Apr 09

Rating Agencies and Bond Mispricing

As reported in March, over the coming months this site will report results of a real-time experiment in high yield bonds.

Casting an eye over potential candidates for the High Yield Portfolio, my attention was caught by two rather curious features of the Co-operative Bank’s 11% Subordinated Loan Notes.

These notes were issued in December 2013 as part of a major refinancing exercise to save the bank from the threat of extinction. The funding raised was used to repay the Bank’s preference shares and perpetual subordinated bonds, which were redeemed at a significant discount. The Notes have two maturities – one repayable on December 20th 2023 (EPIC 42RQ), offered at a price of 120 on April 9th, and the other maturing on December 20th 2025 (42TE), offered at a price of 127.

Here’s the first curious feature. At the offered prices, the 2023 Notes have a yield to maturity (YTM) of 7.8%, compared to a YTM of 7.3% on the 2025 Notes. The implication would seem to be that the Co-operative Bank has a negative expectation of default between 2023 and 2025. But that is a logical impossibility.

But it is not just the relative yield that looks odd. The absolute yield is high, indicating a high risk of default. It is as if the December 2013 refinancing never took place. Or, perhaps more accurately – since, as a matter of historic fact, it did take place – it is very likely to fail.

How has the bond market arrived at such a conclusion?

My suspicion is that it is with the help of a couple of leading ratings agencies.

Fitch awards the bank a “B” rating, which “indicates that material default risk is present…Financial commitments are currently being met; however, capacity for continued payment is vulnerable to deterioration in the business and economic environment.” Moody’s assigns a Caa2 rating – “Obligations rated Caa2 are judged to be of poor standing and are subject to very high credit risk.”

But is this fair? Neither Fitch nor Moody’s have proved exactly infallible in the past, having failed to identify financial stress in a number of major banks during the run-up to the financial crisis of 2007/08. For that reason, I prefer to apply my own forecasting model of financial stress, as set out in the fourth chapter of The Golden Guinea. I benchmarked the Co-op Bank’s final accounts for the year to December 2014, published a couple of weeks ago, against Northern Rock’s accounts for the year to December 2006, applying the seven leading indicators of bank failure set out in The Golden Guinea:

1. Extremely rapid growth of its loan portfolio. The value of Northern Rock’s portfolio more than tripled between 2003 and 2006, suggesting deteriorating loan quality. By contrast, the Co-op Bank’s loan portfolio has fallen by a fifth over the past four years, from £34 billion to £28 billion, suggesting tighter loan control.

2. Increasing loan to value (LTV) ratios. In Northern Rock’s case, the bank advanced mortgages with a value of 100% or more of the properties against which they were secured. The days of 100% mortgages are now long over, and the Co-op bank is lending on far more prudent LTV ratios.

3. Falling interest margins. Northern Rock’s net interest margin – the difference between the interest earned on its loans and the interest it had to pay on its own funding as a percentage of its total loan portfolio – narrowed from 1.53% in 2003 to 0.98% in 2006. Applying the same formula, I calculate the Co-op Bank’s net interest margin as 1.28% for the year to December 31st 2014, up from 0.94% the year before and moving in the right direction.

4. Falling administrative and staff costs as a proportion of the total loan portfolio. This suggests less thorough due diligence of new loans and less intensive monitoring of existing loans. Northern Rock’s staff costs fell significantly as a proportion of its loan portfolio in the lead up to its financial collapse. By contrast, the Co-op Bank’s staff costs rose from 0.92% of its loan portfolio in 2013 to 1.20% in 2014. Unless the bank’s staff are making cups of tea all day (which hopefully is not the case), this suggests that greater resources are being committed to loan monitoring and appraisal.

5. Rising leverage and a falling equity buffer. Northern Rock’s equity fell from 3.6% of its gross assets in 2003 to 1.8% by the end of 2006. By contrast, the Co-op Bank’s shareholders funds have increased from 3.7% of its gross assets at December 31st 2012 to 5.4% at December 31st 2014.

6. Increased dependence on wholesale funding, and reduced support from customer deposits. Northern Rock’s wholesale funding increased from 35% of its gross assets in 2003 to 64% by the end of 2006, leaving it dangerously exposed when the wholesale funding markets froze in July 2007. The Co-op Bank relies on wholesale funding for less than 10% of its total funding, with customer deposits accounting for more than 75%, a much more stable funding structure.

7. Declining cash and liquid reserves. Northern Rock’s cash reserves were less than 1% of its gross assets at December 31st 2006, leaving it desperately short of ready funds to meet customer withdrawals and the loss of access to the wholesale funding market in July 2007. By contrast, the Co-op Bank’s cash reserves represented 12.7% of its gross assets at December 31st 2014, with the Bank holding £4.8 billion of cash within its gross assets of £37.6 billion.

You will notice that a bank’s bad debt provisions are not among the leading indicators that I have identified for bank failure. Banks facing financial distress are very likely to “extend and pretend” – extend further credit to borrowers in difficulty, and pretend that their loans will be repaid. It turns out that bad debts are a lagging rather than a leading indicator of bank failure.

Given these statistics, how can Fitch and Moody’s have assigned an investment grade rating to Northern Rock in 2006, while assigning a junk bond rating to the Co-operative Bank nine years later?

My guess is that they are looking mainly through the rearview mirror, basing their assessment on the Co-op Bank’s historical record under its previous, now departed, management team, rather than on its position and prospects under new owners and managers. My impression is that the bank’s chief executive, Niall Booker, who took up his post in June 2013, is a steady hand on the tiller, steering his stricken vessel to calmer waters after a period of turbulence.

Only time will tell whether I am right, or whether the ratings agencies more pessimistic view is correct. In the meantime, the Co-op bank’s 11% 2023 Notes become the second investment of the high yield bond portfolio.

