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WHY CAPITALISM DIDN’T FAIL

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Contents“An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today. “ Laurence J. Peter

Mention it at your peril, but the word ‘recovery’ has found itself tentatively creeping back into the global vocabulary in recent times. If arrogance is inherent to the human condition (and the last couple of years have failed to suggest otherwise), at least our tendency towards hyperbole has balanced things out a bit: perhaps things aren’t quite as bad as some of this world’s more imaginative doomsayers had forecasted. Unless you happen to be searching for a job.

Luckily, help is as hand; UCL’s Economics and Finance Society may not quite be ready to take on the brunt of the world’s economic problems (yet), but we do know a thing or two about career opportunities. Despondent undergraduates (and indeed, those who maintain a resilient optimism) could do worse than keep an eye on EFS’s regular events, designed to provide valuable advice and assistance to students who seek a competitive advantage in the current climate.

Equilibrium Magazine, as always, is here to ask the big questions. Did capitalism fail? Is there a workable solution to the Israel-Palestine conflict? How do we tackle global poverty? Drawing upon retrospective analysis and our predictions for the future, we present a range of articles written over the first half of 2009, ready to be scrutinised and contested in accordance with this publication’s underlying philosophy:

‘To present the diverse views and opinions of one of the world’s major economics departments, and stimulate debate amongst its members’

Over to you...

[If you would like to write for Equilibrium, e-mail: robert@uclefs.com]

EDITORIAL

EDITORIAL BOARD

WHY CAPITALISM DIDN’T FAIL

TWO STATE SOLUTION /ONE STATE ECONOMY

INDIA: ORGANISED CHAOS

MICROFINANCE AS A TOOL TO FIGHT POVERTY

LOSING POUNDS

WORLD CRISIS & PROTECTIONISM

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WITH THANKS TO PROOFREADERS RICH JEREMY BRICK, YONG JING TEOW, BIRAJ BORKHATARIA . COVER IMAGE BY E. LEESON.

These are uncomfortable times for free marketers. With a worldwide

recession looming, in fact only ideological opponents have a reason to cheer as capitalism finally seems to show its real face. But it all seemed so plausible. Decades of economic growth, low inflation and macroeconomic stability appeared to prove Adam Smith right. In increasingly free markets, the ruthless self interest of all market participants indeed led to an unprecedentedly desirable allocation of resources. And at the forefront and the very heart of this impressive global crusade of free trade ideology stood the financial system: international, dynamic and impeccably efficient. So it was until August 2007, when euphoria tipped into panic and the collapse of the US housing market precipitated the financial meltdown conventionally dubbed the credit crunch. As the mess gradually unfolded, more than just a huge speculative bubble threatened to burst – as the financial system trembled, the ideology of laissez faire capitalism was suddenly at stake. With financial institutions short of liquidity turning to national governments for help, French president Nikolas

Sarkozy was not alone in proclaiming “the ideology of the dictatorship of the market” to be “dead” and calling for massive state intervention. And with bailouts approaching 8.5 trillion dollars of taxpayer’s money1 in the US alone, the case for a “return of politics” in the running of the economy seems indeed hard to respite. As coverage of the credit crisis slowly exposed its full extend, the culprits seemed readily at hand, Société Générale’s Jérôme Kerviel and Bernard Madoff being but prominent examples: overpaid and corrupt investment bankers and hedge fund managers seemed to be the personification of an opaque and grotesquely inflated system that, guided merely by the desire to maximise profit, misappropriated clients’ funds by engaging in irresponsibly risky business such as the subprime market. When homeowners defaulted on their debt and financial institutions struggled to find the necessary liquidity to service their own debt and consequently contract their lending, Joe Bloggs had to pay bankers’ greed dearly. As Alan Greenspan, former US Federal Reserve chairman, recently acknowledged2, the theory had failed – self interest did not suffice to ensure responsible lending

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WHY CAPITALISM DIDN’T FAIL

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The following article was composed at the turn of 2009, when the global economic crisis was still very much languishing at its lowest

ebb. Months later, with speculation that the first shoots of recovery are tentatively emerging, its message remains strikingly relevant...

practices. In reality, however, the causes of the credit crisis are far more varied and complex than popular perception suggests and a careful inquiry into the reasons for capitalisms apparent failure is needed to form an educated opinion on determining the real culprits of the financial crisis. Critical to investment banks’ spectacular success prior to the crash, and arguably the spectacular crash itself, was a financial innovation called securitisation, essentially involving repackaging mortgages into securities that could then be resold to investors. A secondary mortgage market encompassing the trading of these financial tools – namely mortgage backed securities (MBS) and collateralised debt obligations (CDS) – was hence created. While recent events seem to provide evidence that the subsequent adaptation of an “originate to distribute” model creates moral hazard as risk is distributed and diluted, this needed not have been the case had the assets traded been accurately priced. This, however, is precisely what went dramatically wrong in the build up of the credit crunch. Risk, including the possibility that the borrower defaulted on his loan, and depreciation of the assets value, the crucial factor in determining the price of the respective asset, was severely underpriced across the board. The organisations responsible for classifying the credit-worthiness of the issuer and hence affecting the interest rate on the security, credit rating agencies such as Moody’s and Standard & Poor’s, are now under scrutiny for having given grossly flawed credit ratings and hence distorting the working of the market. Moody’s alone awarded Aaa ratings to billions of sub-prime mortgages, before these securities lost as much as 90 % of their value3. It seems hardly fair to blame issuers of structured securities for trying to minimise their risk whilst maximising their return on assets; nor does it appear justified to hold accountable investors in such products for buying junk bonds if these had an investment rating. But it seems equally naive to scapegoat rating agencies suffering from their own notorious conflict of interest, as issuers rather than investors in financial assets employ their services. Instead of discarding securitisation and the “originate to distribute” model altogether, it is worth questioning how governments could turn a blind eye on this evident flaw in the agencies’ business models and whether they shouldn’t have supervised rating agencies more closely to ensure the provision of unbiased and correct pricing information elemental to the proper functioning of the market. In fact, the US government did quite the opposite when the Securities and Exchange Commission (SEC) reduced disclosure requirements on securities in the wake of the 2001 Enron scandal. Throughout the build up of the crisis, the actions the US government and its regulatory subsidiaries took were equally debatable as its inaction. Eager to increase home ownership, both the Bush and the Clinton administration subsidised firms operating in the mortgage industry (such as Fannie Mae and Freddie Mac) to buy MBSs in order to lower lending

