Canada's banks not so much stronger than U.S.'s

Despite their reputation, Canada’s six largest banks do not necessarily have stronger balance sheets under new global banking rules than their major U.S. counterparts, a new report has found.

In a study of large Canadian and U.S. banks, Canaccord Genuity analyst Mario Mendonca said Canada’s biggest lenders, on average, have lower Tier 1 capital ratios than seven of the largest U.S. banks. Tier 1 capital can be easily liquidated to help a bank absorb losses in a financial crisis, and is considered a key measure of financial strength.

Though Mr. Mendonca points out that Canada’s largest banks are expected to meet new global capital standards being implemented in 2013, the findings throw some cold water on the widely held belief that they’re swimming in excess capital.

Canadian banks have enjoyed a reputation over the past few years of being far better-capitalized than their global peers, due mostly to conservative rules that require them to hold more capital than global standards dictate. That reputation was further bolstered amid the global financial crisis as major Canadian banks emerged unscathed from the meltdown that damaged many U.S. and European lenders.

However, Mr. Mendonca points out several large U.S. banks took steps during the crisis to bolster their capital and appear to have caught up, once the new Basel III banking standards are applied. On average, the Tier 1 capital levels of the big Canadian banks are tracking 160 basis points behind seven large U.S. banks that recently disclosed their pro-forma Tier 1 capital ratios in quarterly earnings. (A basis point is 1/100th of a percentage point.)

“Reflecting just how well Canada’s banks weathered the crisis as well as all the back-slapping among regulators and politicians, we have consistently expressed the view that Canada’s banks will have little or no difficulty reaching the required minimum capital ratios according to the schedule laid out by Basel III,” Mr. Mendonca said.

However, Canada’s banks, “are not in fact better capitalized than their U.S. peers” when the new rules are taken into consideration.

Mr. Mendonca looked at the Tier 1 capital projections made recently by seven U.S. banks in their quarterly earnings, including JPMorgan, PNC Financial Services Group Inc., SunTrust Banks Inc., Wells Fargo Corp., BB&T Corp. and Regions Financial Corp.

Two of the largest U.S. banks – Citigroup Inc. and Bank of America Corp. – were not included because their recent quarterly earnings did not come with Tier 1 capital projections under the new rules.

The report comes as Canada’s banking regulator is expected to issue its plan for “capital adequacy” on Tuesday. The guidelines will be released by the Office of the Superintendent of Financial Institutions Canada and will spell out what targets must be met in Canada, and by when.

Under the Basel III process, banks around the world will have to raise their Tier 1 capital levels to 7 per cent by 2019. That ratio must be at 3.5 per cent by 2013.

Though Mr. Mendonca said he doesn’t expect any of the Canadian banks will have trouble meeting either global standard, the general expectation in the market is that Canadian banks will achieve the 7-per-cent ratio by 2013, ahead of the rest of the world’s banks.

He said National Bank of Canada, Bank of Montreal and Canadian Imperial Bank of Commerce could be sitting on “significant excess capital,” while Royal Bank of Canada, Toronto-Dominion Bank and Bank of Nova Scotia will have a harder time pushing significantly above the 7-per-cent threshold by the end of 2012.

“Reaching a 7-per-cent common equity Tier 1 ratio by 2012 is not as easy as we originally thought,” Mr. Mendonca said.

However, the analyst said it appears the market is not distinguishing between the two scenarios.

“Either the market is not fully aware of the major differences in capital strength on a Basel III basis, or investors simply do not care as long as the banks can get to 7 per cent by the end of 2012,” without raising more capital, the research note said.

In the U.K., a dangerous game takes shape

On a wet, chilly day in North London’s unglamorous Kentish Town neighbourhood, Brenda Poynton is doing something she hasn’t done in many years. Food price inflation is forcing her to trudge from store to store in a hunt for the lowest prices.

“My word, it’s terrible,” says the trim 74-year-old retired midwife. “You have to go to every other shop to find a bargain.”

She emerges triumphant from the discount supermarket Iceland with several litres of milk at £1.10 a pop – pleasingly short of the typical price of £1.65. Then it’s off to Marks & Spencer to test the poultry prices.

Ms. Poynton is terrified that rising prices for food and other essentials will chew into her fixed pension. Like many elderly Britons, her nightmare scenario is a repeat of the early 1970s when inflation in Britain exceeded an astonishing 25 per cent. Even as late as 1990 the figure was 10 per cent. Since then, inflation has come down dramatically and remained subdued.

But inflation has made a rude comeback in the past year or so. In December, the consumer price index hit 3.7 per cent, almost double the Bank of England’s 2 per cent target, and it is widely expected to go as high as 5 per cent this year. Inflation is also making a comeback in the euro zone, though at 2.2 per cent in December, the rise is less sharp than Britain’s.

Inflation has emerged as a risk to global economic recovery, but different brands of inflation are sprouting up in different areas. In fast-growing emerging markets such as China, surging demand for food staples and other goods is driving prices higher, and pressuring central banks to raise interest rates.

The big risk

Britain, however, suffers from weak to non-existent growth – gross domestic product unexpectedly fell by 0.5 per cent in the fourth quarter – meaning that any inflation-busting rate hikes risk plunging the country back into recession. While both the Bank of England and the European Central Bank are making the right noises about the dangers of inflation and their intention to fight it, they are in essence trapped. They’re holding interest rates at rock-bottom levels to stimulate the economy, taking the risk that inflation could suddenly shoot higher.

Even though the Bank of England has consistently underestimated the inflation problem – its February, 2009, prediction was for a mere 0.5 per cent inflation today – bank governor Mervyn King’s message is: Relax, this too will pass.