Issuer: Co-operative Bank plc
EPIC: 42RQ
Coupon: 11.0%
Coupon Payment Dates: Quarterly on March 20th, June 20th, September 20th and December 20th
Maturity date: December 20th 2023
Minimum Denomination: £100
Offer Price: 120
Running yield (at Offer Price): 9.1%%
Yield to maturity (at Offer Price): 7.8%
Nominal Amount: £1,000
Cost: £1,207.17 (inclusive of £7.17 accrued interest) + £11.75 commission = £1,218.82

Permanent link to this article: http://www.goldenguinea.com/rating-agencies-and-bond-mispricing/

Mar 16

A Real Time Financial Experiment in High Yield Bonds

Over the coming months, I am conducting a real-time financial experiment designed to test the validity of the hypothesis that investments in high yield bonds (so-called “junk bonds”) systematically outperform investments in apparently safer options such as gilt-edged securities or investment grade corporate bonds.

The High Yield Hypothesis emerged from research undertaken by W Braddock Hickman, who studied corporate bond performance in the USA between 1919 and 1943. He found that a high-yield bond portfolio, provided it was sufficiently large, diversified, and held for a sufficient period of time, generated greater returns than a portfolio held in investment grade bonds. Although the high yield portfolio suffered more defaults, in aggregate the greater yield more than compensated for the losses. Hickman’s findings were updated by T. R. Atkinson, who confirmed that the same result held for the period between 1944 and 1965.

My experiment is intended to address three questions:

1. Is the hypothesis valid for the UK as well as the USA?
2. Does it apply in the peculiar monetary circumstances of 2015, when bond yields have been compressed to artificially low levels by Quantitative Easing and other Central Bank interventions in the financial markets?
3. Can the hypothesis be profitably applied by a retail investor, as opposed to a large investment bank?

The third question is, from a purely selfish viewpoint, the most interesting. During the period covered by Hickman and Atkinson, bonds were often issued in minimum blocks of £50,000 or £100,000, well beyond the means of the average retail investor. But two recent developments have enabled retail investors to participate in the corporate bond market on more or less equal terms with large institutions. The first was the creation of the Order Book for Retail Bonds (ORB) on the London Stock Exchange in 2010, which considerably increased the universe of bonds available in small denominations to the retail investor. The second was the development of Individual Savings Accounts (Isas), and an increase in their annual investment limits to £15,240 for the 2015/16 financial year. These two developments have made it possible for a small investor to build up a diversified bond portfolio in a tax-sheltered fund. The Isa incentives in particular are very important for high yield bonds. A £1,000 investment in an 8% bond would generate a net annual income of £80 if it is held within an Isa, but less than £50 if held outside an Isa by a higher rate taxpayer.

The rules of my High Yield system are as follows:

1. An equal amount will be invested in the portfolio on or about the 15th day of each month, equal to 1/12th of the annual Isa allowance. This equates to approximately £1,300 per month in 2015/16. In practice, the actual sums may be slightly higher or lower, as bonds will be bought in blocks of £1,000 each.

2. The monthly amount will be placed into the highest yielding bond eligible for an Isa, provided that there has been no prior purchase of the same bond during the financial year. This rule implies that 12 different bonds must be purchased in any financial year.

3. Bonds will be sold either when they mature, or when their yield has fallen to less than half the yield on the next bond due to be purchased under Rule 2. The funds raised from the sale will then be reinvested in this “next best bond”.

As far as possible, these rules will be applied on a purely mechanical basis.

Of all the bonds currently listed on ORB, one stands out as offering the highest yield by a clear margin – the bonds maturing in February 2022 issued by North Sea oil producer EnQuest Plc. These bonds currently trade below 70p, implying a running yield above 8% and a gross redemption yield above 12%.

Yields at this level imply that the bond market has priced in a distinct possibility of default, and with good reason. Reports suggest that EnQuest needs a crude oil price of around $80 per barrel to break even, against a current level closer to $55. The recent slump in oil prices has already claimed one casualty this month, with African oil explorer Afren defaulting on a $15 million interest payment due on March 4th “in order to preserve cash while a review of the company’s capital structure and funding alternatives is completed.” Translated into the vernacular: “Can’t pay, won’t pay.”

So there is a genuine risk of default on the EnQuest bonds. This could be averted if the crude oil price recovers, or if the company is able to reduce its cost base. The company’s senior debt providers have already relaxed their lending covenants to give EnQuest some breathing space. A White Knight may ride to the rescue, taking over the company and its liabilities; or the company’s shareholders may agree to rescue rights issue to help EnQuest through a temporary bad patch.

It must be admitted that these are an awful lot of “ifs”, “buts” and “maybes”. Yet the High Yield Hypothesis, if correct, would indicate that, if a sufficiently wide number of high risk bonds like EnQuest are built into a diversified portfolio, overall their return should more than compensate their risk of default.

So, with a degree of trepidation, the first investment of the experimental High Yield Portfolio is committed.

Issuer: EnQuest plc
EPIC: ENQ1
Coupon: 5.5%
Coupon Payment Dates: 6-monthly on August 15th and February 15th
Maturity date: February 15th 2022
Minimum Denomination: £100
Offer Price: 67.845
Running yield (at Offer Price): 8.1%
Yield to maturity (at Offer Price): 12.3%
Nominal Amount: £2,000
Cost: £1,366.32 + £10 commission = £1,376.32

Permanent link to this article: http://www.goldenguinea.com/a-real-time-financial-experiment-in-high-yield-bon-ds/

Feb 05

Chronicle of a death foretold. Five prophecies fulfilled and one yet to come to pass.

“The only relevant test of the validity of an hypothesis is comparison of its prediction with experience.” [Milton Friedman “The Methodology of Positive Economics” (1953)].

Five predictions of The Golden Guinea:

Prediction 1: The Euro will inflict great economic damage on the nations that adopt it.

“The case put by supporters of the Euro for maintaining the single currency is that the alternative is so much worse. Yet the narrative put forward by apologists for the European single currency completely discounts evidence of the damage done by the Euro. The Eurozone authorities have sought to address this damage by successive bailouts, adding to the national debt of sovereign states that are already over-borrowed. This has led onwards to attempted fiscal consolidation on a scale that has plunged the continent of Europe into the most severe and prolonged recession seen since the Great Depression, causing mass unemployment and social distress on a scale not experienced in living memory.” (The Golden Guinea, 2012)
Result: Prophecy fulfilled.

