<![CDATA[Bruegel - Latest Updates]]> http://www.bruegel.org Tue, 02 Sep 2014 16:05:00 +0100 http://www.bruegel.org/fileadmin/images/bruegel-logo.png <![CDATA[Bruegel - Latest Updates]]> http://www.bruegel.org Zend_Feed http://blogs.law.harvard.edu/tech/rss <![CDATA[Blogs review: The bond market conundrum redux]]> http://www.bruegel.org/nc/blog/detail/article/1424-blogs-review-the-bond-market-conundrum-redux/ blog1424

What’s at stake: Fed tapering was widely expected to push up US yields. Instead, US yields have fallen since the beginning of the year, raising the question of whether we’re seeing a new version of the Greenspan 2005 conundrum. Interestingly, a successful explanation of this new conundrum cannot just rely on a flight to safety explanation as it also needs to rationalize why 5-year yield and 10-year yield have diverged over the same period.

Tapering and interest rates

Jeff Sommer writes that yields have been falling with embarrassing consistency in 2014 despite forecasts to the contrary from most Wall Street analysts at the beginning of the year. David Beckworth writes that the Fed has been tightening monetary policy with its tapering of QE3 and yet the benchmark 10-year treasury interest rate has been falling since the beginning of 2014. Marc to Market writes that moreover, the US market rally has taken place amid a tick up in both core and headline measure of consumer prices.

Source: Dealbook

James Hamilton writes that as the U.S. economy returns to healthier growth, many of us expected long-term interest rates to return to more normal historical levels. But the general trend has been down since the end of the Great Recession. The 10-year rate did jump back up in the spring of 2013. But during most of this year it has been falling again.

In his famous 2005 testimony before Congress, Alan Greenspan noted that long-term interest rates [had] trended lower in recent months even as the Federal Reserve [had] raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. Calculated Risk writes that Mr. Greenspan is referring to the expectations theory of interest rates were long rates are the geometric average of expected future short rates plus a risk premium that would usually increase with duration of the instrument. This theory assumes that arbitrage between instruments of different durations will set the price. 

David Beckworth uses a decomposition of the long term interest rate into an average expected real short-term interest rate, average expected inflation and a term premium to argue that it’s the term premium has been steadily falling.

The divergence of 5-year and 10-year yields

James Hamilton writes that interestingly while the return on a 10-year Treasury has been falling for most of this year, the 5-year yield has held fairly steady. If investors are risk neutral, the drop in the forward rate during 2014 indicates that something happened this year to persuade people that rates in the future (for 5 to 10 years from now) were going to be lower than they had been expecting.

Robin Harding and Michael Mackenzie write that this is unprecedented: no other global shock going back to the 1960s has ever caused US 5 and 10-year yields to diverge like this.

Note: US 5y10y yield correlation; Source: @RobinBHarding

James Hamilton writes that it’s hard to attribute it to changing perceptions about the Fed, which should surely matter more for the next 5 years than they would for 5 to 10 years from now. More confidence that the U.S. government will be able to keep debt from growing relative to GDP over the next decade may have played a role. Another possibility is that more people are starting to take seriously the suggestion that we’re on a path now of secular stagnation with weak economic growth and poor investment opportunities over the next decade. But that’s hard to reconcile with the stock market, which climbed impressively this year.

Tue, 02 Sep 2014 06:52:56 +0100
<![CDATA[Is Europe saving away its future?]]> http://www.bruegel.org/nc/blog/detail/article/1423-is-europe-saving-away-its-future/ blog1423

This article was published by Vox.

The Crisis affected public spending. Research and innovation is one area often highlighted as needing protection. This column does not find strong evidence that European countries sacrificed research and innovation more than other government expenditure. However, there is strong heterogeneity across countries. Innovation lagging and fiscally weak countries cut R&I spending while innovation-leading forged it ahead. Research of this divide and long-term growth is still limited.

Trends in public R&I budgets in EU countries during the crisis

The dangerous cocktail in many European countries of high debt and subdued growth calls for smart fiscal consolidation. Cost-cutting programmes should minimise the potentially negative short-term effect on economic activity, while establishing a foundation for long-term growth, with growth-enhancing public expenditure safeguarded from cuts, or even increased (Teulings 2012).

An area often highlighted as needing protection in the context of shrinking overall public budgets is Research and Innovation. To examine how public expenditure on R&I fared in Europe during the crisis (i.e. since 2007), in Veugelers (2014) we look at the GBAORD (government budget appropriations or outlays for research and development) data.1

On average, there is no strong evidence that EU countries sacrificed their R&I budgets more than other government expenditure during the crisis. However, while R&I investments were part of the stimulus packages at the onset of the crisis, more recently, R&I spending has started to trend downwards.

Figure 1. Trend in government expenditures on R&D in the EU 2007-2012 (GBOARD)

Source: Veugelers (2014) on the basis of Eurostat and Ameco.

The average EU trend masks, however, an increasing divide among EU countries.   To further explore this country heterogeneity, we distinguish innovation leaders (Denmark, Finland, Germany, Sweden, and the UK), innovation followers (Austria, France, Ireland, Luxembourg, and the Netherlands) versus the rest (innovation laggards).2 We also distinguish high fiscal consolidationcountries (Bulgaria, Cyprus, the Czech Republic, Estonia, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Poland, Portugal, Romania, Slovakia, and Spain) versus the rest (low fiscal consolidation).3

Figure 1 shows that innovation leaders increased public expenditure on R&I during the crisis by more than their increase in other public expenditure.4 Innovation followers reduced their public R&I expenditure more than other categories of public expenditure.5 Innovation laggards – including Italy and Spain – substantially cut public R&I expenditure, even more so than other parts of their budgets, resulting in a considerable drop in the share of R&I in public expenditure, which was already below the EU average. Most innovation laggards, perhaps not by coincidence, are also under greater fiscal consolidation pressure. Countries under high fiscal consolidation pressure have significantly cut their public R&I expenditure.6,7  

  • The crisis seems therefore to have widened the gap in public R&I expenditure between EU countries.

Public budgetary support for business R&I includes direct support through grants but also indirect support – predominantly through tax incentives. This indirect support is not visible in the GBAORD data. Tax incentives have become the main channel of government support for business R&I in countries such as Belgium, France, Ireland, and the Netherlands. In all of these countries, use of tax credits increased much faster than grants during the crisis.8

The increasing shift towards tax credits during the crisis is unsurprising given that tax credits for R&I are an easier-to-use instrument in times of fiscal consolidation. However, there is no strong evidence that tax credits are a more effective instrument for boosting private R&I compared to grants (see Veugelers 2014 for more on this).

European Commission policy on public R&I in a time of fiscal consolidation

How has the EU treated public R&I during the crisis, both through its own EU budget (structural funds and research funds), and its monitoring of member state R&I budgets and policies through the European Semester?

EU own R&I budget spending

The major sources of EU R&I funding are the structural funds (from 2007-13, about a quarter of structural funds went to R&I) and the Framework Programme research funding/Horizon 2020. This funding complements member states’ own public investment in R&I. In some countries, structural funds for research and innovation are of the same magnitude as national R&I budgets.9

Figure 2. EU research and innovation funds and Innovation Union scoring

Note: EU funds are both the structural RTDI funds (left panel) as well as the FP7 funds (right panel). Latvia is excluded as an extreme outlier in the left panel
Source: Bruegel calculations on the basis of IUC 2007, Eurostat and AMECO.

The EU budget serves as mechanism to somewhat ease the growing public R&I divide in Europe. EU funds are relatively more significant for innovation-lagging countries with low national R&I budgets. Figure 2 illustrates clearly the negative relationship between EU funds as a share of national R&I spending and countries’ innovation scores. This is particularly evident for the structural funds. But it also holds, albeit to a lesser degree, for research funds allocated through FP7 excellence-based competitions.

EU funding in countries with declining R&I spends is likely to become even more important in future. With Horizon 2020, EU funding for R&I will amount to €80 billion, an increase of 30% compared to its predecessor (2007-13).10 In addition, a greater share of the structural funds is earmarked to be spent on Europe 2020 challenges during 2014-20 – from 50 to 80%.

Country-specific recommendations for R&I in the European Semester

The European Commission monitors the progress of member states towards their own R&I targets in pursuit of the Europe 2020 goals through the European Semester. An analysis of the Commission's latest country-specific recommendations (Veugelers 2014) shows that recommendations related to R&I are patchy. The recommendations are not supported by the systematic use of evaluation tools to assess the impact on long-term growth.

The ‘investment clause’ use for public R&I budgets

A further means by which the Commission could promote R&I investment during crisis as part of smart fiscal consolidation is through the so-called ‘investment clause’. This allows member states that are in deep recession but that have budget deficits below the 3% of GDP threshold and that respect the public debt reduction rule, to temporarily deviate from the fiscal targets of the Stability and Growth Pact (SGP), to the extent of their national co-funding of EU-funded investments. The Commission proposed this in summer 2013 in response to the request of the European Council (2013). The investment clause, which extends beyond R&I, has however so far not been activated (Barbiero and Darvas 2014).

Are EU public R&I budgets being consolidated smartly?

The critical question that still needs to be addressed is whether the diverging trends on public R&I are good or bad news. Are the cuts in the weaker countries evidence of smart use of public R&I investment, i.e. were they effective in supporting recovery and growth and in eliminating inefficiently spent public resources? Or have the public R&I cuts been too aggressive, jeopardising long-term growth? Is the Commission right to not allow members states in weak fiscal positions, which also happen to be weak innovators, to shelter their public R&D budgets from fiscal exigencies? Or should the Commission be more lenient and exercise the investment clause option?

Answering these questions requires an assessment of the long-term impact of public R&D on growth with the appropriate methodologies to evaluate causal effects.11  Although the number of studies evaluating public R&I programmes have grown substantially, they are still grappling with the causal link between public intervention and its impact on growth, and establishing proper counterfactuals to assess what the outcome would have been for the beneficiaries had they not received the support. In addition, most evaluation studies only look at the immediate impact of public support on private research and development and innovation, checking whether it crowds out or generates additional private investment (the so- called ‘additionality’). There are few assessment exercises that pin down the longer-term social returns and growth impact of R&I, which is the impact that matters for smart fiscal consolidation. Assessing social returns and the growth impact is a much more complex exercise requiring an integration of micro-additionality exercises into macro-growth-models.12 Such an integrated approach will allow an assessment of the complementary framework conditions needed to realise the growth dividend from public R&I and when needed, to identify which structural reforms (in product markets, labour markets, financial markets) are needed to generate innovation-based endogenous growth. An advantage of deploying integrated macro-models at the EU level compared to a country-by-country approach is that the EU scale allows assessment of the cross-country spillovers from national R&I policies.13

Only when member states’ public R&I plans are properly assessed for their growth impact in an integrated framework, will we be able to conclude if the growing EU public R&I divide is a good or a bad trend.

LEGAL NOTICE: The research leading to these results has received funding from the Socio-economic Sciences and Humanities Programme of the European Union's Seventh Framework Programme (FP7/2007-2013) under grant agreement no. 290597. The views expressed in this publication are the sole responsibility of the authors and do not necessarily reflect the views of the European Commission.


Barbiero, F and Dalvas, Z (2014) “In sickness and in health: protecting and supporting public investment in Europe”, Bruegel Policy Contribution, Brussels.

Teulings C (2012), “Fiscal consolidation and reforms: Substitutes, not complements”, VoxEU.org, 13 September

Veugelers, R (2014), “Undercutting the future? European research spending in times of fiscal consolidation”, Bruegel Policy Contribution 2014/06, Bruegel, Brussels.   

Veugelers R (2014), “Public R&I budgets for smart fiscal consolidation”, SIMPATIC working paper, presented at the second annual SIMPATIC conference, The Hague, April 2-4, 2014, available at http://www.simpatic.eu


1Source: Eurostat. An alternative source to look at is the government financed part of GERD (Gross Expenditures of R&D) (Source: OECD). Both series have their strengths and weaknesses. GBAORD covers budgeted items, while GERD covers actual expenditures. GBAORD allows direct comparison with the other budgeted items. GBAORD data is more recently available compared to GERD.  Trend results are similar when using GERD rather than GBAORD (see Veugelers 2014).

2This classification is based on the European Commission's Innovation Union Scoreboard indicator for innovative performance pre-crisis (2007); countries are classified according to whether they are well above, around, or below the EU average score. Source: EU Innovation Union Competitiveness Report 2007.

3This classification is based on their budgetary consolidation position: countries with an above-median cumulative change in their structural primary balance since the year in which consolidation started (the year with the lowest negative structural primary balance in the period 2008-10). Source: EUROSTAT and AMECO.  Also included in the high fiscal consolidation group are the Economic Adjustment Programme countries.

4Among the leading innovators, Sweden, Germany and Denmark increased their public R&I budgets even more than other government spending. In Finland, the increase has remained flat since 2011. The UK began to cut its public R&I budgets already in the early years of the crisis, and more deeply than its overall public expenditure.

5Among the innovation followers, Austria has increased its public R&I budget substantially, by more than its overall public budget. France has increased its public R&I budget on average, but not consistently. In the Netherlands, there was a decline in the R&I share of the public budget.

6Among the innovation laggards, Estonia was under high financial consolidation pressure but has nevertheless continued to expand its R&I budget so substantially that it now the EU's highest public R&I spender, in relative terms.

7Spain cut its public R&I budget substantially, by even more than its overall public budget, driving the R&I share of its overall budget down to 1.25% in 2012 from 1.95% in 2007. Italy has seen similar substantial cuts in public R&I spending, reducing the share of R&I in its public budget to an historic low (1.1% in 2012). Greece also had to cut its R&I budgets mostly in line with its overall budgetary cuts, but these cuts have deepened, reducing the share of R&I in Greece's overall budget from an already-low share (0.7% in 2012). By contrast, Portugal has expanded its public R&I budget and has only made cuts in recent years.

8Other countries, including Estonia, Finland, Germany, and Italy, have no substantial R&I tax incentives. The use of tax credits, therefore, seems to mark another divide in Europe – some countries are heavy and increasing users, while others continue to refrain from using the instrument.

9This is the case for Estonia, Hungary, Lithuania, Poland, and Slovakia. In Latvia, structural fund allocations even triple the public R&I budget. But also in Portugal, structural funds represent 31% of total public R&I. In Greece, structural funds support for public R&I represents 40%. A low implementation rate brings the actual share in Greece down to 21%. Lacking resources for co-funding may imply that not all of the allocated budget can be implemented.

10The share of R&I in the total EU budget is now about 8% much higher than the share of R&I spend in member state budgets (1.4% in 2012).

11The impact and hence justification for public funding of science and innovation goes beyond its economic effects on GDP growth; it also encompasses societal challenges, such as health and a clean environment. Here we look at a more narrow question, namely the justification for public R&I budgets as areas of smart fiscal consolidation, which is why the discussion concentrates on the growth-enhancing impact of public R&I.

12The EU-FP7 funded SIMPATIC project aims to contribute to micro- assessment of the causal impact of R&D grants and tax credits, by assessing the net private and social rates of return using structural modelling and integrating this micro-assessment into an endogeneous R&D macro model to assess the long-term impact on growth and jobs. For more on SIMPATIC, see www.SIMPATIC.eu

13If Italy spends less public money on R&I, does this increase the supply of R&I employees in the UK? If the UK introduces a patent box scheme, should France follow? How much could be gained from coordinating member states R&I tax credits, in order to avoid the negative effects of R&I tax competition?  How much does Greece benefit from increased German R&I spent?

Mon, 01 Sep 2014 08:46:03 +0100
<![CDATA[EU at a Crossroads]]> http://www.bruegel.org/nc/events/event-detail/event/457-eu-at-a-crossroads/ even457

We are pleased to announce that Italian Finance Minister Pier Carlo Padoan is coming to Bruegel to talk about the economic choices ahead for Europe.

High unemployment, low private and public investment and rising social inequalities mark the current stagnation of European economy. Despite the joint effort of Member States, the recovery is still fragile and it calls for strong action to foster growth and jobs. The EU is therefore at a crossroads, where it has to review its policy mix both at EU and country level.


  • Introduction by Guntram Wolff, Director of Bruegel
  • Keynote by Pier Carlo Padoan, Italian Minister of Finance
  • Moderated by Tom Nuttall, The Economist

The keynote will be followed by a commentary by the moderator and a lively discussion with the audience.

Practical details

  • Venue: Bruegel, Rue de la Charité 33, 1210 Brussels
  • Time: Monday 13 October, 12.45-14:30. Lunch will be served at 12.45 after which the event begins at 13.00
  • Contact: Matilda Sevón, Events Manager - registrations@bruegel.org

Fri, 29 Aug 2014 15:45:00 +0100
<![CDATA[Improving the role of equity crowdfunding in Europe's capital markets]]> http://www.bruegel.org/publications/publication-detail/publication/844-improving-the-role-of-equity-crowdfunding-in-europes-capital-markets/ publ844


Crowdfunding is a growing phenomenon that encompasses several different models of financing for business or other ventures. Despite the hype, equity crowdfunding is still the smallest part of the crowdfunding market. Because of its legal framework, Europe has been at the forefront of equity crowdfunding market development.

Equity crowdfunding is more complex than other forms of crowdfunding and requires proper checks and balances if it is to provide a viable channel for financial intermediation in the seed and early-stage market in Europe. It is important to explore this new channel of funding for young and innovative firms given the critical role these start-ups can play job creation and economic growth in Europe.

We assess the potential role of equity crowdfunding in the overall seed and early-stage financing market and highlight the potential risks of equity crowdfunding. We describe the current state of play in this nascent industry, considering both the innovations introduced by market operators and existing regulation. Currently in Europe there is a patchwork of national legal frameworks related to equity crowdfunding and this should be addressed in a harmonised way.


Crowdfunding is increasingly attracting attention, most recently for its potential to provide equity funding to start-ups. Providing funding to young and innovative firms is particularly relevant given their importance for job creation and economic growth (OECD, 2013; Haltiwangner et al, 2011; Stangler and Litan, 2009). In addition, at a time when banking intermediation is under pressure (Sapir and Wolff, 2013), it is important for European Union policymakers to further explore alternative forms of financial intermediation. But questions remain about the appropriateness of crowdfunding for providing seed and early stage equity finance to new ventures and how this market could be developed and regulated.

While there is growing hype around crowdfunding, there are also many wrong perceptions. The bulk of crowdfunding is for philanthropic projects (in the form of donations), consumer products often for creative ventures such as music and film (in the form of pre-funding orders) and lending. Equity crowdfunding, sometimes called crowdinvesting is relatively new and currently comprises the smallest part of the crowdfunding market. However, it is currently more active in Europe than in other regions.

Growth of crowdfunding

Crowdfunding can be defined as the collection of funds, usually through a web platform, from a large pool of backers to fund an initiative. Two fundamental elements underpin this model and both have been enabled by the development of the internet. First, by substantially reducing transaction costs, the internet makes it possible to collect small sums from a large pool of funders: the crowd. The aggregation of many small contributions can result in considerable amounts of capital. Second, the internet makes it possible to directly connect funders with those seeking funding, without an active intermediary. Crowdfunding platforms assume the role of facilitators of the match.

While people tend to talk about crowdfunding in general, the crowdfunding phenomenon encompasses quite heterogeneous financing models. There are four main types:

  • Donation-based, in which funders donate to causes that they want to support with no expected compensation (ie philanthropic or sponsorship-based incentive).
  • Reward-based, in which funders’ objective for funding is to gain a non-financial reward such as a token gift or a product, such as a first edition release.
  • Lending-based (crowd lending), in which funders receive fixed periodic income and expect repayment of the original principal investment.
  • Equity-based (usually defined as crowdinvesting), in which funders receive compensation in the form of fundraiser’s equity-based revenue or profit-share arrangements. In other words, the entrepreneur decides how much money he or she would like to raise in exchange for a percentage of equity and each crowdfunder receives a pro-rata share (usually ordinary shares) of the company depending on the fraction of the target amount they decide to commit. For example, if a start-up is trying to raise €50,000 in exchange for 20 percent of its equity and each crowdfunder provides €500 (1 percent of €50,000), the crowdfunder will receive 0.20 percent (1 percent of 20 percent) of the company’s equity.

The four models vary in terms of complexity and level of uncertainty. The donation-based model is the simplest. Legally the transaction takes the form of a donation. The risk is that the project does not achieve its declared goals, but the backer does not expect any material or financial return from the transaction. Equity crowdfunding is the most complex. From a legal standpoint, the funder buys a stake in the company, the value of which must be estimated. Moreover, the level of uncertainty in equity crowdfunding is much greater compared to the other models because it concerns the entrepreneur’s ability to generate equity value in the company, which is extremely difficult to assess. Overall, these complexities pose problems that are distinct and more fundamental than those of the other crowdfunding models. These complexities require special attention from policymakers, as this Policy Contribution will discuss.

In general, crowdfunding is experiencing exponential growth globally. In the period 2009-13, the compound annual growth rate (CAGR) of the funding volumes was about 76 percent with an estimated total funding volume of $5.1bn in 2013. In terms of geography, the biggest market has been North America (and mostly the US where the concept of crowdfunding started) with 60 percent of the market volume, followed by Europe, which has 36 percent.

Equity crowdfunding is the smallest category of the overall industry and had a CAGR of about 50 percent from 2010 to 2012. Most of that growth was through European crowdfunding platforms because legal barriers currently prevent the development of equity crowdfunding in the US (see Box 2). As a result, Europe is currently the leading market for this financing model (see further discussion in section 4).

While in Europe equity crowdfunding is growing, the understanding of its risks and opportunities is still limited. We first assess the potential role of equity crowdfunding in the overall seed and early-stage financing market. Second, we point out the potential risks of equity crowdfunding. Third, we describe the state of this nascent industry considering both the innovations introduced by market players and existing regulation. Finally, we discuss the implications of our analysis for policy.

The seed and early-stage financing market

Equity crowdfunding is receiving attention from policymakers as a potential source of funds for start-ups, a segment of the economy that has limited access to finance. Young firms have no track record and often lack assets to be used as guarantees for bank loans. In addition, information asymmetries make it difficult for investors to identify and evaluate the potential of these firms.

Traditionally there have been three sources of equity funding for young innovative firms: founders, family and friends; angel investors; and venture capitalists.

  • The most common source of funding for new ventures is the founders’ own capital, even if that is funded through credit cards. Family and friends sometimes also provide finance to the entrepreneur in the first phases of development of the start-up (seed stage).
  • Angel investors are experienced entrepreneurs or business people that choose to invest their own funds into a new venture. They typically invest in seed and early stage ventures with amounts ranging from $25,000 to $500,000. Angels invest not only for the potential financial return, but in many cases to give back by helping other entrepreneurs.
  • Venture capital is considered ‘professional’ equity, in the form of a fund run by general partners, and aims at investments in firms in early to expansion stages. The source of capital pooled into venture capital funds is predominately institutional investors. Venture capital firms typically invest around $3m and $5m per round in a company.

The contributions of angel investors and venture capital firms are not limited to the provision of finance. They are actively involved in monitoring the companies in which they invest and often provide critical resources such as industry expertise and a valuable network of contacts (Gorman and Sahlman, 1989; Baum and Silverman, 2004; Hsu, 2004).

The importance of angel investors has increased in recent years given the difficulties young innovative firms face in securing finance from other channels (Wilson, 2011). As a result of the financial crisis, banks are even more reluctant to fund young firms because of their perceived riskiness and lack of collateral (Wilson and Silva, 2013). Meanwhile, venture capital firms are focusing more on later-stage investments and have left a significant funding gap at the seed and early stage. Angel investors, particularly those investing through groups or syndicates, are active in this investment segment and thus help to fill this increasing financing gap.

Equity crowdfunding departs from the models of traditional angel investors and venture capital firms because transactions are intermediated by an online platform. Some platforms play a more active role in screening and evaluating companies than others (see section 4). Also, their role during the investment and post-investment stages can vary dramatically. While there is a great deal of variation among the approaches adopted by the different platforms (Collins and Pierrakis, 2012), equity crowdfunding platforms generally follow the phases described in Figure 3.

Platforms usually charge companies a fee, typically 5-10 percent of the amount raised, plus sometimes a fixed up-front fee. Some platforms also charge fees to investors that are either fixed or a percentage of the amount invested or a percentage of the profit for investment. For example, Crowdcube charges entrepreneurs 5 percent plus a £1,750 fee for successful fund raising. Symbid charges entrepreneurs a €250 registration fee plus 5 percent of the amount raised and charges investors 2.5 percent of the amount invested. Seedrs charges entrepreneurs 7.5 percent of the amounts raised and charges investors 7.5 percent of the profits from the investment.

To understand how equity crowdfunding can complement the market incumbents in seed and early-stage finance, we have to consider characteristics such as investment size, investment motives, the risk/return profile, the investment model and investor characteristics.

Figure 4 shows the funding per project in equity-based crowdfunding. Compared to the other sources of finance described above, we can see that equity crowdfunding mostly operates in the financing segment covered by angel investors1.

Another characteristic that equity crowdfunding has in common with angel investors is that financial return is not the sole motive for an investment. Crowdfunders might also derive social and emotional benefits from financing a company. In other words, they are likely to be motivated to provide funding to a company to be connected with an entrepreneurial venture that shares their own values, vision or interests. A survey of Seedrs2 users revealed that the three top motivations for investors to fund start-ups are the desire to help new businesses get off the ground, the ability to exploit tax reliefs3, and the hope of achieving meaningful financial returns (Seedrs, 2013).

In terms of investment preferences, venture capitals tend to concentrate on technology-based companies, which typically are high-risk/high-return investments. Angel investors tend to invest in a wider range of sectors and geographies, covering some investment segments in which venture capital typically would not invest (Wilson, 2011). Because the crowd might encompass quite heterogeneous investment motives, the investment spectrum of equity crowdfunding can be even broader. For example, Seedrs users have invested in sectors as diverse as food and drink, high-tech, art and music, fashion and apparel, real estate and many others (Seedrs, 2014). The fact that crowdinvestors derive also non-financial benefits from the investment implies that they might also be willing to accept higher risks or lower returns than an investor seeking to maximise financial returns (Collins and Pierrakis, 2012).

Unlike venture capital and angel investment, equity crowdfunding requires entrepreneurs to publicly disclose their business idea and strategy. This early information disclosure might be harmful for firms with an innovative business model that can be easily imitated (Hemer, 2011; Agrawal et al, 2013; Hornuf and Schwienbacher, 2014a). Therefore, crowdfunding might be most beneficial for start-ups that can protect their intellectual capital through means other than secrecy, or for start-ups whose business is not particularly innovative.

Another common element shared by business angels and crowdinvestors is that neither type of financing model necessarily involves an active financial intermediary that makes the investment decisions. Venture capital firms pool financial commitments from institutional investors into funds and then select a portfolio of companies over time in which they invest. For angel investors and crowdinvestors, the decision to finance a company is ultimately made by the individual investor. Some equity crowdfunding platforms pool the funds of the crowd into an investment vehicle and act towards the company as the representative of the interests of the crowd. However, even in this case the platform does not act as a financial intermediary in portfolio management for the crowd, and the decision to invest in a specific company is taken by the individual investor.

While angel investors are typically high net worth individuals who are sophisticated investors, crowdinvestors are individuals that might or might not have experience and knowledge of financial markets and early-stage financing. Moreover, while angel investors tend to invest locally, crowdinvestors might invest in start-ups that are quite distant from them. Agrawal et al (2011) show that the average distance between a revenue-sharing crowdfunding platform's entrepreneurs and investors was approximately 3,000 miles (4,828 km). According to their study, only 13.5 percent of the investors provided funds to entrepreneurs within 50 km.

Table 1 summarises the key characteristics of equity crowdfunders, angel investors and venture capitalists, highlighting their similarities and differences.

Overall, equity crowdfunding can provide a complementary channel through which start-ups can obtain finance. In addition, equity crowdfunding can provide some advantages by fully exploiting the potential of the internet.

For example, crowdfunding allows a start-up to gain online visibility in the first phases of its development. As crowdinvestors are also potential consumers, an entrepreneur can benefit from crowdfunding through early advertisement of its products and by obtaining information on potential market demand and product preferences (Agrawal et al, 2013; Hornuf and Schwienbacher, 2014a). This early assessment of demand could help to reduce inefficient investments in start-ups with weak business potential.

Compared with traditional angel investing transactions that rely mostly on word-of-mouth, crowdfunding can improve the efficiency of the market by enabling faster and better investor-company matches. Moreover, geographical factors that might affect traditional forms of seed and early-stage financing might be less important in crowdfunding (Mollick, 2013a; Agrawal et al, 2011 and 2013).

Finally, the crowdfunding industry is well-positioned to benefit from the so-called 'big data' paradigm (Agrawal et al, 2013). Being online-based, crowdfunding deals leave data trails on investors, entrepreneurs, companies and deals, unlike angel investment and even most venture capital transactions. Through time, the analysis of this data could enable crowdfunding platforms to provide better matches between investors and companies and maximise the correlation between the crowd and product demand.

