October 2016Vol. 7 Ed. 9The Bulletin

Monetary to fiscal Point of inflection

FOCUS on Frankfurt’s new path Charles Goodhart, Geoffrey Wood on QE risks

Kingsley Chiedu Moghalu on African democracyVicky Pryce on Germany and the G20Ignazio Visco on the euro policy mix

William White on zombie banks and companies

Global Public Investor 2016 is the third annual report by OMFIF on public sector asset management and ownership. The increased detail and

coverage builds on analysis in the 2015 and 2014 editions.

GPI 2016 is focused on two fundamental developments on the world investment scene: the use of a rising number of currencies in world asset management; and the growth of low-carbon investment, part of a general

upgrading of the importance of sustainable investment.

Selected media coverage

To order your copy visit www.omfif.org/shop

#OMFIFGPI2016

GPI 2014

The march of the sovereigns

The Economist17 June

Heimliche Strippenzieher der Finanzwelt

Die Welt27 June

GPI 2015

Global state investors shift into property

Financial Times20 May

Sovereign funds risk inflating global property bubble

South China Morning Post21 May

GPI 2016

China’s central bank remains world’s top public investor

China Daily29 June

Central banks lead fall in GPI’s assets in 2015The Business Times

29 June

Contents - Vol. 7 Ed. 9 October 2016

October | ©2016 omfif.org CONTENTS | 3

22

COVER STORY: Monetary to fiscal Monthly Review6-7 Briefings – OMFIF meetings, Advisory Board

International monetary policy8 Limits of ‘low-for-long’ interest rates Stijn Claessens, Nicholas Coleman, and Michael Donnelly

10 Merkel’s tasks for divided continent Vicky Pryce

11 Global liquidity under pressure Ben Robinson

12 Fed holds off amid election campaign Darrell Delamaide

13 Quite erroneous policy Charles Goodhart and Geoffrey Wood

Sustainable investment14 Market approach to climate change Flavia Micilotta

Europe15 A suboptimal policy mix Ignazio Visco

16 Italy’s ‘doomsday’ scenario Steve H. Hanke

17 Cyprus, Greece and ‘whatever it takes’ Panicos Demetriades

18 Costs for financial system Peter Warburton

Emerging markets19 Renminbi payments show limited gains Ben Robinson

20 Three headwinds for Brazil Danae Kyriakopoulou and Bhavin Patel

22 Directing policy to growth sectors Donald Mbaka

23 African democracy: work in progress Kingsley Chiedu Moghalu

Book review26 Best chancellor New Labour never had William Keegan

OMFIF Advisory Board poll27 ECB expected to extend QE to new asset classes

7

FRANKFURT

III Enhanced prowess and responsibilities Ben Robinson

V Formidable springboard for the future FrankfurtRheinMain

VI Promising real estate pipeline FrankfurtRheinMain

VII Combining lifestyle and performance Stefan Bredt and Armin Winterhoff

Frankfurt forgesEuropean path

October 2016

The Official Monetary and Financial Institutions Forum is an independent platform for dialogue and research. It serves as a non-lobbying network for worldwide public-private sector interaction in finance and economics. Members are private and public sector institutions globally. The aim is to promote exchanges of information and best practice in an atmosphere of mutual trust. OMFIF focuses on global policy and investment themes – particularly in asset management, capital markets and financial supervision/regulation – relating to central banks, sovereign funds, pension funds, regulators and treasuries.

AnalysisOMFIF Analysis includes research and commentary. Contributors include in-house experts, Advisory Board members, and representatives of member institutions and academic and official bodies. To submit an article for consideration contact the editorial team at editorial@omfif.org

MeetingsOMFIF Meetings take place within central banks and other official institutions and are held under the OMFIF Rules, where the source of information shared is not reported. A full list of past and forthcoming meetings is available on www.omfif.org/meetings. For more information contact meetings@omfif.org

MembershipOMFIF membership is comprised of public and private institutions, ranging from central banks, sovereign funds, multilateral institutions and pension plans, to asset managers, banks and professional services firms. Members play a prominent role in shaping the thematic agenda and participate in OMFIF Analysis and Meetings. For more information about OMFIF membership, advertising or subscriptions contact membership@omfif.org

Advisory BoardThe OMFIF 168-strong Advisory Board, chaired by Meghnad Desai, is made up of experts from around the world representing a range of sectors, including banking, capital markets, public policy and economics and research. They support the work of OMFIF in a variety of ways, including contributions to the monthly Bulletin, regular Commentaries, seminars and other OMFIF activities. Membership can change owing to rotation.

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Official Monetary and Financial Institutions Forum

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Board

John Plender (Chairman) Jai AryaJean-Claude Bastos de MoraisPooma KimisEdward Longhurst-PierceDavid Marsh John NugéePeter Wilkin

Advisory Board

Meghnad Desai, ChairmanPhil Middleton, Deputy ChairmanLouis de Montpellier, Deputy ChairmanFrank Scheidig, Deputy ChairmanSongzuo Xiang, Deputy Chairman

Mario Blejer, Senior AdviserAslihan Gedik, Senior AdviserNorman Lamont, Senior AdviserFabrizio Saccomanni, Senior AdviserTed Truman, Senior Adviser

Editorial Team

Danae Kyriakopoulou, Head of ResearchAngela Willcox, Production ManagerJulian Halliburton, Subeditor Ben Robinson, EconomistDarrell Delamaide, US EditorWendy Gallagher, Marketing

Strictly no photocopying is permitted. It is illegal to reproduce, store in a central retrieval system or transmit, electronically or otherwise, any of the content of this publication without the prior consent of the publisher.

While every care is taken to provide accurate information, the publisher cannot accept liability for any errors or omissions. No responsibility will be accepted for any loss occurred by any individual due to acting or not acting as a result of any content in this publication. On any specific matter reference should be made to an appropriate adviser.

Company Number: 7032533ISSN: 2398-4236

July-August 2016Vol. 7 Ed. 7

Official monetary and financial institutions ▪ Asset management ▪ Global money and credit

The Bulletin

March of female powerA referendum and its consequences

Caroline Butler on Big Data and marketsKevin L. Kliesen on the slow US economy Patrick J. Schena on Saudi sovereign fundBoris Vujčić on central bank independence

Harald Walkate on impact investment

May 2016Vol. 7 Ed. 5

Official monetary and financial institutions ▪ Asset management ▪ Global money and credit

The Bulletin

Efraim Chalamish on China investment in USRichard Koo on European self-financingJohn Mourmouras on negative interest rates Michael Stürmer on the geopolitics of oilMarsha Vande Berg on stagnating wages

Fed and the election Elusive American dream

June 2016Vol. 7 Ed. 6

Official monetary and financial institutions ▪ Asset management ▪ Global money and credit

The Bulletin

Claudio Borio on dollar dominanceMojmír Hampl on activist central bankersGeorge Hoguet on Fed political pressures Ravi Menon on Beijing's debt vulnerabilitiesGary Smith & John Nugée on reserves growth

Storm-tossed currencies Steering through volatility

September 2016Vol. 7 Ed. 8

Official monetary and financial institutions ▪ Asset management ▪ Global money and credit

The BulletinModi and the marketIndia passes a milestone

FOCUS on Luxembourg’s role in Europe Darrell Delamaide on Obama’s legacy

Mar Guðmundsson on financial integration John Mourmouras on debt sustainability

Wang Yao on Chinese green bonds

HISTORICAL REVIEW: SEVEN AGES OF GOLD

4 | ABOUT OMFIF October | ©2016 omfif.org

Central bankers responded to the global financial crisis with a mix of unconventional policies, including negative rates and asset purchases. Addressing September’s OMFIF main meeting in Rome, Banca d’Italia Governor Ignazio Visco noted that such policies helped cushion the

initial shock, and that both subsequent GDP growth and inflation would have been lower without them. But they have hardly provided a panacea. As Visco also noted, such policies have distorted markets and created risks for financial stability.

Extraordinarily loose policies have not only failed to boost growth substantially, but have also created dangerous debt overhangs in many economies. There have been some collateral effects too, examined in this month’s Bulletin. Charles Goodhart and Geoffrey Wood argue that these measures have hurt bank profitability, while Stijn Claessens and Nicholas Coleman of the Federal Reserve Board of Governors, and Michael Donnelly of MIT, consider evidence on the effect on banks’ net interest margins. Ben Robinson presents the findings of an OMFIF report, produced with BNY Mellon, showing that unconventional policies have reduced the supply of liquid assets for collateral. Panicos Demetriades, former governor of the Central Bank of Cyprus, highlights the negative consequences for central banks’ credibility and the notion of their independence.

The good news is there are signs that monetary policy is reaching an important inflection point. This might not be apparent at first sight. The US Federal Reserve defied expectations that it would raise rates at its September meeting. But as Darrell Delamaide argues, this was driven more by politics than economics – a December rate rise is now a virtual certainty. Meanwhile, the Bank of Japan’s decision to refrain from a rate cut and introduce yield curve controls in asset purchases confirms a shift to a more flexible approach. Some monetary alchemy will still be needed to help Japan exit its debt trap without pain – the subject of OMFIF’s latest report, published in September, by John Plender. The case of the Bank of England is more worrying, maintains Peter Warburton, who argues that even a shock as big as Brexit did not warrant the Bank’s August rate cut.

Yet escaping from this unconventional quicksand dragging down central bankers will not be easy. As Luiz Pereira da Silva of the Bank for International Settlements told an OMFIF City Lecture in September, central bankers face a ‘singular dilemma’: continuing with such policies carries dangers in the long run, but exiting also risks market panic. One way to exit is to use more fiscal policy to ease the pain of tightening the monetary screws. With borrowing rates at historical lows, it is now time for governments to invest and they are not doing enough of it. This is not just a feature of developed markets: Donald Mbaka of the Central Bank of Nigeria echoes Visco’s warnings of a ‘suboptimal policy mix’.

Despite these risks, the central bank that was the slowest to join the QE party may still find it hard to leave. A third of responses to our Advisory Board Poll expect the ECB to expand its QE programme into new asset classes instead of letting it expire in March 2017. This could bring the economics back into the spotlight, but for now Europe’s biggest headache remains its politics. As Vicky Pryce highlights, divisions across the euro area have risen and anti-euro movements are gaining ground in many countries. Steve Hanke alerts us to a doomsday scenario for Italian banks – even though the well-publicised problems of Deutsche Bank may provide Italy with a welcome distraction. There may be some silver linings for the European economy however, as Brexit creates an opportunity for financial centres on the continent. This month’s edition includes the second in OMFIF’s series of Focus reports, examining the case for Frankfurt. We round off with William Keegan’s review of an account of his time in politics by Ed Balls, the UK Labour party’s shadow chancellor who lost his parliamentary seat in the 2015 election.

EDITORIALMonetary point of inflection getting closer

October | ©2016 omfif.org MONTHLY REVIEW | 5

Unconventional monetary policies – as the bond-buying programmes by central banks in Japan, the US and continental Europe have been baptised – are really fiscal policy in disguise. As a result of central banks’ transgression into the political sphere, the 40-year period of

central banking independence is now effectively over. We will discover whether this puts the world on to a more or less stable footing. Current policies foster financial instability. By squeezing credit and term spreads, the business models of banks, insurance companies and

pension funds are put at risk, as is their lending. The functioning of financial markets has changed dramatically, with many asset prices bid up dangerously high, threatening future growth. Resources misallocated before 2008 have been locked in through zombie banks supporting zombie companies.

The insidious effects of persistently ‘easy money’ policies can be seen in the alarming slowdown in global growth. Two vicious circles are at work, with a wounded financial system contributing to both. On the demand side of the economy, accumulating debt creates headwinds that slow demand, leading to still more monetary expansion and yet more debt. On the supply side, misallocations slow growth, again leading to monetary easing, more misallocation and still less growth.

There is a route out of the impasse – reliant on government action rather than that of central banks. We need to adopt precepts from both Keynes and Hayek. To please Keynes, governments should use whatever room they have for fiscal expansion, with an emphasis on infrastructure investment in concert with the private sector. Into the Hayekian category fall measures to address excessive debt through careful debt write-offs and restructuring; this might require recapitalisation or closure of those financial firms that made the bad loans. Structural reforms to raise growth potential and the capacity to service debt will pay longer-term dividends.

A paradigm shift in thinking about how the economy and policy actually work is required – and then the political leadership to bring about well-balanced and judicious solutions. One way or another, the bill for accumulated debts will have to be met. If we do not marry the approaches of Keynes and Hayek, the bill will be paid by Greek taxi drivers and German taxpayers – in a fashion that would not only be profoundly unsatisfactory but also highly disorderly. I hope that this is not the path we end up taking.

William White is Chairman of the Economic and Development Review Committee at the OECD.

Perils of fiscal policy in disguiseZombie banks, zombie companies: the reckoning William White, Organisation for Economic Co-operation and Development

6 | MONTHLY REVIEW October | ©2016 omfif.org

Japan’s economy on ‘the edge of a shock’

Search for better policy mix in Rome

‘Clouded outlook’ for Europe and euro

Japan’s monetary and financial system is living on the edge of a shock, with the potential to rock a global financial system still worryingly fragile in the aftermath of the global financial crisis, according to an OMFIF report by John

Plender, published in September.Almost four years after the launch of ‘Abenomics’ – Prime Minister Shinzo Abe’s three-pronged programme aimed at

reviving Japan’s economy – Japan remains stuck in an atypical debt trap. The country’s aging demographic profile and history of excessive rates of corporate saving lie at the heart of an unsustainable build-up of debt that has necessitated increased public spending and caused the government to borrow as a substitute for tax receipts. Abenomics has failed to reverse this reality radically. Plender identifies three potential scenarios out of the debt trap, all of them problematic, and concludes that all encompass significant risks of financial stability that could spill over to the rest of the world. For more details contact editorial@omfif.org.

The ever more urgent search for a better mix of European fiscal and monetary policies was a guiding theme at OMFIF’s Seventh Main Meeting in Europe at the Banca d’Italia on

22-23 September in Rome, against a background of slowing growth, high debt and political fragmentation in many countries.

The overall mood was sombre, with a widespread perception that political risk – from the US presidential election to an upsurge of anti-European political parties – had increased. One well-known political speaker said Europe’s leaders were unable to resolve their difficulties because the continent’s time-honoured recipe of dealing with crises through emergency action forged in the heat of upheaval was no longer working.

According to another top-line speaker, ‘Not even in the global financial crisis have the problems been more difficult… There has been an erosion of the mutual trust on which 2008 co-operation was based,’ he said, listing as the main European problems migration, Brexit, the rise of ‘nationalist and populist’ movements, financial and macroeconomic imbalances, and banking fragility.

Several speakers underlined the need for innovative thinking on Europe, including the possibility of co-operation between blocs of countries, placing different degrees of emphasis on political and economic integration. There was a broad discussion throughout the meeting on the support for ‘populist’ polices in the US and Europe, with opinion divided about the validity and longer-term effects of this development. For Banca d’Italia Governor Ignazio Visco’s speech see p.15.

The clouded outlook for Europe and the euro following the UK vote to leave the European Union, and the need for flexible and innovative fiscal and monetary policies to lift growth

and employment, topped the agenda at an OMFIF Economists Meeting at the National Bank of Hungary on 29 September.