Prediction 2: The Eurozone fiscal compact won’t work.
“The only prediction that an economist can confidently make about the compact – which stipulates that Eurozone governments will at all times limit their budget deficits to a maximum of 0.5% of their GDP – is that its chances of realisation are precisely zero.” (Comment on this site, May 8th 2012).
Result: Prophecy fulfilled.

Prediction 3: Piecemeal reform of the Euro will fail.
“Attempts to remedy the fundamental weaknesses of the euro by means of piecemeal reform will not be successful. The crisis will drag on. The repeated confidence expressed by Eurozone leaders – that with one more bailout, or another round of fiscal austerity, or one final push towards fiscal union, debt mutualisation and a United States of Europe, and all will be well – will ring increasingly hollow as output stagnates and unemployment continues to rise.” (Comment on this site, June 29th 2012).
Result: Prophecy fulfilled.

Prediction 4: Quantitative easing (QE) will not stimulate economic activity, and the UK economy will only recover when it is abandoned.
“If the Bank of England responds with yet more quantitative easing, my prediction is that it will have precisely the same effects as QE has had already – driving down real incomes, driving up inflation and sending the British economy back into a stagflationary recession. However, if QE is consigned to the dustbin of history as it deserves to be, then, notwithstanding uncertainties in the Eurozone and the USA, there is a realistic prospect for a recovery in the UK economy in 2013.” (Comment on this site, December 28th 2012).
Result: Prophecy fulfilled.
[For an analysis of why QE failed, see http://www.goldenguinea.com/why-quantitative-easing-hasnt-worked/ and http://www.goldenguinea.com/the-bank-of-englands-report-on-quantitative-easing-an-independent-assessment/]

Prediction 5: The 2012 Greek bailout will only make a bad situation worse.
“Antonis Samaras (the then Prime Minister of Greece) is going to the President of the Euro Group, Jean-Claude Juncker, like Oliver Twist, to ask for more – more money to help Greece through its financial difficulties, and more time to repay. And, on balance, he is likely to get more. But any temporary sustenance will not end Greece’s problems. For once, there was an honest assessment of Greece’s predicament on this morning’s Wake up to Money programme on Radio 5. Needless to say, it came, not from a Eurozone politician, but from an academic – Yanis Varoufakis, Professor of Economics at the University of Athens. Professor Varoufakis accused the Eurozone’s leaders of “keeping Greece in suspended animation” while they sought to address the larger problems of Spain and Italy. Another bail-out would do nothing to resolve Greece’s economic problems, he said. The Greek economy is trapped in a “death spiral”. In an analysis which precisely mirrors that in Chapter 11 of The Golden Guinea, Professor Varoufakis pointed out that the terms attached to any assistance from the EU will force the Greek Government to make further public expenditure cuts while raising taxes. This would not resolve the problem, but merely result in “more austerity and lower outputs”. A further dose of austerity is only going to make the situation worse.” (Comment on this site, August 22nd 2012).
Result: Prophecy fulfilled.

The selfsame Professor Varoufakis has now emerged as Greece’s Minister of Finance in the newly elected Syriza Government, with the unenviable task of persuading other Eurozone nations to provide further assistance to his beleaguered nation. Will he succeed?

Prediction 6: The Euro will start to disintegrate between 2015 and 2017.
“My view remains that the most likely outlook – and perhaps the least bad option – is for the managed exit of Greece, with transitional assistance from the troika of the ECB, the IMF and the European Commission. But because of the amount of political and financial capital invested in the single currency, this is unlikely to happen next year or the year after. There will be at least one more round of bailouts until it becomes obvious that the whole exercise is futile. So it might take between three and five years for the huge vested interests supporting the single currency to admit defeat. Under this scenario, the euro will start to disintegrate somewhere between 2015 and 2017.” (Comment on this site, August 22nd 2012).
Result: ?

Permanent link to this article: http://www.goldenguinea.com/chronicle-of-a-death-foretold-five-prophecies-fulfilled-and-one-yet-to-come-to-pass/

Jan 01

Kondratieff, Schumpeter and the Outlook for 2015

Thirty years ago, my book The Age of illusions (1983) contained an exposition of the long waves in economic life, first identified by the Russian economist Nikolai Kondratieff during the 1920s. Kondratieff’s thesis was that long waves lasting approximately half a century each occur in the economic activity of capitalist economies. These waves have two main phases – an upswing, in which the level of activity is increasing, followed by a downswing, in which it is falling, with each phase lasting a generation.

Kondratieff did not explain why these long waves occur. However, his observation was developed by Joseph Schumpeter, particularly in his monumental tome on Business Cycles. Schumpeter’s case was that long waves are driven by innovation.

I believe that Schumpeter’s thesis does indeed accurately describe the process of capitalist development. What I termed the Space Age Kondratieff in The Age of Illusions extended from the late 1940s to approximately 1990. This was succeeded by the Internet Kondratieff – a global innovatory boom stimulated by the development of the worldwide web. The primary upswing of this long wave extended to the turn of the millennium, until the original dot.com bubble burst in 2000. It was succeeded by a secondary upswing, which came to a juddering halt with the international financial crisis of 2008/09.

We are now in the downswing phase of the current long wave, when the mountain of debt built up during the upswing – first to finance innovation, and then to fund speculation – has to be purged from the system. Either those who borrowed heavily during upswing will have to pay down their debts, or their lenders will have to write them off.

Either way, the impact is likely to be deflationary.

In Schumpeter’s analysis, the recessionary phase is not only necessary, but desirable. Corporate insolvencies are an inherent part of what Schumpeter termed “the gale of creative destruction” which drives capitalism forward.

Viewed in this context, the policies of quantitative easing adopted by central banks internationally are not merely unhelpful, they are damaging. Quantitative easing hampers the process of adjustment by providing cheap credit to enable insolvent institutions and businesses to stay afloat, by rolling over their loan obligations – “a rolling loan gathers no loss”, to misquote the old proverb.

The problem with this policy is that it can lead to a lost generation, as in Japan, where zombie companies are kept afloat on a sea of cheap credit, rather than being restructured, sold or liquidated. This means that resources of both labour and capital are tied up in insolvent firms,and are not redeployed to dynamic new enterprise. The result is likely to be economic stagnation.