Risks in equity crowdfunding

Seed and early-stage financing can be high risk but with the hope of a high return. Eurostat data4 show that in EU the one-year survival rate for all enterprises created in 2009 was 81 percent, while the five-year survival rate of all enterprises started in 2005 was only 46 percent. Despite the expertise of professional investors, the risk of investing in start-ups remains high. Shikhar Ghosh, senior lecturer at Harvard Business School, analysed data from more than 2,000 US companies that received venture financing and found that about 30-40 percent of them fail, while more than 95 percent fail to generate the expected return on investment (WSJ, 2012). There is a misconception about success rates and returns on investment in start-ups (Shane, 2008) and the average individual is not aware of the risks.

The characteristics of crowdfunding can make investments in seed and early-stage companies even riskier. Information asymmetry problems common to seed and early-stage financing are exacerbated in equity crowdfunding. Below we describe some of the issues that might arise in each phase of the investment.

Selection and valuation

Before investing in a company, business angels and venture capitalists routinely perform due diligence to assess the potential value of the firm. This can be costly in terms of time and resources. However, evidence shows that due diligence is a major determinant in achieving returns on the investment (Wiltbanks and Boeker, 2007). This expense is often justified in light of the considerable size of such investments. Because their investments are relatively small, crowdinvestors have less incentive to perform due diligence. Moreover, individual investors have the possibility of free-riding on the investment decisions of others. This implies that the crowdfunding community may systematically underinvest in due diligence (Agrawal et al, 2013).

Crowdfunders also likely lack the expertise and skills to perform adequate due diligence. Since everyone is able to join, the crowd often includes non-professional investors, who do not have the knowledge or capabilities to properly estimate the value of a company.

Finally, company valuation performed by a crowd might be affected by social biases and herding behaviour5. Evidence suggests that a crowdfunder’s investment decision might be affected by those of the other investors (Agrawal et al, 2011; Kuppuswamy and Bayus, 2013). Moreover, different studies have found that both the crowd and entrepreneurs are typically initially overoptimistic about potential outcomes (Mollick, 2013b; Agrawal et al, 2013).


Equity crowdfunding often relies on standardised contracts that are provided by the portal. However, equity investment into seed and early-stage firms often requires tailored contracts to align the interests of the entrepreneur to those of the investor. For example, venture capital and business angels use various covenants in their contracts, such as anti-dilution provisions that protect against down-rounds6, tag-along rights7 that facilitate exit opportunities, and liquidation preferences that secure higher priority in the distribution of value (Hornuf and Schwienbacher, 2014a). Moreover, in order to reduce risk exposure and increase control over the entrepreneur’s behaviour, seed and early-stage investors often split their investments into tranches that are conditional on the attainment of defined milestones. All of these mechanisms are difficult to replicate in the crowdfunding setting.

Another strategy applied by venture capitalists and business angels is to invest in a portfolio of companies in order to diversify their risk. Equity crowdfunders might be able to replicate this strategy given that crowdfunding platforms expose them to a variety of projects. However, non-professional investors might not be aware of the importance of this strategy and could potentially concentrate all their investments in a single venture. For example, Seedrs statistics show that 41 percent of investors hold only one company in their portfolio (Seedrs, 2014).

Moreover, crowdfunders might not be able to participate in follow-on investment rounds. The failure to do so might mean that the investor’s shares get diluted, thus reducing their chances to attain a positive return from the investment.

Post-investment support and monitoring

As we have described, business angels and venture capitalists not only provide finance to start-ups, but are also actively involved in increasing the value of the company. While the crowd could potentially provide active support to the venture, there are reasons to believe that this support can be less valuable than that provided by traditional seed and early-stage financiers. Given their typical small level of investment, crowdfunders have less incentive to provide active support to the company because the return for their action is lower (Agrawal et al, 2013). However, if too many investors choose to become active, it could be excessively costly for a small firm to manage a crowd of investors that want to participate. This is particularly relevant considering that the venture has limited ability to select its crowdinvestors.

Moreover, high information asymmetry also characterises the post-investment phase, thus limiting the monitoring potential of the crowd. One of the elements contributing to the increase in information asymmetry is geographical distance between funders and the entrepreneur. While this characteristic enables backers to attain access to a wider pool of entrepreneurs (and visa-versa), it also entails higher monitoring costs. Literature suggests that distance increases the costs that an investor must bear in order to monitor the venture (Grote and Umber, 2007). This is in line with the observation that venture capital funds invest predominantly in firms close to them (Lerner, 1995).

Finally, the lack of repeated interactions reduces the potential of reputation as a mechanism to incentivise the entrepreneur to behave in line with the interests of the investor (Agrawal et al, 2013). In other online marketplaces, such as eBay, participants have a low incentive to misbehave because, if they do, they might, in effect, be prevented from participating in the market in the future because of the feedback and ratings mechanisms. Since sourcing equity finance through the internet is often a one-time event for an entrepreneur, the incentives for behaving correctly are lower, which can lead to potential fraud. More active crowdfunding platforms screen companies. However, not all platforms have the same standards.


The lack of adequate monitoring is particularly worrisome in a setting in which investments often take 5-10 years or more to produce a return, if any. Crowd investors might not appreciate that long periods are necessary for these investments to either succeed or fail, or that most of these investments are unlikely to yield any return. Moreover, equity investments are mostly long-term illiquid assets. Therefore, it is important that non-professional investors are adequately informed about the illiquid characteristics of this asset class.

For equity investments to provide a return to investors, a positive 'exit' must take place at some point. This can be through an initial public offering (IPO) or, as more often the case, through a merger or acquisition (M&A). Unfortunately, these positive exits became increasingly rare during the financial crisis. In Europe, EVCA data (2013) shows that only 15 percent of venture capital exits in 2012 (in terms of number of companies) were through trade sales, and even fewer, 5 percent, were IPOs. These numbers are clearly lower than pre-crisis (2007) figures that pointed to 22 percent of exits through trade sales and 8 percent through IPOs.

For angel investments and equity crowdfunding investments, the path to a positive exit can be longer and even less likely. IPOs and M&As do not happen by chance. Venture capitalists and the firms themselves often have an exit strategy in mind from the beginning and proactively work towards making it a reality over a long period (Wilson and Silva, 2013).

In conclusion, the lack of adequate pre-investment screening and due diligence, weaker investment contracts and poorer post-investment support and monitoring can make the risk associated with equity crowdfunding significantly higher than the risk usually borne by business angels and venture capitals. Moreover, while the potential for fraud is exacerbated in the equity crowdfunding setting, information asymmetry makes investments in the start-ups of even well-intentioned entrepreneurs riskier, since the competence of the entrepreneur and the quality of the business plan cannot be properly assessed.

While there are some successful equity crowdfunding cases (such as the biotech start-up Antabio8 in France, which succeeded in producing a positive return for its investors) and failure cases (such as the liquidation of betandsleep9 or sporTrade10 in Germany), the industry still lacks a sufficient track record to assess its ability to create value for both investors and entrepreneurs.

Crowdfunding platforms and the regulatory environment

The issues we have raised demonstrate the greater exposure that equity crowdfunding market has compared to other forms of seed and early-stage investment. In particular, adverse selection problems could increase the cost of capital up to the point at which only low-quality ventures will eventually choose to seek financing through crowdfunding, while high-quality ventures will continue to secure venture capital or angel investor financing (Agrawal et al, 2013). Competition between platforms and between the crowdfunding industry and traditional financing is pushing platforms to design innovative solutions to avoid the unintended consequence of creating a ‘market for lemons’.

Overall, the main limitation of equity crowdfunding is that it allows a non-professional investor, who might lack the incentive and/or capabilities to adequately assess and monitor a start-up, to make an investment. Efforts to address this limitation to date have included the introduction of an intermediary between the crowd and the company that is able to perform these tasks, or the reduction of the crowd to only qualified investors.

The first approach involves the provision of an active intermediary that could act as a representative of the interests of the crowd in performing due diligence and monitoring start-ups. Following this trend, many platforms are active in performing due diligence, while others operate a nominee and management system in which they represent the interests of investors with the crowdfunded business (eg Seedrs). Another example is provided by platforms such as MyMicroInvest in Belgium, which allows investors to co-invest with an experienced business angel. In this case, the crowd benefits from the financial contracting skills and from the post-investment monitoring of an experienced active investor. While this approach provides some benefits, it also entails some risks: by leveraging the investment decisions of a business angel, this mechanism may increase the risk propensity of the angel, thus biasing his or her investment decisions.

A second approach is to reduce the crowd, by limiting the investment to a restricted group of people, possibly accredited investors, each contributing more capital than the average crowd investor. In this case, crowdinvesting would more closely resemble angel investor groups than the typical crowdfunding model. Examples of this model are CircleUp and FundersClub in the US or Seedups based in Ireland, whose offers are restricted to accredited investors. Other examples are platforms that impose high investment minimums, thus reducing the crowd to a few investors. Finally, some platforms (such as Seedrs and Crowdcube in the UK) require crowdinvestors to pass a test before investing in a company, to certify that they are sufficiently aware of the investment risk.

The efficacy of these measures needs to be evaluated and appropriate policies should take into account these assessments. Moreover, while the market gives incentives to platforms to adopt the best practice, some platforms could deviate from the best practices because of lack of long-term vision, incompetence or other hidden interests (Griffin, 2012). The financial crisis showed that leaving the financial market to self-regulate can be costly. Many of these crowdinvestors could lose their money before the market has time to self-correct and force out inadequate platform models.

Crowdfunding platforms have an incentive to build a good reputation by securing attractive deals for their crowds, since in the long run reputation results in market-share gains. Apart from this reputational incentive, platforms differ in the structure of fees they derive from the deals. As described in section 2, most of the platforms derive revenues as a percentage of the amount raised, while only a few (eg Seedrs) derive monetary benefit from a successful exit by imposing a fee as a percentage of investor’s profits. This typical fee structure implies that platforms derive monetary incentive to close deals while there are only reputational incentives to provide successful deals in the long run. If long-run reputational incentives are lower than short-term monetary incentives, conflicts of interest could arise and platforms might downplay investment risk to the crowd in order to secure deals. In light of this potential conflict of interest, a supervisory body for crowdfunding platforms is probably desirable.

From a legal standpoint, equity crowdfunding is currently possible in some jurisdictions by exploiting exemptions to existing securities regulations (Hornuf and Schwienbacher, 2014b). Securities laws generally require an issuer to register with the national securities authority and to comply with strict reporting standards in order to gain access to the general public. These requirements are prohibitively expensive for small firms, which are the typical beneficiaries of crowdfunding.

In the EU, exemptions as defined in national regulations pertaining to prospectus and registration requirements, allow start-ups to gain access to the general public through equity crowdfunding (Hornuf and Schwienbacher, 2014b). Exemptions include the maximum amount that can be offered to the public, the maximum number of investors to whom the offer is made, the minimum contribution imposed on investors and whether the offer is made to ‘qualified’ or ‘accredited’ investors. While these exemptions to existing securities legislation allow small firms access to the general public for financing, they also imply weaker protections for investors.

EU member states have adopted different practices on whether the equity crowdfunding platform must register as an investment intermediary or obtain a bank license. For example, in Germany, crowdinvesting platforms explicitly stating that they do not provide any investment advice or brokerage service have no obligation to provide any documentation in terms of advisory records or to act in the interest of the investor (Dapp and Laskawi, 2014). As a result, most German platforms are not registered as investment intermediaries (ECN, 2013). In the UK, platforms are regulated by the Financial Conduct Authority (FCA) (ECN, 2013; Hornuf and Schwienbacher, 2014b). In France, equity crowdfunding platforms such as Wiseed, Anaxago, Finance Utile and SmartAngels are registered as financial investment advisers, since their activities consist of advice in providing financing (ECN, 2013; Hornuf and Schwienbacher, 2014b).

Finally, national corporate laws can also have an effect on equity crowdfunding (De Buysere et al, 2012; Hornuf and Schwienbacher, 2014b). For example, because they are relatively inexpensive in most countries, closely held company types (eg private limited liabilities companies) are the typical entity type chosen by start-ups. However, in many countries these company types have limitations or might be prohibited from offering equity to new investors. Even when allowed, equity transactions for these kinds of companies often require formalities, such as notarial intervention, which increases the costs for start-ups.

Despite the harmonising role played by Directive 2010/73/EU (Box 1), the EU remains a patchwork of different regulations. This lack of uniformity inhibits the development of a pan-European industry by making cross-border deals more difficult, and highlights the lack of consensus on whether equity crowdfunding could be welfare-enhancing or not.

Considerations for policymakers

Crowdfunding can be an additional tool for providing seed and early-stage equity finance to new ventures. However, policymakers should proceed with caution by carefully assessing the risks of this new financial intermediation tool. We argue that the challenges that equity crowdfunding poses are distinct and more complex than those posed by other forms of crowdfunding. As we have outlined, the risks also differ from other forms of seed and early-stage equity finance, such as angel investing and venture capital. Equity crowdfunding can open up additional channels for new ventures to access finance at a time when securing funding is difficult, but the risks, including those related to investor protection, need to be addressed.

These risks could result from potential fraudulent activities of start-ups or platforms or, more likely, poor investment decisions made by unsophisticated investors. The current legal framework mainly addresses this issue by reducing the exposure that individual investors can have to riskier assets. The goal is to make sure that the investor is able to bear a potential loss. However, as the equity crowdfunding volumes continue to grow, this solution does not prevent the potential loss of significant amounts of capital.

Overall, the legal framework should not allow a crowd of investors, who might lack the incentive and/or the expertise to invest in a start-up, to do so without adequate intermediation and protection. If the crowd is made up of non-qualified investors, we argue that there should be at least one participant that legally represents the interest of the crowd in the investment in a business. This participant could be the crowdfunding platform. The crowd could also be allowed to co-invest alongside professional investors. However, also in this case, the platform should take significant steps to protect the interests of the crowd from the misbehaviour of other investors. Finally, in order to monitor potential conflicts of interest of platforms, supervision by national security authorities is important.

Crowdfunding currently is a highly deregulated market with little legal protection provided to funders. In the EU, some member states have introduced ad-hoc legislation for crowdfunding, while some others will introduce new laws soon. The European Commission is currently studying equity crowdfunding, along with the other forms of crowdfunding, to assess its risks and opportunities. In this regard, the Commission started a public consultation late in 2013 and published a Communication in March 2014 (EC, 2014). At this stage, the Commission’s efforts are focused on increasing awareness of the opportunities and risks of crowdfunding, spreading best practice and improving the general understanding of this growing phenomenon. The Commission is also exploring the potential of a ‘quality label’ to spread good practice and build user confidence.

Being based online, equity crowdfunding has the potential to contribute to a pan-European seed and early-stage financial market to support European start-ups. However, in order to maximise this benefit, harmonised policies to address equity crowdfunding models should be adopted in common by all member states. This approach would maximise the benefits of equity crowdfunding and help to reduce the risks. We urge the Commission to work with member states to address the current patchwork of national legal frameworks, which constitute an obstacle to the development of this nascent model of funding across Europe.

Finally, legislators should take a holistic approach in assessing the regulatory burden on the industry. Corporate law in many countries imposes limitations or prohibits closely held company types – the typical legal form chosen by start-ups – from selling equity to new investors. These provisions are another significant obstacle to the development of equity crowdfunding. Corporate laws should be harmonised and should take into account this new financing channel for start-ups. In addition, other financial regulations which might interact with and have an impact on the market should be assessed.

In conclusion, all types of crowdfunding can provide significant and new sources of funding for many types of organisations, ranging from charities to companies. Equity crowdfunding, however, is more complex and requires the proper checks and balances if it is to provide a viable channel for financial intermediation in the seed and early-stage market in Europe.


1. Nevertheless, this distribution might not reflect simply the investment preferences of the crowd. Legal constraints currently provide upper limits to the capital that can be raised from nonqualified investors. See section 4.

2. Seedrs is an equity crowdfunding platform based in the United Kingdom. It allows users to invest as little as £10 into the start-ups. In the first 18 months since its launch in July 2012, Seedrs collected more than €6.8 million through 56 funded campaigns and counted more than 29,000 users.

3. In particular, the Seed Enterprise Investment Scheme (SEIS) launched by the UK government in April 2012.


Improving the role of equity crowdfunding in Europe's capital markets (English)
Fri, 29 Aug 2014 07:44:28 +0100
<![CDATA[Healthcare Systems and Ageing Populations]]> http://www.bruegel.org/nc/events/event-detail/event/456-healthcare-systems-and-ageing-populations/ even456

The ageing of populations is the most influential factor of healthcare system design. In Japan, 25% of the total population in 2013 was aged 65 years or older and the government population agency predicts that the proportion of this age cohort will rise to 30% and 39% in 2025 and 2050, respectively. A key concept of healthcare reform in Japan is “integration” in terms of both healthcare delivery system and healthcare finance system. There are, however, high political barriers.

Europe is facing similar issues in terms of an ageing population and the implications for healthcare systems. Europe has the added challenge of balancing EU and Member State responsibilities in terms of the economic and social imperatives in healthcare.

This event aims to shed light on the nexus of aging population and the sustainability and efficacy of healthcare systems. It will explore the funding and healthcare delivery systems in Japan and Europe, highlighting some of the lessons learned from Japan and their possible implications for Europe.

Note that the program for this event is still under construction. More information will be available soon.


  • Yukihiro Matsuyama, Research Director, The Canon Institute for Global Studies, Japan
  • Chair: Karen Wilson, Senior Fellow at Bruegel

About the speakers

Yukihiro Matsuyama, PhD, is Research Director, the Canon Institute for Global Studies, Appointed Professor, International University of Health and Welfare, Visiting Professor, the Center for Clinical Governance Research, Faculty of Medicines, University of New South Wales, Australia. His research examines the sustainability of safety-net systems in Japan including healthcare, pension, pandemic crisis and employment through international comparison analysis.

Practical details

  • Venue: Bruegel, Rue de la Charité 33, 1210 Brussels
  • Time: Tuesday, 23September 2014, 8.15-10.00.The meeting will start promptly at 12:00 and run until 13:30. A light lunch will be served until 14:00 to provide time for further discussion and networking.
  • Contact: Matilda Sevón, Events Manager - registrations@bruegel.org

Thu, 28 Aug 2014 14:47:54 +0100
<![CDATA[Fact: Dim Sum bonds are not coming to rescue Russia's banks]]> http://www.bruegel.org/nc/blog/detail/article/1421-fact-dim-sum-bonds-are-not-coming-to-rescue-russias-banks/ blog1421

The imposition of joint US-EU sanctions meant a significant number of investment opportunities for both Russian companies and banks disappeared. Despite Russian efforts, it seems Asian markets will not provide a quick fix, as yields on yuan-denominated bonds issued by Russian entities have been increasing after the sanctions.

China and Russia are getting increasingly closer economically and financially. China matters more and more in Russia’s export and Russia reached a $400 billion agreement in May 2014 to supply natural gas to China through a new pipeline over 30 years. Bloomberg reports the ruble-yuan currency pair reached a record 3.8 billion rubles in trading volume ($105 million) on July 31st 2014.

As the US and the EU imposed new sanctions this summer, Russian companies and banks were therefore prompted - being traditionally reliant on dollar-denominated syndicated loans - to look to China for a financial escape route.

Dim sum is the name used to indicate bonds denominated in Chinese yuan and issued in Hong Kong, attractive to foreign investors who wish to get into yuan-denominated assets, but are restricted by China's capital controls from investing in domestic Chinese debt. The issuers of dim sum bonds are largely entities based in China or Hong Kong, and occasionally foreign companies. Dim sum bonds issuance has been going a bit up and down during 2012 and 2013, probably due in part to concerns about the Chinese economy (Figure 1 from WSJ).

Russian companies are not new to the renminbi market and Dim Sum bonds issuance. In early 2013, Russian banks – including JSC VTB Bank, Russian Agricultural Bank OAO and Russian Standard Bank ZA– had already raised $482m, compared to $477m by Chinese companies and compared to the just $309 million issued over the previous three years (Figure 2 from FT).

These developments seem to have been mostly demand driven. Comments reported in the FT and the WSJ suggest that investors are keen to buy these bonds because being issued by state-backed Russian banks they offer an attractive yield and exposure to the Chinese currency while having a lower risk profile than many of the local issuers. For Russian banks themselves, dim sum bonds represented a significantly cheaper source of funding. Russian Agricultural Bank for example issued in 2013 a three-year dim sum bond with a yield of 3.6 per cent, compared to a comparable (slightly longer maturity) dollar bond, that paid a  coupon of 5.3 per cent.

In the immediate aftermath of sanctions, therefore, a question was whether Asia’s capital markets could serve as an easy funding alternative for Russian companies frozen out of the US and Europe.

It looks like this is not going to be so easy. Yields on Russian corporate bonds denominated in yuan have been rising after the sanctions (IFR Asia). The yield on VTB’s 4.5% October 2015 offshore renminbi bonds rose to around 6% in end of July from less than 4% on July 24, while Russian Agricultural Bank’s 3.6% February 2016s were quoted at between 5% and 6.6%, up from 4.67% on July 16. Both banks were added to the list of those subject to US sanctions last week. The yield on Gazprombank’s 4.25% January 2017 Dim Sum bonds rose to 6.5%  from 5.01% on July 16, the day Gazprombank was hit with US sanctions.

These data suggest that Asian investors may be  becoming increasingly wary of credits from Russia and worried of the impact of sanctions, even if they are not directly involved. And the dim sum way around western sanctions may prove harder than expected.

Thu, 28 Aug 2014 08:12:39 +0100
<![CDATA[Chart: Sharp decline in intra-EU trade over the past 4 years]]> http://www.bruegel.org/nc/blog/detail/article/1420-chart-sharp-decline-in-intra-eu-trade-over-the-past-4-years/ blog1420


Source: Bruegel based on IMF data (Direction of Trade Statistics database).

Note: The above figure shows intra-EU and intra-Eurozone shares of export on total export of the two groups respectively. Each of the two lines were constructed taking into account the changing composition of the European Union and the Euro Area over time, meaning that a given country is included in the series only by the time it joined the EU or the Euro. However, further calculations shows results do not change dramatically if considering a fixed group of countries in either series.

The share of the intra-EU export of the EU total export experienced a steady rise since the early 80’. In fact, the rise was up to 8 percentage points in that period. However, after stagnating from the mid-90’s until the end of the 2000’s, intra-EU saw a sharp downward trajectory in the last four years, implying global trading partners have become and are becoming more important. Interestingly, the data also show that the Euro Area has been following nearly the exact same pattern as the European Union as a whole, suggesting the common currency might not have had the expected effect on trade between Euro Area members.

Wed, 27 Aug 2014 13:18:25 +0100
<![CDATA[Modi has promises to keep]]> http://www.bruegel.org/nc/blog/detail/article/1419-modi-has-promises-to-keep/ blog1419

This opinion was published by the Business Standard.

The roar of Narendra Modi's sweeping election victory and its narrative of radical change set up high expectations. Soon, however, came the whimper. The proposal of a modest rise in rail fares was quickly pulled back. And the appeasement of the Maharashtra sugar lobby deepened long-standing inefficiencies and inequities. At first, the mood was to dismiss these in the hope of a radical Budget. But the straws in the wind proved reliable guides: Finance Minister Arun Jaitley lost his nerve.

Is radical change really underway but perhaps artfully hidden from the public? Is the government biding its time, first wooing voters with goodies in the coming state elections and then launching into a new era of transformative governance?
Modi offered a focal point for the collective disgust and increasingly frustrated public aspirations. He had an apparently credible storyline around the Gujarat experience and the image of a tough leader. And he fed the fantasy of a saviour. He will, most likely, undo the most egregious failings of the United Progressive Alliance administration, and the stalled economy should show some life.

But transformative change will remain elusive. The business-as-usual economic policy, with which this government has begun, should have been expected. For about a century, a motley group of lower middle class voters has steered Indian politics. Since independence, meeting their insistent livelihood demands has been the prime objective of every political party and government. The Bharatiya Janata Party (BJP) attentively wooed this coalition with finely-tailored promises and remains anxious to hold on to this constituency in the forthcoming state elections. India's central political dynamic remains intact.

In his autobiography, Jawaharlal Nehru reflected that the political base of the Indian National Congress - and, hence, of the freedom movement - was the petite bourgeoisie, the lower middle classes. Picking up on Nehru's theme after independence, K N Raj, the diminutive but intellectually-towering economist and political thinker, argued that the lower middle classes had remained India's central political constituency. They defined, he said, the country's governing coalition, an "intermediate regime."

The "intermediate regime" is a heterogeneous patchwork of claimants, including salaried workers, farmers and small entrepreneurs. They earn enough to get by and because they have established property rights - and enjoy government largesse - they have a stake in the system. But they live under a basic insecurity that their livelihoods may be easily compromised and eroded.

Raj's claim was that political success in India required harnessing this "intermediate" coalition of interests. The formal coalition may require multiple parties or be absorbed in single party (as in the Congress in its dominant years and the BJP in its latest election). But although the characters in Delhi inevitably change, all governments must cater to the demands of the "intermediate" regime - not least because members of every party are drawn from the same milieu. Hence, indispensable policy continuity is built into the political process.

While the poor are important to the rhetoric and receive some sops, their aspirational benchmarks remain those of the lower middle classes, who, therefore, remain salient in framing the policy dialogue. The political equilibrium is reached by granting generous rents to the rich.

Today, the heterogeneous "intermediate" group is more extensive, better off, more educated and more politically active. Indeed, with progress in reducing the number below the poverty line, the ranks of the "intermediate" class have swelled.

Between 2009 and 2014, the BJP and Congress essentially swapped vote shares: the BJP's share rose from 19 to 31 per cent between 2009 and 2014, while Congress' share fell from 29 to 19 per cent. Roughly 50 per cent voted for regional parties in both elections. The electorate may well have sought major changes in how the government functions, but it is not yet ready to give up on the blend of consumer subsidies, income-support programmes and the coddling of agricultural interests.

For any political party, the political calculation is simple. Is it possible to inflict short-term pain on the "intermediate" groups with the promise of acchey din, better days? The narrow electoral arithmetic dictates the answer. Because acchey din are uncertain and, in the meantime, no lobby can be left behind, the goodies cannot be taken away.

Technocratic cheerleaders of the new government are dismayed. India's threat to disrupt the World Trade Organisation (WTO) unless subsidies to farmers are allowed, leads the distinguished economist Surjit Bhalla to lament, "Why, in the name of god and India, is Modi-BJP pursuing an illogical and regressive stance at the WTO?" The government's WTO position should not be any more surprising than its pandering to Mumbai's urban commuters, Maharashtra's sugar lobby or kerosene consumers.

The accommodation with Indian business interests has been achieved through the entrenchment of a rentier class. Then, it was industrial licences and protection through high import tariffs. Now, it is the award of rights to land, natural resources and government contracts. The new rent-seeking is more distasteful and corrosive. With inherited wealth increasingly concentrated in a few families, the new maharajas - and their acolytes - show contempt for public norms and distaste for productive enterprise.

The Jaitley Budget had three telltale signs of political continuity. First, the government plans to hold on to the nationalised banks. Put simply, there is no economic reason for them today - if ever there was one. All social objectives can be met through more efficient and equitable means. Nationalised banks persist because they are a source of fiscal largesse to political constituents. The banks are especially desirable because the financial favours can be doled out without public scrutiny. Eventually, the unaccounted losses on account of waivers and non-performing loans appear as claims on the central government's Budget for bank recapitalisation.

Second, all are agreed that the public-private partnership (PPP) model of infrastructure construction has failed to deliver, even as it has spawned wanton corruption. But PPPs are another avenue to feed the rentier class, while claiming that other financing options are largely closed. Third, the BJP, which voted for MGNREGA, cannot now dismantle it. Perhaps, the programme's productivity can be improved, but the political "leakages" will remain endemic.

The nod to aspirational India comes in the promise of "smart" cities, high-speed trains and linking of India's river systems. This over-the-top promise is either a cynical ploy or a serious disconnect with reality. While China remains the elusive model for such grand ventures, its example of low-cost housing for hundreds of millions and clean toilets does not have a political constituency.

What is missing is a coherent programme for growth. Today, more so than ever, the one variable that will determine long-term growth prospects is the quality of education. The achievements remain dismal. In a fiercely competitive global system, as the Red Queen may have said to Alice, we must run faster to stay in the same place. But are we willing to learn from China's example in the provision of world-class primary and secondary education?

The absence of a transformative agenda is a calculated accommodation to India's political economy. Modi brilliantly channelled the cry for change into an electoral platform. But the government has neither the mental model nor the political courage to effect real change. As so often, political and bureaucratic elites have made promises to the Indian electorate that they cannot keep. Acchey din may be a long way off.

