A debate between Christopher Balding and Daniela Gabor, moderated by Jo Michell

Thursday November 2nd 2017, 4-5.30 pm                                                                                    Faculty of Business and Law building Room 2X242                                                                      UWE Bristol, Frenchay Campus

Since the global financial crisis, shadow banking in China has grown rapidly as a result of financial repression, macro policy, and the politics of local-central government relationships. Is this the financial Wild West, the escape valve of a financial system repressed by the long hand of the state or a carefully engineered process to bring market forces into the financial system? How successful are China’s policies to transform shadow banking into securities-market based finance? Have they really addressed concerns about implicit state guarantees? And how do reforms fit with the need for deep and liquid securities markets if Reminibi internationalisation is to succeed?

Christopher Balding is an Associate Professor in Business and Economics at the HSBC Business School of Peking University Graduate School in Shenzhen, China. One of the leading experts on the Chinese economy and financial markets, he is a Bloomberg View contributor and advises governments, central banks, and investors around the world. He has contributed to Bloomberg, the Wall Street Journal, the Financial Times, BBC, CNBC, and Al-Jazeera. He tweets at @BaldingsWorld

Daniela Gabor is Professor of Economics and Macrofinance at UWE Bristol. Her research project ‘Managing shadow money’, funded by the Institute for New Economic Thinking since 2015, explores shadow banking in the US, Europe and China. One of the project papers, ‘Goodbye (Chinese) shadow banking, hello market-based finance’, will be published in Development and Change in December 2017. She is finalising a book manuscript on Shadow Money. She blogs at criticalfinance.org and tweets at @DanielaGabor

Jo Michell is Associate Professor in Economics at UWE Bristol. He has a PhD in Economics on from SOAS University of London, written about the Chinese banking and financial system. His research interests include macroeconomics, money and banking, and income distribution. He has published on macroeconomics and finance in peer reviewed journals including the Cambridge Journal of Economics and Metroeconomica. He co-edited the Handbook of Critical Issues in Finance with Jan Toporowski (Elgar, 2012).

For further inquiries, please email daniela.gabor@uwe.ac.uk

On May 23, 2016, 83 scholars from Europe wrote to the European Parliament to call for a careful consideration of the European Commission’s proposals for a new market for STS securitisations, part of the Capital Markets Union agenda. Members of the ECON Committee of the European Parliament are currently working on this proposal. Read the full letter here  – Open letter to MEPs – STS securitisation.

One more cue to how controversial government debt markets are in Euroland these days.

The European Commission’s progress report on Capital Markets Union, manages to make no reference whatsoever to the issue of government bond markets, their life after the ECB’s QE (bound to end someday) and their critical role in capital markets integration. It’s all about securitisation, corporate bond market liquidity and covered bonds.

Compare this with early views on what it takes to create a market-based financial system in Euroland. In May 1999, Alexandre Lamfalussy, recently appointed head of EuroMTS  and former head of the European Monetary Institute (that would become the ECB), had this to say:

 “We’ve seen an accelerated move to a market-centric system from the bank-centric system that has tended to prevail in Europe,” Lamfalussy said in London last month. “I have no doubt that a market-centric system is more efficient, but there’s a question whether it is stable.” The key to stability, he concludes – for the pricing of corporate as well as public debt – is a liquid and transparent government debt market.’

This is a story of shadow money – the ongoing struggle to define a social contract for liabilities issued against sovereign collateral.

No, this is not a blog about the impossible triangle IMF-Commission-Greece. I am skeptical anything new can be said about it.

It’s about something perhaps more fundamental: the IMF’s willingness to confront its inglorious past on the free movement of capital.

A couple of months ago, in February 2016, the Fund released a working paper by Atish Ghosh and Mahvash Qureshi, of the Research Department. That paper traces the historical processes through which capital controls became anathema to policy communities around the world, including the IMF. It doesn’t hide behind pretty memes (capital flow management) and technical language: visceral opposition to capital controls,  it argues, arose from the free market ideology of the 1980s and 1990s! It’s the politics.

The IMF Research Department, that paper shows, doesn’t need to hide behind closed doors to read Keynes, Eric Helleiner or Kevin Gallagher* . It can now do it in the open.

