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Howard Davies, the first chairman of the United Kingdom’s Financial Services Authority (1997-2003), is Chairman of the Royal Bank of Scotland. He was Director of the London School of Economics (2003-11) and served as Deputy Governor of the Bank of England and Director-General of the Confederation of… read more

OCT 19, 2015 13

The Trouble With Financial Bubbles

LONDON – Very soon after the magnitude of the 2008 financial crisis became clear, a lively debate began about whether central banks and regulators could – and should – have done more to head it off. The traditional view, notably shared by former US Federal Reserve Chairman Alan Greenspan, is that any attempt to prick financial bubbles in advance is doomed to failure. The most central banks can do is to clean up the mess.

Bubble-pricking may indeed choke off growth unnecessarily – and at high social cost. But there is a counter-argument. Economists at the Bank for International Settlements (BIS) have maintained that the costs of the crisis were so large, and the cleanup so long, that we should surely now look for ways to act pre-emptively when we again see a dangerous build-up of liquidity and credit.


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Hence the fierce (albeit arcane and polite) dispute between the two sides at the International Monetary Fund’s recent meeting in Lima, Peru. For the literary-minded, it was reminiscent of Jonathan Swift’s Gulliver’s Travels. Gulliver finds himself caught in a war between two tribes, one of which believes that a boiled egg should always be opened at the narrow end, while the other is fervent in its view that a spoon fits better into the bigger, rounded end.

It is fair to say that the debate has moved on a little since 2008. Most important, macroprudential regulation has been added to policymakers’ toolkit: simply put, it makes sense to vary banks’ capital requirements according to the financial cycle. When credit expansion is rapid, it may be appropriate to increase banks’ capital requirements as a hedge against the heightened risk of a subsequent contraction. This increase would be above what microprudential supervision – assessing the risks to individual institutions – might dictate. In this way, the new Basel rules allow for requiring banks to maintain a so-called countercyclical buffer of extra capital.

But if the idea of the countercyclical buffer is now generally accepted, what of the “nuclear option” to prick a bubble: Is it justifiable to increase interest rates in response to a credit boom, even though the inflation rate might still be below target? And should central banks be given a specific financial-stability objective, separate from an inflation target?

Jaime Caruana, the General Manager of the BIS, and a former Governor of the Bank of Spain, answers yes to both questions. In Lima, he argued that the so-called “separation principle,” whereby monetary and financial stability are addressed differently and tasked to separate agencies, no longer makes sense.

The two sets of policies are, of course, bound to interact; but Caruana argues that it is wrong to say that we know too little about financial instability to be able to act in a preemptive way. We know as much about bubbles as we do about inflation, Caruana argues, and central banks’ need to move interest rates for reasons other than the short-term control of consumer-price trends should be explicitly recognized.

At the Lima meeting, the traditionalist counterview came from Benoît Cœuré of the European Central Bank. A central bank, he argued, needs a very simple mandate that allows it to explain its actions clearly and be held accountable for them. So let central banks stick to the separation principle, “which makes our life simple. We do not want a complicated set of objectives.”

For Cœuré, trying to maintain financial stability is in the “too difficult” box. Even macroprudential regulation is of dubious value: supervisors should confine themselves to overseeing individual institutions, leaving macro-level policy to the grownups.

Nemat Shafik, a deputy governor of the Bank of England, tried to position herself between these opposing positions. She proposed relying on three lines of defense against financial instability.

Microprudential regulation, she argued, is the first line of defense: if all banks are lending prudently, the chances of collective excesses are lower. But the second line of defense is macroprudential manipulation of capital requirements, to be applied across the board or to selected market segments, such as mortgages. And, if all else fails to achieve financial stability, central banks could change interest rates. Because British law assigns capital regulation and interest-rate policy to two separate committees – with different members – within the Bank of England, the Shafik strategy would require some clever political and bureaucratic maneuvering.

Industrial quantities of research, analysis, and debate have been devoted to the causes of the 2008 crisis and its consequences; so it seems odd that senior central bankers are still so sharply divided on the central issue of financial stability. All those days spent in secret conclave in Basel, drinking through the BIS’s legendary wine cellar, have apparently led to no consensus.

My view is that Caruana had the best of the arguments in Lima, and Cœuré the worst. Sticking to a simple objective in the interests of a quiet life, even if you know it to be imperfect, is an inelegant posture at best. We need our central bankers to make complex decisions and to be able to balance potentially conflicting objectives. We accept that they will not always be right. However, it is surely incumbent on them to learn from the biggest financial meltdown of the last 80 years, rather than to press on, regardless, with policy approaches that so signally failed.


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Anatole Kaletsky

Anatole Kaletsky is Chief Economist and Co-Chairman of Gavekal Dragonomics. A former columnist at the Times of London, the International New York Times and the Financial Times, he is the author of Capitalism 4.0, The Birth of a New Economy, which anticipated many of the post-crisis transformations of the global economy. His 1985 book, Costs of Default, became an influential primer for Latin American and Asian governments negotiating debt defaults and restructurings with banks and the IMF.


