The finance industry ten years after the crisis
Buddy, can you spare a Daimler?
Oct 14th 2017
MANY people complain that the finance industry has barely suffered any adverse consequences from the crisis that it created, which began around ten years ago. But a report from New Financial, a think-tank, shows that is not completely true.
The additional capital that regulators demanded banks should take on to their balance-sheets has had an effect. Between 2006 and 2016, the return on capital of the world’s biggest banks has fallen by a third (by more in Britain and Europe). The balance of power has shifted away from the developed world and towards China, which had four of the largest five banks by assets in 2016; that compares with just one of the biggest 20 in 2006.
The swaggering beasts of the investment-banking industry have also been tamed. The industry’s revenues have dropped by 34% in real terms, with profits falling by 46%. Return on equity has declined by two-thirds. Staff are still lavishly remunerated, but pay is down by 52% in real terms. (Perhaps it is time for a charity single: “Buddy, can you spare a Daimler?”) The relative importance of different divisions has also shifted, with the revenues of the sales, trading and equity-raising departments shrinking more than the merger-advice or debt-raising divisions.
This last change reflects market developments. In 2016 stockmarkets were smaller, as a proportion of GDP, than they were in 2006, despite the record highs on Wall Street; that was because Europe and Asia have not performed as well. Both government- and corporate-bond markets were bigger than they were a decade earlier. Although the crisis started because of overindebtedness, corporate-bond issuance has doubled in real terms over the decade, while the volume of stockmarket flotations has fallen by half.
Meanwhile the game of “pass-the-parcel” of assets around the markets has speeded up; trading volumes in equities, foreign exchange and derivatives have increased in real terms. In the corporate-bond market, trading in American securities has grown but trading in European debt has declined.
In the midst of the crisis, central banks stepped in with quantitative-easing programmes to buy financial assets. This has had profound effects, most notably in the bond markets, where yields have fallen to historic lows (and hence prices have risen). In contrast to equities, the value of both corporate and government bonds is significantly higher, relative to GDP, than it was ten years ago.
This has proved to be a pretty decent climate for money managers, who earn fees based on a percentage of the assets they invest. The industry’s pre-tax profits rose by 30% between 2006 and 2016, despite the growing market share of low-cost index-tracking funds at the expense of actively managed ones. At the other end of the cost spectrum, hedge funds, private equity and venture capital have all increased their assets, relative to GDP. The asset-management industry has become more concentrated. The 20 largest firms control 42% of assets, up from 33% a decade ago.
Overall, the authors of the report remark that “it is perhaps surprising how little has changed”. It may be less surprising if you consider that finance has two faces: first, as a driver of the economic cycle via credit expansion; and second, as an instigator of crises when creditors lose confidence. If markets are plunging and banks failing, as they were in 2008, it is understandable that the authorities do all they can to stabilise markets and rescue banks. As Tim Geithner, a former treasury secretary in America, put it: “The truly moral thing to do during a raging financial inferno is to put it out.”
By making the banks take on additional capital, the authorities have at least made the system less likely to suffer an exact repeat of the last crisis. But the world is still marked by a combination of high asset prices and high levels of debt. Outside the financial sector, there is even more debt than there was ten years ago; the combined total of government, household and non-financial debt levels are 434% of GDP in America, 428% in the euro zone and 485% in Britain.
In other words, the borrowing has been shifted to other parts of the economy; but that makes the finance industry no less vulnerable. A sudden fall in asset prices, or a sharp rise in interest rates, would reveal the jagged rocks beneath the surface. Central banks know this; that is why they are so cautious about unwinding monetary stimuli. At the heart of the next economic crisis will be the finance business; that is something that has not changed in the past decade.
The internationalisation of China’s currency has stalled
And the forthcoming Communist Party congress is unlikely to kick-start it
Oct 14th 2017
ON OCTOBER 18TH, President Xi Jinping will preside in Beijing over the most important political event in five years. At the Communist Party’s 19th congress much will be made of the triumphs achieved in nearly four decades of reform and opening up. So expect a glossing over of one part of that process where progress has largely stalled: the “internationalisation” of China’s currency, the yuan.
This seems odd. Just a year ago, the yuan became the fifth currency in the basket that forms the IMF’s Special Drawing Right (SDR). This marked, in the words of Zhou Xiaochuan, China’s central-bank governor, in a recent interview with Caijing, a financial magazine, “historic progress”. Symbolically, China’s monetary system had been awarded the IMF’s seal of approval. A further boost to prestige was the announcement in June this year that some Chinese shares would be included in two stockmarket benchmarks from MSCI.
Yet the yuan’s international reach has in fact fallen in the past two years. It has regained its ranking as the world’s fifth most active for international payments, after slipping to sixth in 2016. But its share of this market has slipped from 2.8% in August 2015 to 1.9% now (see chart). Use of the yuan in global bond markets over this period has fallen by half, as companies have instead raised funds within China. In Hong Kong, the largest offshore market, yuan deposits have plunged by 47% from their peak in December 2014. Of the foreign-exchange reserves held by the world’s governments, just 1.1% are in yuan, compared with 64% for the dollar.
The constraints on the internationalisation of the currency are largely self-imposed—and in many cases predated admission to the SDR. A minor devaluation of the yuan in August 2015, intended to make the currency more flexible, was botched. This led to speculation about further falls in the yuan’s value, and forced the central bank to tighten capital controls and spend foreign-exchange reserves to prop it up.
Since January this year, China’s reserves have been growing again. But stringent capital controls remain in place. In his interview Mr Zhou called for a renewed drive to free up China’s financial system, citing a “troika” of targets: increased foreign trade and investment; a more market-based exchange rate; and a relaxation of capital controls. He said there was a “time window” for this. If missed, the cost of reform would be higher in the future.
Few observers, however, take Mr Zhou’s comments as official policy. In office since 2002, he is expected to be replaced next year. He represents one side of a continuing debate. In September two capital-control rules were indeed eased, but foreign traders tended to share the view of Mitul Kotecha of Barclays, that the move was purely cosmetic. In the words of Eswar Prasad, an economist at Cornell University and author of “Gaining Currency”, a book about the yuan, “what the government giveth, the government can taketh away.” Most foreign investors are all too aware of that.
So the currency’s international advance is unlikely to resume soon. More likely is a gradual opening of yuan markets. One avenue is to standardise systems such as the China International Payment System, which processes cross-border payments. Another is to expand the Bond Connect and Stock Connect programmes that link Chinese markets to Hong Kong. A third involves China’s intense diplomatic drive to push its “Belt and Road Initiative”, involving massive investments in infrastructure to boost transport, trade and investment links between China and Central Asia, Europe and Africa.
However, David Woo of Bank of America Merrill Lynch argues that none of this is likely to lead to a big surge in foreign holdings of Chinese financial assets. That will depend on the liberalising measures Mr Zhou is advocating, as indeed does the future shape of the Chinese economy. “There isn’t a single country,” Mr Zhou argued, “that can achieve an open economy with strict foreign-exchange controls.”
But his apparent belief that measures already taken, such as joining the SDR basket, have set the yuan on a remorseless path towards internationalisation has been contradicted by the experience of the past two years. The party’s watchword remains “stability”. And whatever the benefits of capital-account liberalisation, it would bring a measure of unpredictability. In a battle between openness and control, Mr Xi is likely to favour control.
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