European recession next year 'almost inevitable': Soros

Business Times - 16 Jun 2010

LONDON - Europe faces almost inevitable recession next year and years of stagnation as policymakers' response to the euro zone crisis causes a downward spiral, billionaire investor George Soros said on Tuesday.

Flaws built into the euro from the start had become acute, Soros told a seminar, warning that the euro crisis could have the potential to destroy the 27-nation European Union.

The euro's lack of a correction mechanism or of a provision for countries to leave it could be a fatal weakness, he said.

Germany had imposed its criteria on how a 750 billion euro (US$1 trillion) euro zone rescue mechanism should be used and was imposing its own standards - a trade surplus and a high savings rate - on the rest of Europe, Mr Soros said.

'But you can't be a creditor country, a surplus country, without somebody being in deficit,' he said.

'That's the real danger of the present situation - that by imposing fiscal discipline at a time of insufficient demand and a weak banking system, by wanting to have a balanced budget you are actually ... setting in motion a downward spiral,' he said.

Germany would do relatively well because the decline in the euro had boosted its economy, he told the seminar on the euro zone crisis organised by two thinktanks, the European Council on Foreign Relations and the Centre for European Reform.

'Germany is going to smell like roses but (the rest of) Europe is going to be pushed into a downward spiral, stagnation lasting many years and possibly worse than that,' he said.

'In other words, I think a recession next year is almost inevitable given the current policies,' Mr Soros said, later clarifying that he meant a recession in Europe as a whole.

Warns of social unrest

'If there is no exit, (it) is liable to give rise to social unrest and, if you follow the line, social unrest can give rise to demand for law and order and (sow the) seeds of what happened in the inter-war period,' he said.

Political will to forge a common fiscal policy in Europe was absent and since Europe was liable to move backwards if it did not advance, 'the crisis of the euro could actually have the potential of destroying the European Union,' he said.

European banks had bought large amounts of the sovereign bonds of weaker euro zone countries for a tiny interest rate differential, Mr Soros said.

'That's one of the reasons why the banks are so over-leveraged and why the German and the French banks own Spanish bonds,' he said.

'Now ... they have a loss on their balance sheets which is not recognised and it reduces the credibility of those banks so the banking system is in serious trouble,' he said.

'The commercial paper market, for instance, in America is now refusing to lend to European banks so there is even a funding crisis and the ECB (European Central Bank) has to step in and the banks are unwilling to lend to each other,' he said. -- REUTERS

Responsible planning for retirement

Business Times - 28 Apr 2010

MONEY MATTERS

An asset solution should not purely maximise returns but should be relevant for all investment climates and have the highest probability of meeting retirement liabilities, with due consideration given to liquidity and inflation

By AL CLARK

INDIVIDUALS are becoming increasingly responsible for the outcome of their retirement solutions, as the world moves away from Defined Benefit towards Defined Contribution schemes. It is essential that individuals are equipped with the adequate tools to make appropriate decisions when constructing retirement solutions, to ensure that they maximise the probability of delivering a sufficient and stable income.

As we have always emphasised, simply recommending 100 per cent equities for an individual with more than 10 years to retirement is not a responsible solution. Attention needs to be given to the potential range of outcomes this asset mix can deliver - some favourable or, as the past 10 years have shown, some very poor. A more responsible approach needs to be taken to make sure that the solution can perform in all market environments - not just an equity bull run.

A useful starting point is to consider the liabilities that the individual will encounter in retirement. There will be significant variation between individuals, depending on the expected lifestyle. But the basic exercise requires making assumptions on potential future payments for discretionary and non-discretionary items. Cash flows for needs such as housing, food, clothing, health, transport, entertainment and travel can all be estimated and, from the aggregate sum, an assumption can be made about the individual's expected liabilities for each year after retirement.

This can be a cumbersome exercise. A quick look through the plethora of 'retirement calculators' available on the Web shows the short cut commonly used is to simply consider future liabilities as a percentage of current income. This is a fairly neat solution to a complex problem, based on the logic that an individual's current salary is a good representation of the amount required to meet living expenses.

However, the key point to then recognise is that the present cost of these payments will not be representative of the real cost. It is not reasonable to expect a movie ticket in 2030 to cost the same as a movie ticket in 2010. Any assessment of future liabilities needs to consider inflation.

Once the expected liabilities are determined, the next step is to establish the appropriate asset mix that maximises the probability of meeting these liabilities. It is worth remembering that this is the money that an individual will live on in retirement, so the level of risk taken in the asset mix should consider the implications of significant under-performance relative to the expected liabilities.

A prominent US academic recently advocated placing 100 per cent of assets in inflation-linked bonds. This solution has virtually no risk as the bonds are government guaranteed with an implicit link to keep pace with inflation. It is difficult to argue against the logic - but the unfortunate reality is that for the majority of individuals, this solution will not deliver sufficient funds in retirement. This is simply because most people do not have enough current capital, or ongoing contributions, to invest in low-risk - and subsequently low-return - assets to generate enough funds to meet retirement liabilities. Most people need to take some level of risk, with the expectation of capital growth helping to offset the deficit.

So here is the rub: How do we get enough returns to generate sufficient funds to meet retirement liabilities - without taking so much risk that the whole solution blows up and leaves the retiree substantially under-funded? Financial advice in the past may simply have been to load up on equities. Hopefully, we have moved on from there. The more innovative approach that is evolving is to supplement a core holding of sovereign and inflation-linked bonds with a diversified basket of risky assets that may include equities, credit, property and commodities. The goal is to create an asset solution with the highest probability of meeting the liabilities, with due consideration given to liquidity and inflation.

A simplified example is laid out in Table 1 below. Take a 45-year-old individual currently earning $60,000 a year, with the expectation of 2 per cent annual salary increases until the retirement age of 68. This will result in a terminal salary of around $91,000 at retirement. The individual has chosen to contribute 10 per cent of his salary each year and feels he will need 60 per cent of his terminal salary to meet his expected liabilities after retirement (which will increase by an assumed inflation rate of 3 per cent). The other fortunate input for this individual is that he already has $100,000 invested in his retirement account.

The following solution assumes an investment return of 6 per cent in the growth phase (before retirement) and 4 per cent in the drawdown phase (after retirement). In the past, retirement solutions sought to take significantly more risk in the growth phase (possibly recommending 100 per cent equities) without sufficient analysis of the potential shortfalls that this may produce in the drawdown phase. Solutions now are more risk-conscious in the growth phase, mindful of protecting an investor's capital to allow compounding to work its magic and provide sufficient funds for the drawdown phase.

As Table 1 shows, this solution will fund the individual into his 80th year. The important question now to be answered is: What is the appropriate asset mix to deliver the return assumptions for the growth and drawdown phases? There is generally a consensus on the drawdown phase, where individuals are recommended to invest in liquid and low-risk assets - like annuities - to protect the capital that they have accrued. The contention is generally centred on the correct mix for the growth phase.

Table 2 shows the analysis for a Singapore dollar-based investor. Based on some fairly conservative assumptions, this portfolio is expected to deliver a 6 per cent return each year with significantly lower risk than equities. This increases the probability of generating sufficient funds to satisfy the liabilities expected, giving the individual greater certainty in being able to meet his retirement needs.

This analysis is based on a hypothetical example and should not be construed as financial advice. But it seeks to demonstrate the evolution of constructing an asset mix for retirement that maximises the potential of achieving the expected liabilities rather than purely maximising return without due consideration to the impact of under-performing the liabilities.

As an industry, the responsibility lies with financial advisory practitioners to provide sound advice to individuals, with an increasing level of choice when it comes to their retirement solutions. The advice needs to be relevant for all investment climates, with due consideration given to inflation, to ensure that the investment strategy of the individual has the highest probability of meeting its objective - a sufficient and stable income for retirement.

The writer is Asia-Pacific head of multi asset, Schroder Investment Management

Interpreting the Crisis

Business Times, 26 Aug 2009

The events of last September and October exhibited some features of a classic panic

This is the second and final part of an excerpt of the speech by US Federal Reserve chairman Ben Bernanke at the Federal Reserve Bank of Kansas City's Annual Economic Symposium at Jackson Hole, Wyoming on Aug 21.

HOW should we interpret the extraordinary events of the past year, particularly the sharp intensification of the financial crisis in September and October? Certainly, fundamentals played a critical role in triggering those events. As I noted earlier, the economy was already in recession, and it had weakened further over the summer. The continuing dramatic decline in house prices and rising rates of foreclosure raised serious concerns about the values of mortgage-related assets, and thus about large potential losses at financial institutions. More broadly, investors remained distrustful of virtually all forms of private credit, especially structured credit products and other complex or opaque instruments.

At the same time, however, the events of September and October also exhibited some features of a classic panic, of the type described by (British economist and journalist Walter) Bagehot and many others.

A panic is a generalised run by providers of short-term funding to a set of financial institutions, possibly resulting in the failure of one or more of those institutions. The historically most familiar type of panic, which involves runs on banks by retail depositors, has been made largely obsolete by deposit insurance or guarantees and the associated government supervision of banks.

