Defaltion in the Euro Zone, for real?

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Deflation is bad. Just ask Japan. First, by creating expectations that prices will be lower next year it gives consumers incentives to postpone purchases.As a result, aggregate demand declines putting further downward pressure on prices. Second, since private and public debts are fixed nominally, declining prices increase the real burden of the debt. Put differently, as prices decline government and private revenues decline while the service of the debt remains unchanged. This forces the private and public sectors to spend an increasing proportion of revenues to service the debt, forcing them to cut back their spending on goods and services. This in turn increases the intensity of the deflationary process. This is probably the most important negative effect of deflation.

Are these risks becoming a reality in the euro zone? The consumption-postponement effect is not yet operative. Prices are still increasing in the euro zone. Only if consumers actually expect prices to decline will it start operating. The second effect, the debt-deflation dynamics, however, is already working. It is important to stress that this effect does not crucially depend on inflation being negative. It starts operating when inflation is lower than the rate of inflation that was expected when debt contracts were made. Thus, during the last ten years inflation expectations in the euro zone have been very close to 2%, which was also the average rate of inflation during that period. Current nominal interest rates on long-term bonds reflect the expectation that inflation will be 2% for the next five to ten years.

Inflation in the euro zone has been declining since early last year and now stands at 0.8%. This disinflation exerts debt-deflation dynamics. The nominal debt increases with the nominal rate of interest (which includes a 2% inflation expectation), but the nominal income in the euro zone increases by only 0.8%. As a result, an increasing proportion of these revenues must be spent on the service of the debt. Less is left over to spend on goods and services. Thus, the euro zone as a whole already suffers from debt-deflation dynamics. It is not yet catastrophically intense, but surely it should be stopped before it gets worse when inflation turns negative.

Moreover, there is a tug-of-war starting between the euro zone and emerging markets (EMs). As American output and interest rates rise, capital outflows in one or both regions are likely to rise. What form these outflows will take, which region will suffer more, depends on each region’s financial vulnerabilities, and how their politicians are expected to operate under duress. That is, the main game that will be played now in capital markets. It resembles a tug-of-war because the effect of American economic recovery may greatly depend on the relative strengths of these regions. If the balance tilts against the euro zone, investors will shift the composition of their portfolios and deteriorate its credit channel. Whether or not this triggers deflation of euro-zone prices depends on the role of euro-denominated assets for collateral and in facilitating commercial transactions.

However, the euro area is a large currency zone where the euro is well-established as a unit of account, and a central bank which is strongly averse to inflation; therefore, the “flight to quality” may produce opposite effects, namely, strengthening of the euro and price deflation. This moght not be good at all for the euro-zone real sector because, to the weaker competitive conditions triggered by currency appreciation, price deflation may add two lethal factors: (1) debt deflation (A situation in which the collateral used to secure a loan decreases in value), and (2) the expectation that prices will continue falling. Factor (1) further dries up credit flows, while factor (2) increases the real return of cash balances and, hence, lowers aggregate demand. A major flight- to-quality episode would call for further relaxation of ECB credit, which is likely to meet major opposition in its board.

Moreover, EM banks have been largely free from “toxic assets” and can better fend for themselves than euro-zone banks that so far have survived partly due to the ECB help. Thus, if the ECB falters in coming to their rescue in a new flight-to-quality episode, their chances of surviving are bleak compared to EM banks. Moreover, despite their dysfunctionality as a trade or currency union, some key EMs (notably in the Middle East, Africa and Latin America) are resource-rich, and they still have vast expanses of unexploited resources. These areas will benefit from continued growth in China, while for the euro zone it may signify stiffer industrial competition from abroad.

Inflation in the United States followed a pattern similar to the euro zone between the end of 2009 and the end of 2010. After observing a few months of declining inflation readings, the Federal Reserve started to act. Firstly, in August 2010, the Federal Open Market Committee (FOMC) announced the reinvestment of principal payments from agency debt and mortgage-backed securities purchased during the first round of Large Scale Asset Purchases (LSAP). Secondly, in September of the same year, the FOMC statement introduced the first instance of post-crisis forward guidance language (“economic conditions are likely to warrant exceptionally low levels for the federal funds rate for an extended period.”). Thirdly, in November, the Committee announced the second LSAP program for $600 billion. While other factors may have played an important role, both headline and core inflation measures did bottom out between November and December 2010 and reverted back close to the 2% target within the next six months.

So, may be the time ripe for the ECB to follow in the Fed’s footsteps and become more aggressive against low inflation. but the ECB is unlikely to embark in quantitative easing, due to the Bundesbank’s concern about blurring the line between monetary and fiscal policy. The ECB is paralysed by internal dissension that prevents it from increasing liquidity in the system, the only sure way to prevent deflation.

At the moment, the risk of deflation for the euro zone is real. America lived through a similar experience in the recent past. The Federal Reserve ramped up its response, with a number of unconventional policy actions. Perhaps, now is the time that Europe moves one step beyond what America has done and experiments with more aggressive policy actions.

The above has been compiled  from an on going debate on Deflation in the euro zone in the Economist.


Is Japan Debt Crisis Next?

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Exact predictions of the date may differ, but the general consensus on Japan remains the same. In a matter of just three to 10 years, the world’s third-biggest economy may start running out of the savings needed to fund its massive public debt.

The days of Tokyo’s finance mandarins being admired for their fiscal prudence are long since gone. According to the IMF, Japan’s general government debt first crossed 100 percent of gross domestic product (GDP) in 1997 as the authorities tried hard to pump prime the economy out of its post-bubble scenario.

But, ending the credit binge – and its famous “bridges to nowhere” construction projects – has proved challenging for governments dealing with a deflationary downturn, rising welfare costs and dwindling tax revenues.

Since 1990, public finances have deteriorated significantly. In recent decades, Japanese governments have piled up debts worth some €11 trillion ($14.6 trillion). In 2011, general government gross debt totaled nearly 230 percent of GDP and is projected to reach 245 percent in 2013, with the government’s fiscal deficit currently around 10 percent of GDP. Net public debt, which subtracts from gross debt government assets such as public pension funds, has also increased tenfold over the past two decades to reach more than 125 percent of GDP. The US government has gross and net debt of 107% and 84%. Total gross debt (government, non-financial corporation and consumer) is over 450% of GDP, compared to around 280% for the US.

In the post war period, Japan enjoyed decades of strong economic growth – around 9.5% per annum between 1955 and 1970 and around 3.8% per annum between 1971 and 1990. Since the collapse of the Japanese debt bubble in 1989/ 1990, Japanese growth has been sluggish, averaging around 0.8% per annum. Nominal gross domestic product (“GDP”) has been largely stagnant since 1992. Japan’s economy operates far below capacity, with the output gap (the difference between actual and potential GDP) being around 5- 7%.

The Japanese stock market is around 70-80% below its highs at the end of 1989. The Nikkei Index fell from its peak of 38,957.44 at the end of 1989 to a low of 7,607.88 in 2003. It now trades around 8,000-12,000. Japanese real estate prices are at the same levels as 1981.

Despite the highest public debt to GDP ratio in the industrialized world, Japan remains the world’s biggest creditor with net foreign assets of around US$3.1 trillion, with its 2011 per capita GDP of US$34,294 above Italy, Spain and South Korea and four times the size of China’s. And in comparison with Europe’s indebted economies, Greece reached crisis point with its debt to GDP ratio of just 150 percent, while the Spanish government has faced a storm with a debt ratio below 100 percent. While Greece has recently had to cough up interest at double-digit rates, for example, the comparable figure for Japan has been a mere 0.75 percent. Even Germany, the euro zone’s healthiest economy, has to pay more.

The reason behind this is Japan has maintained a high corporate savings rate and low levels of fixed investment (both residential and nonresidential), making Japan a net exporter of capital. However, its fiscal profligacy is catching up with it: Its fiscal deficit has risen to more than 11% of GDP, where it remains today.

Household assets of an estimated 1,500 trillion yen, surplus funds held by the private sector and the demand from Japanese banks and other financial institutions for low-risk investments have given the government a ready market for its JGBs.

In addition, Japan’s low ratio of taxes to national income provides scope for increasing the burden. According to OECD data, Japan’s 27.6 percent ratio in 2010 compared with the United Kingdom’s 35 percent and was below the average 33.8 percent of tax revenue as a percentage of GDP.

Japan’s current account surplus has also allowed the government to run large budget deficits which can be funded domestically. Since 2007, the Japanese trade account surplus has fallen sharply, turning into a deficit in 2012..

“But Japan is not Greece as it funds its own debt, whereas in Greece 70 to 75 percent of government bonds were owned by non-Greeks. Crises happen when your creditor goes on strike, and the fact is that Japan’s debt is held almost exclusively by the Japanese themselves so any comparison just doesn’t make sense,” Japan economist Jesper Koll, Japan Director of Research at JP Morgan, said.

The reason is simple: Unlike countries in the euro zone, Japan borrows most of its money from its own people. Domestic banks and insurers have purchased more than 90 percent of the country’s sovereign debt using the savings deposits of the general population. What’s more, the Japanese are apparently so convinced that their country will be able to pay off its debts one day that they continue to lend their government a seemingly endless amount of money.

Unlike Greece, Spain and other members of the Euro zone’s monetary straightjacket, Japan has its own currency which could prove an important advantage, Koll added.

“If it comes to a point where domestic savings can’t fund the deficit any more, the currency is likely to weaken, making yen assets such as Japanese bonds more attractive. That’s something that is in fact already started.


The story begins with Japan’s post-war economic miracle. In order to rebuild its economy after the devastation of World War II, the Japanese government adopted an export model, like that in Germany, to boost export growth and import know-how. Japan invested heavily in education, research and manufacturing. A key element of the export model is, of course, accommodative monetary policy whereby a country uses credit creation, infrastructure development, and lower-than-market interest rates (known in monetary parlance as “financial repression”) to focus the country on exports. As the original “Asian Tiger,” Japan employed this strategy to great effect over the years, growing GDP sharply on the back of strong exports. As long as GDP and exports are growing, this model works. But when GDP stops growing and exports become slow, the model fails. In the post war period, Japan enjoyed decades of strong economic growth – around 9.5% per annum between 1955 and 1970 and around 3.8% per annum between 1971 and 1990.

The Plaza Accord signed on 22 September 1985 called for France, West Germany, Japan, the United States, and the United Kingdom to devalue the dollar relative to other major currencies (including the yen) by intervening in currency markets with the specific intent of reducing trade imbalances. Between 1985 and 1987, the Yen increased in value by 51% against the dollar.

Japan moved from an era of En’yasu, an inexpensive Yen, to a period of Endaka or Endaka Fukyo, an expensive Yen. The higher Yen adversely affected Japanese exporters. Japanese economic growth fell sharply, from 4.4% in 1985 to 2.9% in 1986.

Desperate to restore growth and offset the stronger Yen, the Japanese authorities eased monetary policy with the BoJ cutting interest rates five times from 5% to 2.5% between January 1986 and February 1987, leaving it finally at 2.5% — which remained in effect until May 1989. The BOJ was ferociously trying to stimulate the economy with aggressive easing. The lower rates led to a rapid increase in debt funded investment, driving real estate and stock prices higher. At the peak of the “bubble” economy, the 3.41 square kilometer (1.32 square miles) area of the Tokyo Imperial Palace had a theoretical value greater than all the real estate in the state of California. The point of failure for Japan was when it’s easy monetary policy stimulated a real estate and stock market bubble instead of fueling exports.

