“But, if recent history has taught us anything, it’s that self-regulation doesn’t work in finance, and that worries about reputation are a weak deterrent to corporate malfeasance.”
-James Surowiecki, Staff Writer, The New Yorker
-As quoted in The New Yorker, July 30, 2012. Bankers Gone Wild
The recent kerfuffle over LIBOR (or perhaps, Lie-bor) has led many, including those living in developing countries but reliant on the global interest rate benchmark, wondering how the apparently flawed system was allowed to become such an major global institution. Blame for the entire fiasco has, predictably, come from the usual suspects on the usual suspects: apportioned equally to bankers' moral shortcomings and/or regulator complicity. These strike one as lacking imagination: after all, people (bankers and regulators inclusive) respond to incentives, and it is the institutional setting that governs the types of incentives individuals embedded in the system face. Presumably, if the existing framework for obtaining reported LIBOR rates did not involve substantial submitter discretion,[*] then both traders and regulators would react very differently to potential exploits of the system. After all, both groups would see little benefit from attempting to game the system if it offered little chance of success.
Through all the spilled ink (or pixels)---especially with regard to the now-conventional proposal to simply base LIBOR on actual transactions data, rather than self-reported numbers---little has been said about whether moving to such a system would yield actual efficiency improvements. In thinking about such issues, it is useful to keep two aspects of economic theory in mind.
First, in a standard double-auction setting such as LIBOR, theory and experiment suggest that efficient price discovery can occur with a remarkably small number of participants; with markets fiding equilibrium with as few as 6 to 8 agents (JSTOR subscription required). The argument that LIBOR is inherently inefficient just because it has only a small number of participating banks is therefore a weak one, in light of this fact. By the same token, however, the ease of attaining efficient outcomes with a small number of agents means that a setting where only actual transactions data are used to establish LIBOR need not be threatened by the fear of potentially thin markets.
Indeed, the natural advantage that using actual transaction data offers is the possibility that rates adapt to changing market conditions. In calm times when markets are thick, large institutions with superior economies of scale will tend to possess a funding cost advantage. Consequently, the transacted market LIBOR rate will be lower, reflecting the overall positive spillovers that result from having larger players engaged in the wholesale funding market. In turbulent times, however, the size and relative opacity of large bank balance sheets may lead to rational concerns by market participants over counterparty risk. In such circumstances, smaller banks with balance sheets less exposed to market volatility could find themselves being able to secure funds at a lower cost than the larger banks can. These smaller banks will then be the ones setting LIBOR at the margin. Again, the transacted rates will ultimately reflect the best available rates, even in such thin markets.
Second, even if we want to move away from a straightforward market mechanism based on realized transactions, we are aware of mechanisms that elicit truthful, incentive-compatible bids from market participants in alternative auction settings. Although such mechanisms alone cannot, alas, guarantee the absence of collusion (the problem with LIBOR), we also know that collusion becomes harder to sustain with a large number of players and free entry. So a system that combines both of these elements---preference revealing bids and ease of entry---could be the basis for an alternative market structure for generating LIBOR. Note that even in this setup, it would still be the case that LIBOR should be set on the basis of actual transactions, rather than imagined ones.
The bottom line is that there are good reasons to rely on actual transacted data to establish LIBOR, subject to some potential tweaking of the mechanism. LIBOR is widely considered one of the world's most important benchmark rates, and the erosion of trust in the system due to recent events suggests that it is high time to move away from the traditional, "gentleman's agreement" approach to LIBOR rate-setting. This would yield clear benefits not just for the millions of people around the world who implicitly rely on LIBOR in their financial contracts, but also for rebuilding trust in the international financial system, more generally.