There was a general discussion about the impact of the UK vote on faultlines in Europe, and agreement that this had caused great political uncertainty in all 28 member states, with UK doubts and questions about how to go forward compounding the problems. On a more optimistic view, the meeting heard, the UK would become associated with the EU through some form of ‘satellite relationship’ that would allow the City of London to maintain business through modified ‘passporting’ arrangements.

On a more pessimistic reading, delegates discussed how the EU was heading towards a painful period of transition, with heightened tensions both within and between members and non-members of the euro. The meeting also heard how the National Bank of Hungary was adjusting to increased vulnerability and pressure on GDP growth with a new monetary policy approach using a more flexible set of instruments. This policy balanced financial and monetary stability with the bank’s inflation target and credit initiatives under ‘funding for lending’.

At the edge of the shockJapan’s problematic monetary future

John Plender

21 September 2016

Advisory Board

Professor Jenny Corbett is distinguished professor in the Crawford School of Public Policy at the Australia National University. She is reader in the Economy of Japan at the University of Oxford, a Research Fellow of the Centre for Economic Policy Research and a Research Associate of the Centre for Japanese Economy and Business at Columbia University. She was formerly the executive director of the Australia-Japan Research Centre. She has been a consultant to the Asian Development Bank, the Organisation for Economic Co-operation and Development, the World Bank and the European Commission.

OMFIF has appointed Jenny Corbett to the Advisory Board. For the full list of members, see p.24-25.

October | ©2016 omfif.org MONTHLY REVIEW | 7

Governments ‘should move on stimulus’Governments globally must place greater emphasis on fiscal stimulus and systemic reform to

raise growth in view of low interest rates and diminishing effectiveness of monetary policy, Carolyn Wilkins, Bank of Canada first deputy governor, told an OMFIF City Lecture in London on 14 September.

Wilkins outlined the dangers of slow growth, caused by structural factors such as weak demographics and decelerating productivity. The effects include threats to financial stability, as lower neutral rates raise the risks for indebted households and impede the effectiveness of monetary policy. To address these concerns, Wilkins argued for promoting a sound global financial system through greater use of macroprudential tools, and stressed the importance of pro-growth policies, particularly on the fiscal side.

Canuto: Structural reforms key

Rules ‘unevenly enforced’

Asia meetingsOMFIF Singapore office opening reception A reception to mark the opening of the OMFIF office in Singapore in the presence of Lord (Meghnad) Desai, chairman, OMFIF Advisory Board, Prof. Kishore Mahbubani, Dean, Lee Kuan Yew School of Public Policy and Mr Ravi Menon, managing director of the Monetary Authority of Singapore.16 November, Singapore

Positioning Asia for growth in a challenging global economic environmentThe gathering brings together senior representatives of official and private sector institutions from Singapore, the Asia Pacific region and beyond to discuss critical policy and investment issues facing the region. Co-hosted by the Monetary Authority of Singapore. 17 November, Singapore

Financial stability in an uncertain global environmentThe goal of the seminar is to have candid, interactive discussions of the most significant current threats to financial stability, what needs to be done now to mitigate the most significant risks, what potential spillovers might occur, and whether crisis management arrangements are sufficient.23 November, Kuala Lumpur

For details visit www.omfif.org/meetings.

Greater coordination needed in BeijingOn 3 October, the first day for markets following the renminbi’s inclusion in the special drawing right, OMFIF held a telephone briefing which discussed the need for greater coordination between

economic and financial reforms in Beijing. Ben Shenglin, executive director, Renmin University International Monetary Research Institute, moderated the call between Alain Raes, chief executive, EMEA and Asia Pacific, SWIFT and Linda Yueh, fellow in

Economics at St Edmund Hall, Oxford University.

Election influence on Fed rate decision Nick Verdi, senior foreign exchange strategist at Standard Chartered Bank, and Joseph Gagnon, senior fellow at the Peterson Institute for International Economics, told an OMFIF telephone briefing on 20

September that the US Federal Reserve was unlikely to raise rates the following day, reflecting the influence of the electoral cycle. The discussion also covered the Bank of Japan, with speakers agreeing that more monetary policy action was needed to

support growth in the Japanese economy.

Otaviano Canuto, executive director of the World Bank and member of the OMFIF

Advisory Board, gave a City Lecture on 20 September in London on global imbalances.

These have recently re-emerged as an important topic for policy-makers, with current account positions across economies diverging again after a narrowing of imbalances following the global financial crisis. A rebalancing of internal and external objectives across countries would help support global growth, but it is not a panacea: country-specific agendas of structural reforms are key to help economies overcome ‘income traps’. Canuto also touched on the economic outlook of his home country, Brazil. While he admitted that the economy is suffering from a double malaise of productivity anaemia and ‘fiscal indigestion’, he argued that a reduction in the risk premium for businesses, more competition in the private sector, and improved efficiency in the public sector should all contribute to a stronger economy.

Financial globalisation provided ‘freedom’ for advanced economies to run large current account

deficits that amplified the effects of the crisis on emerging markets, Luiz Pereira da Silva, deputy general manager of the Bank for International Settlements, told an OMFIF City Lecture on 19 September in London.

Pereira da Silva drew attention to challenges facing emerging markets such as the uneven enforcement of rules in the international system. On advanced economies, he highlighted the ‘singular dilemma’ faced by international monetary policy-makers, between continuing with risky and decreasingly effective monetary policies and entering tightening that could cause market panic.

8 | INTERNATIONAL MONETARY POLICY October | ©2016 omfif.org

Limits of ‘low-for-long’ interest ratesHow fluctuating economies affect bank margins and profits Stijn Claessens, Nicholas Coleman, and Michael Donnelly

While overall bank profitability in advanced economies, measured by

return on assets, has recovered from the worst of the global financial crisis, it remains low. Many banks are facing profitability challenges related to low net interest margins, typically measured as net interest income divided by interest earning assets, and weak loan and non-interest income growth.

While NIMs across many banks in advanced economies have been trending downwards over the longer term, they have fallen more sharply since the financial crisis – in part, it appears, because of lower interest rates.

In many ways, banks can benefit from low interest rates both directly (such as through valuation gains on securities they hold) and indirectly (for example, levels of non-performing loans will be lower as borrowers’ debt service is less burdensome). On the narrower question of the effects of low interest rates on banks’ NIMs, however, analytics and empirical findings suggest that NIMs are lower when interest rates are low.

Low short-term interest rates can depress bank margins. For many types of deposits,

banks are reluctant to lower interest rates. As they must pass on lower rates on assets linked to contractual repricing terms (such as floating rate loans) to borrowers with other financing choices – and have an incentive to do so – bank margins compress as rates decline.

Analysing a sample of 108 relatively large international banks, many from Europe and Japan, and 16 from the US, Claudio Borio, Leonardo Gambacorta and Boris Hofmann, in their 2015 paper ‘The influence of monetary policy on bank profitability’ (BIS Working Paper 514, October 2015), documented the negative effects of low interest rates (and shallow yield curves) on banks’ NIMs and

profitability, concluding that effects were stronger at lower interest rates.

Evidence from the US supports this conclusion, though the direct effects of low rates are relatively small. Analysis for Germany suggests normally small long-run effects of interest rate changes on NIMs, but large effects in the recent, low-interest rate environment. Evidence for other countries has been more scarce.

New analysis: data and methodologyOur new cross-country analysis confirms and expands on these findings. A database was assembled with 3,418 banks from 48 countries for the period 2005-13. Countries were classified each year as being in either a low- or high-rate environment, based on whether the interest rate on their three-month sovereign bond was below or above 1.25% (other cut-offs were also tested and yielded similar results).

Chart 1 shows the sample of countries covered and the range and median of the short-term yields in each country. The variations in rates are large for a number of countries, with many both in the high- and low-yield environment for some time (the

Source: Bloomberg, Federal Reserve staff calculations

N.B. Values used are yearly averages of the implied three -month rate between 2005 -13 as published by Bloomberg

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Interest rate range Boundary for low interest rate (1.25%) Median three-month sovereign yield

Chart 1: Advanced economies affected most by low yields

Range and median of short -term yields, %, and low interest rate boundary

Chart 1: Advanced economies affected most by low yieldsRange and median of short-term yields, %, and low interest rate boundary

Source: Bloomberg, FRB staff calculations. Values used are yearly averages of the implied three-month rate published by Bloomberg.

“Net interest margins are lower when

interest rates are low – banks must pass on lower rates on assets linked to contractual repricing terms.

October | ©2016 omfif.org INTERNATIONAL MONETARY POLICY | 9

median provides a sense of how long each country has been in each environment).

Particularly advanced economies faced low yields after the global financial crisis – 19 such countries in 2009 as opposed to just two in 2005. These shifts help to estimate the differential impact of low rates on banks’ NIMs.

Chart 2 shows that average NIMs are higher in the high-rate environment than in the low-rate environment. Profitability, measured by return on assets, is higher too in the high-rate environment. This is likely to reflect both higher NIMs and concurrent better overall economic and financial environments.

To isolate effects, we regressed the NIMs for all banks for each year on the average level of the three-month sovereign rate in that year (a common proxy for banks’ marginal funding costs) – controlling for the bank’s own lagged NIM, other time-varying bank characteristics, and a bank fixed effect, as well as GDP growth and the spread between the three-month and 10-year sovereign rates. The sample was then split into banks in low- and high-interest rate environments.

The results show that a decrease in the short-term interest rate lowers NIMs in both low- and high-rate rate environments, with effects symmetric for an interest rate increase. But, all other things being equal, effects are statistically greater in a low-rate environment.

Chart 3 summarises the regression results. For a representative bank, a one percentage point decrease in the short-term rate is associated with a 0.09 percentage point decrease in NIM in the high-rate environment versus a 0.17 percentage point decrease in the low-rate environment.

We also analysed separately the effects of movement in interest rates on changes in interest expenses and interest income.

The more pronounced effects on NIMs in the low-rate environment are largely driven by the greater pass-through of low rates on interest income rather than on interest expenses.

Specifically, a one percentage point decrease in the short-term rate is associated with a 0.63 percentage point decrease in the ratio of interest income to earning assets in the low-rate environment, and only a 0.35 percentage point decrease in the high-rate environment, a 0.28 percentage point difference. The equivalent difference is

around 0.20 percentage points for the ratio of interest expense to liabilities.

In other words, at low rates, banks have greater difficulty reducing their funding rates. Moreover, they still largely have to pass the lower rates on to their borrowers.

This is likely to be due to greater competition, including from non-bank lenders, and lower demand for loans. Economic activity is lower in times of low interest rates, causing NIMs to decline more.

Overall effects and conclusionsWhile there are caveats, our findings strongly suggest that NIMs are low when interest rates are low.

An important issue then is how banks can adjust their activities and cost structures to offset adverse effects on profitability and capital. Although institutions are making adjustments, such efforts take time, with limited immediate pay-offs when facing weak cyclical conditions and deleveraging pressures.

This poses a challenge for banking systems in many low-interest rate countries. Until lost income can be offset through other actions, lower profitability will reduce financial institutions’ ability to build and attract capital.

This increases their vulnerability to shocks and declines in market confidence, undermines their ability to support the real economy, and potentially weakens the transmission channel of monetary policy. ▪Stijn Claessens and Nicholas Coleman are Economists at the Board of Governors of the Federal Reserve System. Michael Donnelly is a Masters student at MIT. The views expressed are those of the authors and should not be attributed to the Board of Governors of the Federal Reserve System.

Chart 2: Negative impact when rates fall below 1.25%Net interest margins and return on assets, %

Source: Bankscope, Federal Reserve staff analysis

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Chart 2: Negative impact when rates fall below 1.25%

Net interest margins and return on assets, %

Source: Bankscope, Federal Reserve staff analysis

Chart 3: Short-term rates drive bank returnsEstimated impact on bank margins in low- and high-interest rate environments (bps)

Source: Federal Reserve staff analysis

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Estimated impact on bank margins in low and high interest rate environments (bps)

Source: Federal Reserve staff analysis

10 | EUROPE October | ©2016 omfif.org

The G20 leaders’ communiqué on 5 September following their summit

in Hangzhou, China, was the last before Germany takes over the G20 leadership on 1 December. It was, as would be expected, a positive one, full of good intentions – geopolitical stability, solving the refugee crisis, containing environmental damage, fighting terrorism, and so on.

On the economic front, the leaders acknowledged that although the world recovery was ‘progressing’, this was not happening fast enough. Investment and trade remain sluggish, unemployment is still too high in many countries, and volatility in commodity and financial markets provides a threat to stability.

The threat of protectionism emerges when economies do less well. At times the threat is realised, backed by populist movements, before unravelling over time. But the damage can be significant.

The G20 leaders called for protectionist trends to be curtailed and restated their commitment to reducing trade barriers further, setting themselves firmly against competitive devaluations. The fear of protectionism and its negative impact on world trade were also highlighted by the International Monetary Fund in its latest World Economic Outlook published in early October.

A tide of nationalist fervourBut this is hard to achieve against a tide of increased nationalist fervour, in both economics and politics. Despite the rhetoric, a World Trade Organisation report on G20 trade restrictions, published in June, found that around 70% of restrictive measures were instigated by G20 economies.

The campaign slogan ‘Taking back control’ was instrumental in convincing the majority of British voters to support ‘Brexit’ on 23 June. Donald Trump’s presidential campaign in the US has protectionism, even isolationism, as its core message.

Europe, severely shaken by the British vote to leave the European Union, has yet to decide in a cohesive way how to respond – something that the divisions evident at the conclusion of the EU’s Bratislava summit on 16 September made very clear.

Meanwhile, nationalist parties are gaining ground in France, Italy, the Netherlands, Austria and Germany. Countries such as Poland, Hungary, and Slovakia protest that their voices are not being heard. Hungary’s 2 October referendum overwhelmingly

rejected European refugee-sharing proposals, although turnout was below the threshold for validity.

Southern Europeans are increasingly united and vocal about the unfairness, as well as the negative economic and social impact, of policies often perceived as being imposed by supranational European policy-makers. This creates the strong impression of a divided Europe.

One of the G20 leaders’ main pledges clearly is not being met, namely the need for well-designed and coordinated monetary and fiscal policies to achieve ‘strong, sustainable, balanced and inclusive growth’.

Rhetoric and realityThe European Central Bank is doing what it can on the monetary front, but this alone will not guarantee balanced growth. That requires other policy elements, including fiscal.

The G20 sets down a high standard: ‘We are using fiscal policy flexibly and making tax policy and public expenditure more growth-friendly, including by prioritising high-quality investment, while enhancing resilience and ensuring debt as a share of GDP is on a sustainable path.’

The reality is somewhat different. Spain and Portugal narrowly escaped being fined for missing their deficit targets. Southern European countries’ debt to GDP ratios remain unsustainable – not only Greece’s 188% but Italy’s 137%, Portugal’s 130%, and Spain’s now nearly 100%.

At the opposite extreme, Germany has ignored bodies including the Organisation for Economic Co-operation and Development, the European Commission and the International Monetary Fund by running a budget surplus and a current account

surplus of some 7% of GDP. The current account surplus this year is expected to be even more, 9% of GDP

The popularity of Angela Merkel, the German chancellor, is falling following last year’s significant influx of refugees. This led to her suffering setbacks in recent regional elections.

In Italy a constitutional referendum on 4 December could result in Prime Minister

Matteo Renzi’s downfall, though Renzi has stated that his government will remain in place irrespective of the result.

There is still no firm government in Spain after two elections – a third is expected in December – and increasing talk of new elections in Greece.