Skeptics of IMF’s revolutionary transformations (and I am one, as I argued here for IMF’s view of capital controls and here for global banking), would point to the institutional pathologies of the IMF. The Research Department has far greater liberty to engage in/with heterodox  alternatives, but that doesn’t always translate into profound institutional change.

What is different here: Lagarde has just nominated Atish Ghosh, together with the Princeton historian Harold James, to ‘chronicle defining moments in the Fund’s history’.

Professor James and Mr. Ghosh will write the Fund’s official history from 2000 to 2015, a period characterized by the global financial crisis, the crisis in Europe, and the growing role of emerging and developing countries in the world economy — all defining moments in the Fund’s history

This history  will include the pre-2008 near fall in oblivion (‘assisted’ by Venezuela’s oil money helping large countries pay back the IMF), the Eastern European and then Greek/Irish/Portuguese adventures, Blanchard’s reign with shifts on capital controls, on DSGE ‘supremacy’, on fiscal multipliers, on ‘we need to build analytical capacity for understanding global finance’. Cant wait to read it.

Daniela Gabor

*odd that the paper does not reference Helene Rey’s dilemma, but small miracles…

This article is taken from EREP’s 2016 budget report.

At the end of February, Chancellor George Osborne made an admission: ‘the economy is smaller than we thought in Britain’. The tone has changed since November when, following the unexpected discovery of a spare £27bn by the OBR, the Chancellor triumphantly declared, ‘our long term economic plan is working.’ As it turns out, the UK economy is around one per cent, or £18bn, smaller than the OBR predicted, leaving the Chancellor with at least £5bn in missing tax revenues this year alone, and more in future years (estimated at £9bn per year by the Institute for Fiscal Studies). There is no chance he will keep to his own misguided fiscal rule.

EREP have consistently argued that the supply-side optimism implicit in the OBR forecasts was unwarranted. We were right. Economic indicators across the board have deteriorated significantly since the November forecast. Even the service sector, the single remaining engine of the UK’s imbalanced economy, is now showing signs of mechanical failure. The Markit UK services PMI – a key indicator of activity in the services sector – fell sharply in February. There is no chance that UK growth will be 2.4% in 2016, as claimed by the Chancellor in November.

Osborne’s tax shortfall is the result of much lower than predicted wages and prices. The broadest measure of inflation, the GDP deflator, has fallen to zero, while wage growth has slowed substantially to around two per cent – the OBR had predicted wage growth of three to four per cent over the rest of this parliament.

Despite weakening wage growth, retail sales have remained strong: the most recent figures showed year-on-year spending increases in excess of two per cent. Retail sales strength has driven in part by lower prices resulting from the sharp decline in oil prices. But while households in other major economies largely saved the windfall from lower oil prices, those in the UK spent it, and more. The UK household savings ratio, at 4.4% of disposable income, is now the lowest on record.

And despite weakening wage growth, the UK economy is now entirely reliant on continued household consumption spending. Contrary to Osborne’s claim that growth ‘is more balanced than in the past’, the UK trade deficit is a drag on economic activity and business investment –  which only recently regained pre-crisis levels – fell sharply in February.

How have UK households increased spending despite wages remaining well below pre-crisis levels? Unsecured consumer credit is growing at around nine per cent per annum – the fastest rate since 2005. At over 140% of disposable income, UK household debt is higher than in the US, Japan or the largest European nations. Even the optimistic and now-discredited OBR forecasts predicted the household debt-to-income ratio would need to rise to 160% by 2020 for growth to be maintained and the deficit eliminated.

A recent report by the Money Advice Service – an independent body set up by the government – reports that 8.2 million adults in the UK – one in six of the population – are over-indebted. Among poorer regions, such as the Welsh valleys, the figure rises to one in four. The problem is particularly acute among young people, those in rented accommodation and those with children.

It is exactly these groups – working families and young people – whom the Chancellor will target in the next round of austerity. In the previous Parliament, austerity was targeted at the most marginalised: the sick, the disabled and the unemployed. Since these people have least voice in society, they are unable to put up resistance. Cutting the incomes of working families will be more difficult, as Osborne’s U-turn on tax credits shows.

