -3.2 -2.6 -2.2 The price of oil has begun to climb sharply again. The euro Spain -3.5 -2.7 -2.0 area inflation rate for July was 2.4%, or 0.1 percentage UK -1.9 -1.5 -1.2 points higher than in the previous month.

In the months ahead we can expect to see inflation remaining Produced in association with DZ Bank group, above 2%, as VAT hikes (like the 3 percentage point rise in a partner and supporter of OMFIF Spain in September) begin to filter through into the index. Further upward pressure on consumer prices may come from higher food costs resulting from drought-induced crop failures in the US. y

September 2012 29

OMFIF 2012-09_08.indd 29 8/30/2012 10:03:38 AM SAVE THE DATE: 13 November 2012, Bank Indonesia, Jakarta The Second Asian Central Banks’ Watchers Conference

INVESTMENT FOCUS INDONESIA

ASIA AS AN ENGINE FOR WORLD GROWTH Hosted by Dr. Darmin Nasution, Governor, Bank Indonesia

Conference background In light of the structural changes taking place in the world economy, and a general shift in economic power to the rapid-growth and high-potential countries of East Asia, the Official Monetary and Financial Institutions Forum (OMFIF) created the Asian Central Banks’ Watchers Group, bringing together public- and private-sector bodies to examine issues in economic and monetary policy related to the Asia-Pacific region.

The Jakarta meeting is an important component of OMFIF’s framework for global dialogue, as we seek to help form a more cohesive and resilient world economy. The series will capitalise on and satisfy the growing interna- tional interest in Asian central banking policies as the region extends financial and trade cooperation, becoming both a more integrated economic area and a progressively more important force in world policy-making.

The one-day Jakarta conference is the second in a series of Asian Central Banks’ Watchers Conferences and follows the inaugural meeting at Bank Negara Malaysia in Kuala Lumpur in November 2011, hosted by Governor Dr. Zeti Akhtar Aziz.

For more details contact:

Vikram Lopez y Royo For general information about OMFIF, E: [email protected] including details of our lectures, meetings, T: +44 (0) 20 3008 5265 conferences and publications, visit: F: +44 (0) 20 3008 8426 www.omfif.org

OMFIF 2012-09_08.indd 30 8/30/2012 10:03:38 AM OMFIF Official Monetary and Regulatorynews structures Financial Institutions Forum

The shift to external lawyers How best to guard against conflicts of interest Pooma Kimis, OMFIF mid a tide of recrimination about regulatory scandals affecting large international Where banks are Abanks, some of the biggest institutions have undergone a silent professional exodus, with in-house lawyers being replaced in many cases by external legal advisors. This move outsourcing tasks to to outsource legal counsel and bring in external advisers for complex cases is not unusual allow non-conflicted for banks that already have in-house teams. But the trend throws up some important analysis of areas like questions about checking and dealing with misconduct in the financial industry. trading, compliance Does sending out work to external attorneys automatically introduce further checks and teams must adopt the balances into the bank’s present systems? Or are such measures simply a means to lower the bank’s own liability for errors, shortcomings or illegalities? Could conflicts of interest in highest standards of some fields of in-house lawyers’ behaviour simply be replaced, when outside advisers are vigilance to thwart hired, by similar problems in the external field? illegal or unethical

These shifts take place against the background of continued interrogation of banks’ conduct. standards and considerable criticism of their perceived lack of integrity and conscience. Significantly, the lawyers in these banks are being implicated too. Pointing to cases of shambolic due diligence processes and opportunistic legal advice focused on finding dubious loopholes, some critics blame general counsels for lacking moral backbone and ethical responsibility.

Lawyers are meant to be guardians of banks’ sanctity. When transactions are hidden from the books or trades manipulated, internal legal teams have a case to answer. But in- house lawyers are ultimately directed by decisions made by senior management. It might therefore be seen as unfair to expect them to stick to a separate standard of conduct, unaffected by internal organisational hierarchy and power levers.