*. Submitters repond to the question: "At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?" Even setting aside deliberate manipulation, the scope of the question offers significant flexibility to the submitter, both morally and legally: the language includes terms such as could and reasonable, which leave substantial scope for individual judgement and discretion. To the extent that this was by design---maybe the BBA fears thin markets rendering LIBOR too volatile on a day-to-day basis---it is now clear that such a degree of flexibility is, on net, a negative for the system as a whole.
| Renewed concerns earlier in the week about the Greek bail-out plan and the possibility of a credit rating downgrade for several European economies drove borrowing costs up. The European Central Bank’s (ECB) announcement on Thursday to defend the Euro has helped ease concerns somewhat. As inflationary pressures abate and the global economy slows down, more developing countries are cutting interest rates, however, where inflationary pressures remain high, policy tightening continues. Notwithstanding the pick-up in tourism arrivals in the first four months of 2012, the recent slowdown in economic activity is likely to dampen tourism flows in the second half of 2012.
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| Borrowing costs for high-spread Euro Area governments rise. Renewed worries about Greece being able to reach set fiscal targets; Moody’s negative credit outlook for Germany, the Netherlands, and the European Financial Stability Mechanism; and increasing concerns related to regional finances in some countries caused bond yields to rise for Euro Area governments earlier this week. Ten-year Spanish government bond yields rose to fresh record highs at 7.621% and Italian bonds hit a 2012-high of 6.597%. Comparable yields also increased for French and even German bonds, albeit slightly. In contrast, U.S. government bonds yields touched record lows as investors sought safe haven. However, the announcement on Thursday by the ECB that it would defend the Euro has helped to push Spanish and Italian bond yields further down from earlier highs.
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| Interest rate cuts in developing countries continue. As inflationary pressures abate and the global economy slows down, interest rate cuts among developing countries have continued, unlike in large high-income countries where the policy space for interest rate cuts remains limited. In recent months some of the larger developing countries (Brazil, China, the Philippines, South Africa and Vietnam) have cut nominal policy rates, although real interest rates may be higher due to sharper declines in inflation. In contrast, policy tightening has occurred in developing countries where domestic factors (rapid credit growth, poor harvests, currency depreciation) are putting pressure on prices: Peru and Uruguay increased reserve ratios and Malawi increased its policy rate. Nonetheless, most developing countries continue to keep their interest rates on hold at relatively low levels, in a bid to balance the need to keep a lid on inflation and stimulate domestic demand.
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| The pick up in global tourist arrivals observed so far in 2012, is likely to slowdown in latter half of the year. The tourism sector remains an important source of revenue and job creation for several developing countries (accounting for up to 32% of GDP in Maldives, see chart). Data released by the United Nations World Tourism Organization shows international tourist arrivals increased by 5% in the first four months of 2012 (compared to 4.5% for same period in 2011). Among developing regions, the increase was strongest in the Middle East and North Africa, bouyed on by a strong rebound in Tunisia (48%, y/y) and Egypt (29%, y/y) – thanks to the ongoing stabilisation of the situation there. However, with the global economy slowing down, and consumer confidence weakening in major tourist-origin countries, the pace of increase in tourist flows is likely to slow down in the second half of 2012.
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A few weeks ago a rare storm event known as "Derecho" ravaged the Washington, DC area, claiming many lives and leaving 1.3 million homes and business without electricity. My house was unfortunately among those hit hard by the power outage and in an attempt to cope with the 90F+ temperatures unleashed by the storm, we moved down to the basement -- generally, the coolest part of the house.
For the first few days the novelty was fun for the kids, but as the days wore on, frustration grew, in part because we had no idea when the power would come back on.
Important developments today:
1. European shares and euro continue to slump as Moody’s cuts the rating outlook for Germany, the Netherland, and Luxembourg
2. Output in the Euro Area contracts for the sixth month in July
Important developments today:
1. Crude oil prices fall from 9-week high
2. German producer price inflation falls to lowest in two years
Renewed Euro Area tensions cut into capital flows to developing countries in May and June, and prompted a sharp downturn in business sentiment worldwide. Together these developments point to slower growth in 2012Q2 and Q3, unless recent improvements in financial markets and policy steps cause business sentiment to strengthen. Falling industrial commodity prices, notably oil prices, may mitigate impacts for importing countries, but will exacerbate strains on government revenues in commodity exporting nations. | |
| Capital flows to developing countries picked up slightly in June after falling sharply in May due to renewed Euro Area tensions. The resurgence of Euro Area turmoil in May caused gross capital flows to developing countries to fall by a revised 45% in May (solid line in figure). The bulk of the decline was in bond and equity issuance, as borrowers may have voluntarily delayed going to market given heightened uncertainty. In June, total gross capital inflows picked up somewhat. Perhaps surprisingly, in the most recent period syndicated bank lending has held up (despite European banking-sector deleveraging). Overall, inflows in May-June are down 36% from the levels observed in the first four months of the year. Should capital flows remain depressed they could contribute to weaker investment and growth in developing countries in the second half of the year.