By reducing working peoples’ incomes, Osborne is attempting push the burden of debt onto the household sector. The strategy will fail – without wage growth, consumer spending will eventually be constrained, dampening growth and pushing Osborne’s deficit-reduction strategy yet further off track. That deficit reduction is not really the ultimate aim of Osborne’s strategy is made plain by his intention to continue cutting tax for those on higher incomes.

There is no long-term economic plan; Osborne’s strategy is one of redistribution by taking from those who least can afford it. As the latest figures show, his strategy has backfired.

The report’s authors include:

Ann Pettifor & Jeremy Smith on “The British economy is even “smaller” than the Chancellor asserts”

John Weeks on the Chancellor’s “Growing record in fiscal mismanagement”

Jo Michell on “A weakening economy, reliant on consumption and debt”

Graham Gudgin & Ken Coutts on “A history of missing fiscal targets”

Richard Murphy on “Tax in the 2016 budget”

Information on EREP is available here.

Peter Praet, member of the Executive Board of the ECB, gave an interesting speech on the ECB’s lender of last resort (LOLR) activities in crisis on February 10, 2016.

The ECB, he argued, had a two-folded approach: a ‘monetary approach’ LOLR and a ‘credit approach’ LOLR.

The ‘monetary’ LOLR, following the classic advice from Walter Bagehot, lent European banks base money (reserves) if these banks had acceptable collateral. The purpose:

to create new reserves, on demand, for cash-stripped banks with viable business models, and thus to help these banks go through an emergency liability substitution operation without being forced to make large- scale fire sales of assets that would lead to insolvency

This approach, he suggests, was used in the first phase of the crisis, immediately after Lehman, when banks became reluctant to lend to each other, and in the second phase, the European sovereign debt crisis. In his account, the ECB bears no responsibility for either, the crisis being rather a combination of the confidence fairy and the sovereign-bank loop, somehow only ‘diabolical’ in Europe:

The second phase of the crisis came as a consequence of a much more targeted and disruptive loss of confidence: the sovereign debt crisis. This was special to Europe; it brought on the development of redenomination risk and thereby threatened the integrity of our currency. Banks’ exposures to selected governments came under intense market scrutiny and entire national banking systems lost access to wholesale funding.

The ‘credit’ approach involved the provision of emergency liquidity assistance – the now famous ELA. In contrast to the ‘monetary’ LOLR, this involves a more discretionary approach, whereby national central banks assume the responsibility, and the potential costs, for supporting banks without eligible collateral.

Imagine that Praet decides to read his own research before writing this speech. He chooses a 2008 paper he wrote with Valerie Herzberg, entitled ‘Market liquidity and banking liquidity’, while both were at Bank of Belgium. Here is a copy-paste of their arguments:

1. Interbank funding is itself becoming increasingly dependent on market liquidity as a growing proportion of interbank transactions is carried out through repurchase agreements.
2. This increasing reliance on secured operations means that (European) banks are mobilising a growing fraction of their securities portfolio as collateral.
3. Banks are increasingly mobilising their traditional government and corporate bond portfolios to finance less liquid, but higher yielding forms of assets that again can be reused as collateral.
4. In periods of stress, margin and collateral requirements may increase if counterparties have retained the right to increase haircuts or if margins have fallen below certain thresholds.
5. Asset liquidity may no longer depend on the characteristics of the asset itself, but rather on whether vulnerable counterparts have substantial positions that need liquidating.

This, we argue with Cornel Ban in our paper ‘Banking on bonds’, is the untold story of the European sovereign debt crisis. Not a story of a confidence fairies and redenominations risks, but of rapidly growing European repo markets before the crisis (1 above), of European banks mobilizing their portfolios of European government debt as collateral (2 and 3), of runs on collateral markets, including the government bond markets of the European periphery (4), that reflected more the funding pressures of large banks involved in US shadow banking than the fiscal probity of sovereigns (5). The European sovereign debt crisis was a story of fragile collateral in market-based banking, rather than the convenient eruption of redenomination risk.

More importantly, we argue, the ECB increased stress in collateral markets exactly as Praet predicted in point 4: in its lender of last resort operations, the ECB increased margin and collateral requirements, made margin calls, and in general worsened funding conditions at critical junctures in the crisis, both for European banks and European sovereigns.

