Martin North – Page 1001 – Digital Finance Analytics (DFA) Blog

Greece: a Europe forged in one crisis may have laid the foundations for the next

Greece has just experienced a nasty reality check. For Europe, the reckoning might simply lie a little further down the road. The Syriza party and prime minister Alexis Tsipras secured a triumph in the elections of January 2015 based on promises to “tear up” the bailout agreements and put an end to austerity. Until a week ago, when the notorious referendum took place, the party and its leader seemed to stick by their conviction that an aggressive stance towards EU partners should and could broker a better deal for Greece, away from half-hearted compromises. This morning it became obvious that this was not possible.

The Greek government had to sign an agreement not too different from those to which previous governments agreed and which were opposed by Syriza – in fact, some of the measures the Greek parliament is being asked to pass were part of previous agreements but were never implemented. Was Syriza naïve? Were they populists? Probably a combination of the two.

Grexit not dead yet

At least for now, Tsipras seems like a leader who found the courage to assume responsibility and came to realise – the hard way – that the EU is all about compromise. Tsipras has now two choices: either follow the steps of previous Greek governments, equivocate and eventually fail taking the country with him or truly support the plan and try making a positive change out of a very difficult deal. Despite the deal, a Greek exit from the euro is closer than ever, particularly if he chooses the former.

Mobilizing their popularity. Syriza have an edge. George Laoutaris, CC BY-NC-ND

Something that could help Tsipras choose the latter is that his government is the first to enjoy very wide political support, at least for the moment. Because of the high stakes and high tension of the last few weeks, all political parties with a clear European orientation have backed Tsipras in the negotiations and seem to support the agreement. This is a weapon that no other government had before in promoting reforms. A Syriza-led government is also the best option for stability in Greece, given the popularity that Syriza and Tsipras enjoy and which should be respected.

But this does not mean that Tsipras would not face opposition or that anti-austerity or populism in Greece has ended. In fact, it is quite the opposite.

Eurosceptics

A sizeable proportion of Syriza MPs, including some of the party’s ministers, have made clear they do not support the agreement. The next few days will show whether this group will take control over the anti-austerity camp. At the same time, others, like members of the government coalition partner Independent Greeks or even far-right party Golden Dawn, remain opposed to the agreement. What happened this weekend would probably only fuel their euroscepticism.

But the way this deal was struck could have implications far beyond Greece. The nature of discussions between eurozone elites uncovered once more the huge distance between what goes on in Brussels and the European citizens. While discussions among the finance ministers of the eurogroup and at the Eurosummit were taking place, social media was filled with frustration over the apparently rather aggressive form of negotiations. International media, meanwhile, were keen to underline the lack of solidarity shown by eurozone countries, especially Germany.

Farage in action at the European Parliament. European Parliament, CC BY-NC-ND

European leaders seem oblivious to that and the impact that this whole process could have had on euroscepticism across Europe. The leader of Britain’s anti-EU UK Independence Party, Nigel Farage, was quick to comment that if he was a Greek politician he would vote against this deal, and if he was a Greek who voted No in the referendum he would be protesting in the streets. Just a year after the European elections in 2014, there is a risk of a new wave of euroscepticism which the EU will have to address in the long term.

Crisis management

Jean Monnet, the French political economist, said in 1976:

Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.

Indeed, the EU is the child of World War II and, after that, has evolved through many other crises. One could imagine a similar social media frenzy had the means existed during the failed European constitution of 2005 or even the so-called “empty chair” crisis of the mid-1960s when France withdrew its representatives from the European Commission.

Let’s hope this crisis improves the EU and allows it to progress; however much this latest crisis has been an important one for the public debate, it is by no means the first – and it probably contains the seeds of the next.

Author: George Kyris, Lecturer in International and European Politics at University of Birmingham

Five misconceptions about the Greek debt crisis

From The Conversation.

It is widely accepted that the Greek bailout and austerity package has led to wealth flowing from Greece to its European creditors, benefiting foreign banks at the expense of Greeks, that its debt is unprecedented and unsustainable, that its recession is the unprecedented result of reforms that cannot succeed, and that Greece’s exit from the Eurozone would be calamitous.

Amazingly, none of the statements above are strictly true, leading much of the public discussion of Greece to be unusually detached from the facts.

In this article, I outline my reasons for no longer believing these claims – which I had been led to believe were true when I began to try to understand the Greek debt crisis. This is not meant as a comprehensive guide: I do not presume to make policy recommendations, but do hope that it will help readers better understand some of the issues at stake.

