Tuesday, 31 March 2009

Bonn climate meetings 2 - Climate financing and four-letter words

I spent much of today attending plenary sessions and 'side-events' on financing and technology transfer. It is easy to get lost in the rhetoric that envelopes the debates. I have seen this happen so many times in trade negotiations, and am witnessing the same in climate talks. But the essential issue is this:

1. The climate change problem is real to which there could be two responses: either countries can try to mitigate the problem by reducing greenhouse gas emissions (the world needs at least a 50% cut in emissions by 2050 to restrict average temperature increases to 2 degrees Celsius); or countries can adapt to an already changing climate, which means changing agricultural practices, building flood defences, preparing for sharp changes in water availability, etc. In practice, both mitigation and adaptation are necessary and sometimes the activities cannot be easily distinguished.

2. In order to do so, all countries need money and access to new technologies. Developing countries argue that since they played no part in creating this problem, they should receive funding from developed countries. The UN Framework Convention on Climate Change recognises this obligation of developed countries, in principle.

The consensus ends there and the debates begin.

1. The first issue is the amount of funding required for techology research, development, deployment and diffusion (or RD3 in the jargon). Estimates vary wildly. For mitigation, the spending is anywhere between $70 billion and $165 billion a year; and additional funding of $262 billion to $670 billion is needed. Adaptation spending is about $1 billion a year when some estimates suggest $86 billion are needed. Thanks to such a wide range, one NGO representative told me that developing countries are hesitating to put any specific estimate in their proposals. Fair enough, but then how do you get a concrete commitment and, more importantly, by what standard would you measure compliance? Compliance has been one of the biggest problems with the climate regime so far, and there has been little progress so far to overcome it on the question of climate financing.

2. Where will the money come from? There is a major debate about private versus public financing. Developed countries argue that since much of the technology spending comes from private sources, that would also be the source of funding for developing countries. Developing countries are calling the bluff. They argue that private investment can flow into developing countries only when profits are expected, not when the higher capital, operational and intellectual property costs make a project commercially unviable. Hence, public funding has to cover the difference in costs. As the Indian delegate put it, "If the initial upfront capital investment and lifetime expenses [of a clean technology project] are positive, then developed countries must recompense developing ones. I'd love to see which are the commercial institutions that will invest in projects that have no return!"

3. Under what conditions will the funding be given? There is a fear that, even if commitments for funding mitigation and adaptation activities were secured, developing countries would be treated as aid recipients, subject to conditionalities imposed by rich donors. Developed countries are, of course, interested in ensuring that the money is spent in a verifiable manner. But poor countries argue that the process cannot be top-down, there has to be a sense of "ownership", as the Filipino delegate noted.

In the end, the debate boils down to the purpose of climate funding. Developing countries, like Uganda, insist that "funding climate change is a commitment, not a donation." For them it is a right, both from a legal point of view and from an ethical one. But the modalities of financial and technology transfer will not be resolved easily. The Indian delegate ended his intervention by asking for grants, not loans: "A 'grant' is a four-letter word in some dictionaries, so I will introduce a new phraseology: we want interest-free, non-repayable transfer of money." The current climate negotiations are meant to conclude in December this year. There will be many more four-letter words whispered under diplomatic breaths before then.

Monday, 30 March 2009

Bonn climate meetings 1 - U.S. setting expectations on climate change?

U.S. climate envoy, Todd Stern, is trying to set expectations on the prospects for climate negotiations. Speaking in Bonn at the climate meetings, he said, 'I don't think anybody should be thinking that the U.S. can ride in on a white horse and make it all work.'

As I have written before, President Obama has already taken steps to move away from the Bush era's almost complete lack of engagement with the climate issue. There is palpable enthusiasm among climate activists about potential U.S. leadership to drive through a global agreement in Copenhagen at the end of this year. Meanwhile, developing countries have announced measures of their own.

But here in Bonn, the first of three major sets of meetings before Copenhagen, the United States is making it clear that ambitious targets for emission reductions will not be politically or economically feasible. 'It is in no one's interest to repeat the experience of Kyoto by delivering an agreement that won't gain sufficient support at home,' says Stern. As always, the United States wants China and other major developing countries to share the burden of cutting greenhouse gas emissions.