Thus, we show that the ECB has played a critical role in trying to energize the integration of national repo markets in the Eurozone in the early 2000s. It decided to treat all Eurozone governments as equal collateral for its collateral framework – the terms on which it lends, via repo operations, against collateral. With this, it hoped private repo markets would follow suit, and accelerate integration of European financial markets. Anticipating objections that this effectively encouraged fiscal indiscipline in Europe (objections so loudly formulated by 2005 by Willem Buiter that Trichet was forced to defend the ECB’s collateral decisions in the European Parliament), the ECB adopted the risk practices of repo market participants: daily mark-to-market, margin calls and haircuts.

In doing so, the ECB could argue that its collateral policies had no substantive impact on government bond markets for two reasons. First, banks had little incentive to use government bonds to borrow from the central bank, since its repos carried higher haircuts than private repo transactions (where haircuts were zero for government debt) and ECB-held collateral could not be re-used in the repo market. Second, the ECB stressed that its collateral policie accommodated market views of credit quality. If markets distrusted Germany, its bonds would fall in market value. Like any repo market participant, the ECB would mark German collateral to market and make margin calls. Rather than disrupt, the ECB argued that its collateral policies reinforced private market discipline.

By trying to strike a delicate balance between its financial integration priorities and its independence, the ECB made a radical departure from how central banks in EMU countries had previously managed lending operations, including lender of last resort. These central banks rarely marked to market and never made margin calls when lending to banks (except the Dutch central bank), and few used initial haircuts.

By 2012, the ECB recognized that market collateral practices matter, but refused to include its own practices in that analysis. Vitor Constâncio noted that ‘the decline in collateral values translates in additional collateral calls possibly compounded with higher haircuts and margins requirements. A system in which financial institutions rely substantially on secured lending tends to be more pro-cyclical than otherwise’. He could have added: ‘ a system in which the central bank relies substantially on secured lending tends to be more pro-cyclical than otherwise’. The graph below is illustrative – it shows that the ECB was making increasingly large margin calls throughout 2012, and those calls only diminished once it announced OMT.

Short memory vs. politics and accountability? Had Praet followed through with his 2008 analysis, he would have had to make the ECB an active actor in the crisis. The dominant narrative that he reproduces in his 2016 speech –  that it miraculously came to the rescue of inept governments in the periphery – does not hold under scrutiny of his 2008 predictions. The European public – including governments – would have good reason to hold ECB accountable for its disruptive role in the European crisis.

With impecable timing, we are organising a one day conference on China in Copenhagen, on January 26. The blurb below, program and registration here.

Since the global financial crisis, it is becoming increasingly apparent that China matters for the stability and growth of the world economy. Yet questions of how, why and to what extent have not been settled. Pessimists predict a hard landing that will spread deflationary pressures across the world, while optimists retain their faith in the ability of China to learn from its experiments and keep the engine running. In this conference, we engage regulators, academics and market participants in a conversation that explores critical questions of macroeconomic rebalancing, debt and currency management, RMB internationalization, monetary policy and capital account liberalization.

Streetwise Professor warns that clearing and collateral mandates create a ‘sort of liquidity death star’ because collateral-based funding (through repo markets) creates systemic liqudity vulnerabilities: margining leads to spikes in demand for liquidity, that in turn forces sales in illiquid markets, with further price volatility and margining. The mechanics of fire-sales and liquidity illusions are well known to regulators since Lehman (read Tarullo here), though the solution – clearing houses – doesn’t do away with the problem since it increase reliance on collateral sourced through repo markets.

Two further points.

1. Central banks cannot fight the liquidity death star until they get off it. For a central bank to fight the liquidity death star, the Professor argues, it will need to ease collateral constraints by expanding the definition of ‘good’ collateral. This, of course, was the first measure that central banks across the world took after Lehman. But accepting ‘bad’ collateral won’t solve liquidity problems as long as central banks’ extraordinary lending relies on the same collateral practices that created (funding and market) liquidity problems in the first place.

Since the late 1980s, central banks have increasingly used repos to implement monetary policy, lending against collateral    instead of outright purchases of government bonds (the traditional form of open market operations). The turn to repos in monetary policy implementation prompted central banks to adopt the collateral risk management practices used by repo markets – the graph below shows that as the ECB took over from national central banks, it marked the beginning of a new regime for lender of last resort, where ECB marks collateral to market, and calls margin on a daily basis*.