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| The financial turmoil in the Euro Area has cut into business sentiment worldwide. Purchasing manager indexes (PMIs) published by national sources and Markit deteriorated further in June. The global indicator descended into sub-50 territory, suggesting that global output shrank in June, with all economic regions weakening (except China whose official PMI improved slightly). A similar decline in PMIs occurred in the second half of 2011, when Euro Area tensions rose in July of that year. Perhaps, reflecting lessons learned from that earlier episode, the deterioration has been quicker and more marked this time around. The decline in sentiment is consistent with a scenario where firms and consumers are holding back on expenditures because of increased uncertainty. Economic outturns for the second and third quarters of 2012 will depend critically on whether confidence remains weak or begins to strengthen in response to recent policy steps.
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| Euro Area tensions and global growth concerns have accentuated downward pressure on industrial commodity prices, notably oil prices. International prices of crude oil and other industrial commodities have been on a downward trend in recent months, reflecting strong supply growth and weak demand. The initial easing in prices occurred even as global economic activity was firming, but has accentuated with financial market tensions and expectations of weaker growth. As of July 3rd, international crude oil prices were $25 lower than their first quarter highs, and copper and aluminum prices were down 10 percent and 16 percent respectively. Internationally traded wheat prices have strengthened in recent weeks amid concerns that high temperatures may reduce global supplies, especially from key exporters including the United States and Russia. Compared with a year ago, wheat prices are up 15 percent and maize prices are up 14 percent. While lower oil prices will help to cushion the real-income effects of weaker GDP growth in most developing countries – lower oil and metal prices can be expected to cut into incomes and government revenues in exporting countries, exacerbating the downturn in those economies.
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Yesterday, I discussed India’s incredible economic transformation over the last two decades and some of the challenges that the country is currently facing. So, what can India do to reduce the impact of global uncertainty and improve growth performance and boost investor confidence?
India’s firepower to respond to a crisis with traditional monetary and fiscal stimulus is much weaker now than prior to the 2008 crisis. Fiscal space for additional spending is severely constrained in light of continued high deficits. Room for monetary policy easing is modest in light of continued high inflation, and still low real interest rates. Moreover, when investor confidence is at a low ebb as it is in India, easing monetary policy would be tantamount to “pushing on a string.”
India has been a beacon to the world on how a thriving and vibrant democracy can transform itself into an economic powerhouse. The metamorphosis that took place in the Indian economy after the reforms of the early 1990s is nothing short of spectacular. The Indian economy was transformed into a dynamo of innovation and diversification. This fundamental transformation unlocked two decades of explosive growth in which poverty rates fell by nearly 20 percent, exports as a share of GDP increased nearly five-fold, and standards of living increased by a factor of almost four. This trajectory received but a glancing blow from the 2008 global financial crisis—this resilience was a testimonial to the benefits of the economic reforms of the previous 15 years.
Challenges to India’s Growth
But now, India’s economy once again faces formidable challenges and the fear is that it is considerably less well placed to deal with these challenges than at any time over the past two decades. The global economy is facing a new phase of the crisis characterized by an extreme bout of uncertainty, risk aversion and volatility, this time originating in the Euro Area. Some skeptics have recently questioned: Will India weather this storm as well as it did in 2008-09 and will the story of “Incredible India” remain credible?
Last week, British NGO Global Witness published Grave Secrecy, a report on how U.K. registered companies were allegedly used to launder the profits of corruption. Hundreds of millions of dollars passed through the corporate accounts of dozens of shell companies that held bank accounts at Asia Universal Bank (AUB), the largest bank in Kyrgyzstan. Although the report is based on one concrete case of alleged corruption and money laundering in that country, its relevance goes beyond that single example.