standards and thus encourage investment in the housing market. Channelling government funds into the subprime market via government sponsored enterprises (GSEs) significantly contributed to the nearly tenfold increase in the volume of subprime mortgages in the period 1994 – 2003. By 2008 GSEs effectively owned about half of the total outstanding residential mortgages4. The key to the crisis, however, is excessive indebtedness throughout the economy. It is the reason why this downturn is likely to turn into a full grown recession as it weakens confidence, the key driver of all economic activity, and hence renders monetary policy virtually ineffective. The bothersome fact that debt needs to be serviced despite diminishing sales gives rise to the general uncertainty concerning the level of leverage and liquidity, the asset structure and

the entanglement of the respective financial institution with the subprime market ) that is blocking the arteries of global finance. It is necessarily valid to inquire how these unsustainable debt levels could develop. With households and financial institutions (the red and the grey sections of the graph) contributing most to the total rise in the aggregate stock of US debt, mortgages appear to be of crucial importance. Essentially betting on a continuing rally in the housing market to ensure cash flows on mortgages, financial institutions invested the proceeds of debt issues in MBS’s. Following a 2004 SEC ruling allowing financial institutions to significantly up their debt issues, total leverage ratios (on- and off-book assets and exposure divided by tangible equity) increased to 88:1 for Citibank and 134:1 for Bank of America5. To put it in Martin Wolf’s (chief economics commentator at the Financial Times) words: The balance sheets of the financial sector exploded, as did the sector’s notional profitability. But leverage, alas, works both ways6. Considering the vulnerability that comes with this increased exposure, the risk-management undeniably appears to be absurd in retrospective. Yet, it could argued that not greed, but a lack of information and - as we now know - undue belief in the sustainability of bull market conditions caused this irrational behaviour. This ignorance was greatly nurtured by the

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Fed’s low interest rates policy. More than signalling unconditional confidence in the future, this overly expansive monetary policy provided the cheap money that sponsored much of the US’s consumption driven economic growth, excessive household indebtedness and property bubble inclusive. Arguably, the Fed’s commitment to rescuing banks considered “too big to (let) fail” - a generous interpretation of its lender of last resort function - has further fed on the issue of moral hazard as it practically rules out the option of bankruptcy for major banks. The financial system has collapsed – it would be dramatic if the whole intellectual edifice of competitive capitalism would come down with it. For despite all its apparent flaws it should not be forgotten that it brought unprecedented riches to an increasingly large proportion of the population. Most of whom will endure the crisis. In my opinion it is a dangerous oversimplification to extrapolate a systematic failure from the fact that the financial market failed, especially if the consequent “return of politics” in the running of economies is to mean the adaptation of supposedly populist measures such as the nationalisation of the financial intermediary system, over-regulation or protectionism. It is complacent to believe that the state should know better how to run a business than specialists and far too dangerous to lay an industry of such key importance to the economic activity in the hands of politics. Even though current evidence seems to suggest the contrary, market players exposed to the impersonal competition of a well-functioning and transparent market are much less prone to fraud, corruption and above all human frailty than politicians. Equally naive, however, is the belief that markets are utilitarian per se. The free market is not an unimpeachable sanctuary; it should be regarded as nothing more than a powerful tool to create welfare. Once put in place, markets develop an incredible internal dynamic which some might call the invisible hand. Great care and insight is needed

when setting up markets because once implemented every meddling can disastrously distort its workings. Personally I believe that the financial market didn’t fail because participants behaved irrationally or irresponsibly, but because grave regulatory shortcomings had distorted the market in such a way that its dynamics produced undesirable effects. The existence of imperfect knowledge concerning the ‘price’ of assets, for example, led to cheap mortgages, increased debt levels and ultimately allowed the formation of a “rational” asset bubble. Economic theory clearly states the conditions under which a competitive market will yield the desirable outcome. It should be the role of the government to ensure that perfect market conditions (or as

close as you can get to these...) apply and penalise violations rather than feeding on the imperfections (consider GSE involvement in the secondary mortgage market). I find it hardly credible that policymakers were ignorant of economic theory, or, as is often argued, blindly trusted in the self-regulation of markets. Maybe too much interference of politics in the economy is a much more likely explanation for the financial crisis than too little thereof. After all, any economically rational government intervention in the financial market would have had to mean choking off the fabulous economic performance that put politicians of the status quo ante crisis in such a favourable light... With “change” being a catchphrase this year, I agree that a paradigm shift is needed: rather than abandoning free market ideals altogether, however, I believe that this should mean a thorough redefinition of the market. Regulators should return to being enforcers rather than enablers and transparency should be promoted. And finally, free market fundamentalism should indeed be abandoned and a healthy intellectual competition should ensue. Even though the gravity of economic hardship still to come might necessitate compromising intellectual tidiness in the short run, I am confident that as long as perfect market conditions apply and economic populism doesn’t distort the debate, free market ideology will use its competitive advantage of best accommodating human behaviour and ultimately come out on top. After all, to paraphrase the generally wise and quotable Winston Churchill, “it has been said that capitalism is the worst form of economic system except all the others that have been tried.”