Wed, 27 Aug 2014 07:15:57 +0100
<![CDATA[Asia and Europe’s challenges for the autumn: A macroeconomic and financial perspective]]> http://www.bruegel.org/nc/events/event-detail/event/455-asia-and-europes-challenges-for-the-autumn-a-macroeconomic-and-financial-perspective/ even455

Side-event to the 11th ASEM Finance Ministers Meeting, Milan, Italy

Growth remains sluggish in Europe and increasingly is beginning to slow down cross emerging markets in Asia. This roundtable of leading economists will examine this issue by looking at the key factors that are likely to shape the evolution of Asian and European economies in the forthcoming months. Key issues that will be addressed include the effectiveness of monetary expansion in Asia and Europe as well as possible spillover effects of the US Federal Reserve’s tapering; the importance of the macro-financial links and the role of fiscal policy in European and Asian perspectives; the effectiveness of the new institutional framework developed in the context of the European Banking Union as well as the impact of the ECB’s comprehensive assessment; and the role of global demand factors and of investment in fostering sustainable growth.


10:00: Introductory remarks by Ambassador ZHANG Yan, Executive Director, Asia-Europe Foundation

10:15: Presentation of the panel by Moderator Mr. Guntram WOLFF, Director, Bruegel

Discussion with

Dr. Alan AHEARNE – Head of Economics at the National University of Ireland, Galway and External Advisor to the Strategy, Practice and Review Department of the International Monetary Fund

Dr. FAN Gang – Director, National Economic Research Institute and Secretary-General of China Reform Foundation

Mr. Carlo MONTICELLI – Director General for International and Financial Relations, Treasury Department, Ministry of Economy and Finance Italy

Dr. André SAPIR – Professor of Economics at Université Libre de Bruxelles and former Economic advisor to the president of the European Commission

12:00: Buffet lunch offered by the Asia-Europe Foundation (ASEF) to all attendees


Alan Ahearne is Professor and Head of Economics at the National University of Ireland, Galway. He is currently Adviser to the Strategy, Practice and Review Department of the IMF, and a Member of the Commission (Board of Directors) of the Central Bank of Ireland. He has been a research fellow at Bruegel since 2005. He served as Special Adviser to Ireland’s former Minister for Finance Brian Lenihan from 2009 to 2011. In this role, he advised the Minister on economic, budgetary and financial policy in responding to the economic and financial crisis. Alan obtained his PhD from Carnegie Mellon University (in Pittsburgh) in 1998 and subsequently joined the Federal Reserve Board in Washington DC, where he worked for seven years as a Senior Economist. At the Fed, he advised Alan Greenspan, Ben Bernanke and other Fed Governors on developments in the global economy. He was the principal economist at the Fed covering the Japanese and Chinese economies.

Fan Gang is chairman of China Reform Foundation and Director of the National Economic Research Institute. He is also Professor of Economics at Peking University and the Graduate School of Chinese Academy of Social Sciences. He is also an advisor to various departments of Chinese Central government and provincial governments; was independent member of China Monetary Policy Committee during 2006-2010; guest professor of number of universities and graduate schools; and served as economic consultant to various international organizations and played leading roles in research projects commissioned by The World Bank, ADB, UNDP, OECD, etc. PhD in economics, he received Docteur Honoris Causa (Honorary Doctor) from University of Auvergne, France, and Royal Road University of Canada, in 2004 and 2011 respectively, and was listed as one of “World’s Top 100 Public Intellectuals” jointly by Foreign Policy and Prospect, in 2005 and 2008 consecutively and listed as one of “100 Global Thinkers” by Foreign Policy in 2010.

Carlo Monticelli is Head of International Financial Relations in the Italian Ministry of the Economy and Finance.
His responsibilities include analysis of economic, financial and institutional matters, the preparation of Ministerial international meetings like Eurogroup-Ecofin, G7, GB, G20 as well as the participation to formal and informal groups and committees. He is Alternate Governor for Italy in the World Bank, in the Asian Development Bank and in the African Development Bank. He is also Member of the Board of Directors in the EIB.
He has contributed to develop the Advance Market Commitment for Vaccines pilot project on pneumococcal disease, successfully completed with joining and support of international donors and partners. Until 2002, he was for long attending to economic research and policy analysis, particularly in Monetary and in International Financial sectors, as Deputy Director in the Research Departments of Bank of Italy and, successively, as Head of European Economy - Global Markets Research of the Deutsche Bank in London.
His activities still include presentations at many conferences and workshops of international relevance, as well as teaching in post-graduate courses. He has contributed several articles to academic journals.

André Sapir is Senior Fellow of Bruegel and Professor at the Solvay Brussels School of Economics and Management, Université Libre de Bruxelles. He is Vice-Chair of the Advisory Scientific Committee and voting member of the General Board of the European Systemic Risk Board (ESRB). From 2005 to 2009 he was member of the Economic Advisory Group to European Commission President José Manuel Barroso. Previously, he worked 12 years for the European Commission, first serving as Economic Advisor to the Director-General for Economic and Financial Affairs, then as Economic Advisor to President Romano Prodi. André Sapir has written extensively on various aspects of Europe’s Economic and Monetary Union, including banking, as well as on international policy coordination, international trade and globalisation. He received a PhD in Economics from The Johns Hopkins University in Baltimore, USA. He was elected Member of the Academia Europaea in 2010 and of the Royal Academy of Belgium for Science and the Arts in 2012.

Guntram Wolff is the Director of Bruegel since June 2013. His research focuses on the European economy and governance, on fiscal and monetary policy and global finance. He regularily testifies to the European Finance Ministers' ECOFIN meeting, the European Parliament, the German Parliament and the French Parliament and is a member of the French prime minister's Conseil d'Analyse Economique. He joined Bruegel from the European Commission, where he worked on the macroeconomics of the euro area and the reform of euro area governance. Prior to joining the Commission, he was coordinating the research team on fiscal policy at Deutsche Bundesbank. He also worked as an adviser to the International Monetary Fund. He holds a PhD from the University of Bonn, studied economics in Bonn, Toulouse, Pittsburgh and Passau and previously taught economics at the University of Pittsburgh and at Université libre de Bruxelles.

Practical details

  • Venue: Meliá Milano Hotel, Via Masaccio, 19, 20149 Milan
  • Time: 10.00-12.00, 12 September 2014
  • Contact: Matilda Sevón Events Manager at Bruegel - registrations@bruegel.org

Mon, 25 Aug 2014 15:06:33 +0100
<![CDATA[Blogs review: Is this a European U-turn?]]> http://www.bruegel.org/nc/blog/detail/article/1418-blogs-review-is-this-a-european-u-turn/ blog1418

What’s at stake: Speaking at the Federal Reserve Bank of Kansas City's annual conference Jackson Hole, Wyo., ECB President Mario Draghi made an important speech recognizing that the recovery in the euro area remains uniformly weak and that the euro area fiscal stance was not helping the ECB do its job. Interestingly, French leaders also reintroduced over the weekend the notion of aggregate demand, a concept they had noticeably moved away from with the “Pacte de responsabilite”.

The qualification of the European economic outlook

Joe Weisenthal writes that Draghi’s speech is significant because it acknowledges that the eurozone is in a massive ongoing crisis. Only two weeks ago, ECB President Draghi still considered that “the available information remain[ed] consistent with our assessment of a continued moderate and uneven recovery of the euro area economy”. This time, Draghi described that the “the most recent GDP data confirm[ed] that the recovery in the euro area remains uniformly weak, with subdued wage growth even in non-stressed countries suggesting lackluster demand.”

Greg Ip writes that Mario Draghi sounded strangely dismissive of price development concerns after his last press conference. He noted that excluding food and energy inflation was 0.8%, and argued that the decline in inflation expectations was all in the short term, whereas “long-term expectations remain anchored at 2%.” At his speech on Friday in Jackson Hole, his tone was much less sanguine. Inflation, he noted, has been on a downward path from around 2.5% in the summer of 2012 to 0.4% most recently. Departing from his prepared text, he said, if “low inflation were to last a long period of time, risks to price stability would increase.” He said inflation expectations had experienced a “significant decline at the long horizon,” by 15 basis points (five-year inflation starting in five years’ time). “If we go to shorter and medium term horizons,” the declines “are even more significant.

Source: Wonkblog

Joe Weisenthal reports that Citi's top economist, Willem Buiter, expects monetary policies to widely diverge as both the Bank of Japan and the European Central Bank would engage in "major" quantitative easing programs later this year or early next year. This is because their economies are flagging, particularly in Europe, where inflation expectations are collapsing. On the flipside, the Fed and the Bank of England are both expected to begin the normalization process (rate hikes) fairly soon (sometime next year). In its daily email, Sober Look writes that the euro’s decline accelerated on Sunday evening, as Jackson Hole discussions solidified the expectations of diverging monetary policies between the US and the Eurozone.

The departure from previous fiscal policies

Brian Blackstone writes that ECB President Mario Draghi on Friday signaled a departure from the austerity-focused mind-set that has dominated economic policy-making in the euro zone since the onset of the region's debt crisis nearly five years ago. Mario Draghi writes that “since 2010 the euro area has suffered from fiscal policy being less available and effective, especially compared with other large advanced economies […] it would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy, and I believe there is scope for this, while taking into account our specific initial conditions and legal constraints.“

Simon Wren-Lewis writes that to understand the significance of Draghi’s speech, it is crucial to know the background. The ECB has appeared to be in the past a center of what Paul De Grauwe calls balanced-budget fundamentalism. Traditionally ECB briefings would not be complete without a ritual call for governments to undertake structural reforms and to continue with fiscal consolidation. The big news is that Draghi does not (at least now) believe in balanced-budget fundamentalism. Instead this speech follows the line taken by Ben Bernanke, who made public his view that fiscal consolidation in the US was not helping the Fed do its job.

Simon Wren-Lewis writes that we should celebrate the fact that Draghi is now changing the ECB’s tune, and calling for fiscal expansion because it may begin to break the hold of balanced-budget fundamentalism on the rest of the policy making elite in the Eurozone. But Draghi is only talking about flexibility within the Stability and Growth Pact rules, and these rules are the big problem. Paul Krugman writes that even if Draghi gets the situation, the combination of the euro’s structure and the intransigence of the austerians means that the situation remains very grim.

Richard Portes and Philippe Weil write European citizens must hope that their policy makers will recognize that the acute, pressing problem is aggregate demand. Repairing the credit system, implementing serious reforms of state expenditure and taxation, creating more flexible labor markets, finally opening the services market to cross-border competition – all are indeed very important. But they will not liberate the eurozone from stagnation.

France and Jean-Baptiste Say

There has also been a striking change in the language used by French President Francois Hollande over the weekend. A few months ago, Francois was re-named Jean-Baptiste Hollande in the blogosphere for reviving the “supply creates demand” fairy as he embraced the view of his compatriot Jean-Baptiste Say that to boost growth one needs only to care about creating optimal condition for production and supply, and that demand will follow.

In his recent interview with Le Monde, Francois Hollande appeared to rebalance his approach saying that Europe faced a clear lack of demand (“le diagnostic est implacable: il y a un problème de demande dans toute l'Europe”). He suggested that Europe should support overall demand while national policy should mostly remained focus on supply side policies. Meanwhile, Arnaud Montebourg, the economy minister, shortly joined by Benoit Hamon, the Education minister went further and called for a new policy direction, also at the national level, arguing that the fiscal consolidation path needed to be adjusted substantially and that France shouldn’t accept the economic choices and ideological preferences of the German CDU. 

Mon, 25 Aug 2014 07:35:08 +0100
<![CDATA[Economic curriculum reform: why do we need it?]]> http://www.bruegel.org/nc/blog/detail/article/1417-economic-curriculum-reform-why-do-we-need-it/ blog1417


A student learns a paradigm to become a member of a particular scientific community. As he graduates, he “joins men who learned the bases of their field from the same concrete models, his subsequent practice will seldom evoke overt disagreement over fundamentals.

- Thomas Kuhn, The Structure of Scientific Revolutions

The economic curriculum reform has been a burgeoning topic of debate in academic and policy circles since the global financial crisis erupted in 2008. High-level policymakers and student groups from numerous universities around the world are pushing for a curriculum reform to bring the so called “dismal science” closer to the real world and introduce pluralism into its educational system.

A single dominating paradigm in economics

One of the most controversial aspects of the current economics curriculum is that it focuses almost exclusively on mainstream economics - both Neoclassical and New Keynesian. The International Student Initiative for Pluralism in Economics’ (ISIPE) state that:

Such uniformity is unheard of in other fields; nobody would take seriously a degree program in psychology that focuses only on Freudianism, or a politics program that focuses only on state socialism. An inclusive and comprehensive economics education should promote balanced exposure to a variety of theoretical perspectives...

The report Economics, Education and Unlearning by the Post-Crash Economic Society heavily criticises what they call the “monoculture” of mainstream or orthodox economics at the University of Manchester, which they claim is a generalised problem in UK universities:

This monoculture also makes it easier for professors to believe that their way is the only way to do economics or at least that it is the only valid way which in turn justifies its status as the only kind of economics taught at our university. Many of our lecturers sincerely believe that the economic paradigm their methods represent is the only legitimate way of doing economics…

It is no accident that economics is dominated by a single paradigm: applying Kuhn’s theory

Economics is a monoculture discipline because it is an established normal science, while other social sciences are still pre-paradigmatic.

Following the historic evolution of natural sciences, Thomas Kuhn describes in his Structure of Scientific Revolutions how science evolves from a ‘pre-paradigm period’ to a ‘normal science’. Once it has become a normal science, it progresses through consecutive cycles involving crises that may lead to a scientific revolution and its subsequent paradigm shift, returning to normal science.

The pre-paradigm period “is regularly marked by frequent and deep debates over legitimate methods, problems, and standards of solution, though these serve rather to define schools than to produce agreement.” Instead of having a consensus over a single paradigm that defines how the science should progress, there is “competition between a number of distinct views of nature, each partially derived from, and all roughly compatible with, the dictates of scientific observation and method.”

A paradigm arises when a scientific community universally recognises a set of scientific achievements “that for a time provide model problems and solutions to a community of practitioners”. A paradigm’s achievements have to be “sufficiently unprecedented to attract an enduring group of adherents away from competing modes of scientific activity.” It also needs to be “sufficiently open-ended to leave all sorts of problems for the redefined group of practitioners to resolve […] Men whose research is based on shared paradigms are committed to the same rules and standards for scientific practice. That commitment and the apparent consensus it produces are prerequisites for normal science, i.e., for the genesis and continuation of a particular research tradition.”

When a paradigm (as defined above) exists, we can speak of a normal science. Kuhn describes the kind of research performed by a normal science “as a strenuous and devoted attempt to force nature into the conceptual boxes supplied by professional education.”

Normal science, the activity in which most scientists inevitably spend almost all their time, is predicated on the assumption that the scientific community knows what the world is like […] Normal science, for example, often suppresses fundamental novelties because they are necessarily subversive of its basic commitments.

Kuhn only mentions economics once in his essay, when he briefly discusses the state of social sciences back in 1962:

It may, for example, be significant that economists argue less about whether their field is a science than do practitioners of some other fields of social science. Is that because economists know what science is? Or is it rather economics about which they agree?

Funnily enough, when Kuhn wrote his essay, macroeconomics had not yet reached the consensus of being dynamic, quantitative and micro-founded. This would not happen until the beginning of the 70s when the freshwater vs saltwater schools had a pre-paradigmatic battle of sorts - a crisis - that did not lead to a scientific revolution. Neoclassical economics arose as a definitive victor when Keynesian economists decided to use the methods of the dominating paradigm (i.e. to micro-found their theories) to create what became New Keynesian economics.

If all normal sciences are dominated by a single paradigm, why should we worry about the lack of pluralism in economics?

In short, the world has become too aware of the anomalies (those phenomena that cannot be explained by the paradigm) of economics to keep ignoring them or explaining them in an ad hoc manner within the paradigm. Thus, economics is facing a crisis that may lead to a scientific revolution and introducing pluralism to its educational system could increase its likelihood.

No paradigm can explain all the phenomena of a science. Behavioural and experimental economics have been highlighting the anomalies that cannot be explained under the assumption of rational expectations since the publication of Prospect Theory in 1979. Contrary to what Popper’s falsificationism would suggest, falsifying a paradigm is not enough to reject it. And going back to Kuhn:

The decision to reject one paradigm is always simultaneously the decision to accept another, and the judgment leading to that decision involves the comparison of both paradigms with nature and with each other […] To reject one paradigm without simultaneously substituting another is to reject science itself.

The current economic paradigm has not been replaced and will not be replaced until a better substitute arises; there is also no way back to the pre-paradigm period, although “research during the crisis very much resembles research during the pre-paradigm period…”

All crises begin with the blurring of a paradigm and the consequent loosening of the rules for normal research. As this process develops, the anomaly comes to be more generally recognised as such, more attention is devoted to it by more of the field's eminent authorities.

Using Kuhn’s terminology and definition, economics is in a crisis period as the world has become too aware of its anomalies. And as noted by Benoît Cœuré, “the Nobel prize co-awarded to Robert Shiller last year will certainly encourage more research in [an alternative] direction”.

The teaching of economics is “both rigorous and rigid”. An economics student learns the paradigm (mainstream economics) to become a member of the economic community. As he graduates, he joins economists “who learned the bases of [the] field from the same concrete models, his subsequent practice will seldom evoke overt disagreement over fundamentals.”

This is exactly how Kuhn described the educational system of any mature science. But in the case of a science that is facing a crisis, changing this rigid educational system to a more pluralistic one, might help to increase the likelihood of a scientific revolution, i.e. the transition to a new paradigm.

For Kuhn, science progresses in two levels: in a cumulative manner through puzzle solving or efforts to fit nature into conceptual boxes of normal scientific research and in leaps through scientific revolutions. Without the latter, i.e. if the scientific community was not aware of anomalies, and crises and paradigm shifts did not occur, science would degenerate.

Student networks around the world call for a curriculum reform

What most of the leading student organisations and other global institutions are jointly pushing for is an economic curriculum with increased pluralism and greater relevance to real-world policy issues.

By pluralism these institutions mean, as ISIPE’s open letter puts it:

Theoretical pluralism: covering a wider range of schools of thought

Methodological pluralism: including qualitative methods

Interdisciplinary pluralism: the interaction between economics and other social sciences, for instance, philosophy of economics, history and history of economic thought, psychology, political science, etc.

“Bringing the discipline closer to the real world” could be interpreted in at least two different ways. For some, it is a call for less abstraction (less model-based) and more empiricism in economics and public policy analysis. For others like Benoît Cœuré, it is about introducing more real-world complexities, instead of stopping short at the models’ often oversimplified representations of reality.

The former interpretation might not be a problem for all economics undergraduate programmes, as some departments do emphasise applied over theoretical economics. But in many cases, the analysis of real-world events with theoretical tools is relegated to Q&A sessions or to the final class of each course, which is often not even graded. Regardless of the way we interpret it, bringing economics closer to the real world would allow students to apply the theoretical tools they learn to analyse contemporary challenges.

Breeding better economists for better policies

Today’s undergraduates are tomorrow’s policymakers”. Improving the economics curriculum is essential to produce better equipped professionals and deliver better economic policies in the future.

For a central banker, the problem with the economics curriculum is a different one. In his speech, Rethinking economics after the crisis, Benoît Cœuré emphasises the temporality problem between academia and policy making: academia pursues a long-run objective of searching for the truth, while policymakers “do not have the luxury of a long time horizon”.

Unfortunately, these different temporalities have an impact on economic thinking. The typical methodology of economic theory is first to consider a frictionless benchmark, corresponding for instance to a long-run steady state equilibrium, and then enrich it with frictions. While this is understandable from a methodological point of view, this approach can easily imply a neglect of the short and medium-term dynamics, drastic adjustments and complexities that are important for central banks.

Benoît Cœuré’s perspective is somewhat different from that of student groups: although he also mentions the need for a more pluralistic approach and making economics more relevant for policy, he focuses on the importance of teaching of frictions and complexities of the real world within the mainstream approach, something that is usually only covered at the PhD level.

Another unfortunate outcome is that the typical economics curriculum tends to emphasise the frictionless benchmark more than the realistic variants. Shifting the academic focus to a world with frictions would have a welcome impact on teaching, allowing central banks to hire from a pool of young economists better equipped with methods and tools to address policy challenges...

The most common justification for using oversimplified models at the undergraduate level is that they involve a degree of mathematical complexity that goes beyond what an average student can be expected to understand. Nevertheless, the implications of micro-founded models with frictions, market failures, sticky prices and other real world complexities, like bounded rationality, can be taught effectively without the mathematical rigor of a doctoral programme.

Students’ understanding of economics could be greatly enhanced by teaching them economic intuition and conclusions of complex models that they would otherwise only learn if they undertook a PhD in economics.

Concluding remarks

To recapitulate, economic schools should improve their economics curriculum by:

Bringing economics closer to the real world
though the introduction of complexities into undergraduate level education: this would allow public institutions, as well as private firms, to hire from a pool of better equipped young economists with tools to address policy challenges and understand our current unconventional economic environment.

Increasing theoretical, methodological and interdisciplinary pluralism without giving up the necessary rigor - which prepares students to solve the puzzles of normal science - in the teaching of mainstream economics. This would result in a new generation of more critical economists that are more likely to question the foundations of economics and will ultimately lead scientific progress.

I gratefully acknowledge Esther Bañales and Noah García for their editing and suggestions and professor Luís Marciales for his comments.

All quotations from Kuhn (including both, those in quotation marks and paragraphs in italics are taken from: Kuhn, Thomas S. (2012-04-18). The Structure of Scientific Revolutions: 50th Anniversary Edition . University of Chicago Press. Kindle Edition.

Thu, 21 Aug 2014 15:11:35 +0100
<![CDATA[Monetary policy cannot solve secular stagnation alone]]> http://www.bruegel.org/nc/blog/detail/article/1415-monetary-policy-cannot-solve-secular-stagnation-alone/ blog1415

This article is an extract from the vox.eu eBook Secular Stagnation: Facts, Causes and CuresEdited by Coen Teulings, Richard Baldwin

Larry Summers crystallized an important development and question in a recent speech given at the IMF research conference: has the world economy entered a period of “secular stagnation”? The slow recovery in the US since the financial crisis is his starting point and he argues that secular stagnation could retrospectively also explain features of previous decades such as low inflation. Professor Summers thereby picked up an old term by Alvin Hanson (1939), who made it in the Presidential Address of the American Economic Association in 1938. Back in 1938, Hanson focussed on the importance of (public) investment expenditure to achieve full employment. His argument was that for such investment to happen, the economy needs new inventions, the discovery of new territory and new resources and finally population growth.

Summers argument is centred on the fact that inflation rates have been falling in the past two decades and have been mostly lower than expected. Is there a permanent fall of the equilibrium real interest rates? Do our economies need real interest rates of -2 or -3 % to generate enough demand to achieve full employment? Is the fact that inflation rates were so low and even falling over the last decades really a sign that the global economy suffered from a permanent demand weakness? Was there really no demand excess?

Olivier Blanchard (2013) has published a blog post summarizing the recent IMF conference at which Larry Summers spoke and drawing lessons. One lesson is that it paid off if one had kept one’s fiscal house in order prior to the crisis. He then focuses on how to macro-manage a liquidity trap. In fact, if one agrees with his assessment that the effects of unconventional monetary policy are “very limited and uncertain”, then one can come rapidly to his conclusion that it would be advisable to have higher inflation rates in normal times, which makes it possible that in a crisis to drive down nominal interest rates more so that real interest rates fall even further. Krugman (2013)) goes one step further and even argues that the new normal may be a permanent liquidity trap, it would therefore not be advisable to have low inflation rates in the euro area (Krugman 2013b)

Three central policy measures to deal with secular stagnation

While I see the merit of the arguments by Krugman, Blanchard and Summers, I am worried that too little thinking is being put into the actual real economic drivers of secular stagnation and what could be done about them. Let me organize my thinking around three central points.

First of all, prior to the crisis, the global economy generated just enough demand to achieve reasonable employment rates thanks to significant bubbles in a number of major economies, excess borrowing by low-income households, high corporate borrowing, and/or unsustainable fiscal policies to balance the large amount of global savings. With the erupting crisis, high household, corporate and government borrowing and the house-price bubbles became visible as unsustainable sources of global demand. So would the answer to secular stagnation really have been more demand? Or put differently, how could one have achieved higher inflation rates prior to the crisis as Blanchard suggested without creating even more bubble-like phenomena? Isn’t the suggestion to solve the liquidity trap problem by running higher inflation rates prior to the crisis an attempt to cure the problem with the problem itself? If there is an insufficiency of demand even in normal times, this problem would need to be addressed with structural policies. The answer can hardly be more bubbles so that inflation rates go up. Using monetary policy to drive the real interest rate permanently to low, or perhaps, even negative rates is difficult and can create significant distortions in the economy.

This point can be illustrated by the US example: while monetary policy has been very supportive and has helped avoid a slide into deflation during the crisis, arguably before the crisis it contributed to the build-up to many of the problems in the US economy. The massive bubbles that resulted from the combination of lax monetary policy and an inadequate financial regulatory system should certainly be considered a problem, not a solution. A perhaps more important part of the solution to the current problem has been the acceptance of structural policies that are more conducive to a recovery: the US recovery has been helped by very significant debt reductions in the household sector thanks to non-recourse mortgages and similar things. More importantly, the banking system has been relatively quickly cleaned up, which also helped the recovery.

Turning to the euro area, I would advise against changing the ECB’s inflation target of close to but below two percent for two reasons. For once, such a step would severely undermine trust in a young institution, whose actions are still criticized in some countries of the EU’s young monetary union. It would constitute a break in the contract under which Germany subscribed to the monetary union. Second, changing the target in current circumstances would be largely ineffective: already the current target will not be achieved in the relevant time horizon and a higher target would only increase this gap.


Second, like Hansen, I believe in the importance of the structural factors that actually provide investment opportunities. The overall lesson of secular stagnation, as outlined by Larry Summers, seems to go in a different direction than monetary policy that in normal times can hardly help address an equilibrium negative real interest rate without risking major bubbles and unsustainable borrowing as the European and US experiences suggest. The fundamental question is why globally the equilibrium interest rate has been falling and the global economy has entered “secular stagnation”. Is it global demographics? Is it the lack of good investment opportunities? Is it the fact that we miss new places that can be “conquered”?

Certainly, population growth is starting to fall in many countries, especially in the more advanced economies. Yet, global population is still increasing. This would suggest that globally there should still be ample investment opportunities if framework conditions are put right. This is where the role of the integration of Asian and African economies into the global economy becomes central. More than half of the world population is concentrated in a small circle in Asia, including China and India. The more they are integrated into the global economy, the more they should increase global demand. The more opportunities for profitable investment should exist. To achieve this, a well-working financial system is critical. It would need to prevent excessive risk taking while channelling savings to the right countries and deployments. Clearly, a critical question is if and how saving and investment patterns will change in Asia. It will also be critical how sustainably capital accounts are opened up.

The euro area also provides important evidence that structural policies that allow for capital to be channelled into productive uses, that allow new innovations to emerge and that allow for new inventions are critical. Prior to the crisis, many thought that the euro area had solved the secular stagnation problem and actually provided the right framework conditions for more investment. The capital flows in the European periphery were praised for proving that capital would flow “downhill”, where its marginal productivity is still highest. Unfortunately, the reality turned out to be much less rosy. Instead of being used productively, much of the capital flows went into consumption spending, including on housing. Like in the US and UK, the increasing house prices initiated a financial accelerator model, in which more and more borrowing followed thereby driving a consumption boom.

The European experience underlines the importance of structural reforms that allow for proper business opportunities and innovation. The downhill capital flows are in principle welcome, but they only contribute to sustainable growth if they flow into an environment, in which they can drive investment as Hansen had outlined. In the European case, part of the problem was that the financial system did not properly steer capital flows into those productive uses. The regulatory and supervisory system of Europe’s monetary union was not properly developed, risk became too concentrated and moral hazard was prevalent. The creation of Europe’s banking union, while incomplete, is certainly a step in the right direction to solve this problem. But I am also convinced that Europe should be able to create much better investment opportunities to solve its stagnation. For this, reforms that reduce administrative burdens, improve education systems and better conditions for R&D are central.

Turning to Japan, the importance of structural reforms also becomes apparent. Since the election of Shinzo Abe as prime minister, Japan has embarked on a QE program of unprecedented scale. The effect has been a much weaker yen together with an increase in inflation. This was a welcome policy development. Yet, one year later, it also becomes clear that a strategy based on a weaker yen to increase export as the only anti-deflation strategy cannot work forever. To return to growth and inflation, the third arrow of Abenomics equally matters: improving investment conditions, creating new business opportunities, increasing competition in the economy and deepening trade integration.


