The quest for growth and stability amid European turmoil

Many features of the UK economy remain puzzling to economists and investors. How big is the output gap, and what are its longer-term implications for the economy? When will recovery gather pace? Why is productivity weak? Is inflation or deflation a bigger threat? Is lack of demand for credit a bigger threat than shortage of supply? How much is there left in the QE armoury? And does any of this matter if there is no resolution to the eurozone’s dilemma?

  • 26 Sep 2012
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To unravel some of these issues, three economists gathered at the EuroWeek UK macroeconomic roundtable, which took place in London in September.

Participants in the roundtable were:

Jamie Dannhauser, director, research group, Lombard Street Research

Patrick Foley, chief economist, Lloyds Banking Group

Ross Walker, UK economist, RBS Markets

Phil Moore, moderator, EuroWeek

EUROWEEK: Has Chancellor Osborne’s Plan A failed? Is the IMF right to warn that if drastic action is not taken, the UK may face a "permanent loss of productive capacity"? If so, are we moving towards Plan B, and what will Plan B look like?

Patrick Foley, Lloyds: Clearly, austerity is not going to be enough to turn the economy around. Whether or not that means Plan A has failed, I don’t know.

But clearly we need more than a focus purely on deficit reduction and on the belief this will be enough to create confidence and crowd in the private sector. That simply isn’t going to work. I think the government realises that and is clearly on the case in terms of what it can do to get the economy going.

The IMF’s comment that you refer to in your question is a very important one, because I’m one of the people who believes that the output gap is quite large but is shrinking over time as productive capacity is destroyed by lack of recovery. The longer the economy takes to turn around, the slower the long term growth rate of the economy will be. So I think it is very important that the government does everything it can to get the economy to turn around.

We’ve seen two occasions in the past where the government has significantly tightened fiscal policy as a result of deficit widening in a recession — at the beginning of the 1980s and again at the beginning of the 1990s. In both cases that didn’t prevent the economy from growing at 3%-plus.

But I think there are two differences this time. The first is that governments everywhere are trying to do the same thing. One of the things that has driven growth in the past has been better exports performance, and we’re not going to get that at a time when everyone else is trying to do the same.

The second is that the severity of the financial crisis is unprecedented. So we have a private sector that is trying to deleverage, and on top of that the government is imposing austerity measures.

Ross Walker, RBS: Has it failed? There’s been a little bit of a slippage in terms of fiscal tightening relative to the original plan. But the spirit of it is still there. Over two years we’ve seen a reduction in the deficit of 3% of GDP, so some progress is being made.

But the government doesn’t have to do this at the breakneck pace at which some other economies are having to implement austerity programmes. On balance I’d probably put myself more on the hawkish side of the fiscal debate. Even with the weaker growth environment I would probably like to have seen even greater expenditure cuts.

I think you can criticise the mix, because there has probably been too much in terms of investment expenditure cuts and almost nothing by way of current expenditure cuts, which are still rising in nominal terms.

It’s clearly not enough. But I’m sceptical that the answer is that we need a pause in the modest fiscal tightening that we have, because with deficits of this magnitude there are strong arguments that the fiscal multiplier would not be that big, because businesses can see that at some point quite soon there is going to have to be some even deeper adjustment.

If deficit financing really worked, and could deliver even short term growth, then the UK ought to be one of the fastest growing economies in the world because we continue to have one of the largest deficits. In an ideal world we would have had a mix of monetary stimulus, be it conventional or unconventional, backed up by fiscal stimulus — in the form of both expenditure rises and tax cuts. But that option wasn’t available because of our starting point.

So I sense that the government probably just has to stick to the course.

Have we moved from Plan A to plan B? Not yet — we may be at Plan A minus now. I don’t think we’ve quite abandoned the spirit of it, but there is a bit of dilution slipping in. So in the Autumn Statement the government may begin to prepare the ground for some subtle shift and we’ll see that materialise in the Spring budget of 2013.

Jamie Dannhauser, Lombard Street: I agree with Patrick and Ross. The interesting part of this debate that gets lost in the Balls versus Osborne nonsense is that nobody is talking about how consolidation has been undertaken. For me, the failing is not the size — I don’t think the aggregate size of the consolidation was ever going to be too much for Britain. The problem for me is the way it was chosen to be done.

We know that public investment cuts have the biggest multipliers. VAT has large effects on demand as well. So if you’re going to undertake consolidation why do so by picking the two areas of fiscal action that have big multipliers? The answer is easy: it’s politically simple to do, so you can easily rationalise why the government has chosen the route it has. But I’d like to see a shift in this debate away from size and timing to the best way of achieving consolidation.

I agree with Ross entirely that we’ve barely started to cut public services yet. My view has always been that cuts to departmental spending are totally unachievable. If you look at some of the plans for real terms spending for transport, for example, they’re insane and cannot be achieved. It’s not even as though departments like transport had excessively large budgets pre-crisis.