Seeking to reverse the unsustainable asset price inflation, the authorities increased interest rates to 6% between 1989 and 1990 triggering the collapse of the boom. The bubble manifested itself in both real estate and the stock market. It finally popped as the BOJ raised interest rates in 1989–1990(with historic collapses from which — even now, some 22 years later — the country has not recovered).As Japan’s economic problems worsened rapidly, the government responded with large fiscal stimulus programs. The BoJ cut interest rates to zero. But the policy measures failed to revive the economy, which slid into deflation.

Following the collapse of the bubble, policymakers implemented a variety of economic stimulus programs. Japan’s budget surplus of 2.4% in 1991 has become a chronic budget deficit, increasing from 2.5% in 1993 to about 8% by the end of the 1990s. It has remained high during the 2000s. The BoJ has tried unsuccessfully to increase inflation to reduce debt. Japanese inflation has averaged minus 0.2% in the 2000s, a decline from levels of 2.5% in the 1980s and 1.2% in the 1990s. The policies have failed to restore economic growth, trapping Japan in a period of economic stagnation.

Since the collapse of the Japanese debt bubble in 1989/ 1990, Japanese growth has been sluggish, averaging around 0.8% per annum. Nominal gross domestic product (“GDP”) has been largely stagnant since 1992. Japan’s economy operates far below capacity, with the output gap (the difference between actual and potential GDP) being around 5- 7%.

The Japanese stock market is around 70-80% below its highs at the end of 1989. The Nikkei Index fell from its peak of 38,957.44 at the end of 1989 to a low of 7,607.88 in 2003. It now trades around 8,000-12,000. Japanese real estate prices are at the same levels as 1981.

There was a parallel deterioration in public finances. At the time of collapse of the bubble economy, Japan’s budget was in surplus and government gross debt was around 20% of GDP. As the Japanese economy stagnated, weak tax revenues and higher government spending to resuscitate growth created substantial budget deficits.

Japan’s total tax revenue is currently at a 24 year low. Corporate tax receipts have fallen to 50 year lows. Japan now spends more than 200 Yen for every 100 Yen of tax revenue received.

The period of Japanese economic decline was known as the Lost Decade or Ushinawareta Jūnen. As the economy failed to recovery and the problems extended beyond 2000, it has come to be referred to as the Lost Two Decades or the Lost 20 Years (Ushinawareta Nijūnen).

Japan’s large pool of savings, low interest rates and a large current account surplus has allowed the build-up of government debt. Japan has a large pool of savings, estimated at around US$19 trillion, built up through legendary frugality and thrift during the nation’s rise to prosperity after World War II. High savings rates also reflected the country’s young age structure especially until the 1980s, the low level of public pension benefits, the growth of income levels through to the late 1980s, the bonus system of compensation, the lack of availability of consumer credit and incentives for saving.

In recent years, household savings were complemented by strong corporate savings, around 8% of GDP. This reflects slow growth, excess capacity, lack of investment opportunities and caution driven by economic uncertainty.

Much of these savings are invested domestically. A significant amount of the savings is held as bank deposits, including large amounts with the Japanese Postal System. In the absence of demand for credit from borrowers, the banks hold large quantities of government bonds to match the deposits, helping finance the government. Japanese banks hold around 65-75% of all Japanese government bonds (“JGBs”) with the Japanese Postal System being the largest holder. Around 90% of all JGBs are held domestically.

The high levels of debt are sustainable because of low interest rates, driven by the BoJ’s ZIRP and successive rounds of JGB bond purchases as part of quantitative easing (“QE”) programs since 2001. The BoJ balance sheet is now around US$2 trillion an increase from around 10% of Japan’s GDP to 30% since the mid-1990s. BoJ holdings of JGBs are around US$1.2 trillion, around 11% of the total outstanding.

Low interest rates perversely have not discouraged investment in bank deposits or government bonds. This reflects the poor performance of other investments, such as equity and property, during this period. The strong Yen has increased the risk of foreign investments. Although nominal returns are low, Japanese investors have received high real rates of return, because of falling prices or deflation.

Over the last 50 years, Japan has also run large current account surpluses, other than in 1973–1975 and 1979–1980 when high oil prices led to large falls in the trade balances. The current account surplus has resulted in Japan accumulating foreign assets of around US$4 trillion or a net foreign investment position of approximately 50 % of GDP. This helped Japan avoid the need to finance its budget deficit overseas and also boosted domestic resources, increasing demand for JGBs.

These foreign currency holdings generate substantial amounts of investment income each year. However, the control of these vast sums is concentrated in a few hands. Likewise, the bond market (and hence, interest rates) is controlled by many of these same hands. And because bonds are priced in a market, if and when the managers of this capital decide to sell, they can cause a stampede for the exit.

Since the global financial crisis and more recent European debt crisis, Japan has been viewed as a “safe haven”. Investors have purchased Yen and JGBs, pushing rates to their lowest levels in almost a decade and increasing foreign ownership of JGBs to around 9%, the highest level since 1979, the first year for which comparable data is available. These factors have assisted Japan to finance its budget deficit.

These factors which allowed Japan to increase its government debt levels are unlikely to continue.

Private consumption is weak, further reducing domestic demand. This reflects weak employment, lack of growth in income and the aging population. Strong exports and a current account surplus have partially offset the lack of domestic demand, as firms focused on overseas markets.

With investment and consumption weak, large budget deficits have supported economic activity, avoiding an even larger downturn in economic activity. In a balance sheet recession, monetary policy is ineffective with limited demand for credit. Government stimulus spending is the primary driver of growth.

The Japanese government’s ability to finance spending is increasingly constrained by falling Japanese household savings rates, which have declined from between 15% and 25% in the 1980s and 1990s to under 3%, a level below the US until recently. This decline reflects decreasing income and the aging population.

In terms of debt capacity, the net assets of Japanese households reach 1,156 trillion yen; while the national debt is 1,133 trillion yen. The difference is around 23 trillion yen. The increase in assets buyback already hits 10 trillion yen, which means there is not much domestic capacity left for absorbing any newly issued debt, which means there is not much domestic capacity left for absorbing any newly issued debt. In other words, if the Japanese government continues with its current economic policies and has no way out in economic development, it has to go to foreign lenders for funds. Worst still, it is doubtful if the Japanese government can issue debt at such interest rates. With the worsening debt to GDP ratio and an unreasonable debt level, new lenders are likely to ask for a fair premium for the lending.

Wage have fallen with average annual salaries including bonuses falling every year since 1999 and decreasing by around 12% in total. Between 1994 and 2007, labor costs as a percentage of manufacturing output declined from 73% to 49%. Japanese worker’s share of GDP fell to 65% in 2007, from a peak of 73% in 1999.

Compounding matters, Japan’s manufacturing prowess is weakening while the country as a whole is becoming less competitive. They have lost leadership positions in a number of key industries and the rise of the yen is making their exports less competitive as well. Moreover, pressured budgets make it more difficult to engage in the long-range R&D spending that had helped the country become a global leader in manufacturing. As an example, once a stalwart in consumer technology, Sony recently announced the layoff of 10,000 workers.

Since the epic global financial meltdown in 2008, the U.S. Federal Reserve has maintained an aggressive policy of depreciating the U.S. dollar. The yen has appreciated some 30% against its post-bubble average, as well as against the dollar, since the collapse in 2008.

This recent appreciation of the yen is exacerbating all of Japan’s problems — its export products are now 30% more expensive on global markets. Its profile is similar against other major currencies. For the first time since the Japanese bubble collapsed, Japan will now need substantial alternate forms of funding to keep the government afloat.

Japan’s demographics parallel its economic decline. Japan’s population is forecast to decline from its current level of 128 million to around 90 million by 2050 and 47 million by 2100. A frequently repeated joke states that in 600 hundred years based on the present rate of decline there will be 480 Japanese left.

The proportion of Japan’s population above 65 years will rise from 12% of the total population to around 23%. Japan’s work force is expected to fall from 70% currently by around 15% over the next 20 years. For every two retirees there will be around three working people, down from six in 1990. This aging population further reduces the savings rate. Household surveys indicate that around a quarter of households with two people or more have no employment.  In aggregate, the amount of money being paid to retirees from savings exceeds the amount of new money that is going into savings funds. This is compounded by low returns on investments which accelerates the rundown of savings.

The secular factors driving the fall include an appreciating Yen and slower global growth, which has reduced demand for Japanese products, such as cars and consumer electronics. In late 2012, territorial disputes with China exacerbated the decline in exports. It also reflects the impact of the Tohoku earthquake and tsunami as well as the subsequent decision to shut down Japanese nuclear power generators, which increased energy imports, especially Liquid Natural Gas.

Deep seated structural factors also underlie changes in the trade account. Since the 1980s, rising costs and the higher Yen have driven Japanese firms to relocate some production facilities overseas, taking advantage of lower labor costs and circumventing trade barriers. More advanced, technologically complex and high value manufacturing was kept in Japan. But post 2007 Japanese firms have increasingly been forced to close these domestic production facilities as they have become uncompetitive.

The combination of falling exports, lower saving rates, declining corporate earnings and cash surpluses is likely to move the Japanese current account into deficit. In turn, this will force Japan to become a net importer of capital to finance government spending, altering the dynamics of its finances.

If Japan continues to run large budget deficits, as is likely, then the falling saving rate and reversal in its current account will make it more difficult for the government to borrow, at least at the current low rates.

Ignoring foreign borrowing and debt monetization by the central bank, the stock of private sector savings limits the amount of government debt. In the case of Japan, this equates to around 250-300% of GDP. Japan’s gross government debt will reach this level around 2015, although net government debt will not reach this limit until after 2020.

Even  before Japan’s government debt exceed household’s financial assets, the declining savings rate and increasing drawing on savings by aging households will reduce inflows into JGBs making domestic funding of the deficit more difficult.

Insurance companies and pension funds are increasingly selling their holdings or reducing purchases to fund the increase in payouts to people eligible for retirement benefits. Institutional investors and to a lesser extent retail investors are also increasingly investing in other assets, including foreign securities, in an effort to increase returns and diversify their portfolios.

Japan’s large portfolio of foreign assets will cushion the effects for some time. Japan has accumulated large foreign assets totaling around US$4 trillion, making it the world’s biggest net international creditor. The BoJ is the largest investor in US Treasury bonds, with holdings of around US$1 trillion.

Unless public finances improve, Japan ultimately will be forced to finance its budget deficit by borrowing overseas. Where the marginal buyers of JGBs are foreign investors rather than domestic Japanese investors, interest rates may increase, perhaps significantly. Even at current low interest rates, Japan spends around 25-30% of its tax revenues on interest payments. At borrowing costs of 2.50% to 3.50% per annum, two to three times current rates, Japan’s interest payments will be an unsustainable proportion of tax receipts.

Higher interest rates will also trigger problems for Japanese banks, Japanese pension funds and insurance companies, which also have large holdings of JGBs.

In fact, the major banks, such as Bank of Tokyo-Mitsubishi UFJ, Sumitomo Mitsui, and Mizuho, regularly buy JGBs — even viewing it as a “public mission” to support Japan. In addition, the Bank of Japan buys lots of JGBs on the open market, trying to drive up prices and drive down yields, thereby manufacturing low rates. While this monetization of debt creates inflationary pressures, it has thus far been offset by the deflationary pressures of a declining workforce and declining population. Looking forward id there happens to be some mild inflation of, perhaps, 2–4% (depending on how much monetization and how much debt issuance occurs), but it would likely be enough to re-calibrate the bond market’s expectations. And if JGB yields rise from 1% to just 2%, Japan’s debt service will explode. Thus, a vicious cycle of higher yields, greater fiscal deficits, greater monetization, and greater inflation will occur.