Third, how shall macroeconomic policies deal with the liquidity trap, low inflation and insufficient demand problem in the euro area of today? Six years after the beginning of the crisis, growth remains sluggish and inflation rates are low or falling. The euro area is still at risk of falling into deflation. Euro area core inflation rates, i.e. inflation rates excluding volatile energy and food prices, have been falling since late 2011. Inflation expectations two years ahead are hardly above one percent and even at the five-year horizon, the market-determined inflation forecast is 1.19 percent. This has consequences. Lower-than-expected inflation redistributes wealth from debtors to creditors and increases the burden of the debtors. Thus, disinflation in the euro area undermines private and public debt sustainability, in particular in the periphery where the debt overhang is greatest. It is therefore a real risk for the euro area as a whole and should be addressed.

I see a role for both, monetary and fiscal policy, in helping overcome this low growth-low inflation environment. Turning first to monetary policy, it has to deal with two central problems in the euro area. The first is that monetary policy should not undermine the ongoing relative price adjustment process between the euro area periphery and the euro area core (see Figure). A monetary policy measure that would increase inflation in the periphery only would undermine the restoration to health of the Eurozone economy. Instead, the policy measure should ensure to increase inflation rates in Germany as well as in the periphery. Ideally, German inflation rate should move well above the two percent target that the ECB has set for the euro area as a whole. The second concern in the euro area right now is that the process of banking sector clean-up is unfinished. The ECB certainly would like to avoid preventing a bank restructuring with monetary policy measures that would overly distort prices.




Source: DG ECFIN – E4. Note: the real effective exchange rate vs EA 18 aims to assess a country’s price or cost competitiveness relative to the currency area as a whole. It corresponds to the nominal effective exchange rate deflated by the GDP deflator.



In Claeys et al (2014), we have argued that a quantitative easing programme focussed on the purchase of ESM/EFSF/EIB/EC bonds, corporate bonds and ABS would overcome those constraints and help to increase inflation via a portfolio rebalancing effect and a weaker exchange rate. The recent decision by the ECB (2014) – while a welcome form of monetary and credit easing – is unlikely to be enough to push demand and inflation upwards. I am thus not quite as negative on QE as Olivier Blanchard and also the Japanese experience shows that a large monetary policy measure can be part of the solution even if the nominal interest rate is already at the zero lower bound.

But fiscal policy will also have to play a larger role. One of the big problems in the euro area has been the weakness in public investment in the last years in contrast to the US, where public investment actually increased. A lot of the weakness in public investment needs to be solved by more public investment in Germany. More European level investment in European public goods such as new and better energy and digital networks should also be undertaken. This brings us back to the work by Hansen: public investment and new investment opportunities are needed to address secular stagnation.



Blanchard, Olivier (2013), Monetary policy will never be the same, Voxeu Blog, 27 November 2013 

Claeys, Darvas, Merler, Wolff (2014), Addressing low inflation: the ECB’s shopping list, Bruegel policy contribution.

ECB (2014), ECB press conference 

Hansen, (1939), Economic progress and declining population growth, American Economic Review, March

King, Stephen (2013), There is no easy escape from secular stagnation, FT blog 25 Nov 2013 

Krugman, Paul (2013), Three charts on secular stagnation 

Krugman, Paul (2013b), Secular stagnation in the euro area

 Summers, Lawrence H (2013), "Crises Yesterday and Today", speech at the 14th Jacques Polak Annual Research Conference, November

Tue, 19 Aug 2014 09:53:44 +0100
<![CDATA[Blogs review: The forever recession]]> http://www.bruegel.org/nc/blog/detail/article/1414-blogs-review-the-forever-recession/ blog1414

What’s at stake: As the recovery takes hold in the US, Europe appears stuck in a never-ending slump. With the ECB systematically undershooting its inflation target and recent signs that inflation expectations could become de-anchored, the bulk of commentators in the blogosphere are again calling for more monetary actions. Noticeably, some have completely lost hope in the ability of the European institutions to turn this situation around and are now calling for countries to simply break away from the EMU trap.



The greater depression

The Economist writes that this week’s figures for the euro-zone economy were dispiriting by any measure. An already feeble and faltering recovery has stumbled. Output across the euro area was flat in the second quarter. The new GDP figures are yet more evidence that the euro-zone economy is in a bad way. It is not only that growth is evaporating; inflation is also extraordinarily low. 



Matt O’Brien writes that it's been six-and-a-half years, and eurozone GDP is still 1.9 percent lower than it was before the Great Recession began. It "only" took the U.S. economy seven years to get back to where it'd been before the Great Depression hit. Eurointelligence writes that until earlier this year, the eurozone’s macroeconomic development was a core vs. periphery story. If that had continued, the eurozone would have gone through a somewhat painful adjustment. But with core economies growth and inflation also low and falling, this is not happening. Brad DeLong writes that in the middle of 2011 it was possible to say that Germany had recovered from the crisis, that the remaining problems of southern Europe were the result of their own fecklessness, and that German growth was about to resume–it was wrong to say that, but it was possible. But we will soon have three years of no industrial production growth in Germany.

Source: Philippe Waechter

Ambrose Evans-Pritchard writes that it takes spectacular policy errors to bring about such an outcome in a modern economyEurointelligence writes that this is a recession caused by policy failure. It was not a financial crisis that has damaged the eurozone as much as the policy response to it: obsessive deficit cutting in a poisonous conjunction with obsessive central bankers (who obsess about everything, except meeting their own inflation target).

Jeffrey Frankel writes that the peculiar way individual European economies define a recession makes it harder for the public to see that the same wrong policies have been followed throughout the crisis. Under U.S. standards (where the start and the end of a recession is determined by a cycle dating committee) Italy would, for example, probably be treated as having been in the same horrific six-year recession ever since the shock of the global financial crisis in 2008. Citizens in Italy have now been given the impression that they have entered a new recession.  Voters may draw the conclusion that their new political leaders must have done something wrong.   But the picture is different if Italy has been in the same recession for six years.  The implication may be that the leaders have been doing the same wrong things throughout that period.   


Structural reforms, the ECB and the EMU trap

Antonio Fatas writes the central bank should, as in the US, communicate its view on how close the economy is to potential output, how much slack there is in the economy and how they plan to use their economic tools to address that gap. Otherwise, by always invoking structural reforms, the ECB sounds defensive as if they feel too much pressure to lift growth rates and they want to explain to the public at large that the low economic performance is not really their fault but the fault of governments' failure to reform.


Wolfgang Munchau writes that if the ECB continues blaming eurozone governments for not implementing structural reforms and continues missing its own targets, the eurozone will end up looking like Japan, but with one difference. Countries whose policy goes off track have nowhere to go. The member states of a monetary union have alternatives. By failing to deliver on its inflation target, the ECB could give member countries a good reason to leave the eurozone: they could have a better central bank.

Ambrose Evans-Pritchard writes that there is no point negotiating. The European institutions have failed to ensure a symmetric adjustment that compels both North and South to take equal steps to close the intra-EMU divide from both ends, befitting their equal responsibility for mismanaging the EMU joint venture in its early years. Italy must look after itself. It can recover only if it breaks free from the EMU trap, retakes control of its sovereign policy instruments and redominates its debts into lira, with capital controls until the dust settles.

Matt O’Brien writes that the euro is the gold standard with moral authority. And that last part is a problem. Both are fixed exchange rate systems that can turn a recession into a depression, because they make countercyclical policy impossible. But people are even more attached to the euro today than they were to the gold standard then. Now, in the 1930s, people equated the gold standard with civilization itself, and were willing to sacrifice their economies for it. The euro doesn't just represent civilization, but the defense of it, too. After all, the past 60 years of civilization have all been about making sure it never happens again. Europe's leaders aren't going to give that up because of a little thing like a never-ending slum.

Mon, 18 Aug 2014 10:46:05 +0100
<![CDATA[The global economy’s Groundhog Day]]> http://www.bruegel.org/nc/blog/detail/article/1413-the-global-economys-groundhog-day/ blog1413

This piece was published by Project Syndicate on 7 August 2014.

In the movie “Groundhog Day,” a television weatherman, played by Bill Murray, awakes every morning at 6:00 to relive the same day. A similar sense of déjà vu has pervaded economic forecasting since the global economic crisis began a half-decade ago. Yet policymakers remain convinced that the economic-growth model that prevailed during the pre-crisis years is still their best guide, at least in the near future.

Consider the mid-year update of the International Monetary Fund’s World Economic Outlook, which has told the same story every year since 2011: “Oops! The world economy did not perform as well as we expected.” The reports go on to blame unanticipated factors – such as the Tōhoku earthquake and tsunami in Japan, uncertainty about America’s exit from expansionary monetary policy, a “one-time” re-pricing of risk, and severe weather in the United States – for the inaccuracies.

Emphasizing the temporary nature of these factors, the reports insist that, though world GDP growth amounted to roughly 3% during the first half of the year, it will pick up in the second half. Driven by this new momentum, growth will finally reach the long-elusive 4% rate next year. When it does not, the IMF publishes another rendition of the same claims.

This serial misjudgment highlights the need to think differently. Perhaps the focus on the disruptions caused by the global financial crisis is obscuring a natural shift in developed economies to a lower gear following years of pumped-up growth. Moreover, though emerging economies are also experiencing acute growth slowdowns, their share of the global economic pie will continue to grow. In short, tougher economic competition, slower growth, and low inflation may be here to stay.

In the United States, conditions for an economic takeoff ostensibly have been present for the last year. Household debt and unemployment have fallen; corporate profits and cash reserves are large; the stock market is valuing the future generously; banks are ready to lend; and fiscal consolidation is no longer hampering demand.

Yet, contrary to expectations, growth in household consumption has remained lackluster, and businesses have not ramped up investment. In the first two quarters of this year, America’s GDP barely exceeded the level it attained at the end of last year, and much of the increase was driven by goods that have been produced but not yet sold. The prevailing explanation – a brutally cold winter – is wearing so thin that everyone should be able to see through it.

American consumers remain scarred by the crisis. But there is another problem: in their homes and workplaces, the sense of excitement about the future is missing, despite all the gee-whiz gadgetry that now surrounds them. And while the US Federal Reserve’s policy of quantitative easing has propped up businesses, it is no substitute for the enthusiasm and anticipation needed to propel investment.

Even the reduced global forecast of 3.4% GDP growth for this year is likely to prove excessively optimistic. Before the crisis, world trade grew at 6-8% annually – well faster than GDP. But, so far this year, trade growth remains stuck at about 3%.

Failure to recognize the fundamental slowdown that is occurring is reinforcing the expectation that old models can revive growth – an approach that will only create new fragilities. Atif Mian and Amir Sufi warn that US consumers’ purchases of cars and other durables have been bolstered by the same unsustainable “subprime” lending practices that were used to finance home purchases before the crisis.

Similarly, Mark Carney, Governor of the Bank of England, envisages a Britain with a Cyprus-sized financial sector amounting to 900% of GDP. And economist Michael Pettis cautions that China’s reliance on policy stimulus to kick-start the economy whenever it stalls will merely cause macroeconomic vulnerabilities to accumulate.

The two tectonic shifts in the global economy – slower GDP growth and increased emerging-market competition – have created a fault line that runs through Europe. The technical lead held by Europe’s traditional trading economies is being eroded, while wage competition is encouraging fears of deflation. And, with the eurozone’s most debt-burdened economies bearing the brunt of these shifts, Italy is sitting directly atop the fault.

The European Central Bank, however, is unable to revive eurozone growth on its own. Given the resulting drag on the global economy – and especially on world trade – it is in the world’s interest to engineer a coordinated depreciation of the euro. At the same time, a globally coordinated investment stimulus is needed to create new opportunities for growth.

Just as Bill Murray’s character could not escape Groundhog Day without radically changing his life, we cannot expect different economic outcomes without fundamentally different growth models.

Fri, 08 Aug 2014 10:22:40 +0100
<![CDATA[Fact: Banco Espirito Santo gets a 4 billion euro recap]]> http://www.bruegel.org/nc/blog/detail/article/1412-fact-banco-espirito-santo-gets-a-4-billion-euro-recap/ blog1412

Over the weekend, Portuguese authorities announced the recapitalisation plan for Banco Espirito Santo, involving a 4.4 bn euro capital injection. The plan will also include a bail-in of junior debtholders and shareholders as well as a restructuring of the bank, which will be split in two. BES is a test case for the new European approach to the management of banking crises and will be an important case study for policy makers.

After a month of rumors and suspicion, the extent of Banco Espirito Santo’s troubles - once Portugal’s biggest lender - have fully come into light. The central bank of Portugal unveiled on 3rd August a recapitalisation plan, including a restructuring of the bank and bail-in of shareholders and junior debt-holders.

This comes after the bank announced 3.6bn euro losses on July 30, greatly exceeding what was anticipated from previously published information.

As a consequence, BES fell below the minimum solvency ratios in force (recording a Common Equity Tier 1 ratio of 5 per cent, i.e. 3 percentage points below the minimum regulatory level) and its access to the ECB’s liquidity was suspended.

According to the Central bank, “the public perception of the Banco Espírito Santo, S.A. deteriorated further, as shown by the strongly negative performance of its securities, undermining depositors’ confidence. This negative public perception led to the suspension of transactions on Friday afternoon, 1 August 2014, with the risk of contaminating the perception regarding the other institutions of the Portuguese banking system”. In other words, thanks god it was friday, or the week could possibly have ended with a deposit run.

Source: WSJ

BES will end up being restructured and  split in two units. A new “good bank” or bridge bank in the European Commission’s wording, will collect depositors, senior bondholders and healthy assets, whereas bad loans, shareholders’ fund and junior creditors will remain in the old unit that will eventually be shut down. The new EU state aid regime, which was set in place by the European Commission last summer in order to deal with the transition towards the full Bank Recovery and Resolution Directive’s (tougher) provision, requires in fact the imposition of losses on shareholders and junior bondholders before using public funds. Senior debt will instead not be touched. Whether or not the bail-in of junior debt will be enough to absorb losses cannot be certain, especially in light of uncertainty prevailing on the actual size of intra group operations and final exposures. This will be an important variable to look at, with potential effects on the final outcome for public finances.

The newly created “good bank” will be capitalised by the Portuguese Resolution Fund, which will underwrite all its equity, to the amount of 4.9bn. Since the Portuguese Resolution Fund does not actually have enough money to do that - it’s been created in 2012 - it will receive a loan of 4.4 bn euro by the Portuguese State. And the Portuguese State allegedly will draw on some 6.4bn euro leftovers from the IMF/EU bailout funds that were specifically earmarked to banks’ assistance.

Whether or not the operation will turn out to be neutral, for public finances, will depend on whether and how this loan will be reimbursed. This is a very important point in light of Europe’s struggle to overcome the sovereign-banking fragilities that has emerged as a characteristic feature of the crisis and meet the objective that taxpayers’ money are less on the frontline in the future. But there seems to be a bit of confusion on this crucial point, at the moment,

The European Commission states that this loan will be primarily reimbursed by the proceeds of the sale of assets of the Bridge Bank. Which means that the ultimate outcome for the Portuguese State is uncertain, and it will ultimately depend on the valuation that will be given to these assets, on the interest of investors in them and on the actual value that it will be possible to extract on the market. Incidentally, the central Bank of Portugal does not mention asset sales for the bridge bank but suggests that “the loan granted by the State to the Resolution Fund will be temporary and replaceable by loans granted by credit institutions”. On top of this, there is the issue of whether the bad bank will be able to function up to the point when it will be wound up without any additional funding.

A second point raised by this case concerns the supervision of very complex cross border structures (like BES turned out to be). It is by now known that the problems of BES stem from the very opaque transactions that were conducted within its highly complex group structure. As a reminder, Figure 1 shows the ownership chain. BES is 25% owned by ESFG (Espirito Santo Financial Group). 49% of ESFG is owned by Espirito Santo Irmaos SGPS SA, which in turn is fully owned by Rioforte Investment, which is in turn fully owned by ESI (Espirito Santo International).

BES - BES.png

Source: Tracy Alloway FT (@tracyalloway)

Frances Coppola has a must read detailed account of how the intra-group exposure led to the disastrous results. In short, BES was exposed to Rioforte for 270mn euro. It’s exposure to EFSG and subsidiaries in Panama and Luxembourg accounts for 927mn (most usecured) and it is interesting to point out that BES had sold debt issued by ESI and Rioforte to its own retail customers through its branches, with a guarantee to be provided by ESFG. When EFSG filed for creditor protection in Luxembourg, BES was also left to bear the guarantee to its retail clients that ESFG was no longer able to provide. 297mn euro more problems for BES came from the sell of ESCOM by Rioforte to an Angola company, which apparently never paid back. BES's actual exposure to debt securities from other parts of its Group that it has sold through its branches to clients is not yet clear but it could reach up to 3bn euro. And this may not even be  the full story, as it seems that in July the existence of three special purpose entities (SPEs) was found out, whose assets mainly consisted of bonds issued by BES and that were kept off the book.

Source: BES results

This picture shows probably better than anything else why the establishment of a single supervisor is an absolute necessity in Europe. Part of the reason why all this could happen even though - it is important to stress it once again - Portugal was under an EU/IMF/ECB programme that included also a monitoring of the financial sector, is that the complexity of this group was out of reach for the national supervisory authority that was in charge (Rioforte and ESI for example are based in Luxembourg, and they are not banks).

A third question concerns the bank-bank cross holdings. Figure 1 shows that the second largest shareholder of BES is in fact another bank, i.e. Credit Agricole. Credit Agricole said on Tuesday that it took a 708 mn euro hit from its stake in BES, nearly wiping out its second-quarter net profit, which fell 97.5 percent to 17 million euros. This raises a point of general importance, as banks tend to be important investors into other banks, also outside the Portuguese case. Almost 40% of securities other than shares issued by banks in the euro area are held by other banks in the euro area at the aggregate level, according to ECB data. The next question to ask therefore could be whether by trying to solve the sovereign-bank vicious circle we are not just unveiling another one, that deserve equal attention.

Wed, 06 Aug 2014 07:22:00 +0100
<![CDATA[Seed and Early Stage Finance and the Role of Policy]]> http://www.bruegel.org/nc/events/event-detail/event/454-seed-and-early-stage-finance-and-the-role-of-policy/ even454

Young innovative firms face many difficulties accessing seed and early stage finance, and these difficulties have increased over the past several years. Banks have been reluctant to provide loans to startups as a result of the financial crisis. Meanwhile venture capital firms have become more risk averse and, in many cases, have focused on later stage investments. Angel investors have become more visible and active through groups, syndicates and networks, and increasingly are playing an important role in seed and early stage finance. Crowdfunding platforms in Europe are also engaging in equity financing.

There has been increasing concern from policymakers around the world about the growing financing gap for high growth firms, particularly in the seed and early stage. As a result, governments in many countries have sought to address the financing gap and perceived market failures by supporting the seed and early stage market. However, the objectives behind these interventions often go beyond addressing financing gaps. Many countries recognize the critical role that young innovative firms play in creating jobs and economic growth and are seeking ways to facilitate the creation and growth of these firms.

This event will highlight the gaps that exist in the seed and early stage market and the policies that governments have put in place, in Europe as well as other countries around the world, to address those gaps.


  • Thomas Hellman, Professor of Entrepreneurship and Innovation, Saïd School of Business. Oxford University, United Kingdom
  • Anne Glover, Chief Executive and Co-founder of Amadeus Capital Partners and Chair of EVCA

About the speakers

Dr. Thomas Hellmann is a Professor of Entrepreneurship and Innovation at the Saïd School of Business at Oxford University. He holds a BA from the London School of Economics and a PhD from Stanford University. He previously was a member of faculty at the Graduate School of Business, Stanford University, and the Sauder School of Business, University of British Columbia. He also held visiting positions at Harvard Business School, the Wharton School (University of Philadelphia), Hoover Institution (Stanford), INSEAD (France) and the University of New South Wales (Sydney, Australia). Professor Hellmann has taught executive, MBA and undergraduate courses, mostly in the areas of entrepreneurship and entrepreneurial finance. Professor Hellmann’s research interests include entrepreneurial finance, entrepreneurship, innovation, strategic management and public policy. He is also the founder of the NBER Entrepreneurship Research Boot Camp, which teaches the frontiers of entrepreneurship economics and entrepreneurial finance to PhD students.

Anne Glover is Chief Executive and Co-founder of Amadeus Capital Partners, the international technology investor, which has raised £600m for investment in high growth technology companies since 1998. There she brings together her many threads of her experience — as a scientist, operating manager, and venture capitalist. Early in her career, she worked in the US, in manufacturing before moving into strategy consulting. In 1989, she joined Apax Partners (& Co) in the UK to invest in early stage companies, before becoming a business angel and then Chief Operating Officer of Virtuality Group. Anne was Chairman of the British Venture Capital Association (BVCA) from 2004 to 2005 and is currently Chairman of the European Venture Capital Association (EVCA). She is a member of the UK Government’s Council for Science and Technology, a member of the London Business School’s Private Equity Institute Advisory Board and serves on the boards of Glysure, Covestor Inc, Nomad plc and the Royal Society Enterprise Fund. Anne holds an MA in Metallurgy & Materials Science from Clare College, Cambridge, and a Masters in Public and Private Management from Yale School of Management. In June 2006 she was awarded a CBE for services to business, and in July 2008 was elected an honorary fellow of the Royal Academy of Engineering.

Practical details

  • Venue: Bruegel, Rue de la Charité 33, 1210 Brussels
  • Time: Tuesday, 16 September 2014, 8.15-10.00. Breakfast will be served at 8.15 after which the event begins at 8.30.
  • Contact: Matilda Sevón, Events Manager - registrations@bruegel.org

Tue, 05 Aug 2014 15:11:51 +0100
<![CDATA[Are financial conditions in China too lax or too stringent?]]> http://www.bruegel.org/nc/blog/detail/article/1411-are-financial-conditions-in-china-too-lax-or-too-stringent/ blog1411

The pronounced slowdown in China’s GDP growth in recent years has raised the important question of what might be its principal causes. The usual suspects are many and might include rebalancing pains associated with China’s domestic and external imbalances, less favourable demographics resulting in a stagnant labour force, fewer low-hanging fruits in market liberalisation, a less-accommodating global economy that no longer serves as a ready outlet for China’s surplus savings, and even the ongoing anti-corruption campaign that might have slowed government outlays and hit sales of luxury goods.

Could tighter Chinese financial conditions be another, unusual suspect contributing to the marked growth slowdown in recent years? If the recent economic slowdown was primarily structural, lax financial conditions would not help and might even worsen the structural problems that dragged down economic growth in the first place. Indeed, China over the past few years has witnessed concurrently weaker growth and rising credit as a ratio to GDP, in contrast to a ‘creditless recovery’ in the euro area.

I recently made a case for China to ease its monetary policy in the face of slowing economic growth and benign inflation. Moreover since the global financial crisis, the Chinese central bank until recently maintained a tighter monetary policy relative to its international peers such as the US Fed, the European Central Bank, the Bank of Japan and the Bank of England, on the basis of both the real policy rate and the real effective exchange rate.

However, whether a different monetary policy is to have a meaningful effect on economic agents depends in part on transmission channels. Europe’s half-asleep banking sector is a case in point.

To better assess the financial environment that actually influences economic behaviour in China, I construct a crude ‘financial conditions index’ (FCI) that is a weighted sum of five key financial asset prices — policy rate, one-year treasury yield, ten-year treasury yield, effective exchange rate and benchmark stock market index. Higher readings denote tightness for the first three rates and the effective exchange rate, so I use the inverse of the stock market index to capture changes in equity prices.

I place an equal weight of 20 percent on each of the z-scores of these five financial prices. Thus, increases in interest rates, the effective exchange rate and the inversed stock market index all result in a rise in the FCI, indicating a tightening of financial conditions. I will focus on the post-crisis period from January 2007 to March 2014 before the latest Chinese monetary easing. A positive FCI reading suggests tighter financial conditions than the period average.

Let’s consider two versions of the FCI, one based on nominal interest rates and the effective exchange rate and the other on their real (ex post) counterparts. It is also useful to construct the FCIs for the US, euro area, Japan and Britain using the same consistent methodology, so that the Chinese FCI can be compared both over time and to its peers.

The central message from these FCIs is that China’s financial conditions have tightened the most among the major economies since the global financial crisis (Graph 1). Also, China started with relatively lax financial conditions, but post-2011 tightened considerably, at least until the second quarter of 2014. By contrast, financial conditions in the G4 generally became less stringent over the same period, as shown by both the nominal and real alternatives.

Moreover, all of the five asset prices underlying the Chinese FCI indicate an unmistakable financial tightening over this period — rising short- and long-term interest rates, a strengthening renminbi and a languishing Shanghai stock market that lost 27 percent of its value during this episode.

Finally, the paths of the nominal and real FCIs have differed somewhat for these big five economies in the post-2007 period, but all indicate tighter financial conditions in China both over time and relative to its international peers. While the real FCIs of the five major economies have shown noticeable swings, their nominal counterparts except China’s display steady, large and synchronised declines, indicating considerable easing of the financial conditions outside China.

In sum, China’s financial conditions have become unmistakably tighter since the global financial crisis. Intuitively, this revealed financial tightening, both over time and relative to its international peers, could have meaningfully contributed to China’s recent slower economic growth. Puzzlingly, our price-based FCI seems to sharply contrast with the observed Chinese credit boom in the wake of the global financial crisis.

In any case, Chinese policymakers ought to take notice of such marked, sustained and broad-based tightness of the financial conditions. A good starting point would be to better understand the underlying causes behind the tighter Chinese financial environment. For instance, a rigid 75 percent regulatory cap on the bank loan-to-deposit ratio and a punitive 20 percent reserve requirement both might have added to financial tightness, prompting policymakers in Beijing recently to tweak these rules in an attempt to loosen the domestic financial conditions.

Assistance by Giulio Mazzolini and Noah Garcia is gratefully acknowledged.

Tue, 05 Aug 2014 13:56:45 +0100
<![CDATA[Chart: The UK reaching pre-crisis GDP levels]]> http://www.bruegel.org/nc/blog/detail/article/1410-chart-the-uk-reaching-pre-crisis-gdp-levels/ blog1410

Last week the UK Office for National Statistics announced that British GDP had reached its pre-crisis levels in the second quarter of 2014. As the figure above shows, in terms of year-on-year GDP growth rate, the UK has been one of the fastest growing Western European economies for the last year and a half and its growth has been accelerating. Germany, the second fastest growing economy, grows by 1% slower than the UK.

However, when put in a broader perspective, the UK economy still lags in comparison to other European economies. As the chart below shows, several of the major economies had already recovered to their pre-crisis GDP levels by the end of 2011, while the UK reached it only now. The reasons behind the British sluggish recovery could be many and their precise identification would require further analysis. However, in the context of long-term growth, the British performance is less impressive.

Note: GDP data for 2014Q2 was not yet available for the countries other than the UK at the time of publication.

Tue, 05 Aug 2014 05:51:36 +0100
<![CDATA[Blogs review: The new proposed IMF lending framework]]> http://www.bruegel.org/nc/blog/detail/article/1409-blogs-review-the-new-proposed-imf-lending-framework/ blog1409

What’s at stake: As many authors worry about the consequences of the peculiar interpretation of the pari passu clause in the Argentina saga, a relatively unnoticed proposal, which was discussed on June 13 2014 by the Executive Board of the IMF to reform its lending framework, could also have large implications in the context of sovereign debt vulnerabilities. If introduced, the new framework would most likely eliminate the systemic risk waiver, which allowed the Fund to lend large amounts to countries whose debt didn’t qualify as sustainable with high probability and would instead introduce the possibility of maturity extensions as a policy tool.

The need for a new system

Joseph Stiglitz writes that in the 1980s, when sovereign debts were mainly held by banks, restructurings could be done relatively smoothly. But with the growth of capital markets, these matters have become more difficult, as we have repeatedly witnessed. And with the growth of credit-default swaps and derivatives, they have become still worse. The experience of the recent eurozone crisis stands in sharp contrast to the Latin American debt crisis in the 1980s, when banks were not allowed to exit precipitously from their loans.

Kenneth Rogoff writes that Argentina’s latest debt trauma shows that the global system for sovereign-debt workouts remains badly in need of repair.  With emerging-market growth slowing, and external debt rising, new legal interpretations that make debt future write-downs and reschedulings more difficult do not augur well for global financial stability. Back in 2003, partly in response to the 2001 Argentine crisis, the IMF proposed a new framework for adjudicating sovereign debts. But the proposal faced sharp opposition not only from creditors who feared that the IMF would be too friendly to problem debtors, but also from emerging markets that foresaw no near-term risk to their perceived creditworthiness. The healthy borrowers worried that creditors would demand higher rates if the penalties for default softened.