So it seems to me that the criticism should be levelled towards how they’ve chosen to go about it which has been based on political considerations rather than economic desirability.

I agree with Patrick’s point about the IMF’s comment. I think the Bank and the OBR have pushed themselves into a corner in believing that the output gap is relatively small and that Britain suffered all this damage. But the problem is that it’s hard to find solid, empirical evidence to show that Britain has lost 10% of its output forever.

I can see a much more powerful argument that recognises that we’ve had a crisis in the banking sector and elsewhere, so if we could generate recovery somehow a lot of this apparently lost output would miraculously reappear as many of the constraints on the financial sector are primarily about uncertainty.

So we face major issues to do with the broader recovery and the broader balance of policy. This fairly puerile debate about how far and how fast means that we are missing the much bigger picture on this question.

Walker, RBS: I may be a little bit more agnostic on the output gap. It’s one of these things that we can’t measure directly and isn’t worth crossing the street to have a fight about it.

We know there are some problems with the GDP numbers — you can see that in the construction sector. And there are probably some measurement issues in financial services, where pre-crisis, when there was all this credit washing around the system, there was probably a lot of froth and false activity going on that was nonetheless captured in the nominal variables. When you apply a normal deflator you get plenty of real output but it was certainly never sustainable.

So the peak in the level of output in 2006 and 2007 was probably exaggerated. We’ve had a somewhat anaemic bounce in the activity numbers that doesn’t quite sit with the employment data, so maybe the recovery has been a little less tepid than it seems.

None of this changes the big picture which is that there has been a large drop and a weak recovery. But if you make these adjustments, suddenly the UK’s position looks a bit less anomalous compared to other Western economies, and might explain why the output gap is not quite as big as the headline peak-to-trough numbers suggest.

There is still some price stickiness. Given the shock to output you would have thought that some of these underlying measures of inflation would have been even lower and that there would have been an even more ferocious squeeze in terms of discretionary spending.

But the fact that we haven’t seen this makes me wonder if a lot of this previous capacity has been rendered redundant or if there was more creative destruction early on. I don’t know, but I would put the real output gap at 2% or 3% of GDP, as opposed to 4% or 5% or even larger.

Dannhauser, Lombard Street: For me, the output gap debate is concerning. The OBR has suggested that it’s 2.5% of GDP. That is a big call, since it is the primary justification for the very sizeable structural fiscal adjustment we’re going through.

So the OBR has come up with an output gap estimate which then predetermines how big the fiscal hole is. What’s worrying is that this very difficult judgment is determining a lot of our macroeconomic policies. It could create very serious long term damage if we fail to understand what this crisis is really about. By not doing enough now, we may be running the risk of allowing a persistently weak and sluggish recovery to become long run damage, and it need not be the case.

I’m not saying that this is a remotely easy judgment. But this is the debate I’d be having if I were sitting on the MPC, because we are taking a serious risk if we don’t do enough now. If you think about the potential long run cost as the net present value of the lost output for the rest of time, the price to pay for inaction could be very significant.

So there needs to be a much deeper debate about what is really happening on the supply side.

We’re seeing productivity weakness across the whole economy, not in individual sectors. Pre-crisis it was not the case that workers were moving into high productivity sectors. It was the other way round. All the analysis on why productivity is so weak leads you down a blind alley.

We are flying blind to an extent. The size of the output gap is such a vital influence on the macro policy of this country for the next five to 10 years that if we get it wrong there will be big consequences. We might conceivably find that we have lost all this capacity and created a big inflation problem for ourselves five years down the line if we do more now. Alternatively, we may find that this lost output and high levels of unemployment can be undone while keeping inflation low. So I would like to see the debate at the Bank and at the political level go a little deeper.

Foley, Lloyds: I strongly agree. In a sense the problem is that if both fiscal and monetary policy is set on the basis of a calculation of an output gap which is too small, then it almost becomes a self-fulfilling prophecy. Over time you get to a small output gap even if you didn’t start with one.

For me, it’s almost worth taking some risks with inflation because the consequences of underestimating the output gap are so severe for the economy in net present value terms.

Walker, RBS: We do have very loose monetary policy settings and they’re going to get looser. Maybe the benefits of conventional QE Gilt purchases have largely expired, although I think we’ll see more of it.

We are now moving slowly towards credit easing which I think could be more effective. One way we can begin to resolve some of the supply side debate is once you see credit flowing again into wider parts of the economy, particularly into the SME sector, we’ll get a clearer sense of how strong the recovery there is.

The problem with the output gap measure is, where do we think the output gap was in the recessions of the early 1980s and 1990s? There was spare capacity then — you can see that clearly in the labour market. But at the same time we had inflation overshoots. So you come back to the fundamental question of what is policy trying to achieve?

If I were on the MPC I’d be doing as much as I could to stimulate policy because there is still the risk of a huge economic problem otherwise. But at the back of my mind I’d be worrying about the problems we could be storing up. The policy challenge won’t be over as soon as we string together three or four quarters of decent GDP growth. In some ways that will be when the challenge begins.