But a panic is possible in any situation in which longer-term, illiquid assets are financed by short-term, liquid liabilities, and in which suppliers of short-term funding either lose confidence in the borrower or become worried that other short-term lenders may lose confidence.

Although, in a certain sense, a panic may be collectively irrational, it may be entirely rational at the individual level, as each market participant has a strong incentive to be among the first to the exit.

Panics arose in multiple contexts last year. For example, many financial institutions, notably including the independent investment banks, financed a portion of their assets through short-term repo agreements. In repo agreements, the asset being financed serves as collateral for the loan, and the maximum amount of the loan is the current assessed value of the collateral less a haircut.

In a crisis, haircuts typically rise as short-term lenders attempt to protect themselves from possible declines in asset prices. But this individually rational behaviour can set off a run-like dynamic: As high haircuts make financing portfolios more difficult, some borrowers may have no option but to sell assets into illiquid markets. These forced sales drive down asset prices, increase volatility, and weaken the financial positions of all holders of similar assets, which in turn increases the risks borne by repo lenders and thus the haircuts they demand.

This unstable dynamic was apparent around the time of the near- failure of Bear Stearns in March 2008, and haircuts rose particularly sharply during the worsening of the crisis in mid-September.

As we saw last fall, when a vicious funding spiral of this sort is at work, falling asset prices and the collapse of lender confidence may create financial contagion, even between firms without significant counterparty relationships. In such an environment, the line between insolvency and illiquidity may be quite blurry.

Panic-like phenomena

Panic-like phenomena occurred in other contexts as well. Structured investment vehicles and other asset-backed programmes that relied heavily on the commercial paper market began to have difficulty rolling over their short-term funding very early in the crisis, forcing them to look to bank sponsors for liquidity or to sell assets.

Following the Lehman collapse, panic gripped the money market mutual funds and the commercial paper market, as I have discussed. More generally, during the crisis, runs of uninsured creditors have created severe funding problems for a number of financial firms. In some cases, runs by creditors were augmented by other types of 'runs' - for example, by prime brokerage customers of investment banks concerned about the funds they held in margin accounts. Overall, the role played by panic helps to explain the remarkably sharp and sudden intensification of the financial crisis last fall, its rapid global spread, and the fact that the abrupt deterioration in financial conditions was largely unforecasted by standard market indicators.

The view that the financial crisis had elements of a classic panic, particularly during its most intense phases, has helped to motivate a number of the Federal Reserve's policy actions.

Mr Bagehot instructed central banks - the only institutions that have the power to increase the aggregate liquidity in the system - to respond to panics by lending freely against sound collateral.

Following that advice, from the beginning of the crisis, the Fed (like other central banks) has provided large amounts of short-term liquidity to financial institutions. As I have discussed, it also provided backstop liquidity support for money market mutual funds and the commercial paper market, and added significant liquidity to the system through purchases of longer-term securities.

To be sure, the provision of liquidity alone can by no means solve the problems of credit risk and credit losses; but it can reduce liquidity premiums, help restore the confidence of investors, and thus promote stability. It is noteworthy that the use of Fed liquidity facilities has declined sharply since the beginning of the year - a clear market signal that liquidity pressures are easing and market conditions are normalising.

What does this perspective on the crisis imply for future policies and regulatory reforms? We have seen during the past two years that the complex interrelationships among credit, market, and funding risks of key players in financial markets can have far-reaching implications, particularly during a general crisis of confidence.

In particular, the experience has underscored that liquidity risk management is as essential as capital adequacy and credit and market risk management, particularly during times of intense financial stress. Both the Basel Committee on Banking Supervision and the US bank regulatory agencies have recently issued guidelines for strengthening liquidity risk management at financial institutions. Among other objectives, liquidity guidelines must take into account the risks that inadequate liquidity planning by major financial firms pose for the broader financial system, and they must ensure that these firms do not become excessively reliant on liquidity support from the central bank.

But liquidity risk management at the level of the firm, no matter how carefully done, can never fully protect against systemic events. In a sufficiently severe panic, funding problems will almost certainly arise and are likely to spread in unexpected ways. Only central banks are well positioned to offset the ensuing sharp decline in liquidity and credit provision by the private sector. They must be prepared to do so.

Systemwide approach

The role of liquidity in systemic events provides yet another reason why, in the future, a more systemwide or macroprudential approach to regulation is needed. The hallmark of a macroprudential approach is its emphasis on the interdependencies among firms and markets that have the potential to undermine the stability of the financial system, including the linkages that arise through short-term funding markets and other counterparty relationships, such as over-the-counter derivatives contracts. A comprehensive regulatory approach must examine those interdependencies as well as the financial conditions of individual firms in isolation.

Since we last met here, the world has been through the most severe financial crisis since the Great Depression. The crisis in turn sparked a deep global recession, from which we are only now beginning to emerge.

As severe as the economic impact has been, however, the outcome could have been decidedly worse. Unlike in the 1930s, when policy was largely passive and political divisions made international economic and financial cooperation difficult, during the past year, monetary, fiscal and financial policies around the world have been aggressive and complementary.

Without these speedy and forceful actions, last October's panic would likely have continued to intensify, more major financial firms would have failed, and the entire global financial system would have been at serious risk. We cannot know for sure what the economic effects of these events would have been, but what we know about the effects of financial crises suggests that the resulting global downturn could have been extraordinarily deep and protracted.

Although we have avoided the worst, difficult challenges still lie ahead. We must work together to build on the gains already made to secure a sustained economic recovery, as well as to build a new financial regulatory framework that will reflect the lessons of this crisis and prevent a recurrence of the events of the past two years.

I hope and expect that, when we meet here a year from now, we will be able to claim substantial progress towards both those objectives.

Looking back at the Crisis

Business Times, 25 Aug 2009

Bernanke reflects on the events of the past year, the challenges they posed, the measures taken, and the lessons learnt

This is the first part of an excerpt of the speech by US Federal Reserve chairman Ben Bernanke at the Federal Reserve Bank of Kansas City's Annual Economic Symposium at Jackson Hole, Wyoming on Aug 21. The second and final part will appear tomorrow.

BY THE standards of recent decades, the economic environment at the time of this symposium one year ago was quite challenging. A year after the onset of the current crisis in August 2007, financial markets remained stressed, the economy was slowing, and inflation - driven by a global commodity boom - had risen significantly. What we could not fully appreciate when we last gathered here was that the economic and policy environment was about to become vastly more difficult.

One very clear lesson of the past year - no surprise, of course, to any student of economic history, but worth noting nonetheless - is that a full-blown financial crisis can exact an enormous toll in both human and economic terms. A second lesson - once again, familiar to economic historians - is that financial disruptions do not respect borders. The crisis has been global, with no major country having been immune.

History is full of examples in which the policy responses to financial crises have been slow and inadequate, often resulting ultimately in greater economic damage and increased fiscal costs. In this episode, by contrast, policymakers in the United States and around the globe responded with speed and force to arrest a rapidly deteriorating and dangerous situation. Looking forward, we must urgently address structural weaknesses in the financial system, in particular in the regulatory framework, to ensure that the enormous costs of the past two years will not be borne again.

September-October 2008: The crisis intensifies

When we met last year, financial markets and the economy were continuing to suffer the effects of the ongoing crisis. We know now that the National Bureau of Economic Research has determined December 2007 as the beginning of the recession. The US unemployment rate had risen to 53/4 per cent by July, about one percentage point above its level at the beginning of the crisis, and household spending was weakening.

Ongoing declines in residential construction and house prices and rising mortgage defaults and foreclosures continued to weigh on the US economy, and forecasts of prospective credit losses at financial institutions both here and abroad continued to increase. Indeed, one of the nation's largest thrift institutions, IndyMac, had recently collapsed under the weight of distressed mortgages, and investors continued to harbour doubts about the condition of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, despite the approval by the Congress of open-ended support for the two firms.

Notwithstanding these significant concerns, however, there was little to suggest that market participants saw the financial situation as about to take a sharp turn for the worse. For example, although indicators of default risk such as interest rate spreads and quotes on credit default swaps remained well above historical norms, most such measures had declined from earlier peaks, in some cases by substantial amounts.

And in early September, when the target for the federal funds rate was 2 per cent, investors appeared to see little chance that the federal funds rate would be below 13/4 per cent six months later. That is, this time last year, market participants evidently believed it improbable that significant additional monetary policy stimulus would be needed in the United States.

Nevertheless, shortly after our last convocation, the financial crisis intensified dramatically. Despite the steps that had been taken to support Fannie Mae and Freddie Mac, their condition continued to worsen. In early September, the companies' regulator placed both into conservatorship, and the Treasury used its recently enacted authority to provide the firms with massive financial support.

Shortly thereafter, several additional large US financial firms also came under heavy pressure from creditors, counterparties, and customers. The Federal Reserve has consistently maintained the view that the disorderly failure of one or more systemically important institutions in the context of a broader financial crisis could have extremely adverse consequences for both the financial system and the economy. We have therefore spared no effort, within our legal authorities and in appropriate cooperation with other agencies, to avert such a failure.