Lawyers are trained specifically to pay attention to detail. So a directive to find a loophole by a managing director pressured to satisfy the needs of a core client, or a trader trying to maximise profits, would in many cases be accepted not as an incitement to wrongdoing but as a satisfying professional challenge.

Aware of the natural conflict of interest faced by in-house staff, banks’ managements might consider independent counsels as an ideal means of providing reliable ethical guidance and honest due diligence. Outside firms might prove more likely to spot shortcomings and risks in documents and transactions, and can give a neutral assessment in a range of issues where in-house teams may be conflicted. This does not of course obviate the need for thorough verification of their work.

Another part of banks that has been drawn into regulatory abuse cases is the compliance team, whose job is to double check details and ensure regulatory requirements are met. Even (or especially) where banks are outsourcing tasks to allow non-conflicted analysis of areas like trading, compliance teams must adopt the highest standards of vigilance to thwart illegal or unethical conduct. The volume of trades in a typical bank requires large teams in the middle and back office to control traders. Many banks are under-resourced in this field.

Where banks have performed aberrantly, or may be tempted to do so in future, general counsels and compliance departments are under enormous scrutiny, and this will only increase. Increasingly external bodies have had to step in the compliance process, such as the US Securities and Exchange Commission (SEC) which has been bringing higher volumes of civil suits against delinquent market participants. Many of these proceedings have been settled out of court with large fines, which clearly affect banks’ profits and reputation but obscures the clear analysis of culpability that could take place in a trial and may, furthermore, reinforce the view that standards of behaviour remain unchanged. y

September 2012 31

OMFIF 2012-09_08.indd 31 8/30/2012 10:03:40 AM OMFIF Official Monetary and Financial Institutions Forum Switzerland & the world High Swiss stakes in euro drama National Bank could face further pressure on peg Michael Kaimakliotis, Quantum Global

s the euro crisis eased somewhat in August, the Swiss National Bank breathed a sigh The Swiss National Aof relief. The euro/Swiss franc floor, set at 1.20 on 6 September 2011, continues to Bank has replaced hold and option-implied volatilities signal a drop in speculative selling interest. But with foreign exchange reserves surging above SwFr400bn (70% of Swiss GDP) at the end of the People’s Bank July, the stakes are high for the National Bank, for the Swiss cantons (main owners of the of China as the SNB’s shares) and for the 8m citizens of Switzerland whose taxes fund the cantons. main accumulator At the least, a continuation of euro weakness against the Swiss franc could expose the of foreign reserves cantons to a drying up of dividend flows from the National Bank. At worst, if the floor were globally. to collapse altogether in the event of severe euro turmoil, then the National Bank would make outright losses that could require some form of recapitalisation.

So far, the National Bank has performed steadily. Like an experienced mountaineer leading an expedition across a high ridge, the bank has maintained calm despite the dizzying drop below. ‘Repeat after me: the floor is solid, the floor is solid.’ Will they cross the ridge successfully? Or will they succumb to vertigo?

Everyone agrees that the Swiss franc is overvalued. The current floor is only an attempt to prevent the currency becoming more overvalued. The Swiss National Bank can print francs in unlimited quantities and use them to purchase euros (or take similar actions using derivatives). In theory then, the floor should be easily defended and indeed the strategy of buying euros for Swiss francs should eventually yield significant profits when the euro reverts to a fair value of, say, 1.45.

Another reason to think that the floor will hold is that the National Bank has already showed much more resolve than other central banks which have intervened to weaken their currencies. To put things in perspective, between 1 April 1991 and 31 March 2004, the Japanese Ministry of Finance (using the Bank of Japan as its agent) intervened 307 times to weaken the yen with total sales of $577bn. The period of greatest intensity was January 2003 to March 2004, when the Bank of Japan bought $325bn. So intervention in dollar terms peaked at approximately half the volume carried out by the Swiss National Bank – but this took place in an economy 10 times the size of Switzerland’s.