In a speech in Newcastle, England, on Tuesday, the day Britain’s worrisome growth reversal was revealed, Mr. King argued that while inflation was “uncomfortably high,” domestic factors are not to blame.

He identified three culprits. The first was the 20 per cent fall in the value of the pound since 2007, a decline that drove prices higher by making imports more expensive. The second was soaring energy prices.

Measured in exchange rate terms, the cost of oil is up 110 per cent since early 2007. The third was the two recent increases in Britain’s value-added tax (VAT, the equivalent to Canada’s GST), now at 20 per cent.

Taken together, he said, those three factors contributed three percentage points a year on average to the inflation rate over four years. “Since the consumer price index as a whole rose by not much more, the contribution of domestically generated inflation over that period was close to zero,” he said.

Mr. King expects inflation to fall “sharply” next year. The pound has edged up on the expectation of a rate hike (as has the euro); the VAT increases were one-off events that skewed the recent inflation figures; the British economy is running below capacity; and unemployment is high, meaning sharp wage increases are unlikely.

The big danger is that the Bank of England is dead wrong. Since the start of 2008, inflation has consistently hovered above the bank’s 2 per cent target. Oil prices could continue marching higher, and U.K. consumers could respond to rising prices by demanding high wage increases.

Some economists acknowledge the risk of runaway inflation, but most attach a low probability to it. “There is a risk that inflation could accelerate, but wage inflation is not there so far,” said Jens Larsen, a former Bank of England economist who is now chief economist for Royal Bank Of Canada’s investment arm in London.

Some inflation is to be desired – hence the Bank of England’s and the ECB’s 2 per cent targets. Very high inflation is not, even though it can have one advantage: As inflation rises, growing government revenues make it easier to service debt. While cynics would suggest that the finance ministers of Europe’s most indebted countries (Greece and Italy, among them) are secretly thrilled that inflation is above target, all the better to make their debt burdens more manageable, high inflation can wreck household finances and business

confidence.

It does so by eroding consumer buying power, the equivalent of a national pay cut that keeps on cutting. High inflation punishes the people who did the right thing by saving their money while rewarding those that did the wrong thing by becoming debtors. It strains the relationship between employees and employers as demands for wage hikes gain momentum. In extreme cases, it triggers social unrest as food and energy prices become unaffordable to the poor.

The big doubts

The Bank of England’s own nine-member monetary policy committee (MPC), which meets monthly to set interest rates, is divided on the wisdom of leaving rates unchanged as inflation picks up momentum. MPC member Andrew Sentance has been calling for a rate increase since mid-2010 to deal with price pressures. He gained an MPC ally this month in Martin Weale, who is also calling for a rate hike of 0.25 percentage points.

Mr. Larsen, the RBC economist, thinks Mr. King is probably right about inflation coming down next year. But he also knows that central bankers have no magic forecasting powers. “There is so much uncertainty now,” he said.

Even the economists at the European Commission have their doubts about the Bank of England’s conviction that high inflation is not embedded in the economy. In its autumn economic forecast, the EC said: “As the high inflation persists [in Britain], the assumption that it is driven by temporary factors becomes harder to maintain.”

It certainly appears that Mr. Sentance thinks the bank is making a mistake. His argument is that imported inflation, as a result of high GDP growth rates in most of the developing world, is here to stay and could propel British inflation to painful levels. He argues that modest interest rate increases now would forestall the need for the shock treatment of aggressive rate hikes later. “It would be a mistake to label all the global factors affecting inflation as one-off short-term disturbances,” he said in a Jan. 24 speech in London.

The euro zone’s predicament is similar, if less urgent. Inflation is coming back, but is relatively benign compared to the British figure. Both the Bank of England and the ECB think there is enough slack in their respective economies to prevent an inflation crisis such as stagflation – rising prices in a sagging economy.

Britain and the euro zone have launched austerity measures that range from the mild (France and Germany) to the aggressive (Britain, Ireland and Greece). In essence, the central bankers and political leaders know they can’t have it both ways. “The success of fiscal tightening is conditional on loose monetary policy.” Mr. Larsen said.

It appears that the Bank of England and the ECB will wait until they see strong evidence of a sustained economic upturn before they hit the interest rate button. It’s a gamble, one that hasn’t always worked in the past.

Meanwhile, Britons are bracing for the high inflation rates that the central bankers insist are not coming. In London’s Kentish town, Ms. Poynton is getting nervous. “You really have to think about how much you can spend on food now,” she said.

Euro zone January inflation jumps

Euro zone consumer prices jumped more than expected in January, rising well above the European Central Bank’s target, but the bank seems more likely to step up its inflation rhetoric than raise interest rates for now.

Inflation in the 17 countries using the euro rose 2.4 per cent year-on-year in January after a 2.2 per cent rise in December, the European Union’s statistics office Eurostat estimated on Monday.

This is the highest level of inflation since October 2008, when it was 3.2 per cent . Economists polled by Reuters had expected a 2.3-per-cent rise.

The ECB, which aims to keep inflation below, but close to 2 per cent, next meets on interest rates on Thursday, when it will also face the problem of how to respond to stark discrepancies between the pace of recovery in different euro zone states.

“While the ECB will be far from happy to see euro zone consumer price inflation move further above target..., it is still highly unlikely to prompt the bank into action at its February policy meeting,” said Howard Archer, economist at IHS Global Insight.

“It will probably step up its anti-inflation rhetoric and stress that it is prepared to hike interest rates despite growth risks if the current spike-up in euro zone consumer price inflation shows any significant sign of leading to a significant pick-up in second round inflationary effects, such as rising wage settlements.”

No monthly figure or breakdown of the year-on-year estimate was available from Eurostat, but economists have attributed higher inflation mainly to more expensive energy.

