The Wheels Are Off – the Italian Referendum Results

The majority of Italians have voted against the constitutional reforms proposed in a national referendum and Italian Premier Matteo Renzi’s “experience of government” is now over as he steps down.

The Italian economy has been like a Ferrari with its wheels slashed – its economic performance has been the worst amongst any of the Eurozone country with the exception of Greece; it’s government loans sit at 130% of GDP and unemployment exceeds 11%.

This failure of the referendum is now akin to the Ferrari with its wheels completely off the axle – and the casualties won’t just be the Italians in the Ferrari but indeed the whole of the Eurozone.

Early indicators are that the Euro has fallen sharply against the Dollar and the Asian markets are spooked by what is to come from Europe.

What does this result mean for Italy, Europe and the world?

1. Brace for a hard landing of the banking sector.

We could see the demise of a few banks in Italy, starting with the Monte dei Paschi di Siena (MPS) – the world’s oldest bank – which has already lost almost 90% of its value this year. MPS is already one of Europe’s weakest banks and they are subject to a bailout plan which may now not come to fruition.

Italian banks are struggling with about €360 billion of bad loans and are significantly undercapitalised. There will be a huge sell-off of Italian and European banking stock once the markets open.

The problem is that the scale of interconnectedness means that a hit to the Italian banking system will leave a trail of destruction across the rest of the European and global banking sector starting with the largest European lenders such as Deutsche Bank.

2. The EU and Euro are both going to go through an existentialist phase

Brexit dealt a big blow to the EU project. The rise of the Five Star Movement, a Eurosceptic opposition which has already claimed ‘victory’ in this referendum means that over time their views on EU and the Euro are going to gain even further traction. Even if the Five Star Movement do not win in any early elections called as a result of this referendum (they have a campaign promise to hold another referendum on Italy’s membership within the EU), their views are going to be, over time, become mainstream.

3. Imposition of capital controls?

In 2015 we saw capital controls applied in Greece to stop a run on the banking system and see a flood of capital out of the country. A run on the Italian banking sector will have a colossal impact and a pre-emptive series of capital controls, though damaging from a reputational perspective, may be required for reasons of survival.

4. An Italian sneeze will cause an European contagion.

This result will no doubt cause another slump in the Eurozone economy and will cause a negative investment sentiment. Unemployment will continue rising and living standards will fall, not just in Italy but across Europe.

The people have spoken and have demonstrated a willingness to face a hard landing. Whether they are prepared for a hard reset is another matter altogether and this is going to be the start of a period of extreme uncertainty, economic uncertainty and hardship.

What Italy needs now is an expert driver who is going to be able to manouvere the Ferrari with no wheels skillfully so that it causes the least damage both to the Ferrari’s passengers and other Eurozone travellers.

 

 

 

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What the Asian Infrastructure Development Bank means for Asia and the world

Almost exactly a year ago, just prior to the Asia Pacific Economic Co-operation (APEC) hosted in Bali in October 2013, President Xi Jinping announced the proposal for the establishment of the Asian Infrastructure Investment Bank (AIIB). This was a major announcement which was unforeseen and unexpected particularly as no clear plans were outlined at the time.

Since the announcement however, Chinese officials have been very busy in encouraging other fellow Asian partners to be the initial founding partners of the AIIB.

To date, the Chinese Ministry of Finance has convinced over 22 Asian partners including the likes of Singapore and Bangladesh to confirm their participation as founding partners and contribute to the initial funding capital.

Other major partners such India, Qatar and Saudi Arabia have been very bullish about the prospects and the promise of the AIIB and have made very positive overtures publicly about their participation as founding members. Other South East Asia partners such as Thailand and Malaysia remain positive and other major partners such as South Korea and Australia are still studying the Chinese proposals.

 

The Asian Investment Infrastructure Bank

The role and rationale for the AIIB

The mandate of the AIIB, as a multilateral development institution, is to support the financing of infrastructure developments across Asia that supports economic growth and activity nationally and regionally.

Traditionally Asian nations have turned to the Asian Development Bank (ADB), the International Monetary Fund (IMF)  and the World Bank for financial support. However, the level of financial assistance, particularly from the World Bank and the IMF have dropped since the 2008 financial crisis.

The ADB is also being increasingly viewed as a bureaucratic entity which takes almost seven years to launch a project or initiative (from proposal to the approval of funding) which leads to significant delays due to red-tape.

These conditions do not support the urgent need for infrastructure investment by a number of Asian economies. The ADB estimates that Asia needs about US$8 trillion of physical infrastructure investment between 2012 and 2020. The OECD estimates that globally over US$50 trillion of infrastructure investment is required over the next two decades to support sustained economic activity.