The case of the investment bank Lehman Brothers proved exceptionally difficult, however. Concerted government attempts to find a buyer for the company or to develop an industry solution proved unavailing, and the company's available collateral fell well short of the amount needed to secure a Federal Reserve loan of sufficient size to meet its funding needs. As the Federal Reserve cannot make an unsecured loan, and as the government as a whole lacked appropriate resolution authority or the ability to inject capital, the firm's failure was, unfortunately, unavoidable. The Federal Reserve and the Treasury were compelled to focus instead on mitigating the fallout from the failure, for example, by taking measures to stabilise the triparty repurchase (repo) market.

In contrast, in the case of the insurance company American International Group (AIG), the Federal Reserve judged that the company's financial and business assets were adequate to secure an US$85 billion line of credit, enough to avert its imminent failure. Because AIG was counterparty to many of the world's largest financial firms, a significant borrower in the commercial paper market and other public debt markets, and a provider of insurance products to tens of millions of customers, its abrupt collapse likely would have intensified the crisis substantially further, at a time when the US authorities had not yet obtained the necessary fiscal resources to deal with a massive systemic event.

The failure of Lehman Brothers and the near-failure of AIG were dramatic but hardly isolated events. Many prominent firms struggled to survive as confidence plummeted. The investment bank Merrill Lynch, under pressure in the wake of Lehman's failure, agreed to be acquired by Bank of America; the major thrift institution Washington Mutual was resolved by the Federal Deposit Insurance Corporation (FDIC) in an assisted transaction; and the large commercial bank Wachovia, after experiencing severe liquidity outflows, agreed to be sold. The two largest remaining free-standing investment banks, Morgan Stanley and Goldman Sachs, were stabilised when the Federal Reserve approved, on an emergency basis, their applications to become bank holding companies.

Nor were the extraordinary pressures on financial firms during September and early October confined to the United States: For example, on Sept 18, the UK mortgage lender HBOS, with assets of more than US$1 trillion, was forced to merge with Lloyds TSB. On Sept 29, the governments of Belgium, Luxembourg, and the Netherlands effectively nationalised Fortis, a banking and insurance firm that had assets of around US$1 trillion.

The same day, German authorities provided assistance to Hypo Real Estate, a large commercial real estate lender, and the British government nationalised another mortgage lender, Bradford and Bingley. On the next day, Sept 30, the governments of Belgium, France, and Luxembourg injected capital into Dexia, a bank with assets of more than US$700 billion, and the Irish government guaranteed the deposits and most other liabilities of six large Irish financial institutions.

Soon thereafter, the Icelandic government, lacking the resources to rescue the three largest banks in that country, put them into receivership and requested assistance from the International Monetary Fund (IMF) and from other Nordic governments. In mid-October, the Swiss government announced a rescue package of capital and asset guarantees for UBS, one of the world's largest banks. The growing pressures were not limited to banks with significant exposure to US or UK real estate or to securitised assets. For example, unsubstantiated rumours circulated in late September that some large Swedish banks were having trouble rolling over wholesale deposits, and on Oct 13, the Swedish government announced measures to guarantee bank debt and to inject capital into banks.

The rapidly worsening crisis soon spread beyond financial institutions into the money and capital markets more generally. As a result of losses on Lehman's commercial paper, a prominent money market mutual fund announced on Sept 16 that it had 'broken the buck' - that is, its net asset value had fallen below US$1 per share. Over the subsequent several weeks, investors withdrew more than US$400 billion from so-called prime money funds.

Conditions in short-term funding markets, including the interbank market and the commercial paper market, deteriorated sharply. Equity prices fell precipitously, and credit risk spreads jumped. The crisis also began to affect countries that had thus far escaped its worst effects. Notably, financial markets in emerging market economies were whipsawed as a flight from risk-led capital inflows to those countries to swing abruptly to outflows.

The policy response

Authorities in the United States and around the globe moved quickly to respond to this new phase of the crisis. The financial system of the United States gives a much greater role to financial markets and to non-bank financial institutions than is the case in most other nations, which rely primarily on banks. Thus, in the United States, a wider variety of policy measures was needed than in some other nations. In the United States, the Federal Reserve established new liquidity facilities with the goal of restoring basic functioning in various critical markets. Together, these steps helped stem the massive outflows from the money market mutual funds and stabilise the commercial paper market.

During this period, foreign commercial banks were a source of heavy demand for US dollar funding, thereby putting additional strain on global bank funding markets, including US markets, and further squeezing credit availability in the United States.

To address this problem, the Federal Reserve expanded the temporary swap lines that had been established earlier with the European Central Bank (ECB) and the Swiss National Bank, and established new temporary swap lines with seven other central banks in September and five more in late October, including four in emerging market economies. In further coordinated action, on Oct 8, the Federal Reserve and five other major central banks simultaneously cut their policy rates by 50 basis points.

The failure of Lehman Brothers demonstrated that liquidity provision by the Federal Reserve would not be sufficient to stop the crisis; substantial fiscal resources were necessary. On Oct 3, on the recommendation of the administration and with the strong support of the Federal Reserve, Congress approved the creation of the Troubled Asset Relief Program, or TARP, with a maximum authorisation of US$700 billion to support the stabilisation of the US financial system.

Markets remained highly volatile and pressure on financial institutions intense through the first weeks of October. On Oct 10, in what would prove to be a watershed in the global policy response, the Group of Seven (G-7) finance ministers and central bank governors, meeting in Washington, committed in a joint statement to work together to stabilise the global financial system. In particular, they agreed to prevent the failure of systemically important financial institutions; to ensure that financial institutions had adequate access to funding and capital, including public capital if necessary; and to put in place deposit insurance and other guarantees to restore the confidence of depositors.

In the following days, many countries around the world announced comprehensive rescue plans for their banking systems that built on the G-7 principles. To stabilise funding, during October, more than 20 countries expanded their deposit insurance programmes, and many also guaranteed non-deposit liabilities of banks. In addition, amid mounting concerns about the solvency of the global banking system, by the end of October, more than a dozen countries had announced plans to inject public capital into banks, and several announced plans to purchase or guarantee bank assets.

This strong and unprecedented international policy response proved broadly effective. Critically, it averted the imminent collapse of the global financial system, an outcome that seemed all too possible to the finance ministers and central bankers that gathered in Washington on Oct 10. However, although the intensity of the crisis moderated and the risk of systemic collapse declined in the wake of the policy response, financial conditions remained highly stressed.

For example, although short-term funding spreads in global markets began to turn down in October, they remained elevated into this year. And, although generalised pressures on financial institutions subsided somewhat, government actions to prevent the disorderly failures of individual, systemically significant institutions continued to be necessary. In the United States, support packages were announced for Citigroup in November and Bank of America in January. Broadly similar support packages were also announced for some large European institutions, including firms in the United Kingdom and the Netherlands.

Although concerted policy actions avoided much worse outcomes, the financial shocks of September and October nevertheless severely damaged the global economy - starkly illustrating the potential effects of financial stress on real economic activity. In the fourth quarter of 2008 and the first quarter of this year, global economic activity recorded its weakest performance in decades.

In the United States, real GDP plummeted at nearly a 6 per cent average annual pace over those two quarters - an even sharper decline than had occurred in the 1981-82 recession. Economic activity contracted even more precipitously in many foreign economies, with real GDP dropping at double-digit annual rates in some cases. The crisis affected economic activity not only by pushing down asset prices and tightening credit conditions, but also by shattering household and business confidence around the world.

In response to these developments, the Federal Reserve expended the remaining ammunition in the traditional arsenal of monetary policy, bringing the federal funds rate down, in steps, to a target range of zero to 25 basis points by mid-December of last year. It also took several measures to further supplement its traditional arsenal. In particular, on Nov 25, the Fed announced that it would purchase up to US$100 billion of debt issued by the housing-related GSEs and up to US$500 billion of agency-guaranteed mortgage-backed securities, programmes that were expanded substantially and augmented by a programme of purchases of Treasury securities in March.

The goal of these purchases was to provide additional support to private credit markets, particularly the mortgage market. Also, on Nov 25, the Fed announced the creation of the Term Asset-Backed Securities Loan Facility (TALF). This facility aims to improve the availability and affordability of credit for households and small businesses, and to help facilitate the financing and refinancing of commercial real estate properties.

The TALF has shown early success in reducing risk spreads and stimulating new securitisation activity for assets included in the programme. Foreign central banks also cut policy rates to very low levels and implemented unconventional monetary measures.

On Feb 10, Treasury Secretary Geithner and the heads of the federal banking agencies unveiled the outlines of a new strategy for ensuring that banking institutions could continue to provide credit to households and businesses during the financial crisis. A central component of that strategy was the exercise that came to be known as the bank stress test.

Under this initiative, the banking regulatory agencies undertook a forward-looking, simultaneous evaluation of the capital positions of 19 of the largest bank holding companies in the United States, with the Treasury committing to provide public capital as needed. The goal of this supervisory assessment was to ensure that the equity capital held by these firms was sufficient - in both quantity and quality - to allow those institutions to withstand a worse-than-expected macroeconomic environment over the subsequent two years and yet remain healthy and capable of lending to creditworthy borrowers.