BNP Paribas economist Clemente de Lucia said oil prices were probably the main factor behind the higher inflation in January because in one month they rose by more than 3 euros per barrel and were up by almost 20 euros against January 2010, which meant an almost 37 per cent year-on-year increase.

De Lucia said food prices were probably stable in January, but core inflation, which excludes food and energy prices, probably increased to 1.2 per cent from 1.1 per cent.

Full inflation data for January will be released on February 28, Eurostat said.

The ECB has said it expected prices to grow faster than its target in the coming months, peaking at 2.4 per cent in March and then subsiding.

ECB Governing Council member Ewald Nowotny said last Tuesday he did not expect a decision to raise interest rates in the first half of the year.

But economists noted the bank’s monetary policy choices were becoming more difficult because of the difference in growth rates, and therefore inflationary pressures, between countries like Germany and strugglers on the euro zone periphery such as Greece, Ireland and Spain. “Clearly, setting a common monetary policy for divergent economies will not be an easy task for the ECB,” Mr. de Lucia said.

“The peripheral countries are facing serious deflationary risks. By contrast, the output gap is closing in Germany, where the unemployment rate is already below the pre-crisis level. Therefore, some upward pressures are likely in Germany,” Mr. de Lucia said.

Economists said the central bank would not raise rates any time soon, but would probably step up its rhetoric.

“ECB President Jean-Claude Trichet will probably again sound hawkish at Thursday’s press conference,” said Nick Kounis, economist at ABN Amro.

“Although, given high unemployment and elevated economic slack more generally, the risk of second-round (inflation) effects seems low, Mr. Trichet can have a dampening effect on inflation expectations by sounding tough,” he said.

Egypt’s credit rating cut by Moody's

Moody’s Investors Service cut its rating on Egypt’s debt on Monday on concern about its public finances, becoming the second credit agency to turn negative since the country was plunged into political crisis.

Moody’s said the one-notch downgrade, to Ba2 from Ba1 with a negative outlook, was prompted by a significant rise in political risk and concern that the government’s response to mounting unrest could undermine Egypt’s already weak public finances.

One analyst suggested the cut, coming as protesters camped out in central Cairo vowed to stay until they had toppled President Hosni Mubarak from power, was overdue.

“Finally the rating agencies wake up. Egypt rated flat with Turkey was always a joke,” Timothy Ash, head of CEEMEA research at RBS, said.

Moody’s joined peer Fitch Ratings, which cut the outlook on its BB+ country ceiling to negative on Friday, in saying the political turmoil would likely undermine Egypt’s economic reform program.

“There is a strong possibility that fiscal policy will be loosened as part of the government’s efforts to contain discontent,” Moody’s said in a statement.

“A background of rising inflationary pressures further complicates fiscal policy by threatening to increase the high level of budgetary expenditure on wages and subsidies.”

Mr. Mubarak, who sacked his inner circle of ministers on Saturday, ordered his new cabinet on Sunday to preserve subsidies, control inflation and provide more jobs, state television reported.

The growing protest movement is driven in large part by public anger at rising prices, unemployment and the huge disparity between rich and power.

That means any successor administration to Mr. Mubarak, should he be forced from power, would be likely to keep subsidies in place and might boost social spending, putting further pressure on already strained government finances.

“Given that around half of the government’s expenditure is spent on subsidies and wages, there is clearly a risk that the public finances could deteriorate significantly,” Tristan Cooper, Moody’s head analyst for Middle East sovereigns, told Reuters in an email. The Moody’s cut also reflects rising unease among rating agencies at the impact of political tensions across swathes of North Africa.

Standard and Poor’s said on Thursday that political and fiscal uncertainty were weighing on the sovereign ratings of several Middle Eastern and North African countries, with Egypt, Algeria and Jordan most vulnerable to unrest similar to what occurred last month in Tunisia.

Fitch said on the same day said it would decide in 3-6 months whether to cut its rating on Tunisia, following weeks of unrest that forced a change of government and had hit economic growth.

Pound Falls, Gilts Gain as U.K. Economy Contracts While Inflation Rises

The pound posted weekly losses against most of its 16 most-actively traded peers as data showed the economy shrank and confidence plunged, fueling concern the government’s austerity measures are hurting growth.

The pound fell against the dollar for the first time in three weeks and declined against the euro for the fourth consecutive week on speculation the Bank of England may not be able to raise interest rates to fight inflation as growth slows. GfK NOP Ltd.’s index of sentiment fell 8 points from December to minus 29, the lowest since March 2009, data yesterday showed. The country’s gross domestic unexpectedly shrank 0.5 percent in the three months through December.

“We continue to see the pound as responding negatively to the stagflationary environment,” said Ian Stannard, a senior currency strategist at BNP Paribas SA in London. “We prefer to sell the pound against the dollar on rallies.”

The pound fell 1 percent in the week to $1.5838 as of 5:17 p.m. in London yesterday. Against the euro, it weakened 0.9 percent to 85.93 pence. The British currency declined the most against the yen in a month, shedding 1.6 percent to 129.99.

The currency has fallen 7 percent against nine of its developed-nation peers in the past 12 months, according to Bloomberg Correlation-Weighted Currency Indexes.

U.K. two-year government notes rose for the first time in four weeks as signs of economic slowdown prompted investors to seek a refuge in the safest assets. The yield on two-year securities fell eight basis points to 1.26 percent. The 10-year yield was five basis points lower on the week at 3.65 percent.

‘Tough Year’
“It’s going to be a tough year for gilt investors as the market is caught between data which suggested the economy is slowing and rising inflation,” said Nick Stamenkovic, a fixed- income strategist at RIA Capital Markets Ltd. in Edinburgh. “We see gains in gilts as short-lived as we believe policy makers will increasingly focus on inflation.”

