No deal may be likelier than we think

Featured Image Credits: Ala z on Wikimedia Commons

A serious disruption of the free flow of commercially valuable data between Europe and the UK.

£13 (around $16) more to be spent each week per household on food in the UK.

A £100bn loss to the EU economy.

Regardless of your opinion on whether the above is waffle or a genuine threat of a no-deal Brexit, it seems pretty logical for both sides of the UK-EU negotiating table to see this as an avoidable scenario. Unfortunately the world, and most certainly geopolitics, is not exactly replete with magnanimity. Whilst public perception of politicians as a swarm of Machiavellis can be seen as a tad harsh, politicians, like regular people, in general tend to act in their own self-interest. Numerous groups, though, across the UK are unceasing in their attempts to stamp out a no-deal Brexit from the list of potential outcomes of the negotiation. However, previous attempts have fallen flat and so for the moment the blocking of no-deal from potentiality seems unlikely. Given this probability the potentially destructive no-deal black hole is coming closer and closer to Europe. This is not because it wouldn’t hurt both sides greatly but because if either side is seen to be the one to give ground, it could have dramatic implications.

First, a brief description of the issue: the Irish backstop.

To maintain the seamless transfer of goods, services and people across the border separating Northern Ireland and the Republic of Ireland, the agreement reached between the May administration and the EU involved a so-called “backstop” in the region. In this case, Northern Ireland would have to comply with some rules of the EU single market, thereby necessitating the whole UK acquiescing to the EU rules. Given one of the major concerns for the UK populous in the very beginning was the claimed iron fist of the EU strangling the great British will to be free, the deal is hardly likely to curry favour with them. But forget the public, it didn’t even make it past the politicians, even after four tries! This is the essential bone of contention here.

Let’s firstly look at this from the UK perspective. PM Johnson already knows he cannot even consider bringing any deal with a backstop involved to the House of Commons, lest it be rejected for a hysterical fifth time. He now has two alternatives: a no-deal and an alternative to the current backstop arrangement which is acceptable to both the Commons (so the deal can actually pass) and the public (unless he wants to become May 2.0 and plunge the Conservatives into a deeper rut). He could, of course, revoke Article 50 altogether, but unless he wants to be known as the man who caused civil unrest, he’s going to stay well clear of that route. Now although both parties have indicated a willingness to explore alternatives to the traditional backstop (for example, the technology-driven border mechanism frequently espoused by many UK MPs), there has been precious little detail on the matter. As of now there remains no workable solution to the border issue and so the only option left on the table for Johnson is a no-deal.

What about for the EU? A backstop certainly isn’t the preferable outcome for them either, given the many benefits to the Republic, and thus the EU economy, of free trade between themselves and Northern Ireland. If there is no backstop (and no alternative arrangement) and the EU agrees to no hard border on the island of Ireland,  they are essentially allowing the UK access to the EU single market without the UK “giving” anything in return, for example, through membership of the customs union. This sets a dangerous precedent because the EU has numerous times said that it will not give the UK such preferential treatment. Countries like Norway and Switzerland have had to give substantial ground with regards to contributions to the EU’s budget and accepting the free movement of workers.

Now, don’t get me wrong; politicians are commonly hypocritical and go back on their word often, and I’m not for a moment suggesting that EU politicians such as European Council President Tusk aren’t capable of this. The issue is that this issue is extremely high profile and contentious. If the EU secedes this issue to a country that is, even slightly, anti-EU, it is capable of reigniting anti-EU moments driven by politicians such as Geert Wilders in the Netherlands and Marine le Pen in France. Once these movements are bolstered, the very fabric of the EU is under existential threat. If this sounds sensational, ask yourself this: how many people would have predicted Brexit in 2010? Hence the EU cannot be seen to give the UK any sort of preference in this negotiation, otherwise it opens up a Pandora’s box of potential difficulties for the bloc.

It’s clear to see then, that taking an elementary game theoretical stance on the matter a clear Nash equilibrium is the UK crashing out of the EU with no deal. While not the optimal solution, given what is at stake for both parties it seems the most likely outcome unless a viable alternative to the Irish backstop is found.

While this presents a rather melancholy view, it seems to me as if it’s pretty realistic. The market may have to price in much greater odds for a no-deal than 50% soon.

