Browse by Tags

For China to become a high-income country, policy makers have to make some significant changes. Pingfan Hong , Chief of the Global Economic Monitoring Unit of the United Nations Department of Economic and Social Affairs, says those changes must begin with financial reform. And top on his list is liberalizing interest rates. From Project Syndicate : In many ways, China is breaking the mold. Despite severe financial repression, it has experienced extremely high savings and investment, owing mainly to Chinese households’ strong propensity to save and massive government-driven investment, particularly by local governments. The adverse effects of financial repression in China are reflected primarily in its economic imbalances. Low interest rates on deposits encourage savers, especially households, to invest in fixed assets, rather than keep their money in banks. This leads to overcapacity in some sectors – reflected in China’s growing real-estate bubble, for example – and underinvestment in others. More important, financial repression is contributing to a widening disparity between state-owned enterprises (SOEs) and small and medium-size enterprises (SMEs), with the former enjoying artificially low interest rates from commercial banks and the latter forced to pay extremely high interest rates in the shadow-banking system (or unable to access external financing at all). Interest-rate liberalization – together with other financial reforms – would help to improve the efficiency of capital allocation and to optimize the economic structure. It might also be a prerequisite for China to deepen its financial markets, particularly the bond market, laying a solid foundation for floating the renminbi’s exchange rate and opening China’s capital and financial accounts further – a precondition for the renminbi’s eventual adoption as an international reserve currency. Read China's Interest Rate Challenge here .

In their latest World Economic Outlook , IMF analysts pointed out that inflation "has become less responsive to cyclical conditions." This prompted Simon Wren-Lewis to consider valid explanations. At his Mainly Macro blog, he puts forward one that has to do with banks, risk, and sacrificing long term strategy because of short term fears: The story I want to tell involves firms’ pricing behaviour, and the role of more risk averse banks. Suppose a firm sees demand for its output fall. Its profits are lower, but it calculates that it can reduce that decline in profits by cutting its price, if that price cut increases demand. There are two risks involved in doing this. First, the price cut might raise demand by much less than expected, with the consequence that profits fall further still. Once the firm realises this it can always put prices back up again, but in the short run profits will decline. Second, it may take time for the price cut to feed through into higher demand: those buying competing products may not immediately realise that they should switch. So although profits might rise eventually, they could fall in the short run. So in both cases, there is a risk that profits in the short run might suffer as a result of the price cut. In normal times firms would be prepared to take those risks, either because the risks are symmetric (maybe demand will increase by more than expected), or because they represent an investment with a positive eventual payoff (as customers switch products). Critically, even if the short run might actually bring losses rather than profits, the firm’s bank will cover the losses because it is taking a long term view. However, since the financial crisis, the firm may have noticed that the behaviour of its bank has changed. It refused the business down the road any credit, even though by all accounts its difficulties were clearly temporary. Although the firm would like to cut prices in the expectation that this will eventually raise profits, if the price cutting idea does not work out and the bank plays tough that could mean bankruptcy. The idea is that the aftermath of the financial crisis, by raising the risk of bankruptcy associated with short term losses, has lead to greater price rigidity. In addition, there are two related effects that could actually lead to higher inflation in the short run. First, the firm does not like the fact that it can no longer depend on the bank to cover any short term losses. Who knows what might happen. So although a price increase might reduce profits if sustained (as customers gradually switch), in the short run profits will rise, and that allows the firm to pay off those debts which would otherwise keep its owners awake at night. This is the firm as a precautionary saver. Second, firms might be keeping prices low not because of existing competition, but because of the threat that a new start-up might emerge and steal some of its business. The one silver lining of the financial crisis for existing firms is that new start-ups are much less likely to get any money from the bank, so this diminished threat of new entry allows the firm to safely increase its profit margins. Read the full post here .

While we continue to watch events in Cyprus , MarketWatch 's Jim Je l ter looks at countries that might be "the next Cyprus." To be more specific, Jeiter notes other countries where the overall economy is highly dependent on the banking sector. Switzerland and the UK, for example, are two countries that are, as Jelter puts it, "most exposed to the ups and downs of their banks":

A lot of analysts are expecting 2013 to be a year of change in China. At McKinsey Quarterly , Gordon Orr , a Director and Chairman of McKinsey Asia , recently predicted 10 ways in which "China might surprise us," this year. Here they are: 1. Banks underperform 2. Pork or chicken prices rise 100 percent 3. Local protests intensify—and succeed more often 4. China spends more on infrastructure 5. Online competition bankrupts a major main-street retailer 6. Even the middle classes hedge their bets 7. European soccer teams invest in the Chinese Super League 8. Investment in overseas agriculture is the “next big thing” 9. A third-tier city goes bankrupt 10. National holiday weeks are abolished (please) You can read Orr's explanations for each of these predictions (and then come to your own conclusions on which ones are based on analysis and which ones seem based more on Orr's own values and hopes) here .