Minutes released on Jan. 26 from the Bank of England’s monetary policy meeting earlier this month showed a second policy maker favored higher rates to curb consumer-price growth. Inflation accelerated to an eight-month high in December, rising 3.7 percent from a year earlier, as fuel and food prices climbed.
The bank’s Governor Mervyn King said on Jan. 26 that rising prices would be temporary. European Central Bank Executive Board member Lorenzo Bini Smaghi said on Jan. 27 that policy makers can no longer afford to ignore imported inflation after ECB President Jean-Claude Trichet pledged to do what’s needed to ensure price stability.

The U.K. 10-year breakeven rate, a market gauge of inflation expectations derived from the yield gap between nominal and index-linked bonds, rose nine basis points to 3.21 percentage points, the biggest weekly gain since the week ended Dec. 10.
U.K. gilts handed investors a 2.2 percent loss this month, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies. It underperformed German bonds and Treasuries which lost 1.67 percent and 0.14 percent respectively.

To contact the reporter on this story: Anchalee Worrachate in London aworrachate@bloomberg.net

Japan Industrial Production Gains Most in 11 Months

Japan’s industrial production increased the most in 11 months in December, boosted by overseas demand that’s spurring the nation’s recovery.
Factory output climbed 3.1 percent from November, when it rose 1 percent, the Trade Ministry said in Tokyo today. The median estimate of 29 economists surveyed by Bloomberg News was for a 2.8 percent gain. The increase was driven by higher output in the transport equipment and electronic parts industries, the ministry said.
Honda Motor Co. and Nissan Motor Co. are among companies raising production to meet demand from China and the U.S., Japan’s largest export markets. The benchmark 10-year Japanese government bond yield has advanced 9 basis points this year amid expectations of a domestic economic recovery.
“The Japanese economy is returning to an expansionary path buoyed by foreign demand, a typical way for Japan to recover,” said Hiroaki Muto, a senior economist at Sumitomo Mitsui Asset Management Co. in Tokyo. “With today’s production data and last week’s robust export increase, we can be pretty sure that the economy will escape from its lull in the current quarter.”
The yen traded at 82.15 per dollar at 10:53 a.m. in Tokyo from 82.17 before the report was published. The Nikkei 225 Stock Average fell 1.2 percent.
Growth to Accelerate
Japan’s economic growth will accelerate in each quarter this year, after shrinking in the three months through December due to the expiration of government subsidies to encourage consumer spending, according to a survey of economists by Bloomberg News.
The economy contracted at a 0.75 percent annual pace last quarter, a median estimate of 14 economists surveyed by Bloomberg shows.
Industrial output gained 15.9 percent for all of 2010, the first increase in three years, today’s data showed. The trade ministry upgraded its assessment for production for the first time since April 2009, saying output “is showing signs of picking up.”
Supporting growth in Japan is demand from the U.S. and China, the destination of more than a fifth of Japanese shipments.
Auto Output
Chinese imports soared 39 percent last year, with the monthly value reaching a record $141 billion in December. The country’s retail sales rose 18 percent in 2010.
The U.S. economy grew at a 3.2 percent annual rate in the fourth quarter of 2010 as consumer spending climbed by the most in more than four years, a Commerce Department report showed last week.
Automakers are raising output to meet overseas demand. Nissan Motor, Japan’s third-biggest carmaker, said last week global production rose 19.8 percent in December from a year ago. Honda Motor, the country’s second-largest automaker, said global output of its cars and light trucks gained 0.3 percent.
Panasonic Corp. may double its production capacity for light bulbs using light-emitting diodes within two years to tap the growing market for energy-saving devices, Yoshio Ito, president of Panasonic’s lighting business, said last week.
Manufacturers said they plan to increase output 5.7 percent in January then decrease production 1.2 percent in February, a government survey included in today’s output report showed.
Deflation Easing
Japanese economic data released Jan. 28 showed that deflation eased in December and the unemployment rate declined to 4.9 percent from 5.1 percent. Consumer prices excluding fresh food declined 0.4 percent from a year earlier, the statistics bureau said, the smallest drop since 2009. The country’s export growth accelerated for a second month in December, a government report showed last week.
Posing a risk to the country’s export-led recovery is the strength of the yen, which has gained about 10 percent against the dollar in the past year. A higher yen rate tends to weigh on companies’ overseas income.
A 3.3 percent decline in household spending in December also underscores the weakness of domestic demand.
“Based on where Japan is in its economic cycle, the pickup in exports suggests about a six-month lag before” capital expenditures may improve, Chiwoong Lee and Yuriko Tanaka, Tokyo- based economists at Goldman Sachs Group Inc., said in a report today. “But if we narrow our focus to recent trends, the pace of recovery” in capital spending “looks likely to be gradual.”
S&P Downgrade
Meanwhile, investor concern is growing about the country’s increasing debt, projected to reach 210 percent of gross domestic product in 2012, according to the Organization for Economic Cooperation and Development.
Standard & Poor’s last week cut Japan’s credit rating to AA-, the fourth-highest level, saying it expects the country’s government debt ratios to continue to rise.
Prime Minister Naoto Kan has called for a national debate on increasing the 5 percent sales tax rate to boost the government’s revenue. He’s also striving to win passage of spending bills for a record 92.4 trillion yen ($1.1 trillion) annual budget through the opposition-controlled upper house, after a regular parliament session started last week.
To contact the reporter on this story: Keiko Ujikane in Tokyo at kujikane@bloomberg.net

Lonely Analyst Warns of 2015 Bank Crisis Amid `Upbeat' Davos

As politicians, executives and financiers networked at parties and panels last week in Davos, Switzerland, Barrie Wilkinson was in a nearby hotel, warning that a 2015 financial catastrophe may be looming.
“The fundamentals haven’t been addressed at all,” Wilkinson, a London-based partner at consulting firm Oliver Wyman, said in an interview at the Hotel Morosani Schweizerhof. “The things that caused the previous crisis -- loose monetary policy and trade imbalances -- they’re actually bigger now than they were then.”