1 Phoenix Business Journal, 26/11/082 “Fare Well, Fair Trade” The Economist, 18/12/083 Rogue Economist Rants, 03/07/08)4 “Government policies and the subprime mortgage crisis” Wikipedia5 Niall Ferguson - “Global Economy: The Age Of Obligation” Financial Times, 18/12/086 Martin Wolf – “Paulson’s Plan Was Not A True Solution To The Crisis” Financial Times, 23/09/08

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The Ephramites, an ancient Tribe of Israel, attempted to return west to their homelands, defeated by the Gileadites, known today as the people of the Kingdom of Jordan. The rivers were heavily guarded. The refugees, disguised, would attempt to cross at their peril, subject to a test. “Are you an Ephraim?,” they were asked- “No”, the Ephramites would reply.-“ Very well. Pronounce the word Shibboleth”, ordered the Gilean guards. Due only to their phonetic handicap, most could not and would subsequently perish. Divisions and tensions persisted for over a millennium. However, since 1996, Israel and Jordan have begun trading goods. Starting at a modest 9 million dollars worth of Israeli exports, exports to their new partner have seen exponential growth, increasing 130% per annum. Israel textiles firms have opened on Jordanian soil. Jordanian agricultural experts share knowledge of irrigation systems with Israel. Israel provides Jordan with 75 million cubic metres of water a year. Jordanians flood to Israel in a wave of tourism. What underpins this success? And can it be repeated in a conflict that has grasped the Middle East since 1948?Shekel after Shekel is pumped into the Israeli and Palestinian economy. Round after Round is pumped out. It is hard for an economist, staring down into this gaping abyss of molten political manoeuvres, deterrence by disillusioning brute military force (and spending), misused aid and complete sclerotic checkpoints, to think anything but the classic sitcom punch line: “I’m not cleaning it up”. However, economics might be the answer after all.Israel and Palestine have been waging war since 1948, or as some would argue, much longer than

even that. We endeavour to understand how the war has affected their economies both individually, and the trade links between them, the extent of the interdependencies and whether they maintain or distort the war. Our short term goal is to assess the viability of war for their respective economies, while our longer term goal is to offer a possible solution, based on how trade interrelates with democracy and peace. The Situation. The Israeli economy is a well oiled machine connected, seemingly safely (until recently), to the veins and arteries of the body economic, through well established free trade agreements with the larger players in the WTO - The United States of America, the European Union and Mercosur - and smaller, but equally important agents in the battle for economic and political economic stability – including, amongst others, Turkey, Jordan and Egypt. Israel’s most prominent comparative advantage is its labour force. Unlike other newly born and independent nations, it has not had to escape the binding social forces of colonialism that left many African nations with a largely unskilled working population and plenty of old tribal affairs. Instead, from Israel’s birth in 1948, the Jews of an eclectic mix of developed countries returned to the Holy land of their forefathers to infuse it with fresh, innovative ideas. And the waves keep on coming; for example, the collapse of the Soviet Union in 1990 brought another welcome injection to its labour force. Packed within their suitcases were vast knowledge, diverse skills and a willingness to work that promotes economic growth. Subsequently, its major exports seem

TWO STATE SOLUTION

ONE STATE ECONOMY

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somewhat self explanatory: electronics, medical and scientific equipment, chemical products, computers and diamond cutting, all requiring intense research & development coupled with industrial production – an economy for all skills. Unsurprisingly, their largest trading partner is the USA for whom it delivers the above, and imports large amounts of advanced weapons and military equipment. Presumably, ye ol’ ethical economics would apply in that the war sustains American military industry, but I’m not an 18 year old socialist, so I won’t be arguing that. The long standing feud has had varying effects on Isreal’s neighbouring economies. Lebanon was ravaged by war in the summer of 2006 when members of Hizbullah, well entrenched in southern Lebanon, kidnapped Israeli soldiers, thus inviting Israel’s reign of fury. Attempting to attack Hizbullah strongholds, Israel’s military might unfortunately destroyed a substantial part of Lebanese infrastructure, And the Lebanese, of course, picked up the bill. That particular war had an estimated cost of $2.8 billion. Israel and Hizbullah are possibly the worst gatecrashers ever. Lebanon’s infrastructure emerged crippled at best; houses were destroyed, bridges and roads lay in ruins, as a lively tourist industry was reduced to a wasteland of haunted houmous stands and shaken shisha shops. The indirect effect was for the 6% GDP growth to fall into the negative, contracting at a rate of 5% a year. The Lebanese government was forced to plunge into an immense pool of debt to begin the reconstruction. And how has the Israeli economy been affected by the summer war - did it defy all economic reasoning and give new meaning to Schumpeter’s ‘creative destruction’? It survived, but certainly suffered some minor scratches and bruises. Tourism of course was vastly reduced, while factories in the north of Israel (along the Lebanese border) had to close. Compared to Lebanon however, Israel’s GDP growth escaped relatively unscathed; a fall of about half a percentage point (from just over 5% to 4.5%) seems a small economic price to pay for a lost war. This war, however, was not fought on Israeli or occupied soil, unlike events that took place just a few years earlier. From the end of 2000 to early 2002, one might say that a perfect storm loomed over Israel. The Al-Aqsa Intifada plagued the security situation with violent riots, the (occasional) hail rain of rockets and brutal murders of the young, as always, depriving the Middle East of any tourism. The darkness of a world depression enveloped Israel’s strongest industries, as at its core was born of a crash in the advanced technology sectors. The macroeconomic mismanagement (higher VAT to fund healthcare and defence costs) allowed the rivers of fiscal conservatism to turn red and overflow with debt. Nonetheless, the Israeli’s economy has shown an incredible buoyancy which allows it to oscillate back to full health in a relatively short period - either it’s on a stable growth path with the occasional outlier, or it’s (somewhat frighteningly) getting used to bouncing back from fighting short wars. But the dark storm clouds begin to gather again. The recent war in Gaza, coupled with the