The Bank of England’s confident forecasts of the benefits of its quantitative easing programme between 2009 and 2012 proved hopelessly optimistic. The concerns expressed by those of us who criticised the policy were entirely vindicated.

As I wrote on this site 2 years ago, on December 28 2012,

“If the Bank of England responds with yet more quantitative easing, my prediction is that it will have precisely the same effects as QE has had already – driving down real incomes, driving up inflation and sending the British economy back into stagflationary recession. However, if QE is consigned to the dustbin of history as it deserves to be, then, notwithstanding uncertainties in the Eurozone and the USA, there is a realistic prospect for recovery in the UK economy, although the recovery is likely to be weak.”

However, while QE has hopefully now been abandoned in the UK, it is still being promoted as a mechanism to stimulate recovery in the Eurozone. If the European Central Bank does deploy QE, it could be the last throw of the dice for a bankrupt policy.

The euro remains a structurally flawed currency, driven by a political agenda against the interests of the ordinary citizen whom European politicians are elected to serve. The forthcoming election in Greece will inject a further level of instability into the system.

My analysis on this site two years ago, in November 2012, has not been altered by the passage of time:

“My view remains that the most likely outlook – and perhaps the least bad option – is for the managed exit of Greece, with transitional assistance from the troika of the ECB, the IMF and the European Commission. But because of the amount of political and financial capital invested in the single currency, this is unlikely to happen next year (2013) or the year after (2014). There will be at least one more round of bailouts until it becomes obvious that the whole exercise is futile. So it might take between three and five years for the huge vested interests supporting the single currency to admit defeat. Under this scenario, the euro will start to disintegrate somewhere between 2015 and 2017.”

Permanent link to this article: http://www.goldenguinea.com/kondratieff-schumpeter-and-the-outlook-for-2015/

Aug 15

Monetary policy in an independent Scotland – currency union and beyond

There is now just over a month to go before the Scottish independence referendum on September 18th 2014.

My purpose in this analysis is not to express a political opinion on the desirability or otherwise Scottish independence. It is rather to give a view as a professional economist on Scotland’s optimal monetary policy, if it were to become independent.

As stated in my Financial Times letter of February 2014 (“Mr Salmond and the £” on this website), my view is that the currency union concept is flawed.

If it is set up, it may not last very long. It may well be true, as advocates of currency union argue, that we are now in a “Goldilocks” era, where the Bank of England’s stance is too hot for London – where property prices are in an unsustainable bubble – too cold for the North of England, which continues to suffer from high rates of unemployment – but just right for Scotland. However, there is no reason to suppose that this will continue to be the case over the next 5, 10 or 15 years. And if there is a divergence between Scotland’s economic interests and those of the rest of the United Kingdom, there is no doubt which will dominate the decisions of the Bank’s Monetary Policy Committee.

Strains within the currency union could lead a simple choice for a future Scottish Government. Either to leave it, or to maintain it at the cost of economic stagnation, as has been the fate of the peripheral eurozone countries.

The better choice would be to leave the currency union. This is a choice which may be forced upon The Scottish Government anyway, if the Westminster Government simply refuses to engage in negotiations to set up a currency union in the first place.

“Sterlingisation”

Outside a currency union, Scotland could continue to use the £, but without a formal central bank. This is how the Republic of Ireland operated immediately after it achieved independence in 1922. It is an option that has secured support from some surprising quarters, including economists at the Adam Smith Institute and Institute of Economic Affairs in London who advocate a “free banking” system. This doesn’t mean that banking services are provided free of charge, but rather that there is minimum regulation of the banking system, no central bank and no possibility of banking bailouts.

This approach is based on the theories of the Austrian economists Ludwig von Mises and Friedrich Hayek, classical liberals who followed the Jeffersonian adage that “the best government is the least government.” In the Austrian view, the lack of a safety net would impose market discipline on commercial banks and avoid moral hazard risks. In simple terms, it removes the possibility of a “heads we win, tails you lose” approach, whereby reckless and greedy bankers take risks which will generate hefty bonuses for them if they pay off, but leave any losses to be picked up by the government and the taxpayer.

A Scots Pound

The reasons that libertarians like Sterlingisation is that it would leave a future Scottish Government with no role in the nation’s monetary affairs.

To my mind, this would expose a relatively small independent country to international crises with no means of combating them. It might be different if the rest of the world also adopted a free banking approach, or if international trade were carried out through a unit of exchange independent of national governments, such as gold. But as matters stand, sovereign states need control over their own currency if they are to protect themselves from crises emanating from the irresponsible policies of their trading partners. As, for example, Switzerland and Germany did in the 1970s, when they allowed their currencies to appreciate in order to sterilise the effects of rampant dollar inflation originating in the USA. Or more recently here in the UK, when the external value of the £ depreciated in the wake of the global financial crisis. Between the onset of the credit crunch in July 2007 and “Blue Monday” on January 19th 2009 when the Royal Bank of Scotland announced the biggest corporate loss in British history at £28 billion, the trade-weighted value of the £ fell by almost 30%. This external adjustment helped to stabilise the UK economy and stimulate a fragile recovery.

To a limited degree, responsibility for monetary policy is already shifting to Scotland. From 2015, the Scottish Government will have the right to issue bonds for an amount of up to £2.2 billion. How it uses this power will influence monetary conditions in Scotland. If it sets up a Scottish Debt Management Office to manage its borrowing programme, it will, in effect, already have created the embryo of a central bank. The first function of a central bank is to act as the government’s bank.

Its second function is to act as “the bankers’ bank”, by providing banking services to regulated financial institutions within its territory. They deposit funds at the central bank, which are used to clear inter-bank balances on a daily basis and ensure the smooth functioning of the money markets. The central bank may also use its deposits to make loans to any financial institution in temporary need of funds. This is the famous “lender of last resort” facility, where the central bank acts as the ultimate source of finance for commercial banks.

Under a currency union, these functions would be carried out by the Bank of England.