In the caste system of the World Economic Forum’s annual event in the Swiss ski resort, Wilkinson was at a bottom rung, with an identification badge that denied him access to most sessions and soirees. His message clashed with the optimistic tone of many at the center of the meeting, who were eager to emphasize the progress made after two years of hand-wringing in the wake of the 2008 financial crisis.

“The systemic reforms that have been accomplished are significant,” Canadian Finance Minister Jim Flaherty said as he left a private meeting with finance company chief executive officers on Jan. 29. “We need to communicate better that financial institutions globally are operating on a very different basis today, that they are operating with higher capital and are better regulated.”

‘An Avoidable History’
Wilkinson’s report, titled “The Financial Crisis of 2015: An Avoidable History,” isn’t so sanguine. The 24-page study describes how banks, unwilling to accept the lower returns on equity, or ROEs, that result from higher capital requirements, may fuel a new bubble by chasing high returns in commodities or emerging markets. Regulators, by focusing their restraints on banks, may drive risk-taking into unregulated funds that also pose danger to the system.

The report urges bank executives and shareholders to accept that returns of the past are unsustainable and that they need to do a better job of monitoring risks, especially in areas that produce unusually high profits.
“Banks need to be less leveraged,” said Wilkinson, who has an engineering degree from the University of Cambridge and has worked at Oliver Wyman since 1993, according to his LinkedIn page. “The true test for me of whether they’ve deleveraged is if the industrywide ROEs come down. If they don’t, I’m very suspicious that there are hidden risks in the system.”

UBS Advice
Oliver Wyman, a subsidiary of New York-based Marsh & McLennan Cos., played a role in the last financial crisis. The firm’s strategy consultants advised UBS AG’s fixed-income unit, which was lagging other divisions in early 2007, to invest in U.S. mortgage securities and collateralized debt obligations to boost returns, according to a review submitted by UBS to Switzerland’s federal banking commission in April 2008. Those investments helped fuel almost $58 billion in losses and writedowns at the Zurich-based bank.
After the 2008 crisis, governments and central banks spent unprecedented amounts of taxpayer money to bail out the financial system. Part of Wilkinson’s concern is that if the system is allowed to return to its old boom-bust habits, debt- strapped governments may not be able to handle the fallout of another crisis, either financially or politically.

“If there is another banking crisis, the Western governments are just in no shape to stabilize the system, they’ve expended their entire arsenal on the last round of fiscal injections,” Wilkinson said.

‘Incipient Sovereign Crisis’
The same theme pervaded a World Economic Forum dinner on Jan. 28 that discussed what would happen if a big bank were allowed to fail. The group, which included Nomura Holdings Inc. Chief Operating Officer Takumi Shibata, 58, former Italian Finance Minister Domenico Siniscalco, 56, and ING Groep NV CEO Jan Hommen, concluded that governments have no choice but to come to the rescue of any failing multinational megabank because there is no system to handle a controlled failure.

If a government was unable to save such a bank, the contagion and damage could be severe.
“I came into this dinner somewhat pessimistic and worried about the assignment we are here to discuss,” Simon Johnson, a professor at the Massachusetts Institute of Technology’s Sloan School of Management and a Bloomberg News columnist, said halfway through the evening. “I am now terrified. There is an incipient sovereign crisis here mixed in with the bank crisis.”

Dimon, Dell
Financiers at Davos this year weren’t talking much about future returns on equity or potential bubbles. Instead they were holding parties and meeting clients. JPMorgan Chase & Co. CEO Jamie Dimon, 54, hosted guests including Bank of Canada Governor Mark Carney and Dell Inc. founder Michael Dell, 45, at a reception one night. He was out late the next night with hedge- fund manager Louis Bacon, 54, and other guests at a party hosted by Google Inc.

Siniscalco, who now leads Morgan Stanley in Italy, said he had about 35 meetings in Davos this year compared with 15 last year. The co-head of investment banking at one firm was overheard telling someone on his mobile phone that he’d lined up five mandates.

“In Davos, there’s a lot of optimism here, and I’m quite surprised by it, especially from corporate CEOs,” said Tarun Jotwani, CEO of Europe, the Middle East and Africa and global head of fixed income at Nomura. “It is against a backdrop of potentially the biggest macroeconomic public-finance mismatches that I’ve ever seen in my career.”

Pushing Risk-Taking
When bankers weren’t trying to win business, they were worrying about governments’ fiscal policy in the U.S. and Western Europe or reiterating the role that finance plays in economic growth. And they echoed one element of Wilkinson’s report -- the part that said a focus on bank rules could push risk-taking into hedge funds or other types of financial companies that don’t fall under the regulations.
While German Chancellor Angela Merkel said on Jan. 28 that too little had been done to prevent another financial crisis, politicians focused mostly on defending their efforts to restore growth, curb inflation and deal with the debts of European countries such as Greece and Ireland. As French Finance Minister Christine Lagarde told a panel on Jan. 29, “the euro zone has turned the corner” and “we learned from our mistakes and we learned from the crisis.”

Closed-Door Meeting
U.S. Treasury Secretary Timothy F. Geithner, Bundesbank President Axel Weber and Spain’s finance minister, Elena Salgado, also spoke to a private gathering of some of the world’s top investors, including hedge-fund and private equity fund managers, according to two people who attended the meeting. The officials sought to assure the money managers that their policies would lead to growth and prevent a crisis in Europe.