Don’t Fear a Rising Dollar

LONDON – The US Federal Reserve is almost certain to start raising interest rates when the policy-setting Federal Open Markets Committee next meets, on December 16. How worried should businesses, investors, and policymakers around the world be about the end of near-zero interest rates and the start of the first monetary-tightening cycle since 2004-2008?

Janet Yellen, the Fed chair, has repeatedly said that the impending sequence of rate hikes will be much slower than previous monetary cycles, and predicts that it will end at a lower peak level. While central bankers cannot always be trusted when they make such promises, since their jobs often require them deliberately to mislead investors, there are good reasons to believe that the Fed’s commitment to “lower for longer” interest rates is sincere.

The Fed’s overriding objective is to lift inflation and ensure that it remains above 2%. To do this, Yellen will have to keep interest rates very low, even after inflation starts rising, just as her predecessor Paul Volcker had to keep interest rates in the 1980s very high, even after inflation started falling. This policy reversal follows logically from the inversion of central banks’ objectives, both in America and around the world, since the 2008 crisis.

In the 1980s, Volcker’s historic responsibility was to reduce inflation and prevent it from ever rising again to dangerously high levels. Today, Yellen’s historic responsibility is to increase inflation and prevent it from ever falling again to dangerously low levels.

Under these conditions, the direct economic effects of the Fed’s move should be minimal. It is hard to imagine many businesses, consumers, or homeowners changing their behavior because of a quarter-point change in short-term interest rates, especially if long-term rates hardly move. And even assuming that interest rates reach 1-1.5% by the end of 2016, they will still be very low by historic standards, both in absolute terms and relative to inflation.

The media and official publications from the International Monetary Fund and other institutions have raised dire warnings about the impact of the Fed’s first move on financial markets and other economies. Many Asian and Latin America countries, in particular, are considered vulnerable to a reversal of the capital inflows from which they benefited when US interest rates were at rock-bottom levels. But, as an empirical matter, these fears are hard to understand.

The imminent US rate hike is perhaps the most predictable, and predicted, event in economic history. Nobody will be caught unawares if the Fed acts next month, as many investors were in February 1994 and June 2004, the only previous occasions remotely comparable to the current one. And even in those cases, stock markets barely reacted to the Fed tightening, while bond-market volatility proved short-lived.

But what about currencies? The dollar is almost universally expected to appreciate when US interest rates start rising, especially because the EU and Japan will continue easing monetary conditions for many months, even years. This fear of a stronger dollar is the real reason for concern, bordering on panic, in many emerging economies and at the IMF. A significant strengthening of the dollar would indeed cause serious problems for emerging economies where businesses and governments have taken on large dollar-denominated debts and currency devaluation threatens to spin out of control.

Fortunately, the market consensus concerning the dollar’s inevitable rise as US interest rates increase is almost certainly wrong, for three reasons.

First, the divergence of monetary policies between the US and other major economies is already universally understood and expected. Thus, the interest-rate differential, like the US rate hike itself, should already be priced into currency values.

Moreover, monetary policy is not the only determinant of exchange rates. Trade deficits and surpluses also matter, as do stock-market and property valuations, the cyclical outlook for corporate profits, and positive or negative surprises for economic growth and inflation. On most of these grounds, the dollar has been the world’s most attractive currency since 2009; but as economic recovery spreads from the US to Japan and Europe, the tables are starting to turn.

Finally, the widely assumed correlation between monetary policy and currency values does not stand up to empirical examination. In some cases, currencies move in the same direction as monetary policy – for example, when the yen dropped in response to the Bank of Japan’s 2013 quantitative easing. But in other cases the opposite happens, for example when the euro and the pound both strengthened after their central banks began quantitative easing.

For the US, the evidence has been very mixed. Looking at the monetary tightening that began in February 1994 and June 2004, the dollar strengthened substantially in both cases before the first rate hike, but then weakened by around 8% (as gauged by the Fed’s dollar index) in the subsequent six months. Over the next 2-3 years, the dollar index remained consistently below its level on the day of the first rate hike. For currency traders, therefore, the last two cycles of Fed tightening turned out to be classic examples of “buy on the rumor; sell on the news.”

Of course, past performance is no guarantee of future results, and two cases do not constitute a statistically significant sample. Just because the dollar weakened twice during the last two periods of Fed tightening does not prove that the same thing will happen again.

But it does mean that a rise in the dollar is not automatic or inevitable if the Fed raises interest rates next month. The globally disruptive effects of US monetary tightening – a rapidly rising dollar, capital outflows from emerging markets, financial distress for international dollar borrowers, and chaotic currency devaluations in Asia and Latin America – may loom less large in next year’s economic outlook than in a rear-view glimpse of 2015.

© 1995-2015 Project Syndicate

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Photo of Richard Kozul-Wright

Richard Kozul-Wright

Richard Kozul-Wright, Director of the Division on Globalization and Development Strategies at the United Nations Conference on Trade and Development, is the author, most recently, of Transforming Economies: Making Industrial Policy Work for Growth, Jobs and Development.