Sure, the global economic crisis complicates matters (see my previous blog): climate-friendly investments are not as profitable, and the domestic political economy of distributing the costs of shifting to lower carbon trajectories is complicated further by rising unemployment.

Yet, for all the reality checks, there is still nothing concrete on offer for developing countries. They want specific commitments on financing, technology transfer and adaptation measures. The trouble is that the discussions and the rhetoric focus on targets for emission reductions and the remaining issues are treated more like 'side payments' to induce cooperation by developing countries. Unless the demands of poor countries are elevated to the same status, there is little hope for progress.

Friday, 27 March 2009

Rebuilding global trade, during and beyond an economic crisis

Today the International Centre for Trade and Sustainable Development (Geneva) and the Global Economic Governance Programme (Oxford) published a collection of essays by trade scholars and experts from around the world: Rebuilding Global Trade: Proposals for a Fairer, More Sustainable Future.

In the context of the current economic crisis, the contributing authors propose concrete trade-related actions for the G20 leaders meeting in London next week, outline longer-term reforms for global trade governance, and focus attention on the needs of developing countries.

You can download an electronic copy here. Individual contributions can also be accessed here.

My contribution was on the need for strengthened trade monitoring at a time when there is a heightened threat of protectionism. Trade is one of the first casualties of a global economic crisis. We saw this happen during the Great Depression, after the oil shocks of the 1970s, in the early 1980s, and now the first contraction in global trade since 1982. A reformed and robust trade monitoring system should be among the top priorities for world leaders meeting in London in April and beyond. Continue reading here. I look forward to your comments.

Thursday, 26 March 2009

Reserve Bank of India Governor explains India's response to economic crisis

Central bankers are in the lecturing mode. Soon after I wrote about the Chinese central bank governor calling for a new reserve currency, I came across this speech by the Governor of the Reserve Bank of India (RBI) on how India is managing the impact of the financial crisis.

Addressing the Confederation of Indian Industry today, Governor Duvvuri Subbarao explained that, although India's banking sector had no direct exposure to sub-prime mortgages, India has been hit by the crisis because of its 'rapid and growing integration into the global economy'. India's trade (merchandise exports plus imports) to GDP ratio increased from 21.2% in 1997-98 (when the Asian financial crisis hit) to 34.7% a decade later. More significantly, India's financial integration with the global economy has accelerated: the ratio of total external transactions (current and capital account flows) to GDP jumped from 46.8% to 117.4% in the same period.

The financial and real economies in India have had to take the blow. Since a large proportion of corporate investments was financed by incoming capital flows, the global credit crisis has badly hit Indian firms. Demand from India's major export markets (US, Europe and Middle East) has slumped simultaneously. The dominant services sector will see slow growth. And remittances have fallen.

India responded with a relaxed monetary policy and a fiscal stimulus. On the monetary policy side, the RBI reduced interest rates, reduced bank reserve ratios, relaxed external commercial borrowing for firms, allowed non-banking financial companies (NBFCs) and housing companies to tap into foreign debt. RBI also established a rupee-dollar swap facility to help banks with their short-term funding requirements. More importantly, it has established exclusive refinance facilities with increased resources for vulnerable sectors: micro, small and medium enterprises, the housing sector, the export sector, and NBFCs (plus a special purpose vehicle for the latter).

On the fiscal side, the government used emergency provisions in the Fiscal Responsibility and Budget Management Act to offer stimulus packages in December 2008 and January 2009 (amounting to 3% of GDP). The stimulus includes funding guarantees for infrastructure, indirect tax cuts and support to exporters. (The government has also offered farm loan waiver package and is hoping social safety nets like the rural employment guarantee programme will insulate the poor, but it is too soon to tell.)

The RBI expects these strategies to succeed. For the moment, although bank lending rates have dropped, bank credit has not grown as fast as in previous years and not fully cushioned the impact of lower NBFC lending. But Governor Subbarao expects that with the refinance facilities, lower interest rates and higher government spending, India will be able to manage its balance of payments. He remains optimistic that 'once the global economy begins to recover, India's turn around will be sharper and swifter, backed by our strong fundamentals and the untapped growth potential.'

China wants a new international currency

Last week I blogged that China is concerned about the value of its investments in US Treasuries. This week, Zhou Xiaochuan, the governor of the People's Bank of China, proposed a new international reserve currency to replace the U.S. dollar. The full essay can be found here.