While the National Bank’s resolve cannot be underestimated, some risks cannot be ignored. The most obvious risk to the floor would be a scenario in which the euro disintegrates. In such an instance, market demand for Swiss francs might exceed the purchase limits given to traders by the National Bank. Admittedly we do not know what these limits are – but they are certain to exist. In such an instance, the bank’s traders would simply stop buying euros and the floor would collapse. During recent market uncertainty, from April to end-July, Swiss foreign currency reserves rose by more than SwFr150bn, or SwFr50bn a month. Thus the Swiss National Bank has replaced the People’s Bank of China as the main accumulator of foreign reserves globally. But Swiss franc demand earlier this year would seem modest compared to what would transpire in a chaotic breakup of the euro.

Global daily foreign exchange trading volume is roughly $4tn (using 2010 figures) – 6% of which typically involves the Swiss franc. At these volumes there are trades of SwFr240 bn per day or SwFr5tn per month. Excess demand for Swiss francs of 10% would require the National Bank creating about SwFr500bn in one month.

Would the Swiss be prepared to purchase SwFr500bn worth of euros in a single month? And if so, would politicians be prepared to watch the central bank’s balance sheet grow at this pace while the euro collapsed? The main risk to the floor would therefore be a change in the National Bank’s mandate that would prevent further intervention.

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OMFIF 2012-09_08.indd 32 8/30/2012 10:03:40 AM OMFIF Official Monetary and news Financial Institutions Forum

Market participants At a time of negative inflation, Swiss politicians seem to back the SNB, above all because the export (and tourism) industry is happy with a policy that has prevented the franc from have attributed soaring further. The National Bank may be moving into negative equity territory, but it recent surges in the could be said that the floor has resulted in unrealised profits rather than outright losses. value of the Swedish If, at a time of great unrest, the National Bank allowed the floor to collapse for a short time, crown and the but sought to reinstate it when market conditions calmed, that could lead to large losses for Australian dollar to investors who speculated on a lower Swiss franc rate. But the large recognised losses for the National Bank in the meantime could bring political intervention. Swiss demand.

Other risks are overstated. The risk of inflation is small as the strong Swiss franc provides a strong deflationary impulse. Consumer prices fell by 0.7% in July from a year earlier. That’s the 10th straight month of deflation. Although the bubbling property sector has been buoyed by the inflow of Swiss francs, the authorities have brought in new regulations to cool property demand. Banks’ capital requirements on mortgage lending will probably be increased if these measures prove insufficient.

Another risk is conflict with other central banks. Since the National Bank seeks to maintain the proportions of the various foreign currencies it holds, the policy of accumulating foreign reserves has implications beyond the euro. Indeed, market participants have attributed recent surges in the value of the Swedish crown and the Australian dollar to demand from the SNB. (The National Bank also owns Korean won and Singapore dollars).

If foreign central banks were to challenge the Swiss intervention, then the floor could come under pressure. This is unlikely however – particularly since the International Monetary Fund has come out in support of the floor. Any differences of opinion are unlikely to lead to conflict in the markets.

One final risk is almost too scary to contemplate. What if Germany leaves the euro? Then the fundamental support for the floor would evaporate. A euro without Germany would probably have a fair value of below $1. This outcome remains unlikely, but there are two sources of concern. The first is the German Constitutional Court ruling due on 12 September on the legality of the permanent European rescue fund, the ESM, which is crucial to the Spanish bail-out programme.