The Better Together campaign argues that, if a currency union does not exist, an independent Scottish Central Bank could not act as lender of last resort or bail out major banks such as RBS and Lloyds-HBOS which had run into trouble. Their implication is that this would be a retrograde step.

I take a different view, which could be termed “quasi-Austrian”. It is helpful that a Central Bank of Scotland could not underwrite commercial banks operating in Scotland to an unlimited extent. With the safety net removed, banks will be encouraged to behave more prudently.

But I don’t go the whole way with the Austrians in advocating no central bank support. A Scottish Central Bank should be able to lend limited amounts to financial institutions within Scotland to help them meet short-term liquidity requirements. But there should be no presumption that the central bank is the sole provider of funds in such circumstances. After all, Barclays Bank turned to Qatar for the funding it needed in preference to the Bank of England’s Asset Protection Scheme, while more recently the Co-op Bank was restructured without the assistance of any taxpayer support.

A final role for a Scottish Central Bank will be to ensure the convertibility of a Scots Pound. To fulfil this function, it would deploy Scotland’s foreign exchange reserves, initially to maintain parity with the £ Sterling, but with the ultimate ability to adjust upwards or downwards against Sterling as domestic economic conditions within Scotland require.

This would not be an easy option. It would require an independent Scotland to maintain strict monetary discipline and, at least initially, to run a Balance of Payments surplus to build up foreign exchange reserves. However, over the longer term, I believe that sound money would deliver significant economic benefits compared to the alternative of a currency union dominated by England. Underpinned by strong and dynamic economy, there is no reason why the external value of a Scots £ should not appreciate against Sterling, as have the currencies of a number of other small nations, including Switzerland, Singapore and Australia.

Such a strategy would address the fundamental paradox that lies at the heart of the economic strategy set out in the Independence White Paper. If it is the case that no-one will look after Scottish interests better than the Scottish people themselves, exercising their sovereign will through a democratically elected Scottish Government, how can it be that the monetary and financial affairs of an independent Scotland are best managed from London?

At the very least, the creation of a Scots Pound is an option that should be considered in greater detail. In considering alternatives to currency union, the only thing we have to fear is fear itself.

Michael Nevin
August 15th 2014

Permanent link to this article: http://www.goldenguinea.com/monetary-policy-in-an-independent-scotland-currency-union-and-beyond/

Mar 18

The morning after the night before: six steps to Scottish economic independence

For success in politics or business, leaders need a coherent and effective “Plan A” to submit to the public and their key stakeholders. But they also need a viable “Plan B” – a contingency plan that can be rolled out in the event that Plan A cannot be delivered for reasons beyond their control.

The SNP’s plan a for a currency union and continued EU membership on the same terms as at present has increasingly been called into question. As an economist, I have no comment to make on the political case for Scottish independence. However, from an economic viewpoint, there is no reason why an independent Scotland could not survive, and indeed thrive – provided the Scottish Government puts in place an appropriate policy framework. This policy framework could involve rolling out a “Plan B” for both the currency and relations with Europe, as set out below.

Six steps on the path to Scottish economic independence.

1. Referendum Night: September 18th / 19th 2014.

In the headquarters of the “Yes” campaign, joy is unconfined, as news comes in of a decisive vote in favour of independence. The music is raucous and the water of life flows freely. Until, that is, at around 3 AM, when the plaintive voice of a junior adviser, who has imbibed slightly less copiously than others present, is heard above the hubbub, asking the killer question:
“What the (expletive deleted) do we do now?”

2. The Hangover: September 19th 2014.

As the revellers slowly come back into consciousness, sometime around midday on September 19th, the reality of the situation becomes apparent. Despite opinion polls showing gathering support for the Yes campaign in the months leading up to the referendum, the markets had genuinely failed to discount the result. The London Stock Market is in meltdown. The FTSE 100 records its worst one-day fall since the collapse of Lehman Brothers. Major companies, including RBS and Standard Life, announce that they are implementing plans to transfer their head offices from Edinburgh to London – and with them will go several million pounds of corporation tax and the income tax paid by their senior executives. Elsewhere in Scotland, major investment projects are put on hold as funders state that they are reviewing their commitments “pending clarification of the independence settlement.” The Scottish property market seizes up – there is a complete absence of buyers for both commercial and residential properties, and those who wish to buy are finding it increasingly difficult to raise money from the banks to complete their purchases.

3. The Emergency Budget: late September 2014.

Faced with the threat of a flight of human and financial capital from Scotland, Finance Secretary John Swinney gathers together his closest and most trusted advisers. Mr Swinney has proved himself to be a competent and prudent Finance Minister within the devolved administration, but nothing has prepared him for the panic that threatens to engulf Scotland even before the first date for detailed negotiations on the independence settlement is set. The Finance Ministry team devise a plan to combat the panic. An Emergency Budget is introduced, developing commitments given in the Independence White Paper to cut corporation tax to 12.5% and reduce Air Passenger Duty. More widely, the Finance Secretary gives an unequivocal commitment that income tax in an independent Scotland will be levied rates no higher than those that apply in England, and that the Scottish Government will manage its affairs to comply with the Maastricht criteria. This means that the Scottish Government will not at any time run a budget deficit that exceeds 3% of national GDP.

The message is clear. Companies are free to relocate from Scotland to England if they so wish. But if they do so, they will face a higher corporation tax bill on their profits, and their employees will have to pay higher taxes on their incomes.

Faced with this message, the threatened haemorrhage of Scottish companies south of the border slows to a trickle, as their Chairmen announce they are adopting a “wait and see” approach before taking any final decision.

4. The Medium Term Financial Strategy (MTFS): 2014-2015.

One implication of the Finance Secretary’s commitment to a competitive taxation regime is that public expenditure has to be kept under tight control. Over the succeeding months, the Finance team at Victoria Quay works well into the night and over weekends to develop a public spending strategy for post-independence Scotland. Out go previous expenditure plans that will no longer be affordable within the framework of the MTFS, such as the proposal to increase defence expenditure in an independent Scotland above the levels that applied within the UK (Why? Does an independent Scotland fear invasion from England – or perhaps from Russia?!). Little by little, as the resource constraints that an independent Scottish Government will face become clear, the Finance team is forced to look at more radical options, including a fundamental shake-up of the welfare system. The spending review concludes that minimum welfare standards must be guaranteed for all, but that real increases in benefits funded from general taxation are neither economically beneficial nor financially affordable. Instead, an independent Scotland will move towards an insurance-based system similar to those of Scandinavia or Germany, as Lord Beveridge himself envisaged in the 1940s.
Little by little, Scotland is weaning itself off the dependency culture of the UK, and moving towards a self-sustaining system of social insurance.