1. The bailouts have extracted resources from Greece

A common belief in discussions of the Greek economy is that the eurozone “has become an extractive project that imposes austerity on poor nations in order to collect debts on behalf of rich ones”. A recent study of capital flows to and from Greece by economists Jeremy Bulow and Kenneth Rogoff debunks this. As the tables below show, capital flows into Greece have not just remained positive, but have increased since the first bailout in 2010. 2014’s flow is slightly negative, partly as the Greek government chose to miss reform targets, preventing release of bailout funds.

Jeremy Bulow, Kenneth Rogoff

Jeremy Bulow, Kenneth Rogoff

2. Bailouts benefit foreign banks more than Greeks

Another misconception is that: “It is not the people of Greece who have benefited from bailout loans … but the European and Greek banks which recklessly lent money to the Greek State.” This was the charge of the Jubilee Debt Campaign, which campaigns for further debt relief for Greece. They report that €252 billion has been lent to Greece by the “Troika” (the EU, the European Central Bank and the IMF) since 2010, which they claim has been used as follows:

€35 billion in “sweeteners” to get the private sector to accept the 2012 debt restructuring

€48 billion to bail out Greek banks following the restructuring

€149 billion on paying the original debts and interest.

These add up to €232 billion, causing Jubilee to conclude that “less than 10% of the money has reached the people of Greece”.

This conclusion incorrectly assumes that none of the recipients of the €232 billion are “people of Greece”. But if the “sweeteners” were for the Greek private sector, they benefited Greeks; bailing out Greek banks directly helps Greeks who have bank deposits, who hold shares in banks (whether directly or via their pensions), and who work for banks.

The best data that I’ve seen suggests that Greek banks may have held just under half the Greek government debt before the 2012 restructuring – twice as much as any other country. Thus, payments to creditors also reached Greeks. Finally, even payments to foreign creditors benefit Greeks by removing obligations from Greeks to pay.

Perhaps the most amazing estimate to come from Bulow and Rogoff’s study is that Greek citizens have “withdrawn over a hundred billion euros from the banking system” since 2010: where has that money gone?

3. A debt-to-GDP ratio of 180% is unsustainable

Japanese prime minister, Shinzo Abe, has said he will work with the G7 and other Asian countries to ensure economic and financial market stability as the eurozone grapples with Greece’s debt crisis. This news is unremarkable and unsurprising: the third-largest economy in the world is standing by to help. Unreported is that Japan has the world’s highest debt-to-GDP ratio, at about 240% – much higher than Greece’s.

Furthermore, Japan does not seem to have any easy measures for quickly reducing this: unemployment is already low, leaving little slack in the labour market. And, as one of the world’s least corrupt countries, its unofficial sector is small, leaving little hope that actual GDP is much higher than official GDP. Japan faces serious economic challenges (including two decades almost without growth), but no one sees it as other than stable.

By contrast, there are many ways that Greece could quickly reduce its debt-to-GDP ratio: its unofficial economy is estimated at 25% of its official economy; while some officially unemployed Greeks may be working unofficially, many are not – so labour market reforms could spur rapid growth.

There’s an open debate on how to interpret debt-to-GDP ratios and higher numbers are certainly worrying. Yet, Japan suggests there is no magic number: how a country can manage its debt depends on the circumstances and choices of that country.

4. Greece’s transition recession is unusually long

The graph below shows real GDP as a percentage of 1989 GDP in post-Soviet transition economies. Produced by economists Nauro Campos and Abrizio Coricelli, it shows that going through a political and economic transition simultaneously, without a coherent reform strategy, can be disastrous for economic growth. After the collapse of the Soviet Union, post-Soviet countries suffered decreases in official output for years, in spite of international support, including help from the European Bank for Reconstruction and Development. Twelve years after 1989, only six of the 25 countries had official GDP figures above their 1989 levels.

GDP in post-Soviet states in the decade after the collapse of the Soviet Union. Nauro Campos and Abrizio Coricelli

Greece’s political transitions between democratically elected governments have been less fundamental than the post-Soviet transitions, but its commitment to reform has been questionable throughout. Its poor performance in privatisating inefficient state-owned enterprises has drawn particular attention: the following graph shows privatisation not only well behind schedule, but falling further behind all the time. This deprives the Greek state of revenues, and the Greek people of more efficient services.

IMF

Greece finally seemed to have turned back up in 2014: having fallen by about 20% since its peak in 2008, real GDP grew, officially ending the recession; the government balanced its books before debt payments, and had earned a primary surplus in 2013; unemployment fell; the government was able to borrow on the regular markets, rather than via support packages.