The second is the increasing likelihood of a public referendum on further integration on banking regulation and fiscal policy. Both could prevent Germany from taking the action needed to guarantee the euro’s sustainability. As it seeks to protect its currency from wild gyrations, the National Bank will continue to have to look northwards to its large European neighbour for a lead on how to adjust its policy. y

Swiss foreign currency reserves, SwFr bn SNB Foreign Currency Reserves (in bn.'s of CHF) 450

400

350

300

250

200

150

100

50

- 1996 12 1997 06 1997 12 1998 06 1998 12 1999 06 1999 12 2000 06 2000 12 2001 06 2001 12 2002 06 2002 12 2003 06 2003 12 2004 06 2004 12 2005 06 2005 12 2006 06 2006 12 2007 06 2007 12 2008 06 2008 12 2009 06 2009 12 2010 06 2010 12 2011 06 2011 12 2012 06

Source: SNB

September 2012 33

OMFIF 2012-09_08.indd 33 8/30/2012 10:03:41 AM OMFIF Official Monetary and Financial Institutions Forum Archive Insight

A monthly foray into monetary secrets hidden in archives The Bundesbank's bond-buying spree How closeness to Chancellor Schmidt prompted German central bank to buy DM7.7bn in bonds – and then regret it or the German Bundesbank, 1974-75 was a testing time. Quite apart from storms and Even for Schmidt, Falarums on the external currency front, it had to repair deep differences of opinion with the German government under supremely self-confident Chancellor Helmut Schmidt over there were limits to purchases of German government bonds on the central bank’s own account. The dispute his alignment with is intriguingly reminiscent of the present-day struggle over whether or not the European the Bundesbank, Central Bank should intervene on secondary markets to buy Italian and Spanish bonds as part of a wider rescue scheme for economic and monetary union. shown when he tested the bank’s In the wake of the breakdown of the fixed rate Bretton Woods system in 1971-73, the oil price shock of autumn 1973 and the collapse of efforts to bring about monetary union in independence on Europe by 1980, European countries were forced increasingly into ‘go-it-alone’ polices. interest rates. France left the European currency Snake (the forerunner of the European Monetary System that eventually turned into EMU) at the beginning of 1974. In a preview of many future monetary disputes with the Germans, President Georges Pompidou told his finance minister Valery Giscard d’Estaing in January 1974: ‘At the last summit conference, I noticed that [the Germans] do not have much understanding for our situation. As soon as one comes to them with monetary questions, they react completely egoistically. They like to exploit their superiority.’

Schmidt, who became Chancellor in May 1974 almost simultaneously with the arrival of Giscard as French president after Pompidou’s unexpected death, quickly became the pivotal figure in German monetary affairs. Profiting from his friendship with Bundesbank president Karl Klasen, who unusually combined membership of the Social Democratic Party with solid credentials as a previous ‘speaker’ of the Deutsche Bank management board, Schmidt attempted to use his relationship with the Bundesbank to build up German monetary influence throughout Europe. Significantly, Klasen is the only Bundesbank president (either before or since) to have used the word ‘autonomy’ rather than ‘independence’ to describe the central bank’s positioning with the government.

The alliance with the Bundesbank centred on the fight against international inflation (which had risen to 24% in Italy, 16% in the UK, 12% in the US and France and 7% in West Germany), on credit assistance for weaker European countries – and, increasingly, on battling against recession in Germany. On the European front, Schmidt focused attention on Italy, realising that shoring up the country’s balance of payments was crucial to preventing a further lira decline that could damage European trade in general and German exports in particular. During the summer of 1974 Schmidt drew on his close relationship with Klasen to mastermind a $2bn German credit for Italy from the Bundesbank’s reserves, secured against part of Italy’s official gold holdings. Klasen ensured that Schmidt won Bundesbank acceptance for the transaction without the time-consuming necessity of seeking approval from the Bundesbank council.

But, even for Schmidt, there were limits to his alignment with the Bundesbank, shown when he tested the bank’s independence on interest rates – and met an uncompromising rebuff. Early in 1974 the Bundesbank injected liquidity into the German banking system by loosening restrictions on minimum reserves, but kept its discount and Lombard rates unchanged at the high 1973 levels. In a blatant attempt to bring down interest rates before important regional elections in October, Schmidt wrote a highly unusual personal letter to Klasen in July 1974, warning that Germany’s economy was slowing down. ‘I would like to see credit policy providing stronger support for the economy and for business sentiment,’ he wrote. Schmidt’s letter was ineffective. The Bundesbank waited until October 1974 to reduce interest rates, for the first time since the beginning of 1972.