Merkel must be wishing that another country could head the G20 from 1 December. Taking responsibility for unachievable G20 pledges adds one more task to her list of unenviable challenges. ▪

Vicky Pryce is a Board Member at the Centre for Economics and Business Research and a former Joint Head of the UK Government Economic Service.

Merkel’s tasks for divided continent Taking responsibility for unachievable G20 pledges Vicky Pryce, Advisory Board

“The threat of protectionism emerges

when economies do less well. At times the threat is realised, backed by populist movements, before unravelling over time. But the damage can be significant.

Angela Merkel, Chancellor of Germany

Global liquidity – a vital ingredient in the factors driving markets and growth

worldwide – has been under severe strain in the eight years since the financial crisis. This is underlined by periodic disruption in even the most liquid market of sovereign bonds, as well as limits on some fund redemptions and less frequent trades and lower turnover for some assets. As an OMFIF report published on 11 October demonstrates, global public investment institutions have contributed to this situation, but sovereigns show a growing willingness to play a role in mitigating the challenges.

Low interest rates from central banks led to an expansion of high-yield and ‘junk’ bond issuance, while large public purchases of safe and liquid assets reduced yields for investors, pushing them towards these riskier assets.

A second cause of lower liquidity – the tightening of banking regulations which have raised the cost of balance sheet-intensive activities such as market-making – has meant banks have become less able and less willing to stabilise markets. In the past, banks and securities firms helped smooth the market when an immediate buyer or seller could not be found, by using their balance sheet to become the counterparty to trades. However since 2008 they have lowered their inventories by over 80%, reducing their ability to play a stabilising role.

Substantial dangersThe result is a large growth in primary market issuance despite a lack of secondary market depth, making assets vulnerable to rapid price corrections when monetary policy or market sentiment changes. The speed with which this may happen has increased as market participants have changed, including the growth of ‘shadow banking’ institutions, mutual funds and high-frequency traders, adding to complexity over counterparty risks and trade strategies.

The dangers are substantial. If liquidity in financial markets and the ability of corporate and sovereign bond issuers to raise funds at affordable prices are reduced, second round effects could emerge which set off a series of bankruptcies and insolvencies.

As seen after the financial crisis, when trust in financial markets evaporates, along with confidence in the quality of assets and the ready availability of funds on which liquidity depends, the reverberations can be deep and long-lasting.

The prospect of divergent monetary policy between different central banks brings these

risks to the fore, as many emerging economies are highly leveraged, many mutual funds offer open-ended daily redemptions, and large amounts of post-crisis debt issuance remain outstanding. Future US rate hikes risk asset price deflation, a decline in new issuance and an increase in short positions.

In this context, compensating for the lack of liquidity-enhancing but balance sheet-intensive activities of banks, stabilising markets to prevent investor runs, and ensuring access to wholesale market funding are vital to avoiding a liquidity shock. As underlined by an OMFIF survey of sovereign institutions with $4.74tn in assets under

management, sovereigns are willing to meet these challenges, particularly via increased capital markets activities such as securities lending and direct funding of less-liquid asset classes including private debt and equity.

Among other palliatives, sovereign investors suggest widening collateral eligibility for repo transactions, increasing sovereign participation in wholesale funding markets, ‘renting’ their balance sheets, and directly funding some assets and projects to offset some of the issues of bank disintermediation.

Obstacles to overcomeObstacles need to be overcome, however, including regulations on banks and dealers, a lack of coordination between regulators and sovereigns, and a lack of coordination among sovereigns themselves.

Some GPIs need to overcome internal rules that prevent them from pursuing a more active role in securities lending or repo markets. They need to manage the implied counterparty, credit, collateral and cash collateral reinvestment risk involved in these expanded activities.

Reforms to market infrastructure and practices can offset some of these challenges, including via better collateral valuation rules and margining policies, as well as increased counterparty risk management. The tri-party repo reform in the US, and the European Markets Infrastructure Regulation which places a central clearing counterparty between traders, have helped to tackle some of these concerns. They have, however, raised costs and increased demand for high quality collateral. This raises the importance of collateral management and reuse facilities from custody banks.

Scope for sovereign involvementThe desirable level of sovereign institutions’ involvement in capital markets is contested, with some survey respondents arguing that it is not the role of official institutions to price risk or make markets, and should instead act as asset managers with a long-term view. However more than 40% of institutions believe there is an increased capital markets role for sovereigns as a result of bank disintermediation.

The potential benefits are significant: not just an increase in market liquidity and resilience to destabilising shocks, but also the rewards of higher yields to offset the disbenefits of low or negative interest rates on high-quality liquid assets.

Ben Robinson is Economist at OMFIF. This is an edited version of ‘Mastering flows, strengthening markets: how sovereign institutions can enhance global liquidity‘. For a copy of the report, please contact editorial@omfif.org.

October | ©2016 omfif.org INTERNATIONAL MONETARY POLICY | 11

“Compensating for the lack of liquidity-

enhancing but balance sheet-intensive activities of banks, stabilising markets to prevent investor runs, and ensuring access to wholesale market funding are vital to avoiding a liquidity shock.

Global liquidity under pressureOMFIF report highlights role of Global Public InvestorsBen Robinson

Mastering flowsStrengthening markets

How sovereign institutions can enhance global liquidity

In association with

12 | INTERNATIONAL MONETARY POLICY October | ©2016 omfif.org

Fed holds off amid election campaignDecember rate hike likely after 8 November voteDarrell Delamaide, US editor

Despite the protests to the contrary, it was never likely that the US Federal Reserve

would raise interest rates in September, just weeks before the presidential election. Even less so in November, just days before the vote.

Fed chair Janet Yellen sought to emphasise at the press conference following the late September meeting of the Federal Open Market Committee that the US central bank is not political in any way, shape or form.

‘I can say, emphatically, that partisan politics plays no role in our decisions about the appropriate stance of monetary policy,’ she said in response to a question. ‘We do not discuss politics at our meetings and we do not take politics into account in our decisions.’

But that affirmation means it could not take any action with uncertain consequences so close to an election.

Raising rates could have a negative impact on stock prices. Making the move just as the last voters are making up their minds would bring a barrage of criticism from the staff of Hillary Clinton, who is campaigning on the steadiness of the economy under her fellow Democrat, Barack Obama.

‘Fed doing political things’Of course, not taking action can also be interpreted as political, and Donald Trump did not hesitate to level this charge in the first presidential debate.

‘We are in a big, fat, ugly bubble,’ Trump said, commenting on the US economy. ‘And we better be awfully careful. And we have a Fed that’s doing political things. This Janet Yellen of the Fed. The Fed is doing political – by keeping the interest rates at this level.’

The controversial candidate continued in his colourful, stream-of-consciousness way: ‘And believe me: The day Obama goes off, and he leaves, and goes out to the golf course for the rest of his life to play golf, when they raise interest rates, you’re going to see some very bad things happen, because the Fed is not doing their job. The Fed is being more political than secretary Clinton.’

Some Fed officials themselves have voiced concerns about asset bubbles forming after the long period of low interest rates, so Trump’s critique is not outlandish.

But his personalising the criticism and directing it at Yellen puts her in an awkward position if Trump wins the election – which cannot be ruled out. Some analysts have gone so far as to suggest that Yellen would step down in the event of a Trump victory, even before the December FOMC meeting, if

only to take the heat off the other Fed policy-makers.

That may sound somewhat far-fetched, but it indicates that the Fed cannot help but be drawn into the political quicksand of this bizarre election. It does not necessarily mean, however, that the Fed’s explanation for leaving rates unchanged in September is just so much window-dressing.

‘The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the

time being, to wait for further evidence of continued progress toward its objectives,’ the consensus statement read. ‘The stance of monetary policy remains accommodative, thereby supporting further improvement in labour market conditions and a return to 2% inflation.’

Dissent among the FOMCHowever, there was an unusually high level of dissent. Three of the five regional bank heads who are voting members – Esther George of Kansas City, Loretta Mester of Philadelphia, and Eric Rosengren of Boston – said they would prefer to raise the target rate for federal funds a quarter point to 0.75% right now. Only James Bullard of St. Louis and William Dudley of New York supported Yellen and the other four in the Washington-based board of governors.

Could a decision come in November, she was asked at the press conference. ‘Every meeting is live, and we will again assess as we always do incoming evidence in November and decide whether or not a move is warranted.’ Don’t hold your breath.

But Yellen also said that ‘most participants do expect that one increase in the federal funds rate will be appropriate this year, and I would expect to see that if we continue on the current course of labour market improvement and there are no major new risks that develop and we simply stay on the current course.’

This seems to make a rate hike in December a virtual certainty, barring any unexpected bad news. (A Trump victory, for instance,

could provoke a negative market reaction that would give the Fed pause.)

In a widely noted speech the week before the FOMC meeting, Fed governor Lael Brainard signalled decisively that the Fed would wait on action. She said in Chicago that ‘the costs to the economy of greater than expected strength in demand are likely to be lower than the costs of significant unexpected weakness.’

Brainard, who many think could become Treasury secretary if Clinton wins, concluded: ‘This asymmetry in risk management in today's new normal counsels prudence in the removal of policy accommodation.’

Restless regional bank chiefsBut the regional bank chiefs are restless. In an unusual move, Rosengren, usually a dove, issued a statement defending his dissenting vote: ‘The economic progress since the last tightening in December might, by itself, be sufficient to justify a further increase in the rate target. However, it is in considering the implications of current policy for the sustainability of the expansion that the case for raising rates has now become even more compelling.’

Another dove, San Francisco Fed chief John Williams, indicated that the dissenting voters have support for their arguments from the seven regional bank heads who currently do not have a vote.

‘It is getting harder and harder to justify interest rates being so incredibly low given where the US economy is and where it is going,’ he told Reuters in an interview. ‘I would support an interest rate increase. I think that the economy can handle that. I don’t think that would stall, slow or derail the economic expansion. ▪Darrell Delamaide is a writer and editor based in Washington.

“Some Fed officials have voiced concerns

about asset bubbles forming after the long period of low interest rates.

Esther George, President, Kansas City Fed

October | ©2016 omfif.org INTERNATIONAL MONETARY POLICY | 13

At a time when interest rates, throughout the yield curve, are at an all-time low,

it could be argued that the public sector, the biggest debtor, should be trying to lock in such rates by shifting to ever longer maturities and duration.

However, if one adjusts for central bank swaps, under which central banks effectively buy longer-dated government debt in exchange for sight deposits, the overall maturity of public sector debt in most countries practising quantitative easing has been going down, not up.

We are told that such central bank deposits need not, indeed should not, ever get repaid. That they are, or should be, the equivalent of Consols (a type of British government bond redeemable at the option of the government) – quasi-permanent debt.

Jeremy C. Stein, professor of economics at Harvard University, argues that satisfying liquidity needs enhances financial stability and that monetary policy can continue by varying the interest paid on central bank deposits.

He adds that enlarged central bank balance sheets should remain a permanent feature. But as such reserve deposits are now interest-bearing, the huge volume of central bank deposits increases the public sector interest rate roll-over risk just as much as if the Treasury had issued a similar amount of Treasury bills.

If liquidity needs are satiated in this way – at a time when debt ratios have been climbing at a rate hitherto unparalleled in peacetime – why are there still claims that interest rates are being held down by excessive demand for

‘safe’ assets? Is this claim consistent with the narrowed risk premia now being observed?

Furthermore, if the demand for liquidity, and reserves, by banks is to remain satisfied, what then constrains, and determines, the aggregate money stock, mostly consisting of commercial bank deposits, and bank lending to the private sector? The answer, we would presume, is the availability of bank (equity) capital. But capital will be made available only if the business is sufficiently profitable to earn a competitive return (unless the public sector injects the capital itself).

In the banking sector, negative interest rates, a flat yield curve, and substantial fines on the banking institutions (rather than the

bankers who perpetrated, or failed to prevent, the misdeeds) are not conducive to greater profitability. Profitability is procyclical.

Has policy been actively damaging bank profitability and hence growth of money and credit? In most academic studies of the efficacy of monetary policy, all that appears to matter is the direct link between riskless official short-term rates, and future expectations thereof, and the real economy.

In David Reifschneider’s 2016 Federal Reserve Board paper, ‘Gauging the ability of the FOMC to respond to future recessions’, the words ‘bank’, ‘money supply’ and ‘credit’ do not appear. The same official insouciance about the profitability of financial intermediation goes wider than just banks. Insurance companies and pension funds are pressured to hold matching assets against their liabilities. Policy then serves to reduce the availability and yield of such assets.

If the effect of monetary policy has been to weaken the profitability of financial intermediation, might this help to explain why the massive monetary expansion measures undertaken by central banks have had so little impact on the real economy? Perhaps QE has now become ‘Quite Erroneous’. ▪Charles Goodhart is Professor Emeritus at the London School of Economics and Political Science. Geoffrey Wood is Professor Emeritus of Economics at the Cass Business School.

Quite erroneous policyBond-buying has little impact on real economy Charles Goodhart and Geoffrey Wood

6

5

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US UK Euro area

Fed QE Nov 2008

BoE QE Mar 2009

ECB QE Mar 2015

2006

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Chart 1: Despite QE, inflation remains subdued Annual consumer price inflation, %

Source: US Bureau of Labour, ONS, Eurostat , OMFIF analysis

Despite QE, inflation remains subduedAnnual consumer price inflation, %

“Negative interest rates, a flat yield curve, and

substantial fines on the banking institutions are hardly conducive to greater profitability.

Source: US Bureau of Labor, ONS, Eurostat, OMFIF analysis

14 | SUSTAINABLE INVESTMENT October | ©2016 omfif.org

The 21st UN Climate Change ‘Conference of the Parties’, held in Paris in December

2015, ended with the milestone agreement for countries to reduce their greenhouse gas emissions sufficiently to keep the increase in global temperatures well below 2°C this century.

The agreement established a system for measuring individual countries’ commitments and contribution every five years. A progress assessment is set for 2018.

Although it is too early to determine whether the agreement has been drafted sensibly or whether it will deliver on its commitments, it sets the tone for policies and businesses.

Investors now have a number of options to contribute to the transition to a more sustainable economy. In this context, the best-case scenario is a race to the top for both investors and companies to take part in the fight against climate change.

Policy pushThe strongest policy push following the Paris conference came from France, where the government encouraged the financial community to adopt Article 173 of France’s law on energy transition and green growth.

By asking investors to disclose how they factor environmental, social and governance criteria, as well as carbon-related aspects, into their investment policies, the law points

the way towards more sustainable patterns of investment.

The Paris agreement also led a number of investors to reconsider their investments in oil. Mark Carney, the governor of the Bank of England, declared in September 2015 that investors faced potentially significant losses as a result of climate change action. Following this, even investors who did not think of

themselves as particularly ‘pro-environment’ began to reconsider the viability of investing in oil companies. Now they are pondering the real costs of the carbon bubble.

The European Commission demonstrated an understanding of the various issues of relevance to different stakeholders, as well as strong willingness to support this change.

In the last six months, it has launched two key consultations. These have examined how companies can increase their transparency, following up on the new directive on non-financial reporting, and how investors can improve their standards in respect of long-term and sustainable investments.

Both pieces of the same puzzle, the consultations have sent a strong message about the importance of those ‘intangible’ criteria, most often referred to as economic, social and governance criteria.