This exercise, unprecedented in scale and scope, was led by the Federal Reserve in cooperation with the Office of the Comptroller of the Currency and the FDIC. Importantly, the agencies' report made public considerable information on the projected losses and revenues of the 19 firms, allowing private analysts to judge for themselves the credibility of the exercise. Financial market participants responded favourably to the announcement of the results, and many of the tested banks were subsequently able to tap public capital markets.

Overall, the policy actions implemented in recent months have helped stabilise a number of key financial markets, both in the United States and abroad. Short-term funding markets are functioning more normally, corporate bond issuance has been strong, and activity in some previously moribund securitisation markets has picked up. Stock prices have partially recovered, and US mortgage rates have declined markedly since last fall.

Critically, fears of financial collapse have receded substantially. After contracting sharply over the past year, economic activity appears to be levelling out, both in the United States and abroad, and the prospects for a return to growth in the near term appear good.

Notwithstanding this noteworthy progress, critical challenges remain: Strains persist in many financial markets across the globe, financial institutions face significant additional losses, and many businesses and households continue to experience considerable difficulty gaining access to credit. Because of these and other factors, the economic recovery is likely to be relatively slow at first, with unemployment declining only gradually from high levels.

Fed chief: We have tools for an exit strategy

Business Times - 22 Jul 2009

US economic outlook improving but joblessness to stay high, says Bernanke

(WASHINGTON) US Federal Reserve chairman Ben Bernanke yesterday said that the outlook for the long-suffering US economy appears to be improving and that the US central bank was carefully reviewing ways to withdraw its massive monetary policy stimulus when conditions permit.

But Mr Bernanke cautioned that unemployment was likely to remain high into 2011, and he warned that this could sap fragile consumer confidence and potentially undermine what is expected to be a very gradual recovery.

'The (Fed) believes that a highly accommodative stance of monetary policy will be appropriate for an extended period,' he said in remarks prepared for delivery to the House of Representatives Financial Services Committee.

'However, we also believe that it is important to assure the public and the markets that the extraordinary policy measures we have taken in response to the financial crisis and the recession can be withdrawn in a smooth and timely manner as needed, thereby avoiding the risk that policy stimulus could lead to a future rise in inflation,' he said.

Said Boris Schlossberg, director for currency research at GFT Forex in New York: 'The Fed has zero intention of tightening monetary policy any time in the near future. They want to keep the conditions in place to sustain this fragile economic recovery.'

The Fed has cut interest rates to almost zero and doubled the size of its balance sheet to around US$2 trillion as it pumped money into the economy to fight a severe recession after a financial panic last year cracked global credit markets.

Some economists, including some policymakers, have worried that this dramatic expansion of Fed liquidity and lending may have sown the seeds for inflation to blossom as the recovery gains traction.

Mr Bernanke, delivering the Fed's semi-annual report to Congress on the economy, took pains to promise that the US central bank had an array of weapons at its disposal to withdraw its unprecedented monetary stimulus when the time was right, even if its balance sheet remains large for a time.

'The (Fed) has been devoting considerable attention to issues relating to its exit strategy, and we are confident that we have the necessary tools to implement that strategy when appropriate,' he said, echoing comments he made in an article published late on Monday on the Wall Street Journal's website.

'Should economic conditions warrant a tightening of monetary policy before this process of unwinding is complete, we have a number of tools that will enable us to raise market interest rates as needed,' Mr Bernanke said.

Paying interest on the reserves that banks hold at the Fed - a tool used by other central banks - is chief among these devices, Mr Bernanke said. By raising the amount of interest it is willing to pay, the Fed can encourage banks to park excess cash at the central bank.

The Fed's monetary policy report also detailed a number of other measures that policymakers could employ, steps that Mr Bernanke had also outlined in his newspaper piece.

The report said the Fed could arrange so-called reverse repurchase agreements with financial firms. The Fed would sell securities from its portfolio, taking cash out of the system, with an agreement to buy them back at a higher price later.

It could also offer 'term deposits' similar to certificates of deposit to banks. Bank funds held at the Fed in such instruments would not be available for lending.

In addition, the Treasury Department could issue securities and leave the funds on deposit with the Fed, or the Fed could sell some of the securities that it has accumulated. -- Reuters

Global system needs global currency: Volcker

Business Times - 12 Jun 2009

He questions if US$ as an international currency is in US's long-term interests

By ANTHONY ROWLEY IN BEIJING

SPEAKING in Beijing's Great Hall of the People, former US Federal Reserve chairman Paul Volcker last night acknowledged the legitimacy of China's concerns over the dollar and questioned whether it was in the long-run interests of the United States to continue providing an international currency.

The 'ultimate logic of a globalised financial system is, to me, a global currency', said Mr Volcker, now head of President Barrack Obama's Economic Recovery Advisory Board, in a speech to senior Chinese and other bankers from around the world.

His comments seem bound to open up a controversial debate on the future of the dollar as a global currency. Us Treasury Secretary Timothy Geithner has been criticised recently for also appearing sympathetic to China's concerns on this issue.

Mr Volcker also suggested during his speech as guest of the Institute of International Finance at its Beijing meeting that 'the sudden and unsettling drop' in global economic activity is slowing. But he warned that 'prospects for a really strong recovery, typical of most recessions seems unlikely'.

Instead, 'a long slog with continuing high levels of unemployment seems to be in store'. he said. 'For most of the developed world, sources of strong, spontaneous growth are hard to envisage. In the US, as elsewhere, even modest growth remains dependent on strong fiscal and monetary stimulus.'

Likewise, although 'a healing process in financial markets seems to be underway, the global financial system remains in intensive care', said the monetary world veteran. The best that can be said is that the system is 'out of the emergency room', he added.

On the dollar issue, Mr Volcker noted that 'Chinese officials have recently raised questions about the implications for China and others that are holding so many dollars'.

'I think it is reasonable to ask whether it is in the long-run interests of the United States itself to provide what is essentially a public good - an international currency - in amounts so large as to raise questions about its ultimate stability.'

However, he added: 'The fact is that there are no practical alternatives for today or for many tomorrows to the US dollar as an international currency.

'I think it should be clearly understood that the central responsibility of the United States - in its own interest, in China's interest, and in the world's interest - is to maintain both the purchasing power of the dollar at home and in international markets, and a strong and open financial system.'

He acknowledged that 'the present state of world affairs has made clear that our international monetary arrangements have not provided a needed element of discipline for either surplus or deficit countries'.

'Deep and ultimately destabilising imbalances have been prolonged, specifically the growing and seemingly irresistible current imbalances between China and much of the rest of Asia and the US. These have for years been covered by flows of foreign official and privately held dollars back to the US.

'Indirectly, those flows have to some degree helped fuel the mortgage market and the housing bubble that touched off the financial collapse.'

Touching on the financial crisis, Mr Volcker warned that 'moral hazard' is in danger of becoming embedded as a result of official bailouts of financial institutions and because of the 'too big to fail' ethos that pervades official attitudes towards mounting rescues of such institutions.

'We can, and we should, take steps to limit the need and possibility of official bailouts.'

He also called for accounting reforms and questioned the wisdom of attempts to enforce strict mark to market accounting for financial institutions.

Poking holes in a theory on markets

Business Times - 10 Jun 2009

The efficient market hypothesis, near dogma for decades, has taken some serious body blows

(NEW YORK) FOR some months now, Jeremy Grantham, a respected market strategist with GMO, an institutional asset management company, has been railing about - of all things - the efficient market hypothesis. You know what the efficient market hypothesis is, don't you? It's a theory that grew out of the University of Chicago's finance department, and long held sway in academic circles, that the stock market can't be beaten on any consistent basis because all available information is already built into stock prices. The stock market, in other words, is rational.

In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioural economists, like Richard H Thaler at the University of Chicago and Robert J Shiller at Yale, who convincingly showed that mass psychology, herd behaviour and the like can have an enormous effect on stock prices - meaning that perhaps the market isn't quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.

These days, you would be hard-pressed to find anybody, even on the University of Chicago campus, who would claim that the market is perfectly efficient. Yet Mr Grantham, who was a critic of the efficient market hypothesis long before such criticism was in vogue, has hardly been mollified by its decline. In his view, it did a lot of damage in its heyday - damage that we're still dealing with. How much damage? In Mr Grantham's view, the efficient market hypothesis is more or less directly responsible for the financial crisis.

'In their desire for mathematical order and elegant models,' he wrote in his firm's quarterly letter to clients earlier this year, 'the economic establishment played down the role of bad behaviour' - not to mention 'flat-out bursts of irrationality'.

He continued: 'The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. 'Surely, none of this could be happening in a rational, efficient world,' they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.'

I couldn't help thinking about Mr Grantham's screed as I was reading Justin Fox's new book, The Myth of The Rational Market, an engaging history of what might be called the rise and fall of the efficient market hypothesis.

