The G30 has flinched from tackling the big obstacles standing in the way of long-term finance
Watching governments, central bankers and economists explore the remaining ruins of the old pre-2007 economic structure is like watching children playing a game of blind man’s bluff. Being blindfolded, they cannot see what is around them, and are compelled to rely on their other senses. Much amusement is to be had for the onlookers, as they watch players bump into one obstacle after another.
Casting around for a foothold in the new landscape, the G30 study group has been exploring the devastated territory of long-term funding for infrastructure and other long-term capital intensive projects. The stream of funding seems to have dried up, while they are informed that there will be a growing demand for long-term finance in the years ahead. Their spies, called McKinseys, tell them that demand for long term investment in nine major economies is likely to rise from $12 trillion to nearly $19 trillion a year by 2020. Yet the global economic and financial tsunami has crippled the supply of such finance. Fiscal consolidation, de-leveraging by banks and new financial regulations will continue to inhibit the growth of many channels of finance – especially bank lending. Privately many senior bankers believe that the flow of banking scandals may well continue (e.g. investigations into LIBOR criminality may implicate others) , prompting further possibly drastic political action against the banks.
This points in the direction outlined in The Money Trap, where I argue that the global systemic banks are heading for the break-up yard – or would be, if they were not supported by taxpayers/central banks. They remind me of the great painting by JMW Turner (to be distinguished from Adair Turner!) of “The Fighting Temeraire being Towed to her last Birth” – ignominiously, by a little tug boat. But the tug boat is powered by steam, the old fighting ship by sail – it is goodbye to an era. So it will prove with the dinosaurs of today’s financial system once state subsidies are withdrawn.
A useful checklist?
But not yet. The G30 report says governments should institute major reforms and encourage the growth of new instruments to support long-term capital especially cross-border flows, which have collapsed. Fine. But they would retain old-fashioned banks, the “Fighting Temeraires” of the financial system, in service, despite their huge social cost. It points out that there is an abundance of liquid savings “still on the sidelines” and hence new bridges are needed to re-connect suppliers and users of such finance. This is the right direction and could have been taken much further. Introducing the report at a press conference in London, Jean-Claude Trichet, chairman of the G30, said we needed “major changes to the global financial system” . He is 100% right. This is precisely the major theme of The Money Trap. What do they have in mind?
They present a useful list – please see the report. Adair Turner said that the Financial Stability Board should look critically at the impact of new regulations on the supply of long-term finance and consider favourable accounting treatment for assets held with long-term purposes in view. There was an urgent need to promote long-term investment horizons of public pension funds and sovereign wealth funds (SWFs). This is very much in line with what Paul Woolley and others have been saying. At present pension funds have rules favouring investments in what are perceived to be “low risk” fixed income securities, while allocation to equities has fallen. Most SWFs sit on huge cash piles. Central bank reserves are sometimes deemed to be far in excess of what is required (a swipe at China and some Middle East countries). Bank loans, the main source of finance outside the US , have no chance of supplying the funds needed – and as mainly short term lenders are not suitable vehicles to do so anyway. Cross-border flows, driven by short-term capital movements, are running at only 60% of the pre-2007 level. The report makes many sensible practical suggestions – though it is far too soft on the dysfunctional US banking system – and does not flinch from tackling some politically sensitive issues, such as the preferential tax treatment for debt over equity, notably the tax deductibility of interest. This clearly contributed to the build-up of leverage before 2007.
Yet the G30 has fought shy of discussing many key issues that a report on this topic surely should address. One is the point I discuss in my article “What George Osborne should have said” – the need to phase out public support for financial institutions.