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The Bundesbank The interest rate cut formed a precursor to a year of difficult economic policy dilemmas in which the Bundesbank ended up at one stage owning ‘saw no necessity 21% of the total issuance of German government bonds. The central to buy bonds in bank entered into the operation to purchase bonds on its own account previous volumes on the open market with reluctance and soon became convinced that it was leading to counterproductive results. The Bundesbank took several on the open market. months to extricate itself. The episode has been given publicity in 2012 This does not rule out as part of the general controversy about whether the German central Karl Klasen bank should relax its generally hostile stance to government bond market smoothing purchases. Previously, the Bundesbank’s 1975 bond buying spree was operations for the not widely known – a lacuna that backed up the oft-stated view that future.’ government bond purchases had never been part of the Bundesbank’s creed. Even Jürgen Stark, the former Bundesbank deputy president who was on the board of the ECB until the end of last year, professed at one stage that he was unaware of the Bundesbank’s 1975 action.

Otmar Emminger Heinrich Irmler, the Bundesbank’s board member responsible for money market activities, told the council meeting on 3 July 1975 that the Bundesbank has stepped up open market bond purchases because of a ‘fundamental change’ in bond markets. He could not recommend ‘pegging’ interest rates since this would cause ‘distortions in the interest rate structure.’ Action by the Bundesbank to hold down yields on public bonds would cause investors to switch to buying other instruments at higher yields issued in other sectors such as Schuldscheindarlehen (promissory notes). Klasen admitted in a press conference the Bundesbank had Helmut Schlesinger fundamentally changed its intervention policy.

The open market operations continued during the summer but failed to lead to a significant improvement of issuing conditions, especially at the longer end of the market. Irmler told the council meeting on 14 August that the poor state of the bond market had also spilled over to Schuldscheindarlehen, so that the government had been forced to resort to financing through short-term paper that amounted to variable interest rate financing – a variation that the Bundesbank opposed. ‘Under these circumstances,’ according to the Bundesbank meeting minutes, ‘Dr Irmler expressed the view that the open market operations followed hitherto should be continued for the time being.’

The problem with the ‘pegging’ policy was that – even though the daily amounts purchased by the Bundesbank grew continuously – the yield gap between the ‘supported’ and ‘non- supported’ securities had grown, as the Bundesbank council was told on 9 October. Klasen was absent from the Bundesbank because of illness; his place was taken by his deputy Otmar Emminger, who had a much lower tolerance for the market distortions introduced by the opening market policy. The issuing authorities decided to suspend government bond operations. Irmler spoke of ‘legal concerns.’

In mid-October Emminger visited Schmidt, together with Helmut Schlesinger, the directorate member for economics. The Bundesbank pointed out that large-scale invention had not led to any significant long-term easing of interest rates but had greatly narrowed the market for German bond issues. Halting the open market policy was only a question of time.

News of the government meeting soon was made public, with the result that government bonds were hit by renewed selling. At the next Bundesbank council meeting on 23 October, Emminger reported on the talks with the government. Irmler said that Bundesbank holdings of government bond issues, including those from the German railways and post office, had swollen to DM7.7bn – 20.8% of total issuance. Including volumes held by the issuers for market-smoothing operations, no less than 23.6% of total issuances had been held back from the market. The council voted on a 12 to 3 majority to end with immediate effect ‘the hitherto inflexible open market policy with the freezing (pegging) of prices for government bonds.’ The decision was announced in a sparsely worded press statement which said the Bundesbank ‘saw no necessity to buy bonds in previous volumes on the open market. This does not rule out market-smoothing operations for the future.’ y