Zhou's main argument is that countries that issue reserve currencies face a conflict of interest: between their domestic monetary policy goals (inflation targeting) and the demand for the currency abroad. So, inflation-control measures at home would not meet international demand and, as China fears now, fiscal stimulus measures at home could create excess liquidity in global markets and reduce the value of Chinese dollar-denominated assets. Instead, Zhou argues that an international reserve currency would eliminate the 'inherent risks of credit-based sovereign currency' and allow the IMF to 'manage global liquidity'.

Zhou wants the IMF's Special Drawing Rights (SDRs) to be given an expanded role. (SDRs were created in 1969 to bolster official forex reserves, to be allocated to countries based on their IMF quotas. But their use has fallen since the collapse of the Bretton Woods fixed exchange rate system in 1973.) In the short to medium run, Zhou's plan would include: an increase in SDR allocations; a settlement system between SDRs and other currencies; greater use of SDRs in international trade; new financial assets denominated in SDRs; and SDR valuation based on a basket of currencies of all major economies, not just the four currencies used today. In the longer run, centralised management of the reserves of IMF member countries could mean that SDR allocations would eventually replace existing reserve currencies.

The dollar briefly fell 1.3% against the euro yesterday after Tim Geithner, U.S. Treasury Secretary, said that the U.S. was 'quite open to that' idea. He cautioned, however, that greater use of SDRs would be an 'evolutionary step', not a move towards 'global monetary union'. The U.S. insists that the dollar is still the world's dominant currency.

Given China's losses on investments in other currencies, at least in the near future China will still hold much of its reserves in dollars. And despite the proposal, calls for China to raise domestic consumption and stop artifically holding the renmimbi down to boost its exports are not going to get drowned out any time soon.

China in Africa - staying in or getting out?

The New York Times reports that, thanks to the global economic crisis, China is becoming more hesitant with its investments in Africa. With falling commodity prices and unstable political environments in some countries, the Chinese are apparently driving a hard bargain. But the government still wants to take a long view.

The Times's report focuses on Guinea, the West African nation awash with mineral deposits, especially bauxite and iron ore. In the current climate, China (according to its Ambassador to Guinea) finds the political situation 'not stable' and the international markets 'not favourable' for billions of dollars of investments in Guinean infrastructure in return for access to its minerals. Instead, China is building a 50,000-seat stadium in Conakry, the capital.

Similarly, a $9 billion deal struck in 2007 with the Democratic Republic of Congo (copper, cobalt, tin and gold in return for roads, railways, dams and schools) is stuck. Chinese investments are in the form of minerals-backed loans , so falling commodity prices means higher debt burden for African countries and lower potential investments by Chinese companies. Unlike until a year ago, when China was pouring billions of dollars into Africa, it is now making clear that large infrastructure projects are 'not gifts, but investments'.

But the story is more mixed than it seems. Ngaire Woods, professor of international political economy at Oxford, reports in a recent BBC documentary that even as Chinese companies are exiting Africa, the Chinese government is staying put. China's banking system is 'awash with liquidity' and the government has a strategy for using nearly $2 trillion in foreign exchange reserves. One such strategy is to buy mineral assets at low prices. In the same programme, Deborah Brautigam, who researches Chinese investments in Africa, argues that China has past experience in buying mines (like a copper one in Zambia in 1995) at 'bargain basement prices'. It is now looking for similar opportunities. Brautigam quotes the President of the Chinese Ex-Im Bank: 'We have a very long-term view...we're in Africa for the long-term...we have increased our reserves at the Ex-Im Bank.'

Postscript: Meanwhile, other continents might not be as welcoming. Chinalco (the state-owned aluminium company) wants to invest $19.5 billion in Rio Tinto, an Anglo-Australian mining giant. Although Australia's competition commission approved the deal yesterday, there is a stir among some Australian MPs that Chinese investments in Rio Tinto (and other mining companies) would be against Australia's national interest. (They draw inspiration from China's own rejection of Coca-Cola's bid for Huiyuan Juice.) Australia's Foreign Investment Review Board is now putting the deal through 'national interest' compliance tests. Tit-for-tat protectionism is on the rise.

Monday, 23 March 2009

Where is Sweden on the map?