So I agree with Jamie that we are flying blind on this. The immediate problem is one of deflation rather than inflation globally, and of a weaker economy. But I think you have to be aware that we are storing up some potentially large imbalances in other parts of the economy.

EUROWEEK: Where does all this leave you in terms of being able to forecast growth for 2013 and 2014?

Walker, RBS: I was looking the other day at my forecasts for the past few years and they have always been essentially the same, which is that this year is going to be quite flat but next year will be a little better. Inflation will fall and the corporate sector will start to spend some of its cash pile. And it hasn’t happened: it has always turned out to be a year one redux.

I think that’s where we are today. I’m forecasting 1.4%-1.5% growth for next year but not with any huge conviction.

Dannhauser, Lombard Street: Ross has touched on the question which for most of us has been our greatest puzzle — why aren’t corporates spending? Three years ago when we saw the size of corporates’ cash piles and a financial surplus of 3% or 4% of GDP, and when none of the surveys suggested uncertainty was particularly high, who would have thought that subsequent spending would have been so extraordinarily depressed?

This is the biggest demand-side macro puzzle. We have a corporate sector that looks in relatively rude health in balance sheet terms but has performed very differently compared with past cycles and previous recessions. It’s remarkable that the corporate sector is carrying on with such a defensive financial policy based on a desire to pay down debt and build up cash.

If you look at the BBA’s numbers on SMEs they are unbelievable. Cash balances are growing at an annual rate of 10% and have been for the last two years, while small firms are paying down debt at roughly the same speed.

Building up cash at that speed while paying down debt is extraordinarily defensive behaviour in the third year of a recovery. I’m yet to talk to any economist here or in the US who has an explanation as to why this defensive behaviour is so persistent.

Foley, Lloyds: Maybe corporates are just better forecasters and economists. There have been lots of stories in the press about the potential for deflation and long periods of low growth, so perhaps they are just waiting until there is some certainty about the recovery before they invest. Certainly that is what industrialists are telling me. For them there’s no puzzle at all as to why they’re not investing. It’s all down to the fact that there is so much uncertainty out there and they won’t invest until they see some solid evidence of recovery. And if they’re going to invest at all, they’re not going to invest in the UK but in Asia or somewhere else where the prospects look better.

Walker, RBS: One treasurer said to me in a recent meeting that nobody ever got fired for not spending money in this sort of environment. At the personal level, nobody wants to stick their head above the parapet.

Foley, Lloyds: This might also shed some light on why inflation has been quite sticky. The Bank of England made the point three or four Inflation Reports ago that one of the reasons why inflation hasn’t fallen more is that when there is a large output gap you would normally expect corporates to cut prices in order to use up their spare capacity. But if you’re really pessimistic about your prospects to sell anything, you’re better off sticking to your existing price, and using your revenue to run down debt.

Dannhauser, Lombard Street: And to what extent are credit constraints exaggerating that process? If you’re fearful about your access to credit lines, either today or tomorrow, you’re going to pursue the kind of strategy Patrick described.

Nobody seems able to pick apart whether it’s weak demand or credit supply, but I’ve been struggling for three or four years now to explain why corporates remain as defensive as they do.

If you look at the surveys both here and in the US, uncertainty is not that high. It may be that qualitative measures aren’t picking up just how uncertain businesses are, but in the CBI surveys there is no suggestion that uncertainty is that much higher than we would expect in a normal recession. It’s not as though it’s out of line with the 1980s or 1990s. If you look at some of the US surveys the same thing emerges.

EUROWEEK: Is this not a reflection of the unprecedented uncertainty about what is going to happen in Europe?

Foley, Lloyds: That is maybe the way a number of large corporates look at it. All the risk is on the downside because something awful could happen in the eurozone and then we would have a severe double-dip recession here. That’s what the papers keep telling them so why shouldn’t companies believe them?

Walker, RBS: In the first half of last year we saw a slight uptick in investment intentions. It was only in the second half of the year that they turned down as the strains in the financial sector and concerns about the euro area grew.

So to some extent there is fear about euro area contagion. As the ECB slowly moves towards some kind of solution, some confidence should begin to come back. But if we had any meaningful pick-up by this time next year you’d be pleased. It’s probably further into the distance before we start to see any significant increase in corporate expenditure.

EUROWEEK: So the problem is one of credit demand, not credit supply?

Dannhauser, Lombard Street: The Funding for Lending Scheme (FLS) will tell us which it is. Policymakers have noted that we have seen a big rise in risk premia, that the euro crisis is here to stay and we can’t do anything about it, so the answer is to subsidise banks. I think it’s a good idea and it’s something we should have done a long time ago.

We will find out pretty quickly if credit supply is a binding constraint for risky mortgage borrowers, for example. The incentives in the scheme seem pretty powerful for banks either to lend more or to cut prices. This will be the proof of the pudding.

Foley, Lloyds: I suspect demand is quite weak at the moment. If corporates only expect a very weak recovery, they’re not going to be rushing to borrow money, especially if they are quite strongly leveraged in any case.