Looking to the long termEmbedding these criteria into investment analysis and portfolio construction across a range of asset classes is the underlying principle of sustainable and responsible investment. According to Eurosif’s definition, socially responsible investment ‘is a long-term orientated investment approach which integrates ESG factors in the research, analysis and selection process of securities within an investment portfolio. It combines fundamental analysis and engagement with an evaluation of ESG factors in order to better capture long-term returns for investors, and to benefit society by influencing the behaviour of companies.’

ESG incorporation In ESG incorporation, investment institutions complement traditional quantitative analysis of financial risks and returns with qualitative and quantitative analyses of ESG policies, performance, practices and impacts.

Asset managers and asset owners can incorporate ESG issues into the investment process in a variety of ways. Some may actively seek to include companies that have stronger ESG policies and practices in their portfolios, or to exclude or avoid companies with poor ESG track records.

Others may incorporate ESG factors to benchmark corporations to peers or to identify ‘best in class’ investment opportunities based on ESG issues. Still other responsible investors integrate ESG factors into the investment process as part of a wider evaluation of risk and return.

Regulators have come a long way in pushing the socially responsible investment industry forward. But much can still be done to help SRI become a significant factor in the transition to more sustainable economies. ▪Flavia Micilotta is Executive Director of Eurosif, the European Sustainable Investment Forum.

Market approach to climate change Necessary transition to more sustainable economiesFlavia Micilotta, Eurosif

Source:

S&P 500 ESG Index

Performance

Suggested title: ESG market indices shows stronger performance compared to their market -cap weighted counterparts.

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S&P 500 ESG S&P 500

ESG market indices outperform market counterparts Growth of S&P 500 and ESG variant of index, %

“Asking investors to disclose how they factor

environmental, social and governance criteria, as well as carbon-related aspects, into their investment policies, points the way towards more sustainable patterns of investment.

Source: S&P 500 ESG Index

Frankfurt forgesEuropean path

October 2016

“Frankfurt and its hinterland provide

the crucible for fast-developing financial technology companies, as well as expanding foreign investment and trade.

II | FOCUS : FRANKFURT October 16 | © 2016

This second report in the OMFIF series on European financial centres after the UK European Union vote goes beyond the issue of financial innovation and capital markets discussed in

September’s Luxembourg analysis. We focus on the crucial juxtaposition of the real economy and Europe’s financial sector, giving

Frankfurt and the surrounding Rhine-Main area – known as the FrankfurtRheinMain region – a pivotal place in the overall European economy.

As the heart of European manufacturing, Germany provides traditional emphasis on financing larger and smaller businesses, including the legendary Mittelstand category of smaller, often family-owned firms that form the country’s economic backbone. Frankfurt is a nexus for this interplay between finance and industry, as well as an important regulatory, financial and monetary policy-making centre. The city is home to the European Central Bank and the Deutsche Bundesbank, the ECB’s most important and often most vocal shareholder.

Frankfurt and its hinterland provide the crucible for fast-developing financial technology companies, as well as expanding foreign investment and trade that have been one of the mainsprings of German growth since the 19th century. Benefiting from roots in German industry, Frankfurt has global reach, seen in the international activities of Deutsche Börse and the growing role of renminbi clearing and settlement, as well as the city’s experience in connecting start-up companies to European and international investors.

The potential for interlinked EU projects such as the Commission’s strategic investment plan and capital markets union points to further possible extension of Frankfurt’s role in raising funds and mobilising capital. Brexit vicissitudes provide opportunities for Frankfurt expansion, not least its ability to attract international financial institutions and regulatory bodies, including those which may move from London. This is not a zero sum game; there is plenty of room for growth- and revenue-generating co-operation between Frankfurt and London, as the planned merger of Deutsche Börse and the London Stock Exchange (whatever the post-UK-referendum uncertainties) demonstrates.

Germany and the Frankfurt region have a vital position bridging the needs of European households and businesses and the exigencies of dynamic banking and financial markets. In the new structures emerging after the UK vote, Frankfurt looks set to forge a still more important European path.

FRANKFURT FOCUSA growing centre with European and global reach

CONTENTSII A growing centre with global reach

III Enhanced prowess and responsibilities Ben Robinson

V Formidable springboard for the future FrankfurtRheinMain

VI Promising real estate pipeline FrankfurtRheinMain

VII Combining lifestyle and performance Stephan Bredt and Armin Winterhoff

Source: Global Financial Centres Index 19 (March 2016), examining financial centres’ global competitiveness, based on profiles, ratings and rankings for 86 centres.

EUranking

Financial centre

GFCI 19ranking

1 London 1

2 Luxembourg 14

3 Frankfurt 18

4 Munich 27

5 Paris 32

6 Amsterdam 34

7 Stockholm 37

8 Dublin 39

9 Vienna 40

10 Warsaw 48

GFCI financial centre ranking tableTop 10 EU performers

‘Frankfurt Focus’ forms part of the OMFIF Bulletin for October 2016. It is not to be distributed separately without permission of OMFIF. The same disclaimer applies as on p.4 of the Bulletin.

“Euro clearing and settlement activities,

the majority of which take place in London, may move within the euro area, again potentially providing a boost to Frankfurt.

“Access to renminbi liquidity facilitates

trade between Chinese and euro area companies by removing currency risks, time delays and exchange rate costs.

October 16 | © 2016 FOCUS : FRANKFURT | I I I

Germany is Europe’s largest economy, leading exporter, biggest creditor and the base for euro area financial, regulatory and monetary policy-making institutions. Frankfurt is at the heart

of this activity, as Germany's largest financial centre and a pivotal location for European capital markets.

As the home of the European Central Bank and the Bundesbank, Frankfurt is a key location for non-EU companies and banks, particularly from China, seeking access to European policy-makers and regulators as well as financial market operators across many sectors. This role has become still more significant since 2014 when the ECB assumed supervisory responsibility for banks operating in the euro area, under the Single Supervisory Mechanism. Frankfurt is home to the European Systemic Risk Board, responsible for macroprudential regulation. The European Insurance and Occupational Pensions Authority is based in the city, as is the European Banking Federation, the main body for the European banking sector.

Post-Brexit this concentration of institutions, prowess and responsibilities could be strengthened further. The European Banking Authority, which regulates the European banking sector, is based in London. After the UK voted to leave the EU the EBA argued that this can no longer continue, placing the institution in search of a new home within the EU. Though Frankfurt faces competition from Paris, the city’s powerful presence in housing other EU supervisory and regulatory bodies puts it in a strong position.

Euro clearing and settlement activities, the majority of which take place in London, may move within the euro area, again potentially providing a boost to Frankfurt. In 2015 the ECB lost a court case seeking to move euro clearing within the euro area and away from London, on the basis that it would discriminate against an EU member. London may now be vulnerable to a second attempt. Some industry observers however say that no other EU centre will gain the clearing business, maintaining that the only financial metropolis with sufficient economies of scale to play this role lies outside the EU – in New York.

Whether or not various Frankfurt overtures are successful, the uncertainty surrounding the UK’s access to the single market and to ECB liquidity once it leaves the EU means banks may pre-emptively move at least some of their operations to the euro area. As unquestionably the euro area’s central banking hub, Frankfurt is well positioned to attract this business.

A European base for Chinese banksAmong the financial institutions that have been attracted to Frankfurt are Chinese banks, including the People’s Bank of China, which maintains its euro area base in the city, along with the five largest Chinese commercial banks, which have used the city as a focal point for expanding their European activities. In 2014 Frankfurt was chosen as the location for the first renminbi clearing and settlement centre outside Asia, following the establishment of a currency swap agreement between

the ECB and the PBoC in 2013, and the granting of Renminbi Qualified Foreign Institutional Investor status to Germany in 2014.

Frankfurt offers a wide range of renminbi products and services to companies based in the euro area, so long as their bank maintains an account at the Bank of China in Frankfurt. These include renminbi trading and hedging; opening and processing letters of credit; issuing bank guarantees; processing capital transfers in China; and active currency management, via onshore renminbi hedging and offshore currency swaps.

Access to renminbi liquidity facilitates trade between Chinese and euro area companies by offsetting currency risks, time delays and exchange rate costs. The share of euro area-China trade denominated in renminbi, currently around 20%, is expected to double within the next few years, putting Frankfurt at the centre of an important financial development.

Market infrastructure and new technologiesFrankfurt has expanded its role beyond Europe, becoming an important player in global capital markets. It is home to Eurex, the third-largest derivatives exchange in the world (by contract volume), and the largest futures and options market in Europe. It has been investing in market infrastructure and new technologies, resulting in it winning many awards for excellence in European exchange and clearing house performance.

Frankfurt-based Deutsche Börse, one of the leading global stock exchanges, has increased its activities, purchasing important index providers and trading platforms, including the 360T currency trading platform, contributing to expanded trading and investment on the Frankfurt exchange.

In response to the opportunities and disruptive repercussions of digitisation sweeping global banking and finance, Deutsche Börse has invested heavily in fintech. Between 2013 and 2015 German investment in fintech companies increased more than fivefold, to €580m. This is far ahead of France but still slightly below the UK, the biggest fintech investment centre in Europe with just over €700m in 2015.

Enhanced prowess and responsibilitiesBen Robinson

“The shape of the planned merger

between the Frankfurt and London stock exchanges has not been completely clarified following the Brexit vote.

“These two diverse yet complementary

cities play interlocking roles in wholesale banking and trading, international asset and wealth management and corporate deal-making.

“As part of a broader strategy by Beijing

to internationalise the renminbi and improve access to international investors, Frankfurt benefits from potential for further renminbi product development.

IV | FOCUS : FRANKFURT October 16 | © 2016

Vital outcome of Deutsche Börse negotiationsFrankfurt is establishing an incubator for fintech and other financial start-up companies, centred on the cluster of Goethe University, the Technical School of Darmstadt and the Frankfurt School of Finance and Management. The stock exchange has established the ‘Venture Network’ platform to increase interaction between investors and start-ups, as well as providing free space to start-up companies around the business district, to enhance the city’s role in fintech innovation.

The shape of the planned merger between the Frankfurt and London stock exchanges has not been completely clarified following the Brexit vote. The structure of the new group, assuming the merger goes ahead, is still under discussion. Deutsche Börse wants it formed as a joint holding company, rather than a London-based holding company as was initially planned. This would see the legal domicile of the company based in London, with the exchange itself remaining in Frankfurt. The outcome of these negotiations is vital, as losing its globally important stock exchange would strip Frankfurt of an important string to its financial bow.

Areas for potential growth outside EuropeFrankfurt has diversified its activities and focus over the last few years and some of the main areas for its potential growth lie outside Europe. In 2015 it opened the China Europe International Exchange, in partnership with the Shanghai Stock Exchange and China Financial Futures Exchange.

CEINEX was the first platform for authorised renminbi-denominated trading outside mainland China, helping to establish Frankfurt as a major centre for European investors and traders seeking to access Chinese markets. It allows international investors to buy shares in exchange-traded funds that hold renminbi-denominated assets, providing access to the Chinese economy that was previously subject to restrictions imposed by the Chinese authorities.

As part of a broader strategy by Beijing to internationalise the renminbi and improve access to international investors, Frankfurt benefits from potential for further product development and service offerings, providing significant growth in renminbi bonds, ETFs and derivatives.

While both Eurex and CEINEX are either owned or partly owned by Deutsche Börse, both have told OMFIF that, even if the planned Deutsche Börse-London Stock Exchange merger goes ahead, all activities will remain in Frankfurt.

The challenges of benefiting from BrexitAttracting activities necessary to make Frankfurt a beneficiary of Brexit presents challenges. It has a less well-established tradition of financial innovation than

other locations, and it has been less active in marketing its services than Paris, Luxembourg or Dublin. Competition with other financial centres requires substantial investment in new capabilities, infrastructure and skills to

maintain Frankfurt’s edge. The question marks over the EU’s future are weighing on business and investment sentiment across Europe. So too are, in a specific Frankfurt setting, the difficulties burdening Deutsche Bank and (to a less severe extent) Commerzbank, the county’s premier two banks. However, many of the causes – including global banking regulations, low and negative interest rates, worries over excessive debt, and the sluggish euro area economy – are exacting a toll on Germany’s rivals too.

Väth: ‘Frankfurt cannot and does not want to replace London’The exact role Frankfurt plays as a financial centre may be limited by factors outside its control. Yet the city prides itself on its solid foundations, its efficiency and technological development, as well as its linkages with Europe’s strongest real economy. As Hubertus Väth, managing director of Frankfurt Main Finance, has said, Frankfurt cannot and does not want to replace London. Instead it hopes to play to its strengths and improve its position in core areas.

As the global financial system evolves, Frankfurt is gaining over other European financial centres in its commitment to fintech and improving financial market infrastructure. While it is unlikely to replace London as ‘the central financial centre’, Frankfurt could become an important bridge linking London, China and other fast-growing economies to the euro area. All of these developing country partners will in time become platforms for capital market activities on both the asset and liability side of western firms’ and asset managers’ balance sheets.

Against this changing international background, with the gravitational centre of world finance moving gradually yet inexorably toward Asia, there is abundant potential for beneficial linkages between London and Frankfurt. These two diverse yet complementary cities play interlocking roles in wholesale banking and trading, international asset and wealth management and corporate deal-making.

There is no reason why these twin metropoles – a Continental financial nucleus embedded in the real economy and a globally connected, multivalent money centre close to, yet outside, the EU – cannot co-exist on highly favourable terms for all involved. ▪Ben Robinson is Economist at OMFIF.

October 16 | © 2016 FOCUS : FRANKFURT | V

“Even without concrete indications

of Brexit’s eventual shape, companies in both the UK and Germany are drawing up scenarios and contingency plans.

The UK’s vote to leave the European Union has prompted much discussion of possible alternatives to London. Some companies and banks with a presence in the City, and Britain

more broadly, may be required to extend their European footprint. Some may decide to leave the UK altogether to protect their European market share.

Frankfurt is taking a different approach to many of its European and global competitors for foreign direct investment. The city and the surrounding region are not aiming to convince businesses to leave the UK. Rather, FrankfurtRheinMain is positioning itself as a powerful and dynamic alternative for companies that are required for any reason to seek a continental solution for future growth.

Frankfurt’s financial sector and international airport – comparable in size to London’s Heathrow or Charles de Gaulle in Paris – are well known. The mutually reinforcing benefits of the FrankfurtRheinMain region are less immediately evident, but all the more relevant for businesses taking a longer-term view.

Large numbers of foreign businesspeople visit Frankfurt each year to participate in international trade fairs. This benefits both the city and the surrounding region, which has a centuries-old record of welcoming, accommodating and integrating travellers to this traditional European hub for carry out trade, finance and commerce.

FrankfurtRheinMain hosts more than 100 foreign consulates, as well as the headquarters of around 20% of the largest foreign companies in Germany. It is home to more than 1,000 US companies and the largest Korean business community in Europe. There is a growing contingent of Japanese, Chinese and Indian companies.

A combination of a service and industry-driven economyFrankfurt is home to the largest concentration of banks and financial service providers in Germany. But there is much more than finance: FrankfurtRheinMain contributes around 10% of German manufacturing output. Major life science, ICT and automotive clusters provide an attractive combination of a service economy mixed with forward-looking 21st century industry.

Part of the appeal lies in plentiful opportunities for a desirable life-work balance. The region has more than 30 international schools. Around 40% of FrankfurtRheinMain is unspoiled, often gently undulating countryside threaded by rivers and studded with alluring towns and villages. Frankfurt’s compact size and modern transport system allow easy access to airports and other cities as well as recreational and cultural highlights, often no more than half an hour away by car, train or tram.