Speaking at the Economic Club of New York yesterday, Federal Reserve Chair Ben Bernanke said the U.S. economy is on track for a "very good year." But there are some significant ifs attached. Primary among them are continuing the housing recovery, improved conditions in Europe, further thawing of the credit markets, and the big if, avoiding the so called fiscal cliff: First, the Congress and the Administration will need to protect the economy from the full brunt of the severe fiscal tightening at the beginning of next year that is built into current law--the so-called fiscal cliff. The realization of all of the automatic tax increases and spending cuts that make up the fiscal cliff, absent offsetting changes, would pose a substantial threat to the recovery--indeed, by the reckoning of the Congressional Budget Office (CBO) and that of many outside observers, a fiscal shock of that size would send the economy toppling back into recession. Second, early in the new year it will be necessary to approve an increase in the federal debt limit to avoid any possibility of a catastrophic default on the nation's Treasury securities and other obligations. As you will recall, the threat of default in the summer of 2011 fueled economic uncertainty and badly damaged confidence, even though an agreement ultimately was reached. A failure to reach a timely agreement this time around could impose even heavier economic and financial costs. As fiscal policymakers face these critical decisions, they should keep two objectives in mind. First, as I think is widely appreciated by now, the federal budget is on an unsustainable path. The budget deficit, which peaked at about 10 percent of GDP in 2009 and now stands at about 7 percent of GDP, is expected to narrow further in the coming years as the economy continues to recover. However, the CBO projects that, under a plausible set of policy assumptions, the budget deficit would still be greater than 4 percent of GDP in 2018, assuming the economy has returned to its potential by then. Moreover, under the CBO projection, the deficit and the ratio of federal debt to GDP would subsequently return to an upward trend.9 Of course, we should all understand that long-term projections of ever-increasing deficits will never actually come to pass, because the willingness of lenders to continue to fund the government can only be sustained by responsible fiscal plans and actions. A credible framework to set federal fiscal policy on a stable path--for example, one on which the ratio of federal debt to GDP eventually stabilizes or declines--is thus urgently needed to ensure longer-term economic growth and stability. Even as fiscal policymakers address the urgent issue of longer-run fiscal sustainability, they should not ignore a second key objective: to avoid unnecessarily adding to the headwinds that are already holding back the economic recovery. Fortunately, the two objectives are fully compatible and mutually reinforcing. Preventing a sudden and severe contraction in fiscal policy early next year will support the transition of the economy back to full employment; a stronger economy will in turn reduce the deficit and contribute to achieving long-term fiscal sustainability. At the same time, a credible plan to put the federal budget on a path that will be sustainable in the long run could help keep longer-term interest rates low and boost household and business confidence, thereby supporting economic growth today. Coming together to find fiscal solutions will not be easy, but the stakes are high. Uncertainty about how the fiscal cliff, the raising of the debt limit, and the longer-term budget situation will be addressed appears already to be affecting private spending and investment decisions and may be contributing to an increased sense of caution in financial markets, with adverse effects on the economy. Continuing to push off difficult policy choices will only prolong and intensify these uncertainties. Moreover, while the details of whatever agreement is reached to resolve the fiscal cliff are important, the economic confidence of both market participants and the general public likely will also be influenced by the extent to which our political system proves able to deliver a reasonable solution with a minimum of uncertainty and delay. Finding long-term solutions that can win sufficient political support to be enacted may take some time, but meaningful progress toward this end can be achieved now if policymakers are willing to think creatively and work together constructively. Read the full speech here .

The Federal Reserve will be keeping the federal funds rate at or near zero for a few more years, and it will continue to use quantitative easing as a tool to battle the effects of a slow recovery. In June, Fed chair Ben Bernanke held the door open for more Fed monetary policy action, and now it appears to be coming. From the Fed's release following the Federal Open Market Committee 's September meetings this week: To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative. The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases. Here are the projections for overall GDP growth, unemployment, and inflation released at the conclusion of the Federal Open Market Committee September meetings: Read the full FOMC release here .

An interesting booking by Charlie Rose a couple of nights back. He brought in Jeffrey Lacker , president of the Federal Reserve Bank of Richmond . Lacker gave his brief take on the history of bank regulation and bank rescues. He cited two key time periods: the Seventies, and the 12 months between August 2007 and September 2008. He hits both in this excerpt: Watch the full interview here .