There are also short-term fluctuations from year to year, but it is clear when looking at the averages decade by decade that funding pressures in Japan have been growing over time. JGBs total around 24% of all bank assets, which is expected to rise to 30% by 2017. An increase in JGB yields would result in immediate mark-to-market large losses on existing holdings, although higher returns would boost income longer term. BoJ estimates that a 1% rise in rates would cause losses of US$43 billion for major banks, equivalent to 10% of Tier 1 Capital for major banks or 20% for regional banks.

This cash flow cycle is how Japan has funded itself over the past 22+ years. Only now, the profile is changing. The Japanese debt crisis is being spawned by a burgeoning fiscal deficit. As the fiscal deficit has expanded, it has placed greater pressure on the Japanese government to sell debt and on the Bank of Japan to purchase it. Of course, the BOJ has been stepping in and buying JGBs when corporate demand has not been strong enough to keep rates low.

To avoid the identified chain of events, Japan must address the core problems. But reductions in the budget deficit are difficult. Spending on social security accounts and interest expense now totals a major part of government spending. Increasing health and aged care costs are expected by 2025 to be around 10-12% of GDP.  An aging population and shrinking workforce will continue to drive slower growth and lower tax revenues. Tax increases are politically unpopular. Reductions in the budget deficit are likely to reduce already weak economic activity, compounding the problems.

Prime Minister Ryutaro Hashimoto tied in 1997 to raise the sales tax. Hashimoto’s move cost him his job.

According to the OECD, Japan’s tax revenue in 1991 totaled some 66 trillion yen in individual and corporate income taxes. By 2009, this had fallen to 36 trillion yen, with bond issuance exceeding tax revenues in fiscal 2012 for the third straight year.

The IMF has warned that the increase in consumption tax goes only halfway toward achieving a desired fiscal adjustment of 10 percent of GDP over the next decade to put the debt ratio on a downward path. With some fiscal adjustments, the public debt to GDP ratio is forecast at 300 percent of GDP by 2030, with further cuts deemed necessary to stabilize and then start reducing the ratio.

The government has forecast a primary deficit of between 1.9 and 3.1 percent of GDP by fiscal 2020, compared with the fiscal 2011 deficit of 7.4 percent.

Bringing the primary balance, where fiscal expenditures can be covered without borrowing, into equilibrium is estimated to require an additional 5 to 6 percent hike in the consumption tax.

But, some have argued that Japan can ameliorate its budget shortfall by raising tax rates. In economics, there are no grand solutions, only trade-offs. So, it is a fallacy to think that increasing tax rates necessarily increases tax revenues to the government. Many governments and countries have tried raising tax rates and failed to increase tax revenues either due to tax avoidance or damage to economic growth (or both).

Other analysts have compared Japan’s relatively low tax revenue/GDP ratio with that of other countries, claiming that there is ample room to raise taxes. However, this belies the welfare society construct that Japan has developed in the past 75 years. In contrast to the welfare state, the welfare society provides social benefits through private employers. Japan’s welfare society attempts to maintain near-total employment via liberal government loans to private companies, often circumventing the need for unemployment benefits. Also, retirement pensions come largely from personal savings and company compensation rather than as benefits from the state. So, the state has intentionally shifted the cost of its social programs to companies. Should it raise taxes on the private sector, additional pressure would be placed on corporate budgets, and thereby weakening the economy.

When Hashimoto increased the rate by just two percentage points to its current level, the economy plunged into a 20-month recession, albeit worsened by the Asian financial crisis.

Proposed solutions to Japan’s economic woes have included measures to deregulate the agricultural, electricity and service sectors, along with the politically sensitive measures of joining the Trans-Pacific Partnership and increasing immigration.

The IMF has suggested the fiscal consolidation include raising the consumption tax rate to 15 percent – closer to the OECD average – while reducing corporate taxes, broadening the personal income tax base and increasing the pension retirement age to 67.

In its August 2012 report, the IMF warned that “even a moderate rise in yields would leave the fiscal position extremely vulnerable…Failure to implement a credible fiscal consolidation plan could lead to sovereign downgrades and trigger similar actions for financial institutions, which could eventually erode confidence in the JGB [Japanese government bond] market.”

Higher JGB yields would further damage public finances, with the government’s budget already at a point where bond issuance exceeds taxation revenues. The IMF calculates that a spike in bond yields would slash output by 6 to 10 percent over 10 years, potentially harming not only other Asian economies but also the United States and Euro-zone.

In 2012, for example, the Japanese government needs to issue debt amounting to 59.1 percent of GDP; that is, for every $10 that Japan’s economy generates this year, the government will need to borrow $6. It will probably be able to do so at very low interest rates—currently well below 1 percent.

The fact that government debt is held mostly by Japanese citizens is not sufficiently reassuring. The same was true in Germany during the 1920s and Russia during the 1990s, yet in both cases the elderly lost their savings to high inflation.

Japan’s problems have been compounded by two major natural disasters – the 1994 Kobe earthquake and the 2011 Tohoku earthquake and tsunami.

In the face of the nation’s long term decline, Japanese politics has become increasingly fractious. Frequent changes of leadership, often driven by arcane internal factional politics, have created an unstable environment and a lack of policy continuity. Japan has had seven prime ministers in six years and six finance ministers in three years. Former Brazilian President Luiz Inácio Lula da Silva once joked that in Japan you say good morning to one prime minister and good afternoon to another.

What makes the problem so serious in Japan is the country’s refusal to do what other countries have done: admit massive immigration of younger people from overseas. It is very difficult to immigrate to Japan, and (having immigrated) even harder to obtain citizenship. Japan is the world’s most homogeneous large country.

Japanese policy makers have other options. Financial repression forcing investment in low interest JGBs is one alternative. The BoJ can maintain its zero rate policy and monetize debt to finance the government. Japan can try to inflate away their debt. But ultimately, Japan may have no option other than a domestic default to reduce its debt levels.

Rising inflation helped the United States nearly halve its debt burden from World War II over the period from 1946 to 1955, but Japan’s policymakers, including the Bank of Japan (BOJ), have struggled in recent years to overcome persistent deflationary expectations.

Older Japanese, especially retirees who are major holders of JGBs, would suffer large losses. Younger Japanese would benefit from the reduction in debt and reduced claims on future tax revenues. Such a drastic alternative, with its massive economic and social costs, is difficult to conceive other than as the last option.

However, the status quo in Japan — if left unchanged — will see to it that the funding deficit widens materially. As debt continues climbing and GDP continues falling, the growth in the debt-to-GDP ratio accelerates. The combination of a rising yen and stagnating corporations will result in the structural trade surplus deteriorating over time (which is why the BOJ is trying to get the yen to decline somewhat). Additionally, debt service and social security spending will continue growing as percentages of the federal budget — all without any increase in interest rates. So there is a widening funding deficit that must be made up for with some combination of debt issuance and/or monetization. The combination of large fiscal deficits, funding shortfalls, and private sector not able to save will ensure that Japan must seek investors on the international markets. Consequently, the (natural) domestic demand base for JGBs will fall, while the government’s need for foreign investors is rising. Although some have suggested that the Bank of Japan could devalue the yen. (Remember that Japan imports virtually all of its raw materials, such as energy and hard commodities.) If it chopped the yen in half and many of its input costs doubled, could its export companies be competitive? What would happen to the balance of trade (all else being equal)?

While the underlying economics will change gradually over time, the crisis will erupt when the bond market breaks from the past. When the market realizes that the status quo has changed, rates will rise and force the government’s fiscal budget to explode, creating a sequence of cascading events. Watch closely to see what the major Japanese banks do with their JGB holdings. In addition, watch pension fund managers. The stewards of capital changing their policy allocations will determine when the status quo shifts.

Moreover, Japan has an average debt maturity of 6 years, shorter than Spain, Italy and France. Around 60% of its debt must be refinanced in the next 5 years. This will expose Japan to the discipline of market investors at a vulnerable moment.

Venture capitalist Hitoshi Suga suggested a “debt-equity swap” where the government converted JGBs into 100-year debts, similar to Britain’s “perpetual bonds” issued after the First World War, as well as more fiscal prudence.

Ironically, despite its recent crises, Europe offers an example to Japan of managing fiscal reconstruction while also raising growth. Both the Netherlands and Sweden achieved this feat in the 1980s and 1990s through persistent public finance reforms along with greater labor market mobility and other market opening measures.

The Bank of Japan’s 63-year-old governor, Masaaki Shirakawa — a thin man with neatly parted hair — no longer adheres to the disciplined monetary policies his Western counterparts preach. Instead, Shirakawa keeps the money printers going to stimulate the economy. Since 2011, his bank has launched emergency programs with a total volume of around €900 billion. In comparison, the euro bailout funds jointly financed by the euro zone’s 17 member states only add up to €700 billion.

So far, though, his strategy has done little to help. “At the moment,” Shirakawa admits, “the effect of our monetary policy in stimulating economic growth is very limited.” The cheap money is stuck in the banks rather than flowing into the real economy. “The money is there, liquidity is abundant, interest rates are very low — and, still, firms do not make use of accommodative financial conditions,” Shirakawa adds. “The return on investment is too low.”

Money is only a means with which “to buy time,” he says. “It can alleviate the pain. But the government has to implement reforms too.”One thing is sure, warns central banker Shirakawa, “If we don’t deliver fiscal reform, then the yield on Japanese government bonds will rise.”

At any rate, one thing is clear: change is coming to Japan.

Once the problems emerge, they will be difficult to contain. As Economist Rudiger Dornbush once observed: “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought”.

To learn more about Asset bubble Crisis of Japan in 1980, click here 🙂

The Currency Wars!

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Suddenly the press and media were buzzed with the word ‘Currency War’. People are discussing that sooner than later all countries would go for this currency war. This got my curiosity and I decided to look into what is called as ‘currency war. I found some general things. I would like to share them with you all and discuss how it all started. But to start with, I would like to add that with much of Europe in a recession, Japan struggling with deflation, and the weak American economy potentially falling back into a recession if the automatic spending cuts go through, the global economy is fragile. The last thing the world needs is a currency war. Hehehe, anyways to start with:

Brazil’s finance minister coined the term “currency wars” in 2010 to describe how the Federal Reserve’s quantitative easing was pushing up other countries’ currencies. In mid January, 2013 Alexei Ulyukayev, the first deputy chairman of the Russian central bank, resurrected the phrase to warn of another round of competitive devaluations.

The starting-point for this skirmish was the election of Shinzo Abe as prime minister of Japan in December, and his promise to reorient economic policy. Mr. Abe stormed to an election victory in December with bold promises to end decades of intermittent growth. He wants the Bank of Japan to double its inflation target to 2% and to buy government bonds until that target is achieved. If his goal is realized, Japanese interest rates would finally become negative in real (i.e., after inflation) terms. Because of deflation, real rates have been positive for much of the past decade, even though the economy has been sluggish. That has kept the yen strong, making life more difficult for exporters.

Mr. Abe’s move has had a tremendous impact on the currency markets, pushing the yen down from 78 per dollar in October to 90. According to Alan Ruskin of Deutsche Bank, this was the fifth-fastest decline in the yen since the collapse of the Bretton Woods exchange-rate system in 1971. The yen, for instance, has fallen by about 11 percent against the dollar since the recent election in Japan of Prime Minister Shinzo Abe. The Bank of Japan, the central bank said it would pump more money into the economy via a new, open-ended commitment to buying assets beginning in 2014 — measures known as QE and intended to lift the country out of its fourth recession since 2000. Critics say those policies are aimed at lowering the value of the yen, which Mr. Abe’s government has denied, saying that the Bank of Japan is trying to end nearly 20 years of deflation — not manipulate the yen.