5. The End of the Currency Union: 2015-16.

While the Finance Secretary is creating a sustainable fiscal system for an independent Scotland, the Deputy First Minister is tasked with leading delicate negotiations with the rest of the UK on the thorny issue of the proposed currency union.

Perhaps Nicola Sturgeon will be proved right, and the Unionist Parties have been bluffing in ruling out a currency union in the run-up to the Independence Referendum. But I hope not. For if they were, she and her team face months if not years of arduous and difficult negotiations with a reluctant and probably sullen counterparty, who will quibble over every minor issue, and seek to squeeze every concession they can from the Scottish negotiators. The end result is likely to be an unstable and unsatisfactory compromise, which will probably collapse within a few years, as the First Minister appears to recognise.

A far better alternative would avoid going down this blind alley. Instead, an independent Scotland takes complete control of its own currency and monetary policy. The Government announces the creation of a new Scots pound, pegged at parity with the £ Sterling – in exactly the same way as the Irish pound used to be – to be managed by a newly created Reserve Bank of Scotland.

The powers and operations of the Reserve Bank are modelled on those of the successful Hong Kong Currency Board, established 30 years ago when the Hong Kong dollar was pegged to the US dollar, at a rate which has prevailed ever since, through years of radical constitutional change and financial turbulence.

John Greenwood OBE, one of the main architects of the Hong Kong currency board, has set out six conditions for such a board to operate successfully. On my analysis, an independent Scotland could fulfil all six.

Prime among them is the need to maintain high levels of gold and foreign exchange reserves. A couple of days ago, George Soros cautioned against the option of creating a new Scottish currency, warning that it would inevitably come under attack from currency speculators at some point (I wonder whom he could possibly have had in mind?). There is no doubt that Mr Soros is correct. It would therefore be imperative for the Reserve Bank to accumulate sufficient foreign currency to repel any speculative attack. It should also keep its own interventions in the foreign exchange markets a closely guarded secret, so that speculators would never know from day to day when the Bank might enter the market with heavy Buy orders for Scots Pounds, driving up its value and causing severe losses for any speculators naïve enough to believe that they could make easy profits by going short of the currency.

In order for the Reserve Bank of Scotland to command respect in international markets, it is important that it maintains reserves of foreign currency that are significant in relation to the value of Scottish GDP. This in turn implies that an independent Scotland would need to run a Balance of Payments surplus at least for the first few years after independence. So the fiscal framework put in place by the Scottish Government would need to encourage exports – electronics, IT, oil, renewable energy, financial services, whisky, and tourism. For example, the Republic of Ireland applies a 9% VAT rate to hotels and restaurants, recognising that a competitive VAT regime is essential if they are to compete in highly price-sensitive international tourism markets. As a result, Ireland has gained market share at the expense of the UK, where VAT is applied at 20%. An independent Scotland should follow the Irish model in this regard.

6. Relations with Europe: 2015-16.

Immediately after the Referendum result is announced, the First Minister makes contact with the European Union seeking to confirm the terms of Scotland’s continued membership.

There are two alternative scenarios of what happens next. Under the first scenario, EU leaders would enter into a constructive and positive dialogue. This is the scenario for which Alex Salmond – and indeed myself – would hope. In which case, Scotland’s continued membership of the European Union, on broadly the same terms as at present, is assured.

However, there is a second scenario, which has to be considered following recent ill-judged remarks by Mr Barroso and others in the EU hierarchy. These hint that Scotland’s continued membership of the EU in the event of independence is likely to be fraught with difficulty.
It would be demeaning for the leaders of an independent Scotland to go like a beggar to the banquet pleading for crumbs from the rich man’s table. There seems to be an attitude, exemplified by Mr Barosso and others, that wee Scotland should be grateful for any attention the panjandrums of Brussels deign to give us, and we should be duly humble if these great men so much as admit us into their august presence.
Nothing could be further from the truth. The reality is that the EU needs Scotland more than Scotland needs the EU. Whatever the merits of the European Union as originally conceived, in recent years it has increasingly corrupted into a self-regarding and self-serving bureaucracy whose incessant demands for the transfer of more power, wealth and influence to the centre has weakened the peripheral Member States – Portugal, Ireland, Italy, Greece and Spain – and, yes, Scotland.

The leaders of an independent Scotland should make it unequivocally clear from the outset of any post-independence negotiations that they are not prepared to join the EU club on any terms they care to dictate. If the terms are not acceptable, Scotland has a perfectly viable “Plan B” – namely, to remain outside the European Union but with a commitment to free trade and open frontiers with it – going the way of Norway, Switzerland, the Channel Islands, Monaco and others – none of whom seem to have suffered unduly as a consequence.

Following these six steps, within two years of a Yes Vote, despite current scaremongering and a reaction that is likely to be negative in the short term, Scotland could put in place three key pillars of stable growth and full employment – fiscal prudence, sound money and free trade. If it does so, the foundations of prosperity in a free society will have been laid.

MJN, March 2014

Permanent link to this article: http://www.goldenguinea.com/the-morning-after-the-night-before-six-steps-to-scottish-economic-independence/

Feb 07

Mr Salmond and the £

As the date of the Scottish independence referendum approaches, a key issue is the question of Scotland’s currency if it were to become an independent nation. The policy advocated by the Scottish National Party is to maintain a currency union with England, a proposal that is causing increasing concern among many economists, myself included. I put these concerns to Scotland’s First Minister, Alex Salmond, at a meeting just before Christmas, and in fairness he did make a couple of valid points in response:

1. His Council of Economic Advisers, which includes Nobel laureates James Mirrlees and Joseph Stiglitz, has concluded that Scotland and England constitute an “optimal currency area”.