What worries me is that if the economy does start to pick up, will credit supply be a constraint on how fast the economy can grow? That’s the real issue. It’s not really a question of supply versus demand now. It’s a question of whether there will be sufficient supply to support a decent recovery in the future.

EUROWEEK: Where will the impetus for this come from, and is there a danger that it will be hindered by regulation?

Foley, Lloyds:
The overlay we need to put on top of all this is that for very good reasons we’re seeing regulatory standards for banks changing considerably in terms of capital, liquidity and so on. This makes a lot of sense in the long run. But the process of moving towards those higher standards is inevitably going to lead to a reduction in the size of banks’ balance sheets which will make the recovery of credit supply much more challenging.

So I think the government, the Bank of England and the FSA need to be very careful about how they manage the speed at which they ask banks to move towards higher capital standards.

We’ve done a lot of modelling of the impact this will have on the economy, and it suggests that there can be a strong and adverse feedback loop between banking regulation and its impact on the economy.

EUROWEEK: To what extent will this be influenced by the fact that we are drawing closer to an election year in 2015?

Walker, RBS: I still believe that the coalition will survive for at least three years. The Realpolitik at the moment is that based on the polls the Liberal Democrats have nowhere to go. As much as they may regret having gone into the coalition in the first place, with a share of the vote of just 8% in the opinion polls they would be left facing oblivion if they walked out. They just have to hope that there is a public recognition that the unpleasant medicine is working.

Dannhauser, Lombard Street: It seems to me that at a very simple political level the strategy has always been to have a recovery by 2014. It’s as simple as that. If there’s no recovery, the Conservatives won’t win. That tells me that they will have to do something to generate a recovery.

But the idea that we’re going to get a full U-turn on Plan A seems unlikely to me. I would assume we’re going to see some kind of infrastructure spending programme possibly financed through QE or a similar mechanism. I can see many ways they would attempt to do it, but a pre-election retreat from Plan A looks unlikely to me. That would be too much for Chancellor Osborne, given that Plan A is very much his baby.

EUROWEEK: Patrick, do you see political risk increasing as we approach the election?

Foley, Lloyds: No. The reason is that this is one of those strange times when the needs of the government in power and the needs of the economy are pretty well aligned.

To go back to the IMF’s point, it seems to me that the longer we carry on with a very weak recovery the more important it becomes to do something to get the recovery going, and that happens to coincide with the electoral cycle — so in some ways the fact that we’re moving closer to an election is quite helpful.

EUROWEEK: If the government is pushed into some form of extra stimulus, where does it leave the triple-A rating? Is the triple-A rating important, or just a political football? Would a downgrade affect the UK’s funding costs to a meaningful extent?

Walker, RBS: I think we will lose the triple-A rating from at least one of the big agencies, although not until next year. We’ve already been downgraded by Egan Jones. But I don’t think it matters. The sterling asset class will continue to trade as a relative safe haven because there is a shrinking pool of high quality global assets, and there is still plenty of liquidity in sterling assets. We have a country with its own currency and a central bank that is prepared to do what it takes in terms of QE.

There’s going to be no hard default, and the UK looks a significantly better credit than even Germany because of the risk mutualisation that is taking place in the eurozone.

So as long as we don’t see something specific to the UK that triggers a downgrade, it shouldn’t be an issue for markets. I suspect other larger EU economies would be downgraded either at the same time or before the UK. In that sense double-A is the new triple-A.

Dannhauser, Lombard Street: I think Ross is spot on. The short answer about whether the rating matters is no. I’ve always been a strong believer that a country with its own currency and central bank has more flexibility when it comes to running massive deficits than most people think, and especially more than those in currency unions. Britain is quite ugly at the moment, but less ugly than virtually every country in the eurozone.

Foley, Lloyds: When you look at what the ratings agencies are saying about the UK, the reason they talk about the possibility of a downgrade is that they are worried about growth, not because they’re worried that the government is going to fail to cut the deficit. So it seems to me that it’s worth the government taking a risk by spending more on infrastructure if that has a positive effect on growth.

Dannhauser, Lombard Street: Some countries are clearly getting killed in the bond markets because of a lack of growth. Some are getting killed because of high levels of public debt. I fear that views on Britain may move from it being seen as a safe haven to being regarded as an economy that is no longer growing. That is what happened to Spain 12-18 months ago. The concern there was that the economy would see no growth for a long time. That was more of a concern than the existing stock of government debt.

There’s a chance that Britain goes into the category of countries seen as having low growth and unresolvable problems in their banking sector. That is different from how we are seen now, which is as a country with a solid government and a credible medium-term fiscal strategy.

The rating debate is good fun for the papers and the politicians, but for the real world of economics I don’t think it’s massively relevant.

Walker, RBS: The triple-A issue has become part of the front page language, whereas the emphasis always ought to have been on affordable borrowing costs. The rating probably should be lost in any case, because it is questionable how an economy with a deficit of 8%-plus and a stock of debt of 70% and rising can really be regarded as triple-A — even one with its own currency.