When bank CEOs including Bank of America Corp.’s Brian Moynihan, Deutsche Bank AG’s Josef Ackermann and Barclays Plc’s Robert Diamond held a closed-door meeting with politicians and central bankers on Jan. 29, the tone was conciliatory.

The main topics were the need to improve international coordination and to better oversee the non-bank parts of the financial system, said Howard Davies, chairman of the London School of Economics and a former chairman of the U.K.’s Financial Services Authority.
“There was a very positive mood about what had been done so far,” said Davies, who is also a board member of New York- based Morgan Stanley and London-based insurance company Prudential Plc. “It was quite an upbeat session.”

To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net

Egypt Spurs Jump in Developing Money-Market Rates

Money-market rates in developing nations are increasing at the fastest pace since 2008 as central banks from China to Brazil lift borrowing costs and banks hoard cash on concern unrest in Egypt may destabilize the Middle East.

The yield on JPMorgan Chase & Co.’s ELMI+ Index of short- term debt in emerging markets rose to 2.5 percent on Jan. 28 from a record-low of 1.74 percent on Dec. 31. Overseas borrowing costs also jumped, sending the extra yield on developing-nation dollar bonds over U.S. Treasuries to a two-month high of 2.63 percentage points, according to JPMorgan’s EMBI+ Index.

Inflation is accelerating in seven of the 10 biggest developing nations after surging prices for food, cotton and oil pushed the S&P GSCI Index of commodities to the highest level since September 2008. Oil advanced 4.3 percent in New York trading on Jan. 28 as Egyptian protesters clashed with police in the most populous Arab country, calling for an end to President Hosni Mubarak’s 30-year rule. Middle East shares sank yesterday, sending Abu Dhabi’s index to its biggest drop in 14 months.

“The geopolitics is clearly a warning to investors,” said David Cohen, the head of Asian forecasting at Action Economics in Singapore. “Oil prices have spiked higher. That would be one more source of upward pressure on interest rates.”

The last time short-term borrowing costs in developing nations rose this fast was the second half of 2008, when the global financial crisis and record commodity prices pushed the world economy into a recession. The yield on JPMorgan’s ELMI+ Index jumped as high as 21 percent in October 2008, prompting central banks around the world to slash benchmark borrowing costs.

Rate Increases
Now policy makers are raising interest rates as the global economy expands. Brazil’s central bank lifted its benchmark overnight rate by 50 basis points, or 0.5 percentage point, to 11.25 percent on Jan. 19, as traders predict borrowing costs may climb to a three-year high by the end of 2011. India raised rates to the highest in two years on Jan. 25 and signaled further increases. China has raised borrowing costs twice since October.

Russia’s worst drought in a half-century helped send a United Nations gauge of food prices to an all-time high last month, cutting the buying power of 2.8 billion people in the so- called BRIC countries of Brazil, Russia, India and China who spend 19 percent of their income on groceries, compared with 6 percent in the U.S., Euromonitor International data show.

Rising milk and flour costs triggered protests in Algeria this month that left three people dead and 420 injured. Tunisian President Zine El Abidine Ben Ali was forced to hand over power to his prime minister on Jan. 14 and leave the country after failing to end a month of protests by promising lower prices for bread and sugar.

Egypt Yields Surge
The Tunisian uprising inspired anti-government rallies in Egypt that drew tens of thousands into the streets and led to looting and gunfire as protesters clashed with the police. As many as 150 people have been killed in the unrest, Ibrahim al- Zafarani, head of the rescue and emergency committee at the Arab medical union, told Al Jazeera television yesterday.

Mubarak has ignored demands to resign, instead appointing the first vice president since his rise to power in 1981 and naming a new premier. U.S. Secretary of State Hillary Clinton said on ABC’s “This Week” program yesterday that Mubarak has done “the bare beginning of what needs to happen.”
Yields on Egypt’s dollar bonds due in 2020 surged 67 basis points to 6.97 percent on Jan. 28, the highest level since the notes were issued in April. Credit-default swaps insuring Egyptian debt against non-payment rose 123 basis points last week to 430, the highest since April 2009, according to CMA. The government delayed two debt sales scheduled for yesterday.

Stocks Plunge
Egypt’s stock exchange was closed yesterday and will remain shut today after the benchmark EGX 30 Index tumbled 16 percent last week, Al Arabiya said.
Emerging-market equity mutual funds had their biggest weekly outflows since mid-2008 in the week ended Jan. 26, according to data compiled by EPFR Global. The funds lost $3 billion, or about 0.4 percent of their total assets, the data show. The MSCI Emerging Markets Index dropped 0.9 percent last week to the lowest level in a month.

“Inflationary pressures, moves towards capital controls, renewed attention being paid to political risk and the weakness of the U.S. dollar have all weighed on emerging markets in recent weeks,” Brad Durham, managing director at EPFR, wrote in a Jan. 28 report.
Most emerging-market currencies depreciated against the dollar on Jan. 28, with the South African rand falling 1.9 percent and Turkey’s lira dropping 2.1 percent to lead declines. Asian currencies including South Korea’s won and Indonesia’s rupiah strengthened against the U.S. currency last week.

Political Uncertainty
China’s seven-day repurchase rate, which measures the availability of funds between banks, increased 84 basis points last week to 8.14 percent, according to a daily fixing rate by the National Interbank Funding Center. It reached 8.30 percent on Jan. 28, the highest level since October 2007.
India’s three-month interbank borrowing costs climbed 17 basis points this month to 9.17 percent, the highest since December 2008.

“The developments in Egypt will unlikely bring the global economic recovery to a halt,” Robert Pavlik, chief market strategist at Banyan Partners LLC in New York, wrote in an e- mailed note Jan. 28. “However the market does not like uncertainty and these developments have brought uncertainty to the geo-political landscape.”