Mr Fox is a business columnist for Time magazine (and a former colleague of mine) who has long been interested in academic finance. His thesis, essentially, is that the efficient marketeers were originally on to a good idea. But sealed off in their academic cocoons - and writing papers in their mathematical jargon - they developed an internal logic quite divorced from market realities. It took a new group of young economists, the behaviouralists, to nudge the profession back toward reality.

Mr Fox argues, echoing Mr Grantham, that the efficient market hypothesis played an outsize role in shaping how the country thought and acted in the last 30-plus years. But Mr Fox parts company with him by also arguing that the effect wasn't necessarily all bad. As for the question of whether an academic theory hatched in Chicago led to the financial crisis, suffice it to say that some questions can never be answered definitively. Which isn't to say they shouldn't be asked.

'There are no easy ways to beat the market,' Mr Fox said when I spoke to him a few days ago. If you want to point to the single best thing the efficient market hypothesis taught us, that is the lesson: we can't beat the market. Indeed, the vast majority of professional money managers can't beat the market either, at least not on a regular basis.

As Mr Fox describes it, much of the early academic work that led to the efficient market theory was aimed at simply showing that most predictive stock charts were glorified voodoo - just because a pattern had developed didn't mean it would continue, or even that it had any real meaning. Dissertations were written showing how 20 randomly chosen stocks outperformed actively managed mutual funds. (Hence the phrase 'random walk,' to connote the near impossibility of beating the market regularly.) Mr Thaler, the Chicago behaviouralist, says that evidence on this point - 'the no free lunch principle,' he calls it - is clear and convincing.

In time, this insight led to the rise of passive index funds that simply matched the market instead of trying to beat it. Unless you're Warren Buffett, an index fund is where you should put your money. Even people who don't follow that advice know they should.

As it turns out, Mr Grantham was an early advocate of index funds, mainly for unsophisticated investors who have no hope of beating the market. But he also believes that professionals should do better precisely because, as he puts it, 'the market is full of major league inefficiencies.'

'There are incredible aberrations,' he told me over lunch not long ago. 'The US housing market in 2007. Japan in the 1980s. Nasdaq. In 2000, growth stocks were three times their fair value. We were quoted in The Economist in 2000 saying that the Nasdaq would drop by 75 per cent. In an efficient world, you wouldn't have that in a lifetime. If the market were truly efficient, it would mean that growth stocks had become permanently more valuable.'

As Mr Grantham sees it, if professional investors had been willing to acknowledge these aberrations - and trade on the fact that the market was out of whack - they should have been able to beat the market. But thanks to the efficient market hypothesis, no one was willing to call a bubble a bubble - because, after all, stock prices were rational.

'It helped mould the 'this time it's different' mentality,' he said. Indeed, professional money managers who tried to buck the tide wound up losing their jobs - because everybody else was making money by riding the bubble for all it was worth. Meanwhile, government officials, starting with Alan Greenspan, were unwilling to burst the bubble precisely because they were unwilling to even judge that it was a bubble. 'Our default reflex is that the world knows what it is doing, and that is extravagant nonsense,' Mr Grantham said.

But as much as I've admired Mr. Grantham's writings over the years, I think the truth, in this case, is a little more subtle. Given the long history of bubbles, I suspect this crisis would have taken place with or without the aid of the efficient market hypothesis. People thought 'it's different this time' in the 1920s, long before anyone was writing about efficient markets. And over the course of history, professional money managers have been just as fearful of bucking the trend as they were during the Internet bubble.

Mr Fox sees it somewhat differently. On the one hand, he says, the efficient market theoreticians always assumed that smart market participants would force stock prices to become rational. How? By doing exactly what they don't do in real life: take the other side of trades if prices get out of whack. Their ivory tower view reflected an idealised market that simply doesn't exist.

On the other hand, Mr Fox says, what was truly pernicious about the efficient market hypothesis is the way it allowed us to put asset prices on a pedestal that they never deserved. Stock options - supposedly based on a rational price - became prevalent in part because higher stock prices were supposed to be the rational reward for good performance.

Or take the modern emphasis on market capitalisation. 'At some point in the early 1990s (or maybe it was in the late 1980s), market capitalisation became accepted as the best measure of a company's importance,' Mr Fox wrote me in an e-mail message. 'Before then it was usually profits or revenue. I think that's a classic example of the way efficient market theory seeped into popular discourse and shaped how we perceived the world. It wasn't entirely stupid - profits and revenue are flawed, limited measures, and market value does tell you something useful about a company. But it was another one of the ways in which asset prices came to rule the world, which eventually turned out to be a bad thing.' - NYT

Geithner calms Chinese fears - for now

Business Times - 03 Jun 2009

TIMOTHY Geithner's maiden visit to China as US treasury secretary appears to have, for now, calmed some of the fears surrounding one of the world's most important bilateral economic relationships. However, the Obama administration will have to be seen to deliver on some of Mr Geithner's ambitious-sounding promises.

On the eve of his visit to Beijing, the US treasury secretary was faced with a delicate challenge. During his confirmation hearings in January, he had labelled China a 'currency manipulator', which had riled the Chinese establishment. Subsequently, as the US financial crisis deepened, Chinese Premier Wen Jiabao openly voiced concerns about the vulnerability of the US dollar in which the bulk of China's reserves are denominated, and hinted at the need for an alternative reserve currency.

Mr Geithner's priority was clearly to reassure the Chinese that the US dollar would remain a safe bet and that China had no cause to worry about its holdings of US Treasuries, amounting to US$768 billion as at the end of March.

But at the same time, he had to get the message across that China, too, has its part to play: it needs to make its currency more flexible and shift its economy away from export-led to domestic demand-led growth, to both help reduce its oversized trade surplus and to augment global reflation.

While in Beijing, Mr Geithner said all the right things: the US is committed to a 'strong dollar', China's investments in US financial assets are very safe, and the Obama administration is committed to reducing the US fiscal deficit over the medium term to a sustainable level. He also reiterated - more diplomatically than during his confirmation hearings - the US desire for a more flexible (read 'stronger') yuan and the need for Beijing to boost domestic demand.

But the promises will have to be backed up with meaningful action. Mr Geithner suggested, for instance, that the US aims to bring its fiscal deficit down to 'roughly 3 per cent' of GDP over the medium term, from close to 13 per cent at present. There are no credible policies in place to achieve this; much would depend on how the Obama administration proceeds with tax and spending measures, and particularly, healthcare reform, in the months to come.

Absent effective fiscal policies, the dollar, as well as US Treasury yields, would remain vulnerable. For its part, China, while professing to keep the yuan 'stable', did not oblige with any promises to appreciate its currency. And while it has put in place an aggressive economic stimulus package, the extent to which this will boost domestic consumption (as opposed to investment) demand remains to be seen.

Thus while the rhetoric on the US-China economic relationship might have helped calm nerves following Mr Geithner's visit to Beijing, what matters will be delivery on promises made - and the markets will be watching.

Geithner reassures China on US$ holdings

Business Times - 03 Jun 2009

Washington committed to keeping dollar strong and inflation low, he says

(BEIJING) Chinese officials are giving US efforts to pump up its ailing economy a vote of confidence and understand why higher budget deficits are a temporary necessity, US Treasury Secretary Timothy Geithner said here yesterday.

Mr Geithner, on his first visit to China as Treasury chief, gave fresh assurances that Beijing can sleep easy over its huge holdings of US Treasury debt because Washington is committed to keeping the dollar strong and inflation low.

President Barack Obama's administration, moreover, is determined to get back to living within its means as soon as the crisis has passed, Mr Geithner said in a trio of interviews ahead of meetings with President Hu Jintao and Premier Wen Jiabao. 'I've actually found a lot of confidence here in China, justifiable confidence, in the strength and resilience and dynamism of the American economy,' he said.

China is the single-biggest holder of US government debt - it held US$768 billion in Treasuries in March - and has watched uneasily as Washington has spent lavishly to try to haul the US economy out of its deepest recession in 80 years.

Mr Obama is budgeting for a deficit of 12.3 per cent of national output this year - four times China's shortfall - while the Fed has resorted to unorthodox policies, including purchasing hundreds of billions of dollars worth of US Treasury debt, to unclog the arteries of the banking system. The risk that this will spark inflation, eroding the value of China's holdings, has caused unease in Beijing, where leaders are conscious of public criticism that they should be spending more money at home instead of lending it to America.

But Mr Geithner gave a staunch defence of America's expansive policy, describing it as the 'fiscally conservative' option. 'If we had not acted aggressively, our deficits would have been higher in the future,' he said.

'We are very committed to make sure that when recovery is established that we go back to living within our means; that we bring our fiscal deficits down to a sustainable level; that we unwind and reverse these exceptional measures we've taken in the financial sector,' he added.
Mr Geithner spoke to Chinese state television, the CNBC business channel and, in a webchat, to the English-language China Daily.

The Treasury chief heaped praise on Fed chairman Ben Bernanke, who he said had done 'an enormously impressive job in the worst financial crisis in decades'.