When QE started the expectation was that it would be £150bn in total. There was a recognition that it needed to be sizeable but there was a limit to how far it could be pushed. Not from a logistical perspective, because the DMO can issue as much debt as it wants, and the Bank of England can monetise it. But at some point investors say this has been pushed too far and the currency starts to give. This pulls the rug from under your domestic anti-inflation safeguards. None of this has happened in spite of the QE policy having been pushed to quite extreme levels. But at the back of your mind you’re always asking if the brick at the end of the elastic may be about to snap.

Dannhauser, Lombard Street: I agree that this is the constraint. Clearly the Governor and others at the Bank are bearish — rightly, in my view — and might be thinking of some more stimulative measures. If they could make sure they could hold CPI at 4% we would see more stimulus tomorrow. But their concern is that they can’t, and that if they let inflation creep up, it’ll go to 8% and then to 12%. It is this fear that holds them back. The fear is that we may go down the 1970s route — if we allow inflation to creep up, it may be impossible to contain.

QE was clearly the right thing to do in early 2009. There was mass panic and the bazooka had to come out. But now the problem is not just about the risk-free rate which has been driven down to historically low levels. The problem now is risk premia. When you buy Gilts you get some extra effect on risk premia as portfolios are rebalanced — this may be happening at the margin, but the eurozone crisis is adding another level to it. This is why I think it is entirely reasonable now to target more directly risk premia.

The FLS seems to be a reasonable way to start this process, because it is a recognition that bank funding costs are completely unrepresentative of true credit risk. CDS spreads are not reflective of rational investor behaviour; they’re driven by fear of disaster.

The FLS should have been introduced a year ago, when it became clear that this euro mess was going to be here for a long time. I think it will prove to be a fairly powerful tool. But maybe we’ll have to go down even more extreme routes in order to repair the transmission mechanism and address the issue of risk premia. That could involve helicopter drops or public investment with printed money; it could involve buying houses or buying offices with printed money.

There is a long list of things we could try if we continue along this path for a year or two. The FLS is a good first step in that direction. The Fed is interested in it, so it wouldn’t surprise me if we see the Fed starting to talk about active measures to bring down risk premia in the banking sector.

EUROWEEK: Is it too early to judge what impact the FLS is having?

Walker, RBS: FLS launched at the beginning of August so we won’t get any hard data on it until after the November Inflation Report. There’s quite a big lag with the stats. We may get some glimpse of how it’s going from the next BBA and CML numbers.

I think we’ll see less of an impact on the household space, because households are still up to their ears in debt. So from the point of view of kick-starting economic growth it’s more about getting cashflow funding through to the SME sector.

Foley, Lloyds: The SME sector is clearly critical. That’s where we’ll see whether or not FLS works. In the household sector it’s not just the levels of indebtedness; there is a problem in the housing market which is making it very difficult for first-time movers as opposed to first-time buyers. Many are sitting on negative equity because they bought at a 90% LTV five years ago and the price has fallen by 30% since then. So the whole housing market is stuck and whatever banks do in the mortgage market isn’t going to make a massive difference.

But in the SME sector it certainly could make a difference. At Lloyds, we’ve just cut our loan rates to the SME sector as a result of FLS. So it will be interesting to see what impact this has on lending growth. As Jamie said earlier, this will help us to determine whether we have a demand or a supply problem.

Walker, RBS: I can see how the FLS could provide a kind of life-support mechanism for the SME sector. But until you get the larger corporates spending and investing, creating a trickledown of demand, we’re not going to see a sustainable recovery. FLS may help to keep companies alive, which is positive. But for me, everything in terms of the macro recovery story comes back to the issue of when the larger corporates start investing. Until that happens, we’ll be stuck in a sub-1% GDP growth rut.

Dannhauser, Lombard Street: This brings us back to Europe, which seems to me to be the biggest threat. This is why the government will increasingly go down the infrastructure route. The consumer won’t be the driver of demand for obvious reasons. The SME sector is waiting for a return of confidence among the larger companies. And the bigger firms themselves are worried about what’s happening in the eurozone.

At the same time China and other emerging markets are slowing. The last source of demand may well be the government. And if the government is squeamish about debt levels there are plenty of monetary means of addressing the issue. If there are concerns about ending Plan A there are ways of getting around the problem from a presentational perspective. It doesn’t need to mean going on a spending binge; it can just involve identifying some projects which are self-financing. You can pay for them upfront with printed money that can be recouped over time.

I struggle to see where demand will come from if this euro mess continues. I’m not very confident that we’re going to have a resolution of any great magnitude in the next year or two. Unless we can resolve the euro mess somehow, it’s hard to see the UK or any other country returning to any healthy recovery.