Santander delivers a shock

The additional tier 1 (AT1) market for bonds is a relatively new addition into the world of finance. They are a mix between debt and equity, essentially meaning that when a bank’s capital ratio falls below a certain level, the AT1 bonds are converted to equity, or shares in the bank. They were introduced by regulators during the 2008 financial crisis, where worries about both banks’ solvency and liquidity brought the global financial system to its knees [1]. So far, coverage on them has been limited, given that fortunately we have yet to see another major event of the same proportions as the financial crisis. However, last week we saw a relatively unusual event, that had not been seen since more than a decade ago.

The first thing to note is that these AT1 bonds have perpetual maturity; in essence, there is no “maturity date” for these bonds so a sum needs to be paid each year, in theory, in perpetuity, unless the bank pays the whole amount in advance. However, a convention is in place whereby investors in these bonds acknowledge that they will be repaid at the earliest possible date, usually around 5 years after the bond has been sold [2]. However, last week Santander opted to roll over an AT1 bond, which is highly unusual given what has been happening for the past 10 years [3]. The news spooked investors in Santander as they sent Santander’s share price falling lower on Wednesday morning. While the decision makes sense for Santander for purely economical reasons, it jeopardises the global AT1 market as investors no longer can claim almost absolute certainty that these bonds will be called on their redemption date. The bond in question’s value fell two percent rapidly following the news, falling to 96.75 cents on the euro.

Moreso, the news sparks fear in some investors that banks are hoarding capital for longer durations due to falling liquidity. In addition, given that the assets and liabilities of investment banks, being so complex and interconnected, are very difficult to value (let alone quickly in a financial crisis), it is very difficult to determine if a bank is solvent in the event of a financial crisis. Given that Santander is such a large and systemically important bank in the financial system, concerns surrounding it inevitably turn to concerns regarding the financial system as a whole. Since the market for complex financial instruments may only have a few financial institutions in it to begin with, many of the assets and liabilities of major banks are interconnected. Hence concerns understandably amplify, explaining the decline in Santander’s share price but also explaining broader investor uncertainty, especially since we are a decade off the financial crisis and a recession is expected in major economies in the next few years, with Italy already having fallen into one [4].

Overall, then, this case represents an example of why always going for the most purely economical option may not always be the best thing to do for a firm. In their actions Santander upset global investors and, significantly, the AT1 bond market, as yields rose on AT1 debt with falling investor confidence in banks’ ability to repay. While the financial system in at least developed countries is in theory much safer (with more stringent capital requirements), the ability of financial institutions to create complex and murky assets knows no bounds. Given this, valuation of these is inevitably going to prove difficult and so caution still needs to be taken with regards to how banks finance themselves. The AT1 debt instruments were a noticeable step forward in handling this but it also goes to show how quickly the market for these sorts of instruments can change, even in seemingly calm conditions.

In future, given that it seems Santander has no actual issue with paying off their debt the impact of this news will be muted. However, whatever reaction there has been will prove an additional disincentive for other banks to undergo similar kinds of action, for fear of not only unsettling their own investor base but also unsettling the market for AT1 (or CoCo) debt instruments. The news enhances Santander’s own reputation for ruthless frugality but they may indeed regret the move in future.

Bibliography

[1] Euromoney. (2018). AT1 capital/CoCo bonds: what you should know. [online] Available at: https://www.euromoney.com/article/b12kqjlwvsz26k/at1-capitalcoco-bonds-what-you-should-know [Accessed 15 Feb. 2019].

[2] Ft.com. (2019). Santander shocks market with bond decision | Financial Times. [online] Available at: https://www.ft.com/content/8539f7b4-2ad9-11e9-a5ab-ff8ef2b976c7 [Accessed 15 Feb. 2019].

[3] Bloomberg.com. (2019). Santander’s CoCo Bond Creates All Kinds of Trouble. [online] Available at: https://www.bloomberg.com/opinion/articles/2019-02-13/santander-s-coco-creates-all-kinds-of-trouble [Accessed 15 Feb. 2019].

[4] BBC News. (2019). Italy in recession amid sluggish eurozone. [online] Available at: https://www.bbc.co.uk/news/business-47068401 [Accessed 15 Feb. 2019].