contagion effects of the credit crunch, has had dramatic effects on the Israeli economy. Economists have estimated that the daily cost exceeded tens of millions of dollars, not to mention the ballooning budget deficit. The Bank of Israel’s original forecast of 1.5% growth for 2009 has now fallen to -0.2%. I guess they didn’t get the memo on the impending war to include in their estimates. Furthermore, the economic effects on Israel seem only to be getting worse as the wars progress, and their oscillations wilder. War is not economically viable – even when you’re winning. While Israel wages war for the security of its people, it sacrifices the stability of its own economy, thus inviting further unrest. Over 1.4 million Palestinians live from North Gaza to Rafah, forming the strip of land known as Gaza. In 1999, 12% were unemployed; today this number is 41.3%. The sudden change is emblematic of how the Gazan economy works countercylcically to the tensions in the Israeli-Palestinian conflict. Israel instilled strict internal and external security controls as a defensive strategy to the Intifada in 2000. Cut off from the world, Gaza’s state of autarky means businesses are limited to remaining small and family owned, attempting to sustain a vital diversity across the range of products and services such as textiles, halal meet, vegetables and other necessities (impeded further by the limited natural resources). This is reflected in a relatively high (and growing) proportion of the labour force being self employed, as those who once worked in Israel are now cut off from their former jobs. Israel continually fears for its safety, so control of the checkpoints is vital to an edgy peace of mind. Hamas knows and exploits this fact, all the more destabilising the situation. Israel’s control may ensure quasi-security from those who would wish harm upon it, but complementarily enforces economic instability in Gaza, often sparking social unrest. As often is the case, everyone is at fault, except the victim. Furthermore, with their only port long destroyed, external trade is limited to Egypt and Israel - at best filtered thin with the latter and constrained to tunnels with the former. Put into historical context, Gaza has been severely restricted by a number of unjust and/or unfortunate factors, and subsequently has been unable to specialise in any exports (mostly selling fruits, vegetables and flowers). According to a report by Haaretz, a prominent Israeli newspaper, the permitted number of truckloads allowed to cross the guarded checkpoints will not be enough to restart the Gazan economy. Consequently, Gaza is almost entirely dependent on Israel for its imports: consumer goods, construction materials, and most importantly, food. Israel also owns the electricity grid and controls the flow of power – a vital resource that begs dependency. Finally, Gaza depends on aid from Israel, the US and the World Bank, heavily curbed since Hamas’ electoral victory, a party revered as a terrorist organisation. This latter issue is especially complicated regarding the political civil war with Fatah and constant bickering that points blame in all directions, as again, all parties are at fault somewhere. BY ANDREW STUART

Photograph by user ifady habib on www.flickr.com

For most of its history, India has taken a socialist approach to its economy; tight government control over the private sector, regulations and red tape were typical of a system commonly referred to as ‘License Raj’. In 1991 however, the finance minister, Manmohan Singh, implemented policies that reduced the government’s control over foreign trade and Foreign Direct Investment. With an average annual GDP growth rate of 5.7% for the past two decades, India’s economy is now amongst the fastest growing in the world . And interestingly, it is the spontaneous nature with which India has embraced free-market Economics that characterises the nation today.

‘Chaos theory describes the behaviour ofdynamicsystems,systemswhosestatesevolvewithtime, that may exhibit dynamics that are highlysensitive to initial conditions (butterfly effect)’1.

The Taoist Zhuangzi was amongst the first to propose that apparent chaos can result in ‘spontaneous order’. Adam Ferguson, a philosopher and historian of the Scottish Enlightenment, defines spontaneous order as the ‘result of human action, but not the execution of any human design.’ Such order out of chaos is evident in India. From the hustle and bustle of Mumbai’s markets, to the ‘street-entrepreneurs’ of Gujarat and India’s chaotic roads, one can begin to see how the innate behaviour of Indian people has given birth to the free-market at its purest level. Take India’s roads. In essence the driving rules are the three Gs: good steering, good horning and good luck. Crash survivor Harman Sidhu Singh describes that driving on Indian roads is ‘like playing a video game’2. It would not be unusual to see cars and lorries drive on the wrong side of the highway, while vehicles share roads often deficient of traffic lights with cows, elephants and camels. To witness Indian cross-roads is a truly fascinating experience. All vehicles (and animals) cross simultaneously, and on the vast majority of occasions escape without accident. When thrown into such a situation on an everyday basis, people adapt quickly to the lack of regulation, despite operating in circumstances that most in the UK would judge to result in almost an inevitable collision. Traffic in some of the most densely populated areas remains flowing as if an ‘invisible hand’ (to steal form Adam Smith) governs through the chaos. This is not to say that India has the safest roads by any means; it has 1% of the world’s vehicles, but accounts for 10% of the world’s road accidents. But (most of the time) it seems to work. Whilst India’s approach to free markets is not perfect, it is evident that one can see the gradual emergence of social order from self-interested individuals. This is why India never seems to stop moving - inbuilt attitude in its citizens enables them to get things done where and when they want to.