I’ve been saying to our clients for a while that what Britain does is relatively irrelevant. I don’t think we can change our destiny a huge amount. We can tinker at the margin but by and large Britain’s fate is intertwined with Europe’s. If there’s no recovery in market sentiment or the real economy in Europe there’s not much Britain can do.

EUROWEEK: This brings us on to the broader question of Britain’s role within Europe. How would the UK be impacted by a complete blow-up of the euro and a disorderly Greek exit?

Foley, Lloyds: Mervyn King has famously said it is unquantifiable, but at the same time the regulators have been asking banks like us to quantify it.

If you look at the direct trade effect, it doesn’t look that bad. But the big unknown is, what happens to confidence? Not only business confidence but confidence in international financial markets, and how much spreads widen. Your guess is as good as mine about the impact it has, but it could be very big. It could mean we have a true double-dip where the second dip is as bad as the first. But our problems would probably look quite mild compared with those inside the eurozone, including Germany.

EUROWEEK: Would it even enhance the safe haven credentials of the Gilt market?

Foley, Lloyds: It probably would — unless as we were saying earlier, investors worry that the UK is going to be stuck in a low growth environment for many years as a result of the damage done to the economy.

Walker, RBS: I’m rather more pessimistic about the impact on the trade channel. As GDP forecasts have been revised down in the last 12-18 months, exports have taken the biggest hit because of EU demand. This has impacted business investment, which is a less tangible, confidence-related issue.

But the biggest issue is still the exposure of the banking sector to the eurozone and the domino effect created as result. This is where there is a risk of a Lehman re-run.

The UK banking exposure — Ireland aside — is mainly to France and Germany. There isn’t a big Italian or Spanish exposure but the linkages from those countries into the banking networks of core Europe are enormous. So just as we saw the financial crisis resurfacing in the second half of last year, and confidence being obliterated in the corporate sector, we could see another much bigger political risk emerge in the form of the need for another bail-out in the banking sector. Politically it would be a nightmare to have to explain why this has happened again.

EUROWEEK: What would the impact of European banking union be on the UK? Some people have suggested that it could lead to the UK leaving the EU.

Foley, Lloyds: I don’t really see why that should happen. But it would isolate the UK a little more from Europe in a trading and settlement sense.

I guess the issue for UK banks is how much are the rules on banking in Europe going to impact them? To me, it’s not clear what impact that is going to have at the moment. It will be very important for banks that have a lot of business in continental Europe.

So we’re concerned about it, but if it helps sort out the eurozone problem then it must be a good thing.

Dannhauser, Lombard Street: This isn’t my area of expertise, but it has always puzzled me how Britain responds — if banking union is an EU project, how does Britain stay out of it, and if it’s a eurozone initiative what is Britain’s role in it?

An interesting political sideshow for Britain now is our role in the EU. If the ultimate resolution of this euro mess is effectively a federal eurozone government and increased integration of regulation and taxation at a eurozone level, where does Britain stand? Does it accelerate a move towards a referendum which at the moment could only have one outcome given the febrile state of the British electorate on this issue?

So I think there are quite big risks to us as a nation regarding our relationship with the EU and the possibility of things like banking union accelerating our exit. It feels to me that the majority of British voters would happily walk out of the EU if they felt that big issues such as banking regulation were being moved to a centralised authority in Europe.

Walker, RBS: Within the political sphere the parameters of the debate have changed. During the Thatcher government or the Major government, which were both mildly eurosceptic, the British approach was always to try and rein in the integrationist tendency a little. The Conservative side of the coalition is more explicit about saying that monetary union clearly requires fiscal union and more integration. Therefore if you don’t have political union alongside it, there would be no popular legitimacy for it.

I suspect there is a bigger EU integration treaty coming up, because something will have to be put in place to create a more robust fiscal framework. And it’s very hard even to see a Labour government, which would naturally be more pro-European, being able to sign up to that. Certainly you wouldn’t get the British public to vote for it in a referendum. It could conceivably be an issue in the next Parliament, but not in this one.

EUROWEEK: Going back to banking, we haven’t yet mentioned the Independent Commission on Banking’s report and what impact that may have on the credit demand-supply dynamic and therefore on the wider economy.

Foley, Lloyds: I think the ICB process has been very healthy. As a mainly retail commercial bank we have always felt that having a clear delineation between those kinds of banks and those that are very active in investment banking is probably sensible.

So we were very comfortable with the outcome. We have already said publically that we intend to implement ring-fencing sooner than required by the government’s timetable.

I don’t think it’s going to have a massive impact in the short term, either positive or negative, on credit supply. But over the much longer term perhaps it will have a positive impact if it means that the retail parts of banks end up with a better risk funding position and therefore improved and cheaper access to wholesale funding opportunities.

Ring-fencing basically prevents what was going on in the past which was the cross-subsidising of investment banking activities by the retail banking activities of universal banks. If that cross-subsidy goes away it would be to the benefit of the retail banking business of universal banks.

Dannhauser, Lombard Street: My concern has been that a number of traditional retail banks failed in the recent crisis. Look at HBOS, which was a retail bank that went on a ridiculous lending spree.