Another is the utter unsuitability of bank finance for long-term projects – and the policy implications that to be drawn from that conclusion. It is official policy in many countries to encourage banks to lend to businesses, especially small and medium sized enterprises. The G30 report laments that the average maturity of bank loans is 4.2 years in developed countries and 2.8 years in emerging markets. But this is too long not too short! Lord Turner agreed that maturity transformation had been taken to excessive levels pre-2007. Yet he almost choked when asked whether that meant the G30 was in effect giving up on maturity transformation. No,not at all, he said hastily. Yet levels of maturity transformation as still exist are completely unsuitable for institutions with predominantly liquid liabilities, such as bank deposits. Traditionally, in the UK, clearing bank advances were repayable on demand – and that is the correct position. We saw the results of relying on regulation supposed to make banks able to carry excessive maturity transformation in the past five years. The blindfold men are missing the big picture.
We need a wholesale and radical transformation of the financial system to base it on equity and not debt contracts. The G30 horse runs bravely towards that fence but won’t jump.
Nor do they tackle the big problems in the global financial system inhibiting proper flows of finance – unstable macro-economic and monetary conditions. The key fact is that in an unstable monetary environment investors believe that the risk of investing in equities is far too high. To maintain interest rates at ultra-low levels for a prolonged period will do nothing to stimulate appetite for equities. Investors can see that these rates merely maintain the results of past investment excesses in existence – zombie companies and bad investments that were made during a previous period of excess. They naturally fear a repetition. Artificially low long-term rates, far from stimulating expansion and confidence, can be interpreted as portents of a coming depression. Who will invest just before another depression? By distorting market signals, central banks greatly complicate the rational assessment of equity risk.
As for cross-border equity flows, how can they flourish at a time of such uncertainty about exchange rates? A small change in exchange rates can totally change the expected profit of a long-term investment – and contrary to financial market propaganda many risks can NOT be hedged in forward markets (e.g. pre-contract risks).
McKinsey should at least have warned the G30 of this – previous McKnsey reports have indeed underlined such risks. See its report entitled “An exorbitant privilege? Implications of reserve currencies for competitiveness” by a group including Charles Roxburgh, who was heading the study for the G30. This found that “both the level of exchange rates and exchange rate volatility have a large, and growing, negative effect on profits and investment decision making”;
“Some 21 percent of respondents report that exchange rate uncertainty has reduced their planned investment over the next two years. And 29 percent of respondents report that exchange rates have an “extremely” or “very” significant effect on company profits.Companies may argue that grand schemes about global financial architecture are the preserve of politicians and none of their business. But exchange rates that are substantially out of line with economic fundamentals coupled with currency volatility will generate real economic costs. ”
Yet I can not find a word about exchange rates in the G30 report.
At the London press conference, Guillermo Ortiz, who now chairs a Mexican bank (I hope he did due diligence on it before accepting the job), rightly pointed to the damage done by the “balkanization” of finance, the retreat within national borders and increased “home bias” of investors. As Axel Weber, eminent economist-central banker now chairing the disgraced bank UBS, said, the result is a very unlevel playing field for banking. But what was the answer? Oh no, not breaking up these expensive monsters which Andy Haldane says are receiving subsidies of hundreds of billions of dollars a year but a call for regulators “to assess the macro-economic impact of regulatory reforms”. Oh dear. The blindfold men want to recruit another dozen or so of blindfold men to form impact assessment study groups, consultations, discussions – all paid for by taxpayers or bank customers, which is the same thing – stretching far into the investment horizon.
Turner argued that a degree of maturity transformation was essential to reconcile the public’s demand for bank deposits with the needs of borrowers. He pinned his faith on more and better technical regulatory fixes – such as bail -in debt. In other words, business as usual. Immediately, Weber for UBS said that liquidity rules to make banks safer had to be phased in over a longer period because of the worsening economic outlook. So the argy-bargy goes on. Weber was brutally honest in saying that banks had not given up on maturity transformation but “it has given up on us”.
In such a market, we can forget the G30’s dreams about a revival of long-term, cross-border equity funding on anythng like the scale needed. With a proper reform of the GFS, yes, it could, and that’s where official action should be directed.