This article, along with others from my peers, is on the LSE Business and Finance Guild website.

The EU needs to change. Here’s how

It’s the 1st of January, 2002. 12 European countries have officially began to use Euro notes and coins as legal tender. It was seen by some then as a sign, a sign of the peace and togetherness which being a member of the European Union engendered, and a sign of the success which the European Union was enjoying.

Oh, how wrong those people were.

Since the beginning of 2002, 7 more countries have joined the eurozone, Greece has gone back and forth from the depths of economic hell, and a refugee crisis has threatened the very fabric of what the EU stands for.

Oh, and there was that whole Brexit thing.

It’s not an exaggeration in any sense of the word to state that the past few years have been eventful for the EU. However, in truth, much of the blame for the EU’s tumultuous past lies squarely on the shoulders of the EU itself. From the sheer stupidity of the idea of uniform monetary policy for almost 20 countries to the EU’s resistance to compromise with member states on almost anything, it’s fair to say that the organisation has not done itself any favours recently. However, the Union’s death-knell has not come yet. It is possible that if the EU introduces key reforms in significant areas, they could snatch stability from the jaws of disintegration. However, these reforms need to be sweeping, and come sooner rather than later, starting with the abolishment of the eurozone entirely.

Essentially, what the eurozone is is a monetary union which currently comprises 19 of the 28 EU member states; intuitively, all of these countries therefore use the euro as their currency. The monetary policy of the eurozone countries is decided by a large organisation known as the European Central Bank (or ECB). You might already see what the problem with this is, which is that a one size fits all policy cannot possibly work with 19 different countries with completely different economic and financial circumstances to each other. Whilst globalisation has made these countries more interconnected than ever before, there still remain considerable differences; one wouldn’t liken the financial situation of Greece to that of Germany, for example. If one country’s central bank heads wanted to raise interest rates, they likely couldn’t get the ECB to; it has the interests of 18 other countries to think about as well. The result of this is lacklustre growth, accompanied by growing discontent within the eurozone directed towards the ECB, and each other for acting as barricades to collective success. Therefore, the EU is left with two possible choices: ditch the euro, and let each country’s central bank dictate monetary policy, or take control of the fiscal policy of each eurozone country themselves. Given the large political and diplomatic consequences which the latter would have, it would be wise, nay, essential for the euro to go, leaving each country to synergise their own fiscal and monetary policies, facilitating the increased growth and prosperity of these countries and therefore the EU as a whole.

Moreover, the arrogance of the EU in forcing austerity upon countries such as Greece to meet their budget deficit targets, when these countries are already in recession, is confusing at best and asinine at worst. Austerity during a period of recession simply dampens consumer confidence and spending even further, creating a negative cycle of economic contraction and reduced prosperity. Proponents of Keynesian thought here would say that what Greece and countries like it require would be large fiscal stimulus packages to help trigger a positive multiplier effect and bolster the economy through long run economic growth. Having not followed this route, Greek annual economic growth rates are still firmly negative, and showing no signs of changing anytime soon. Had Greece not gone down the road of austerity, it could have potentially trimmed its budget deficits during a period of growth, rather than shatter consumer confidence and therefore any prospect of economic growth in its short-term horizons. For the EU to not see this, even now, is hinging on delusional and suggests that they see their ideas as worth more than recent evidence; the last thing you want from a respectable political institution. This arrogance and blind faith in the powers of austerity needs to go, and soon.

Complementing this arrogance is a string of inefficient directives and rules that have misallocated funds and endangered key sectors of European economies. For example, the famous CAP (Common Agricultural Policy) regulates price levels of food, artificially inflating them and therefore resulting in an oversupply and wastage of food. Arguably, some EU legislation introduced such as this is counterproductive rather than constructive, and the EU member states would do better without it. Granted, almost all countries have that element of bureaucracy within themselves, but if the EU wants to go back to competing with the likes of America, China and India on the global stage, it needs to cut down on these regulations to ensure the most efficient allocation of resources possible within its borders. Compared to its euro and austerity problem, however, this is relatively minor, and should the EU change its policy stance drastically in the way outlined here, it could potentially live to see another day. If not? Well, let’s just say that the dream of EU economic prosperity could be just that, a dream, shunned from the gates of reality by its own stupidity and stubbornness.