The ICB has some good proposals and some possibly not so good ones. We’re always going to have financial crises. The aim needs to be to reduce their costs when they happen. Is it a credible promise to say we will never bail-out any part of the system? Running up to 2007 many parts of the system that we did not think were very important turned out to be extremely important bits of the plumbing. So my worry is that we will never be able to segregate those parts of banks into entities that should function as heavily-regulated utilities and be bailed out, and those that operate as casinos and should never be bailed out.

I don’t think we’ll ever be able to make that separation because financial innovation will always create entities that are critical parts of the plumbing.

Foley, Lloyds: I don’t believe what you describe as utilities should ever be bailed out. Any bank should be allowed to fail in the sense of shareholders being wiped out but depositors protected. That’s the essence of what the ICB is recommending, because it’s not just ring-fencing. It’s higher levels of loss-absorbing capital, bail-in and so on. The objective is that the taxpayer should never have to bail out any bank in the future.

Dannhauser, Lombard Street: If you look at clearing counterparties, regulators aren’t paying enough attention to them but they are becoming increasingly important in the way we run our banking system. My concern is that we’ve spent a lot of time over the last five years worrying about the banks, and that in 10 years’ time banks will look quite different to how they look today. We’re always fighting yesterday’s battle, and investors and regulators need to be a lot more forward-thinking in terms of identifying what may be the seeds of the next crisis in a decade’s time.

I worry that Basel III and the ICB aren’t looking at the likely systemic crises of the future. I think the broad focus of regulation is right in that leverage needs to come down and funding strategies need to be put on a more solid footing. But I do worry about the pace at which it is happening, given the wider global economic climate.

EUROWEEK: The Vince Cable school of thought seems to be that the UK has always been too dependent on financial services anyway and that we need to see a rebalancing towards manufacturing. Is that realistic or desirable?

Walker, RBS: No. I don’t accept that premise at all. The notion that the financial sector was too big does not stand up to any scrutiny. It still has a marginally smaller share of output than manufacturing.

It’s certainly true that banks’ balance sheets got too big but that is a separate problem. As Jamie and Patrick were both saying, there was too much leverage in the system, but you can deal with that in a number of ways.

The big worry I have with this rebalancing argument, when it is expressed by saying we need more output and employment in manufacturing and less in banking, is that we could see manufacturing’s increase as a percentage of GDP rise by 1% or 2% in the next decade. But we won’t see a commensurate rise in employment growth. By definition, any extra output generated by manufacturing will be even more capital-intensive and much of the labour will still be done offshore.

I think what the economy needs in terms of rebalancing is more wealth creators. It has been far too easy to kick the banks. We risk some serious policy errors if we channel tax breaks or subsidies or incentives into one part of the economy and overly onerous regulation into another.

Foley, Lloyds: I agree. It is always presented as financial services versus manufacturing. But there is a bit in the middle which is much bigger than either of them, which is the rest of the service sector. The LSE has done some interesting research on what drove productivity growth in the UK in the 10 years before the crisis — and indeed through the crisis — and it was areas such as business services and distribution rather than financial services or manufacturing.

Business services is also a massively important sector for the UK’s exports. So we should not be preoccupied by the idea that if it’s not financial services it must be manufacturing, and that somehow we need to shrink the City so that manufacturing can become larger.

Dannhauser, Lombard Street: How far do we really need to rebalance? I would argue that the big problem is the government sector. Public spending has too high a share of GDP. If you look at consumer spending as a percentage of GDP it was flat pre-crisis.

To me, we need to think about tradables in general. Anything that Britain can sell overseas ought to be good enough. If we’re trying to forcibly shove a load of resources into manufacturing in order to make something tangible, that to me is industrial policy, it’s picking winners. It’s fairly clear that Britain is one of the world leaders in non-financial tradable services.

I do think it’s tragic that we’re butchering our financial services sector. But we live in a political world; and in a political world the banks are a soft and easy target. Massacring our financial sector will be very costly for Britain in the long run. To be entirely blunt, if the rest of the world wants to buy services that some people don’t consider to be socially useful, who are we to argue?

As long as we’re playing by globally recognised free trade standards and we’re selling products that others want, it seems mad to try and destroy a sector that generates so much export income. But politicians want to win votes and the British public is very angry.

Walker, RBS: I’m concerned about the extent to which Germany is held up as the example to follow in this debate. Germany is not the norm in the sense that it has a significantly bigger share of its output accounted for by manufacturing than most other economies. It’s unusual in that its exports as a share of world trade have been flat while most other countries have seen significant declines. So Germany is the exception. I’m not convinced that you can just transfer that model to the UK.

EUROWEEK: The Bank of England has come under an extraordinary amount of criticism for the way it handled the crisis, and there has been a lot of discussion about governance of the Bank of England. Can anybody comment on the need for change at the Bank and what impact this might have on the UK economy?