The AIIB is expected to have an initial capital of between US$50 billion to US$100 billion with China contributing to half that amount. This will immediately create an entity that is stronger than the Asian Development Bank (which has a current capitalisation of about US$78 billion) and will be around half of the World Bank’s current capitalisation of between US$180 billion to US$200 billion.

 

Implications and impact for major Asian partners

The creation of the AIIB has a number of major implications for Asian economies. Growth prospects With depressed growth prospects – strong investment in infrastructure projects will support the creation of demand and improve production and consumption. The enhanced infrastructure will also support greater trade and economic expansion.

This is certainly the case for India which forecasted a need for approximately US$1 trillion to meet infrastructure requirements under its 12th five-year plan (from 2012 to 2017) but is struggling to meet the investment target. Participation in the AIIB will allow for India to raise greater capital and visibility for some of her public-private infrastructure initiatives. The rest of the South Asian subcontinent, including Sri Lanka, Bangladesh, Nepal and Pakistan have all either signed up with the AIIB or shown strong interest in the initiative. If India chooses to remain on the side lines, her influence across South Asia will further diminish. The AIIB will be a strong platform for India to take on a regional leadership role and be seen to be a partner for the region’s growth and success.

The AIIB will also certainly support a number of smaller Asian economies which have been unable to meet the stringent requirements or payment terms set out by the likes of the Asian Development Bank or the World Bank. This includes the likes of Nepal, Cambodia and Laos.

From a political perspective, the impact for Japan as a result of these developments is significant. The Asian Development Bank has traditionally been led by Japan (who along with the US share the majority voting rights in the ADB) which previously allowed Japan to exert her political and economic influence across Asia. The AIIB will certainly curtail Japan’s political influence across Asia and also strengthen China’s hand in the on-going disputes ranging from the South China Sea territorial issues to legacy World War II disputes.

South Korea on the other hand is trying to navigate its participation in the AIIB tenderly. On one side, Seoul has to please her largest trading partner, China, whom she is working closely with towards greater economic success. On the other side, Seoul’s traditional security partner, the US, remains a critical partner in South Korea’s regional defence strategy.

ASEAN (Association of Southeast Asian Nations) has certainly shown significant support for the AIIB. Indeed Singapore was one of the early founding members of the AIIB as they have a clear stated policy of working with China from the inside rather than remaining out on the side lines looking in. Other major ASEAN economies such as Thailand, Malaysia and Indonesia are likely to sign up to the AIIB to exert greater influence in the way the bank is run and managed which will in turn support their own investment and growth plans. However, there will be concerns, particularly from Philippines and Vietnam, which in recent times have had strong and sharp exchanges with China over the South China Sea islands. Their concern will be that should China take a greater role in economic influencing and funding, it will strengthen China’s hand and erode Vietnam and Philippines’ support in their respective claims in the South China Sea.

Asia has always traditionally had strong savings, currently estimated to be worth over US$3.99 trillion. This supply of savings can meet some of the immediate infrastructure requirements across Asia but there is a mismatch in channelling these savings towards the financing of the infrastructure projects. The AIIB can help resolve this funding gap moving forward.

 

Problems with Uncle Sam?

The US government has not hidden their opposition to the establishment of the AIIB.

Their biggest concerns are around how China will use the AIIB to further project her economic and political dominance across the region. It also gives greater clout to other major Asian partners such as South Korea and India whilst diminishing the influence of the United States’ traditional Asian partner, Japan (who leads the ADB as highlighted above). This does alter the geopolitical realities in the region and softens the US hegemony in the region.

Some of the other concerns highlighted by the US government is that the new bank will not have adequate and robust safeguards in areas such as environmental protection, human rights and a transparent procurement process which will undermine the need for good governance across the region. Indeed, if the AIIB fails to have strong safeguards, it will exacerbate the challenges of corruption, lack of accountability and proper due diligence which have remained endemic problems across Asia (and also around the world). However, it is likely that the AIIB will operate to very high and rigorous global standards when assessing and evaluating projects.

However, it must be noted that China has made it clear from the outset, and also recently at the Boao Forum for Asia, that they welcome the participation of the US and other European Union partners in the AIIB. This will provide an opportunity for non-Asian partners to support the bank and ensure that AIIB’s governance and strategy is in line with global standards.

The US should use this as an opportunity to partake in the region’s continued growth and stability. US participation in the AIIB (which will be subject to lengthy Congressional debates) will certainly do more to support US foreign policy of a safer and prosperous world rather than the current position of dissuading potential partners from participating in the AIIB.