Depending on the outcome of Brexit negotiations, FrankfurtRheinMain is well equipped to absorb a substantial influx of foreign professionals. While quality office space is readily available, newcomers seeking apartments and houses for rental or purchase may – as in other buoyant German cities – face pockets of rising residential property prices, requiring additional forward planning for those seeking a base in the conurbation.

FrankfurtRheinMain has always been open to international business and trade. The region is reacting with relish to the challenges of Brexit; whatever happens, the UK will remain one of Germany’s largest trading partners. Companies in the UK and Germany are drawing up contingency plans to secure best possible outcomes from the UK’s withdrawal negotiations. By providing sensible and efficient options for corporate relocation and expansion, Frankfurt and the FrankfurtRheinMain region offer a formidable springboard for the future. ▪For more details contact Iassen Boutachkov, Director Europe, on +44 (0) 20 3769 0741 or iassen.boutachkov@frm-united.com.

Formidable springboard for the future FrankfurtRheinMain

Frankfurt - The Financial Centre

€3.5tnbalance sheet ofFrankfurt’s banks

€1.7tnlisted companies’

market capitalisation

100+research institutionsbased in Frankfurt

62,700people employed inthe financial sector

196banks basedin Frankfurt

155foreign banksin Frankfurt

Source: Frankfurt Main Finance

VI | FOCUS : FRANKFURT October 16 | © 2016

“The promising real estate

pipeline will strengthen FrankfurtRheinMain’s position in the global market – a self-feeding development promoting and sustaining the area’s drawing power.

Businesses and banks should be aware of the substantial merits of FrankfurtRheinMain in offering attractive and competitively priced office accommodation and commercial real

estate. Particularly compared with other European regions with major international airport hubs, the area provides significant location benefits. This is borne out by a positive environment for investment projects and a string of real estate initiatives that could well be further enhanced by the impact of the UK’s EU vote.

The promising real estate pipeline will strengthen FrankfurtRheinMain’s position in the global market – a self-feeding development promoting and sustaining the area’s drawing power. For discerning pursuers of real estate opportunities, there is no shortage of availability. With 12.4m square metres (sq.m) of total office space, Frankfurt has a vacancy rate of around 11%, or roughly 1m sq.m.

Monthly rents for prime properties have increased slightly over the past year to €38.5 per sq.m and are expected to remain stable in the near term. Average rents of €15.5 per sq.m have also risen slightly. But there is substantial office space in central and other attractive locations at much lower prices.

For warehouse and logistics space in the greater Frankfurt area, building completions have shown the best results for years, reaching 350,000sq.m last year. Monthly prime rents for 5,000 sq.m warehouse and logistics space around Frankfurt airport are unchanged at about €6 per sq.m. For less extensive spaces, under 5,000sq.m, rents can be more than €7 per sq.m. Compared with the previous year, rents for warehouse and logistics space have stabilised.

A combination of an impeccable status quo and an enticing pipeline makes FrankfurtRheinMain a hub of real estate opportunities for companies building a continental base. ▪For more details contact Iassen Boutachkov, Director Europe, on +44 (0) 20 3769 0741 or iassen.boutachkov@frm-united.com.

Promising real estate pipeline FrankfurtRheinMain

A series of specialist monthly reports examining the post-Brexit opportunities for European financial centres

To discuss marketing opportunities contact Wendy Gallagher+44 (0) 20 3008 5262 or wendy.gallagher@omfif.org

©Fr

apor

t AG

LuxembourgSep 2016

FrankfurtOct 2016

October 16 | © 2016 FOCUS : FRANKFURT | VI I

“Europe, its economy, and the

financial services sector in particular, require a reliable and stable framework to remain competitive internationally.

Amid considerable uncertainty over the economic, financial and political implications of the UK vote to leave the European Union, one thing is clear: Europe, its economy, and

the financial services sector in particular require a reliable and stable framework to remain competitive internationally. London’s role as a provider of financial services to the EU is unlikely to persist. Frankfurt is prepared to strengthen its role as a pivotal partner for global financial market operators, in the best interests of the European economy and European development.

Banks, insurance companies and other global financial services providers have a presence in London and Frankfurt. The major German banks and 155 foreign banks are present in Frankfurt, where a broad set of other financial services is offered, including by leading capital market service providers, Deutsche Börse and Eurex Deutschland.

Many other business services – legal, consulting, analytical – are readily available. Frankfurt will remain an attractive environment for financial technology enterprises, providing an environment that facilitates start-ups and new developments while encouraging established businesses to maintain a long-term presence.

Frankfurt is the EU’s leading internet hub. Relatively low costs for companies and employees make it a magnet for other businesses, particularly associated with financial services. Frankfurt is home to financial regulators, including: the European Central Bank, the Single Supervisory Mechanism, the European Systemic Risk Board, the European Insurance and Occupational Pensions Authority, Deutsche Bundesbank, Bundesanstalt für Finanzdienstleistungsaufsicht, Bundesanstalt für Finanzmarktregulierung and the Global Legal Entity Identifier Foundation. Following the UK vote, Hessen is applying for the European Banking Authority to be located in Frankfurt.

Flexible and effective German labour lawGerman labour law, an important factor in business location, is flexible and effective: 66% of disputes are resolved within three months, while redundancy payments are regulated by law. In practice, payments of between 50% and 200% of annual salaries are the norm. A study by the Federal Statistical Office found the number of actions filed involving labour law in 2011 (three years after the financial crisis) was only 60% of the 1995 level.

Overall tax levels in Germany are much lower than often presumed. With a corporate tax rate of 15% and a business tax rate of 10-16%, financial companies in Frankfurt pay generally a total marginal tax rate of 25-31%.

The German economy offers business growth opportunities and political stability. Compared with other prominent euro area countries, Germany – taking up 15th position – is the highest-ranked country in the World Bank’s ‘ease of doing business’ index (ahead of Ireland at 17, France at 27, and the Netherlands at 28).

Frankfurt is part of the FrankfurtRheinMain region, with 5.6m inhabitants and GDP of €216bn, profiting from steady and sustainable growth. The region is second-ranked in the EU in terms of GDP per capita.

The city provides high-quality lifestyles, with the population benefiting from an excellent work-life balance, efficient public transport, and a lively cultural scene. According to the Mercer 2016 ‘quality of living’ survey, helping governments and companies with employees on international assignments, Frankfurt ranks as No.7 internationally, compared with rankings of Amsterdam at 11, Dublin at 33, Paris at 37 and London at 39. Frankfurt’s international workforce and well-integrated expatriate community testify to its global appeal. All these ingredients make Frankfurt well placed to become the EU's leading international financial centre following Britain’s withdrawal. ▪Dr. Stephan Bredt is Director General Economic Sector, Financial Services, Exchanges at the Ministry of Economics, Energy, Transport and Regional Development of the State of Hessen (stephan.bredt@wirtschaft.hessen.de). Armin Winterhoff is Head of Financial Centre Frankfurt at the Ministry (armin.winterhoff@wirtschaft.hessen.de).

Combining lifestyle and performanceStephan Bredt and Armin Winterhoff, State of Hessen

Official financial institutions based in FrankfurtSix regulators located in Germany’s financial hub

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October | ©2016 omfif.org EUROPE | 15

A suboptimal policy mixWhy Europe needs fiscal measures and growth reforms Ignazio Visco, Banca d’Italia

Very low inflation and the persistent risk of a de-anchoring of inflation expectations

continue to dominate the economic outlook for the euro area. The policy mix is suboptimal: there is no common fiscal policy and many countries lack sufficient room for manoeuvre.

Bank profitability remains weak and several intermediaries may need to strengthen their balance sheets against a background of subdued economic prospects and continuing regulatory reform.

The governing council of the European Central Bank has acted boldly to encourage a return to price stability. Official interest rates have been reduced repeatedly, bringing the deposit facility rate to negative levels. New longer-term refinancing operations have been introduced, with conditions rewarding banks which provide more credit to the economy. The Asset Purchase Programme has been progressively expanded.

Effective actionCentral bank action has been effective. Without these measures, economic conditions would have been much worse, possibly leading to a deflationary spiral.Credit supply conditions, particularly tight in 2011-12, have loosened gradually. The cost of credit to the economy has fallen and financial fragmentation in the euro area has eased. The weak credit dynamics still being observed in the euro area mainly reflect subdued demand.

The measures have fostered a decline in yields and bolstered the prices of a wide range of financial assets. This has had a positive impact on consumption, through wealth effects, and on investment, through a fall in the cost of capital. Business and household confidence have been buoyed.

According to ECB estimates, without the wide range of monetary policy measures introduced between mid-2014 and the first part of this year, annual inflation and GDP growth would be more than half a percentage point lower in the euro area in 2015-17.

This highly expansionary monetary policy stance is the result of well thought-out decisions and a response to the weakness of the economy and the risk of deflation.

Low inflation is undoubtedly in part a global phenomenon. It reflects developments in oil prices; deflationary pressures from the Chinese economy; and possibly also technological change. But it depends too on domestic developments that should not be underestimated.

Domestic factors operate both via expectations and via economic activity. In both respects conditions in the euro area differ from those in other main advanced economies.

Since the end of 2014, the risk of a de-anchoring has increased notably in the euro area, where expectations have fallen

further than in other advanced economies. In addition, there is evidence of a stronger link between low inflation and economic slack. In Italy, France and Spain, nominal wages became more reactive to unemployment after the crisis.

Low interest ratesThe ECB is conscious of the potential for negative collateral effects from a long period of very low interest rates.

In the euro area as a whole there is currently no evidence of risks to financial stability related to an excessive increase in the prices of shares, corporate bonds or houses.

Growth in lending relative to the cyclical position of the economy is moderate. Risks that may arise in specific sectors can be addressed with carefully targeted macroprudential instruments, as has already happened in some countries, without interfering with the monetary policy stance.

Nominal rates that are low or negative for too long may hurt the profitability of some institutions. But a less accommodative monetary policy in the current circumstances would harm everyone.

Strengthening the economy is key to ensuring a return to price stability, as well as mitigating risks to financial stability. In the current cyclical conditions, the main risks to financial stability, the profitability of banks and firms, and even to household income, continue to stem from the uncertain

macroeconomic outlook and the persistence of exceptionally low inflation.

The ECB will continue to monitor economic and financial market developments very closely and, if warranted, act again by using all the instruments available within its mandate. The purchase programme is intended to run until the governing council sees a sustained adjustment in the path of inflation consistent with its inflation objective. The relevant committees have been tasked with evaluating the options for ensuring its smooth implementation.

But monetary policy cannot pursue a return to price stability and a more sustained growth rate in isolation. It must be accompanied by fiscal policies consistent with cyclical conditions, and by reforms designed to achieve a permanent return to higher rates of growth potential and job creation.

The fear of continued weak demographics and modest productivity growth is the likely real cause of very low real interest rates.

Structural reformsImportant structural reforms have been adopted in several euro area countries and these efforts must continue. Their benefits are beginning to be felt, but it will take time to exploit their full potential. Each country has its own problems, and solutions are difficult to standardise.

Reforms imply short-term costs, both economic and political, and we should guard against the risk of unintentionally introducing obstacles. For example, excluding some countries from advances in fiscal and political union until they have achieved sufficient convergence would make their reform efforts more difficult.

Reducing uncertainty is one of the most pressing challenges facing European policy-makers. It not only requires adequate institutions and policy tools, but above all true leadership capable of restoring a common sense of purpose and defining a clear vision for the future of the European project.

This is the only possible response to rising populism and the risks it poses to the future well-being of European citizens.

There are many short-term challenges. But we must continue to emphasise the need for a longer-term perspective. ▪Ignazio Visco is Governor of the Banca d’Italia. This is an edited extract of a speech given to OMFIF’s Seventh Main Meeting in Europe on 22-23 September. A full summary of proceedings and other details of the Rome meeting can be viewed at www.omfif.org/analysis/reports/.

“Nominal rates that are low or negative

for too long may hurt the profitability of some institutions. But a less accommodative monetary policy in the current circumstances would harm everyone.

16 | EUROPE October | ©2016omfif.org

On 23 June UK voters gave a collective thumbs-down to continued membership

of the European Union, shocking the establishment and temporarily unsettling the markets. The outcome increased the possibility of an Italian – as well as a euro area – ‘doomsday scenario’.

The results of stress tests for European banks, published on 29 July, showed that Italy’s Banca Monte dei Paschi di Siena was the only European bank out of the 51 tested whose capital was wiped out in the stress test scenario.

The bank subsequently announced that it would raise capital by issuing stock, while the Italian treasury indicated that there would not be a bail-out of Italian banks. Fabrizio Viola, Monte dei Paschi’s chief executive, was dismissed and replaced by Marco Morelli, setting the stage for the bank to raise €5bn in new capital and dispose of around €30bn in non-performing loans.

New capitalNevertheless, storm clouds remain on the horizon. Monte dei Paschi has used up €12bn of capital raised since 2008, and there are no guarantees it would not use up a further

€5bn. Questions remain too over the ability to raise new bank capital in Italy, where banks are loaded with non-performing loans (around €200bn) and bank shares are trading below book value. If new private capital for Monte dei Paschi is not raised, and raised quickly, Italy and the EU will butt heads, and therein lies the potential storm.

Without new capital, Monte dei Paschi bondholders will be forced to take losses (a bail-in) before any government bail-out money could be deployed under EU rules. However, a bail-in would be politically highly problematic for Prime Minister Matteo Renzi as retail investors, making up a powerful portion of the electorate, hold a big chunk of Italian bank debt (bonds).

Suffering losses from a bail-in, bondholders would be likely to vote against Renzi’s proposed changes to Italy’s constitution in December, though this will not prompt a change of government – Renzi has said his administration will remain in place regardless of the referendum result.

The monetary approach posits that changes in money supply, broadly determined, cause changes in nominal national income and the price level. Sure enough, the growth

of broad money and nominal GDP are closely linked. Italy’s money supply (M3) growth rate since 2010 has been well below its trend rate (6.53%) for most of the period (see Chart). Unsurprisingly, nominal GDP growth rate in 2010-15 was only 0.4% per year.

Breaking down the contribution to the money supply growth, state money produced by the European Central Bank accounts for only 17% of Italy’s M3. The remaining 83% is bank money produced by commercial banks through deposit creation. As such, Italy’s banks are an important contributor to the money supply and the economy.

However, banks have been struggling and any contraction of their loan books – which would cause the money supply and credit to the private sector to slow – would produce another recession.

State rescueMonte dei Paschi is not the only problem child of the Italian banking system: all the country’s big banks could benefit from some additional capital.

But issuing new shares is unattractive because bank stock is trading below book value (at the time of writing, Intesa Sanpaolo’s price-to-book ratio was 0.77; that of UniCredit 0.27; UBI Banca 0.24; Banco Popolare 0.22; and Monte Paschi 0.07).

Without new private capital, an Italian state rescue is the most attractive source for the recapitalisation. Otherwise, the banks will be bailed-in by the bondholders, Renzi’s constitutional changes will go down in flames and the government will collapse.

With that, the populist Five Star Movement is most likely to form a government, raising the threat of a serious initiative to leave the euro. If the EU does not bend and allow one of the loopholes in its rules to be used, it risks setting in motion an Italian and euro area ‘doomsday’ machine. ▪Steve H. Hanke is Professor of Applied Economics at Johns Hopkins University.