Dannhauser, Lombard Street: I don’t think the period from mid-2007 to mid-2008 was the Bank’s finest hour. But I think the Bank’s performance since the Lehman crisis has been pretty good, and that history will look back favourably at the way the Bank handled this mess.

I think Mervyn King has generally done a pretty good job. He responded to the severity of the economic crisis well, and I’m always impressed by the Bank’s focus on the big picture. The Bank has been focused on where Britain will be, not in the next two or three years but in 10 or 20.

I don’t agree with the Bank’s stance on regulation because I think it is hugely underestimating the costs of moving as rapidly as it is. I don’t think the Governor’s aggressive tone towards the banking sector is helpful.

I’m also slightly concerned about how the MPC and the FPC will work together. There is the potential for problems arising from how one responds to the other. Perhaps one will need to be subordinated to the other. There may be a lack of communication between the two even though there will be people sitting on both committees.

The governance structure of the Bank needs to improve, given the remarkable amount of power that the bank will be vested with. I think the Bank should always have been the focal point of banking regulation, but there is a question mark about oversight of the Bank and of the Governor in particular, given how many distributional decisions the Bank will be making. This ultimately raises fiscal questions, which means there has to be tighter oversight.

So I do have concerns, but I think the arrangements we’re moving towards are much better than they were between 1998 and 2007.

Foley, Lloyds: The problem between 1998 and 2007 was that through no fault of its own the Bank of England had been given a different mandate which was to hit a 2% inflation target and not to worry about anything else. The Bank did a pretty good job of hitting that target. It’s interesting today when you look back at some of the MPC minutes in 2005 and 2006, they were worried about the rate of growth in house prices and credit, but in some cases in spite of these worries they cut rates because they were worried they were going to undershoot in terms of their inflation target. But the Bank delivered on what it was asked to do.

The powers that have been given back to the Bank of England are those that have traditionally been held by central banks — which means not just worrying about inflation but about the health of the financial system.

The unknown is: have these powers been concentrated in the hands of these two committees in a way that may make it quite difficult for the Bank of England to meet financial stability and inflation goals? We don’t yet know the answer to that.

Walker, RBS: The current regulatory structure is almost addressing the previous crisis. It’s the same with the monetary and macro policy levers. We had inflation problems which we tried to solve for decades using monetary policy and exchange rate management.

While it fixed one problem it also sowed the seeds for the boom. Sometimes I think the Bank is too defensive about the extent to which the CPI regime or the RPIX regime and the way they interpreted it may have fuelled the credit boom. If you keep rates too low for too long you will encourage people to borrow lots of money. That wasn’t the whole story, but it was part of it. So it should be part of the discussion about what went wrong in the middle of the noughties.

I think the Bank needs more policy discretion. I’m sceptical about there being a single target for inflation. Even the Bundesbank has been allowed to deviate away from its ultra-orthodox money supply-targeting mandate. It was able to do so because it had stored up so much credibility. I think that by the mid-noughties the Bank of England had built up sufficient credibility to be given more policy discretion.

Dannhauser, Lombard Street: On the inflation-targeting debate, when Mervyn goes it will be interesting to see if the Bank finally accepts that inflation-targeting was part of the problem. There is a very strong case for moving towards a much broader interpretation of nominal stability in the economy. There are plenty of other possibilities out there — I personally like the idea of a nominal GDP target.

But it seems to me that we may have a problem if we have a MPC with one nominal target, called CPI, and an FPC with separate nominal targets on things like leverage in the banking system.

EUROWEEK: Just to wrap up, are Gilts fit for purpose?

Walker, RBS: I’d still be a buyer of Gilts. I think the focus should still be on return of capital rather than return on capital. We’re not going to get a hard default and I don’t think we’ll see a soft default either. The bigger challenge for the Gilt market and for monetary policy will be how you withdraw the stimulus in an orderly way, but that will only happen when we have sustainable growth. So Gilts aren’t a safe haven in any absolute sense but in relative terms they are. The UK fiscal fundamentals, awful as they may be, are still better than those of the US, and we have far more flexibility to finance our structural deficit than countries in the eurozone.

  • 26 Sep 2012

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 17 Oct 2016
1 JPMorgan 310,048.18 1328 8.75%
2 Citi 285,934.48 1059 8.07%
3 Barclays 258,057.88 833 7.29%
4 Bank of America Merrill Lynch 248,459.06 911 7.01%
5 HSBC 218,245.86 884 6.16%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Oct 2016
1 JPMorgan 29,669.98 55 6.95%
2 UniCredit 28,692.62 136 6.73%
3 BNP Paribas 28,431.90 139 6.66%
4 HSBC 22,935.49 112 5.38%
5 ING 18,645.88 118 4.37%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 18 Oct 2016
1 JPMorgan 14,593.71 79 10.38%
2 Goldman Sachs 11,713.19 63 8.33%
3 Morgan Stanley 9,435.23 48 6.71%
4 Bank of America Merrill Lynch 9,019.27 40 6.41%
5 UBS 8,763.73 42 6.23%