Even the Japanese seem to have been slightly taken aback by the yen’s fall. Japan is heavily dependent on foreign energy supplies, and Akari Amari, the economy minister of Japan, warned that excessive yen depreciation would force up import prices.

The yen’s weakness has added to the pressures on other economies. One of the strongest currencies so far in 2013 has been the euro, which has been buoyed by a feeling that a break-up of the single currency has become less likely.

President François Hollande of France proposed that euro-zone nations should adopt a policy to manage the value of the common currency to maintain the competitiveness of European goods. (The euro has appreciated about 2 percent against the dollar and nearly 10 percent against the yen this year.) Even Chancellor Angela Merkel of Germany waded into the currency debate Thursday, singling out Japan as a source of concern following the Bank of Japan’s moves.

“I don’t want to say that I look towards Japan completely without concern at the moment,” she said at the World Economic Forum in Davos. “It is known that in Germany we are of the opinion that central banks are not there to clean up political bad decisions and a lack of competitiveness.”

The euro has even risen against the Swiss franc, a currency that was so strong in 2011 and 2012 that the Swiss accumulated more foreign-exchange reserves than any other country in the world. The Swiss National Bank acquired those reserves as part of its pledge to prevent the franc from rising above 1.20 to the euro by creating unlimited amounts of francs and buying foreign currencies with the proceeds.

Developing countries like Brazil and Mexico also complain that looser monetary policy in industrialized nations can produce effects similar to currency manipulation. When central banks in countries like Japan and the United States pump more money into their financial systems, investors are driven to put their money into emerging markets where interest rates are higher. That pushes up currencies like the real and peso, making exports from those countries more expensive on the world market.

Typically, a central bank eases by lowering the short-term interest rate. When that rate is stuck at zero, it can buy bonds, i.e. conduct quantitative easing (QE), or verbally commit to keep the short rate low for longer, or it can raise expected inflation. All these conventional and unconventional actions work the same way: by lowering the real (inflation-adjusted) interest rate, they stimulate domestic demand and consumption. America, Britain and Japan are all doing this, although only Japan has explicitly sought to raise expected inflation; America and Britain have done so implicitly. This pushes the exchange rate down in two ways. First, a lower interest rate reduces a currency’s relative expected return, so it has to cheapen until expected future appreciation overcomes the unfavorable interest rate differential. This boosts exports and depresses imports, raising the trade balance. Second, higher inflation reduces a currency’s real value and thus ought to lead to depreciation. But higher inflation also erodes the competitive benefit of the lower exchange rate, offsetting any positive impact on trade.

If this were the end of the story, the currency warriors would have a point. But it isn’t.  The whole point of lowering real interest rates is to stimulate consumption and investment which ordinarily leads to higher, not lower, imports. If this is done in conjunction with looser fiscal policy (as is now the case in Japan), the boost to imports is even stronger. Thus, QE’s impact on its trading partners may be positive or negative; it depends on a country’s trade intensity, the substitutability between it and its competitors’ products, and how sensitive domestic demand is to lower rates. The point is that this is not a zero sum game; QE raises a country’s GDP by more than any improvement in the trade balance.

There are other spillovers. Lower interest rates in one country will generally tend to send investors searching for better returns in another, lowering that country’s interest rates and raising its asset prices. By loosening foreign monetary conditions, that boosts growth, though this may not be welcome if those countries are already battling excess demand and inflation. Countries like Brazil and Mexico fall in this category.

Determining whether QE is good or bad for a country’s trading partners requires working through all these different channels. In 2011, the International Monetary Fund concluded the spillover of the Fed’s first round of QE onto its trading partners was significantly positive, raising their output by as much as a third of a percentage point, while the spillover of the second round was slightly positive. The IMF concludes the weaker dollar was indeed slightly negative for the rest of the world, but this was more than offset by the positive impact of lower interest rates and higher equity prices. This became a motivation for Japan’s stepped-up assault on deflation. The combined monetary boost on opposite sides of the Pacific has been a powerful elixir for global investor confidence.

Currency warriors regularly invoke the 1930’s as a cautionary tale, but they actually show something quite different. In the 1980s, Barry Eichengreen at the University of California, Berkeley and his co-authors demonstrated that the first countries to abandon the gold standard recovered much more quickly from the Depression than those that stayed on gold longer. The direct spillover of depreciation was negative, while the spillover of increased money and credit was positive, as capital outflows “helped to relax conditions in money and  credit markets and moderate expected deflation in other countries.” Nonetheless, he concludes that from both calibration exercises and historical literature, the spillover effect was net negative. This might have been averted if everyone adopted the same monetary policy, i.e. quit gold at the same time:

The irony is that to the extent devaluation led to protectionism and falling trade volume, it was more due to countries that did not devalue. In an earlier paper, Mr Eichengreen and Doug Irwin of Dartmouth College note that countries that remained on gold were more likely to erect protectionist measures against imports than countries those that quit. So while imports did collapse, they fell far less for countries that abandoned gold (like Britain, whose imports rose slightly between 1928 and 1935) than for those that stayed with it, like France, whose imports fell 15%.

The key insight of Mr Eichengreen’s work was that the more countries abandoned gold, the more positive become the spillover effects: “what are now referred to as currency wars were part of the solution, not part of the problem.” The analogy for today is that countries whose currencies are rising because of easier foreign monetary policy should ease monetary policy as well, assuming they, too, suffer from weak demand and low inflation. In fact, America’s QE and the resulting upward pressure on the yen was one of the key reasons Shinzo Abe, Japan’s prime minister, demanded the Bank of Japan take a more determined assault against deflation. The fact that global stock markets have been chasing the Nikkei higher as Mr Abe’s programme is put in place suggests investors believe this is virtuous, not vicious, cycle. This also implies that the euro zone ought to respond with easier monetary policy which would both neutralize upward pressure on the euro and combat recession in the euro zone.

But Mr Eichengreen notes that unlike in the 1930’s, today there is a large group of emerging economies who did not suffer a deflationary shock and thus would not benefit from easier monetary policy. Their optimal response, he says, would be to tighten fiscal policy, which would cool demand, putting downward pressure on interest rates and their currencies. But, as in the 1930’s, he notes that there are political and institutional barriers to doing so, and instead they are opting for second-best policies such as capital controls, currency intervention, and in some cases, import restrictions. To read more about Mr Eichengreen, click on the link at the end of the article.

There’s an interesting debate over whether even intervention constitutes currency war. Economists traditionally thought such intervention had limited effect. If the central bank intervenes but does not change expectations about interest rates, investors will simply buy up all the currency that the central bank sells until expected returns were once again equal across all markets.

But Joseph Gagnon of the Peterson Institute for International Economics challenges this conventional wisdom. Studies that found intervention does not work were done in the 1980’s and 1990’s when the sums were far smaller, he says. Central bank intervention is now hundreds of times larger. He explains in an interview:

“Japan did $177 billion of intervention in 2011. When countries intervene on that magnitude, I don’t think all the hedge funds and investment banks in the world are enough to neutralize that effect. They’re not willing to gamble more than a few tens of billions. Hedge funds need differential rates of return to induce them to take opposing positions. And the riskier it is, the more they have exposed, and the higher return they need. They expect to make money because government is distorting markets in a way they think is not sustainable, but governments can distort markets longer than you can stay solvent. “

This has parallels to the debate over QE. Skeptics believe that if the central bank does not change the public’s expectations of interest rates or inflation, no amount of bond buying will alter asset values or stimulate growth. But advocates believe investors have a “preferred habitat;” they hold certain types of bonds or assets because of legal or institutional constraints, even if their returns seem too low relative to their own expectations of interest rates.

Most intervention is sterilized: the central bank is selling currency previously held by the public, so the money supply does not change. Unsterilized intervention, in which the central bank prints the currency it sells, as the Swiss National Bank has done, has different implications. It is, in practice, QE plus sterilized intervention. Imagine an investor sells Euros to the SNB and gets newly printed Swiss francs. He invests them in Swiss government bonds, buoying their prices. The result is exactly the same as if the SNB had bought Swiss government bonds with newly printed money, then sold those bonds in order to buy foreign exchange. Based on our analysis here, it is getting one thing right (the QE) and one wrong (the intervention). The SNB justified its action based on the fact that its domestic bond market was too small to accommodate QE in sufficient size. Its trading partners must have agreed, because they didn’t kick up much fuss. Or perhaps Switzerland is too small to matter. Japan should not assume it would get the same, hands-off treatment.

Should Japan’s attack on the yen move beyond rhetoric to actual intervention in the markets to drive its value down, then the rest of the world would be right to condemn it (Because If all countries were to competitively devalue their currencies, the result would be a downward spiral that would benefit no one, but could lead to high inflation.). Until that happens, other countries should avoid groundless outcries about currency wars.

The president of the European Central Bank on 14 February, 2013 cited the rising value of the euro as a possible threat to the region’s economic recovery, comments that immediately sent the euro down sharply against the dollar and yen. Mario Draghi, the E.C.B. president, denied that the central bank was trying to influence the value of the euro, no doubt mindful of provoking a currency war with Japan or the United States. But he then made statements that investors interpreted as meaning the E.C.B. could take action if the euro rose too much.

Source: Economist, The New York Times
Click here to read Barry Eichengreen Paper 🙂

Tax Evasion Strategies: The Double Irish & The Dutch Sandwich

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We have been hearing how the US giants have been avoiding taxes (all legal means) for a while now. I, for one being curious, thought of finding what it is that these companies do, or how they avoid paying taxes. I found out these companies (I would rather say the US tech giants) use mostly a combination of two methods: the “The Irish Double” and “The Dutch Sandwich” to dodge taxes. Now before explaining this topics and what it is it, I would like to explain some basics like what is a tax haven and a little bit of history of these tax havens before we come back to the main topic. For the newbie, who are reading this topic for the first time – don’t worry, it is wiki stuff. Pros can directly jump ahead.

A tax haven is a state, country or territory, where certain taxes are levied at a low rate or not at all. According to ‘The Economist’: “What … identifies an area as a tax haven is the existence of a composite tax structure established deliberately to take advantage of, and exploit, a worldwide demand for opportunities to engage in tax avoidance.” Tax Justice Network in 2012 in a report estimated that between USD $21 trillion and $32 trillion is sheltered from taxes in unreported tax havens worldwide. If such wealth earns 3% annually and such capital gains were taxed at 30%, it would generate between $190 billion and $280 billion in tax revenues.

A 2006 academic paper indicated that: “in 1999, 59% of U.S. firms with significant foreign operations had affiliates in tax haven countries”. A January 2009 U.S. Government Accountability Office (GAO) report said that the GAO had determined that 83 of the 100 largest U.S. publicly traded corporations and 63 of the 100 largest contractors for the U.S. federal government were maintaining subsidiaries in countries generally considered havens for avoiding taxes.

Most economists suggest that the first “true” tax haven was Switzerland, followed closely by Liechtenstein. Swiss banks had long been a capital haven for people fleeing social upheaval in Russia, Germany, South America and elsewhere. In the early part of the twentieth century, in the years immediately following World War I, many European governments raised taxes sharply to help pay for reconstruction efforts following the devastation of World War I. By and large, Switzerland, having remained neutral during the Great War, avoided these additional infrastructure costs and was consequently able to maintain a low level of taxes. As a result, there was a considerable influx of capital into the country for tax related reasons.