The 2002 Exceptional Access Framework and its 2010 reform

The IMF writes that prior to 2002, the exceptional access policy was designed to be very flexible—and was implemented that way. In circumstances where a member sought financing in excess of the established limits, the Fund had a policy of waiving the limits on the basis of  “exceptional circumstances”—with no criteria as to what these circumstances were and why they should be considered particularly exceptional. The Fund found itself invoking the exceptional access policy with greater frequency as capital account crises arrived with greater frequency during the 1990s. The Fund’s decision to lend to Argentina in 2001, and the subsequent default of the country’s debt, served as the final catalyst for a broad review of the Fund’s exceptional access policy. This review culminated in the 2002 reform.

The IMF writes that under the “2002 framework” (the Exceptional Access Framework) the Fund may provide large scale financing without the need for a debt restructuring if the Fund determines that the member’s debt is sustainable with high probability. The problem with that approach came to the fore during the Fund’s experience with the euro area programs. While the DSAs produced did not conclude that debt was unsustainable, they were also not able to conclude that the debt was sustainable with a high probability. Under the terms of the 2002 policy, the only choice for the Fund would have been to condition Fund support on the implementation of a debt restructuring operation that was of sufficient depth to enable the Fund to conclude that, post restructuring, the member’s indebtedness would be sustainable with high probability. Out of concern that an upfront debt restructuring operation would have potentially systemic effects, the Fund opted to amend the framework in 2010 to allow the requirement of determining debt sustainability with “high probability” to be waived in circumstances where there is a “high risk of international systemic spillovers.”

Brett House writes that many IMF member countries have argued, however, that this change was both ad hoc and unfair: ad hoc because a major policy change was made in the same meeting that approved a loan; unfair because small countries outside a rich economic club such as the euro zone will never qualify for this special treatment.

Reprofiling instead of restructuring

Brett House writes that the IMF is considering a big shift in its lending rules. Eager to avoid a repeat of the massive loans it provided to the hopeless case that was Greece in 2010 – and Argentina in 2003 – the Fund has just released a staff paper that proposes major changes in its policy framework. The paper argues that the Fund should explicitly recognize that some sovereign crises fall in a messy middle—neither clear-cut insolvency, nor a temporary balance-of-payments problem. This gray zone calls for a new approach to crisis management. Rather than stretching credibility by certifying such cases as sustainable with “high probability,” or invoking the systemic exemption the proposed new policy would allow the Fund to lend in situations where the outcomes look less certain. Creditors would be asked to defer or “reprofile” their debt-service payments for a number of years.

Miranda Xafa writes that the IMF now proposes eliminating the systemic exemption and replacing it with a new framework that would make IMF support conditional on a debt “re-profiling” operation in exceptional access arrangements, in cases where the country has lost market access and there is uncertainty regarding debt sustainability, in order to avoid using Fund resources to bail out private creditors in such cases. Specifically, when these conditions are met, the IMF proposes maturity extensions of privately held debt for around three years through a voluntary debt operation, as a condition for providing exceptional access to IMF resources.

Source: IMF

The IMF writes that this would introduce greater flexibility into the 2002 framework by providing the Fund with a broader range of potential policy responses. Specifically, in circumstances where a member has lost market access and debt is considered sustainable, but not with high probability, the Fund would be able to provide exceptional access on the basis of a debt operation that involves an extension of maturities (normally without any reduction of principal or interest).

With the introduction of reprofiling as an additional tool, if the Board so decides, several Executive Directors favored removing the systemic exemption to the exceptional access framework, which had raised concerns about inequity and moral hazard associated with a large scale bail-out. Some others preferred to retain the systemic exemption, which in their view is a pragmatic way to safeguard financial stability in an increasingly integrated world and to avoid the perception of lack of evenhandedness. A few Directors focused noted that there could be operational difficulty in judging if both conditions for reprofiling have been met and the risk that the reprofiling expectation could trigger market volatility.

Mon, 04 Aug 2014 09:17:36 +0100
<![CDATA[Ukraine: Can meaningful reform come out of conflict?]]> http://www.bruegel.org/publications/publication-detail/publication/843-ukraine-can-meaningful-reform-come-out-of-conflict/ publ843
  • Apart from threats to its national security and territorial integrity, Ukraine faces serious economic challenges. These result from the slow pace of economic and institutional reform in the previous two decades, the populist policies of the Yanukovych era and the consequences of the conflict with Russia.
  • The new Ukrainian authorities have made pro-reform declarations, but these do not seem to be supported sufficiently by concrete policy measures, especially in the critical areas of fiscal, balance-of-payment and structural adjustment. Also, the international financial aid package granted to Ukraine has not been accompanied by sufficiently strong policy conditionality.
  • Ukraine urgently needs a complex programme of far-reaching economic and institutional reform, which will include both short-term fiscal and macroeconomic adjustment measures and medium- to long-term structural and institutional changes.
  • Energy subsidies and the low retirement age are the two critical policy areas that require adjustment to avoid sovereign default and a balance-of-payments crisis.


Since the end of 2013 Ukraine has faced a series of dramatic geopolitical, domestic political and economic challenges. First, there was mass protest in Kyiv’s central square against former president Viktor Yanukovych after he declined to sign an association agreement with the European Union. After collapse of Yanukovych’s regime, the internal Ukrainian conflict became internationalised with the illegal annexation of Crimea by Russia, and Russia’s active role in a ‘proxy’ war in the Donetsk and Lukhansk regions.

For this reason, international attention is concentrated on geopolitical threats and the violation of Ukraine’s territorial integrity. The geopolitical and security challenges are also at the top of the agenda for the new president and government of Ukraine. As result, the economic situation and economic reform are less prioritised, domestically and internationally. However, pressing economic questions must also be addressed. The unsatisfactory results of previous reform rounds were very much responsible for the recent political crisis and the fragility of the Ukrainian state. Most importantly, successful economic and institutional reforms are critical for attempts to consolidate both state and society and to prevent any new authoritarian drift.

The new Ukrainian authorities have made general pro-reform declarations, but these do not seem to be supported sufficiently by concrete policy measures, especially in the critical areas of fiscal, balance-of-payment and structural adjustment. The same must be said about the international financial aid package granted to Ukraine in April and May 2014, which has not been accompanied by sufficiently strong policy conditionality.

History of half-hearted reform

The recent developments in Ukraine are not the first time since independence in 1991 that the country has found itself at a critical juncture. In 1991-92, under Leonid Kravchuk’s presidency and on a wave of independence enthusiasm, Ukraine had the chance to build new democratic and market institutions as was done, for example, by the Baltic countries. Unfortunately, all the political energy went to giving old Soviet institutions ‘new’ Ukrainian names. The macroeconomic and social populism of that period led to hyperinflation at the end of 1993.

After Leonid Kuchma’s victory in the 1994 presidential election, some market reforms were finally enacted: most prices were liberalised, the exchange rate system was unified, subsidies and the fiscal deficit were reduced (but not eliminated), the issuing of money was brought under control and, finally, a new currency, the hryvna (UAH), was introduced in September 1996. This half-hearted reform process was stalled by a coalition of emerging oligarchs – the early winners from partial liberalisation and the macroeconomic disequilibria of early the 1990s, and the beneficiaries of various rents created by them – and old-style ‘red’ directors in industry and agriculture.

The next reform push came after the financial crisis of 1998-99 and Kuchma’s re-election in 1999 alongside Prime Minister Viktor Yushchenko, the former governor of the National Bank of Ukraine. There was some fiscal adjustment, reform of the management of public finance and attempts were made to restructure the loss-making and heavily corrupted energy sector. However, the political life of Yushchenko’s government was short (17 months) and it was soon replaced by a government that was again dominated by ‘red’ industrialists and oligarchs.

After the Orange Revolution at the end of 2004 and Yushchenko’s election as the third president of Ukraine, there was a political window of opportunity to start serious political, institutional and economic reform. Unfortunately, this was prevented by a political split inside the ‘Orange’ camp, in particular, the permanent political infighting between Yushchenko and twice Prime Minister Yulia Tymoshenko (2005 and 2007-10). The only success of the period were entering the World Trade Organisation (WTO) in 2008 and starting negotiations with the EU on the association agreement.

The economic boom of 2000-07 did not create pressure for serious reform either. The macroeconomic situation improved: after 10 years (1990-99) of steep output decline and thanks to reforms that were partially completed at the beginning of the new millennium (especially privatisation of the larger part of the manufacturing industry), a rapid recovery started. This was also fuelled by the 2003-07 global boom (high prices of metals and agriculture commodities, Ukraine’s main exports) and an oil boom in Russia. The UAH exchange rate stabilised against the dollar, inflation diminished for a while, and the fiscal deficit and public debt to GDP ratio declined as result of rapid GDP growth. On the institutional front, the economic system could be considered largely a market system, but heavily distorted by pervasive corruption and nepotism, poor governance (which made implementation of market-related legislation and definition of the rules of the game a permanent problem) and state capture by oligarchic groups, similar to most other post-Soviet countries.

The era of relative prosperity came to the abrupt end with the global financial crisis in 2008. The era of relative prosperity came to the abrupt end with the global financial crisis in 2008. Ukraine was particularly heavily hit, recording in 2009 a decline in GDP of 14.8 percent (Table 1), one of the steepest falls of all emerging-market economies. Despite a low public-debt-to-GDP level (12.3 percent of GDP in 2007), Ukraine was cut off from international markets because of a current account deficit (-7.1 percent of GDP in 2008), external debt exceeding 50 percent of gross national income, external debt service costs equal to 20 percent of export proceeds, and expectations of devaluation. Between September 2008 and January 2009, the UAH depreciated by almost 60 percent, from 4.85 to 7.70 UAH to the dollar, and then further down to 8 UAH to the dollar in 2009 (see Figure 1). Ukrainian authorities had to ask for the International Monetary Fund Stand-by Arrangement (SBA) in the second half of 2008.

Legacy of the Yanukovych era

After the victory of Viktor Yanukovych (who had been prime minister in 2002-04 and 2006-07) in the February 2010 presidential election, and the formation of the government of Mykola Azarov, a new reform effort was declared. Legislation was adopted related, among other issues, to social policy (a gradual increase in the retirement age of women from 55 to 60, lengthening the service period needed to obtain a minimum pension and, for various privileged groups, limiting the maxi-mum pension to 10 times the subsistence mini-mum), Ukraine’s WTO membership commitments, and preparing the legal ground for the forthcoming EU-Ukraine association agreement (including the Deep and Comprehensive Free Trade Agreement, DCFTA). However, corruption and predatory pressure from the narrow oligarchic elite around the president and his family led to a deterioration in the already poor business climate and further declining confidence in state institutions. The continuously deteriorating total investment rate, and the declining gross national savings rate (see Table 1) illustrate well the macroeconomic consequences of dysfunctional governance.

Governance failings and authoritarian drift created fertile social ground for the wave of civil unrest that erupted as the Euro-Maidan protest movement in November 2013, after it became clear that the government would not sign the association agreement with the EU (see the next section).

Another source of social disappointment was the deteriorating economic situation. After the 2008-09 crisis, Ukraine failed to return to its pre-crisis GDP level (Table 1). In 2010 and 2011, GDP grew by 4.1 and 5.2 percent, respectively (not enough to compensate for the 2009 output decline), followed by stagnation in 2012-13. Stagnation was a result of weak external demand (a consequence of the European debt and financial crisis), increasing domestic imbalances, a deteriorating business and investment climate and increasing Russian import restrictions – Russia wanted to discourage the government of Ukraine from signing the association agreement with the EU.

The Azarov government’s populist policies, such as keeping domestic energy prices low and generous wage1 and pension increases, led to deteriorating fiscal and current account balances, a typical manifestation of the twin deficits. These policies also effectively derailed the two subsequent IMF SBAs (of 2008 and 2010), both backed by the EU’s Macro-Financial Assistance (MFA). As result, from summer 2013, Ukraine started to face the growing danger of the subsequent balance-of-payments crisis (the two previous balance-of-payments crises happened in 1998-99 and 2008-09).

Relations with the EU

In 1990s and early 2000s, the EU’s relationships with countries of the former Soviet Union other than the Baltic states were based on the bilateral Partnership and Cooperation Agreements (PCA) which included, in the economic sphere, the Most-Favoured Nation clause, and technical, legal and institutional cooperation in such sectors as transportation, energy, competition policy, and some legal approximation in the areas such as customs law, corporate law, banking law, intellectual property rights, technical standards and certification. Ukraine signed the PCA in June 1994 and the agreement entered into force on 1 March 1998.

The next steps, after the start of the European Neighbourhood Policy in May 2004 and the Orange Revolution in Ukraine at the end of 2004, were the signing the of the EU-Ukraine Action Plan and the granting of market economy status to Ukraine (both in 2005). The action plan was updated and upgraded into the EU-Ukraine Association Agenda3 in 2009 and then, once again, updated in June 2013 with the focus on implementation of the forthcoming association agreement4.

In March 2007, the EU and Ukraine started negotiations on a new enhanced agreement to replace the PCA. At the Paris EU-Ukraine Summit in September 2008, the negotiated agreement was upgraded to the association agreement and included the DCFTA as an integral part. The negotiation was concluded in December 2011, and the text of the association agreement was initialled on 30 March 2012 and signed on 27 June 2014 after a series of dramatic political events in 2013 and first half of 2014. These included the failure of Yanukovych’s administration to meet the political preconditions for signing the association agreement stipulated by the EU (related to fair elections, judicial reform and so-called selective justice against opposition leaders5), the subsequent last-minute refusal to sign the association agreement during the Third Eastern Partnership Summit in Vilnius on 28-29 November 2013, the resulting Euro-Maidan mass protests in Kyiv and regime change (November 2013 – February 2014), Russian annexation of Crimea and war in eastern Ukraine (since March 2014).

The association agreement, in particular, its DCFTA component, will offer Ukrainian companies partial access to the European single market. At the same time, it might stimulate regulatory and institutional reforms in trade and investment-related spheres, and ease the business climate for domestic and foreign firms. It can also help to bring the country’s legal system, public administration and infrastructure services closer to EU standards (the acquis), depending on the political will and determination to reform on the Ukrainian side.

Economic challenges posed by the current crisis

The combination of recent dramatic political developments and the deteriorating economic situation has made the current crisis particularly serious and severe. Ukraine faces an existential threat to its independence and territorial integrity caused by Russia’s aggressive policy, and must also overcome the adverse consequences of its past failures in economic and institutional reform to secure its survival and rebuild domestic and international confidence.

As result of the violent conflict in eastern Ukraine and the related political uncertainty, real GDP will decline in 2014. According to the IMF estimate built into the SBA assumptions, the decline could reach 5 percent; according to the European Bank for Reconstruction and Development May 2014 forecast it could even reach 7 percent.

Decline in GDP and political turmoil, including war in the east, have undermined seriously the revenue flow to Ukraine’s budget and have created additional expenditure needs, especially in the area of national defence and security, humanitarian assistance and infrastructure repair. The same IMF estimates of April 2014 predicted an increase in the general government deficit to 5.2 percent of GDP in 2014 from 4.8 percent in 2013, despite the recommended fiscal adjustment. If the quasifiscal deficit of Naftogaz (the state-owned monopoly in charge of natural gas imports and distribution) is added, the combined deficit will increase from 6.7 percent of GDP in 2013 to 8.5 percent of GDP in 2014. Generally, the IMF projections are based on optimistic assumptions. They might underestimate the downside risks in the national security sphere, potential further disruption to trade relations with Russia and bank recapitalisation needs.

In the first half of 2014, the hryvna depreciated from 8 UAH to more than 11.5 UAH to the dollar, i.e. more than 45 percent. In the face of a looming balance-of-payments crisis, such an adjustment was both unavoidable and necessary to improve trade and current account balances. However, it has also put an additional burden on the balance sheets of unhedged banks, companies (including Naftogaz) and households. The ratio of non-performing loans (NPL) to total loans in the banking sector amounted to 23.5 percent at the end of 2013, i.e. before the UAH depreciation.

Overcoming these negative tendencies requires not only political stabilisation but also far-reaching fiscal adjustment and structural and institutional reforms to help eliminate macroeconomic disequilibria and unlock Ukraine’s long-term growth potential, as we detail in the next section.

International aid package

The international community supported the new Ukrainian authorities with a generous financial aid package. At the core of this package is the 24-month $17.1 billion IMF SBA, i.e. 800 percent of Ukraine’s quota in the Fund6, provided under so-called exceptional access7. The first tranche, which was disbursed immediately after the SBA’s approval (on 30 April 2014), amounted to about $3.2 billion, of which $2 billion could be used as budget deficit financing.

In April 2014, the IMF SBA was backed by an EU MFA loan of €1 billion available in two instalments and the EU’s grant of €355 million (also in two instalments) under the State Building Contract.

Recently, the World Bank approved two loans to Ukraine – the District Heating Energy Efficiency Project of $382 million and the Social Safety Nets Modernisation Project of $300 million. The US Government provided loan guarantees amounting to $1 billion. Investment loans can be provided by the European Bank for Reconstruction and Development and the European Investment Bank.

Weak conditionality

Even the most generous international aid package can provide only temporary respite to Ukraine’s balance of payments. To ensure the sustaining effect, aid must be supplemented by a domestic adjustment and reform package which aims at removing the roots of domestic and external imbalances. This is why the conditionality attached to financial aid should require reform of policies and institutions. However, such conditions are not obvious in the content of the IMF SBA and EU assistance.

The IMF SBA said the following reforms should be implemented:

  • Changes to the monetary policy regime, i.e. replacing the de-facto fixed but adjustable peg of the UAH to the dollar by a flexible exchange rate and inflation targeting, with the targeting of monetary aggregates as the intermediate solution in 2014;
  • Financial sector stability, i.e. in-depth diagnosis of Ukrainian banks and their recapitalisation needs (if necessary), and bringing banking regulations into line with best international practices;
  • Gradual reduction of the structural fiscal deficit;
  • Modernisation and restructuring of the energy sector, gradual adjustment of end-user energy prices accompanied by development of the respective social safety net;
  • Structural and governance reforms, improving the business climate.

At first glance, this looks like a comprehensive approach that aims to address key challenges faced by the economy of Ukraine. However, detailed proposals raise some doubts.

In fact, structural and governance reforms which are essential for improving the business climate and investors’ confidence have not been detailed in the SBA at all. There are no structural bench-marks – they are to be the subject of a separate diagnostic study.

The memoranda signed between the Government of Ukraine and the European Commission on the occasion of both the MFA and the State Building Contract are a bit more concrete in this respect. They set out some detailed conditions on fighting corruption, avoiding conflicts of interest for public servants, government transparency, changes in public procurement legislation and practices, public access to information, civil service reform, constitutional reform, election law and financing for political parties. However, very important areas such as deregulation of business activity, simplifying public administration structures and procedures, reform of the judiciary and law enforcement agencies and decentralisation (building genuine local and regional self-government) are virtually absent.

As we have noted, exchange-rate adjustment was crucial in avoiding a full-scale and uncontrolled currency crisis earlier this year. Similarly, attempts to make the exchange rate more flexible, together with the abandoning of existing restrictions on current account convertibility, should be welcomed. However, moving to inflation targeting in a one-year period does not look feasible, especially in a time of political and security turmoil and continuous fiscal pressure on monetary policy, and considering the limited legal and actual independence of the National Bank of Ukraine.

In order to create room for more independent monetary policy and an inflation-targeting regime, serious fiscal adjustment is needed, but on this the IMF programme looks rather weak and unconvincing. The fiscal adjustment target of 2 percent-age points of GDP annually plus another 1 percentage point of GDP of quasi-fiscal adjustment by Naftogaz cannot prevent further rapid increases in Ukraine’s fiscal deficit and public debt. According to the SBA targets, the general government deficit will stay at the level of 4.2 per-cent of GDP (without Naftogaz) and 6.1 percent of GDP (including Naftogaz) in 2015. Furthermore, several risks have been evidently underestimated in this projection, as we have noted.

As result of lax fiscal policy, the public debt-to-GDP ratio will jump from 40.9 percent in 2013 to 56.5 percent in 2014 and further up to 62.1 percent in 2015. Then it will reduce slowly to 51.9 percent in 2018, under the assumption that the economy will grow by at least 4 percent annually from 2016. So far, the government of Ukraine faced problems accessing private financial markets even at a much lower level of public debt. Similar public-debt funding constraints have been experienced by other post-Soviet and developing countries with similar characteristics to Ukraine. In practical terms, this means that despite the IMF programme, Ukraine will remain cut off from private debt markets for several years, and will be totally dependent on official financial aid.

Furthermore, without bolder fiscal adjustment there is no chance to increase substantially the very low rate of gross national savings (6 percent of GDP in 2013), because most private savings are absorbed by the public sector borrowing requirements, or to improve the current account balance. In turn, this will mean continuous balance-of-payments vulnerability and a limited pool of resources to finance investment.

Some of the proposed fiscal adjustment measures go in the right direction, such as abandoning the previous populist decision to replace the 20 per-cent VAT rate with two much lower rates. However, the fiscal effects of some one-off steps, for example, fighting tax fraud, might be overestimated. Wage and hiring freezes in the public sector might complicate the badly-needed reform of the civil service and public services such as education and healthcare. The Ukrainian public sector suffers from an excessive number of employees, who are poorly paid and managed. In such a situation, targeting the public-sector wage bill would be a better strategy to create both financial room and incentives for deep restructuring of both public administration and major public-service sectors.

In two areas of fiscal adjustment, the SBA looks particularly disappointing: elimination of energy subsidies and social welfare reform.

Energy subsidies

According to the IMF estimate8 post-tax energy subsidies in Ukraine amounted to 7.6 percent of GDP in 2012. They are much higher than in other countries of central and Eastern Europe and the former Soviet Union, apart from Turkmenistan, Uzbekistan and Kyrgyzstan. Most subsidies have the quasi-fiscal form (periodical recapitalisation of Naftogaz) and are aimed to support low house-hold tariffs for natural gas and district-heating services (which use natural gas as an input). The price paid by Ukrainian households for natural gas covers only about 20 percent of the cost-recovery level, and is ten times or more lower than the price paid by Lithuanian and Estonian households.

Low domestic energy prices are not only responsible for high fiscal and quasi-fiscal deficits and the deteriorating current account balance. They do not help to reduce excessive energy consumption and increase energy efficiency, which in Ukraine is among the lowest in the world and has hardly improved since 1990 (Table 2).

Furthermore, low energy prices do not create incentives to increase domestic energy production and invest in energy-saving technologies. They do not allow the elimination of one of the most obvious sources of corruption – trading in, and distribution of, subsidised energy imports – and they prevent the reorientation of the energy sector towards a competitive market environment. As long as Naftogaz is obliged to deliver gas at price below the cost-recovery level, its reorganisation, de-concentration and privatisation will not be possible.

Low energy prices are also counterproductive for reducing Ukraine’s energy dependence on Russia. In this context, the discussion on economic sanctions against Russia has limited merit as long as the international community is ready to support financially Ukraine’s overconsumption of Russian gas.

Unfortunately, despite a correct diagnosis, the IMF SBA sets only a very gradual price adjustment schedule with the aim of eliminating Naftogaz’s deficit only by 2018. The first round of tariff increases, for gas by 56 percent (from May 2014) and for district heating by 40 percent (from July 2014) looks drastic, but only if one disregards their very low initial level. In fact, the 2014 increase only compensates for the effect of UAH depreciation earlier this year. The next planned rounds of tariffs increases (by 40 percent in 2015 and by 20 percent in 2016 and 2017) might bring them closer to the cost-recovery level, but only if the UAH exchange rate and other cost components remain unchanged. And there is no certainty that the tariffs will reach the cost-recovery level even in 2017.

Oversized and inefficient welfare state

The general government total expenditure in Ukraine is close to the level of 50 percent of GDP, one of the highest in Europe and among emerging-market economies. In 2014, it might even exceed 50 percent of GDP. The biggest expenditure item is various social benefits (23.1 percent in 2013), of which public pensions account for 17.2 percent of GDP, again one of the highest shares in Europe and the world. The limited pension reform of 2011 (discussed previously) has stopped the growth in pension expenditure, but is unable to ensure system sustainability over the long term in the context of one of the least favourable demographic trends in Europe.

The retirement age, both statutory and effective, remains low by international standards and taking into consideration the rapid ageing of Ukrainian society. Numerous group privileges and special pension schemes offer opportunities for earlier retirement and generous benefits. As result, 13.6 million pensioners account for about one third of the Ukrainian population. This implies dependency ratio of 1 or higher.

Both the public components of benefits to better-off groups instead of lower-income groups. According to the World Bank’s Atlas of Social Protection, only 13.4 percent of total social-protection and labour-programme benefits went to the poorest 20 percent of the Ukrainian population in 2006.

What should be done?

Our analysis suggests there is an urgent necessity for the new Ukrainian authorities with the help and support of international community to elaborate a complex programme of far-going economic and institutional reforms. These should include both short-term measures of fiscal and macro-economic adjustment (much bolder than currently planned) and medium- to long-term structural and institutional changes. These are closely interlinked. For example, without removing energy subsidies, fiscal and balance-of-payments adjustment looks unrealistic and deeper reform of the energy sector (especially Naftogaz) cannot start, leaving serious distortions and sources of rents and corruption intact. Public pensions are a similar case: without increase in both the statutory and actual retirement age, the fiscal cost of the pension system will further expand, and labour market distortions and widespread informal employment will not be reduced.

Fiscal adjustment must play a central role in short-term policies, i.e. in 2014-15 because of deep dis-equilibria and sovereign insolvency risk. The concern that a too-radical fiscal adjustment can hurt growth prospects through the demand channel might not be justified in the Ukrainian economy in which eliminating distortions (for example, in the energy sector) and uncertainties (related to macroeconomic imbalances), and returning business confidence, can boost both investment and consumption. Long-term growth will be impossible without increasing the national savings rate, which requires, in first instance, the elimination of fiscal imbalances.

Discussion on the speed of reform must take into account both politics and economics. Obviously, fiscal adjustment which is crucial for rebuilding macroeconomic equilibrium and business confidence, will include politically unpopular measures, especially in relation to energy prices and the pension system. There will be social costs and various special interests will be threatened. How-ever, the unfavourable social consequences for the poor can be mitigated by well-targeted social safety nets. In turn, overcoming the resistance of special interest groups requires political mobilisation around the reform programme.

A time of geopolitical confrontation with a powerful neighbour might be considered to be an unlikely opportunity for difficult economic and political reform. However, Ukraine does not have any more time to waste. It must quickly rebuild confidence in its state institutions and economy. Perhaps the current patriotic mobilisation of Ukrainian society in the face of a threat to the country’s independence and after political change can create sufficient window of opportunity for difficult reforms.

Past experience tends to illustrate that such a window of opportunity is usually short-lived. Revolutionary mobilisation does not last long. People who do not see visible positive changes become disappointed, and enthusiasm is replaced by apathy and impatience. This opens door to populism and authoritarianism as experienced by Ukraine itself after the failure of the Orange revolution, or recently in Egypt. Easing social pain over longer period does not necessarily make life easier compared to a more radical and upfront reform package.

The resignation of Prime Minister Arseniy Yatsenyuk’s government on 24 July 2014 with the objective of facilitating early parliamentary election in October 2014 might help build a stable pro-reform majority. However, it also means a further delay in implementation of reforms, and additional instability and uncertainty, which will accompany the forthcoming election campaign in the environment of the unresolved conflict in the east.

For international donors, the best strategy is to offer a substantial aid package to Ukraine (which has partly happened) but with more stringent conditions on reform compared to the current pack-age, and immediate technical assistance. This means upgrading the existing aid package built around the IMF SBA, EU and World Bank programmes to ensure faster macroeconomic adjustment in short-term and deeper institutional and structural reform in the medium-to long-term, backed by more international resources.

Ukraine: Can meaningful reform come out of conflict? (English)
Fri, 01 Aug 2014 06:39:42 +0100
<![CDATA[Fact of the week: Russia sanctioned from all sides]]> http://www.bruegel.org/nc/blog/detail/article/1408-fact-of-the-week-russia-sanctioned-from-all-sides/ blog1408

Yesterday, the EU introduced new sanctions targeted at specific sectors of the Russian economy. This came one day after an international arbitration court in The Hague had decided for an unprecedented ruling related to Yukos, an oil company with a very controversial fate.

On Monday a Tribunal of the Permanent Court of Arbitration in The Hague ruled unanimously that Russia shall pay 50 billion USD to shareholders of Yukos, which back in 2003 used to be Russia’s biggest oil company. It “used” to be, because Yukos actually does not exist anymore. It was seized by the Russian state ten years ago, after the imprisonment of its principal and controversial shareholder, Mikhail Khodorkovsky.

At the time of his imprisonment, Khodorkovsky happened to be  Russia’s richest man, with a fortune estimated by Forbes to be around $15 billion in 2004, and quite outspoken. In October 2003, he was allegedly seized by “masked agents” aboard his corporate jet during a refueling stop in Siberia and convicted of theft, tax evasion and money-laundering in 2005. After serving 10 years in jail and he was pardoned by Putin in 2013.