Last Thursday, the U.S. House of Representatives slapped retroactive taxes of up to 90% on bonuses for employees earning more than $250,000 at companies which received more that $5 billion of government aid. The Senate is also working on a 70% tax on bonuses at companies beyond the financial sector. By Friday howls of protest had gone up, some justified (about the arbitrary design of the tax and its unintended consequences) and others not so much. In the latter category fell those who are happy for the banks to be bailed out but unhappy to take any share of the responsibility. "Is this Sweden?" some screamed (on Facebook and other online forums), a reference to the Nordic land's high tax rates.

Well, not really. Sweden has actually refused to bail out one of its biggest companies, Saab Automobile. In February, Saab's owner, General Motors, set out a plan to phase out the brand by 2010. Most of Saab's 4000-odd Sweden-based workers come from Trollhättan. The centre-right government does not want to set a precedent by bailing out one company, even as important as Saab. The government is annoyed that GM has let Saab stagnate and is now trying to pass on the costs to the Swedish taxpayer. In the absence of a viable business plan, the government is saying no (or nej, as the Swedish case may be).

But the Swedish government's bailout package of SKr5 billion for the automobile industry (which employs 150,000 in a country of 9 million) is not that pristine either: to qualify for state aid, companies like Saab would have to shift production back to Sweden from other lower cost countries. Swedish jobs for Swedish people, etc. etc. Haven't we heard that before?

Coming (back) to America, the Detroit automakers are meanwhile happily using bailout cash to offer discounts and low-interest loans to attract customers. Such strategies are aimed at keeping the assembly line moving and maintaining market share, even though they hurt profits as well brand value. Chrysler is now giving incentives of up to a fifth of the average sticker price and GM is planning more promotions. In short, the strategy is: take public money (already $17.5 billion and more being demanded), pay it back to the public (with discounts) to increase sales, pretend commercial viability, and do little about real restructuring. The auto companies might be in for a nasty surprise when the public realises this. More punitive taxes? Watch this space.

Monday, 16 March 2009

Keeping it in the family

How ubiquitous are political dynasties? In India we often talk of politics as a family-run business. But India is no exception.

I was struck today by an article on the stranglehold of dynasties over Japanese politics. An astonishing 40% of legislators from the Liberal Democratic Party are descendants of former legislators. Given that the LDP has governed Japan for much of the period since 1958 onwards, the political power of family dynasties has entrenched itself into the machinery of the state. Shinzo Abe (who resigned as Prime Minister in 2007) and Yasuo Fukuda (who resigned from the same post a year later) are the grandson and son, respectively, of former Prime Ministers. Shinjiro Kouzumi, the son of another PM (Junichiro) is contesting a seat that has already been in the family for three generations. Edward Lincoln, an NYU professor, found that in the 18-member cabinet of current PM Taro Aso, four members had fathers or grandfathers who had been PMs and ten were children of former LDP lawmakers. A senior researcher at the Tokyo Foundation, Sota Kato, sums up the situation: 'It takes a blood test to get elected these days.'

Australia is not immune either. Former Foreign Minister Alexander Downer's father was Immigration Minister and his grandfather was Premier of South Australia. Current Trade Minister, Simon Crean, is the son of a former Trade Minister. And so forth.

Meanwhile in the United States, according to a recent report by the National Public Radio, 45% of members of the first U.S. Congress had relatives follow them into the legislature. That rate is still high at 10%.

Intrigued, I looked for more data and came across a fantastic paper by Ernesto Dal Bó (Berkeley), Pedro Dal Bó (Brown) and Jason Snyder (Northwestern). They argue that in U.S. politics, 'power begets power': the longer a legislator enjoys power, the greater are the chances that she/he would start (or continue) a political dynasty. If a politician holds power for more than one term, the likelihood of a relative entering Congress in future increases by 70%. Using data for 1972-2004, the authors compute a 'dynastic bias' for different occupations: the odds that both son and father are in the same profession. For legislators, the bias is seven times stronger than for economists, ten times stronger than for doctors, and forty-seven times stronger than for carpenters! I copy below a table (p. 44) of notable political dynasties in the U.S. Congress.