To contact the reporter on this story: Michael Patterson in London at mpatterson10@bloomberg.net.

Fed Assets Increase to $2.45 Trillion on Treasury Purchases

The Federal Reserve’s total assets rose by $18.5 billion to $2.45 trillion as the central bank bought Treasury securities as part of the second round of its quantitative easing strategy.

Treasuries held by the Fed rose by $34.9 billion to $1.11 trillion as of yesterday, according to a weekly release by the central bank today. Mortgage-backed securities held by the Fed fell by $15.1 billion to $965.1 billion, while holdings of federal agency debt fell by $1.26 billion to $144.6 billion in the week ended Jan. 26.

The central bank has purchased $266.5 billion in Treasuries since Nov. 12 under plans to purchase $600 billion of government debt through June and reinvest proceeds from maturing mortgage debt. The program represents the Fed’s second round of unconventional monetary easing aimed at spurring economic growth and preventing inflation from falling too low.

M2 money supply rose by $46.6 billion in the week ended Jan. 17, the Fed said. That left M2 growing at an annual rate of 3.5 percent for the past 52 weeks, below the target of 5 percent the Fed once set for maximum growth. The Fed no longer has a formal target.

The Fed reports two measures of the money supply each week. M1 includes all currency held by consumers and companies for spending, money held in checking accounts and travelers checks. M2, the more widely followed, adds savings and private holdings in money market.

M1 increased $30.3 billion, and over the past 52 weeks M1 rose 8.1 percent, according to the central bank. The Fed no longer publishes figures for M3.

-- With assistance from Vincent Del Giudice in Washington. Editors: James Tyson, Kevin Costelloe
To contact the reporter on this story: Joshua Zumbrun in Washington at jzumbrun@bloomberg.net

China Will Face Crisis Within 5 Years, 45% of Investors in Global Poll Say

Global investors are bracing for the end of China’s relentless economic growth, with 45 percent saying they expect a financial crisis there within five years.

An additional 40 percent anticipate a Chinese crisis after 2016, according to a quarterly poll of 1,000 Bloomberg customers who are investors, traders or analysts. Only 7 percent are confident China will indefinitely escape turmoil.

“There is no doubt that China is in the midst of a speculative credit-driven bubble that cannot be sustained,” says Stanislav Panis, a currency strategist at TRIM Broker in Bratislava, Slovakia, and a participant in the Bloomberg Global Poll, which was conducted Jan. 21-24. Panis likens the expected fallout to the aftermath of the U.S. subprime-mortgage meltdown.

On Jan. 20, China’s National Bureau of Statistics reported that the economy grew 10.3 percent in 2010, the fastest pace in three years and up from 9.2 percent a year earlier. Gross domestic product rose to 39.8 trillion yuan ($6 trillion).

Any Chinese financial emergency would reverberate around the world. The total value of the country’s exports and imports last year was $3 trillion, with about 13 percent of that trade between China and the U.S. As of November, China also held $896 billion in U.S. Treasuries. The trade and investment links between the two nations were underlined with Chinese President Hu Jintao’s visit last week to the White House for meetings with President Barack Obama.

Worried Neighbors
Investors’ concern contrasts with Chinese government statements on the outlook for the economy, which is poised to overtake Japan as the world’s second biggest. The Politburo said last month that the nation had a “sound base” for stable and fast growth in 2011 after consolidating its recovery.

In an interview in Davos yesterday, Li Daokui, an academic adviser to the central bank, said he doesn’t expect any “hard landing” and the economy may expand about 9.5 percent this year.
Fifty-three percent of poll respondents say they believe China is a bubble, while 42 percent disagree. China’s neighbors are the most concerned: 60 percent of Asia-based respondents identified a bubble in the world’s second-largest economy.

Worries center on the danger that investment, which surged almost 24 percent in 2010, may be producing empty apartment blocks and unneeded factories.

‘Major Dislocations’
Jonathan Sadowsky, chief investment officer at Vaca Creek Asset Management in San Francisco, says he is “exceptionally worried” that the Chinese would eventually face “major dislocations within their banking system.”

Chinese authorities also raised interest rates twice in the fourth quarter in a bid to choke off inflation, a sensitive political issue since the 1989 Tiananmen Square protests, which followed uncontrolled price increases. Food prices last year rose 7.2 percent, according to the National Bureau of statistics.
Haroon Shaikh, an investment manager with GAM London Ltd., cited “rapid wage inflation” and soaring property prices as the financial markets’ chief concern.

Li said rising real estate prices are the “biggest danger” to the Chinese economy, in an interview with Bloomberg News in Davos, Switzerland. The People’s Bank of China should “gradually increase rates in the first and second quarter,” Li said.

Since peaking on Nov. 8 at 3159.51, the Shanghai Composite Index has slid about 14 percent. “The market is right to be nervous,” Michael Pettis, a finance professor at Peking University’s Guanghua School of Management, wrote in his Jan. 26 financial newsletter.

Worst Market
Some investors remain unbowed. “China can continue to grow over 10 percent for the better part of the next five years,” said Ardavan Mobasheri, head of AIG Global Economics in New York.
Still, the poll found other signs of mounting investor caution toward China, where three decades of market-oriented reform has obliterated a legacy of Maoist impoverishment.

Asked to identify the worst market for investment over the next year, 20 percent of poll respondents say China versus 11 percent in the last poll in November. Almost half of those polled -- 48 percent -- say a significant slowing of growth was very or fairly likely within the next two years.

Michael Martin, senior vice president of MDAvantage Insurance Company of New Jersey, says the Chinese government “has executed brilliantly” in managing the economy. The government’s capacity will be tested as the economy grows and becomes more complex, he says.