Italy’s ‘doomsday’ scenarioStorm clouds on horizon for banking sectorBy Steve H. Hanke, Advisory Board

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Growth in Italian money supply hit by bank weaknessesMoney supply (M3) and credit to private sector, annual % change

Source: ECB, ONB, calculations by Steve H. Hanke

“Monte dei Paschi is not the only problem

child of the Italian banking system: all the country’s big banks could benefit from some additional capital.

October | ©2016 omfif.org EUROPE | 17

When Mario Draghi, president of the European Central Bank, declared in

July 2012 that the ECB would do ‘whatever it takes’ to save the euro, financial markets reacted positively. The intention was fleshed out in the Outright Monetary Transactions programme, which had as its declared aim to eliminate what the ECB viewed as ‘unacceptable re-denomination risk’ in Italian and Spanish bonds.

OMT was never used, though its announcement achieved those objectives at the time. However, the programme on its own could never have addressed the weakest links in the chain: Greece and Cyprus.

Significant steps were taken subsequently towards establishing a banking union, including the creation in November 2014 of the single supervisory mechanism, better placed than national supervisors to tame excessive risk-taking by big banks. This is a problem of particular relevance to small countries, as I quickly discovered when I became governor of the Central Bank of Cyprus in May 2012.

Too big to failCyprus’s crisis was very much a tale of two banks becoming too big to fail, too big to save, and too big to regulate. Between 2005 and 2011, the domestic banking sector doubled in size to 9.5 times GDP, while risks were largely ignored.

The two largest banks had assets equivalent to 400% of GDP. Parliament rarely asked the national supervisor, CBC, to explain how these rapidly growing banking risks, which represented a contingent liability for the taxpayer, were being managed.

Important steps have been taken in fiscal policy coordination that should help prevent a Greek-style build-up of public debt in future. Both the Cypriot and Greek crises could have been prevented had all these improvements been in place before 2012.

At the time, addressing legacy problems in banks and public finances remained n the hands of political leaders. The ECB could do little to influence bail-out negotiations, other than to warn that, in the absence of agreement at the political level, it would be forced to cut off or freeze liquidity support.

Since 2012 those warnings have been made openly twice: in Cyprus in March 2013 and in Greece in June 2015. In both cases bail-out negotiations had come to a standstill, and the ECB’s actions resulted in banks shutting down for several days. Faced with the prospect of banks remaining closed

indefinitely or euro exit, political leaders in both countries came to their senses – temporarily at least.

In Cyprus, politicians protested about the ECB’s ‘blackmail’. In his testimony to a judicial inquiry, Nicos Anastasiades, the Cypriot president, said the ECB had ‘put a gun to his head’, otherwise he would never have accepted the write-down on bank deposits. That gun, he explained, was the supply of emergency liquidity assistance. The ECB of course was alluding to its own legal constraints. If the Cypriot government became bankrupt, it could not continue to supply Cypriot banks with euros.

Taxpayers could not bail out banksThe agreement with Cyprus involved imposing losses on bondholders and depositors because, as the International Monetary Fund’s debt sustainability analysis showed, Cypriot taxpayers could not bear the burden of bailing out the big banks.

The much criticised bail-in that was finally agreed (after parliament turned down the broad-based levy on insured and uninsured deposits proposed by the government and agreed by the Eurogroup) affected only 4% of uninsured depositors, and reduced the total bail-out bill by around 33% of GDP. And it spared Cyprus from Greek-style austerity, which goes some way towards explaining the economy’s recovery.

Other upfront banking reforms, including restructuring credit co-operatives and ring-fencing the Cypriot banking system from Greece, were instrumental in restoring confidence and allowing capital controls to be lifted early. However, the reforms resulted in considerable toxic fallout for the central bank.

Political attacks were soon followed by legislative changes to the Central Bank of Cyprus governance. These not only eroded the bank’s independence but undermined its decision-making processes – much as predicted by an ECB legal opinion published in June 2013 (which legislators ignored).

Greece: not on trackIn Greece, public debt is expected to reach 185% of GDP this year, notwithstanding seven years of austerity (and the private sector involvement of 2011), compared with 127% at the outset of the crisis in 2009. No wonder programme legitimacy remains a huge concern. The long-awaited first review of the Greek programme suggests that it remains ‘broadly on track’, but that ‘significant implementation risks’ remain.

September’s programme review remains incomplete, with a number of key reform deliverables outstanding. The Greek government has submitted a bill with reforms to parliament that will need to be passed for the next tranche of bail-out funds, amounting to €2.8bn, to be released by the creditors. It includes reforms to Greece’s electricity market, measures to speed up privatisations and cuts to state pensions.

Prime Minister Alexis Tsipras’ slim majority in parliament may be sufficient to pass the bill this time. However, government officials are pledging to resist labour reforms that could lead to further wage cuts and job losses.

While such political uncertainty persists, the risk of ‘Grexit’, which has subsided since the heights of 2015, could resurface in the near future, even if macro downside risks do not materialise.

The return of bank deposits – a key barometer of confidence in ‘Gremain’ – has been virtually non-existent. Capital controls remain in place and Greek banks continue to be largely funded by the ECB.

A risky strategyWhen it came to the crunch, the ECB may have helped to keep the euro intact. But can the same be said of its key institutional foundation – central bank independence?

Since 2012 attacks on euro area central banks and their governors have become common. Some appear to follow actions that involve imposing losses on bank creditors. Others have been politically motivated. There have been legal challenges to the ECB (as well as associated political attacks) over its unconventional policies from within Germany. They have focused primarily on the Bundesbank’s allegedly unlawful role in the ECB’s outright monetary transactions and quantitative easing programmes.

These developments have shown that ‘whatever it takes’ is a risky strategy, not just for Eurosystem institutions but for individuals taking critical actions for the euro’s survival. But if EMU is to survive the storm that appears to be brewing – involving Brexit, Italian banks, geopolitical risks and the slowdown in China – the ECB can ill afford to relax its guard. Doing ‘whatever it takes’ will remain on the agenda. ▪Panicos Demetriades is Professor of Financial Economics at the University of Leicester and Fellow of the Academy of Social Sciences. During 2012-14 he served as Governor of the Central Bank of Cyprus and Member of the Governing Council of the ECB.

Cyprus, Greece and ‘whatever it takes’Political threats to central bank independence Panicos Demetriades, University of Leicester

18 | EUROPE October | ©2016omfif.org

Costs for financial system When lowering interest rates does more harm than goodPeter Warburton, Economic Perspectives

It is hard to imagine the possible benefits of the August cut in the UK bank rate.

If lower interest rates impart stimulus to the UK economy, is it the case that the lower the rate, the greater the stimulus? And if lower positive interest rates boost aggregate demand, would negative rates have an even more pronounced effect?

Analytically, it is possible to assert that a lower discount rate will bring forward household consumption, that a lower cost of capital will boost fixed capital formation, and that higher property and financial asset prices will inflate the net worth of households and businesses, inducing them to save less and spend more.

But when interest rates are extremely, abnormally and persistently low, other possibilities must be considered.

The risk of concussionWhen interest rates fall out of bed, there is a risk of concussion. Concussion is difficult to incorporate into analytical models, but no less of a reality.

The flip side of very low borrowing rates – for example, the 4.1% personal loan rate and the 2.3% lifetime tracker mortgage rate – is extraordinarily low saving rates. These are exemplified by instant access deposit rates (less than 0.05%) and fixed rate bond deposits of 0.85%.

There comes a point at which borrowing rates are no longer a material obstacle to borrowers. They may fail to qualify for loans based on their disposable income, credit score, postcode or other criteria, but the rate is immaterial. Consumer debt is motoring along at growth of 10% per

annum and in no obvious need of assistance. Older savers, on the other hand, are perplexed by the persistence of low rates. Fearing penury in their latter years, senior citizens are prone to save more of their non-interest income to top up their capital.

Banks typically suffer a squeeze of their net interest margins as interest rates approach zero, occasionally leading them to raise borrowing rates to restore profitability. The systematic compression of the government

yield curve makes it harder for insurance companies to deliver promised returns to policy-holders, and threatens the solvency of the weaker companies.

Pension fund injectionsActuarial adjustments based on lowered bond yields have a profound effect on pension deficits.

With 80% of company-sponsored funds in deficit, many businesses will be required to inject funds into their schemes at the expense of investment spending. Defined contribution pensions will project lower retirement incomes.

There is a generalised cost to the financial system when liquidity is hoarded within financial institutions and large corporations, rather than pooled for the benefit of all.

A zero interest rate equates to zero incentive to offer surplus liquidity into the market. The wider impact of falling returns in a complex, leveraged, financial system could easily overturn the expectation of a net economic stimulus when rates are abnormally low.

Capital spendingBusiness investment in structures, plant and equipment has been a serial disappointment to policy-makers over the past seven years and, if anything, the trends are worsening.

This raises a number of questions. Has the capital spending decision been soured by ultra-easy money and quantitative easing? Are decision-makers unsettled by the fresh doubts cast by policy easing on the economic outlook? As policy uncertainty increases, perhaps the option value of cash rises to offset its lower return?

Other questions include whether large-scale asset purchases crowded investors into the securities of cash-rich companies, persuading them to distribute income rather than commit to fixed investment. And while bond yields may be lower, has the hurdle rate for business capital expenditure risen?

There are ample grounds to suspect that the effectiveness of lower rates as a policy stimulus has been overtaken and overwhelmed by other considerations. In the Bank of England and the Treasury, as well as further afield, it is time to rethink monetary policy. ▪Peter Warburton is Director of Economic Perspectives and a Member of the Institute of Economic Affairs Shadow Monetary Policy Committee.

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Sterling unsecured personal £10k loan rate (left scale) Sterling instant access deposit rateSterling fixed rate bond deposit rate Lifetime tracker mortgage rate

Interest rates trend persistently lower

Selected UK household interest rates, %

Source: Bank of England Source: Bank of England

“The wider impact of falling returns in a

complex, leveraged, financial system could easily overturn the expectation of a net economic stimulus when rates are abnormally low.

Interest rates trend persistently lower Selected UK household interest rates, %

October | ©2016 omfif.org EMERGING MARKETS | 19

Renminbi payments show limited gains Challenges for reserve status after SDR inclusion Ben Robinson

The renminbi was the world’s fifth largest payments currency by value at the end

of August, according to latest data from international interbank telecommunications provider SWIFT. This accounts for 1.86% of world payments. However, while this is a significant improvement from ninth position, which the currency held in August 2013, the internationalisation of the renminbi remains limited.

With the currency still protected by capital controls, a managed peg to the dollar saw the renminbi appreciate by more than 33% in real terms against China’s trade partners between January 2010 and November 2015, a leading factor behind its improved ranking in payments value. Over the same period the yen fell by more than 26% and the Canadian dollar by 17%. The Hong Kong and New Zealand dollars rose, but not as much as the renminbi. These figures have however narrowed this year, reducing the renminbi’s lead and causing it to fall back behind the yen after its August 2015 devaluation.

While the renminbi’s share of global payments has grown, it has been uneven, led predominantly by the Asia Pacific region. Between January and end-August 2016, Asia Pacific was responsible for 47% of all trade with China, of which 45% was denominated in renminbi, followed by Europe with 31%.

By contrast, the Americas accounted for 23% of all trade with China, of which only 3% was denominated in renminbi. Even within the two largest renminbi payment regions, just two centres – Hong Kong and the UK – are responsible for the majority of these transactions, indicating a relatively limited uptake. Other centres are catching up, however – the Middle East is the fastest growing region for renminbi payments.

Substantial gainsDespite these caveats, the currency has made substantial gains in recent years. This partly reflects China’s dominant presence in international trade. As the largest import and export partner for many countries, the logic of converting local currencies into dollars and then into renminbi has weakened, while the costs, exchange rate risks and time delays of doing so have grown.

To facilitate renminbi payments China has rapidly expanded the presence of clearing banks in global financial centres, including Hong Kong, Singapore, Frankfurt, London, Paris, Luxembourg, Doha, Toronto, Buenos Aires and Zurich.

The PBoC also has a growing number of currency swap agreements, with more than 30 countries, to facilitate smooth transactions, lower costs and ensure access to renminbi liquidity.

China is seeking to move beyond a trade role for its currency towards a more sophisticated use in international investments. Beijing has opened up the domestic market, albeit in a limited form, to foreign investors. Strong economic growth, an appreciating renminbi, and low yields and weak growth elsewhere have contributed to international demand for renminbi-denominated A-shares and Chinese corporate and sovereign bonds.

However as an investment currency the renminbi faces challenges: stock market volatility in mid-2015 and at the start of 2016 have reduced confidence in Chinese shares. Fears over a bond market bubble, as well as concerns about the economy, are growing, as indicated by rising yields.

While higher risks and a growing number of bond market defaults may partly reflect a natural rebalancing of the market, the country’s growing debt over the last few years raises concerns over a ‘hard landing’.

Reserve status challengesIn addition to becoming a global trade and investment currency, a long-term goal of the Chinese authorities is for the renminbi to become a global reserve currency. Despite its inclusion in the International Monetary Fund’s special drawing right reserve currency basket, this status remains a long way off.

China’s SDR share is 10.92%. While countries can sell SDRs to access renminbi liquidity if needed, especially if they are facing balance of payments pressures with China, the relatively low share of overall trade conducted in renminbi, as highlighted by the SWIFT data, suggests this will be only a minor consideration.

Boosting the currency’s role as a reserve asset first requires a larger use in trade and investment, for which greater confidence in the Chinese economy, more market-based pricing, clearer risk signals, and less intervention are all prerequisites.

The SDR move, meanwhile, raises questions for the IMF on the acceptable spread between the onshore and offshore rate, on the risk of large movements in the renminbi’s value, and on how the Fund will monitor the currency’s move towards a more market-based rate.

Now that the renminbi has entered the SDR, observers will be paying close attention to gauge its further progress towards internationalisation and reserve currency status. ▪Ben Robinson is Economist at OMFIF.

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Renminbi overtakes four currencies by payment value since 2013

Value of global payments by currency, index figures Renminbi overtakes four currencies by payment value since 2013 Value of global payments by currency, index figures

Source: SWIFT

20 | EMERGING MARKETS October | ©2016omfif.org

A look at the fundamentals suggests that Brazil’s recent investor rally has been

overdone. The country faces a rising stock of debt, which will become increasingly expensive to service as monetary policy remains on a tightening track. Global macro risks, such as the slowdown in China and the commodities market, are creating further vulnerability exacerbated by domestic political uncertainties. After years of partying culminating in the Rio Olympics, Brazil is now suffering a hangover.

Brazil’s financial markets have seen a flurry of inflows in 2016 as investors bet on economic recovery. The Bovespa equity index has risen by 34% this year, the best performance of equities globally.

The real has appreciated by more than 22% since January, making it the highest performing major currency in 2016. Brazil’s finance ministry projects GDP growth of 2% in 2017 against an expected 3% contraction in 2016.

Messy politics, bullish investorsPolitical change has driven investor momentum. Markets have anticipated an economic turnaround, bullishly tracking the impeachment of Dilma Rousseff, unseated as president by the senate in August.

Michel Temer, who has taken over, has pledged to restore market confidence by reining in fiscal spending, spurring job creation, in a bid to stabilise debt levels and re-establish Brazil’s credit rating.

However, while the previous vice president’s policies of limiting budget increases in line with inflation and raising

the retirement age have proved popular with investors, they have been much less so with the broader electorate.