Thus, one of the tragedies of the present situation is that protracted negotiations over the country’s bailout conditions may have just increased the overall cost of the transition process.

5. Greece is too big to fail

The idea that Greece is too big to fail and will have significant knock-on effects for global financial markets has been used in some of the brinkmanship at play in the country’s debt negotiations – including by former finance minister Yanis Varoufakis.

But, while the Greek debt crisis has increased uncertainty and any further default or uncontrolled exit from the euro will pose costs, the markets do not seem terribly roiled by the prospect of its default. This is not surprising: Greece makes up about 2% of Europe’s population and GDP; Europe’s economy is stronger than it was in 2010-2012.

An underappreciated aspect of the “too big to fail” idea is what it does to an economy’s prospects. Indeed, one of the leading explanations of Soviet economic decline is the “soft budget constraint”. Soviet firms tended to be much larger than their Western counterparts, giving each considerable power to renegotiate its production plans – without more resources, it could threaten to harm other sectors in the economy, which had few alternative suppliers to turn to.

This seems to be the concern expressed by many of the other European countries: at the eurozone’s inception, the open question was whether the Bundesbank’s credible, low-inflation, low-interest rate standard would prevail. Or whether the eurozone would end up converging on one of the less credible, high-inflation and high-interest rate standards. If the moving appeals of a country comprising 2% of Europe can successfully soften Europe’s budget constraint, then it can be expected that any larger country will be able to as well, if they can demonstrate a severe enough crisis.

Were Greece to become the first country to leave the eurozone, it would give us invaluable real experience in a fairly controlled context; this would improve eurozone policy when faced with similar situations in the future.

Author: Colin Rowat, Senior Lecturer in Economics at University of Birmingham

Lending Finance For May – Investment Property Lending Still Hot

The ABS released their overall lending data for May 2015. It shows the same old story. Significant growth in investment lending, especially driven by NSW. The total value of owner occupied housing commitments excluding alterations and additions rose 0.4% in trend terms. Investment lending was 1.0% up in the month, and refinance up 1.6%. The trend series for the value of total personal finance commitments rose 0.8%. Fixed lending commitments rose 1.7%, while revolving credit commitments fell 0.3%. The trend series for the value of total commercial finance commitments rose 1.5%. Fixed lending commitments rose 1.9% and revolving credit commitments rose 0.3%. The trend series for the value of total lease finance commitments rose 1.1% in May 2015 and the seasonally adjusted series rose 0.7%, after a fall of 1.5% in April 2015.

The housing data shows that investment lending is still hot. Refinancing is also on the up.

The state data shows that NSW investment lending set a new record on both volume and value.

New ‘Rent vs Buy’ calculator for consumers on ASIC’s MoneySmart website

ASIC has announced that Consumers are now able to easily compare the cost between renting and buying household goods, such as electrical appliances and furniture, by using ASIC’s MoneySmart new ‘Rent vs buy’ calculator.

ASIC Deputy Chairman Peter Kell said the new calculator developed in partnership with the Department of Human Services (DHS) will enable people who are considering a consumer lease to make an informed decision.

‘As part of ASIC’s ongoing work to enhance Australia’s financial literacy, this tool will assist people in understanding the real costs of consumer leases and compare them to other options,’ Mr Kell said.

‘Consumer leases may seem like an attractive option as the upfront costs are low, however, the ongoing payments can quickly add up.

‘ASIC continues to monitor firms offering credit to low income consumers to ensure they comply with responsible lending obligations. We have and will take action where we see vulnerable consumers at risk of inappropriate lending.’

A consumer lease is an agreement where an individual hires household goods, such as electrical appliances and furniture. The consumer receives the item straight away and makes regular payments until the term of the agreement finishes.

Under a consumer lease, a consumer does not have the right or obligation to purchase the goods at the end of the lease agreement, despite having often paid much more than the original purchase price of the goods.

‘It is not uncommon for consumers to pay three or four times more than the purchase price of the leased goods. In some cases it can be up to six times,’ Mr Kell said.

‘When entering into a lease, consumers need to consider the total cost, not just the monthly or fortnightly payments.

‘We encourage people to compare leases with other options such as buying the item outright, using another form of credit or interest-free deal, or seeing if they’re eligible for a no-interest loan.

‘Always carefully read the terms and conditions of any financial agreement and understand what you’re getting yourself into before signing the dotted line.’