2. Evidence that Scotland and England constitute an optimal currency area is provided by the current performance of the two nations. Mr Salmond argued that the Bank of England’s monetary stance, with Base Rate at a record low of 0.5%, could be regarded as too loose for London – whether the labour market is tight and property prices are soaring – but too tight for the north-east, where unemployment remains high and house prices depressed. But it seems to be about right for Scotland.

Notwithstanding these points, I am not reassured, and set out my concerns in a letter published in the Financial Times on February 5th 2014:

“Dear Sir

In article, “England must reject currency union with Scotland” (January 31st), Martin Wolf exposes the flaws in the SNP policy of a currency union with England post-independence. It can only work with a banking union and shared fiscal resources. But these are incompatible with independence.

At a meeting with the First Minister just before Christmas, I put this to him and pointed out that, while the currency proposals in the Independence White Paper – under which an independent Scottish Government would be a shareholder in the Bank of England and have the right to nominate Board members – were all very well, the hard fact is that they have been rejected out of hand by the Westminster Government. In response, Mr Salmond argued that, if his proposals were rejected, an independent Scotland would simply refuse to accept a share of the UK’s National Debt. The Scottish Government then claimed victory a few weeks later, when the UK Government announced that it would underwrite all of Britain’s National Debt, irrespective of the outcome of the Independence Referendum.

But the Scottish Government’s policy is not credible. If an independent Scotland simply refuses to accept a reasonable proportion of the UK’s national debt, its ability to borrow on international markets will be fatally compromised.

I suggested to the First Minister that a preferable alternative would be to adopt the strategy discussed by John Greenwood in his FT article on January 16 (“A hollow independence if Scotland keeps sterling”). Namely, that Scotland should follow Hong Kong’s line in creating its own currency board. The Hong Kong currency board has operated successfully for 30 years of financial turbulence and radical constitutional change, and there is no reason why a Scottish currency board could not do likewise, guaranteeing the convertibility of a Scots Pound, initially at parity with the £ Sterling, but with the ultimate ability to adjust upwards or downwards against the £ Sterling as domestic economic conditions within Scotland require.

This would not be an easy option, as Mr Greenwood quite correctly points out. In order to sustain a currency board, an independent Scotland would have to maintain strict monetary discipline, as has Hong Kong. However, over the longer term sound money would deliver significant economic benefits compared to the alternative of a currency union dominated by England. An independent Scotland could survive and indeed thrive – but only if it has ultimate control of its own currency and monetary policies, as do Norway, Sweden and Denmark, which are frequently cited by the Scottish Government as comparators.

If it is to avoid being skewered on this issue as the independence debate evolves this year, the Scottish Government should have
the courage to propose that a currency board option is a viable “Plan B” in the event that its own “Plan A”, of full currency union with England, proves impossible to deliver on the terms it wishes.

Yours faithfully
Michael Nevin.”

Afternote:

Other authorities are expressing similar concerns. The Governor of the Bank of England, Mark Carney, summarised the issues that would need to be addressed in order for a currency union to be sustainable in a balanced and judicious manner, carefully avoiding political comment, during his visit to Edinburgh last week. And yesterday, the Chairman of the House of Commons Treasury Select Committee, Andrew Tyrie MP, stated that he did not believe that a currency union would gain parliamentary support from an English Parliament in the event that Scotland became independent. He proposed that it should therefore be rejected outright at this stage.

Permanent link to this article: http://www.goldenguinea.com/mr-salmond-and-the/

Aug 29

Have central banks given up on fixing global finance?

In an article in the Financial Times on August 28, “Central Banks have given up on fixing global finance”, Robin Harding concludes that,

“a reliable backstop (to the international monetary system) is impossible when the international system relies on a national currency – the US dollar – as its reserve asset…. The answer is what John Maynard Keynes proposed in the 1930s: an international reserve asset, rules for pricing national currencies against it, and penalties for countries that run a persistent surplus.”

This is exactly the conclusion of The Golden Guinea. Agreed, such an international reserve asset is not going to be created any time soon, but the final comment in the Harding article, that this should not stop the search for a stable international financial system, is entirely valid. Under current arrangements, the world is lurching from one currency crisis to another – the recent instability of the Indian Rupee being merely the latest manifestation. One also wonders what Angela Merkel’s comment that Greece should never have been allowed into the Euro portends for the European single currency after the German elections are out of the way in September.

Whatever happens, it is easy to predict continuing currency instability under “business as usual”, which will be harmful to international trade, investment and employment.

As to the rules of a new international monetary accord – one rule that could be supported by supporters of floating rates and advocates of some form of fixed rate system is that national monetary authorities should commit themselves to maintaining a stable ratio of foreign-exchange reserves to GDP. This would avoid the dangers of a “mercantilist” policy pursued by nations seeking to run permanent Payments surpluses with the aim of building up their foreign exchange reserves without limit.

It would imply that national authorities manage their exchange rates in such a way as to achieve a broad external balance of payments, which is an essential condition for international monetary stability.

Permanent link to this article: http://www.goldenguinea.com/have-central-banks-given-up-on-fixing-global-finance/

Jul 03

The Outlook for the Bond Market

In my comment on April 3rd, “Are Sterling Bond Prices in a Bubble?”, I concluded that,

“Quantitative easing has led to an artificial bond bubble. Investors should be very cautious in committing new funds to UK fixed-income securities. Their risk / return profile is distinctly unappealing – none moreso than gilts issued by the UK Government.”

The reversal that was foreseen in that comment is now occurring. Bond prices have fallen sharply. My PIBS Price Index – a weighted index of Permanent Income-Bearing Shares issued by UK banks and building societies – has fallen by 20% since the end of May, with a commensurate rise in yields.

The reason is that the US Federal Reserve recently announced that they might be looking to withdraw from quantitative easing – i.e. stop buying US government bonds – removing the artificial support for their prices, and sending them tumbling.