Source: The Economist

After Khodorkovsky’s arrest, Yukos was broken up and nationalized, and most of its assets were transferred to Rosneft, the state-owned energy group which is by the way already on the US blacklist and now may be hit by EU sanctions too. The chart above effectively summarizes the share price development in these two years.

More precisely, the FT reports that YNG - Yukos largest oil producing unit - was acquired by a company called Baikal Finance Group, which was established two weeks before the auction and whose registered address seems to have been that of a bar in a town north of Moscow. YNG was allegedly worth ⅔ of Yukos total value (around 40 USD billion), but its core assets were sold to Baikal at 9.35 USD billion. Baikal had a capital of $359 only, but it managed to make the cash deposit of $1.77bn required to register for the auction. Rosneft then acquired the company following the auction.

Anders Aslund’s explains in detail the origins and bases of the case. The arbitration is in fact based on the Energy Charter Treaty, concluded by about 50 European countries in 1994 and entered into force in 1998, which contains strong guarantees against confiscation. Russia happened to have signed but never ratified it. The signature however provided sufficient justification for this case. In 2009, Russia withdrew from the Energy Charter Treaty just after its jurisdiction for this case was accepted by The Hague court. As a consequence, no new case can be raised against Russia on the basis of the treaty, but this one could continue. The defendant was the Russian Federation whereas the main claimant was GML Ltd., which owned 60 percent of Yukos and was formed by Mikhail Khodorkovsky and partners in 1997. The primary beneficiary of trusts that own 70% of GML is Leonid Nevzlin, partner of Khodorkovsky, to whom Khodorkovsky gave up his dominant share in 2005. The original claim was $103.5 billion.

The FT has an interesting collection of quotations from the Yukos judgement, which questions the means and motives of the Yukos affaire.

The arbitrators explicitly states that “The decision to seize and sell Yuganskneftegaz, which accounted for approximately 12% of Russia’s oil output and whose value on any estimation dramatically exceeded that of the alleged tax debt, can only be reconciled with a desire to destroy the Company and appropriate its core assets”.  And again that “the desire of the State to acquire Yukos’ most valuable asset and bankrupt Yukos. In short, it was in effect a devious and calculated expropriation by Respondent of YNG”.

Concerning the company that took over YNG, the judgement points out that “one of the most opaque facets of the YNG auction is the identity of Baikal, the sole and successful bidder at the auction which was acquired by State-owned Rosneft three days after its successful bid. [...] It was obviously a vehicle created solely for the purpose of bidding for YNG at the auction.”

The most important link, however, is the one between Baikal and Rosneft. The judgement states that “Rosneft’s purchase of the YNG shares from Baikal was an action in the State’s interest, the inference being that the State, then 100 percent shareholder of Rosneft, the most senior officers of which were members of President Putin’s entourage, directed that purchase in the interest of the State. It follows that that act, as well as the auction of YNG shares that underlay it, is attributable to the Russian State. ”. FT Alphaville has a must-read account of how it has actually been the loose lip of Putin himself to lead the arbitrators to the conclusion that Rosneft was acting on behalf of the State.

Long story short, Yukos former shareholders were awarded 50 bn USD in damages to be paid by the Russian Federation. The award is largest than any prior international arbitration award (20 times the previous record, to be precise) and large for Russia, as it accounts to almost 2.5% of GDP, 11 per cent of Russia’s foreign exchange reserves and 10 per cent of the national budget. (see figure below for a detail account of how the 50 bn are derived).

Source: FT

In what looks like a masterpiece in perfect timing, this comes one day before the EU also agreed a package of additional restrictive measures against Russia on the reason of its role in Crimea and Ukraine.

According to the statement sanctions will be “targeting sectoral cooperation and exchanges with the Russian Federation. These decisions will limit access to EU capital markets for Russian State-owned financial institutions, impose an embargo on trade in arms, establish an export ban for dual use goods for military end users, and curtail Russian access to sensitive technologies particularly in the field of the oil sector”.

The phase-three sanctions details published by the Council states that:

  • EU nationals and companies may no more buy or sell new bonds, equity or similar financial instruments with a maturity exceeding 90 days, issued by major state-owned Russian banks, development banks, their subsidiaries and those acting on their behalf. Services related to the issuing of such financial instruments, e.g. brokering, are also prohibited.
  • An embargo on the import and export of arms and related material from/to Russia was agreed. It covers all items on the EU common military list. The measures will apply to new contracts and not existing deals. This point that has been quite controversial, due to France’s decision to honour an existing contract to sell Mistral-class helicopter assault ships to the Russian navy.
  • A prohibition on exports of dual use goods and technology for military use in Russia or to Russian military end-users. All items in the EU list of dual use goods are included.
  • Exports of certain energy-related equipment and technology to Russia will be subject to prior authorisation by competent authorities of Member States. Export licenses will be denied if products are destined for deep water oil exploration and production, arctic oil exploration or production and shale oil projects in Russia.

These restrictions will now be formally adopted by the Council through a written procedure and they will apply from the day following their publication in the EU Official Journal, which is scheduled for late on 31 July.

The sky is getting greyer over Moscow and the number of issues that could keep policymakers awake at night is growing, on both fronts. The Yukos ruling hit Russian stocks, and the dollar-denominated RTS index of Russian shares closed down 3 percent according to Reuters. Rosneft shares were down 2.6 percent and Rosneft Dollar Bonds Slump to 12-Week Low (see below).

Source: Bloomberg

The FT reports one person close to Mr Putin saying the Yukos ruling was insignificant in light of the bigger geopolitical stand-off over Ukraine. “There is a war coming in Europe,” he said. “Do you really think this matters?”. Hopefully, at least the first part of the statement will not prove right.

Wed, 30 Jul 2014 06:17:56 +0100
<![CDATA[Blogs review: The economics of big cities]]> http://www.bruegel.org/nc/blog/detail/article/1407-blogs-review-the-economics-of-big-cities/ blog1407

What’s at stake: An intriguing paradox of our age is that the global economy is becoming increasingly local, with super-productive cities driving innovation and growth nationwide. This has generated a discussion as to whether local land use policies, which restrict the housing supply in high productive metro-areas, should be constrained by central governments to limit their negative externalities on overall growth.

Local economies in the age of globalization

Enrico Moretti writes that the growing divergence between cities with a well-educated labor force and innovative employers and the rest of world points to one of the most intriguing paradoxes of our age: our global economy is becoming increasingly local. At the same time that goods and information travel at faster and faster speeds to all corners of the globe, we are witnessing an inverse gravitational pull toward certain key urban centers. We live in a world where economic success depends more than ever on location. Despite all the hype about exploding connectivity and the death of distance, economic research shows that cities are not just a collection of individuals but are complex, interrelated environments that foster the generation of new ideas and new ways of doing business.

Enrico Moretti writes that, historically, there have always been prosperous communities and struggling communities. But the difference was small until the 1980’s. The sheer size of the geographical differences within a country is now staggering, often exceeding the differences between countries. The mounting economic divide between American communities – arguably one of the most important developments in the history of the United States of the past half a century – is not an accident, but reflects a structural change in the American economy. Sixty years ago, the best predictor of a community’s economic success was physical capital. With the shift from traditional manufacturing to innovation and knowledge, the best predictor of a community’s economic success is human capital. 

Ejaz Ghani, William Kerr and Ishani Tewari explain that the debate on whether cities grow through specialization or diversification dates back to Alfred Marshall and Jane Jacobs. Marshall (1890) established the field of agglomeration and the study of clusters by noting the many ways in which similar firms from the same industry can benefit from locating together. Jacobs (1969), on the other hand, pushed back against these perspectives – she emphasized how knowledge flows across industries, and that industrial variety and diversity are conducive to growth. 

Big cities in the crisis

Richard Florida writes that in the years since the economic crisis, powerhouse metros like San Francisco, New York, and Washington, D.C., have continued to grow in importance. In 2012, the top ten largest metropolitan economies produced more than a third of the country's total economic output.

Josh Lehner writes that the largest metros (the 51 largest have a population of 1 million or more) have seen the strongest gains in recovery. The second set of metros have seen some acceleration and the nonmetro (rural) counties have seen deceleration over the past year. It is also interesting to note that only the largest cities have seen growth rates return to pre-recession levels, while the others lag. This is at least partly due to the nature of the Great Recession in which housing and government have been large weights on the recovery. These jobs also play a disproportionately large role in many medium, smaller and rural economies than in big cities.

Source: Oregon Office of Economic Analysis

Dealing with the nationwide externalities of local regulations on land use

Wonkblog reports that for Enrico Moretti we should care about how San Francisco and big cities like it restrict new housing because the economic repercussions of such local decisions stretch nationwide. These super-productive cities have been among the least likely to add new housing since 1990. By preventing more workers who would like to live in the city from moving in, big cities are holding back the U.S. economy from being as productive as it could be. Yet, despite these negative national externalities, land-use policy has always been a local issue.

Chang-Tai Hsieh and Enrico Moretti write that one possible way to minimize this negative externality would be for the federal government to constraint U.S. municipalities’ ability to set land use regulations. Currently, municipalities set land use regulations in almost complete autonomy, since the effect of such regulations have long been perceived as predominately localized. But if such policies have meaningful nationwide effects, then the adoption of federal standard intended to limit negative externalities may be in the aggregate interest.

Chang-Tai Hsieh and Enrico Moretti write that a possible solution is the development of forms of public transportation that link local labor markets characterized by high productivity and high nominal wages to local labor markets characterized by low nominal wages. Enrico Moretti writes that California high-speed rail has always been thought of as a fast way to move people from Los Angeles to San Francisco, as competing with the plane. But it might be that actually its most meaningful economic impact would be as a way to allow people in Central Valley low-wage cities to commute to the Bay Area

Inequality and big cities

Kristian Behrens and Frédéric Robert-Nicoud write that inequality is especially strong in large cities. Large cities are more unequal than the nations that host them. For example, income inequality in the New York Metro Area (MSA) is considerably higher than the US average and similar to that of Rwanda or Costa Rica. Large cities are also more unequal than smaller towns. While larger cities increase the income of everyone, the top 5% benefit substantially more than the bottom quintile.

Tue, 29 Jul 2014 08:25:32 +0100
<![CDATA[Chart of the Week: The Big Mac (index) and euro area adjustment]]> http://www.bruegel.org/nc/blog/detail/article/1406-chart-of-the-week-the-big-mac-index-and-euro-area-adjustment/ blog1406

Following up on previous comments on the Big Mac index and euro area adjustment, the latest data-update suggests a slow-down in the price adjustment between euro area countries taking place since the beginning of the crisis.

Source: The Economist. Note: the price for Portugal in July 2012 are considered an outlier, interpolation has been used to correct for this.

The chart above shows that there was nearly no change in big mac prices over the last year (blue bar, July 2013 to July 2014), except for Greece. While one could still observe major downward price adjustments of big mac burgers in Greece and Ireland in the period from 2011 to 2012, and to a lesser extent from 2012 to 2013, the price adjustment has stopped in Ireland and even reversed in Greece over 2013-2014. In Portugal, Spain and Italy, no downward pressure of prices could be observed, as big mac prices increased somewhat throughout the period.

A similar picture emerges when looking at inflation developments (see below). Inflation in the euro area has been falling since late 2011, and has been below one percent since October 2013. Core-inflation, a measure that excludes volatile energy and unprocessed food price developments, has followed suit. In particular, since the beginning of 2011, the core-inflation rates of Ireland and Portugal have dipped into negative territory at some point. More interestingly, Greece and to a lesser extent Cyprus have both experienced extended periods of deflation, and in the last months also Spain’s’ core inflation dropped to -0.1 % yoy. However, Greece recently experienced somewhat less deflation (-1.4 % yoy in June 2014) than some months ago and also Cypriot and Irish core inflation rates are on an upward trend. This suggests that price adjustment has slowed down in these countries.  

Source: Eurostat

Mon, 28 Jul 2014 14:03:21 +0100
<![CDATA[India torpedoes the Bali Trade Facilitation deal]]> http://www.bruegel.org/nc/blog/detail/article/1405-india-torpedoes-the-bali-trade-facilitation-deal/ blog1405

Citing concerns over food security, after a Cabinet meeting headed by the Prime Minister Narendra Modi last week, India reportedly decided against signing onto the trade facilitation protocol that was agreed upon at the WTO’s the Ninth Ministerial Conference at Bali last December as a key deliverable under the Bali package2. While this is not yet an official position on the issue, concerns are rife that India may actually make good on the threat, if only as calculated brinkmanship to get its way at the WTO on its food security and public stockholding concerns.

Other than South Africa and a few members from the G33 group, India stands alone in this most recent negotiating spat. Several countries even issued statements saying that a failure to agree on the protocol would be a massive blow to the WTO’s credibility3. Member’s adopting/signing onto the TFA protocol on July 31 is a key first step before the deal can be ratified for implementation by July 31, 2015.

The Bali package is an early harvest of the 13 year old multilateral trade negotiations under the Doha Development Round (DDR), which has been faltering since its inception given the wide divergence in expectations of the key negotiating partners from the trade agreement. The Bali package included 10 agreements. They comprise a binding agreement on trade facilitation4 and four descriptive items in agriculture such as general services, public stockholding for food security purposes, understanding the tariff rate quota administration provisions of agriculture products, and export competition. In the development dossier, the Bali package offered non-binding best endeavour outcomes on preferential rules of origin for least developed countries, organisation for the waiver concerning preferential treatment to services, duty-free and quota-free market access, and a monitoring mechanism on special and differential treatment.

As this author had noted in an earlier post, “the net immediate gains from the Bali agreement therefore boils down to the symbolism of resurgent multilateralism and the WTO”, given that other than in trade facilitation and food security, “in several other areas the ministerial declaration only consists of statements of intent and conditional implementation promises”. However, while commentators have noted the various asymmetries marking WTO's Bali package and the hypocritical stance of the developed countries at the WTO, and in particular the USA in the agriculture negotiations, the adoption of the mini-agreement in December 2013 did indicate a support for multilateral trade negotiations at a time when the world’s leading economies have decidedly turned pro-regional and increasingly nationalistic in their approach to trade liberalisation negotiations.

Is there any method in India’s madness?

As regards its design, under the paragraph 47 of the Doha Declaration of 20015, the early harvest Bali package is part of DDR’s single undertaking, although it can be implemented in a manner decided during the negotiations. And the Bali package envisaged agenda-wise sequential timelines for delivery6 of the different parts of the package, without hinting that progress in the different protocols need to be simultaneous or at similar speed, with the TFA adoption being the first deliverable scheduled for July 31, 2014 in order to facilitate implementation within the next 12 months.

The next key deliverable on the timeline was finalisation of the post-Bali DDA work programme before December 2014, while the permanent solution on public stockholding for food security purposes under the Agriculture Committee negotiations were slated for conclusion with a 2017 deadline, the latter’s extended timeline also reflecting the fact that food security issues still have to be negotiated, most likely as a part of the overall agriculture agreement. The only assurance on the subject was that the Peace Clause7 expiry was tied to the timeline of a “permanent solution” on the dispute over the legitimate uses of food reserves for food security, a definite negotiation gain that India scored at Bali.

Thus it can be argued that the above differential implementation timelines have determined prioritisation of certain sections of the Bali package in the Geneva based negotiations in 2014, although it has drawn criticism from the LDC group that expressed unhappiness stating that “everything else is being held hostage pending the conclusion of discussions on the TFA”. Critics have however argued that the concept of the single undertaking was undermined because trade facilitation had a quick implementation deadline while the other two parts of the Bali package, food security and policies to support least developed countries, had only vague commitments and distant deadlines. The fear is that by advancing agreement on only some parts of that broader development agenda, and by fast-tracking an issue of most interest to developed countries – trade facilitation8the logic of the single undertaking would dissolve and they would see no movement on the issues that matter to them most, agriculture and food security.

As discussed above, in light of the fact that India is likely to push for an extension of the July 31 first implementation deadline or suggest that the trade facilitation agreement be made “provisional” subject to progress on other Bali issues, countries now fear a derailment of the tentative gains in the multilateral track negotiations at the WTO. Concerned WTO members, in particular industrialised countries and other major developing country trading nations, have warned that failing to seal the trade facilitation protocol would unravel the whole package of trade agreements agreed upon in Bali, effectively destroying the chance of further global trade reform, something that India has long demanded. New Delhi’s stance that progress in food security negotiations would determine its adoption of the TFA protocol is thus treading on dangerous waters.

But it may be interesting to understand whether India’s threat to withhold its support for trade facilitation can effectively scuttle the Bali deal in the WTO’s consensus-based process. In fact there is a legitimate view emerging that perhaps too much is being made out of the TFA protocol outcome. All the protocol does is open the Marrakesh Agreement establishing the WTO to allow another agreement, in this case the TFA, to be added to the existing WTO Agreements. The protocol is therefore a mere legal instrument which allows this change to happen. Governments must still ratify the TFA following WTO’s procedural requirements, and only when two-thirds of the Members do so does it enter into force, but only for those countries which ratify. In fact it is theoretically possible that India could actually never ratify and thus never have to comply with the TFA requirements.

Unfortunately that move will be counterproductive for Indian businesses and their external competitiveness, even when Indian exports are largely in a narrow band of product categories that are either commodities or niche (traditional and manufactured) products and services, and are unrelated to any major global production networks’ trade chain. And this is the reason why Indian industry has been vocal in its disapproval over the current supposedly pro-business government’s willingness to put in jeopardy an agreement that would enhance national export competitiveness merely to “ensure that Indian minimum support prices (MSPs) for food products continue to be high”. Others have argued that if India's refusal to back the protocol derails the Bali deal, it could lose the four-year reprieve and face sanctions on its current foodgrain stockpile9 which critics say could be dumped into global markets, although in practice India does not have a history of dumping grain that it acquires for purposes of food security for the economically vulnerable, and its exports are usually at market prices.

Strategy or Lack of Vision?

Multilateral negotiations at the WTO are an extremely complicated exercise, requiring the fine balancing of a multitude of sectors and interests. Countries have to play off their internal lobbies' demand against the gains from trade, which are generally spread out over all their citizens; and unanimity is required, making progress subject to vetoes from countries with no stake in the future. It is doubly tragic, therefore, if such hard-won outcomes get torpedoed by one of the countries with most to gain from a strong multilateral trading system; India’s current economic development and trade patterns indicate that unilateralism and multilateralism are its welfare-optimising options, and ought to be preferred over the much-hyped gains from regionalism.

The new Prime Minister has often emphasised that all his policy actions will have only one single criterion of whether or not they serve India’s national interests. Mr. Modi has vowed to spur economic growth through sweeping changes to policies and seems committed to boosting India’s competitiveness by improving its business climate. In that light, the present government’s fixation with focusing primarily on alleviating domestic infrastructure and policy constraints for growth is laudable if India hopes to catch up with its neighbouring Asian powerhouse; China’s GNI per capita (PPP, in current international $) in 2013 stood at $11,850 – more than double of India’s $5,35010. And his government’s apathy to global governance issues and proactive multilateral engagement is then a corollary if one believes that good bureaucratic and diplomatic resources are limited and become ineffective when spread out thin.

That said, the strategists in the present Indian government would do well to consider in totality the related geo-economic developments before determining the country’s future stance towards regional/ global engagement. Unfortunately, not unlike the other economic powerhouses, the new Indian government’s current stance on the TFA (and multilateral trade negotiations in general) seems to reinforce the concern that a grand vision on future trade policy and a longer-term governance strategy is sorely lacking; the current thinking seems to be largely dominated by short-termism and protectionist-nationalist mindsets. As the panellists argued in a recent Bruegel workshop on the subject, this lack of strategic thinking may have grave consequences for the future of the global trade governance system, which if evolves in favour of fractured regional trade governance regimes will harm most the weaker developing countries, including emerging markets like India with limited integration into the global production and supply networks, and a large population of poor low-skilled workforce.

India has a history of resorting to aggressive brinkmanship to get its way at the GATT/WTO, but as an oft-used strategy it may have lost its edge already. It is clear that there is very limited support for its latest stance on the TFA protocol. On the other hand, doing nothing is an acceptable strategy only when it is backed by a long-term strategic thinking and foresight. Inertia and political opportunism are also often confused with continuity in policy making. Thus, one only hopes that there is more to India’s recalcitrant stance in the WTO this time around, beyond its use as a mere negotiating tactic. For it is becoming painfully apparent that in the current geo-political and economic context, doing nothing/ maintaining status quo in the multilateral forums is likely to extract a very stiff price in the future from everyone, and in particular a country like India.


[1] Marie Curie Fellow at Bruegel (Project MULTITRADE, No. 328351). This blog reflects only the author’s views and the European Union is not liable for any use that may be made of the information contained therein.

[2] However, media reports on the following day seemed to suggest that a change of stance is possible, and India might finally relent on the trade facilitation agreement (TFA), provided it gets an “assurance” from the WTO’s  member-countries, especially the developed nations, that issues concerning food security would be addressed along with TFA.

[3] The European Union has warned: "Without adoption of the Trade Facilitation Protocol by July 31 a great opportunity to mobilise trade as an instrument for growth and development would be lost, and the credibility of the WTO, which has during the financial crisis proven its value as a firewall against protectionism, would be further damaged." Japan also said it strongly urged "those members who take a contradictory stance" to try to achieve the common objective. A statement made by Thailand, Malaysia, Vietnam, Pakistan and other developing countries said: “A decision to step away (from TFA) will be in no one’s interest. It will undermine the ability of WTO to deliver for the future.”

[4] The TFA is often described as a "good governance agreement" for customs procedures that industrialised countries want the developing and the poorest countries to implement on a binding basis, failing which the latter can be hauled up at the WTO’s dispute settlement body.

[5] Paragraph 47 states:  With the exception of the improvements and clarifications of the Dispute Settlement Understanding, the conduct, conclusion and entry into force of the outcome of the negotiations shall be treated as parts of a single undertaking. However, agreements reached at an early stage may be implemented on a provisional or a definitive basis. Early agreements shall be taken into account in assessing the overall balance of the negotiations.

[6] And several countries have already said that renegotiation of existing timelines is not an option.

[7] We acknowledge here the inherent injustice of the Bali Peace Clause being offered to India and the G‐33 countries for just four years, and also that it excludes the subsidies measures and expires even if there has been no resolution of the other outstanding Doha issues. This is in sharp contrast to the nine-year long Peace Clause that the US and the EU negotiated in 1994 to protect themselves from WTO lawsuits over their hugely distorting subsidies and countervailing measures.

[8] This unfortunately has indeed been recommended by some American trade policy experts.

[9] India’s vast grain stockpiling and a US$22 billion annual food subsidy programme implemented by the previous government are (price) subsidies in breach of the WTO’s current specified limits.

[10] The corresponding figures in GDP per capita (current US$ ) are China: 6,807, India: 1,499, indicating a more than 4-fold gap.  

Mon, 28 Jul 2014 10:01:03 +0100
<![CDATA[Is the BRICS rise over?]]> http://www.bruegel.org/nc/blog/detail/article/1404-is-the-brics-rise-over/ blog1404

On one level, this seems like a rather odd time to be asking such a question, especially when the BRICS political leaders have just agreed to set up a joint development bank to be headquartered in Shanghai. So the BRICS name is certainly here to stay, and in terms of global governance, their influence is likely to rise as a group because of this development.  

Previously, the BRICS political leaders meetings had failed to agree anything specific and even once the creation of such a bank was first mooted, for the past two years, they appeared to have difficulties in agreeing where it might be located and how it should be capitalised. At this Fontaleza meeting in Brazil, they have confounded sceptics by agreeing not only both these key things, but also to have the first head of the Bank to be an Indian. What the Bank will prioritise in terms of lending and projects, we will have to wait and see, but one can think of many good ideas including shared road and rail infrastructure challenges, especially those with some common borders, projects for energy efficiency, alternative energies, clean and safe water, and of great importance to themselves, to focus on the growing resistance to antibiotics, a challenge that if a solution cannot be found will be very harmful for their futures.

But if the BRICS leaders hadn’t made this breakthrough, I am sure the siren rising about the end of the BRIC economic phenomena would be even louder and it is important to try and objectively deal with this, separately from this announcement, important as that is.

So, let’s deal with the case as to why the BRIC story might be past its prime. Some observers believed that the whole notion of a grouping of Brazil, Russia, India and China never made any sound sense because beyond having a lot of people, they didn’t share anything else in common. In particular, two are democracies, and two are not, obviously, China and Russia.  Similarly, two are major commodity producers, Brazil and Russia, the other two, not. And their levels of wealth are quite different, with Brazil and Russia well above $10,000, China around $ 7-8 k, and India less than $ 2k per head.  And the sceptic would follow all of this by saying, the only reason why Brazil and Russia grew so well in the past decade was simply due to a persistent boom in commodity prices, and once that finished, as appears to be the case now, then their economies would lose their shine, as indeed appears to be the case.  Throw in that China would inevitably be caught by its own significant challenges at some point, which the doubters would say, is now, then all is left is India, and if it weren’t for the election of Modi recently, there has not been a lot to justify structural optimism about that country recently.

It is factually the case that all four BRIC countries have seen their GDP growth rates slow sharply in this decade. From 2011-13, China has grown by 8.2pct compared to 10.5 pct the last decade, India has slowed to 4.6pct , down from 7.6, Brazil has grown by 2pct, down from 3.6, and Russia , some 3pct, compared to 4.6pct.  So all four have grown less, and in all cases, there are plenty of issues to worry about.

But, let’s now start to get serious. Because of China’s huge importance, the weighted average performance of the BRIC growth rate since 2011 is 6.5pct. Now this is down from 7.9pct the last decade, but higher than the previous two decades. China today is one and a half times the size of the other three put together, so its influence on their combined growth rate is more important. Related to this, the BRIC countries combined GDP is nearly as large as the US, and by end 2015, it will be the same size in current US$. (In PPP terms, it is already substantially larger than the US). So even with slower growth, the BRIC country’s economic influence is on the rise. In US$ terms, they are contributing decade to date more than 3 times to the world economy that of the US, and obviously in PPP terms, even more.

So, the idea that the importance of the BRICs is over is really not a credible objective economic issue. ( note I don’t make any inclusion of South Africa as that economy is so small, it is not justified to be regarded in the same economic sphere. It is actually not even the largest economy in sub-Sahara Africa anymore, Nigeria is today. And there at least 8 other so called emerging economies are much bigger than South Africa, some of them at least 3 times)

What is undoubtedly true is that the RATE of BRIC growth has slowed, but while this might be a surprise to the casual observer, it certainly isn’t to most who follow them closely. In fact, the 6.5pct decade to date is just 0.1pt less than I had assumed in 2010 that they would grow by 6.6pct. China, crucially is actually growing by more than I assumed, so far by 8.2pct, actually more than the 7.5pct I assumed. This is compensating for the weaker growth in the other three, which indeed has disappointed my expectations, especially Brazil and Russia, and to some degree India. So it might be truer that the BRIC story decade to date has been purely supported by China, and without that, then the disappointment might be much more justified. And it would follow that if China is about to slow a lot further, which many sceptics think, then the BRIC economic story would become marginally less.

The problem with this line of thinking is that while there are considerable challenges for China, in many cases, there is evidence that the policymakers are rising to those challenges and trying to deal with them, which I might point out is quite different from many other countries that often ignore them until they cause massive crises. For example, how many readers can recall any country deliberately trying to stop house prices rising as China has- possibly-successfully-done? A couple of years ago, people worried about housing bubbles in Beijing and Shanghai, they don’t talk about that anymore. Why? Because the problem has eased due to policy. Today the sceptics fear bubbles in so-called second and third tier cities, but I think there is a reasonable chance that the policymakers will deal with them especially with so many migrants still to migrate and, now, to receive proper full blown urban citizen rights including house ownership. And more importantly still, is the data itself. After months of clear slowing, much of it, including the recent PMI’s and June’s raft of economic data has all improved further, and from what I can see, 7.5pct looks to be in the bag for 2014, if not a bit stronger.

I do believe each of Brazil and Russia have got some challenges to face, that they are not yet confronting, which at the core is to reduce their dependency to the commodity cycle, and while there are many differences between them, they do both need to become more competitive and entrepreneurial outside of commodities and to boost private sector investment. Which leaves India, about who I have to say, following the really powerful election victory of Modi, I think there are clear reasons to expect big policy improvements, and I now don’t entirely rule out that this country could still match my 7.5pct expectation for the decade. It will be really difficult, but what is quite likely is that they may grow more than 7.5pct in the second half of the decade, and possibly faster than China.

So the BRIC economic story over? I think not, even without their historically important decision to create a shared development bank, the consequences of which we are set to learn about.