Brazil’s population has enjoyed a substantial boost in living standards over the past decade, with GDP per capita between 2006 and 2016 rising by 11%, the biggest increase in Latin America. This was partly financed by the commodities boom, but

also by credit expansion, mainly through the highly leveraged public sector.

Continued credit-fuelled growth is unsustainable. For example, Brazil’s pension spending is among the highest in emerging markets, second only to Turkey: at 8% of GDP, it is higher even than that of Sweden, an economy with a much older demographic profile. Sharp rises in borrowing tend to result in an inefficient allocation of investments.

Brazil’s high inflationary stance implies that the monetary tightening course pursued

by the country’s central bank is here to stay. Rising interest rates in turn will put further pressure on the cost of servicing an already high debt pile, raising further questions over debt sustainability.

This situation cannot be maintained in the long run, but implementing policies that will put Brazil on a more sustainable fiscal path requires huge levels of political capital. While Temer remains popular among the public, this could change.

History may repeat itself. Rousseff enjoyed similar approval ratings during her presidency before corruption charges saw her officially impeached. Temer is also being investigated over corruption allegations in connection with the Petrobras scandal. He could quickly lose cross-party support, putting current political stability at risk.

Running out of steamExternal conditions are adding to Brazil’s headache. Growing trade and investment links with China served the country well during the boom years – China is Brazil’s largest trading partner, according to the latest data from 2015, in contrast to the majority of economies in the region which are more connected to the US. Foreign direct investment from China into Brazil soared between 2005 and 2015, from around $8m to $232m.

But China’s economy is slowing. From double-digit growth in 2005-10, annual GDP growth has now eased to just over 6%, according to the latest official data. Alternative measures of the strength of the economy estimate growth at 3%-4%.

More important for Brazil, though, is not that China’s economy is slowing, but rather the nature of the slowdown.

The fact that China’s previously rapid expansion is running out of steam is not a surprise. Beijing is rebalancing its economy away from exports and manufacturing to focus on domestic consumption and the services sector.

Demand for industry-heavy commodities such as iron ore and steel has collapsed, but commodities such as sugar or petrol have brighter prospects as China’s middle class develops a greater appetite for richer foodstuffs and car ownership.

Although this creates important opportunities for Brazil (vegetable products and other foodstuffs make up around 30% of the country’s exports), the downturn in the commodity price cycle acts as a third and final headwind to the Brazilian economy

Three headwinds for BrazilPotential shock for economy after investor flurry Danae Kyriakopoulou and Bhavin Patel

Chart 1: Brazil’s growth tracks commodity marketsAnnual S&P commodity index return, %, and Brazil’s real GDP. annual % change

Chart 1: Brazil’s growth tracks commodity markets

Annual S&P commodity index return, %, and Brazil’s real GDP, annual % change

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“Brazil’s pension spending is among

the highest in emerging markets, second only to Turkey: at 8% of GDP, it is higher even than that of Sweden, an economy with a much older demographic profile.

October | ©2016 omfif.org EMERGING MARKETS | 21

in the short term. As Chart 1 shows, Brazil’s economic performance traditionally has been closely tied to the commodities market.

Dependence paradoxAt first sight, this strong dependence appears paradoxical. Commodities play a relatively small role in Brazil’s economy: rents from natural resources comprise around 5% of GDP, close to the global average. In the boom years this figure was higher, peaking at 8% in 2007.

While they have greater weight in exports (agricultural and mineral products alone make up around half of Brazil’s exports), exports on the whole play a very small role in Brazil’s economy, accounting for less than 15% of GDP – the fifth lowest ratio in the world, according to the World Bank. Only

Sudan, Afghanistan, Burundi, and Kiribati have a lower contribution of exports to GDP.

To put this further into context, the exports to GDP ratio can be well above 100%, as is the case in city states such as Hong Kong and Singapore, or even countries such as Ireland. Even emerging markets of a similar size to Brazil such as India, Russia, or Mexico tend to have a substantially higher share of exports in their economies.

Commodity currencyBrazil’s economic fortunes may be so tied to the commodities market because of the close association in investors’ minds between Brazil and commodities – resulting in capital outflows and a bearish attitude each time the commodities market turns down. This seems to be supported by the data to an extent,

with the real also performing as a commodity currency (see Chart 3).

The recovery in commodities and the possibility of a Chinese soft-landing has seen Brazil benefit. Investment has flowed into the region, and the outlook for a Brazilian recovery appears positive.

The question now is how long the positive trend will last. Brazil’s financial market recovery could be generating bubbles – recovery of fundamentals have lagged behind the growth in assets. If the Fed raises interest rates more quickly than expected, market sentiment could change abruptly, capital inflows could turn into outflows – and Brazilian investors could be in for a shock. ▪Danae Kyriakopoulou is Head of Research and Bhavin Patel is Research Assistant at OMFIF.

Chart 2: Brazil’s exchange rate driven by inflation Brazil-US inflation rate differential, %, and real per dollar

Source: Central Bank of Brazil, US Bureau of Labor, Brazilian Institute of Geography and Statistics, OMFIF analysis

Nowhere has the recent investor flurry into Brazil been more pronounced than in the performance of the real. After depreciating by 33% in 2015, the currency has recouped 47% of last year’s losses and is the best-performing currency in 2016.

This volatility, driven by market sentiment related to political developments, obscures the fundamental drivers of the currency’s valuation. With a floating currency such as the real, the exchange rate will be determined by the economy’s links to international markets through international trade and capital flows.

Trade plays an exceptionally small role in Brazil’s economy. Yet with commodities making up roughly half of Brazil’s exports, investors in the foreign exchange market tend to associate Brazil’s performance with that of commodities.

To assess the fundamentals-implied exchange rate, economists usually rely on the ‘law of one price’ – the principle that exchange rates correct so that any product should cost the same wherever it is purchased.

As a result, changes in inflation tend to drive changes in the exchange rate. This seems to be supported by the data for the real/dollar exchange rate (see Chart 2).

The inflation differential between Brazil and the US looks set to widen: the Federal Reserve has hesitated to raise interest rates once again, and any rate rise will be very modest. Meanwhile, the Central Bank of Brazil remains on a tightening schedule to combat high inflation. The fundamentals point to depreciation of the real over the long term.

Real may depreciate after rally as US-Brazil inflation differential widens

Chart 2:

Brazil- , percentage points, and real per dollar

Source: Central Bank of Brazil, US Bureau of Labou , OMFIF analysis

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Chart 3: Brazil’s ‘commodity currency’ challenge

S&P commodities index total return, $, and dollar per real

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Directing policy to growth sectors Nigeria seeks better monetary-fiscal coordination Donald Mbaka, Central Bank of Nigeria

22 | EMERGING MARKETS October | ©2016omfif.org

In its quest to keep price increases within defined limits, the Central Bank of Nigeria

has consistently ensured that Nigeria’s banking system – the key platform for transmitting monetary policy impulses – remains sound and stable, with low threats from systemic risks.

However, the central bank has grappled with the effects of low levels of domestic economic activity, particularly their impact on the exchange rate. This can be attributed largely to widespread dependence on receipts from crude oil sales, resulting in the neglect and stifling of other economic sectors.

It has not always been this way. Nigeria was noted in past decades for the large-scale production of high-value agricultural exports such as cocoa, groundnuts and palm produce, among others. These generated substantial foreign exchange resources and formed the bedrock of the country’s economic growth in the early years after independence in 1960.

But while the discovery and commercial exploitation of crude oil continues to yield additional and significant inflows of foreign exchange, which account for around 75% of government revenues, this has yielded worse than expected outcomes.

Large-scale importsNigeria’s domestic resources – both human and natural – have not been adequately exploited. This has resulted in large-scale imports to meet numerous domestic and industrial requirements, large outflows of foreign exchange to pay for these imports, and resulting problems with exchange rate management.

As the warehouse for official crude oil receipts – which account for around 90% of foreign exchange inflows – the CBN by default is the major supplier of foreign exchange to satisfy in-country demand. It does this at the expense of its stock of foreign exchange reserves, which has been consistently depleted over time.

The global financial crisis, coupled with the subsequent collapse in crude oil prices, highlighted the need for adequate domestic capacity to cushion the effects of negative external developments.

In particular, widespread dependence on imported products accounted for a major proportion of the consumer price index, and was a significant contributor to domestic inflation.

Given these challenges, the CBN decided to provide monetary stimulus to the

economy, as was the case in several other jurisdictions where unconventional monetary policies were implemented. The underlying goal was to precipitate real sector activity and generate domestic economic activity to support local capacity and reduce imports.

Several intervention funds were established to provide low-income financing to economic sectors with the potential to galvanise an economic revival – key sectors include micro, small and medium-sized

enterprises, agriculture, and power. Leverage for this venture hinged on powers granted to the Bank to facilitate development functions, as enshrined in its enabling statutes.

The funds undoubtedly have opened up newer channels to satisfy the financial resource requirements of various business ventures as against prohibitive bank loans.

However, adopting such an unconventional monetary policy tailored to development financing has inevitably prompted concerns in Nigeria over the design and implementation of monetary policy – the prime responsibility of central banking.

Monetary interventionsThese interventions were quasi-fiscal in nature and increased money supply to the economy. This naturally translated into an upside risk for inflation where a single-digit rate had been targeted.

As a result, and in addition to other fiscal measures with implications for prices, the inflation rate has significantly breached the single-digit target. There have also been claims that the Bank has gone beyond its monetary policy remit and ventured into broader economic policy.

While there is no doubt that the design and implementation of monetary policy should always be the central bank’s primary

preoccupation, domestic economic factors have necessitated some ingenuity on the part of monetary authorities.

The Bank of Japan has committed to increasing the monetary base annually by a given amount to pull the country out of prolonged recession.

The US Federal Reserve, the Bank of England and the European Central Bank have adopted the purchase of financial instruments (including government bonds).

These jurisdictions have well-organised and vibrant economies, and financial markets provide the only feasible avenue for non-standard measures.

The same may not necessarily apply to a less developed country like Nigeria. Here, the financial system is thriving but still developing, while economic activity remains far below potential.

Monetary interventions should target points likely to produce greater impact. The CBN has directed its unconventional monetary policy towards sectors that are more likely to boost domestic economic activity and enhance productivity.

Price stabilitySuch concerns are nevertheless valid. Central banks should focus on achieving and maintaining price stability, to create a macroeconomic environment conducive to sustainable economic growth. Keeping inflation within specified targets should be their primary goal.

In this regard, the CBN – which follows a monetary targeting strategy and has adopted the corridor system for implementation of monetary policy – may need to isolate the various unconventional measures while providing adequate guidance and supervision, and re-focus on price stability.

Fiscal authorities, on the other hand, should provide the direction and incentives for structural efficiency. Economic growth and development are within this jurisdiction.

Monetary policy cannot succeed when the economy is comatose, and fiscal policy cannot push through with economic growth measures while other significant monetary (and macroeconomic) indicators perform poorly.

Healthy coordination between monetary and fiscal policy can produce beneficial results. This must be the aim for Nigeria’s policy-makers. ▪Donald Mbaka is Economist at the Central Bank of Nigeria.

“While there is no doubt that the design and

implementation of monetary policy should always be the central bank’s primary preoccupation, domestic economic factors have necessitated some ingenuity on the part of monetary authorities.

Observing the presidential election campaign in the US, a more than

200-year-old democracy, provides a reminder of the need for some perspective when assessing the progress of democracy in Africa.

That a vast majority of Africa’s 54 nations are now democracies is a good thing. This represents a radical shift away from the military dictatorships that dominated the continent just a quarter of a century ago.

The shift has come about partly in response to the innate urge for individual human freedom and free societies, and partly in response to the hegemonic forces of globalisation as the cold war ended in the late 1980s and the struggle between the Soviet and US superpowers ended on American terms.

Moreover – as a result of this – it has also come about in part in response to the felt need in African nations to meet the evolving minimum requirement for legitimacy in a global order increasingly based on democratic norms (even if the main international institution that spread these norms, the UN, is not fully democratic).

Democracy has been broadly good for Africa, but not because the dictatorships it replaced could not have created progress. Those military regimes failed largely because they were self-serving, and lacked a world view of economic transformation.

Mixed election outcomesElections in Africa in 2015-16 have pointed to progress and challenges, as well as the evolving maturity of pluralistic political spaces.

In Nigeria, an opposition party led by Muhammadu Buhari, a former military leader, defeated Goodluck Jonathan, the incumbent president, in a national presidential election in 2015. Even more remarkably, Jonathan conceded defeat and oversaw a peaceful transfer of power to the new government.

In South Africa, the majority African National Congress’ hold on political power has slipped significantly this year as opposition party candidates make significant inroads in mayoral races in important urban centres.

In east and central Africa, Tanzania held successful presidential elections in 2015. However, polls in Uganda were marred by controversies over allegations of political repression by Yoweri Museveni, president for the past three decades. Burundi descended into civil conflict in 2015 as President Pierre

Nkurunziza sought to extend his hold on power by removing constitutional term limits.

In Rwanda, the country’s parliament in 2015 voted to remove term limits to the

leadership of Paul Kagame. In some ways reminiscent of Singapore’s Lee Kwan Yew, Kagame has led his country from an age of genocide in 1994 to a new era of development and undeniable economic progress, even as western governments question his human rights record.

Democratic ethosIt is clear that the rituals of democracy such as voting by themselves do not constitute the sum of real democracy. More important – and needed in Africa – is a deepening of the democratic ethos.

Acquiring power through the ballot box needs to be accompanied by a sense of the limitations imposed by the real meaning of democratic governance, including the strengthening of independent institutions and the tolerance of dissent. There is a need to guard against ‘democratic despotism’ – a

‘licence’ conferred by winning elections to quash the voices of opposition.

Additionally, democracy in Africa needs to be organised around ideas that can lead to real progress. Such ideas incorporate inclusive economic growth that will make the popular notion of ‘Africa rising’ more real than the media- or investor-led hype that has soured of late, even as the continent remains a business destination of today and tomorrow.

Too often, elections are still contests for control of power and patronage resources by ethnic and religious identities. Zambia’s presidential elections in August point to a regression towards these motivating forces. These atomistic definitions of self-interest have blocked the emergence of more unifying national visions that create real progress.

Third, an important lesson of Africa’s democratic trajectory is that, to create real wealth for Africa’s nations, democratic contests will require the participation of technocrats skilled in the art and science of leadership, economics, public policy and management, engineering, and innovation.

This trend is already taking root in a few countries such as Ghana. In many other countries, the old guard of ‘chartered politicians’ still holds sway, conflating the longevity of their political careers with their perceived ability to take their citizens into the future in a competitive world. Africa’s citizens and voters must be educated to recognise the difference.▪Kingsley Chiedu Moghalu is Professor of International Business at The Fletcher School at Tufts University and a former Deputy Governor of the Central Bank of Nigeria.

African democracy: work in progress Moving to better governance and inclusive growth Kingsley Chiedu Moghalu, Advisory Board

“It is clear that the rituals of democracy

such as voting by themselves do not constitute the sum of real democracy. More important – and needed in Africa – is a deepening of the democratic ethos.