There are several reasons for a nation to become a tax haven. Some nations may find they do not need to charge as much as some industrialized countries in order for them to be earning sufficient income for their annual budgets. Some may offer a lower tax rate to larger corporations, in exchange for the companies locating a division of their parent company in the host country and employing some of the local population. Other domiciles find this is a way to encourage conglomerates from industrialized nations to transfer needed skills to the local population. Still yet, some countries simply find it costly to compete in many other sectors with industrialized nations and have found a low tax rate mixed with a little self-promotion can go a long way to attracting foreign companies.

Now focusing on the topic at hand, much of the economic activity in tax havens today consists of professional financial services such as mutual funds, banking, life insurance and pensions. Generally the funds are deposited with the intermediary in the low-tax jurisdiction, and the intermediary then on-lends or invests the money (often back into a high-tax jurisdiction). Although such systems do not normally avoid tax in the principal customer’s jurisdiction, it enables financial service providers to provide multi-jurisdictional products without adding an additional layer of taxation. This has proved particularly successful in the area of offshore funds.

This type of methodology has been used by Google and came to light in the year 2010 when it was reported that Google uses techniques called the “Double Irish” and “Dutch Sandwich” to reduce its corporate income tax to 2.4%, by funneling its corporate income through Ireland and from there to a shell in the Netherlands where it can be transferred to Bermuda, which has no corporate income tax. The search engine is using Ireland as a conduit for revenues that end up being cost to another country where its intellectual property (the brand and technology such as Google’s algorithms) is registered. In Google’s case this country is Bermuda. In the year 2009, the internet giant made a gross profit of €5.5bn, but reported an operating profit of €45m after “administrative expenses” of €5.467bn were stripped out. Administrative expenses largely refer to royalties (or a license fee) Google pays it Bermuda HQ for the right to operate. Google has uncovered a highly efficient tax structure across six territories that meant Google paid just 2.4% tax on operations outside the US. In December 2012, Google was found to have moved $10 billion from Ireland via the Netherlands to Bermuda—avoiding huge sums of taxes in Ireland, the Netherlands, and its real home country, the United States. At a November 2012 hearing, members of Parliament quizzed executives from Google and Starbucks Corp. about their use of Netherlands subsidiaries to cut taxes.

Now, what is this “Double Irish”?

Double Irish arrangement relies on the fact that Irish tax law does not include U.S. transfer pricing rules. Specifically, Ireland uses territorial taxation, and hence does not levy taxes on income booked at subsidiaries of Irish companies that are outside of Ireland proper, typically in current or former British Overseas Territories.

It is called “double Irish” because it requires two Irish companies to complete the structure. The first Irish company is the offshore company which owns the valuable non U.S. rights. This company is tax resident in a tax haven, such as the Cayman Islands or Bermuda. Irish tax law provides that a company is tax resident where its central management and control is located, not where it is incorporated, so that it is possible for the first Irish company not to be tax resident in Ireland. The first Irish company licenses the rights to a second Irish company, which is tax resident in Ireland, in return for substantial royalties or other fees. The second Irish company receives income from exploitation of the asset in countries outside the U.S., but it is taxable profits are low because the royalties or fees paid to the first Irish company are deductible expenses. The remaining profits are taxed at the Irish rate of 12.5%.

For companies whose ultimate ownership is located in the United States, the payments between the two related Irish companies might be non-tax-deferrable and subject to current taxation as Subpart F income under the Internal Revenue Service’s Controlled Foreign Corporation regulations if the structure is not set up properly. This is avoided by organizing the second Irish company as a fully owned subsidiary of the first Irish company resident in the tax haven, and then making an entity classification election for the second Irish company to be disregarded as a separate entity from its owner, the first Irish company. The payments between the two Irish companies are then ignored for U.S. tax purposes (Heavy Stuff!!!). To understand properly go to the end and you can read the pdf at the link given.

Major companies known to employ the double Irish strategy are:

Apple Inc.
Eli Lilly and Company
Forest Laboratories
Oracle Corp.
Pfizer Inc.
Adobe Systems

And, what is “The Dutch Sandwich”?

The addition of a Dutch sandwich to the double Irish scheme further reduces tax liabilities. Ireland does not levy withholding tax on certain receipts from European Union member States. Revenues from income of sales of the products shipped by the second Irish company are first booked by a shell company in the Netherlands, taking advantage of generous tax laws there. Funds needed for production costs incurred in Ireland are transferred there; the remaining profits are transferred to the first Irish company in the Cayman Islands or Bermuda. If the two Irish holding companies are thought of as “bread” and the Netherland’s company as “cheese”, this scheme is referred to as the “Dutch sandwich”. The Irish authorities never see the full revenues and hence cannot tax them, even at the low Irish corporate tax rates. There are equivalent Luxembourgish and Swiss sandwiches.

Let’s take Google’s example. In Bermuda there’s no corporate income tax at all. Google’s profits travel to the island’s white sands via a convoluted route known to tax lawyers as the “Double Irish” and the “Dutch Sandwich.” It generally works like this: When a company in Europe, the Middle East or Africa purchases a search ad through Google, it sends the money to Google Ireland. The Irish government taxes corporate profits at 12.5 percent, but Google mostly escapes that tax because its earnings don’t stay in the Dublin office.

Irish law makes it difficult for Google to send the money directly to Bermuda without incurring a large tax hit, so the payment makes a brief detour through the Netherlands, since Ireland doesn’t tax certain payments to companies in other European Union states. Once the money is in the Netherlands, Google can take advantage of generous Dutch tax laws. Its subsidiary there, Google Netherlands Holdings, is just a shell (it has no employees) and passes on about 99.8 percent of what it collects to Bermuda. (The subsidiary managed in Bermuda is technically an Irish company, hence the “Double Irish” nickname.)

In recent years, governments have become increasingly aware of the fact that lots of major corporations—notably tech companies including Apple, Google, Yahoo, Dell, and many others—are using this shady, albeit legal, techniques to shift income in ways that drastically minimize a company’s tax burden. Attracted by the Netherlands’ lenient policies and extensive network of tax treaties, companies such as Yahoo, Google Inc. (GOOG), Merck & Co. and Dell Inc. have moved profits through the country. Using techniques with nicknames such as the “Dutch Sandwich,” multinational companies routed 10.2 trillion Euros in 2010 through 14,300 Dutch “special financial units,” according to the Dutch Central Bank. Such units often only exist on paper, as is allowed by law.

By routing profits through the Netherlands en route to island havens, companies receive an important benefit: They generally don’t have to pay taxes on payments leaving or entering the country. Technology and pharmaceutical companies often seek to reduce their tax bills by paying royalties to license patent rights from offshore subsidiaries. Such transactions could incur a cost: many developed nations impose a withholding tax — sometimes as high as 33 percent — on royalties leaving for zero-tax locales with which they don’t have tax treaties, such as Bermuda and the Cayman Islands. By contrast, the Netherlands doesn’t impose withholding taxes on royalties leaving the country, regardless of their destination. Countries often either eliminate or reduce those taxes when such payments head to a treaty partner. The extensive Dutch treaty network thus protects payments on the way into the country as well.

The Netherlands’ role in facilitating tax avoidance began in force in the late 1970s, when it started so-called advance- pricing agreements to attract multinational companies. Under such agreements, multinational companies agree to leave a tiny amount of income in the Netherlands to be taxed in exchange for being permitted to route profits through the country. This remainder left for the revenue authorities in the Netherlands is known to tax planners as “the Dutch Turn.”

Yahoo, for instance, has an agreement to pay taxes equal to about 1.35 percent of the unit’s total revenue. The benefit of the Netherlands is that the company knows all upfront. Records show that the Yahoo unit reported Dutch income taxes in 2009 of 1.28 million Euros — out of the 101.5 million Euros in royalties it funneled through the subsidiary that year. That’s a small price to pay. In return, Yahoo can move profits to virtually any destination without paying a withholding tax.

Tax avoidance has fostered a sizable industry in the Netherlands of so-called trust firms, generating about 1 billion Euros in annual tax revenues and about 3,500 jobs, according to a 2009 study by SEO Economic Research. Local companies such as Intertrust Group Holding SA and TMF Group set up high-priced mailboxes for multinational companies. The benefits to Holland are employment, high-level tax advisers. In December, Blackstone Group LP (BX), the New York-based private equity giant, announced it would buy one of the biggest such firms, Intert rust, for $833 million.

Merck, the maker of diabetes drug Januvia and asthma treatment Singulair, lists 54 subsidiaries in the Netherlands. From 2002 to 2010 the company routed more than 7 billion Euros in royalties, mostly from European sales, to Bermuda via an Amsterdam subsidiary called Crosswinds BV. The unit — which had no employees — was named Crosswinds to conjure the image of royalties crossing in and out “like wind blowing.” In late 2010, after Merck acquired Schering Plough Corp., it stopped using Crosswinds to route royalties. Merck cut $1.9 billion off its tax bill that year because of Schering Plough’s offshore arrangements, securities filings show.

Double Non-Taxation is to prevent companies from paying tax twice in two different countries on the same profit. Dell, however, uses the Netherlands to avoid paying income taxes in either place. The world’s third-largest personal- computer maker has avoided about $4 billion in income taxes since 2004, thanks partly to its use of a Dutch unit. The subsidiary, called Dell Global BV, paid income taxes at a rate of 1/10 of 1 percent on profits of about $2 billion in 2011, the most recent year for which records are available. That means the unit took credit for almost three quarters of Dell’s worldwide income. That subsidiary had no actual employees in the Netherlands as of 2009, filings show. The Dutch company conducts its business through a branch in Singapore (DELL), where it designs and sells laptops and other equipment for the U.S., European and Asian markets.

For tax purposes, Dell says the unit’s profit is generated in Singapore, where it obtained an income-tax holiday in 2004. Although the company pays almost no income taxes in Singapore, the Netherlands doesn’t impose any significant income taxes either because “avoidance of double taxation can be claimed with respect to the” profit earned in Singapore, according to the Dutch subsidiary’s 2011 annual report.

The U.S. Internal Revenue Service is seeking back taxes avoided through Dell’s intra-company arrangements, according to a company securities filing. Dell is contesting the IRS’s proposed assessment. While the company didn’t disclose the amount in dispute, it said an unfavorable outcome could have a “material impact” on its financial position.

Yahoo is taking advantage of the Swiss tax generosity: In late 2009, the company began shifting profits from its European sales into a small subsidiary in Rolle, Switzerland, a picturesque town 25 miles north of Geneva at the foot of the Alps. Through Yahoo! Netherlands BV, headquartered at Dooves’s suburban home, Yahoo has also routed European and Asian revenues from Web ads to a subsidiary incorporated in Ireland that claims its residency in the tax-friendly Cayman Islands, according to filings.

In 2009, for example, the Dutch unit collected 101.5 million Euros in royalties from around the world — and promptly paid out 98.7 percent of that to the Cayman subsidiary, records show. If those payments went directly from, say, Yahoo’s France sales arm to the Cayman unit, they could trigger a 33.3 percent withholding tax in France. In 2011, a Yahoo French sales subsidiary reported 66 million Euros of revenue, yet paid just 462,665 Euros in income taxes, records show.

Yahoo recently introduced another circuitous path through the Netherlands to cut the taxes on profits from its Asian sales: Royalties travel from Singapore, to another subsidiary in Mauritius, a tax-friendly island off the southeast coast of Africa. In 2011, the Dutch unit collected 110 million Euros from Asian sales, before paying royalties to the Mauritius subsidiary. On paper, the cash remains with the Dutch subsidiary, which uses it to finance operations throughout the world outside the U.S. In reality, much of it sits in a HSBC Holdings Plc bank account in London.