Sat, 26 Jul 2014 08:55:03 +0100
<![CDATA[Legal and illegal cartels in Europe]]> http://www.bruegel.org/nc/events/event-detail/event/453-legal-and-illegal-cartels-in-europe/ even453

Economists and policy analysts know very little about the conditions under which cartels are formed in different legal environments, how they behave against outsiders, how they behave against deviating insiders, and how they react to changes in the economic environment. This event will provide a space to discuss these aspects, based on two projects funded by SEEK.

One of the projects studies cartel organization – a topic on which there is little information to date – through the lens of legal cartels. While such cartels did not have to fear detection and prosecution, they faced the same internal organizational challenges as illegal cartels. The focus is on comparing empirically, in specific sectors, the organizational forms of legal cartels in countries with different legal regimes. The project has collected data on Austrian, Finnish, Norwegian, Swedish and American legal cartels.

The other project has developed new theoretical insight into the anatomy of hard-core cartels and combined it with a rich data set on the recent German cement cartel. The results of this project will be presented to the audience attending the event. The private data set comprises about 340.000 market transactions from 36 customers of German cement producers and encompasses most of the period during which the cartel was functioning, as well as a period after the collapse of the cartel.

This event is jointly organised by SEEK.

<br/> <br/> <br/> <br/>


11.30 -11.45: Welcome speech by Reinhilde Veugelers, Bruegel

11.45 – 12.15: Legal Cartels in Europe – A Historical Episode?

  • David Genesove, The Hebrew University of Jerusalem, Israel

12.15 – 12.45: Legal Cartels in Europe – A Cross National Comparison

  • Otto Toivanen, KUL Leuven Belgium
  • Konrad Stahl, University of Mannheim, Germany

12.45 – 13.00: Coffee Break

13.00 – 13.30: Illegal Cartels in Europe - the case of the German cement cartel

  • Kai Hüschelrath, MaCCI, ZEW, and University of Mannheim

13.30 – 14.00: Discussion

  • Member of the Cartel group, DG COMP
  • Member of a National Competition Authority

14.00 - 14.30: Lunch

Please note that this event will be held under the Chatham House Rule.

Fri, 25 Jul 2014 15:50:56 +0100
<![CDATA[Fact of the week: Lithuania changes the ECB’s voting system]]> http://www.bruegel.org/nc/blog/detail/article/1403-fact-of-the-week-lithuania-changes-the-ecbs-voting-system/ blog1403

Lithuania will become the 19th member of the Euro area on the 1st of January, following Wednesday’s Council endorsement. The most important part of the story - however - is not that someone is still brave enough to join the Euro area, but that Lithuania's accession will trigger a change in the voting system of the ECB.

Lithuania’s accession to the euro area will be effective on the 1st of January 2015. This will bring the number of eurozone members to 19 and the Governing Council’s members to 25 (6 members of the executive board and 19 National Central Bank governors). Enough to trigger a change in the ECB’s Governing Council’s voting system, which will start rotating.

Actually, the statutes of the European System of Central Banks and of the ECB already envisaged the switch to a rotating system when the number of euro area countries exceeded 15 (which has been the case since quite some time). However, in December 2008, the Governing Council decided to defer the decision until the number of governors exceeded 18. This was an exception possible under the letter of the Treaty, but no other escape clause is offered and the rotation is therefore unavoidable.

The idea behind the rotation is to ensure the effectiveness of the ECB’s decision making even with an increased number of participants. The Federal Open Market Committee (FOMC) of the US Federal Reserve uses a similar system, with 12 voting members, 7 of whom are members of the Board of Governors and hold permanent voting rights. Differently from the ECB’s case, in the US specific regional governors enjoy special treatment. The President of the New York Fed has a permanent voting right, the Presidents of the Federal Reserve Banks of Chicago and Cleveland vote every other year and the Presidents of the other nine Federal Reserve Districts vote every third year.

At present, the ECB governing council works under the principle of “one man, one vote” and decisions are taken with simple majority. Under the new regime, voting rights will invariably rotate every month. Only 15 (out of 19) governors will be given the right to vote every month, based on a rotating selection. 6 votes will come from the members of the ECB’s Executive Board, which will retain the voting right permanently, bringing the total number of votes to 21 (3 less than at present).

On top of that, votes will not be completely independent on the size of the countries anymore. The member of the Governing Council will in fact be assigned to groups, depending on the respective weight of their countries in the euro area economy (GDP at market prices, weighted for ⅚) and financial sector (MFIs’ aggregated balance sheet, weighted ⅙). The aggregate reference measure will be adjusted either every five years or when the number of EMU member states changes. Based on this ranking and as long as the number of governors does not exceed 21, the groups will be as follows (figure 1):

  • Group 1: will comprise the governors of the NCBs of the 5 countries with the largest weight in the euro area. At present, members would be Germany, France, Italy, Spain and the Netherlands. This countries will  share 4 votes, so each country will miss one vote every five.
  • Group 2: includes the rest of the world, i.e. the governors of the NCBs of the remaining countries. These are 14 countries and will share 11 votes.

Figure 1

Source: Deutsche Bundesbank

This system will hold until the number of euro area member countries reaches 22. At that point, rotation will become more complex and it will be structured around three groups, based on the size of the economies. The first group will still be composed by the 5 governors of the national central banks of the main euro area economies, still with 4 votes. The second group will half of the total number of governors, with 8 voting rights and the third group is made up of the residual countries which will share 3 voting rights (Figure 2).

Figure 2

Source: Deutsche Bundesbank

All governors will nevertheless take part to the discussions. The decision making process will still follow the “one man one vote” principle, but this time majority will be computed only among those voters who have the right to vote at a given meeting. And the frequency at which countries will be given the right to vote will depend on the group they are in, which in turn depends on their relative size.

Tables I and II - from ECB’s monthly bulletin of July 2009 - clarifies the point. Countries in Group 1 (the biggest countries) will always retain 80% voting frequency, no matter how many countries were to eventually join the monetary union. Countries in Group 2 will see their voting frequency decrease potentially down to 57%, as long as new members join. Countries in Group 3 (if ever the number of euro area members were to surpass 22) will be allowed to vote at most 50% of the time, less than 40% in the “worst” case scenario. In other words, this means that the biggest 5 can consider themselves in a rather secure position, whereas small countries are likely to see their influence decrease over time, if bigger members were to join.

To avoid excessively long periods of suspension of the voting rights, the rotation will be monthly. In the first group, one governor will join/leave at each rotation. For the second and third groups, things are more complicated. The number of governors gaining voting rights at the start of each month will be equal to the difference between the number of governors allocated to the group and the number of voting rights assigned to it, minus two.  (e.g. with 19 governors as in 2015, 14-11-2 = 1). This means that not all of the governors without a vote in a given month will regain their voting rights in the subsequent rotation period. With this system, the length of suspension of the voting rights will be one month in the first group and three months in the second group in 2015 (assuming less than 22 governors).

What will be the effects of this change? First, the power of the Executive Board will potentially rise, since it will have 29% of the votes at each session and in a permanent way. Second, in terms of voting rights balance, not much changes. The 5 biggest countries will have under this system 19% of the voting power against 20% in the non-rotating system. The small countries will instead have 52% of the votes against 56% at present. Third, the influence of biggest countries will be maintained - the period of rotation is one month, so no one will be excluded for a long period of time -  and most importantly it will be secured in the long term, as they the voting frequency within the group of five will always be 80%. Moreover, since all governors (also those who cannot vote in a given section) are present to the discussions and since this voting is by definition a sort of repeated game, it seems unlikely that decisions will be taken “behind the back” of any big country.

Last but not least, after explaining how it works, there is another “small” issue to point out. This system of rotation is built with a monthly frequency, with rotation occurring at the beginning of the month. The ECB in its Monthly bulletin of July 2009 clarifies that “as a rule, two physical Governing Council meetings take place every month. The first is dedicated exclusively to monetary policy decisions, and the second generally deals with all other issues to be decided by the Governing Council. The one month rotation period allows governors to exercise their voting rights in both types of meeting.” But ECB President Draghi recently communicated that from January 2015 onwards the Governing Council will make monetary policy decisions once every six weeks rather than once every month. Which means that the length of each “voting-right cycle” would be not match (will be shorter) than the “monetary policy decision cycle”.

Unless the ECB wishes to change the rotating voting system again, of course.

Fri, 25 Jul 2014 06:32:23 +0100
<![CDATA[Asset-backed securities: The key to unlocking Europe's credit markets?]]> http://www.bruegel.org/publications/publication-detail/publication/842-asset-backed-securities-the-key-to-unlocking-europes-credit-markets/ publ842

The European market for asset-backed securities (ABS) has all but closed for business since the start of the economic and financial crisis. ABS (see Box 1) were in fact the first financial assets hit at the onset of the crisis in 2008. The subprime mortgage meltdown caused a deterioration in the quality of collateral in the ABS market in the United States, which in turn dried up overall liquidity because ABS AAA notes were popular collateral for inter-bank lending. The lack of demand for these products, together with the Great Recession in 2009, had a considerable negative impact on the European ABS market.

The post-crisis regulatory environment has further undermined the market. The practice of slicing and dicing of loans into ABS packages was blamed for starting and spreading the crisis through the global financial system. Regulation in the post-crisis context has thus been relatively unfavourable to these types of instruments, with heightened capital requirements now necessary for the issuance of new ABS products.

And yet policymakers have recently underlined the need to revitalise the ABS market as a tool to improve credit market conditions in the euro area and to enhance transmission of monetary policy. In particular, the European Central Bank and the Bank of England have jointly emphasised that:

“a market for prudently designed ABS has the potential to improve the efficiency of resource allocation in the economy and to allow for better risk sharing... by transforming relatively illiquid assets into more liquid securities. These can then be sold to investors thereby allowing originators to obtain funding and, potentially, transfer part of the underlying risk, while investors in such securities can diversify their portfolios... . This can lead to lower costs of capital, higher economic growth and a broader distribution of risk” (ECB and Bank of England, 2014a).

In addition, consideration has started to be given to the extent to which ABS products could become the target of explicit monetary policy operations, a line of action proposed by Claeys et al (2014). The ECB has officially announced the start of preparatory work related to possible outright purchases of selected ABS1.

In this paper we discuss how a revamped market for corporate loans securitised via ABS products, and how use of ABS as a monetary policy instrument, can indeed play a role in revitalising Europe’s credit market.

However, before using this instrument a number of issues should be addressed:

First, the European ABS market has significantly contracted since the crisis. Hence it needs to be revamped through appropriate regulation if securitisation is to play a role in improving the efficiency of resource allocation in the economy.

Second, even assuming that this market can expand again, the European ABS market is heterogeneous: lending criteria are different in different countries and banking institutions and the rating methodologies to assess the quality of the borrowers have to take these differences into account. One further element of differentiation is default law, which is specific to national jurisdictions in the euro area. Therefore, the pool of loans will not only be different in terms of the macro risks related to each country of origination (which is a ‘positive’ idiosyncratic risk, because it enables a portfolio manager to differentiate), but also in terms of the normative side, in case of default. The latter introduces uncertainties and inefficiencies in the ABS market that could create arbitrage opportunities.

It is also unclear to what extent a direct purchase of these securities by the ECB might have an impact on the credit market. This will depend on, for example, the type of securities targeted in terms of the underlying assets that would be considered as eligible for inclusion (such as loans to small and medium-sized companies, car loans, leases, residential and commercial mortgages). The timing of a possible move by the ECB is also an issue; immediate action would take place in the context of relatively limited market volumes, while if the ECB waits, it might have access to a larger market, provided steps are taken in the next few months to revamp the market.

We start by discussing the first of these issues – the size of the EU ABS market. We estimate how much this market could be worth if some specific measures are implemented. We then discuss the different options available to the ECB should they decide to intervene in the EU ABS market. We include a preliminary list of regulatory steps that could be taken to homogenise asset-backed securities in the euro area. We conclude with our recommended course of action.

The European ABS market: evolution and current size

The ABS market peaked in Europe before the crisis, with a total of $1.2 trillion in new ABS issuance in 2008. By 2013, total new issuance was only $239 billion (Figure 1). Demand for these assets plummeted after 2008 because of the deterioration in the rating of the collateral behind the various types of ABS, leading to a major market price correction of ABS products.

Figure 1: New issuance in the EU ABS market, 1999-2013 (2014Q2)

Source: SIFMA (July 2014).

Moreover, the freeze in European inter-bank lending reduced demand for these assets as collateral for repurchase (repo) agreements (in other words, agreement to sell an asset and buy it back at a later date). In particular, after the start of the financial crisis in 2007-08, the ECB progressively tightened the rating and structural requirements for ABS it would accept as repo collateral, with the result that using ABS as repo collateral became expensive, in particular compared to covered bonds. Hence, after 2008, the amount of eligible ABS declined by 38 percent while covered bonds increased by 14 percent, until in mid-2012 covered bonds overtook ABS as delivered repo collateral for the first time since 2007.

A final blow to the ABS market during the crisis came from the insurance sector. Insurance funds, traditionally large buyers of ABS products, were also negatively impacted by the introduction of more restrictive regulation in response to the crisis, and consequently limited their ABS purchases.

Country-by-country, the smallest players in the market (eg Belgium and Ireland) saw a decrease in new issuance of more than 95 percent from the peak, while, among the main issuers, new issuance in Italy, the Netherlands and Spain dropped by about 73 percent. In Germany, the decline was 80 percent. It is interesting to look at the United Kingdom: here, new issuance represented almost a third of total European issuance on average until 2008, but after the peak, UK flows dropped by 90 percent, with new issuance in 2013 representing less than 20 percent of the European total. Considering this change in the UK’s role in the structured product market, new issuance in the euro area rose to 73 percent of total European new issuance in 2013, from 63 percent in 2008. However, in volume terms, euro-area issuance was slashed from $766 billion to $175 billion.

Interestingly, the collateral behind the ABS products also varied during the crisis, with the collapse in the issuance of Real Mortgage Backed Securities (RMBS) and European Collateralised Debt Obligations (CDOs), with issuance of both dropping by 90 percent between 2008 and 2013 (Figure 2). The composition of overall issuance thus changed, with a (relative) increase in ABS with consumer credit as collateral, and a marginal increase in ABS backed by loans to small and medium-sized enterprises.

Figure 2: Breakdown of ABS issuance per type of collateral, various years

Source: SIFMA (July 2014).

Another indication of the reduction in the liquidity of this product is the amount of new issuance placed on the market relative to ABS retained by originators, such as banks that package securitised products (Figure 3). Before the crisis, almost 70 percent of new issuance was placed on the market, and the remainder retained by originators. After 2008, the share of new issuance placed on the market dropped to below 10 percent, signalling virtual market refusal of these securities. More recent figures point to a market placement rate of about 40 percent, though at much lower overall volumes.

Figure 3: Retention rate of ABS products, various years and type of collateral

Source: SIFMA (July 2014).

However, originator retention rates vary by type of instrument. Despite the dramatic reduction in issuance of CDO and Commercial Mortgage Backed Securities (CMBS), currently around 90 percent of their new issuance is placed on the market, probably because of demand from specialised investors, who could no longer find these securities on the market. By contrast, there is weaker market demand for RMBS, generic ABS (car loans, leases, etc) and SME ABS. In particular, almost all new SME ABS are retained on banks’ balance sheets, with only 10 percent placed on the market.

What is the potential for an increase in the size of the ABS market?

The outstanding amount of European securitisation, at the end of 2013, was approximately €1 trillion, of which roughly half was placed on the market (Table 1 on the next page). For comparison, at its peak in 2008, the overall outstanding amount of the ABS market reached more than €2.2 trillion. About 60 percent of the market (€637 billion) is made up of mortgage-backed securities (residential and commercial), followed by standard ABS (car loans, leases, etc) with a volume of €150 billion, and SME ABS for €102 billion. CDOs stood at €113 billion.

Table 1: Total outstanding amount of EU securitised products

Source: SIFMA data Q1-2014.

The quality of these securities varies in terms of collateral type, with about 77 percent of the amount outstanding rated above BBB, and therefore eligible for collateral transactions with the ECB3 (Figure 4). The highest presence of high-rated securities is in France and Germany, while Italian and Spanish ABS are more concentrated in the ‘single A’ category, in line with the evolution of the sovereign ratings in these countries. In terms of collateral type, SME ABS are the lowest quality, probably due to the heterogeneity of the collateral and the deterioration of companies’ balance sheets during the crisis. Moreover, in the case of SMEs the quality of financial information reported in balance sheets is in general less regular and accurate, an issue that also impacts negatively on the rating, because it implies a more negative assessment of the probability that loans will be repaid. From 30 to 40 percent of SME ABS are currently estimated to be sub-investment grade or not rated. Italy and Spain are also the countries with the main outstanding volumes of SME ABS.

Figure 4: Rating of ABS products per type of collateral and country, 2013

Source: SIFMA

Given these figures, what potential for growth does the ABS market have overall, on the basis that potential ECB purchases could create sufficient demand to revitalise the market?

Looking at the markets for collateral, data from monetary financial institutions shows (Figure 5) that the outstanding amount of mortgages for house purchases (thus secured lending) stabilised at about €3.8 trillion in 2013 in the euro area, while the outstanding amount of bank loans to non-financial corporations (NFC) in the euro area reached about €4.2 trillion. Figure 5 also compares the trend in the mortgage market to that in the RMBS market (left panel), and NFC loans to SME ABS (right panel).

In both cases, there has been an evident fall in volumes of both types of securitised product, with SME ABS performing relatively worse. The reason is the contraction of credit demand coupled with bank deleveraging, leading to a contraction of NFC loans, compared to relative stability in the volume of mortgage loans outstanding. Hence, collateral for SME ABS operations has been squeezed relatively more compared to RMBS. Moreover, one has to consider the negative regulatory impact on capital requirements associated with the issuance of this type of product.

The question is, then, how much of these outstanding volumes of loans to NFCs or mortgage loans worth €8 trillion could be translated into new issuance of RMBS and SME ABS. In line with Batchvarov (2014), we make estimates on the basis of mortgage loans to households and loans to non-financial corporations, for the countries that represent 80 percent of the total portfolio of outstanding loans in the euro area (Germany, France, Italy, Spain, Ireland and Portugal). The share of SME loans in total NFC loans, as estimated by the OECD (2013), varies between these countries. Applying these shares to the euro area, the implied euro-area SME ABS share is approximately 25 percent of total outstanding NFC loans.

On the basis of the conservative assumption that only 50 percent of the €8 trillion of existing loans is ultimately eligible for securitisation (eg for reasons of maturity or loan characteristics), we then introduce a different haircut so that the securitised products attain an investment grade rating (to be eligible as a collateral for the ECB). Unlike the standard assumption of a homogeneous 10 percent haircut for subordination for all categories of assets (Batchvarov, 2014), we apply a more prudential and differentiated haircut for the three main categories of assets selected, as retrieved from updated statistics for these securities (SIFMA): 35 percent for SMEs loans, 30 percent for ABS backed by loans to large corporations, and 15 percent for mortgages.

Based on this, we estimate a maximum amount of securitisation of roughly €3 trillion (compared to €4 trillion estimated by Batchvarov, 2014), broken down as shown by Figure 6 on the next page. It should be noted that SME ABS would represent the smallest fraction (about 10 percent) of this market.

Figure 6: Estimates of potential ABS market for the euro area (€ billions)

Source: Bruegel.

Table 2 on the next page shows that the estimated breakdown of the potential overall ABS market by country will vary according to the size and composition of each country’s underlying market for collateral5: Germany, France and Italy would each represent almost 20 percent of the total NFC-loan ABS, while in terms of SME ABS, Spain would count for a fifth of the whole amount, with Germany and France accounting for about 17 percent each. The role of Germany is also significant in the RMBS market, representing about 26 percent of the outstanding amount, followed by France, Spain and Italy.

Table 2: Potential availability of ABS per country (%), est.

Source: Bruegel estimates based on MFI data (March 2014) and OECD

The revival of the ABS market: the options

Our estimates show that the euro-area securitisation market has the potential to build significant volume and to be sufficiently liquid for use in possible non-conventional monetary operations. However, a number of trade-offs must be considered relating to the timing of ABS market measures, and the underlying size of the market at that moment: the earlier that measures are taken, the more restricted will be the type of ABS product that can be targeted for direct purchase (eg SME ABS only), reducing the impact of potential ECB operations on credit markets.

These trade-offs arise because the current securitised products on the market differ in terms of underlying characteristics, ie collateral type and thus rating, borrowers’ quality and geographic distribution, loans’ residual maturity, frequency of repayment, cost of credit, type and amount of interest (fixed or variable), prepayment rates and possible credit enhancements built into the structure6. Because of these heterogeneous characteristics, only a fraction of existing ABS products are ‘ready to use’, if ever, by the ECB. Moreover, within the existing range of products, there are different implications of the ECB targeting for direct purchase only SME ABS rather than RMBS. Undertaking specific regulatory steps aimed at standardising the characteristics of securitised products in different countries might allow the full activation of the estimated €3 trillion in potential ABS market volume, but reaching such a figure would require time for implementation.

In the following sections we detail the ECB’s options.

Option 1: Act small and fast

Option 1 would involve the direct purchase of very simple (‘plain vanilla’) existing ABS products with corporate credit exposure7. By pursuing this option, the ECB could act immediately, but would have a limited direct impact on credit markets. Existing ABS products limited to SMEs loans amount to €102 billion (Table 1). If the lease component of generic ABS is included, one could add a further €15 billion8. With respect to these figures, the volume of securitised products available for immediate use with a rating above investment grade is 60 percent of SMEs ABS and 50 percent of the lease components. As a result, with these constraints, the maximum theoretical size of the ABS market for immediate ECB intervention is about €68 billion. This is probably not enough to generate a direct impact on credit conditions in the euro area.

This does not imply, however, that there is no role for an ABS market backed only by corporate credit exposure, even in its current form. In the wake of the crisis, origination of ABS products has been subject to the introduction of stricter regulations on capital requirements for insurance companies, and on risk-weighted assets for banks (see Annex 1 for a summary of ABS capital requirements/risk weights)9. Within the current set of rules, therefore, any type of non-conventional monetary policy under which ABS assets are purchased will ultimately free up capital in banks’ balance sheets. This is particularly true for SME ABS, since their average rating is low and therefore the capital absorption for senior tranches below AAA is huge and greater than capital absorbed by the loans themselves. Consequently, ECB intervention in the ABS market, even if potentially limited in size, could magnify the effects on credit origination of the ECB's targeted longer-term refinancing operation (TLTRO), announced in June 2014, although the exact additional magnitude of these effects is hard to predict.

Option 1 could thus be a way of solving the trade-off for the ECB: intervening immediately in the relatively small (at its current volume) ‘plain vanilla’ ABS market, but limiting the scope of the operation to an ‘indirect’ vehicle through which the effects of the TLTRO could be magnified.

Option 2: Act large and slow

Option 2 essentially implies reviving, deepening and integrating the euro-area ABS market so it can be used as a new tool for non-conventional monetary policy. The ECB and the Bank of England (2014b) point at improving the regulatory environment for ABS products to better differentiate the necessary prudential requirements for relatively simple, robust and transparent ABS products (eg consumer finance ABS, RMBS and SME ABS) from more complex and potentially illiquid instruments. By revamping this market, these instruments could be used effectively as a ‘direct’ vehicle through which non-conventional monetary operations could be run. Clearly, the trade-off here is that developing the latter would require a number of changes to underlying regulation, and would thus take time.

To achieve a high-quality, simple and transparent European ABS product, two areas of regulatory change should be developed: one on collateral rules, for the corporate loan market in particular; the other on ABS product characteristics, ie the format to be applied to various types of ABS10.

Collateral rules

Regarding the rules on collateral, two issues should be addressed:

1 More selective regulation on capital requirements

ABS are a tool that could provide more flexibility to financial institutions to achieve better capital ratios throughout the system, and to reduce leverage ratios, since securitisation, when sold by originators, would enable reductions in risk weighting. Changes in ABS risk weighting could lead to high-quality, simple and prudently-structured securitisation products receiving more consistent regulatory treatment across financial legislation11. In particular, regulators could work to reduce the discrepancy between regulatory treatment of ABS and collateral12.

During 2013, progress was made on financial regulation, but further steps are necessary as part of the implementation of the Capital Requirements Directive IV to clarify whether and to what extent ‘European’ ABS would count as regulatory liquidity, the future risk weights they will have for securitisation in the banking and trading books and the extent to which their rating would be correlated with the sovereign credit rating of the originating country13.

As far as insurance regulation is concerned, in relation to the Solvency II directive (which is to enter into force in 2016), the European Insurance and Occupational Pension Authority (EIOPA) is also examining regulatory capital requirements for insurers’ ABS investments, in order to reduce capital requirements for insurance companies.

2 More transparent and available information on collateral

In order to stimulate further the market for ABS, especially for SME loans, common guidelines on a minimum level of information to be reported in SME balance sheets should be agreed, in line with the ECB eligibility requirement that loan-level data should be publicly available. Balance sheets thus produced should be made available to originators, in order to increase transparency and comparability of collateral. At the same time, rules on standardised rating methodologies for securitised products should be enforced within the Single Supervisory Mechanism.

The homogenisation of company reporting, to also encompass non-listed companies, will enable analysis of the performance of individual companies in European countries, and will facilitate access to credit at the same cost for companies within the same sector in different countries. In addition, steps towards the coordination of default laws in different countries should also be undertaken, to reduce uncertainty for bondholders in case of defaults.

ABS product characteristics

Two issues also need to be addressed in terms of the format of securities:

1 Common guidelines on ABS structure

The risks of ABS are embedded not only in the type of underlying collateral that is securitised, but also in the way collateral is sliced and packaged (see Box 1 for an overview of the basic elements constituting an ABS product).

A common structure for each type of collateral would ease the origination process and imply that the spread between different bonds in each rating category would depend only on differences between collateral characteristics (such as geographical distribution, maturity or the legal framework applying to default). Common structure could tremendously boost market liquidity. Also, the cost of creating the instruments should decrease, as pan-European banks will be able to leverage the size of their loan pool across European markets. With a common structure, the rating framework should become more homogeneous as well, cutting the cost of providing ratings and making the European ABS market much more similar to the US market. Ratings will become more closely related to collateral characteristics and less to the sovereign rating of the originator, and monitoring by rating agencies during the life of the product will focus more on collateral evolution. A straightforward way of achieving this result would be to build on the idea, already hinted at by the ECB, that only an ABS format with a ‘plain vanilla’ structure would be eligible for purchase by the ECB.

2 Common guidelines on the setup of SPVs within national borders

Another key factor in the underlying heterogeneity of the securitisation process is also related to the different role that the ‘Special Purpose Vehicle’ (SPV) might acquire (see Box 1). The SPV is a unique entity the role of which is the acquisition of an identified pool of assets. The SPV is the holder of the collateral within the securitisation. The owner of the SPV, whether it is the originator or a pool of originators, bears the risk of the SPV. A possible guideline is that an originator could establish only one SPV for all the transactions of the same type to be issued, instead of one SPV for each transaction. In the case of a single SPV for all transactions, since the vehicle is immediately available, transaction costs will diminish and the process of securitisation will speed up.

In cases in which a group of originators considers creating a common SPV for the ABS market (whether or not specialised by type of collateral) the risk will be borne by the owners of the SPV. A Banque de France initiative to re-start the securitised SME loan market has worked along these lines.

The creation of a joint SPV within national borders allows for sharing of set-up and operating costs. Standardised legal documentation used by the originators will also reduce costs and operational frictions, and make the SPV a very efficient credit claims mobilisation tool. Whether such a set-up is legally compatible with each country's legal framework, and whether such a choice could be more efficient from the market point of view, are however open questions. The answer in part would depend on the risk weighting assigned to the shareholders of the SPV.

Another reason for the creation of a joint SPV is that, once a common ABS structure with the same collateral type is defined ex ante, there will be less flexibility or creativity in the structuring phase, so that certain type of collateral, if available in volumes that are insufficient to respond to the structuring requirements (such as over- collateralisation criteria), could not be used. While in the past the lack of assets to create credit enhancement in the form of over-collateralisation was compensated for by other forms of internal or external credit enhancement, the absence of this choice in the new system could place a limit on the participation of small and medium players in the ABS market, because of lack of collateral. The problem could however be circumvented through the creation of an SPV at national level, or jointly created by small originators. This would stimulate more consolidation of the banking sector within countries.

In summary for option 2, we can conclude that, under the Single Supervisory Mechanism headed by the ECB, there is ample room to refine all the existing regulation, as we have discussed, in order to create a large pan-European market for simple, robust and transparent ABS products. However, it is also clear that, because of the time it will take to implement the necessary regulatory changes, these developments might only be relevant for the next business cycle, unless this process is accelerated.

Option 3: Act bold

If direct outright purchases in the ABS market are really meant to significantly enhance the functioning of the monetary policy transmission mechanism within the next few months (ie working immediately, and not just as potential amplifiers of the TLTRO), there is a third alternative to the fast/small versus slow/large options we have analysed. A further option, already suggested by Claeys et al (2014), is the direct purchase of RMBS.