The Fed's cooperation with other central banks in ensuring ample levels of cash in global money markets had been critical to helping stabilise the crisis. 'But I am completely confident, as should you be, that he will have not just the will but the ability to bring this down so that we achieve the obligation of making sure that inflation is low and stable in the United States going forward,' he said.

'We will do everything that is necessary to try to make sure we're sustaining confidence in US financial markets, not just in the United States but around the world,' Mr Geithner added.

China has reacted to the risk of inflation leading to losses on its bond portfolio by buying more short-term Treasury bills. The nagging inflation worries and general market shift towards shorter-dated debt have driven up 10-year note yields and pushed the yield gap between two-year and 10-year notes near record highs on Monday.

Premier Wen reminded Mr Geithner of his concerns about the safety of China's dollar assets by saying there was a need to 'tighten oversight of international reserve currencies so as to ensure the stability and growth of China', Xinhua reported.

Analysts assume that Beijing is already hedging its bets by switching at the margin from the dollar into other currencies. Central bank governor Zhou Xiaochuan unsettled markets in March by floating the long-term possibility of even replacing the dollar as the world's main reserve currency with the Special Drawing Right (SDR), the International Monetary Fund's (IMF) unit of account.

Russia said yesterday that it might discuss the idea of such a super-sovereign currency when the leaders of Brazil, India, Russia and China meet later this month.

But Mr Geithner was unruffled by all the talk. 'I believe the Chinese expect the dollar to be the principal reserve currency for a long period of time, as do we,' he said.

Mr Geithner, eschewing confrontation as he seeks to build trust, was gentle in encouraging China to let the yuan's exchange rate rise - something that would help to reduce the country's big trade surplus by making its exports more expensive and imports cheaper.

The Chinese currency climbed 21 per cent against the dollar between July 2005 and last summer.

But since then, to shield China's exporters, Beijing has kept the exchange rate on hold.

'They have committed publicly to continue to move over time towards a more flexible exchange rate system because I think they recognise that is essential to their broader strategy of rebalancing sources of growth,' Mr Geithner said.

Turning to the global economy, he said there had been early signs of stabilisation, and he was very encouraged by signs that confidence was returning to markets. What had been a real risk of financial collapse had receded to a significant degree. 'But it's early, and this is still a very powerful storm. It's causing enormous pressures and damage, uncertainty, not just across our economy but in economies around the world,' he said.

As Mr Geithner flew out of Beijing, the US government announced that the US and China would inaugurate their Cabinet-level Strategic and Economic Dialogue in Washington in the last week of July.

A study in relativity

Business Times - 02 May 2009

The basis for compensation should be the incremental value leaders bring on a per population or per share level, By TEH HOOI LING SENIOR CORRESPONDENT

EVERYTHING is relative. It's an indisputable truth. Generally we cannot take an absolute number and make a value judgment based on that alone.

Take two apartments, for example. One costs $1.5 million and the other $1.2 million. Which is cheaper? Well, we can't say until we know how big each one is, which floors they are on and which district they are in.

Numbers do take on a new perspective when you relate them to something else. In December 2006, Hong Kong financial guru Marc Faber noted that it took fewer than 10 barrels of oil to buy one ounce of gold - and that, according to him, was an indication that gold was cheap compared with oil. At the time, gold was trading at around US$600 an ounce, and oil at just over US$60 a barrel.

In 1999, it took more than 25 barrels of oil to buy an ounce of gold. The average over the 10 years prior to 2006 was around 15 barrels.

Until today, Dr Faber has been proved right - gold was cheap back in 2006. In the past 28 months, the price has risen about 40 per cent to around US$900 now. Oil, meanwhile, surged to a high of US$144 a barrel in July last year before collapsing all the way down to US$36. It is now trading around US$50.

At today's price, it takes 18 barrels of oil to buy one ounce of gold. So if the relative pricing of the two commodities still holds, one can surmise that either gold is now slightly on the high side, or oil is on the low side.

Now let's talk about pay - a very contentious issue these days. Early last month, The Australian newspaper ran an article on the 10 best-paid politicians in the world. Topping the list was Singapore's Lee Hsien Loong at US$2.47 million a year. In the second position was Hong Kong's Donald Tsang, at US$516,000. Barack Obama, who has just marked his 100th day as the President of the United States, earns US$400,000.

Ireland's Brian Cowen and France's Nicolas Sarkozy make US$341,000 and US$318,000 respectively. Tenth on the list was Australia's Kevin Rudd, at US$229,000.

But The Australian pointed out that if you look at the pay relative to the size of the country run by each of the 10 politicians, you would see things in a different light.

'If you divide the salary by head of population, the ladder of remuneration is significantly reshuffled, and our own Prime Minister leaps from 10th to fourth, while Obama slides from third to 10th,' the article said. 'So by this measure, Rudd is earning roughly 10 times what the US President is.'

Based on that measure, Singapore's Prime Minister Lee Hsien Loong still tops the list.

But here's the key question. Are heads of states overpaid? I say they are not. Their compensation pales in comparison with that of corporate head honchos. For instance, Mark Hurd, the chief executive of Hewlett-Packard, was paid US$42.5 million in 2008. And in 2007, CEOs of S&P 500 companies were paid an average of US$10.5 million a year.

Relative to the responsibility that political leaders face - the livelihoods and social well-being of millions depend on their decisions - I think their pay is too low.

Well, what are the justifications for the astronomical sums paid to top executives? In Singapore, the compensation of CapitaLand chief executive Liew Mun Leong came under scrutiny recently.

Mr Liew was paid $20.52 million bonus for 2007, followed by a comparatively modest $2.98 million for 2008. CapitaLand said the 2007 figure was due primarily to an economic value added (EVA) bonus payment. Essentially, EVA measures the group's net operating profit after tax, minus the cost of all capital employed. CapitaLand's EVA was $2.3 billion in 2007, and $660 million in 20080.

Mr Liew pointed out that his $20.52 million bonus for 2007 worked out to 0.74 per cent of the company's net profit, which hit a record $2.76 billion that year. In contrast, the average bonuses drawn for the 2007 financial year by the chief executives of Singapore's 10 biggest listed companies came to a larger 3.9 per cent.

Is EVA a fair measure of the benefits accrued by all shareholders, and therefore a reasonable metric to use when deciding an executive's compensation?

There are, of course, numerous criticisms of EVA as a measure of how well a company has performed. Take two companies. Company A has chalked up a return on capital of 13 per cent on its weighted average cost of capital (WACC) of 8 per cent, and Company B has returned 7 per cent on a WACC of 6 per cent. Obviously, on a return-on-capital basis, Company A has used its capital in more profitable projects and has created more value for its shareholders.

However, had Company B deployed a significantly larger amount of initial capital, say, $2 billion, compared with Company A's $100 million, its economic value added or EVA would have been larger, even though its overall return on capital is lower.

One per cent of $2 billion is $20 million, while 5 per cent of $100 million is only $5 million. So if an executive's compensation is based on EVA, the incentive is to try to grow the company as big as possible and seek to earn slightly above the cost of capital.

And if management grows the company by raising more capital from existing shareholders, the new capital will still be earning a 7 per cent return. Furthermore, if management decides to get a capital injection from new investors, existing shareholders may suffer dilution unless the return on capital is maintained.

So while EVA translates to the addition of firm value, the real goal for managers ought to be 'addition of firm value on a per share basis'.

Another criticism of EVA is the importance placed on a precise WACC. The cost of equity in the WACC calculation is derived from the Capital Asset Pricing Model, or CAPM, which some argued is flawed.

The usefulness of EVA aside, let's get back to the question of relativity. Mr Liew earned a $20.52 million bonus, and the CapitaLand group has about 10,000 employees. So his bonus was a whopping $2,052 per person he managed. Remember, Mr Obama makes 0.1 of a US cent per American citizen.

On the other hand, Mr Liew's bonus represented a mere 0.74 per cent of CapitaLand's net profit. He himself noted that the 3.9 per cent average figure was for the CEOs of the 10 largest locally listed companies.

However, if Singapore's Prime Minister were to get 0.74 per cent of the country's GDP - and managing a country is similar if the end-game is GDP growth - Mr Lee should be paid $1.9 billion based on Singapore's 2008 GDP of $257.4 billion. As for Mr Obama, his pay should be US$105.5 billion.

So obviously, a country's GDP - and arguably a company's net profit figure or EVA - should not be the basis to derive the compensation of a head of state or the head of a company. The basis should be the incremental value they bring on a per population or per share level.

Jason Wee, a former analyst with CLSA, suggested in a recent article in Pulses magazine that besides linking the pay of Singapore's leaders to the average of the nation's best-paid individuals, one might also set a cap on this, based on a multiple of the income of the nation's bottom 20 per cent.

'This multiple can be set at some reasonable level without being excessively onerous, so that future leaders, in pursuit of higher quantitative metrics, will never forget about the less well-off in Singapore,' Mr Wee wrote. To get higher pay for themselves, the leaders should have to bring up the rest. This, I think, would also have the effect of making them continually aware of the harsh reality of the poorest people in the community.