Consider this scenario. When liquidity demand spikes and collateral constraints tighten, financial institutions turn to central banks. As good lenders of last resort seeing the death star approaching, central banks lend against ‘bad’ collateral.  But at the same time,  to protect themselves against credit risk, central banks mark-to-market and call margin if that ‘bad’ collateral falls in market price. Central bank margining means that a financial institution borrowing from the central bank against bad collateral faces the same funding pressures that it would experience in private funding markets.  This is exactly what happened to European banks during the sovereign debt crisis – with ECB making large margin calls at the height of the crisis in 2012.  The traditional crisis intervention – providing banks with funding liquidity – becomes pro-cyclical.

The money view – developed by Perry Mehrling and others – provides important insights. A crisis of market-based finance needs central banks to be much more than lender of last resort. As  dealers, or market-makers of last resort, central banks need to support the monetary quality of collateral-based liabilities, that is, to support (collateral) market liquidity. This is what OMTs did in Europe. A much messier world of central banking, as Mario Draghi well knows.

2. The repo ‘paradox’ – the growing post crisis collateral-based regulatory regime has not been matched by significant regulation of repo markets. At global level, the FSB has watered down plans to impose minimum (through the cycle) haircuts on all collateral – including government bonds. Latest plans leave out repos between banks and repos with government collateral. There is little left after that. In Europe, the Commission and Parliament have finally agreed on transparency requirements for repo markets, without any structural regulations. With the Capital Markets Union plans in full swing, transparency is as far as Europe will go.

Daniela Gabor

*for more on the ECB and the European repo market, read Gabor, D. and C. Ban (2015) Banking on bonds, Journal of Common Market Studies

Today, I attended a CMU event organised by Bruegel and HM Treasury at Westminster. The keynote address from the City Minister Harriet Baldwin was followed by a panel with market participants (the buy side – asset managers and insurers – and a credit rating agency), a Commission official and a Treasury official. The view from the government: UK a staunch supporter, celebrating the CMU as an excellent initiative of the type that Brussels and the EU should be generating more often. Having a UK Commissioner in charge of CMU clearly helps. Beyond the consensus ‘CMU is a good idea’ and between the lines, I noticed three issues.

1. ‘It is our strong belief that institutional change is not required to achieve the objectives of the CMU. Single supervision would not add anything’

This is one of the sensitive points in CMU, and a lot of energy spent in documents and meetings to pretends that’s not the case. Although the Commission and several member states (see the 5 presidents report) would prefer to create a supranational regulator for integrated capital markets, UK opposes it strongly. According to this view, ESMA – the candidate for a pan-European regulator – is best placed to ensure that national regulators implement supervision effectively. In the context of the Brexit referendum, ‘the last thing we need is institutional change’ captures well the British politics of the CMU.

Is there a danger that European states repeat the pre-crisis mistakes with cross-border banking? The banking crisis demonstrated that the prevailing regulatory nationalism  was ill suited to deal with the coordination issues between home and host regulators. Ask any Eastern European banking supervisor.

The pessimistic British response to this question points to the foot dragging on the institutional architecture of the Banking Union. The hesitations and compromises there are steadily eroding (market) confidence in the ability of European politicians to create strong pan-European regulatory bodies. The optimistic view is that supervisory convergence that harmonizes rules would be enough to put the CMU on strong foundations.

One of the panelists questioned the premise of the optimistic view that for a single market it is enough to have common rules (and I would add, a rather fuzzy notion of ‘convergence’). In accounting, the application of rules (international standards) is not uniform – the fragmented enforcement of rules effectively entrenches the type of cross-border barriers that CMU aims to remove. The Commission recognises the validity of this point but is prepared to put the question aside because it wishes to avoid politically divisive topics.

So instead of calibrating the regulatory architecture to integrated markets, CMU envisages as next step a comprehensive review of post-crisis regulation. Given the complaints from the industry on the post Lehman ‘regulatory tsunami’ (loud and clear at this event too), expect this ‘proportionate regulation’ agenda to accelerate the process of watering down regulation that is already unfolding.

Recall this argument when your UK pension fund with exposure to German SME securitisation takes a massive hit due to large defaults in a market illiquid during crisis. And pray that ECB has normalised ABS purchases.