October | ©2016 omfif.org EMERGING MARKETS | 23

Muhammadu Buhari, President of Nigeria

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Meghnad Desai Chairman

Philip MiddletonDeputy Chairman

Louis de MontpellierDeputy Chairman

Frank ScheidigDeputy Chairman

Songzuo XiangDeputy Chairman

Mario BlejerSenior Adviser

Norman LamontSenior Adviser

Aslihan GedikSenior Adviser

Robert JohnsonSenior Adviser

October | ©2016 omfif.org ADVISORY BOARD | 25

OMFIF ADVISORY BOARDKingsley Moghalu

Senior AdviserFabrizio Saccomanni

Senior AdviserNiels ThygesenSenior Adviser

Ted TrumanSenior Adviser

EDITORIAL & COMMENTARY1. Peter Bruce, Business Day2. Reginald Dale, Center for Strategic and International Studies3. Darrell Delamaide, Market Watch4. Jonathan Fenby, China Research, Trusted Sources5. Stewart Fleming, University of Oxford6. Harold James, Princeton University7. Roel Janssen, NRC Handelsblad8. William Keegan, The Observer9. Joel Kibazo, formerly African Development Bank10. Thomas Kielinger, Die Welt11. Jürgen Krönig, Die Zeit12. Willem Middelkoop, Commodity Discovery Fund13. Brian Reading, independent economist14. Janusz Reiter, former Polish Ambassador to US15. Anthony Robinson, formerly Financial Times16. David Smith, formerly United Nations17. Michael Stürmer, WELT-Gruppe18. David Tonge, IBS Research & Consultancy

CAPITAL MARKETS & INVESTMENT1. Andrew Adonis, National Infrastructure Commission 2. Bahar Alsharif, formerly International Finance Corporation3. David Badham, World Platinum Investment Council4. Stefan Bielmeier, DZ BANK5. Mark Burgess, formerly Future Fund6. Caroline Butler, Walcot Partners7. John Campbell, Campbell Lutyens8. Stefano Carcascio, formerly Banca d’Italia9. Hon Cheung, State Street Global Advisors10. Peter Gray, Berkeley Capital11. Trevor Greetham, Royal London Asset Management12. George Hoguet, CFA Research Foundation13. Frederick Hopson, formerly Hessische Landesbank14. Matthew Hurn, Mubadala Development Company15. Paul Judge, Schroder Income Growth Fund16. Mumtaz Khan, Middle East & Asia Capital Partners17. Celeste Cecilia Lo Turco, Italian Ministry of Foreign Affairs18. George Milling-Stanley, formerly World Gold Council19. Paul Newton, London & Oxford Capital Markets20. Saker Nusseibeh, Hermes Fund Managers21. Robin Poynder, formerly Thomson Reuters22. Colin Robertson, formerly Aon Hewitt23. Olivier Rousseau, Fonds de réserve pour les retraites24. Marina Shargorodska, formerly Quantum Global Group25. Gary Smith, Baring Asset Management26. Soh Kian Tiong, DBS Bank27. Marsha Vande Berg, formerly Pacific Pension Institute28. Jack Wigglesworth, formerly LIFFE

EDUCATION & RESEARCH1. Iain Begg, London School of Economics2. Harald Benink, Tilburg University3. Gottfried von Bismarck, Körber Stiftung4. Michael Burda, Humboldt University, Berlin5. Nick Butler, King’s College, London6. David Cameron, Yale University7. Forrest Capie, CASS Business School8. Jenny Corbett, Australia National University9. Mark Crosby, Melbourne Business School10. Jeffry Frieden, Harvard University11. Haihong Gao, Institute of World Economics and Politics 12. Hans Genberg, SEACEN13. Steve Hanke, Johns Hopkins University14. Elliot Hentov, State Street Global Advisors15. Ludger Kühnhardt, Center for European Integration Studies16. Mariela Mendez, Escuela Superior Politecnica del Litoral17. Rakesh Mohan, International Monetary Fund18. José Roberto Novaes de Almeida, University of Brasilia19. Michael Oliver, ESC Rennes School of Business20. Danny Quah, London School of Economics21. Richard Roberts, King’s College, London22. Paola Subacchi, Royal Institute for International Affairs23. Shumpei Takemori, Keio University24. Maria Antonieta Del Tedesco Lins, University of São Paulo25. Daniel Titelman, ECLAC26. Linda Yueh, BBC

BANKING1. John Adams, China Financial Services2. Yaseen Anwar, Industrial & Commercial Bank of China3. Marek Belka, formerly National Bank of Poland 4. Consuelo Brooke, Alliance Trust & BlackRock 5. Moorad Choudhry, formerly Royal Bank of Scotland6. John Chown, Institute for Fiscal Studies 7. Michael Cole-Fontayn, BNY Mellon8. Christian Gärtner, DZ BANK9. José Manuel González-Páramo, BBVA10. Akinari Horii, formerly Bank of Japan11. Korkmaz Ilkorur, Business & Industry Advisory Committee to OECD12. Philippe Lagayette, Fondation de France13. Andrew Large, formerly Bank of England14. Oscar Lewisohn, Soditic15. Wilhelm Nölling, formerly Deutsche Bundesbank16. Athanasios Orphanides, formerly Central Bank of Cyprus17. Francesco Papadia, formerly European Central Bank18. Philippe Sachs, formerly Standard Chartered Bank19. Nasser Saidi, formerly Bank of Lebanon20. Fabio Scacciavillani, Oman Investment Fund21. Miroslav Singer, formerly Czech National Bank22. José Alberto Tavares Moreira, formerly Banco de Portugal23. Jens Thomsen, formerly Danmarks Nationalbank24. Pasquale Urselli, formerly Crédit Agricole25. Makoto Utsumi, Japan Credit Rating Agency26. Tarisa Watanagase, formerly Bank of Thailand27. Ernst Welteke, formerly Deutsche Bundesbank

PUBLIC POLICY1. Antonio Armellini, former Ambassador, OSCE2. Franco Bassanini, formerly Cassa Depositi e Prestiti 3. Frits Bolkestein, formerly European Commission4. Laurens Jan Brinkhorst, University of Leiden5. Colin Budd, formerly UK Diplomatic Service6. Otaviano Canuto, World Bank Group7. Desmond Cecil, Areva UK8. Natalie Dempster, World Gold Council9. Hans Eichel, former German Minister of Finance10. Jonathan Grant, Policy Institute at King’s11. François Heisbourg, Fondation pour la Recherche Stratégique12. Karl Kaiser, Harvard Kennedy School13. John Kornblum, former US Ambassador to Germany14. Ben Knapen, Dutch Senate15. Ruud Lubbers, former Dutch Prime Minister16. Bo Lundgren, formerly Swedish National Debt Office17. Denis MacShane, former British Minister for Europe18. Kishore Mahbubani, Lee Kuan Yew School of Public Policy19. Boyd McCleary, former HM Diplomatic Service20. Luiz Eduardo Melin, formerly Brazilian Development Bank21. Célestin Monga, African Development Bank22. Murade Miguigy Murargy, CPLP23. David Owen, House of Lords24. Jukka Pihlman, Standard Chartered Bank25. Poul Nyrup Rasmussen, former Danish Prime Minister26. Paul van Seters, Tilburg University27. Christopher Tugendhat, House of Lords28. John West, Asian Century Institute29. Paul Wilson, formerly De La Rue

ECONOMICS & INDUSTRY1. Irena Asmundson, California Department of Finance2. Robert Bischof, German-British Chamber of Industry & Commerce3. Eduardo Borensztein, Inter-American Development Bank4. Albert Bressand, European Commission5. Shiyin Cai, Business Adviser6. Efraim Chalamish, New York University7. Vladimir Dlouhy, former Czech Industry Minister8. Brigitte Granville, Queen Mary, University of London9. Graham Hacche, National Institute of Economic and Social Research 10. Hans-Olaf Henkel, University of Mannheim11. Hemraz Jankee, formerly Central Bank of Mauritius12. David Kihangire, formerly Bank of Uganda13. Pawel Kowalewski, National Bank of Poland 14. Gerard Lyons, Greater London Authority15. Stuart Mackintosh, Group of Thirty16. Winston Moore, Moore Asociados17. Vicky Pryce, formerly UK Department for Business18. Edoardo Reviglio, Cassa Depositi e Prestiti 19. Pedro Schwartz, CEU San Pablo University20. Vilem Semerak, Charles University, Prague 21. Song Shanshan, SDIC CGOG Futures22. Gabriel Stein, Oxford Economics23. Takuji Tanaka, Innovation Network Corporation of Japan24. Jorge Vasconcelos, New Energy Solutions25. Obindah Gershon nee Wagbara, Georgetown University26. Volker Wieland, German Council of Economic Experts

Ed Balls is one of the most interesting British politicians of modern times. But

at the age of 49 he is no longer a member of parliament and his political career is over – or is it?

It certainly looks like it. In the general election of 2015, Balls not only witnessed his party’s defeat but lost his own parliamentary seat. He has not put his name down for another constituency and would be unlikely to be selected to stand in another seat. One of the messages that comes across from this engaging memoir, Speaking Out: Lessons in Life and Politics, is that he has no appetite for another five years of opposition politics.

The great British political commentator Alan Watkins was fond of saying, ‘Politics is a rough old trade.’ The fact that a man of Balls’ calibre should have been propelled from the scene so unceremoniously is a classic illustration of the Watkins dictum.

It is a crying shame. Balls played a major role on behalf of his mentor Gordon Brown in fashioning ‘New’ Labour’s economic policies, an achievement for which he has not received the recognition he deserves.

The Conservatives under David Cameron and George Osborne in 2010 managed to persuade more gullible voters that Labour had been responsible for the global financial crisis, and perpetuated the myth throughout the 2010-15 parliament. Slogans like ‘Labour cannot be trusted with the nation’s finances’ were still a factor in the 2015 election.

The fact that Labour was not responsible for what went wrong in the US or the euro area was neither here nor there. Enough British voters were convinced that Labour’s public spending plans had caused the crisis.

However, there has been widespread acknowledgement that Labour was right to make the Bank of England independent and keep the UK out of the euro.

And although the state of the National Health Service is once again a source of concern, a determined effort to save the service in one of Brown’s early budgets as chancellor received broad support.

Balls’ role and influence was crucial in all three of these key decisions. This was when he was a Treasury adviser, before embarking on his political career by winning a seat in the 2005 general election.

Balls is best known for his economic expertise, and confesses in the book that he now regrets never having been chancellor. The possibility of moving to the Treasury arose on several occasions during Brown’s

2007-10 premiership, but something always got in the way. Balls was the best chancellor New Labour never had.

In addition to taking up a fellowship at Harvard University and becoming a visiting professor at King’s College, London, Balls has produced this book just over a year after losing office.

‘A trying relationship’ He admits that, although he was as close to Brown as anyone, it could be a trying relationship.

One revelation is Balls’ firm assertion that, although the press was always replete with stories about disagreements between Tony Blair and Brown, the two were much closer on policy than most people were led to believe.

On the other hand, having worked happily with Ed Miliband at a more junior level, Balls found himself more or less isolated when Miliband became Labour leader.

This did not help Labour’s election chances in 2015, when Miliband abandoned a fundamental New Labour insight – that we

live in a market economy and it is electorally dangerous to come across as anti-business.

The book is beautifully written, in conversational style, and divided into themes such as ‘Decisions’, ‘Ambition’, ‘Mistakes’. Balls is an admirer of the great Labour politician Denis Healey, whom he met shortly before Healey died.

Healey made a great thing about how politicians should always have a cultural ‘hinterland’ to shield them from the slings and arrows of political life.

Balls certainly has one. He is happily married to the politician Yvette Cooper; he is an enthusiastic footballer and marathon runner; plays the piano; and has become a national figure through popular television programme Strictly Come Dancing.

Political career over? He concludes: ‘I’ve had my chance in politics and – while you should never say never – I don’t expect that chance to come again.’ Alas, given the potentially terminal state of the Labour party, he may well be right. ▪William Keegan is Senior Economics Commentator for The Observer.

Best chancellor New Labour never had Back to hinterland for political retiree William Keegan, Advisory Board

26 | BOOK REVIEW October | ©2016omfif.org

“The possibility of moving to the Treasury

arose on several more occasions during Brown’s premiership, but something always got in the way.

ECB expected to expand into new asset classesPercentage of responses

Option 1

New assetclasses

32%

Lower/abolishminimum yield

requirement8%

Change thecapital key

20%

Raise the issuelimit on bonds

20%

No change– let the

programme expire20%

What changes, if any, do you expect the ECB to make to its quantitative easing programme before it expires in March 2017?

What is your prediction for the euro area annual inflation rate, on the ECB’s measurement, in 2017 and 2018?

ECB expected to extend QE to new asset classesDespite monetary expansion, inflation to remain subdued in euro area

This month’s poll focused on the outlook for the European Central Bank’s quantitative easing programme and euro area inflation. Members of the Advisory Board were asked two questions. First, ‘What changes, if any, do you expect the ECB to make to its quantitative easing

programme before it expires in March 2017?’ with five possible options (respondents were invited to select as many or few as appropriate) – expand into new asset classes; lower or abolish the minimum yield requirement; change the capital key governing ECB QE purchases; raise the issue limit on bonds; and no change – let the programme expire. The second question asked members for their prediction for the euro area annual inflation rate, on the ECB’s measurement, in 2017 and 2018.

Of the responses received, 32% expected the bank to expand the QE programme into new asset classes. A further 20% each subscribed to options three, four and five – that the bank would change the capital key governing QE purchases, the ECB raising the issue limits on bonds, and ‘no change – let the programme expire’, while 8% expected the bank either to lower or abolish the minimum yield requirement.

Estimates for euro area inflation in 2017 and 2018 were wide-ranging – at the lower end for 2017, 0.6%, with an upper estimate of 2%. Respondents broadly expected inflation to be higher in 2018. Estimates ranged from 0.6% to an upper estimate of 2.5%.

‘While I don’t expect the ECB to change the capital key that governs QE purchases in its current ordinary programme, it could if one or several countries ask for activation of the ESM. But one could imagine a redesigned programme with some sort of yield targeting whereby the ECB purchases fewer expensive bonds and more higher-return bonds. This would drive German and French yields higher and could be welcomed by the Bundesbank and the German government, as it would reduce the rate of saver pauperisation so dreaded by future retirees.’Olivier Rousseau, Fondation de reserves pour les retraites

‘Market-based inflation expectations in the euro area have recently hovered around lows and have been trending down more markedly after the Brexit vote. Until the ECB sees a sustained adjustment in the path of inflation consistent with its aim, the most likely scenario is that it will extend its QE beyond March 2017. However, QE’s technical restrictions will become an issue, with each option having its share of drawbacks. There are also risks of re-opening rifts within the ECB with QE extension, with Germany sceptical of moves to prolong asset purchases.’Hemraz Jankee, formerly Central Bank of Mauritius

‘QE is now more contentious as the negative impact has become more evident. A fall in risk assets, leading to hits to Central Bank balance sheets, would further damage support for this policy.’Colin Robertson, independent asset allocation consultant

October | ©2016 omfif.org ADVISORY BOARD POLL | 27

Will China’s economy experience a hard landing or recession over the coming five years?

Will the renminbi's inclusion in the IMF’s SDR basket make an essential difference for the international monetary system, or is it largely a ceremonial seal of approval?

November’s question

These additional statements were received as part of the September poll, conducted between 9 and 24 September. It calculates the results as a percentage from a total of 25 responses coming from 17 respondents. A respondent can choose more than one option to the question.

2017 2018

Lowest estimate 0.6% 0.6%

Median 1.0% 1.4%

Highest estimate 2.0% 2.5%

Wide-ranging inflation expectationsEstimates for euro area inflation, OMFIF Advisory Board

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