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Daniel Poon

Daniel Poon is an Economic Affairs Officer at the United Nations Conference on Trade and Development.

MAY 20, 2015

Development Finance with Chinese Characteristics?

GENEVA – After a late flurry of additions to the founding membership of the Asian Infrastructure Investment Bank, attention now turns to setting the China-led AIIB’s rules and regulations. But important questions remain – most important, whether the AIIB is a potential rival or a welcome complement to existing multilateral financial institutions like the World Bank.

Since China and 20 mostly Asian countries signed the AIIB’s initial memorandum of understanding last October, 36 other countries – including Australia, Brazil, Egypt, Finland, France, Germany, Indonesia, Iran, Israel, Italy, Norway, Russia, Saudi Arabia, South Africa, South Korea, Sweden, Switzerland, Turkey, and the United Kingdom – have joined as founding members.

According to China’s finance ministry, the AIIB’s founding members are to complete negotiations on the Articles of Agreement before July, with operations to begin by the end of the year. China will serve as the standing chairman of the negotiators’ meetings, which will be co-chaired by the member country hosting the talks. The fourth chief negotiators’ meeting was completed in Beijing in late April, and the fifth will take place in Singapore in late May. The Chinese economist Jin Liqun has been selected to lead the AIIB’s Multilateral Interim Secretariat, charged with overseeing the bank’s establishment.

While GDP will be the basic criterion for share allocation among the founding members, the finance ministry suggested in October that China does not necessarily need the 50% stake that its GDP would imply. Moreover, although the AIIB will be based in Beijing, the ministry has said that regional offices and senior management appointments will be subject to further consultation and negotiation.

Like the $50 billion New Development Bank announced by the BRICS countries (Brazil, Russia, India, China, and South Africa) last summer, the AIIB has faced considerable scrutiny, with some Western leaders questioning its governance, transparency, and motives. Indeed, many in the West have portrayed their establishment as part of an effort to displace existing multilateral lenders.

But the new development banks seem less interested in supplanting current institutions than in improving upon them – an objective shared by those institutions themselves. As Deputy Finance Minister Shi Yaobin pointed out recently, by recognizing the need to reform their governance, existing multilateral lenders have shown that there are, in fact, no “best practices” – only “better practices.” There is no reason improvements cannot originate elsewhere.

In fact, given its experimental approach to development, China is well-suited – and, as some top officials have hinted, more than willing – to contribute to this process. If China can help find a way to balance the need for high standards and safeguards in project lending with the imperative of rapid loan dispersion, global economic governance would benefit significantly.

In pioneering a more pragmatic approach to development finance, China’s institutional model could be the $40 billion Silk Road Fund that President Xi Jinping announced last November. The SRF and the AIIB will serve as the key financial instruments of China’s “One Belt, One Road” strategy, centered on the creation of two modern-day Silk Roads – the (overland) “Silk Road Economic Belt” and the “Twenty-First Century Maritime Silk Road” – stretching across Asia toward Europe. The initiative will aim to promote economic cooperation and integration in the Asia-Pacific region, mainly by providing financing for infrastructure like roads, railways, airports, seaports, and power plants.

Yet the SRF has received scant attention from Western media. This is unfortunate, because what little is known about it suggests that it could play an important role in transforming development finance.

According to Chinese media, the SRF will be capitalized by four state agencies. The State Administration of Foreign Exchange will hold a 65% stake; the China Investment Corporation (CIC, the country’s sovereign-wealth fund) and the China Export-Import Bank (China Exim) will each have a 15% stake; and the China Development Bank (CDB) will hold the remaining 5%. The Fund was officially registered in December 2014, and held its first Board of Directors meeting the following month.

In a sense, the SRF can be considered China’s latest sovereign-wealth-fund initiative, and some media have even referred to it as the “second CIC.” But, whereas the CIC is under the managerial control of the finance ministry, the SRF’s operations appear to reflect the influence of the People’s Bank of China.

In a recent interview, the PBOC’s governor, Zhou Xiaochuan, suggested that the SRF would concentrate more on “cooperation projects,” particularly direct equity investment, before hinting at the Fund’s “just right” financing features. For example, Zhou indicated that the SRF will adopt at least a 15-year time horizon for investments, rather than the 7-10-year horizon adopted by many private equity firms, to account for the slower return on infrastructure investment in developing countries.

Moreover, the SRF could act as a catalyst for other state financial institutions to contribute to a selected project’s equity and debt financing. The Fund and other private and public investors – would first make joint equity investments in the project. China Exim and the CDB could subsequently disburse loans for debt financing, with the CIC providing further equity financing. When the AIIB is up and running, it, too, could support this process, by arranging debt financing alongside SRF’s initial equity investment.

Of course, there is still much to digest in these new financing initiatives. But one can see the emerging contours of a South-South development-finance landscape – one with the potential to transform multilateral lending more broadly.

© 1995-2015 Project Syndicate

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