Similarly for the private sector, compensation can be made relative to market share gained, earnings per share growth or a company's long-term sustainable growth. Also, there should be a cap, which could be based on, say, a multiple of the pay of the bottom 20 or 30 per cent of employees. Then, the bosses would be well aware of what life is like down the ranks.

As we have seen, relativity - used correctly - can give added perspective; but pegged to a wrong figure, it can lead to preposterous conclusions. And that is one of the reasons the world is in such an economic mess today.

US recovery might be a speedy one

Business Times - 23 Apr 2009

By PAUL SAMUELSON

THE best analysts on macroeconomics seem to agree on so little - and disagree about so much. After two years of such argumentation, the global economy definitely still is experiencing worsening of the business cycle.

Is credit tight? Or is it too easy? Paradox: Credit for ultra-safe asset securities is actually now dirt cheap. Just as the Bank of Japan for more than a 'lost decade' had to cut its official interest rate to virtually zero, most central banks everywhere now have to live a frenetic life: Credits are simultaneously both cheap and dear.

'Stagflation' is widespread from New York to Zurich to Iceland and Ireland. This means stagnant Main Street retail sales at the same time that the unemployment rates are still soaring.

I try to maintain a centrist view, consistent with what prevailed during the Great Depression of 1929-1939. Here are the main centrist tenets:

Unregulated macro-economies cannot heal their own wounds. The irrational public deregulation of 1930 by President Herbert Hoover - which University of Chicago economics professor Milton Friedman propounded throughout the 1940-2005 epoch - was predictably a road to disaster.

What then did end the Great Depression? No, it was not primarily a return to some kind of standard Federal Reserve stabilising programmes. Universal (rational) fear of investment loss led early on to hoarding. Hoarding by whom? Both rich and poor families hoarded, rather than spending freely on consumption.

At the time, my father-in-law was president of the First National Bank of Berlin, Wisconsin. After President Roosevelt closed all the banks in the first week after his inauguration, this Berlin bank was the only one allowed to reopen. Did that end hoarding? No. Mr Will Crawford subsequently invested mostly in zero-yielding 1933 Treasury bills. Such caution created essentially no new jobs for the unemployed.

That suggests that the global recession may continue into 2010. But with plentiful Obama deficit spending, stock indices will eventually stop falling in price. Few short-term or long-term Wall Street traders will luck out in their timing decisions. Typically, too, when the final recovery comes, it will be a speedy recovery.

There are few heroes among the speculators. Alan Greenspan began as one. But even he admits his fallibility. New Federal Reserve governor Ben Bernanke deserves our praises for his flexibility and caution.

In my view, the US is doing better than France, Germany, Britain, Japan and 40 other nations. This must not make us proud or overconfident. It was American financial engineers who originated the 2006 global meltdown.

Luckily, the US voters rejected George Bush's policies at the polls. Maybe luck did play a big role in that? We'll never know. -- Tribune Media Services

The writer is considered a founder of modern neo-classical economics and was awarded the Nobel Prize for Economics in 1970

Volcker urges bank basics, cites 'Great Recession'

Business Times - 24 Apr 2009

Former Federal Reserve Chairman Paul Volcker, an Obama administration economic adviser, on Thursday urged banks to stick to basics and suggested possibly barring them from sponsoring hedge funds.

Wading into the intensifying debate on financial regulation reform, he raised concerns about giving the Fed new duties as a regulator of 'systemic risk' and warned against being too clear about government protections for financial institutions.

'A certain degree of ambiguity, in that respect, I would hope, could help temper moral hazard concerns,' he said in remarks at a conference on banking and financial oversight.

At 81, the tall and deep-voiced Mr Volcker is a legend in financial markets. As head of the US central bank during the Carter and Reagan administrations, he pursued an aggressive monetary policy that purged inflation from the US economy.

President Barack Obama early in his administration named Mr Volcker to be chairman of an Economic Recovery Advisory Board.

He was recently tapped to head a panel on US tax reform.

One of few policy-makers in Washington today to have lived through the Great Depression, Mr Volcker said at the conference that the US economy is mired in a 'Great Recession.'

As the administration tries to stabilise the financial system, Mr Volcker warned the government should not be too clear on which institutions deserve taxpayer help, and which don't.

'We should not encourage ... the view that some financial institutions are to be assured of official support, which in the midst of the present turmoil is, of course, the present presumption,' he said.

Focus on customers

Banks 'are and should remain strong and stable providers of financial services,' he said. 'The priority is and should be to respond to the needs of customers' for safe and liquid assets, credit and financial advice and counsel.

'What does not seem to me to be central to the banking mission ... is extensive participation in impersonal, transaction-oriented capital markets,' he said.

Too much market involvement poses risks, distracts management and conflicts with customer relationships, he said.

'The logic calls, for me, to prohibition of banking organisations sponsoring hedge funds or equity funds and strict supervision, with appropriate capital requirements, for proprietary securities and derivatives trading.'

He said reforming bank oversight along these lines would not mean 'a resurrection of Glass-Steagall,' a 1933 federal law that prohibited bank holding companies from diversifying too broadly into other financial activities.

But reforms like those he discussed would mean 'rewriting of some part of Gramm-Leach-Bliley,' Mr Volcker said, referring to a 1999 law that rolled back much of Glass-Steagall, ushering in an era of aggressive bank mergers and diversification.

Vast banking supermarkets such as Citigroup, Bank of America and JPMorgan Chase resulted.

With their balance sheets now weighed down by toxic assets they helped create, these same banks in recent months have received billions of dollars in taxpayer bailout aid.

Lack of focus

Mr Volcker said large financial institutions have suffered in recent years from overreaching. 'I do suspect that the relatively recent participation in capital markets has contributed, for some important institutions, to an unfortunate lack of focus on core banking functions,' he said.

One of many reform proposals making the rounds in Washington is an idea to create a 'systemic risk regulator' to monitor and manage financial risk in the economy.

'If systemic regulator means that somebody - the Federal Reserve or somebody else - is going to supervise in detail big banks, that's not my vision,' Mr Volcker said.

'But somebody ought to be looking at the overall system ... That's the job for the overall overseer, in my view. It's natural to think that the Federal Reserve is in that role.'

Commenting broadly on the crisis, Mr Volcker added: 'I never thought I would live to see the day when the American financial markets were dependent on the degree of government support and intervention that we have today. There is a plain need for making reform.'

China increases gold reserves by 76%

Business Times - 24 Apr 2009

China revealed on Friday that it had quietly raised its gold reserves by three-quarters since 2003, increasing its holdings to 1,054 tonnes and confirming years of speculation it had been buying.

Hu Xiaolian, head of the State Administration of Foreign Exchange (SAFE), told Xinhua news agency in an interview that the country's reserves had risen by 454 tonnes from 600 tonnes since 2003, when China last adjusted its state gold reserves figure.

The world gold market has been buzzing with talk about China buying gold for years as the country's foreign exchange reserves have rocketed, and speculation has picked up since the global economic crisis threatened to weaken the value of those reserves.

Gold prices jumped on the news and were up 1 per cent on the day at US$910.80 an ounce at 0540 GMT. By a Reuters calculation, China's holding of gold would be worth US$30.9 billion at current prices.

China recently reported the change in its gold holdings to the International Monetary Fund and would include the latest change in central bank reports and balance of payment statistics, Mr Hu said.

China's reserves were now the fifth biggest in the world, with only six countries holding more than 1,000 tonnes, she said.

China had increased its stocks by buying on the domestic market and from domestic producers.
Gold market participants said Mr Hu's revelation was good news for the market and signalled likely further buying.

'The comments indicate that China will buy more gold as reserve to improve its foreign reserve portfolio. This is a trend,' said Yao Haiqiao, president of Longgold Asset Management.

Hou Huimin, vice general secretary of the China Gold Association, said China should build its reserves to 5,000 tonnes.

'It's not a matter of a few hundred, or 1,000 tonnes. China should hold more because of its new international status, and because of the financial crisis,' he said.

'The financial crisis means the US dollar value is changing fast, and it may retreat from being the international reserve currency. If that happens, whoever holds gold will be at an advantage.'

The European Central Bank recommends its member banks hold 15 per cent of their reserves in gold, but among Asian nations the percentage is far smaller, said Albert Cheng, World Gold Council managing director for the far east.

Fed's quantitative easing, inflation and gold

Business Times - 22 Apr 2009

With West likely to debase currencies to ease debt burden in years ahead, gold and silver are safer bets.

ON March 18, the Fed used its last weapon - quantitative easing (QE), when it announced its plan to buy US$300 billion in long- term Treasuries and US$750 billion of mortgage-backed securities. On the back of this news the equity and bond markets surged, the dollar sold off but commodities rallied. Why is it a big deal? Although the Fed regularly buys and sells short-term Treasury bills to set the overnight federal funds rate, it generally does not intervene in long-term Treasuries, allowing the market to set long-term rates.