On January 20 2013, a Dutch parliamentary committee met to consider the fairness of its own tax system and re-evaluate its role as part of a legal financial chain that allows companies to reduce the amount of tax they pay. Last month, the European Commission recommended that EU members require in their treaties that income be subject to tax in one country before being exempt in another. That could prevent companies such as Dell from avoiding taxes in two countries simultaneously. Another EU proposal to combat tax-avoidance strategies has moved slowly through the bureaucracy since 2004. It would allocate multinational companies’ taxable profits into various countries based on factors such as actual sales or number of employees there.

Whether the EU can implement such a change, remains doubtful. Under its rules, the move requires unanimous approval from the 27 member states, including the Netherlands. Last year, representatives from the Netherlands fought at least two internal EU proposals to clamp down on tax avoidance techniques. Other European countries are competing to attract multinational companies with tax inducements. Luxembourg has imitated the Dutch system of conduit companies and advance tax rulings, and Switzerland offers long-term tax holidays and other incentives.

Sources: Wiki, Bloomberg.
To learn more about Irish Double, go to: click here 😀

The dot-com bubble!

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This week I was pretty free, so thought of studying about the dot com bubble that happened in the starting of this century. I feel it is always good to look back and learn what went wrong and learn for the future. I just like to jolt things down in the process and share the facts and my thoughts for any reference by anybody, only if I am able to give a new perspective to the whole situation.

The dot-com bubble(also referred to as the Internet bubble) was a historic speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the Internet sector and related fields.

Now before we go forward, we should know that today NASDAQ is currently 3179.96 (on 22/09/2012). But during the dot-com bubble the market had a climax on March 10, 2000, with the NASDAQ peaking at 5132.52 in intraday trading before closing at 5048.62. More than double its value just a year before. NASDAQ Composite ultimately traced its way to a low 1114.11 losing 78% of its value and hence signified the end of many ‘innovative’ companies. So, here we can see the difference of momentum going through in that period. Most of the technology companies in the US are listed in NASDAQ. So, investors regularly refer to NASDAQ to look at the health of Tech companies. Lately, Facebook has been quoted in the NASDAQ.

Although it was a boom and bust cycle, the Internet boom is sometimes meant to refer to the steady commercial growth of the Internet with the advent of the world wide web, as exemplified by the first release of the Mosaic web browser in 1993, and continuing through the whole decade.

A combination of rapidly increasing stock prices, market confidence that the companies would turn future profits, individual speculation in stocks, and widely available venture capital created an environment in which many investors were willing to overlook traditional metrics such as P/E ratio in favor of confidence in technological advancements. This actually created the environment for the demise.

The Internet Boom began with the advent of the World Wide Web and particularly after the launch of the Mosaic Web Browser. The estimated number of users in 1995 was 18 million. The fast rise in usage and the growing publicity of the internet meant there was an untapped potential and international market. Speculators were unable to control their excitement.

Because of the unknown and innovative nature of online business, traditional business models were eschewed in favor of bold and risky models which focused on brand-building and networking in order to capture market share before profits were even considered. Venture capitalists saw record-setting growth as dot-comcompanies experienced meteoric rises in their stock prices and therefore moved faster and with less caution than usual, choosing to mitigate the risk by starting many contenders(note: Between 1999 and early 2000, the U.S. FED  increased interest rates six times) and letting the market decide which would succeed. The low interest rates in 1998–99 helped increase the start-up capital amounts. A canonical “dot-com” company’s business model relied on harnessing network effects by operating at a sustained net loss to build market share. These companies offered their services or end product for free with the expectation that they could build enough brand awareness to charge profitable rates for their services later. The motto “get big fast” reflected this strategy. Most of the companies were primarily financed by venture capital and IPO. The IPOs of internet companies emerged with frightening frequency. The novelty of these stocks, combined with the difficulty of valuing the companies, sent many stocks to dizzying heights and made the initial controllers of the company wildly rich on paper. The upward trend continued even if there weren’t any profits to show.  Market confidence that these companies would turn in future profits were huge. The Dot-com Boom reached a pinnacle in 1999. There were 457 IPOs in 1999 most of which were internet and technology related. 117 of these 457 IPOs doubled on the first day of their trading!

In spite of this, however, a few company founders made vast fortunes when their companies were bought out at an early stage in the dot-com stock market bubble. These early successes made the bubble even more buoyant. An unprecedented amount of personal investing occurred during the boom, and the press reported the phenomenon of people quitting their jobs to become full-time day traders. American news media, including respected business publications such as Forbes and the Wall Street Journal, encouraged the public to invest in risky companies, despite many of the companies’ disregard for basic financial and even legal principles.

According to dot-com theory, an Internet company’s survival depended on expanding its customer base as rapidly as possible, even if it produced large annual losses. For instance, Google and Amazon did not see any profit in their first years. Amazon was spending on expanding customer base and alerting people to its existence and Google was busy spending on creating more powerful machine capacity to serve its expanding search engine. The phrase “Get large or get lost” was the wisdom of the day. At the height of the boom, it was possible for a promising dot-com to make an initial public offering of its stock and raise a substantial amount of money even though it had never made a profit — or, in some cases, earned any revenue whatsoever. In such a situation, a company’s lifespan was measured by its burn rate: that is, the rate at which a non-profitable company lacking a viable business model ran through its capital served as the metric. Public awareness campaigns were one of the ways in which dot-coms sought to expand their customer bases. Super Bowl XXXIV in January 2000 featured 17 dot-com companies that each paid over $2 million for a 30-second spot. By contrast, in January 2001, just three dot-coms bought advertising spots during Super Bowl XXXV.

Cities all over the United States sought to become the “next Silicon Valley” by building network-enabled office space to attract Internet entrepreneurs. Communication providers, convinced that the future economy would require ubiquitous broadband access, went deeply into debt to improve their networks with high-speed equipment and fiber optic cables. Companies that produced network equipment like Nortel Networks were irrevocably damaged by such over-extension; Nortel declared bankruptcy in early 2009.

Similarly, in Europe the vast amounts of cash the mobile operators spent on 3G licenses in Germany, Italy, and the United Kingdom, for example, led them into deep debt. The investments were far out of proportion to both their current and projected cash flow, but this was not publicly acknowledged until as late as 2001 and 2002. Due to the highly networked nature of the IT industry, this quickly led to problems for small companies dependent on contracts from operators. One example is of a then Finnish mobile network company Sonera, which paid huge sums in German broadband auction then dubbed as 3G licenses. 3rd generation networks however took years to catch on and Sonera ended up as a part of TeliaSonera, then simply Telia.

Over 1999 and early 2000, the U.S. Federal Reserve increased interest rates six times, and the economy began to lose speed. When the NASDAQ started to fall,  this was attributed to correction by most market analysts; the actual reversal and subsequent bear market may have been triggered by the adverse findings of fact in the United States v. Microsoft case which was being heard in federal court.

On 20th March 2000, after the NASDAQ had lost more than 10 percent from its peak, financial magazine Barron shocked the market with its cover story “Burning Up”. Sean Parker stated: “During the next 12 months, scores of highflying Internet upstarts will have used up all their cash. If they can’t scare up any more, they may be in for a savage shakeout. The article pointed out: “America’s 371 publicly traded Internet companies have grown to the point that they are collectively valued at $1.3 trillion, which amounts to about 8% of the entire U.S. stock market.” By 2001 the bubble was deflating at full speed indeed.

Several communication companies could not weather the financial burden and were forced to file for bankruptcy. One of the more significant players, WorldCom, was found practicing illegal accounting practices to exaggerate its profits on a yearly basis. WorldCom’s stock price fell drastically when this information went public, and it eventually filed the third-largest corporate bankruptcy in U.S. history. Other examples include NorthPoint Communications, Global Crossing, JDS Uniphase, XO Communications, and Covad Communications. Companies such as Nortel, Cisco and Corning were at a disadvantage because they relied on infrastructure that was never developed which caused the stock ofCorning to drop significantly.

Many dot-coms ran out of capital and were acquired or liquidated. Several companies and their executives were accused or convicted of fraud for misusing shareholders’ money, and the U.S. Securities and Exchange Commission fined top investment firms likeCitigroup and Merrill Lynch millions of dollars for misleading investors. A few large dot-com companies, such as and eBay, survived the turmoil and appear assured of long-term survival, while others such as Google have become industry-dominating mega-firms.

The stock market crash of 2000–2002 caused the loss of $5 trillion in the market value of companies from March 2000 to October 2002. Some companies, such as, failed completely. Others lost a large portion of their market capitalization but remained stable and profitable, e.g., Cisco, whose stock declined by 86%. Some later recovered and surpassed their dot-com-bubble peaks, e.g.,, whose stock went from 107 to 7 dollars per share, but a decade later exceeded 200.

To deal with this crisis, the Federal Reserve with its then chairman Alan Greenspan decreased the interest rate to 1% in order to boost up the economy. Although hailed as a good move was one of the main factors that contributed to the subprime mortgage crisis. Investors borrowed from the FED and would put the money in the housing market where interest rates were higher and would benefit from the arbitrage. Banks were also suddenly able to lend loan cheaply. The average difference between subprime and prime mortgage interest rates declined significantly between 2001 and 2007. Thus, we can see it was a chain of events starting from the dot-com bubble bust which actually, may be unintendedly, fueled both the housing and the credit bubble. What happened is all left for us to see.

On dropping the FED interest rate from 1.25% to 1 % in 2002, Alan Greenspan stated:

Besides sustaining the demand for new construction, mortgage markets have also been a powerful stabilizing force over the past two years of economic distress by facilitating the extraction of some of the equity that homeowners have built up over the years.

In the wake of the subprime mortgage and credit crisis in 2007, Greenspan stated that there was a bubble in the US housing market, warning in 2007 of “large double digit declines” in home values “larger than most people expect“.However, Greenspan also noted, “I really didn’t get it until very late in 2005 and 2006.”

In 1977, Greenspan obtained a Ph.D. degree in economics from New York University. His dissertation is not available from the universitysince it was removed at Greenspan’s request in 1987, when he became Chairman of the Federal Reserve Board. However, Barron’s(newspaper) has obtained a copy, and notes that it includes “a discussion of soaring housing prices and their effect on consumer spending; it even anticipates a bursting housing bubble“.

Now seriously, I don’t know! And am thinking now!

LIBOR Manipulation

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WHEN a trader asks a colleague to submit false information in order to boost his profits, the correct answer is not “done…for you big boy”. This response was one of a host of exchanges involving 14 Barclays traders that were revealed as part of a probe by Britain’s Financial Services Authority (FSA) and American agencies including the Commodities Futures Trading Commission (CFTC) and the Department of Justice (DoJ).

The probe relates to LIBOR, the London inter-bank offered rate. LIBOR is supposed to be a trusty financial yardstick, measuring the costs banks incur when they borrow from one another. Libor rates are calculated for ten different currencies and 15 borrowing periods ranging from overnight to one year and are published daily at 11:30 am (London time) by Thomson Reuters.

For LIBOR, a borrowing rate is set daily by a panel of banks for ten currencies and for 15 maturities. The most important of these, three-month dollar LIBOR, is supposed to indicate what a bank would pay to borrow dollars for three months from other banks at 11am on the day it is set. The dollar rate is fixed each day by taking estimates from a panel, currently comprising 18 banks, of what they think they would have to pay to borrow if they needed money. The top four and bottom four estimates are then discarded, and LIBOR is the average of those left. The submissions of all the participants are published, along with each day’s LIBOR fix.