In the UK, this has been compounded by the Co-op Bank debacle, with holders of Co-op PIBS still in a limbo, uncertain of how much of their face value they will recover. The only certainty is that any recovery will be significantly below their par value, as bondholders are “bailed in” as part of the Bank’s proposals to restore its capital.

These uncertainties have led to significant outflows from bond funds as investors have panicked in the face of steep price falls. A front page article in today’s Financial Times reports that Pimco has suffered record outflows, which are “the latest sign of nerves among bond investors after a market rout that has seen the worst performance for fixed-income assets since the financial crisis”.

As a consequence, Pimco and other bond funds are having to sell their bonds to raise the cash to repay their investors.

Result: prices are falling to levels which may be artificially depressed, giving an excellent buying opportunity once they settle down.

The key is patience – the PIBS price index needs to bottom out and start to recover before committing any new funds to the bond market. In the meantime, cash is not a bad place to be. Then when the market turns, an investor will be ready to buy into a recovery at prices that represent reasonable value, with PIBS yields of between 8% and 10%.

Permanent link to this article: http://www.goldenguinea.com/the-outlook-for-the-bond-market/

May 16

Sir Mervyn King as Governor of the Bank of England – Marks out of 10

As Sir Mervyn King enters his final days as Governor of the Bank of England, the time is right to assess his overall record over the past 10 years.

1. Monetary policy before the credit crunch. The initial phase of his tenure, between 2003 and 2007, appeared at the time to be a period of monetary stability. But as events transpired, serious problems were beginning to build up in the monetary system. The Bank of England presided over rates of monetary growth well in excess of the growth of output, with the increase in two standard measures of money supply – M3 and M4 – accelerating from approximately 6% per annum when Sir Mervyn took the reins to 15% per annum by 2007. The Bank of England could and should have taken measures to restrict monetary growth, most obviously by raising the Base Rate, but failed to do so. Mark for Sir Mervyn = -1.

2. Banking regulation before the credit crunch. The consequence of rapid monetary growth was an increase in leverage throughout the banking system, a bubble in asset prices, and an escalation in the UK’s external Balance of Payments deficit from less than £1 billion in 1997 to more than £50 billion by 2007. In a public statement in 2012, Sir Mervyn acknowledged that the Bank of England had failed to take account of the dangers of rising bank leverage, let alone take any measures to restrain it. Mark = -1.

3. The Bank of England’s immediate response to the credit crunch of late 2007 was badly fumbled. The first victim of the freeze in international money markets was Northern Rock, but Sir Mervyn vetoed a “white knight” approach from Lloyds TSB to rescue it, opting instead to spend his time lecturing the City on the dangers of moral hazard. Technically he was correct, but his timing could not have been worse. To take an analogy from the world of cricket so beloved of the Governor – it was rather as though the batsman had executed a cover drive that was technically beautiful, but appallingly mistimed, with the result that, instead of the ball flying to the boundary, it lobbed gently up into the air to offer an easy catch to the fielder.

Mark = -1.

In this case, the fielder did not take the catch. Sir Mervyn was fortunate indeed not to be sent back to the pavilion, and to have his mandate renewed. He was a beneficiary of the “camel in the tent” syndrome. The Prime Minister, Gordon Brown, apparently decided that it was safer to retain Sir Mervyn as Governor than to have him as a disgruntled ex-Governor outside the tent criticising the Labour Government’s own distinctly mixed record.

4. Banking regulation after the crisis. In his second term, Sir Mervyn’s record on banking issues improved. He was a strong advocate of the separation of investment banking and retail banking. He recommended restructuring the broken banking behemoths, in particular RBS – “if a bank is too big to fail, it is too big”, as he quite correctly stated. The Bank of England was also reasonably supportive of the entry of new banks into the market, increasing competition and customer choice. Mark = +1.

5. Monetary policy after the crisis. After 2008, the Bank of England aggressively cut Base Rates to an historic low of just 0.5% in early 2009, where they have remained ever since. In my view, quite correctly. Mark = +1.

6. The Introduction of Quantitative Easing. In early 2009, the Bank of England introduced a new measure to stimulate recovery – Quantitative Easing (QE) – in simple English, printing money. I would not criticise the initial decision to attempt QE in the context of early 2009, when there was a general desire that “something must be done”. Mark = 0

7. Later rounds of QE. Where I do criticise the Bank of England, however, is that it persisted with QE long after its damaging effects became all too evident. The mechanism by which QE reduced the real incomes of savers, pensioners, the low-paid and those on fixed incomes and stifled economic recovery has been set out in other comments on this site and in The Golden Guinea, and will not be repeated here. Yet, like an alcoholic who can’t keep off the drink, Sir Mervyn persisted in repeating the dose again and again. In late 2012, he seemed to accept that QE was not stimulating the recovery in output and jobs for which its advocates had hoped, but by early 2013 he was again pressing for a further round. Fortunately, he found himself in a minority on the Bank of England’s Monetary Policy Committee, so it didn’t happen.

As I wrote in my forecasts for 2013 on December 28th 2012

“If the Bank of England responds with yet more quantitative easing, my prediction is that it will have precisely the same effects as QE has had already – driving down real incomes, driving up inflation and sending the British economy back into a stagflationary recession. However, if QE is consigned to the dustbin of history, then there is a realistic prospect for a recovery in the UK economy in 2013.”

Such has indeed proved to be the case, but no thanks to Sir Mervyn.

Mark = -3 for each round of QE supported by Sir Mervyn after the initial round.

In summary, Sir Mervyn King’s tenure at the Bank of England has been distinctly mixed. Yes, it has been a period of turbulence and not all the problems were of his making. But having said that, he presided over an excessively loose monetary policy before the credit crunch, fumbled his response to Northern Rock crisis, and persisted in pursuing the economically destructive policy of Quantitative Easing despite its comprehensive failure to achieve any of the objectives that the Bank of England set for it when it was introduced in March 2009.

Applying a starting mark of 10 – by definition, his record as Governor on taking up the post was unblemished – by my reckoning he finished with a mark of 6 (= 10-1-1-1+1+1-3). A 9 or 10 would be the mark of a great Governor. A 7 or 8 would mark a “safe pair of hands”. A mark of 6 must be judged as only fair.

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