Consider the rise of India’s billionaires. According to Forbes magazine, individuals of Indian origin make up thirty-six of the world’s richest hundred people – most notable amongst these are number four, industrialist and Kensington resident Laxmi Mittal, and number five, businessman Mukesh Ambani. It is India’s embrace of free-market Economics that have allowed these entrepreneurs to flourish. They have been able to tap into the nation’s multi-faceted and diverse human resources that are prepared for whatever their working environment may bring. Over the last decade, India has experienced a boom in its IT sector, which has contributed to the rise in India’s billionaires. It can be said that the Economic growth has instilled a greater need within Indian people to achieve affluence. The need to be successful and rich is rife in Indian culture. It is a subject continually pursued by Bollywood directors and is evident from the way in which Indian’s worship their celebrities, from Shahrukh Khan to Sachin Tendulkar. Such pursuits have reinforced the relevance of the free market to India, - citizens aim for the ‘bright lights’, creating a notable competitive streak within Indian culture. Today, in India we see the result of this competitive mentality, culminating in its chaotic and restless cities. A perfect illustration is Ahmedabad’s C.G. Road. On-street you are inundated with shoe, clothes and DVD sellers who pursue passers-by with vigour until paid to leave, while one can see hoards of people rushing into and out of C.G Road’s many malls and restaurants. All senses are aroused with the intent to get people to spend money. It is simply chaotic, yet the street merchants seem undeterred and remained focused in the environment they must compete in. It is this mentality that has given birth to India’s entrepreneurial drive. Although the number of millionaires in India went up from ‘70,000 to 85,000 in 2005’3 , the trickledown effect of this wealth has yet to reach the rural Indian living below the poverty line - the issue of equity is, as is the case across the world, an increasingly vociferous criticism of India’s economy. Few would suggest that chaos is a sustainable long-term strategy for growth; the need for more stringent regulation is certainly evident. Nevertheless, based on current growth, Goldman Sachs predicts that over the next 50 years India will be the fastest growing economy in the world – thanks in part to a young, increasingly educated, technology embracing population with a dynamic attitude and an innate thirst for success. It seems that underneath a chaotic surface is a growing economy slowly finding order in its own unique way.

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INDIA: ORGANISED CHAOS

1 Wikipedia2 BBC ‘No U-turn on Indian road safety’ 19/04/073 http://www.arabianbusiness.com/497870-india-colour-chaos- and-contradictions

BY TEJUS PARIKH

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THE GROWING IMPORTANCE OFMICROFINANCE AS A TOOL TO FIGHT POVERTY Microfinance – An introductionDoes Microfinance offer a genuine solution to world poverty?THE GROWING IMPORTANCE OFMICROFINANCER O F I N A N C E AS A TOOL TO FIGHT POVERTY Microfinance – An introductionDoes Microfinance offer aS A TOOL TO FIGHT POV genuine solutiond HE GROWING IMPORTANCE OFMICROFINANCE AS A TOOL TO FIGHT POVERTY –

MICROFINANCE – AN INTRODUCTION Back in 1976, Bangladeshi Professor Muhammad Yunus established Grameen Bank, a pioneering organisation that recognised the business potential amongst Bangladesh’s poor. Just over thirty years on, Yunus has a Nobel peace prize to his name, and microfinance has evolved into a world recognised concept perceived by many as instrumental in the fight against global poverty. The idea is to offer impoverished individuals access to basic financial services such as loans and savings, while, unlike as is the case with commercial banks, not stipulating that collateral be required for any transaction. The concept of microfinance has taught us that the “poor are bankable”1 and the evidence is substantial: it has

been estimated that “about 10 000 microfinance institutions are assisting around 100 million customers, with microloans worth approximately 25 billion US dollars”2. The industry has evolved over time from being small and highly localised to its current status as a global phenomenon. It is estimated that over three billion people live with less than $2 a day purchasing power parity3. Microfinance can help provide these low income households with the financial empowerment they need as an essential source of funding for those with poor credit ratings and little or no collateral. The loans are typically not more than a few hundred dollars, usually used to support tiny enterprises like neighbourhood shops. Often borrowers are women and for established microfinance organisations,

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THE GROWING IMPORTANCE OFMICROFINANCE AS A TOOL TO FIGHT POVERTY Microfinance – An introductionDoes Microfinance offer a genuine solution to world poverty?THE GROWING IMPORTANCE OFMICROFINANCER O F I N A N C E AS A TOOL TO FIGHT POVERTY Microfinance – An introductionDoes Microfinance offer aS A TOOL TO FIGHT POV genuine solutiond HE GROWING IMPORTANCE OFMICROFINANCE AS A TOOL TO FIGHT POVERTY – THE GROWING IMPORTANCE OFMICROFINANCE AS A TOOL TO FIGHT POVERTY Microfinance – An introductionDoes Microfinance offer a genuine solution to world poverty?THE GROWING IMPORTANCE OFMICROFINANCE

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repayment rates are high – the aforementioned Grameen Bank of Bangladesh has a repayment rate of 98%. The impact of microfinance has been felt worldwide, with institutions emerging in many global locations; where its effects have been quantified, the results have been largely encouraging.: For instance, in Lombok Indonesia, the average income of Bank Rakyat Indonesia borrowers increased by 112% and 90% of households graduated out of poverty.”4 With the global economic situation looking increasingly dire, it seems to many beyond question that microfinance is proving essential in providing financial independence to many of the world’s poor, both in developing and developed countries.