APRA Confirms Banks Will Need More Capital To Achieve FSI Recommendations

APRA released their comparative capital study today. Overall, whilst it shows that on an international comparison basis Australian banks are well placed, they are not placed in the top quartile of their international peers, so confirms the observation made by the FSI Inquiry. For the purpose of this analysis, APRA has used the 75th percentile (i.e. the bottom of the fourth quartile) as a benchmark. This provides an estimate of the minimum adjustment needed if the FSI’s suggestion is to be achieved. However, it is clearly a moving target, as Banks around the world are lifting capital, and further changes to the Basel framework are in the works.

APRA says positioning CET1 capital ratios at the bottom of the fourth quartile would require an increase of around 70 basis points in CET1 capital ratios; and to simultaneously achieve a position in the fourth quartile for all four measures of capital adequacy, the increase in the capital ratios of the major banks would need to be significantly larger, albeit that there are more substantial caveats on the ability to accurately measure the relative positioning of Australian banks using measures other than CET1.

However APRA also says the conclusions of this analysis are, on balance, likely to provide a conservative scenario for Australia’s major banks, given:

limitations on data availability have meant that certain adjustments that might otherwise have unfavourably impacted the relative position of the Australian major banks have not been possible. These relate to (i) the exclusion of upward adjustments to the capital ratios of some foreign banks, and (ii) the exclusion of the impact of the capital floor on the capital ratios of the Australian major banks;
anticipated changes arising from the Basel Committee on Banking Supervision’s (Basel Committee) review of variability in RWAs will possibly lead to a relatively lower position for the Australian major banks; and
international peer banks are continuing to build their capital levels – over the past couple of years, the major banks have seen a deterioration in their relative position, despite an increasing trend in their reported capital ratios.

We note that while APRA is fully supportive of the FSI’s recommendation that Australian ADIs should be unquestionably strong, it does not intend to tightly tie that definition to a benchmark based on the capital ratios of foreign banks. APRA sees fourth quartile positioning as a useful ‘sense check’ of the strength of the Australian capital framework against those used elsewhere, but does not intend to directly link Australian requirements to a continually moving benchmark such that frequent recalibration would be necessary.

APRA will be responding to the recommendations of the FSI, bearing in mind the need for a coordinated approach that factors in international initiatives that are still in the pipeline. This will mean that, whilst APRA will seek to act promptly on matters that are relatively straight-forward to address, any final response to the determination of unquestionably strong will inevitably require further consideration. In practice, this will be a two-stage process as:

APRA intends to announce its response to the FSI’s recommendation regarding mortgage risk weights shortly. To the extent this involves an increase in required capital for residential mortgage exposures of the major banks, and the banks respond by increasing their actual capital levels to maintain their existing reported capital ratios, it will have the effect of shifting these banks towards a stronger relative positioning against their global peers; and

other changes are likely to require greater clarity on the deliberations of the Basel Committee (unlikely to be before end-2015) before additional domestic proposals are initiated.

As a result of these factors, and the broader caveats contained in this study, an accurate measure of the increase in capital ratios that would be necessary in order to achieve fourth quartile positioning is difficult to ascertain at this time. A better picture is likely to become available over time as, in particular, international policy changes are settled. Based on the best information currently available, APRA’s view is that the Australian major banks are likely to need to increase their capital ratios by at least 200 basis points, relative to their position in June 2014, to be comfortably positioned in the fourth quartile over the medium- to long-term. This judgement is driven by a range of considerations, including:

the findings of this study;

the potential impact of future policy changes emerging from the Basel Committee; and

the trend for peer banks to continue to strengthen their capital ratios.

In instituting any changes to its policy framework, APRA is committed to ensuring any strengthening of capital requirements is done in an orderly manner, such that Australian ADIs can manage the impact of any changes without undue disruption to their business plans. Furthermore, this study has focussed on the Australian major banks; the impact of any future policy adjustments, if any, is likely to be less material for smaller ADIs.

The benefits of having an unquestionably strong banking sector are clear, both for the financial system itself and the Australian community that it serves. Furthermore, Australian ADIs should, provided they take sensible opportunities to accumulate capital, be well-placed to accommodate any strengthening of capital adequacy requirements that APRA implements over the next few years.

So no clarity yet on the amount of additional capital banks will need to hold, nor timing of changes. Here is DFA’s view of how these outcomes will translate in the Australian context:

Banks need to raise $20-40 bn over next couple of years, – that is doable – assuming they will be able to access functioning global markets. It will be ratings positive.
Smaller banks will be helped by the FSI changes to advanced IRB, if they translate, but will still be at a funding disadvantage
Deposit rates will be cut again
Mortgage rates will lift a little, and discounting will be even more selective – Murray’s estimates on the costs are about right
Lending rates for small business will rise further
Competition won’t be that impacted, and the four big banks will remain super profitable
We will still have four banks too big to fail, and the tax payer would have to bail them out in the event of a failure (highly unlikely but not impossible given the slowing economic environment here, and uncertainly overseas). The implicit government guarantee is the real issue.