 

The future

The AIIB will need to create strong and close collaborative partnerships with the likes of the World Bank and the ADB so that they are not working to cross purposes. Encouragingly, the World Bank have announced their wish to work closely with the AIIB when they launched the Global Infrastructure Fund (GIF) earlier in October 2014. Similarly, the ADB have also announced their intentions to work closely with the AIIB.

The AIIB will also need to create a viable and sustainable business model which channels funding appropriately towards infrastructure investment.

Recently, the BRICS Bank or the New Development Bank was set up by Brazil, Russia, India, China and South Africa. The BRICS Bank is headquartered in Shanghai and the Presidency is maintained by India for the initial five years. However, the funding from this BRICS bank is only available to the BRICS nations and not to the rest of Asia. The AIIB helps to alleviate this issue.

The AIIB can potentially create a platform that generates economic ties and greater unity across Asia. It provides a strong and credible opportunity for major Asian rivals to become partners towards growth and development. Initiatives such as these will help to provide resolution to tricky issues that always emerge between partners and friends.

 

Banks – the regulations that govern them – and what happens when they are not governed.

In addition to my Facebook posting previously on the issues that have been faced in the aluminum markets, banks are generally now increasingly involved in a number of markets from energy to aluminum.

I was reading an excellent article in Bloomberg which very neatly explained the connections. Banks are now subsidized by the government. The Federal Deposit Insurance Corporation and the Federal Reserve (both backed by the taxpayers) provide a subsidy to banks – allowing them to draw on reserves during times of market instability.

 

This means that the banks which are too big to fail (and can cause catastrophic consequences should they go under) are effectively allowed to borrow at low or cheap rates.

 

What this means is that banks who can borrow at a lower rate than most other corporations, start investing in markets such as energy or the metal markets such as the aluminum markets, create stockpiles and cut supply which in turn creates a higher price from which they benefit from when they then sell the commodities in the open market.

In the event they bet wrongly, and the prices of the commodities they are stockpiling drop and lead to financial distress at the banks, then the government (and taxpayers) are obliged to provide emerging funding reserves to tide them through.

This creates similar risk-incentive situations which caused the 2008 financial crisis in the first place.

It will be also useful to learn about some of the existing regulations which are in place or which have been lifted but which may need to be considered to prevent the type of problems we had/have now.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Link: in full here) –

This is an act that has polarised America with one faction arguing that the Act does little to prevent another financial crisis or stop risky behaviour that will lead to another bailout whilst another faction argued that it was too restrictive and draconian.

The volcker Rule – Within this Act, under the section of “Improvement to Regulation” is the Volcker Rule – which essentially restricts US banks from making a number of speculative investments that do not benefit their customers and only seeks to boost the banks and bonus payouts of senior management at the banks.

With the aim of reducing the amount of speculative investments on large firms’ balance sheets, it limits banking entities to owning no more in a hedge fund or private equity fund than 3% of the total ownership interest.The total of all of the banking entity’s interests in hedge funds or private equity funds cannot exceed 3% of the Tier 1 capital of the banking entity. Furthermore no bank that has a direct or indirect relationship with a hedge fund or private equity fund, “may enter into a transaction with the fund, or with any other hedge fund or private equity fund that is controlled by such fund” without disclosing the full extent of the relationship to the regulating entity, and assuring that there are no conflict of interest

 

Glass-Steagall Act (Link to Act here)

This was an Act that was around from the time of the Great Depression in the 1930s until the Clinton Administration repealed it at the turn of the century.

Established as a part of President Franklin D. Roosevelt’s New Deal following the Great Depression, the Glass-Steagall Act actually refers to a handful of provisions sponsored by Sen. Carter Glass and Rep. Henry B. Steagall, which were a part of the larger Banking Act of 1933.

These provisions accomplished a number of things, but most notably prohibited commercial banks from participating in investment banking; this includes activities such as underwriting securities (except for certain treasuries), providing services by brokers or dealers in transactions in the secondary market, as well as facilitating mergers, acquisitions and other forms of restructuring. Investment banks were likewise prohibited from accepting deposits.

The ending of Glass-Steagall removed the distinction between investment banks and commercial banks, leading to a scenario where banks started making risky investments with government-guaranteed deposits.

However, in the last few months, a bipartisan group of senators put forward a proposal for new Glass-Steagall legislation that would restore a strict separation between commercial banks and speculative trading. It is argued that this will inhibit the excessively risky behaviours demonstrated by a number of banks and help prevent the next financial catastrophe.