A PROFITABLE INDUSTRY? As the microfinance industry has developed, its largest players have constructed a number of different approaches to the way they operate. There exists a growing divide between institutions like Grameen Bank and NGOs, who view microfinance primarily as a means to help provide credit to the poor, and the likes of Banco Compartamos of Mexico, who operate with a strong profit maximising objective. Supporters of Grameen argue that “there is nothing wrong in earning money serving the poor so long as money earning does not become the prime or only goal of microfinance providers.”5 Banco Compartamos, whose public offering of its stock in April 2007 gave it a market capitalisation of $1.3billion, has taken a rather different perspective. Those in favour of the strategies employed by the Mexican bank envisage “a future in which microfinance routinely attracts investment from the private sector, freeing it from the ghetto of high-minded, donor-supported initiatives”6. This profit seeking approach to microfinance means that expansion of financial services to the poor can be achieved at a faster rate, illustrated by Compartamos’ growth from 60,000 to 800,000 customers between 2000 and 2007.7 But there is always the danger of reckless lending, a threat proliferated by the USA’s recent mortgage market experiences. It is clear that while expansion is good, rapid expansion with little regard for the ability of the borrower to repay the loan is not the direction in which industry wants to head. The danger is that if money is piled into microfinance, the pressure on the borrowers in their repayment timetable may lead to a subprime style crisis for the world’s poorest people. This would not only devastate a highly promising industry, but also create a whole new set of problems for institutions trying to eradicate poverty. That is where Grameen Bank has got it right, in realising that simply throwing money at the poor is not a viable solution to eradicating poverty. It’s not simply the case of scattering loans indiscriminately and watching their recipients thrive: to people not used to handling the sums of money available, a microloan may seem a daunting prospect. Thus Grameen came up with its ‘16 decisions’, a list of key lifestyle points covering issues including children’s education and water cleanliness. They emphasise the close relationship the bank has with its borrowers; at every branch, borrowers recite these decisions

and pledge to follow them. Whereas commercial banks’ approach to microfinance often solely involves financial empowerment, many microfinance institutions have realised that for people to truly escape poverty, all aspects of their lives need to be addressed. Grameen itself has over 20 other sister companies, who are involved in activities ranging from healthcare to renewable energy. I believe that it is this relationship between banks and borrower that is imperative for microfinance to make a marked impact upon poverty.

DOES MICROFINANCE OFFER A GENUINE SOLUTION TO WORLD POVERTY? Microfinance has the potential to make serious inroads into the financial apartheid that many poor people face today. Its benefits will continue to be felt across the globe, as proponents continue to stress the potent argument that access to finance is more important than its price, allowing the world’s poorer populations to take a longer term view of their futures and benefit from vital access to capital. But it is critical that there is growth in the right type of microfinance for the poor to benefit; reckless lending with high interest rates may well create more problems than it can solve. It seems that moving forward, the industry faces challenges about its direction, and in particularly, the fundamental aims of the institutions that provide such a valuable service. Yunus has referred to poverty as a “multi dimensional phenomenon.” The financial aspect is only one side of the problem, and it seems that the microfinance institutions that embrace having a close relationship between bank and borrower can have the greatest impact on the development of the poor population. As a result of the successes of Grameen Bank and others, “large financial institutions have woken up to the benefit of schemes with low default risks, good rates of return and a corporate social angle”8. Banks including Credit Suisse, Barclays and JP Morgan have all entered the microfinance arena. But for most microfinance institutions, access to funding is often difficult, with many relying on donations to survive the early years of existence. With the current liquidity crisis sweeping the world, investors seeking safe havens for their money are hardly likely to look towards poverty-struck borrows. As perhaps best said by Professor Yunus, microcredit is best used to “lay down a solid foundation on which all other anti-poverty programmes can find firm grounding and achieve better results”. Microfinance alone cannot be expected to eradicate the financial hardships of every impoverished individual alive today. But it is certainly a valuable tool in our fight against global poverty. 1 Yunus 1998: 212 Credit Suisse, 09/09/083 Credit Suisse, 09/09/084 CGAP, 20085 Latifee 2006: 26 Cull et al 2008: 17 Cull et al 2008: 18 Financial Times, 27/09/08

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LOSING POUNDSBY ROBERT X. XIE

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Infamous amongst foreign tourists for being upsettingly expensive, the pound has had a change of fate at the turn of 2009. Owing mainly to the worsening economic outlook, the financial-services orientated British economy has taken a beating and the once stalwart pound weakened in the face of the odious financial crisis. This article will give a brief history of last year’s nosedive and how I have found the process both exciting and enjoyable. The British economy shrank by 0.6% according to the Office for National Statistics (ONS) for the three months prior to September ‘08. This is greater than the forecasted 0.5%, and the greatest since 1990. As everyone sought shelter from the falling sky, the wise, steady Bank of England steadily slashed interest rates and correspondingly, the value of the Pound followed a similar route. Uncertainty was in the air after the announcement of the third quarter economic report and in hindsight the UK was clearly careening into a recession despite what news reports at the time tried to have us believe otherwise. Though optimists hammered on that there was nothing to worry about, confidence was still falling with each passing day and the gap between the GBP and the USD closed, reaching

a record low of 1.44USD a pound right before the end of 08 (for purpose of comparison, we will use “USD vs. GDP” since the US is large trading partner whose economy was decimated by the financial crisis). Much to the chagrin (and discredit) of those optimists, Britain’s economy shrunk further in the last quarter of 2008 at the fastest rate since 1980. Furthermore, the Pound plummeted to 1.363 USD on Jan 23rd 09 – the lowest level in 24 years1.

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Figure 1: Shown – USD-Pound Rollercoaster. Not Shown – mortified expressions of British people everywhere.