The Indian elections for the 15th Lok Sabha are exactly a month away. The above data and evidence could be easily misconstrued as justification for condoning political dynasties in India as well. Why should we bother to change when even advanced democracies are susceptible to similar degrees of nepotism? The answer: there are 714 million votes at stake.

Are China's assets 'SAFE'?

On Friday the FT reported that Wen Jiabao, the Chinese Premier, was worried about the value of China's investments in U.S. assets. Now we know why.

One reason is that China is the largest foreign holder of U.S. public. Increased fiscal spending in the U.S. to boost the economy (if not backed by spending elsewhere) could lead to inflation and a drop in the dollar's value.

Another reason is how China's investments have fared in the equity markets. The State Administration of Foreign Exchange (SAFE) started diversifying into equities early in 2007 and continued until the collapse of Freddie Mac and Fannie May in July 2008. During this time, some 15% of China's $1800 billion of foreign exchange reserves were pushed into the equity market. According to the FT, the subsequent fall in stock prices means that half the value of China's investments in equities has been wiped out.

To add to the lack of transparency in China's handling of its sovereign funds, SAFE uses a Hong Kong subsidiary to invest in foreign equities (Chinese investors are largely barred from investing overseas). Brad Setser of the Council on Foreign Relations reports that SAFE buys Treasuries both through China and through London. But the latter shows up in U.S. data only as purchases by a UK-based bank, thus understating the value of Chinese investments.

Meanwhile, the China Investment Corporation (the official sovereign wealth fund) has become the target of the Chinese blogosphere thanks to the losses it has incurred on investments in Morgan Stanley and Blackstone (the private equity group).

Are further losses in the offing and, if so, when will China's citizens - and the rest of us - get to know?

Monday, 9 March 2009

Animal spirits, snake oil and big banks - what would you regulate?

Have banks become big by selling snake oil? If so, do we stop them selling snake oil or should we stop them becoming too big?

Robert Shiller wrote a column in Monday's Financial Times arguing that standard economic assumptions about the corrective behaviour of markets do not hold when set against recent findings by behavioural economists. In short: so-called rational agents demand things they want and their collective wants determine an equilibrium price; but there are also times when individuals demand things that they 'think' they want, based on what others are demanding. In such situations, individuals could even end up paying for snake oil if they were convinced enough that others also found snake oil valuable.

Shiller, a Yale professor, argues that, despite buyers not being able to fully evaluate the quality of financial assets, the market has managed to sell the financial equivalent of snake oil because of how the psychology of 'animal spirits' affects economic behaviour. Stories of people making money on, say, securitised mortgages led others to buy and sell these products without proper due diligence. The influence of 'animal spirits' on economic behaviour results in crises on a regular basis. (Shiller is the co-author of 'Animal Spirits' (Princeton University Press, 2009) along with George Akerlof, who won the Nobel Prize in 2001 for his seminal work on asymmetric information in the famous 1970 article, "The Market for 'Lemons'".)

If the above is correct, then the question for a policymaker or a regulator would be either to ensure that snake oil (a.k.a. dodgy assets) is not sold or that no financial institution becomes so big that it has to be bailed out when its own balance sheet is full of snake oil.

Last Friday, I had the opportunity to be a fly-on-the-wall in a closed-door meeting of central bankers, senior investment bankers and policymakers from around the world. They were discussing what had brought the world economy to its current state, what rules would be needed to prevent this in future, and what institutional reforms were needed to govern the new rules. I cannot mention what was discussed, but later I had a chance to pose three questions that I think are also relevant in light of Shiller's column:

1. As a central banker/regulator, is there a rule/principle/trigger that tells you that a bank or non-banking financial institution has become 'too big to fail'?

2. If not, what kind of boundaries would you put around different activities of financial institutions so that insurance companies, say, do not become hedge funds or put their fingers in so many pies that it is hard to distinguish between legitimate and dodgy transactions?

3. And how is the situation further complicated when institutions that previously operated as investment banks have now become deposit-taking institutions?

What do you think? Since many central bankers have previously been investment bankers, I'd especially like to hear from my banker friends. Information asymmetries are always going to hamper oversight by external agencies. So, if you had the responsibility of overseeing a healthy financial system, what would your answers be? Would you look out for animal spirits (individual behaviour), would you look out for snake oil (dodgy assets/transactions) or would you look out for financial institutions that had become 'too big' too soon?