APRA is concerned about financial stability, not about effective competition, or balancing the interests of shareholders and banks customers.

What’s the turmoil in the Chinese stock market all about?

From The Conversation.

The Chinese stock markets have experienced significant turmoil in recent weeks, with the Shanghai Composite Index – the country’s major reference – falling by 32% since June 12. But this fall was preceded by an equally sharp rise of 150% over the previous nine months. In the 20 years since I have been working in finance, I’ve never seen anything like this. So what is going on with the Chinese stock market?

There are several reasons for this unusual behaviour: firstly, when I teach stock market investment to my Chinese students, I always remind them that the Shanghai stock exchange should be thought of more as a casino, rather than as a proper stock market. In normal stock markets, share prices are – or, at least, should be – linked to the economic performance of the underlying companies. Not so in China, where the popularity of the stock market directly correlated with the fall in casino popularity.

Stocks and casinos

In China, given the low credibility of the financial statements published by listed companies, investors need to rely on other tools to predict share price performance. These tools include a heavy reliance on technical analysis and charts – a method that tends to predict future share price based purely on the company’s past performance, with no regards to its fundamentals. Even the name of the company is often neglected; all that matters is the historic price performance.

While this technique is also used in Western markets, my experience in China is that it is the predominant method for investment. Hence the disconnect between a share’s price movements and economic fundamentals.

There has been, however, a strong correlation between the stock market’s performance and the revenues of the casinos in Macau. While gambling revenues were growing at a fast pace in Macau, people largely ignored the stock market – whose performance was, largely, uninteresting for a number of years. But since China’s president, Xi Jinping, launched a campaign against corruption, gambling activity has started to decline. This was when the stock market started to move up. Coincidence?

Real estate

The other reason why the stock market experienced a sharp increase between September 2014 and June 2015 relates to the Chinese real estate market. In recent years, investment in real estate has been the only way for ordinary citizens to get returns higher than the paltry 3% offered by bank deposits (yes, 3% is paltry in an economy that grows at more than 10% a year in nominal terms). But high capital requirements and growing regulations on the purchase of real estate has meant that benefiting from this growing market has been increasingly difficult for ordinary citizens.

Macau: the traditional home of Chinese gambling. Shutterstock

Commercial banks therefore – in an effort to mimic real-estate returns – started to offer so-called “wealth management products”, which are basically funds that invest in the real estate market. These funds were then repackaged and resold in the retail market. Chinese individuals would take their savings out of current accounts and placed them into these wealth management products and achieve returns similar to those available to buyers of real estate.

This was the modus operandi until the beginning of 2014, at which point the economy and the real estate markets started to show signs of weakness. The once-easy money coming from the property market started to disappear and people with wealth management products started to get into financial trouble and some of them even defaulted on their payments (the government bailed them out, so no individual was at a loss).

Monetary policy

From November 2014 the Chinese central bank, worried about the slowing economy, decided to institute an aggressive monetary policy to rapidly lower interest rates with the aim of stimulating the economy, which also caused current account rates to decline. This created a perverse scenario where individuals who were already seeking returns higher than those offered by current accounts were then denied the opportunity to get them through real estate because of the falling market. As a result, deposit rates were cut further and the return on current accounts became even more dissatisfying. Commercial banks found themselves in a quandary.

The Shanghai Composite Index’s growth and decline in recent months. Yahoo finance

With the casino route closed and real estate off the table, what was left? The Shanghai and Shenzhen stock markets: the two main stock markets that had remained dormant for years.

Banks then turned the old real estate wealth management products into investment vehicles to purchase shares directly on the stock markets. A large portion of customer deposits were then directly invested in the stock market, which then surged on the back of that demand.

An empty bubble?

Meanwhile, however, nothing happened to the earnings forecasts of the underlying companies. In fact, if anything, they should have been revised down because of the deteriorating macroeconomic condition of the Chinese domestic economy. But of course, as we said before, no one really looks at earnings and price ratios.