The choice is theirs.

Could globalisation bring developing countries and their financial systems to their knees?

PHOTO CREDITS: Dieu-Donné GameliPhoto licensed under the Creative Commons Attribution-Share Alike 3.0 Unported license.

If one was to rank recent economic issues by the division and depth of debate they cause, globalisation would surely be up there at the top. Whilst the Republican presidential nominee Donald Trump, amongst others, has spearheaded efforts to thwart the rise of globalisation, liberals around the world argue that the increasing interconnectedness and interdependence of our world today can only be a good thing. However, the actual answer to the question of the impacts of globalisation is not so clear-cut; if any answer exists at all, it would lie firmly in the grey area. But what is globalisation? In essence, globalisation is the process by which economies around the world become more closely and deeply integrated with one another. In a way, it can be thought of as a border-killer, bringing countries that are physically thousands of miles apart firmly together,. Is this desirable, though? A point frequently made is that the effects of the 2008 financial crisis in developing markets were magnified to a great degree by the increased integration between the financial systems of different countries, and without this, the effects would have been far more localised to developed markets. Is this true? Perhaps, although it has to be said that those who use this point as a catch-all of sorts are perhaps not thinking broadly enough. In this article, we can begin by analysing the effect globalisation has on the financial system of developing economies in the context of regulation.

One way in which globalisation has impacted the global economy is an increase in the velocity of international capital flows. While this can entail an increase in money put in to financial markets in developing countries, what it can also do is facilitate an increase in capital flows out of these developing markets, resulting in an increase in uncertainty and volatility in their financial markets. A direct impact of this is that a shock in one country that, at first glance, wouldn’t affect the developing market too much, could result in irrational behaviour and herd mentality driving money out of developing capital markets in bucketloads. The control that these countries so desperately need over their own destiny, is as a result forfeited to a degree due to globalised economic activity; a small shock in the United States could result in large percentage swings in some African markets, for example. This drives away the certainty needed for a long-term sustainable financial system to develop; in this way, it could be argued that the increase in the velocity of cross-country cash flows could actually serve to the detriment of developing economies.

However, a positive impact of the aforementioned variability in foreign direct investment (FDI) is also that the pressure of foreign buyers acts as an economic incentive for the governments of developing countries to solidify their financial system in order to attract and keep foreign capital. The threat of financial contagion should a global shock take place would, in theory, incentivise key individuals within developing countries to make sure that their underlying fundamentals are solid enough to withstand a global depression without too much long-term damage. If key markets are solidified soon enough, a virtuous cycle of investment and further growth could potentially be triggered, blurring the lines between these developing countries and their developed counterparts. Whilst the element of uncertainty and doubt will still be present, if the country is foresighted enough to secure their future prospects, the risk from this should be offset by the potential influx of foreign direct investment that could occur. Even if it does not work out, the meritocratic aspect of this scenario is still something to be commended and looked upon as a positive; countries will gain foreign direct investment if they see it as a rational economic decision to strengthen their financial system.

With the increase in available capital for corporations operating within developing countries to use, it is also important for regulation to be put in place such that the prevalence of moral hazard with regards to the risk/reward ratios of banks reduces. In a developing country, with arguably less financial infrastructure present than a developed one, it is somewhat easier to sign legislation that ensures that banks cannot operate in an unreasonably risky manner. As shown by the political lobbying of banks in the UK, USA and elsewhere, once a massive financial system has been built up, it is extremely hard to get major financial institutions to change their ways. Hence, if government puts its foot down quickly enough, it is possible that the developing countries of today could potentially have less of a glasshouse of a financial system than even the developed countries of today possess. The question of this article initially was “Could globalisation bring developing countries to their knees?”, and the answer to that is a resounding yes. Replace the “could” with a “will”, and you have an answer which depends on a multitude of factors, including primarily the quality of the country’s governance. If government manages itself correctly, globalisation could bring about rapid economic development and the bolstering of financial systems across the developing world. If not? Well then, we’ve all got ample reason to worry.

 

Shinzo Abe’s “Abenomics” has failed. But why?