It is just one illustration of how money launderers and those involved in large-scale corruption use companies to hold criminal assets whilst ensuring that information on the control of those companies is virtually inaccessible. The essence of those schemes is to parcel out different bits of information on the company to different jurisdictions from which such information can only be obtained with difficulty (so-called secrecy jurisdictions). Indeed, how does one find relevant information on a U.K. company owned by a company registered in the British Virgin Islands with a company secretary in the Marshall Islands and a director in Panama? Criminal creativity knows no bounds.
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We came to Rio+20 determined that one outcome of the UN Conference on Sustainable Development must be a plan for what ministers of finance, development and environment and ourselves need to do differently Monday morning, June 25th – if we are to achieve sustainable development for all.
We have our plan.
We came to Rio+20 knowing that inclusive green growth is the pathway to sustainable development, and the evidence here is that this international community agrees.
The analysis behind the World Bank’s report Inclusive Green Growth: The Pathway to Sustainable Development framed many of the conference debates and helped facilitate a new focus on natural capital accounting – a fundamental component of inclusive green growth.
According to the 59 countries, 86 companies, and 17 civil society organizations that supported the World Bank Group-facilitated 50:50 campaign – as well as many others – natural capital accounting is an idea whose time has come.
In fact, natural capital accounting events filled the Rio Convention Center, and government and civil society groups alike highlighted the importance of moving beyond GDP.
This new energy and emphasis around this issue may be the most important outcome of Rio+ 20.
With the recent opening of a rural savings and credit cooperative, the people in Gebremichael’s Ethiopian village no longer have to save their money in pots or under the mattress at home. He and his neighbors are learning to use formal savings and credit systems.
We know that many in Sub-Saharan Africa have benefited from using the formal financial system, but exactly how many are using it to save, borrow, make payments and manage risk?
With the release of the Global Financial Inclusion Indicators (Global Findex) we now have a comprehensive, individual-level, and publicly-available database that allows comparisons across 148 economies of how adults around the world manage their daily finances and plan for the future. The Global Findex database also identifies barriers to financial inclusion, such as cost, travel time, distance, amount of paper work, and income inequality. Our new Working Paper offers an overview of Financial Inclusion in Africa.
Art at the Rio+20 Pavillion reminds those passing by: "The future begins with the decisions we make in the present." UN Photo/Maria Elisa Franco
While negotiators were getting their teeth stuck into the newly circulated text at Rio Centro, I meeting-hopped today around the city to meet with legislators, NGOs, and the private sector.
There may not be the buzz of `92 – yet. But, the sense of urgency, action, and recognition of the need to up the level of ambition at Rio was evident among these critical groups.
In the magnificent Tiradentes Palace, over 300 parliamentarians from more than 70 countries gathered for the first ever World Summit of Legislators organised by GLOBE International. They were there to agree a new mechanism for scrutinizing and monitoring governments on delivery of the Rio agreements (past and present). Also a new Natural Capital Action Plan.
Amid the chronic chasm between the world’s wealthy and its excluded, almost half of the adult population worldwide – an estimated 2.5 billion people – lack access to basic financial services. The global economic crisis has intensified the plight of the financially excluded, preventing even more of the world’s poor from gaining a foothold on an important ladder out of poverty.
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Photo: The scene at the 1992 Earth Summit in Rio de Janeiro, where the conference adopted the Rio Declaration on Environment and Development and the Agenda 21 programme of action, among other actions. UN Photo/Michos Tzovaras.
This week, the city of Rio de Janeiro will become a global stage, home to tens of thousands of people attending the UN Conference on Sustainable Development.
Rio+ 20 is an important global stage upon which those committed to action from government, the private sector, and society can show how they plan to demonstrate that we can accelerate progress, if we change the way we grow.
We need a different kind of growth, a greener and more inclusive growth. We think it is affordable with help to those for whom upfront costs may be prohibitive. We think we should be able to value natural resources differently within our economic model. We think that with the right data and evidence we can avoid the irreversible costs of making wrong decisions now. And we can have economic systems that are much more efficient.