In theory, LIBOR is supposed to be a pretty honest number because it is assumed, for a start, that banks play by the rules and give truthful estimates. The market is also sufficiently small that most banks are presumed to know what the others are doing. In reality, the system is rotten. First, it is based on banks’ estimates, rather than the actual prices at which banks have lent to or borrowed from one another. “There is no reporting of transactions, no one really knows what’s going on in the market,” says a former senior trader closely involved in setting LIBOR at a large bank. “You have this vast overhang of financial instruments that hang their own fixes off a rate that doesn’t actually exist.”

A second problem is that those involved in setting the rates have often had every incentive to i.e. since their banks stood to profit or lose money depending on the level at which LIBOR was set each day. Worse still, transparency in the mechanism of setting rates may well have exacerbated the tendency to lie, rather than suppressed it. Banks that were weak would not have wanted to signal that fact widely in markets by submitting honest estimates of the high price they would have to pay to borrow, if they could borrow at all.

Many financial institutions, mortgage lenders and credit card agencies set their own rates relative to it. At least $350 trillion in derivatives and other financial products are tied to the Libor. It is controlled by the British Bankers’ Association (BBA).The flaw in the system is that banks can estimate their own LIBOR rates. Although these estimates are supposed to be calculated by a team that is ring fenced from other parts of the bank, the probe shows that they were influenced.

The scandal arose when it was discovered that banks were falsely inflating or deflating their rates so as to profit from trades, or to give the impression that they were more creditworthy than they were. The banks are supposed to submit the actual interest rates they are paying, or would expect to pay, for borrowing from other banks. The Libor is supposed to be an overall assessment of the health of the financial system because if the banks being polled feel confident about the state of things, they report a low number and if the member banks feel a low degree of confidence in the financial system, they report a higher interest rate number.

On 27 June 2012, Barclays Bank was fined $200 million by the Commodity Futures Trading Commission, $160 million by the United States Department of Justice and £59.5 million by the Financial Services Authority for attempted manipulation of the Libor and Euribor rates. The United States Department of Justice and Barclays officially agreed that “the manipulation of the submissions affected the fixed rates on some occasions”. The e-mails—the FSA tracked 257 messages asking for LIBOR and its yen and euro equivalents to be altered—make painful reading. That the investigation involved the FBI is a reputational disaster in itself.

In the case of Barclays, two very different sorts of rate fiddling have emerged. The first sort, and the one that has raised the most ire, involved groups of derivatives traders at Barclays and several other unnamed banks trying to influence the final LIBOR fixing to increase profits (or reduce losses) on their derivative exposures. The sums involved might have been huge. Barclays was a leading trader of these sorts of derivatives, and even relatively small moves in the final value of LIBOR could have resulted in daily profits or losses worth millions of dollars. In 2007, for instance, the loss (or gain) that Barclays stood to make from normal moves in interest rates over any given day was £20m ($40m at the time).

Yet a second sort of LIBOR-rigging has also emerged in the Barclays settlement. Barclays and, apparently, many other banks submitted dishonestly low estimates of bank borrowing costs over at least two years, including during the depths of the financial crisis. In terms of the scale of manipulation, this appears to have been far more egregious—at least in terms of the numbers. Almost all the banks in the LIBOR panels were submitting rates that may have been 30-40 basis points too low on average. That could create the biggest liabilities for the banks involved.

     As the financial crisis began in the middle of 2007, credit markets for banks started to freeze up. Banks began to suffer losses on their holdings of toxic securities relating to American subprime mortgages. With unexploded bombs littering the banking system, banks were reluctant to lend to one another, leading to shortages of funding system-wide. This only intensified in late 2007 when Northern Rock, a British mortgage lender, experienced a bank run that started in the money markets. It soon had to be taken over by the state. In these febrile market conditions, with almost no interbank lending taking place, there were little real data to use as a basis when submitting LIBOR. Barclays maintains that it tried to post honest assessments in its LIBOR submissions, but found that it was constantly above the submissions of rival banks, including some that were unmistakably weaker. At the time, questions were asked about the financial health of Barclays because its LIBOR submissions were higher. Back then, Barclays insiders said they were posting numbers that were honest while others were fiddling theirs, citing examples of banks that were trying to get funding in money markets at rates that were 30 basis points higher than those they were submitting for LIBOR.

Following the interest rate rigging scandal, Marcus Agius, chairman of Barclays, resigned from his position. One day later, Bob Diamond, the chief executive officer of Barclays, also resigned from his position.

Barclays later released documents that include a note-to-self written on October 29th 2008 by Bob Diamond immediately after a telephone conversation with Paul Tucker, a deputy governor of the Bank of England. According to the note, Mr. Tucker told Mr. Diamond he had received concerned calls from senior figures in Whitehall about Barclays. They asked why the borrowing costs the bank submitted each day to the panel setting LIBOR, a benchmark interest rate, were always amongst the highest. At the time, Barclays was thought to be having trouble raising cash in the inter-bank market, a potential sign of deeper troubles. Mr. Diamond’s told Mr. Tucker that Barclays had “a market-driven rate policy” (i.e. it based its interest-rate submissions on real transactions)—in contrast to other banks, which were posting rates that did not reflect their true borrowing costs. Mr. Diamond’s note ends thus:

Mr. Tucker stated the level of the calls he was receiving from Whitehall were “senior” and that while he was certain that we did not need advice, that it did not always need to be the case that we appeared as high we have recently.

The note was forwarded by e-mail on October 30th to John Varley, the bank’s chief executive at the time, and copied to Jerry del Missier, one of Mr. Diamond’s lieutenants at Barclays Capital, its investment banking arm. Mr. Tucker’s non-advice advice could quite easily be read as an order from the central bank (invoking “senior” government figures) to Barclays to submit lower LIBOR quotes so as to assuage concerns about its financial health. That apparently was the way Mr. del Missier read it, according to the Barclays documents released on July 3rd ahead of Mr. Diamond’s appearance before a parliamentary committee:

Bob Diamond did not believe he received an instruction from Paul Tucker or that he gave an instruction to Jerry del Missier. However Jerry del Missier concluded that an instruction had been passed down from the Bank of England not to keep LIBORs so high and he therefore passed down a direction to that effect to the submitters. Bob Diamond was subsequently questioned by the Parliament of the United Kingdom regarding the manipulation of Libor rates.

“IT’S difficult for Barclays…to be isolated on this,” said Bob Diamond, as he came to the end of three hours of mostly hostile questioning by a parliamentary committee on July 4th. Mr. Diamond was fighting to preserve not only his own reputation, but also that of the firm whose investment-banking arm, Barclays Capital, he had built from modest beginnings into one of the world’s biggest in little more than a decade.

Appearing before Parliament on 16 July, Jerry del Missier, a former senior Barclays executive and COO, said that he had received instructions from Robert Diamond to lower rates after Diamond’s discussions with bank regulators. He said that he had received information of a conversation between Diamond and Paul Tucker, deputy governor of the Bank of England, in which they had discussed the bank’s financial position at the height of the 2008 financial crisis. It was his understanding that senior British government officials had instructed the bank to alter the rates. Mr. del Missier’s testimony followed statements from Diamond in which he denied that he had told his deputies to report false Libor rates.

Tucker also but voluntarily appeared before parliament, to clarify the discussions he had with Bob Diamond. He said he had never encouraged manipulation of the Libor, and that other self-regulated mechanisms like the Libor should be reformed. “We thought this was a malfunctioning market not a dishonest market,” explained Paul Tucker, deputy governor of the Bank of England, towards the end of his much-awaited testimony to a parliamentary committee. Mr. Tucker was appearing at his own request to give his version of a telephone conversation in October 2008 with Bob Diamond. Asked whether he refuted the note’s suggestion, Mr. Tucker responded: “absolutely”. Did government ministers lean on him to give such an instruction? “Absolutely not,” he said, adding that the Whitehall figures with whom he had conversations during the crisis were senior civil servants, not government ministers. The denials undercut the claim by George Osborne, Chancellor of the Exchequer that ministers of the previous Labor government, including Ed Balls, now the shadow chancellor, were directly implicated in the LIBOR scandal.

Mr. Tucker said he had merely advised Mr. Diamond to be careful that Barclay’s money-market desk was not inadvertently sending up distress signals about the bank’s health by paying over the odds for short-term liquidity. The phone call took place in highly stressed circumstances, shortly after two other British banks had received capital injections from the government to prop them up. “Barclays was the next in line” of the dominoes that might topple, he said.

If Mr. Tucker did not bless the doctoring of LIBOR rates, should he have known it was going on? According to his memo, Mr. Diamond explained to Mr. Tucker that “not all banks were providing [LIBOR] quotes at the level that represented real transactions.” Mr. Tucker told the committee that he took this to mean that other banks, which had submitted LIBOR quotes, but did not need to raise cash, had under-estimated their likely borrowing costs. He did not interpret Mr. Diamond’s remarks as blowing the whistle on the misreporting of LIBOR, Mr. Tucker said—and that he wasn’t aware of any allegations that banks were deliberately “low-balling” LIBOR rates until very recently.

There was little in Mr. Tucker’s testimony to suggest that he did anything wrong or was negligent. But the link with the LIBOR crisis might still hurt his hopes of succeeding Sir Mervyn King as the Bank of England’s governor next year. Sir Mervyn has been criticised that he remained aloof from finance folk in the early weeks of the crisis and so was slow to respond. It would be harsh, then, if Mr. Tucker’s chances to get the top job are hurt by his efforts to keep in touch.

Two days later, it was announced that the U.K. Serious Fraud Office had also opened a criminal investigation into manipulation of interest rates. The investigation was not limited to Barclays. It has been reported since then that regulators in at least seven countries are investigating the rigging of the Libor and other interest rates. Around 20 major banks have been named in investigations and court cases.

The United States Congress began investigating on 10 July. Senate Banking Committee Chairman Tim Johnson said he questioned Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke about the scandal during scheduled hearings.

Documents released by the New York Federal Reserve Bank in July,2012 showed regulators in the United States and England had some knowledge that bankers were submitting misleading Libor bids during the 2008 financial crisis to make their financial institutions appear stronger than they were. Among other details, the Fed documents included the transcript of an April 2008 telephone call between a Barclays trader in New York and Fed official Fabiola Ravazzolo, in which the unidentified trader said: “So, we know that we’re not posting um, an honest Libor.”

Throughout the spring and summer of 2008, in the midst of increasing turmoil in the financial world, the Fed studied what was wrong with Libor. Two weeks after the April phone call, Geithner held a meeting called “Fixing LIBOR” with senior New York Fed staff members. A few weeks later, in a meeting with U.S. Treasury officials, New York Fed staffers, including Ravazzolo, presented slides saying there are “questions regarding Libor’s accuracy and relevance.”

In his second day of testimony to Congress, Geithner reiterated that when he was New York Fed president he told U.S. regulators about the rate manipulation and made recommendations to fix Libor to authorities in Britain where the interest rate is set. When asked by a Senate Banking Committee lawmaker if the New York Fed turned a blind eye to banks’ misrepresentations or if he was aware of any other regulator condoning bankers’ behavior, Geithner said “absolutely not.”

On June 1, 2008, Timothy F. Geithner – then president of the Federal Reserve Bank of New York – sent an e-mail to Mervyn A. King and Paul Tucker, then respectively governor and executive director of markets at the Bank of England. In his note, Mr. Geithner transmitted recommendations (dated May 27, 2008) from the New York Fed’s “Markets and Research and Statistics Groups” regarding “Recommendations for Enhancing the Credibility of Libor,” the London interbank offered rate.