Due to the desire to maximise returns, many individuals then used leverage so that the inflow of money in the stock market was even higher. For example, if someone wishes to purchase shares for a total value of 100RMB, but only has available cash in his deposit account of, say, 60RMB, he could borrow the remaining 40RMB from the brokerage house. By doing this, the original source of 60RMB was turned into an upward push of the stock price equivalent to the full 100RMB. This drove strong share price growth between September 2014 and June 12 2015.

What happened on June 12 2015? Nothing. Just some smarter investors (generally large institutional investors, which represent 20% of all market volumes) started to sell and the rest of the market followed suit. Fear got hold of small investors (who represent 80% of the market) and selling accelerated, with margin calls making those selling do so even faster, and here we are today – a 32% drop and counting since the peak of mid-June.

In the past few days, the Chinese government has adopted a number of measures to try to mitigate this crash. The market finally reacted positively to a relaxation of restrictions on margin requirements. But this measure simply transfers the risks from investors to brokerage houses – it does not change the fact that the market has increased by 70% over the last year. The bubble, if it is a bubble, still has a long way to go.

Author: Michele Geraci, Head of China Economic Policy Programme, Assistant Professor in Finance at University of Nottingham

US Rate Cut Still On The Cards

In a speech Fed Chair Chair Janet L. Yellen “Recent Developments and the Outlook for the Economy“, she outlines the current US economic situation, and confirms the expectation that interest rates will rise later in the year.

The outlook for the economy and inflation is broadly consistent with the central tendency of the projections submitted by FOMC participants at the time of our June meeting. Based on my outlook, I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy. But I want to emphasize that the course of the economy and inflation remains highly uncertain, and unanticipated developments could delay or accelerate this first step. We will be watching carefully to see if there is continued improvement in labor market conditions, and we will need to be reasonably confident that inflation will move back to 2 percent in the next few years.

Let me also stress that this initial increase in the federal funds rate, whenever it occurs, will by itself have only a very small effect on the overall level of monetary accommodation provided by the Federal Reserve. Because there are some factors, which I mentioned earlier, that continue to restrain the economic expansion, I currently anticipate that the appropriate pace of normalization will be gradual, and that monetary policy will need to be highly supportive of economic activity for quite some time. The projections of most of my FOMC colleagues indicate that they have similar expectations for the likely path of the federal funds rate. But, again, both the course of the economy and inflation are uncertain. If progress toward our employment and inflation goals is more rapid than expected, it may be appropriate to remove monetary policy accommodation more quickly. However, if progress toward our goals is slower than anticipated, then the Committee may move more slowly in normalizing policy.

Long-Run Economic Growth
Before I conclude, let me very briefly place my discussion of the economic outlook into a longer-term context. The Federal Reserve contributes to the nation’s economic performance in part by using monetary policy to help achieve our mandated goals of maximum employment and price stability. But success in promoting these objectives does not, by itself, ensure a strong pace of long-run economic growth or substantial improvements in future living standards. The most important factor determining continued advances in living standards is productivity growth, defined as the rate of increase in how much a worker can produce in an hour of work. Over time, sustained increases in productivity are necessary to support rising household incomes.

Here the recent data have been disappointing. The growth rate of output per hour worked in the business sector has averaged about 1‑1/4 percent per year since the recession began in late 2007 and has been essentially flat over the past year. In contrast, annual productivity gains averaged 2-3/4 percent over the decade preceding the Great Recession. I mentioned earlier the sluggish pace of wage gains in recent years, and while I do think that this is evidence of some persisting labor market slack, it also may reflect, at least in part, fairly weak productivity growth.

There are many unanswered questions about what has slowed productivity growth in recent years and about the prospects for productivity growth in the longer run. But we do know that productivity ultimately depends on many factors, including our workforce’s knowledge and skills along with the quantity and quality of the capital equipment, technology, and infrastructure that they have to work with. As a general principle, the American people would be well served by the active pursuit of effective policies to support longer-run growth in productivity. Policies to strengthen education and training, to encourage entrepreneurship and innovation, and to promote capital investment, both public and private, could all potentially be of great benefit in improving future living standards in our nation.

Raising your Digital Quotient

Interesting article in the McKinsey Quarterly about digital strategy. They suggest that following the leader is a dangerous game. It’s better to focus on building an organization and culture that can realize the strategy that’s right for you.

With the pace of change in the world accelerating around us, it can be hard to remember that the digital revolution is still in its early days. Massive changes have come about since the packet-switch network and the microprocessor were invented, nearly 50 years ago. A look at the rising rate of discovery in fundamental R&D and in practical engineering leaves little doubt that more upheaval is on the way.