The Fed has not bought long-term Treasuries since 1952, mainly because 'it's as inflationary as hell', says Howard Simons, a strategist with Bianco Research. Gold, often seen as a hedge against inflation, surged on the news, from US$916 per ounce on March 17 to US$958 on March 19.

The Treasury is not allowed to print money because governments can tend to go a little crazy and print too much, resulting in hyperinflation and often, economic collapse. John Taylor, a Stanford University economics professor says the Fed's move 'raises huge questions about inflation and the independence of the Fed. This is unprecedented'.

I am of the view that inflation will not be a problem as long as the United States remains in a recession. The real problem would start once the economy starts to revive. That's when the banking system will start to expand the money supply. History shows, it's very, very hard for the central bank to raise interest rates rapidly enough to offset the increase in credit. That's when we are going to get the inflation.

In my opinion, QE gimmick is not going to work any better than any of the previous efforts. The question begs the answer is - how are these bailout plans going to stimulate aggregate demand of the US consumers?

As I see it, government stimulus plans are not reaching the consumer and therefore, this is not going to stimulate demand. Fed chairman Ben Bernanke himself admits that we are in uncharted waters, with no map or compass, just simply a hope that more dollars are the answer. What it is doing is saving the greedy bankers that made the bad loans. Printing money out of thin air (quantitative easing) will not fix the problem. Buying up your own debt is no more useful than swapping one credit card for another. It is the last act of desperation when there is nothing else left to do.

It is worth noting, that the Federal Reserve has already dropped the Fed funds rate to a historically low range of 0-0.25 per cent and now it is desperately trying to use other unconventional methods (quantitative easing) to stimulate the economy. This latest development of the Federal Reserve monetising debt is inflationary and confirmation that the Federal Reserve wants to debase the US dollar. It is my firm belief that over the years ahead, the US and all other debt-laden nations in the West will engage in massive money-creation in order to debase their currencies and dilute the purchasing power of paper money. Remember, monetary inflation is a debtor's best friend as it makes the debt easier to service and repay. On the other hand, monetary inflation goes against the interests of savers and creditors. Given the fact that most of the 'developed' nations are up to their eyeballs in debt, you don't have to be a genius to figure out that monetary inflation is our future. So, I don't expect deflation to take hold; rather, I anticipate accelerating inflation which has always led to rising asset and consumer prices.

If monetary inflation is our future, then we should examine which currencies and assets will maintain their purchasing power. If history is any guide, nations which engage in monetary inflation always diminish the purchasing power of their currency. So, in the years ahead, we can expect currencies in the West to depreciate in terms of purchasing power but the trouble is that none of the fundamentally sound nations want a strong currency either! As the world engages in competitive currency devaluations, I expect all the currencies in the world to lose significant purchasing power against hard assets.

Therefore, in the years ahead, precious metals and other commodities with intrinsic value should appreciate considerably. With the world in turmoil and the global financial system on the brink, there has been one relatively steady asset in the storm: gold. The gold price ended up 5.5 per cent for 2008 as stock markets plunged around the world and is currently up over 6 per cent in 2009.

The S&P 500 finished down 38.5 per cent last year and is down over 15 per cent in 2009. The US dollar has also been a safe haven asset recently, but the longer-term fundamentals of the dollar are no match for gold.

Beyond gold's value as a safe haven, the basic supply and demand fundamentals are strong as well. As gold has consistently risen in price since 2001, global gold production has actually fallen. Annual gold production is now 4 per cent less than in 2001, when the price was under US$300 per ounce. Global gold reserves in the ground are also shrinking despite concerted efforts and hundreds of millions of dollars in exploration expenditures. Finding gold is not an easy chore. It is by nature a very scarce mineral, and explorers have been scouring the earth for it for thousands of years. In addition, the rising costs of labour, equipment and energy have made mining a more difficult enterprise to get off the ground.

Contrast those hurdles to the ease with which central banks can create vast mountains of paper money at the blink of a mouse click. Is it any wonder that gold has lasted as a store of wealth for thousands of years? On the other hand, currencies rise, fall and disappear with regularity throughout history. Scarcity and intrinsic value will continue to drive gold prices higher over time relative to paper currencies. As the dollar and other currencies race to debase themselves during this financial crisis, the only remaining yardsticks of value remain gold and silver.

Since August 1971 when the US took the dollar off the gold standard, that spending discipline has disappeared as the Fed has printed money at the government's whim. Over the last 38 years US levels of debt have mushroomed, while the US$ purchasing power has declined.

It's clear that prolonged periods of excessive money creation lead to excessive speculation, debt and finally economic turmoil. It has occurred throughout the ages and is occurring today. Without the disciplining system of a gold standard, it falls on central banks to control money supply. History has shown central banks as independent in name only. They are de facto pawns of government and create whatever amount of currency that government demands.

The simplest and easiest way to buy gold is to purchase gold ETF (ticker - GLD); investors wishing to have exposure to gold mining stocks can buy ETF (ticker - GDX). Gold is the primary beneficiary of investors' fear and uncertainty, while silver often performs like an industrial metal and therefore more volatile than gold. Investors willing to buy silver can purchase silver ETF (ticker - SLV).

Seven Deadly Sins of Banking

1. Greedy loan growth.
2. Glutony for real estate.
3. Lust for high yields.
4. Sloth-like risk management.
5. Pride of low capital.
6. Envy of exotic fees.
7. Anger of regulators.

Quantitative easing could boost some currencies

Business Times - 04 Apr 2009

NEW YORK - Major central banks which have recently ventured into 'quantitative easing', or direct expansion of the money supply, as a way to fire up slumping economies, may yet find the strategy strengthens their currencies unless inflation is allowed to get out of control.

With benchmark interest rates near zero, the Federal Reserve, Bank of England, Swiss National Bank, and Bank of Japan have recently flooded their markets with cash, printing money to buy domestic debt as they try to stimulate lending.

Given the right exit strategy, analysts said this widely-used monetary tool could attract investment flows as their economies return to growth, boosting their currencies.

'So long as investors believe excessive inflation is not being risked by central banks' quantitative easing, increased ...growth prospects can support the currency,' said Michael Metcalfe, head of macro-strategy at State Street in London.

Some investors fear the launch of these unconventional measures may pressure currencies such as the US dollar, sterling, Swiss franc, and yen, with some analysts declaring the Fed move as the death knell for the safe-haven dollar.

Investors are concerned quantitative easing could undermine a currency's value through a rise in money supply which could potentially lead to high inflation. The strategy also raises questions about a government's commitment to keep fiscal budgets under control.

But as central banks like the BoE and Fed have started buying domestic debt, the US dollar and sterling have survived.

The British pound has risen 10 per cent from its lows hit in January. Investors have rewarded the currency for the aggressive stimulus measures by the British government.

In the US dollar's case, the greenback has recovered from sharp losses incurred after the Fed's announcement last month that it would buy US Treasuries.

The US dollar tends to rise in response to bad news because investors view it as the safest store of value at a time when economies around the world are contracting.

John Taylor, chairman of the US$12.5-billion hedge fund FX Concepts in New York, said the perpetual shortage of dollars has made the US currency strong. Despite cash injections by the Fed, banks are still cutting back on lending, he added.

'Even if the Fed is supplying an extra US$10-US$14 billion a week to banks, this is not nearly enough to loosen the financial noose on Main Street or in the global loan market.'

Quant easing starting to bear fruitStill, State Street's Metcalfe said quantitative easing is starting to bear fruit and he cited the rise in cross-border flows into US and UK equities, while their respective bond markets have yet to price in a rise in inflation.

Meanwhile, the case of the SNB and BoJ is a little different and analysts said their quantitative policies should more than likely weaken their currencies. The Swiss central bank, for one, is using extra francs to buy overseas bonds precisely to weaken its currency as it tries to avert deflation.

The BoJ, on the other hand, is in the midst of a second quantitative easing period, which some believe may not be enough to pull Japan out of recession. Subsequent yen weakness would no doubt be welcome in export-oriented Japan.

Historically an expansion of the money supply has often been associated with currency strength, particularly in the United States. Ronald Leven, currency strategist, at Morgan Stanley said US broad money growth tends to be correlated with credit demand and economic growth.

'Quantitative easing may eventually prove to be currency-supportive once it succeeds to jump-start the growth of bank credit,' although it could take time before broad money growth boosts a currency.

Central bank debt purchases and the goal of hastening economic recovery could also bolster a currency through higher interest rate expectations, analysts said.

Both the Fed and BoE have identified a specific part of the yield curve in which government purchases could take place.

In the Fed's case, it buys Treasuries with tenors of two years and higher, while the BoE purchases gilts with maturities of between 5-25 years. Central bank purchases should lower long-term yields but they should also stimulate increased economic growth and raise the prospect of inflation.

In any case, analysts suggested it would take time before quantitative easing spills over to enough money supply growth to raise consumer prices.

'It's a very long chain of events before you actually get inflation,' said Robert Blake, currency strategist at State Street in Boston. What is important, he added, is a central bank's credibility in containing inflation and exiting the strategy if and when they need to.

But until then, Mr Blake said the US dollar will continue to draw safe-haven flows as the world's top reserve currency.