An RMBS purchase programme would have a much greater impact on the economy, given the size of the market already at current volumes, ie €601 billion (Table 1), which becomes some €500 billion of targetable products once the minimum rating eligibility criteria are applied15 .

On top of the size of the market, the argument for RMBS purchases also stems from the potential limited impact that the purchase of SME ABS (option 1) might have in terms of the ECB objective of combating the risk of deflation within the cycle. Even assuming that new loans stimulated by the TLTRO and SME ABS purchases ultimately foster the transfer of central bank liquidity directly to the productive sector of the economy, thus restarting credit markets in the euro-area periphery, part of this additional liquidity might have a muted effect on demand. This could happen because companies face a restructuring phase to increase productivity. Therefore, the additional liquidity companies will receive might be used partly for capital expenditure, helped by low rates, and partly for consolidation within sectors, both within or between countries, with a muted effect on employment.

In other words, intervention aimed at increasing the flow of credit to the economy (TLTRO and direct purchase of SME ABS) might have positive effects on demand, and thus consumer prices, only later in the cycle, ie they might not be immediately successful in countering deflation.

Nevertheless, considering that in Europe a relatively low share of households’ wealth is invested in the stock exchange, but a relatively high share is invested in the housing sector, intervening with outright purchases in an ABS market in which RMBS are also considered might have a larger, more immediate effect in revitalising the demand side of the economy, and therefore putting a floor on the trend of declining inflation within the euro area. In this sense, RMBS purchases would not only act as a mechanism to unlock credit markets in the euro area, but would rather be closer to a form of quantitative easing.

In fact, the improvement in banks’ balance sheets would be marginal (given the lower capital absorption of these instruments), while clearly a careful assessment should be made of the need to minimise the impact of RMBS purchases on house prices (and the ensuing wealth effects for households) in the euro area, in order to avoid new bubbles, or to stop the correction of existing ones. While the monitoring exercise now routinely carried out as part of the Excessive Imbalance Procedure can be deployed to avoid such a risk, the fiscal implications of these actions should nevertheless be carefully assessed.


Our evidence shows how direct ECB intervention could turn ABS products into one of the mechanisms that could unlock credit markets in the euro area.

A number of trade-offs arise in terms of the speed and efficacy of the actions that the ECB could take. Acting immediately on existing ABS products (SMEs and corporate-backed eligible ABS) is likely to produce little direct effect, given the small relative size of the targetable market, estimated at some €68 billion. However, an indirect and not necessarily insignificant effect can arise through this action, through the freeing up of capital on banks’ balance sheets, and thus the possibility to exploit on a larger scale (as more loans can be granted with the same amount of capital) the opportunities available through the new TLTRO programme.

Working on the improvement of the regulatory environment for ABS products might revamp a market that can be conservatively estimated at some €3 trillion for the euro area (€1.6 trillion in RMBS and €1.4 trillion in corporate-backed ABS, of which about €300 billion in SMEs ABS), but these actions require time for implementation.

Finally, resorting to the purchase of existing RMBS can achieve the target of an intervention that is both immediate and sizeable in terms of targetable instruments (we estimate a volume of about €500 billion). The characteristics of euro-area credit markets especially favour this option if, notwithstanding a revamped flow of credit to the economy, deflation risks remain critical over the next few months. However this option is closer to a form of quantitative easing and has implications for fiscal policy, and thus should be considered with care.

On the basis of the above, we recommend parallel actions to be taken by the European institutions at the same time. In particular:

  • From a regulatory point of view, the resolution of the ongoing uncertainty about the selective treatment of ABS products in terms of capital requirements in the context of the implementation of the Basel III agreements for banks and insurance companies, should take priority over other pending issues;The European Commission and the ECB should start work on a common set of guidelines on data availability and reporting for collateral (loans), and on the definition of a simple and transparent ‘European’ ABS format (structure/set-up of the SPV);
  • In the near future, the ECB should start a programme of direct purchases of SME ABS (our option 1), while monitoring the indirect effects this might have on the TLTRO. If deflationary risks persist, notwithstanding positive developments in the credit market, the ECB should also consider purchases of RMBS.

Asset-backed securities: The key to unlocking Europe's credit markets? (English)
Thu, 24 Jul 2014 13:15:48 +0100
<![CDATA[China gingerly taking the capital account liberalisation path]]> http://www.bruegel.org/nc/blog/detail/article/1402-china-gingerly-taking-the-capital-account-liberalisation-path/ blog1402

Since China is the number one trading nation, the second largest economy and a large net creditor, the world has a huge stake in how China manages its tricky transition from a state of binding capital controls to one of closer integration with the global financial market and system.

A natural starting point is, of course, where China currently stands in its financial integration with the rest of the world. How open financially is China when we compare it to its own recent past or its major emerging market peers like India?

To answer this question, Robert N. McCauley and I conducted a study by analysing eight measures of capital account openness (four price-based measures and four non-price ones). Our four price-based measures were based on the ‘law of one price’: the same financial asset should trade at about the same price in the onshore and offshore markets. The study covered the forward market, money market, bond market and stock market.

The non-price indicators involved macroeconomic openness, cross-border financial flows and positions, banking market integration and currency internationalisation.

The study shows that China has been financially less open than India on average over the past decade, contradicting the conventional wisdom and other, more widely known measures of financial openness. This may have a lot to do with a mix of the need to fund current account deficits in India; the greater rigour with which the capital controls are enforced in China; the long-standing multinational operations of Indian private firms that can arbitrage onshore and offshore markets; and a larger footprint of global banks in the Indian domestic banking market.

Both economies over the years have been advancing in their financial integration with the world, though in the wake of the global financial crisis China has beencatching up with India. This in part could relate to the fact that emerging markets running current account deficits, like India, face a more binding external financing constraint, especially in a world of highly pro-cyclical and volatile capital flows. The policy-supported renminbi internationalisation in recent years has also punched holesin the Chinese wall of capital controls.

But both China and India still have quite some way to go in opening their financial markets to the outside world, suggesting that the task of capital opening is a real challenge. Controls of their capital accounts may be leaky but still bind substantially. This is true not only by comparison with advanced economies but also when measured against a benchmark of major emerging market economies.

The evidence indicates strong inward pressure on bond and bank flows in China upon full capital account opening, at least in the short term. This is because Chinese fixed income instruments have been cheaper onshore than offshore. This finding contrasts with consensus forecasts which have predicted that, over the medium term, China is likely to experience net private capital outflows under the channels of direct and portfolio investment. Also, our reading of net inflow pressure in the short term and the consensus reading of net outflow pressure over the medium term could imply that two-way capital flows can be highly volatile during the liberalisation process.

This implies three important things for Chinese policymakers.

Care needs to be taken when drawing lessons and insights from some of the freely available popular measures of financial openness. These do not reliably signal progress in capital account opening.

There must be careful monitoring of the risks that lie along the path of capital account liberalisation. Stronger and more transparent reporting and statistical systems should be put in place so that broad market positions and cross-border flows can be tracked in a timely and systematic fashion. In particular, bank flows need to be monitored closely and any seeming inconsistencies between national data and partner data like those compiled by the Bank for International Settlements need to be explained.

Finally, policymakers need to proactively manage the risks that come with liberalisation. A sustained increase in exchange rate variability ahead of substantial capital opening could serve to render the renminbi a less attractive carry-trade target. The widening of the permitted daily trading band of the renminbi — from plus or minus one per cent to plus or minus two per cent in March 2014 — might help ease short-term inflow pressure and facilitate the transition to medium-term net outflows upon full capital opening.

Thu, 24 Jul 2014 10:25:10 +0100
<![CDATA[The world is ready for a global economic governance reform, are world leaders?]]> http://www.bruegel.org/nc/blog/detail/article/1401-the-world-is-ready-for-a-global-economic-governance-reform-are-world-leaders/ blog1401

Bottom line: A survey of G20 practitioners reveals how, notwithstanding the post-crisis loss of momentum, the G20 is still considered a useful forum of discussions. While changes to its composition and workings would be accepted (to varying degree), major revisions in global economic governance are ruled out, bar in case of another major crisis. Our claim is that, at a time of major rebalancing in world economic weight, intransigence by the detainers of power in (what now looks like) an old global governance framework will imply a fade in relevance of the Bretton Woods institutions and G-fora, and their replacement by new avenues of coordination and discussion.

The 2008 financial crisis has markedly changed the landscape of global economic governance. Fora like the G20, which had existed since the Asian financial crisis with a limited discussion role, suddenly were elevated to ‘global economic steering committee’. Since then, however, it seems as though the G20 has somewhat lost direction and momentum. As the most acute phase of the global economic crisis has passed, heads of state and government have had less need to act in unison and rather returned to focus on their national agendas. To some extent, it naturally follows that the focus both on and of the G20 has become less. However, we need effective global governance permanently, not just in crisis. And this is true for the G20, as it is for the G7/8[1] and the IMF.

In a recent paper, we argued that, given the fast-paced changes in global wealth creation and trade patterns, global governance will have to adapt much more significantly and quickly or else risk becoming insignificant. On top of calling for a far-reaching IMF quota reform (going beyond the pending 2010 revision), we argued that it would make sense for euro area countries to have a united global representation. This could happen in a ‘revised’ G7/8, hence opening up space for China and other emerging economies. If there were a more representative G7/8, it would immediately follow that the G20, close to its current membership group, could survive, although it would not be required to have such a demanding role that it is does currently. As such, a smaller, equally representative G7/8 could be more effective than the representative but cumbersome G20.

Against this background, we decided to test many of these claims with G20 practitioners, former Sherpas, and senior government officials involved with the preparation of the G20. To this purpose, we constructed and administered a survey, with the aim of sensing the degree of acceptance of the need and feasibility of a reform of global economic governance.

The survey was administered via e-mail or phone between the 7 May 2014 and 20 June 2014 to the Sherpas of the countries that belong to the G20 Permanent Members grouping, and to the Invited Members, for which contact details were found (see Table 1). This was complemented by a group of 9 high-level global governance experts and former G20 practitioners. Of the 34 people contacted, 23 agreed to participate in the survey. In the end, 15 questionnaires were returned completed.

Table 1. List of G20 participants

Permanent Members

Invited Members[2]

















Saudi Arabia

South Africa

South Korea


United Kingdom




World Bank











Source: en.g20russia.ru

The survey was conducted under full anonymity, as its purpose was not to detail specific governments’ positions, but rather to build on the expertise of insiders and former practitioners in analysing the problems the current global economic governance framework faces, and verify the conditions for and likelihood of reform.

All in all, while participation was not complete, the response rate was acceptable, bearing in mind that most Sherpas are deputy foreign/finance ministers, top-ranking government officials, ambassadors, heads of cabinet, individuals that tend to be rather short of time. As detailed by Figures 1 and 2 (below), a diverse range of participants replied, both based on post-holdings and geographical origin. As such, we believe our survey to be broadly balanced in composition and to give a fair analysis of the different streams of thought within the G20.

Figure 1 and 2. Respondents’ current post (lhs) and geographical origin of employing institution (rhs)

Note: Geographical origin allowed for multiple answer.    
Source: Bruegel.

Survey Results

The first question we posed in our global governance survey was whether with 19 countries, a two-headed EU, permanent guests, countries invited on behalf of regional groupings, and international organisations, the G20 is too large a group to decide on macroeconomic and monetary issues, for which only few countries are relevant. A large majority of G20 practitioners proved to disagree with this statement. Some of the survey participants who disagreed backed their take by stating:

“I see no evidence the size has made discussions too unwieldy. However, I think it could be better to limit the membership to G20 members instead of also having the IOs and invited countries present.”

Others agreed completely:

“The group is too large and not truly reflective of what would be needed from a representation point of view to 1/ debate and find consensus around set of actions and/or 2/ decide on a set of actions. There are several difficulties with membership: too many Europeans, Argentina not relevant, Saudi Arabia a one-issue member; Africa under-represented.”

Finally, a central banker noted that:

“[the G20 is indeed too large a group] especially for monetary issues. It is possibly the right grouping for regulatory issues. Only group beyond G7 that is good (for monetary matters) is that of the G10 central bankers[4], which meets (informally) in Basel, and this is good, and very open.  For example, in such setting the Fed communicated to everyone (including the Indians…) in advance its intention to start tapering QE.”

We then asked survey participants whether they thought the G20 to be an effective forum of deliberation on global economic issues in non-crisis times. Here the picture was a bit more mixed but still with two thirds of participants positioning themselves in the ‘Yes’ camp.

Notably, a survey participant stated:

 “The definition of effectiveness should be adapted to the current global economic context. It is usually during a crisis period that countries are more incentivised to act in the interest of the “common good” and move faster towards policy coordination. Therefore, the impact and magnitude of the measures taken by G20 are unlikely to be the same in a crisis and non-crisis period. Similarly, the issues that the G20 is best positioned to take on will also depend on the global economic context. In a non-crisis period, focus should be placed on medium-term agenda that can increase the trajectory of global growth on a sustainable basis, such as enhancing trade, investment and infrastructure financing. The effectiveness of a forum is not necessarily determined by the number of participants alone, but also contingent on other factors, such as how well each participant can contribute to the conversation and the ability of the Chair to steer discussions. An effective G20 in a non-crisis period would be able to coordinate meaningful solutions to medium-term issues through robust debates and exploration of constructive ideas.”

On top of this, it was also noted that:

“The time of diplomacy is different from that of financial markets. There is less urgency now. Macroeconomic coordination is complex and unchartered water, but things are moving.”

However, a former G20 Sherpa noted how:

“[the G20] is the best forum for deliberating on global economic issues, provided the membership is adjusted; but it lacks effectiveness: it should have a greater focus on intimate discussions among leaders with less officials around. In many delegations there is a dis-function between Sherpas and finance Sherpas. Also, the agenda has grown too wide.”

This statement connects us nicely to the next question posed, namely regarding the main element potentially hampering the effectiveness of the G20. Results are displayed in Figure 3, below. Respondents seemed to widely agree on the fact that the G20’s agenda is currently too wide. Furthermore, the heterogeneity of interests and preferences of countries involved seemed also to contribute significantly in hampering the G20’s effectiveness. Interestingly, among the “other” reasons, the fact that Sherpas are not sufficiently empowered to act was mentioned.

Figure 3. Which of the following is the main element hampering the effectiveness of the G20?

Note: * In theory, “achieving strong, sustainable and balanced growth for the global economy” – which is admittedly very broad.
Source: Bruegel

Following up on this, we asked survey participants directly whether the G20’s agenda should be narrowed down and, if so, along what lines. Whereas there was almost unanimity (14/15) on the need to restrict the focus of the G20, survey participants had very different views regarding the topics on which the forum should concentrate.

Figure 4. On which topics should the G20 focus?

Note: Multiple answers allowed.
Source: Bruegel

Interesting thoughts were shared under the ‘other’ category (see Table 2, below). Some survey participants highlighted how a narrow agenda should be set every year, whereas others focused on the operations of the working groups.

Table 2. Other elements on which the G20 should focus


Specifications of 'other'


The issue is not to limit the agenda permanently, but focus on a few issues at a time and discontinue working groups when they have finished a specific task instead of giving them new mandates, which may be less relevant.


Essentially it should be about economic governance, climate being an integral part of it.


Supporting global growth.




Trade, Investment, Infrastructure.


Select very small number of specific subjects on a yearly basis.



Source: Bruegel

As various degrees of dysfunctionality were identified, we then turned to questions regarding ways of tackling it. Commentators in the past have claimed that tweaks in the governance of the G20 (including the establishment of a permanent secretariat, better streamlining of internal processes, etc.) could improve its effectiveness, as its weaknesses are not structural in nature. 60% of our survey respondents disagreed with this claim. One survey participant mentioned that a secretariat would just add to the bureaucracy of the forum, and there is no need for it. S/he then added that:

“[within the G20 setting] Nobody listens to the IMF itself, so it is not clear why they would listen to the secretariat.”

The G20 being merely a forum of discussion with no coercive powers, we turned to test the idea that peer-pressure is significantly felt and is effective at nudging country leaders into policy action. Almost the totality (14/15) of survey participants agreed with the proposition that peer-pressure within the G20 can push a sovereign government to take actions based on previously agreed commitments. In the discussion that ensued, survey participants expressed a somewhat milder (positive) judgement:

“Taking policy actions based on previously agreed commitments will be essential to the credibility of the G20, and G20 members need to recognise this as a group. The Accountability Assessment exercise and the peer review process in the Framework Working Group are good steps, but as sovereign states, countries retain the right to take actions aligned with their national interests. It remains uncertain whether peer pressure amongst G20 members would be sufficient to affect agreed policy changes across the board, such as the standstill on protectionist measures. Having said that, the G20 has achieved success in certain areas, such as financial regulation.”

In this respect, we note that several respondents highlighted financial regulation as a field in which peer pressure has had a significant impact within a G20 context.

Finally, two survey participants detailed the requirements for peer-pressure to succeed:

“yes, if done intelligently and in a focused manner, i.e. around a limited set of issues; collective behaviour in resisting temptation to go protectionist was a clear example of this; many countries sued the G20 commitment to resists political pressures at home.”

“This is how the OECD is functioning (peer review/peer pressure in the context of its Committees) and this is working pretty well with concrete outcomes, e.g. the convergence of policies towards the best practices. But peer-pressure, to be effective and yield concrete results, requires initial and specific commitments by members of the Group – that are specific and assessable, that can be monitored and to which countries can be held accountable. To make such commitments, countries need to make compromise and look beyond their immediate short term interest. This requires trust among members, a zone of comfort and a degree of like-mindedness, which G20 members may not have reached as yet.”

Along the same lines, we then asked survey participants whether, more in general, some national-level policies in the past had been taken as a consequence of agreements within the G20, and would not have taken place without this forum. Again, the quasi-totality of survey participants (14/15) was positive in its assessment of the G20’s capacity to nudge countries into action. G20 practitioners clarified how:

“G20 commitments have a real domestic impact in member countries. […] it is worth noting that countries have decided to join international instruments as a result of their G20 membership. For instance, Saudi Arabia decided to ratify the United Nations Convention against Corruption (UNCAC) largely as a result of its engagement with the G20 Anti-corruption Working Group.”

Some enthusiastic detailed the dossiers on which G20 peer-pressure had been successful:

“Yes, definitely, the international tax transparency agenda (fight against tax heavens and bank secrecy) and the fantastic results achieved in this domain by the G20 are the best illustration of this. The AMIS – to reduce food price volatility and improve food security - is also a good example.”

Even the sceptical voices, accepted a role to be played by G20 peer-pressure and commitments:

“It seems more plausible that domestic interests remain the key reasons for the adoption of national-level policies. Such interests might include relations with key international counterparts, therefore concluding that these policies were a consequence of agreements within the G20 might not be entirely accurate. Having said that, it is indeed to the G20’s credit that certain issues are placed in the limelight, so that countries would accelerate the progress or implementation of such policies. In the case of financial regulation, the G20 empowered an international body – the Financial Stability Board – to coordinate international policy development, and monitor implementation of G20 commitments.”

Finally, a central banker noted that peer pressure is much more effective when pursuing stimulus packages than for policies of economic restraint.

At this point, we turned to test the palatability and feasibility of the idea presented in O’Neill and Terzi (2014) of having a ‘revised’ G7/8 (where euro area countries would have a unique representation, opening up space for China and another emerging economy) as an alternative prime forum on global economic issues. In fact, a large majority (73%) of G20 Sherpas and (former) practitioners expressed their scepticism towards this solution. In the discussion that ensued, however, many respondents moderated their dissent:

“There is a need to have a more rational representation of the EU in the G20 and there is a need to have a smaller number of members but it will have to be bigger than the G8 and smaller than the G20.”

Another (dissenting) respondent proved to be in favour of an even smaller prime forum:

“Would use space to reduce the number of seats, not to add new members. Could also use international and regional bodies more effectively to represent those not at the table.”

Others made a more wholehearted plead in favour of the G20 in its current setting:

“The “steering committee” of the world economy needs the perspective of countries that are not necessarily systemic (such as South Africa that somehow gives an African perspective on world economic affairs). A forum of global economic governance needs to balance between: legitimacy – ensuring that all major economies work together on an equal footing in international organisations and effectiveness – the ability to cover the right issues, forge a strong common consensus and effectively co-ordinate across different fora. This is important for its credibility and influence at the global level. Also, the present G20 format provides an opportunity for a genuine joint learning process between advanced and emerging economies and a full-fledged two-way exchange of experiences among them.”

Finally, some of the dissenting voices based their position more on the feasibility of the option, rather than on the palatability:

“We should take note that euro area countries do not necessarily have united position on all the issues being discussed in the G20.  However, at the same time, it might be worthwhile to consider reducing the number of euro area countries and freeing up space for non-euro area countries in Asia and Africa.”

When asked specifically about the feasibility of creating such a ‘revised G7/8’, 100% of the respondents were negative. In the discussion, some explained that further euro area integration is needed before such a step can be taken.

We then asked (only) non-euro area country representatives whether they would prefer to liaise with a united euro area in global fora. Interestingly, some survey respondents chose not to answer this question. Of those who did, 63% (7/11) expressed a positive answer. Interesting comments ensued:

“When EU members agree, having a large representation around the table plus President of the Commission and Council just means repeating the same arguments over and over again, to the frustration of non-EU players; coherence among EU is to be shaped in Brussels and not at the G8 or G20; when it has not been shaped in Brussels, then the multiple EU representation at the G20 simply show the degree of the disagreement.”

Along the same lines, a BRIC representative explained that:

“Yes [it would be better to liaise with a unique euro area representative], also in the G20. Too many Europeans saying the same thing creates the idea of a false majority in the room.”

However, a G20 Sherpa representing an international organisation highlighted that:

“That would make sense indeed but provided it reflects a genuine unity of view. Otherwise the common representation will lack credibility in the G20 – which would be counterproductive for euro area countries and the G20 itself.”

Finally, a G20 Sherpa clarified that, although the composition of the G20 is dubious (only one African country, only three Latin American, and too many Europeans), the forum has decided to focus on policy coordination, and leave aside discussions regarding membership and/or enlargement.

When asking (only) G7/8 members whether our ‘revised G7/8’ seems sensible as an alternative scenario to the current Group of Seven, which increasingly represents a small club of advanced democracies, three out of five respondents disagreed. Defenders of the current G7/8 highlighted the importance of having a small club of likeminded countries:

“A ‘small club of advanced democracies’ can effectively project authority, unity and vision: very valuable goods. This, without pretence of global governance, which needs close-to-universal representation, and is already the goal of other fora.”

This chimes well with another respondent, who made the point that:

“The current G7/8 framework has its own significance and effectiveness as a small club of advanced economies, where the G7/8 Leaders can have frank discussions on important issues that the international community is facing.  It should not be replaced by any alternative framework.”

Moving beyond the G7/8 and the G20, we asked global governance practitioners and experts whether in their opinion the pending 2010 IMF quota reform had gone far enough in rebalancing power between declining and emerging economies. A wide majority of respondents (13/15) agreed that the 2010 IMF reform was now already somewhat outdated. We hence posed the question of whether the implementation of our proposed ‘revised G7/8’ would pave the way for a speedier reform of the IMF. A wide majority of respondents (73%) disagreed, mostly citing the fact that the current reform is being held back by the U.S. Congress and its internal political quarrels, rather than by the G20. However, it was also highlighted how:

“You need the G20, and especially the BRICS, to make the reform advance. G7 would not be really interested in moving it.”

After having underlined the role of the US Congress, one survey participant explained how:

“[...] The IMF has a regular schedule for reviews of quotas and the composition of the Executive Board. The schedule was even accelerated by the G20 in 2010, with a view to bring about a shift in voting share towards emerging markets sooner. It is useful to note that there is a practical limitation to how quickly quota shares of Emerging and Developing countries can be increased. A country can increase its quota share only via its own contributions to the IMF. Countries whose quota shares need to decline cannot be forced to withdraw their contributions. This imposes a mathematical constraint on how much a country’s quota share can rise, particularly when the quota shares of several countries increase at the same time. However, G20 provides additional impetus for reform. 2010 reforms were “historic” in no small part due to the ambition and political commitment from G20.”

To conclude our survey, we asked G20 practitioners and experts under what conditions a far-reaching reform of global economic governance is to be expected, given the current framework (which has at its centre the IMF, WTO, and World Bank) effectively rose from the ashes of World War II and has remained broadly unaltered ever since. Somewhat unsurprisingly, and in many ways, worryingly, the most common response was ‘another crisis’. Strong political will (especially among developed country leaders) was also a recurrent theme. However, other respondents made other valuable points. A current Sherpa offers a dual framework to think about changes in the current global governance framework:

“The current structure of economic governance has never been truly global. It reflects the balance of economic strength that prevailed after the war and in the decades that followed. This balance has shifted more quickly in the last two decades, and the old structure has become increasingly irrelevant. Naturally, those who stand to lose out have resisted allowing the structure to evolve with economic realities. There are two ways a new structure can emerge: by a gradual adjustment from the current state to the one envisioned; or a sudden adjustment in which the old structure is dismantled and a new one constructed in its place. A gradual adjustment is less disruptive. But the longer imbalances persist, the more likely it is that the system becomes unstable and economic multilateralism ultimately disintegrates. In addition, it is important to have an inclusive, open, transparent and merit-based process in selecting the senior leadership of international organisations such as the IMF and World Bank.”

And indeed, some of the survey participants believe that a step-by-step approach will lead to a substantial change in the current framework.

“Time [is needed]. Emerging countries continue to grow at faster rate than advanced one. At some point thing will be reflected in a deeper reform of the current architecture or the creation of a new one, perhaps with new financial institutions outside the control of currently advanced economies.”


All in all, our survey did not really support our policy recommendation for immediate pro-active reform of global governance. Perhaps this is not surprising in view of the fact that most of the participants are actively involved in some aspect of the current governance framework, and institutions tend to self-perpetrate. Nonetheless it was interesting for us to see the general response to far-reaching reform proposals, which go beyond a fine-tuning or streamlining of the internal workings of the current global governance framework.

As it relates to the G20, virtually all respondents answered that the G20 is a useful forum, with many indicating that it plays a positive role. In this sense, the G20 is clearly seen as legitimate by those who participate. A number of participants made it clear however that the G20 agenda is often too diverse and it would benefit from having a more defined focus. Just as interesting, there was not much support for the idea of a devoted secretariat in helping create a regular focus. As could be garnered from the last answer about what would be necessary for further accelerated reform of global governance (answer was overwhelmingly, another crisis), it seems as though G20 participants believe that a crisis forces policymakers to focus on the immediate solutions, and outside of crisis, they will not have the same need or incentives.

When it comes to faster reform of the IMF, as we prescribed in O’Neill and Terzi (2014), very few survey participants believed that the structure of the G20 or G7 was a hindrance, and in fact, it was primarily the inability or lack of desire by the US Congress to ratify already agreed G20 proposals that were holding back any initiatives at faster reform. In this respect, a certain degree of vexation could be sensed among G20 Sherpas and practitioners.

Finally, one of our previous key recommendations that we explored was, that inside the G20, a reshaped G7 should be found in which all euro area members were represented by just one, allowing space for China and other key emerging economies. We did find some sympathy for this idea from non-G7 countries and non-euro area members, perhaps not surprisingly. However, we did not get any voluntary support for such a shift from either euro member countries or other G7 countries, with those that responded actually suggesting that it was impractical to expect such a shift, not least because the euro area member countries still often have different views, and according to some, it is very beneficial still to have an effective group of like-minded advanced country democracies.  One respondent pointed out that when it came to monetary policy, as opposed to fiscal and other policy matters, the central bankers gatherings in Basle are quite effective for discussion and, when necessary, advance warning and co-ordination. The fact that this took place with less fanfare was also advantageous.

It seems as though any revamp of the G7/8 is not set to voluntarily happen from within for the foreseeable future. We believe that, at a time of major rebalancing in world economic weight, intransigence by the detainers of power in (what now looks like) an old global governance framework will imply a fade in relevance of the Bretton Woods institutions and G-fora, and their replacement by new avenues of coordination and discussion. In this respect, the recent agreement to establish a BRICS Development Bank is highly symbolic. The world is fast changing and ready for more representative, more effective global economic governance. G7/8 leaders can drive this change, or merely face its consequences.

[1] Throughout the post, we will refer to the G7 or G8 interchangeably, as in this instance we do not wish to enter the discussions surrounding Russia’s role in the Group of Eight following the Ukrainian crisis.

[2] Invited members vary from summit to summit. These correspond to the invitees of the last Summit (Saint Petersburg – September 2013).

[3] Spain is a permanent guest.

[4] The composition of this informal group was not formalised but seemed to include G7 members, China, India, and Mexico. 



Thu, 24 Jul 2014 09:02:20 +0100