For incumbent companies, the stakes continue to rise. From 1965 to 2012, the “topple rate,” at which they lose their leadership positions, increased by almost 40 percent as digital technology ramped up competition, disrupted industries, and forced businesses to clarify their strategies, develop new capabilities, and transform their cultures. Yet the opportunity is also plain. McKinsey research shows that companies have lofty ambitions: they expect digital initiatives to deliver annual growth and cost efficiencies of 5 to 10 percent or more in the next three to five years.

To gain a more precise understanding of the digitization challenge facing business today, McKinsey has been conducting an in-depth diagnostic survey of 150 companies around the world. By evaluating 18 practices related to digital strategy, capabilities, and culture, we have developed a single, simple metric for the digital maturity of a company—what might be called its Digital Quotient, or DQ. This survey reveals a wide range of digital performance in today’s big corporations.

Their examination of the digital performance of major corporations points to four lessons:

First, incumbents must think carefully about the strategy available to them. The number of companies that can operate as pure-play disrupters at global scale—such as Spotify, Square, and Uber—are few in number. Rarer still are the ecosystem shapers that set de facto standards and gain command of the universal control points created by hyperscaling digital platforms. Ninety-five to 99 percent of incumbent companies must choose a different path, not by “doing digital” on the margin of their established businesses but by wholeheartedly committing themselves to a clear strategy.

Second, success depends on the ability to invest in relevant digital capabilities that are well aligned with strategy—and to do so at scale. The right capabilities help you keep pace with your customers as digitization transforms the way they research and consider products and services, interact, and make purchases on the digital consumer decision journey.

Third, while technical capabilities—such as big data analytics, digital content management, and search-engine optimization—are crucial, a strong and adaptive culture can help make up for a lack of them.

Fourth, companies need to align their organizational structures, talent development, funding mechanisms, and key performance indicators (KPIs) with the digital strategy they’ve chosen.

Collectively, these lessons represent a high-level road map for the executive teams of established companies seeking to keep pace in the digital age. Much else is required, of course. But in our experience, without the right road map and the management mind-set needed to follow it, there’s a real danger of traveling in the wrong direction, traveling too slowly in the right one, or not moving forward at all.

Greece: Sliding from Periphery to Exit

According to FitchRating, Greece’s predicament gives new meaning to the phrase “peripheral eurozone”. Eventual exit is now the probable outcome.

Critical deadlines in the Greek crisis have frequently come and gone without progress or consequence, but the referendum was a defining moment in determining the country’s economic position in Europe.

The resounding “no” vote provides a substantial boost to the position of the Syriza-led government in its negotiations with creditors. The Greek authorities clearly consider the referendum result to provide a sufficiently strong public mandate to insist on less austerity and a meaningful reduction of the government’s debt burden. From the Greek perspective, if creditors want to ensure the country’s continued membership of the eurozone to avoid a serious – perhaps irrecoverable – setback to broader European integration, they must recognise there are limits to the terms Greece can accept.

Has Greece Miscalculated?

Greece’s strong argument in favour of greater accommodation on the part of creditors faces several hurdles that are likely to prove collectively insurmountable. Most obviously, debt relief would be politically difficult for a number of eurozone governments. Countries that have gone through their own painful economic adjustments in recent years will be loath to write down credit extended to a country seen – rightly or wrongly – as not willing to do the same. The prospect is equally unappealing in countries that have largely avoided the crisis but have provided big financial contributions to the various Greek support packages.

Even if public opinion could be swayed, creditors may take the view that there is still the need for significant policy change in Greece, and that debt relief would simply address the consequences of previous shortcomings, not the root causes. Greece still needs to undertake major reforms to deliver sustainable public finances and more robust economic growth, and creditors may be reluctant to surrender the ongoing conditionality provided by support programmes that could be discontinued if there were wholesale debt forgiveness. The risk would be that Greek imbalances re-emerge, eventually threatening the viability of the eurozone again.

The state of Greece’s banks seriously undermines the government’s negotiating position. Capital controls, bank closures and the cap on European Central Bank (ECB) liquidity mean the economy is steadily being asphyxiated, the consequences of which will be faced primarily by the government rather than its creditors. This adds considerable urgency to the need for the Greek authorities to reach an agreement that would ease the pressure on withdrawals and allow the ECB to reconsider the cap. In the absence of an agreement, it becomes increasingly likely that the government will need to introduce a secondary means of payment, commonly referred to as scrip. An officially sanctioned parallel currency could only be interpreted as an important step towards exit from the eurozone.