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OMFIF 2012-09_08.indd 35 8/30/2012 10:03:41 AM OMFIF Official Monetary and Financial Institutions Forum The Keegan commentary

A regular round-up on international monetary affairs Dow’s lesson of past recessions Osborne should focus on UK growth

William Keegan, Chairman, Board of Contributing Editors he economist Christopher Dow, this was to be reform of the House of years were required in which stimulus Twhen economics director of the Lords, to which their stronger coalition measures might be needed to restore Bank of England in the 1970s and partner, the Conservatives, had agreed confidence. He advocated ‘stimulatory early 1980s, would occasionally shake in order to achieve a working majority measures equivalent to between 1% his head in July and mutter ‘things in the House of Commons. For it must and 3% of GDP per year’. When will look very different in September.’ never be forgotten that, despite the confidence was fully restored, and So saying, he would head off with his depths of unpopularity to which the unemployment had come down, then family for the month of August to his Labour government had sunk, David would be the time for contractionary beloved retreat in the Drome. Cameron had failed to win a convincing measures and debt repayment. victory in 2010, and has depended on Things often did look different the support of the Liberals ever since. Now this is so far from what the British in September: sometimes better; government has been aiming at as to sometimes worse. I was thinking of my A key moment was when the Lib-Dem be laughable – painfully laughable. But late friend Christopher in July, when the leadership allowed themselves to be let me be quite clear: what the British death was announced of his brother in frightened by the Treasury and the Bank government has been doing is the law, the distinguished military historian of England into accepting an austerity laughable bit; what Dow advocated John Keegan (no relation, although programme at an early and very was eminently sensible. sharing his surname has often given sensitive stage of the British economic me some reflected glory, particularly recovery. Well, the world now knows Nero fiddled while Rome burned. with Americans). that, notwithstanding the exchange Chancellor Osborne seems recently rate flexibility afforded by the UK's to have been more concerned with The obvious thought was that things absence from the euro, the economy finding the next Governor of the Bank looked so bad for the euro area and has been, in the choice description of of England than with recognising the the British government in July that – shadow chancellor Ed Balls, ‘flatlining’ folly of his policies. Rumours persist who knew? – perhaps they might look since chancellor George Osborne that, given the rate at which the somewhat better after the holidays. tightened policy. There was a recovery, reputations of leading bankers have Unfortunately, they could even look a but it disappeared. We now have even been shattered, he is still trying to lure lot worse. This month I leave the euro to the International Monetary Fund – of Mark Carney, governor of the Bank of others, and concentrate on the UK. In all institutions! – calling for a relaxation Canada, to show an interest. I continue July the vaunted coalition government of policy. to believe this is a non- starter, and that seemed to be falling apart. Carney is probably more interested in Which brings us back to Christopher Canadian politics than the poisoned The junior partners, the Liberal Dow. After retiring from the Bank, Dow chalice of the vast responsibilities that Democrats, had, over the past two spent the best part of 10 years (1988 Osborne is thrusting on the Bank. years, abandoned one principle and to 1997) working on a book entitled policy after another, in the hope of Major Recessions. This was at a time Meanwhile, let us hope that both achieving their long term goal of a when the fashionable view among Chancellor and Bank try to alleviate reform of the electoral system which economists was that major recessions the present crisis by heeding the would give them more effective were a thing of the past. He concluded lessons drawn by that former Bank representation in parliament. Central to that, after a major recession, five to 10 chief economist Christopher Dow. y Looking ahead – 2012 diary dates

Lecture with Jin Zhongxia Lecture with Jaime García-Legaz Director-General, People’s Bank of China Spanish Trade Secretary 3 September, London 26 September, Spanish Embassy, London

Lecture with Prasarn Trairatvorakul Lecture with Marek Belka Governor, Bank of Thailand, President, National Bank of Poland 12 September, London Golden Series, 23 October, London

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