1 http://www.telegraph.co.uk/finance/financetopics/recession/4326363/UK-recession-sends-pound-to-new-low.html2 Not technically pegged. The U.S. Dollar is a constituent in China’s “basket of currencies”, which is a weighted collection of all of China’s major trading partners and the overall movement determines the value of the RMB.3 After converting the Chinese retail price into pounds at exchange rates 15th Dec. 08

EQUILIBRUIM | �7

The second half of 2008 witnessed a drop in the value of the pound by almost a third. Considering the pound’s sustained fall from 1.78 since the beginning of October, this seemed like a glaring sign of trouble. On Nov 15th 08, British politician George Osborne warned of a possible run on the Pound; the move was widely regarded as a bad move for spurring a potential self fulfilling prophecy and just being plain irresponsible for talking down the economy. Such warnings should not be easily dismissed. Though the situation was hardly bad enough to anticipate a run (cue: flashback of Black Wednesday), risk for further bank nationalization still existed with the macabre image of Lehmann Brothers’ lifeless corporate body still burned clearly in our memories. It was literally a matter of time before the UK rates were lowered further. Cuts by the Fed to near zero rates gave other central banks the confidence to hit that round-looking number too; the Bank of England conservatively followed suit with a series of gradual cuts. To their credit, the value of the pound accurately reflected the poor economic conditions of the time; the euro on the other hand, whose rates have only fallen by 125 basis points since June 08 was another story. As the economic situation worsened in Europe, many British were probably tingling with schadenfreude as the European Central Bank finally lowered its rates, which pushed the Euro down just before the dreaded pound-euro parity.

Had the UK been more like China, this fall in exchange rates would’ve helped the economy, but alas it is not. The costs of the weak currency outweigh any of those theoretical benefits we learn about the real exchange rate, theta – at least when your economy is as heavily geared towards services as the UK is. The Chartered Institute of Purchasing and Supply/Markit index announced that the manufacturing sector contracted for eight months in a row due to weakness in the Euro-zone, the UK’s largest trading partner. I could be reading too much into this, but it almost sounds like they’re blaming the rest of Europe. Naturally, this had implications to the many international students studying in the U.K. and namely,

UCL – London’s global university. The near 40% fall in the USD-pound exchange rate was a significant increase in purchasing power for students like me, who use currencies that are pegged to the USD (in my case, the Chinese RMB2 / HK Dollar.) To highlight this with an example, many foreign students are buying luxury goods in the U.K. to take advantage of the “menu cost” effect; the prices of goods do not adjust to changing market conditions instantly due to costs associated with frequent price changes (despite there being a huge difference in value of the same good between countries). Not that I buy these myself, but say I’m a girly kind of guy and I love L.V. man bags – one that costs 1000 Pounds in China would cost around 600 pounds3 in Britain – on top of that, I also get the usual 15% VAT refund when I return home to show family and friends how amazingly frugal I am for saving 400 pounds – hoping they’ll forgive me for blowing off 600 in the process. But of course, in terms of day-to-day life extravagances it might just mean grocery shopping at Waitrose instead of Sainsbury’s (read: pay more for the same stuff to make a social statement). For all the brilliant economists reading, you may be impressed by such a large expansion of my budget constraint and equally outraged by my insensitivity towards the global economy; sorry, what was that? I can’t hear you all the way up here, on my higher indifference curve – optimize that! The more favourable exchange rate between

foreign currencies and the pound sterling was in some respects a win-win situation for the British economy and the large population of international students. After all, a decrease in local demand can be buffered by an increase in enthusiastic foreign demand – if only the pubs and breweries see such benefit. But late January saw a less bleak future for the Pound, as it recovered from its 24 year low, but still meandering around 1.65 USD-pound to this date. With high volatility and turbulence in the currency markets, it’s difficult to speculate future developments – as the old adage goes, time will tell; but if you’re an FX trader and must know, my magic eight ball says “Reply hazy, try again.” So if you haven’t done so already, do yourself a favour and find a new international student friend - while the pound is still low! With more money to blow at the pubs on few more pints, some of us may find ourselves gaining pounds

instead.

Figure 2: Rational Expectations? Graph shows that investors possess the clairvoyance to anticipate an exchange rate fall almost a fortnight before it happens.

WORLD CRISIS &

PROTECTIONISM

BY NABEEL KHUNDAKAR

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EQUILIBRUIM | ��

Protectionism, it seems, is back on the political agenda. As the credit crunch worsens and asset prices free-fall, incomes, investment and jobs have come under threat. The world’s richest economies face one of the worst recessions since the Second World War, whilst the emerging economies are suffering from a shortage in liquidity. The global economy is in downturn and as poverty feeds through borders from country to country, anxious governments may revert back to the old practice of isolation and protectionism.

The two main components of globalisation, trade and capital flows, are currently being driven backwards, with the World Bank estimating a 2% contraction in the volume of world trade in 2009 and a halving of net private capital flow between 2007 and 2009. This is a major reversal in global integration and its reverberations will be painful at the very least. Countries such as Germany and China, which have focussed on export led growth, will face an economic slump unless they can quickly find a way to stimulate domestic demand. The flight of private capital will leave emerging economies with a scarcity in foreign finance and, as domestic income and jobs topple, it is easy to see the attraction that protectionism holds over governments.

In spite of the wider implications, politicians across the world are being pushed to bail out collapsing industries and, as the recession deepens globally, world leaders will be drawn towards the ever-tempting, but futile, beggar-thy-neighbour policies. In today’s global economy of remote supply chains and JIT, even a slight bolstering of trade barriers could throw the economy into greater depths. But due to years of multilateral trade agreements, slight rises in tariffs are not only plausible, but also legitimately possible under WTO rules.