Export Reliance
Chinese officials have said they intend to wean the economy off its reliance upon exports, the source of trade tensions with the U.S., in favor of greater domestic consumption.
Peter Hurst, a broker with Sterling International Brokers in London, says he’s concerned China will struggle to complete the transition.

“Yes, there are 1.3 billion people in China,” he says. “But are they rich enough to become consumers?”
If China stumbles, the global economy will feel the impact, says Suresh Raghavan, chief investment officer for Raghavan Financial Inc. in Houston. “If the PBOC is successful at lowering growth rates to 7 percent, it will still feel like a recession for a lot of people around the world,” he says.

Political Stability
Most poll respondents remained confident of the Chinese government’s ability to fend off demands for greater political liberalization. Just 1 percent expect a political crisis within the next year and 27 percent expect one within the next two to five years.

And by a 60 percent to 30 percent margin, those surveyed say President Hu’s policies were favorable to investors. Hu tied with German Chancellor Angela Merkel for the poll’s top spot.
“The Chinese politicians are able to act on all necessary issues. That gives them a huge advantage compared to the Western economies,” says Henry Littig, who heads his own global investment firm in Cologne, Germany.

The poll was conducted by Des Moines, Iowa-based Selzer & Co. for Bloomberg and has a margin of error of plus or minus 3.1 percentage points.

To contact the reporter on this story: David Lynch in Washington at dlynch27@bloomberg.net

Banking `Toxic Cocktail' Is Too Big to Forget: Simon Johnson

As a senator from Delaware in 2009- 10, Ted Kaufman fought long and hard against the systemic dangers posed by large, highly leveraged U.S. banks. When he left the Senate, at the end of the last Congress, there were some who supposed that his arguments would now get less attention at least from mainstream thinking.
But far from dying out, the points Kaufman made seem to have taken hold within influential government circles.

The latest quarterly report from Neil Barofsky, the special inspector-general for the Troubled Asset Relief Program, is the best official articulation yet of why too big to fail is here to stay. In its executive summary, the document, which was released this week, discusses “perhaps TARP’s most significant legacy, the moral hazard and potentially disastrous consequences associated with the continued existence of financial institutions that are ‘too big to fail.’”

This reasoning builds on evidence presented in Barofsky’s recent report on the “Extraordinary Financial Assistance Provided to Citigroup Inc.” But it goes much further with regard to the general policy issues we now face. Barofsky credits Henry Paulson and Timothy Geithner with making it clear that TARP funds would be used to prevent any of the country’s largest banks from failing during the global financial crisis and thus “reassuring troubled markets.”

‘High-Risk Behavior’
But the very effectiveness of Treasury actions and statements in late 2008 and early 2009 had undeniable side effects, “by effectively guaranteeing these institutions against failure, they encouraged future high-risk behavior by insulating the risk-takers who had profited so greatly in the run-up to the crisis from the consequences of failure.”

And this encouragement isn’t abstract or hard to quantify. It gives “an unwarranted competitive advantage, in the form of enhanced credit ratings and access to cheaper capital and credit, to institutions perceived by the market as having an implicit Government guarantee.”

Of course, the Dodd-Frank financial-reform legislation was supposed to end too big to fail in some meaningful sense. But Barofsky is skeptical -- and with good reason. Our largest banks are now bigger, in dollar terms, relative to the financial system, and relative to the economy, than they were before 2008. So how does that make it easier to let them fail?

Big Gets Bigger
At the end of the third quarter of 2010, by my calculation, the assets of our largest six bank holding companies were valued at about 64 percent of gross domestic product -- compared with about 56 percent before the crisis and about 15 percent in 1995. Barofsky quotes Thomas Hoenig, president of the Kansas City Federal Reserve, who uses similar numbers and draws the same conclusion: The big banks have
undoubtedly become bigger.

Today’s increasingly complex megabanks are global. Their potential collapse can’t be handled within national resolution or bankruptcy frameworks, and there is no chance we’ll get an international agreement on how to handle these issues any time soon. I find relevant economic officials from a wide range of countries increasingly agree, at least in private, with the arguments made in this respect by Kaufman and some of his colleagues (including Senator Sherrod Brown of Ohio).

According to the Barofsky report, the Federal Deposit Insurance Corp. under Chairman Sheila Bair seems to be willing to take this assessment to its logical conclusion -- to force megabanks to simplify their operations and divest themselves of some units, if this is what it takes to make orderly liquidation a feasible option.

Freedom of Action
Unfortunately, there is no sign that the Treasury Department is inclined to move in that direction. The quotes from Geithner are all about preserving his freedom of action in future crises, including the ability to determine that any financial institution is “systemic” and needs to be protected.

The Federal Reserve remains completely on the fence. On the one hand, Chairman Ben Bernanke is capable of clearly defining the problem. Firms perceived as likely to be saved by the government, according to Bernanke, “face limited market discipline, allowing them to obtain funding on better terms than the quality or riskiness of their business would merit and giving them incentives to take on excessive risks.” On the other hand -- although it isn’t in the report -- all indications suggest the Fed isn’t taking a tough line with big banks.
Ted Kaufman was right to worry about the large lenders. His ideas have gained lasting traction, and the debate among officials shows promise. But the situation still is dire. The incentives for large private banks are now as distorted as those that faced Fannie Mae and Freddie Mac, which had too little capital and took on too much risk when they had an implicit government guarantee (though efforts to pin the crisis of 2008 on those institutions are misplaced.)

As the Barofsky report puts it, “TARP has thus helped mix the same toxic cocktail of implicit guarantees and distorted incentives.”

Simon Johnson, co-author of “13 Bankers: The Wall Street Takeover and the Next Financial Meltdown” and a professor at MIT’s Sloan School of Management, is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Simon Johnson at sjohnson@mit.edu