Who would have thought that it would be in the Land of the Rising Sun that three arrows could miss their target so wildly?

Of course, I’m talking about the Prime Minister of Japan, Shinzo Abe’s, three arrows of fiscal stimulus, monetary easing and structural reform that were intended to claw Japan out of a dangerous cycle of recession and deflation. At the time, it seemed like the perfect policy, with fiscal stimulus intended to increase demand for goods and services and monetary easing by the Bank of Japan intended to generate the 2% inflation that Japan has so longed for, increasing aggregate demand and therefore triggering a virtuous cycle of economic growth. In addition to this, the structural reform intended to increase the competitiveness of Japanese industry with regards to the world as a whole should have ideally bolstered and healed Japanese companies’ future prospects, after years of sluggishness. Yet as so often turns out, while Abe’s plans seemed to be worth their weight in gold on paper, they have failed to revitalise Japan and return it to the supreme economic status which it once had. Amongst a whole host of other indicators, Japan’s inflation rate fell to -0.4% in July 2016, lowering the proverbial coffin into the ground of another seemingly great set of economic policies. But why has it failed when it looked so good on paper? How has Abe fallen flat yet again? Could external factors be preventing the three arrows from working their magic?

Well, when you take into account Japan’s rapidly changing demographic, the answer to the latter question would be resoundingly in the affirmative. Since 2010, Japan’s population growth has been negative and birth rates have steadily declined while life expectancy continues to rise. On the health side of things, this is a massive breakthrough for the country, but economically, what it means is that Japan now is faced with the problem of a gradually dwindling labour force. Hence, although Abe is injecting billions upon billions of fiscal stimulus into the economy, the decline in labour force has resulted in a decrease in consumer demand in spite of his policies, due to less people having the money in their pockets to actually spend in the first place. In this regard, what Abe could further focus on is spearhead a further push for immigration to bolster aggregate demand and consumer spending, in turn boosting growth before the arduous and potentially unfruitful wait for Japanese societal norms regarding children to change (he has made great strides towards this with his Abenomics 2.0 programme). Perhaps in the case of Japan, this policy would be far more beneficial to her than any fiscal package that Abe could come up with; it would certainly at least be worth a try.

One side effect of recent Japanese economic policy (in particular the monetary policy of setting negative interest rates) has also been a devaluation of the Japanese yen, allowing Japanese firms to become complacent in the face of high profits. Due to the weak yen increasing Japanese firms’ revenues from abroad, the result is a lack of incentives for these firms to innovate and increase productivity. Due to this, the economy’s productive capacity has stagnated, hindering its potential for long run economic growth. Recent reports indicate that distinguished figures such as former chairman of the Federal Reserve, Ben Bernanke, declaring that “monetary policy is reaching its limits” in many developed countries. Due to this, it is feasible that the cut in interest rates to negative levels, while effective on paper, has not worked so well in reality because it disincentives innovation within Japan, and without innovation, it is extremely difficult for a capitalist framework to thrive and prosper. Therefore, perhaps an appreciation of the yen against the dollar would not be as disastrous as many pundits claim, and instead, may indeed provide a route by which Japanese firms can finally move forward.

Social attitudes in Japan currently are also not exactly conducive to economic progress. Due to many of the current Japanese young generation having known nothing but economic stagnation, deflation (or very low inflation), and failed government policy, these young people, traditionally some of the big spenders in a modern economy, have failed to provide the Japanese machine with a much needed boost. It has gotten so bad that one individual said to the Financial Times that she feels as if she is “more conservative than [her] grandmother.”, such is the backwards direction which Japan has gone in with regards to spending. The solution to this is much less science than it is alchemy, and the only way which Japan can really try and fix this problem is a bottom-up approach to incentivise spending amongst young people. In my opinion, this could be achieved by portraying spending on goods and services as some sort of natural duty, invoking patriotic sentiment and therefore triggering spending to lurch from its slumber. However, Japan’s problems are both deep and wide ranging, and will take years, or perhaps even decades of consistently successful government policy to solve. While Abenomics is well-intentioned, it simply has and will not work in practice, and perhaps what Abe and his fellow policymakers need to do is to think a little bit outside of the box.