While many fret over a sudden rocket in tariffs however, other more subtle means of isolationism are ignored. VOX, a provider in research based policy analysis and commentary, has argued that the real worry lies in aggressive use of technical standards, public subsidies, countervailing duties and anti-dumping duties. By and large, tariffs of OECD countries are already at their bound rate, thus leaving no scope for further increases under WTO rules. In addition, a combination of agreements accepted by China and Taiwan in joining the WTO and zero tariff agreements locked in under NAFTA and the EU means only 20% of world trade is actually threatened by tariff hikes. A real commitment needs to be put towards averting an excess of non-tariff barriers to trade – the number of antidumping cases rose by 40% in the first half of 2008.

Countries need to begin coordinating focused policies against isolationism and America needs to lead the fight for free trade. A leader

is needed for all the greatest struggles, to hold everyone together and make the boldest moves. The US did it after WWII when it spearheaded the creation of the World Bank and the US must do it again. However, the burden cannot fall solely on the shoulders of President Obama; the IMF and World Bank must aid in the restructuring of economies and provide capital in those emerging markets where it is scarce. The IMF has already committed $45bn to six member countries in the fourth quarter of 2008 and has approved a new short term lending facility (SLF), but it also needs to stamp down on any inappropriate protectionist exchange rate policies. It will also need some wide-ranging restructuring in the future, mainly to strengthen its own surveillance powers and provide some coherence in financial regulations. Most importantly, however, the IMF, as an international institution, will need to provide some form of conceptual framework that nations can use as a basis for policy formation in order to prevent future crises.

In times like these political leadership is called for to prevent division and isolationism from compounding an already sorry state of affairs. World leaders must relinquish their hold on beggar-thy-neighbour policies and focus on promoting domestic demand. Whilst monetary policy has been the preferred method of encouraging demand, at present fiscal stimulus would seem to be the better option. Banks have been severely weakened and are wary of passing on any interest rate cuts, while falling incomes and asset prices have hit consumer confidence hard, meaning any interest rate cuts may well be ignored by households. However, current efforts to utilise fiscal policy have been somewhat lacklustre, with the exception of America, which is making considerable bounds. Angela Merkel has been very reluctant to spend and announced a meagre fiscal package of 0.25% GDP to be spread over two years, when a tight fiscal policy is exactly what will hold back the Euro area. Many will argue that Germany should not pay the price for other countries’ fiscal indiscipline, but this is the burden it must carry if the Euro area hopes to brings its operations anywhere close to those of an optimum currency area. In any case, action needs to be taken and not just by Germany.

As we speak, protectionism has already begun rearing its ugly head. ‘British jobs for British workers’ have been demanded by industrial workers across the British Isles, Greek farmers have been protesting for increased subsidies, a one million strong strike in France has demanded increased jobs domestically and the US, the bastion of free markets, has proposed ‘Buy American’ provisions. 1982 was the last time the world volume of trade shrunk. Twenty-seven years later it looks set to drop again.

OPPORTUNITY NEVER SLEEPS.

In Paris, after a hard day studying, Jen’s

finally ready to rest. Six time zones away, in

New York, Lisa – Jen’s future mentor – is

shaking hands on funding for an irrigation

project in Western Africa. Meanwhile, half a

world away, Investment Banking Associate

Rajid is returning from a meeting with

government officials in Kazakhstan.

At any moment, someone in our global firm

is opening new markets. Someone’s closing

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the next generation. A career with us is full of

variety and challenge. Because Jen isn’t

working for us yet, but we’ve already been

working for her. That’s why, at Citi,

opportunity never sleeps. oncampus.citi.com

Dreams. Realities.

©2008 Citibank, N.A. All rights reserved. Authorized and regulated by the Financial Services Authority. Citi and Arc Design is a trademark and service mark of Citigroup Inc., used and registered throughout the world.Citi, Citi Never Sleeps, and Arc Design are service marks of Citigroup or Citibank, N.A. Citi is an equal opportunities employer.

Why is now a great time to start a career in Investment Banking? The answer is simple: banking and finance will always be a competitive, challenging and interesting career that requires the best talent. Citi provides the best and brightest individuals an opportunity to make a difference at the most global bank in the world.

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OPPORTUNITY NEVER SLEEPS.

In Paris, after a hard day studying, Jen’s

finally ready to rest. Six time zones away, in

New York, Lisa – Jen’s future mentor – is

shaking hands on funding for an irrigation

project in Western Africa. Meanwhile, half a

world away, Investment Banking Associate

Rajid is returning from a meeting with

government officials in Kazakhstan.

At any moment, someone in our global firm

is opening new markets. Someone’s closing

deals. Someone’s gaining skills to pass on to

the next generation. A career with us is full of

variety and challenge. Because Jen isn’t

working for us yet, but we’ve already been

working for her. That’s why, at Citi,

opportunity never sleeps. oncampus.citi.com

Dreams. Realities.

©2008 Citibank, N.A. All rights reserved. Authorized and regulated by the Financial Services Authority. Citi and Arc Design is a trademark and service mark of Citigroup Inc., used and registered throughout the world.Citi, Citi Never Sleeps, and Arc Design are service marks of Citigroup or Citibank, N.A. Citi is an equal opportunities employer.

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Graduate Careers in ConsultingYou really can achieve more here.Through the quality of the training, the breadth of the work and thewealth of expertise around you, you will be able to keep learning,developing and moving your career on. So, if your ambition is to attain amanagement or specialist technicalrole in one of a range of industries, wewill do everything we can to ensureyou achieve it.

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