2. ‘CMU will not harmonize borrowing costs for SMEs until there is a mechanism for rebalancing sovereign risks in Europe’

Market participants typically focus their CMU interventions either on deploring ‘regulatory tsunamis’ or identifying CMU areas that would improve synergies of their business model. In an unusual departure from the script, one panelist sought to make constructive criticisms. And it picked the elephant in the CMU room: government bond markets.

It is surely a measure of the creative genius of European regulatory politics that a project on furthering the integration of debt markets manages to say nothing about the largest debt markets in Europe (in Eurozone, EUR 6.8 trillion out of EUR 14 trillion outstanding in August 2015). Before Lehman and the sovereign debt crisis, the European agendas for financial integration used to stress the critical role that government bond markets play in financial markets, as proxy for risk-free interest rates, benchmark and hedging instrument for positions in other fixed income markets, and reserve ‘safe’ asset. The ECB made the integration of sovereign bond markets a priority, and used its lending collateral framework to accelerate it (by treating all Euro sovereigns as identical in terms of credit risk). The 2002 Collateral Directive was designed with the same ambition in mind – to allow private financial institutions to raise funding cross-border regardless of what sovereign collateral they use.

So can we have integrated capital markets with fragmented government bond markets? One of the panelists argued that  securitisation performance across countries reflects credit differences between sovereigns (the graph below, in a rather bad photo, mea culpa). So much for reviving the European securitisation market.

Yet the CMU authorities have tended to fudge this question because answers are as politically divisive as the issue of supranational regulator. If CMU was to make government bond markets a priority, what would concrete policy measures look like? Put differently, if CMU is about persuading German savers to give money to Portugese corporations without a bank in between*, what would it take to persuade that German saver to give money to the Portugese government? Or even more complicated, how much would a Portuguese SME need to pay a German saver to borrow when that saver is reluctant to lend to the Portuguese government?

Here the CMU official supporters answer the usual European way – not a priority to think about it.

3. ‘ As public policy makers we have to deal with competing objectives, and balance them carefully. The FTT / CMU is a good example’

Private finance agreed that the FTT plans are at odds with CMU. Putting the FTT genie back in the bottle has been a priority, particularly for the European banking lobby**.

Yet the FTT genie has proven more resilient than many expected. Recent statements suggest a new impetus to finish negotiations, as France independently decided to extend its own FTT to intraday trades. This raises interesting questions of coordination between DG FISMA, that is designing CMU, and DG Taxud, that designed and (still) defends the FTT in the working groups of the 11 member states. The best that the former can do is to follow negotiations closely and ensure that member states are aware that the tax should minimize impact on market liquidity and NEVER EVER include the repo market.

The repo market has always enjoyed a privileged position in the minds of European regulators – particularly the ECB***. The Green Paper on CMU made some oblique references to it, stressing the importance of collateral fluidity to ensure that securitization activities can be funded in cross-border repo markets. ‘Fluid’ collateral appeals to the pre-crisis image of the repo market as an engine for financial integration that led European regulators to endorse the creation of a market architecture governed entirely by private rules. Since the crisis, we know that private architectures creates systemic vulnerabilities – this is why the FSB has identified repo markets as markets systemic to shadow banking. Yet so far the only reform European regulators are prepared to contemplate has been increased transparency of repo transactions, despite warnings from the ECB that ‘The interaction between CMU and shadow banking reform needs to be addressed. This interaction is not addressed in the Commission’s Green Paper, but it is relevant.’

The priority remains funding for SMEs. Repo, shadow banking, government bonds, and supranational regulation, are not a priority of CMU. The art of political compromise in Europe rests precisely on that ability to postpone critical questions. If we try very hard to ignore these questions they may go away.

* best translation I’ve heard of the CMU ambitions.

** the EBF response to the CMU Action Plan stresses that ‘ If European lawmakers are indeed serious about CMU, they also need to recognise the importance of liquidity in financial markets. Proposals such as the Financial Transaction Tax (FTT) and Bank Structural Reform (BSR) are at odds with the objectives of CMU. Dropping these proposals will greatly enhance the chances of success for CMU’.

*** for those interested in the FTT on repo markets, you can read more here: A step too far? The European FTT on shadow banking. Journal of European Public Policy 

Daniela Gabor