The recommendations accurately summarized the problems with procedures surrounding the construction of Libor – the most important reference interest rate in the world – and proposed some sensible alternative approaches.

While the released memos suggest that the New York Fed helped to identify problems related to Libor and press the relevant authorities in the UK to reform, there is no documentation that shows any evidence that Geithner’s recommendations were acted upon or that the Fed tried to make sure that they were.

“At no stage did he [Geithner] or anyone else at the New York Fed raise any concerns with the Bank that they had seen any wrongdoing,” Bank of England governor Mervyn King said in testimony before a British parliamentary committee.

Later, this was what Ben Bernanke said in front of the Congress:

Senator Toomey:  The question is, why have we allowed it go on the old way when we knew it was  flawed for the last four years, with trillions of dollars of transactions?

Chairman Bernanke: Because the Federal Reserve has no ability to change it.

Mr. Bernanke emphasized that Libor-rigging is a major problem but was adamant that the Fed bore no responsibility for what happened, adding:

We have been in communication with the British Bankers’ Association. They made some changes, but not as much as we would like. It is, in fact, it is, you know, it’s not that market participants don’t understand how this thing is collected. It is a freely chosen rate. We’re uncomfortable with it.  We’ve talked to the Bank of England.

“SINCE we have not more power of knowing the future than any other men, we have made many mistakes (who has not during the past five years?), but our mistakes have been errors of judgment and not of principle.” So, reflected J.P. Morgan junior in 1933, in the middle of a financial crisis.

I just hope that is what the case is.

Some Facts:

On 29 May 2008, The Wall Street Journal (WSJ) released a controversial study suggesting that some banks might have understated borrowing costs they reported for the Libor during the 2008 credit crunch that may have misled others about the financial position of these banks. In response, the BBA claimed that the Libor continued to be reliable even in times of financial crisis. Other authorities contradicted The Wall Street Journal article saying there was no evidence of manipulation. In its March 2008 Quarterly Review, the Bank for International Settlements stated that “available data do not support the hypothesis that contributor banks manipulated their quotes to profit from positions based on fixings.” Further, in October 2008, the International Monetary Fund published its regular Global Financial Stability Review which also found that “Although the integrityof the U.S. dollar Libor-fixing process has been questioned by some market participants and the financial press, it appears that U.S. dollar Libor remains an accurate measure of a typical creditworthy bank’s marginal cost of unsecured U.S. dollar term funding.”

In the first quarter of 2009, Citigroup for example reported that it would make that quarter $936 million in net interest revenue if Libor interest rates would fall by .25 percent a quarter and $1,935 million if they were to fall by 1 percent instantaneously.

The Governor of the Bank of England, Mervyn King by the end of 2008, described the Libor to the UK Parliament saying:

It is in many ways the rate at which banks do not lend to each other … it is not a rate at which anyone is actually borrowing.

JP Morgan, Jamie Dimon and the 2 billion USD trade loss!

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Was waiting to write on this for a while. Thought that once the whole episode is over, I can just summarize or express the whole incident. But that’s not going to happen as something new has come up -the LIBOR rate manipulation fraud. Bob Diamond, CEO of Barclays had too resign. Gone with him are both the Marcus Agius, Chairman and Jerry del Missier, COO of Barclays. But I am not going to discuss that. Surely, will do that some day later. Now that JP Morgan’s loss is shifted down in the list of the most important news, lets recall what transpired and what I understood.

Jamie Dimon was one of the smartest people in Wallstreet. He became the CEO of JP Morgan in 2005. The highlight of his career is during the financial crisis of 2008 when he lead his firm without any losses and also took over Bear Streans in a week-end bone crushing deal where he went toe to toe for every cents on dollar. Mr. Dimon said on the company’s first-quarter earnings on April 13,2012 that questions about the office’s trading were “a complete tempest in a teapot”.  Too an extent he is correct for a company which has 2.3 trillion US dollars asset under it $ 2 billion losses was completely under control which was actually less than 0.1percent of its assets value. So why so much noise is made about the whole affair?

The whole loss to JP Morgan was orginated in its investment bank division in London. This was under JP Morgan’s Chief Investment officer Ina Drew. A series of derivative transactions involving credit default swaps (CDS) were entered into, reportedly as part of the bank’s “hedging” strategy. The position was acquired by a london trader Bruno Iskil nicknamed “London whale”. He is named so due to the massive position he had taken that he could influence the market. He accumulated a position that outsized CDS positions in the market. These positions in the credit derivatives index said to contribute to JP Morgan Chase’s $2 billion loss as the bank and hedge funds trading against it unwind bets. It is said JP Morgan took these position hoping that the European crisis would exaggerate and with this bearish view in mind, they took position that would not only hedge about particular losses but might also help them getting making some profit. But in March, the conditions improved in Europe, with Greece agreeing to its austerity conditions and taking a bailout and the position of JP Morgan started to sour. The exact position of JP Morgan is not made public. I think this was one of the ways how JP Morgan stayed profitable during the financial crisis.

Another problem was  a major defect in one of JP Morgan’s key risk management tools that lead to its losses. JP Morgan changed the gauge called value-at-risk, or VaR, for its chief investment office in mid-January before losses began piling up on derivatives held by the unit.VaR represents the maximum amount that traders would expect to lose on 95 out of 100 trading days, according to New-York based JP Morgan. It’s recalculated daily, and the quarterly average is reported in securities filings.The VaR at the CIO was reported as averaging $67 million in a regulatory filing on April 13, the day JPMorgan posted first- quarter results. When JPMorgan realized the new version was flawed and reverted to the old model, it showed VaR averaged $129 million and ended the quarter at $186 million.The new measurement was “implemented in January and did effectively increase the amount of risk this unit was able to take,” Dimon said. The changes coincided with derivatives trades that later proved to be illiquid and prone to losses. Dimon said that the chief investment office’s hedging strategy was “poorly conceived and vetted,” and that traders at the unit “did not have the requisite understanding of the risks they took.”

The repercussions of these losses were that Ina Drew is fired from JP Morgan and $18 billion US dollar of its market capitalization has been wiped away in days following the announcement. Its share price dropped from $43 to $33  in 10 days. The whole industry reacted in a aggressive way to the news – the FED, the SEC, the CFTC and suddenly every one seemed too have an opinion.

The most important discussion seemed to be would had it come under the jurisdiction of the Volcker rule which is set to be applied the next year. This seemed too be a concern for many. The Volcker rule bans proprietary trading but has no saying in hedging. This is because JP Morgan was basically hedging which would have profited the firm immensely if the conditions had prevailed according to their notions.

Now this is okay since all these rules are introduce to make the banking industry secure from any further financial crisis. But it was the hedge funds who profited by taking opposite position to the “London Whale” when they started knowing his position. In February 2012, hedge fund insiders such as Boaz Weinstein of Saba Capital Management became aware that the market in credit default swaps was possibly being affected by aggressive trading activities. The source of the unusual activity turned out to be Bruno Iksil, a trader for JP Morgan Chase & Co. and referred to as “the London Whale” in reference to the huge positions he was taking. Heavy opposing bets to his positions are known to have been made by traders, including another branch of JP Morgan, who purchased the derivatives JPMorgan was selling in such high volume. Markit CDX North America Investment Grade Series 9 10-Year Index, CDX IG 9 was a derivative which Weinstein had noticed to be losing value in a manner and to a degree which seemed to diverge from market expectations. It turned out that JP Morgan was shorting the index by making huge trades. JP Morgan’s bet was that credit markets would strengthen. This index is based on 121 investment grade bonds issued by North American corporations.

But the losses drew a huge reaction. This is because Jamie Dimon was the face of the banks opposition to the rules regulators suggested following the 2008 financial crisis, which required bank to hold much liquidity and was banned from proprietary trading. He was leading them again the tedious rules the governments and regulators had planed to rule out — especially the Volcker
rule, the Dodd-Frank rule.

Lets have a look at the reactions in US —

Former Federal Reserve Chairman Alan Greenspan isn’t worried by the size of the losses at JP Morgan’s chief investment office. His reaction: “So what?” For a bank with almost $200 billion in equity, a one- or even two-percent loss isn’t very significant, Greenspan said in an interview.“My point is that you have to recognize that banks will lose money on occasion,” Greenspan said, “because that’s the way the system eliminates unproductive capital. Implicit in creating growth and productivity comes some degree of failure”.

Fitch said that while the size of the trading loss is manageable, its magnitude and the ongoing nature of the bank’s positions “implies a lack of liquidity” and raises questions about the bank’s risk management.It downgraded its rating by one notch. S&P Lowers JP Morgan’s Residential Mortgage Servicer Ranking.

“It appears that the bank here in the U.S. is absorbing these losses,” Mr. Gary Gensler, chairman of CFTC said in a speech in Washington. “And as a U.S. bank, it is an entity with direct access to the Federal Reserve’s discount window and federal deposit insurance.”The cross-border proposal is a crucial part of the Dodd-Frank financial overhaul law, the government’s main regulatory response to the financial crisis. Many big banks like JPMorgan run their derivatives businesses out of foreign branches Gensler added.“It appears that the bank here in the U.S. is absorbing these losses,” Mr. Gensler said in a speech. “And as a U.S. bank, it is an entity with direct access to the Federal Reserve’s discount window and federal deposit insurance.”

Treasury Secretary of US Tim Geithner that the recent $2 billion trading loss by JPMorgan “helps make the case” for tougher rules on financial institutions, as regulators implement the 2010 law aimed at policing Wallstreet. Geithner said the Fed, SEC and the Obama administration are “going to take a very careful look” at the JP Morgan incident as they implement new regulations like the so-called “Volker Rule,” which bans banks from making bets with customers’ money.

Former Federal Reserve Chairman Paul Volcker said JPMorgan Chase’s recent multibillion-dollar trading loss may show that the nation’s largest banks are too big to manage.

Federal Reserve Chairman Ben Bernanke said the Volcker Rule may have been able to influence the outcome of JP Morgan’s $2 billion trading loss.

“The leadership of that company will be held accountable for this trading loss, but we don’t want to punish companies, Mitt Romney told NBC. “There was no taxpayer money at risk. All of the losses went to investors, which is how it works in a public market.

“JP Morgan is one of the best-managed banks there is. Jamie Dimon, the head of it, is one of the smartest bankers we got and they still lost $2 billion and counting,” Barack Obama said. “We don’t know all the details. It’s going to be  investigated, but this is why we passed Wall Street reform.”

The best explanation according to me was given by Mitt Romney an American businessman and the presumptive nominee of the Republican Party for President of the United States in the 2012 election. JP Morgan has more asset then the GDP of most countries even India. Dimon faced the questions from Congress on June 13, 2012 and faced the Housing committee on June 19, 2012. In the housing committee meeting Dimon bristled at a suggestion from Rep. Sean Duffy that JP Morgan has become “too big to fail.” With $2.3 trillion in assets, taxpayers might be asked to step in to rescue the bank if its trades put the broader financial system at risk, Duffy said.”No, we’re not too big to fail,” Dimon told Duffy in a heated exchange. “I don’t think there’s any chance we’re going to fail. But if we did, any losses the government would bear should go back, be charged to the banks.”

More will be clear when the bank reports its second quarterly report on July 13, 2012. Word has been that Mr.Dimon might admit a loss up-to $US 5 billion. But losses might have already cost them up-to $8 billion, some expects.

But right now thanks to LIBOR rate manipulation fraud, JP Morgan $2 billion loss would take a back seat, as every one is busy discussing about Barclays and Mr Bob Diamond. And hopefully this will help Jamie Dimon  to take a sigh of relief!

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