A final point, which may only become clear once the history is written, is that the referendum might have tipped the balance of how other eurozone countries weigh the risks of Greece’s continued membership in the common currency area versus its exit. Greece may come to be viewed as a small and uniquely recalcitrant eurozone member that either can be effectively ring-fenced, or cannot be sufficiently altered to fit the eurozone mould, – or both. It could therefore spend some time on the outer edges of the eurozone periphery before membership becomes untenable.

UK Budget Emasculates Negative Gearing

This week the UK Chancellor, George Osborne delivered his latest budget. One strong theme was the need to reduce the bias towards buy-to-let property investors against owner occupied purchasers. Currently, landlords can claim tax relief on monthly interest repayments at the top level of tax they pay of 45 per cent. Mortgage interest relief is estimated to cost £6.3billion a year. Buy-to-let lending has accounted for more than 15% of mortgages taken out – compared with 50% of new mortgages in Australia. The UK has seen the proportion grow by 8% in recent years.

“First, we will create a more level playing-field between those buying a home to let, and those who are buying a home to live in. Buy-to-let landlords have a huge advantage in the market as they can offset their mortgage interest payments against their income, whereas homebuyers cannot. And the better-off the landlord, the more tax relief they get. For the wealthiest, every pound of mortgage interest costs they incur, they get 45p back from the taxpayer. All this has contributed to the rapid growth in buy-to-let properties, which now account for over 15% of new mortgages, something the Bank of England warned us last week could pose a risk to our financial stability. So we will act – but we will act in a proportionate and gradual way, because I know that many hardworking people who’ve saved and invested in property depend on the rental income they get. So we will retain mortgage interest relief on residential property, but we will now restrict it to the basic rate of income tax. And to help people adjust, we will phase in the withdrawal of the higher rate reliefs over a four year period, and only start withdrawal in April 2017”.

So now, this will change, in a move which will ‘level the playing field for homebuyers and investors’, according to the Chancellor, the amount landlords can claim as relief will be set at the basic rate of tax – currently 20 per cent. The change will be tapered in over the next four years. The expectation is that as a result more first time buyers will be able to enter the market.

The Bank of England recently said it would monitor buy-to-let lending more closely, and analysts are concerned about the potential impact should UK rates rise, even with the current incentives in place. A record of a June 24 meeting of the BoE’s Financial Policy Committee shows the bank asked staff to gather evidence for the government consultation later this year, and to look at what action it could take before gaining further formal powers. Last week the Bank of England warned that a surging buy-to-let market could pose a risk to financial stability as landlords are potentially more vulnerable to rising interest rates.

This mirrors concerns raised by the Reserve Bank of New Zealand who cite considerable evidence that investment loans are inherently more risky:

the fact that investment risks are pro-cyclical
that for a given LVR defaults are higher on investment loans
investors were an obvious driver of downturn defaults if they were identified as investors on the basis of being owners of multiple properties
a substantial fall in house prices would leave the investor much more heavily underwater relative to their labour income so diminishing their incentive to continue to service the mortgage (relative to alternatives such as entering bankruptcy)
some investors are likely to not own their own home directly (it may be in a trust and not used as security, or they may rent the home they live in), thus is likely to increase the incentive to stop servicing debt if it exceeds the value of their investment property portfolio
as property investor loans are disproportionately interest-only borrowers, they tend to remain nearer to the origination LVR, whereas owner-occupiers will tend to reduce their LVR through principal repayments. Evidence suggests that delinquency on mortgage loans is highest in the years immediately after the loan is signed. As equity in a property increases through principal repayments, the risk of a particular loan falls. However, this does not occur to the same extent with interest-only loans.
investors may face additional income volatility related to the possibility that the rental market they are operating in weakens in a severe recession (if tenants are in arrears or are hard to replace when they leave, for example). Furthermore, this income volatility is more closely correlated with the valuation of the underlying asset, since it is harder to sell an investment property that can’t find a tenant.

Reaction from the UK has been predictable, with claims the changes will put rents up, slow new property builds, and lead to a deterioration in the maintenance of existing rental property. In addition, some claim it will lead to landlord deciding to sell their property, releasing more into the market. Finally, there is debate about the comparison between investors and owner occupied property holders – Homeowners are not running businesses nor do they pay capital gains tax, for example, on disposal of their property.

That the UK is taking steps when 15% of property is buy-to-let should underscore the issues we have here when 35% of all mortgages are for investment property, and more than half of loans written last month were for investment purposes. This is bloating the banks balance sheets, inflating house prices, and making productive lending to businesses less available. The UK changes provides more evidence it is time to reconsider negative gearing in Australia