Monday, November 30, 2015

The $30 Oil Cliff Threatening Russia's Economy

For Russia, $30 is the number to watch.
Crude prices at that level will push the economy to depths that would threaten the nation’s financial system, according to 63 percent of respondents in a Bloomberg survey. Lower prices for the fuel are next year’s biggest risk for Russia, which is unprepared to ride out another shock on the oil market, most economists said. Other dangers for 2016 include geopolitics, strains in the banking industry and the ruble, according to the poll of 27 analysts.
“If oil prices fall lower and stay at that low level for longer, risks of fiscal and financial destabilization increase significantly,” Sergey Narkevich, an analyst at PAO Promsvyazbank in Moscow, said by e-mail.
Russia, which has adjusted to the worst commodities slump in a generation with spending cutbacks and a weaker ruble, may be hard-pressed for policy answers if the slump in oil prices deepens after a drop of 37 percent in the past year. While Brent, the European benchmark, is trading around $45 a barrel, a warmer-than-average winter could weaken heating-fuel demand enough to trigger a decline in the price of crude to $20, analysts at Goldman Sachs Group Inc. said in a note Nov. 18.

OPEC Persistence

Oil has dropped as U.S. inventories climbed to near a record and the Organization of Petroleum Exporting Countries produced above its quota. OPEC, which meets to discuss policy Dec. 4 in Vienna, is set to stick with its strategy of defending market share by maintaining output and driving down higher-cost production elsewhere, according to all 30 analysts and traders in a separate Bloomberg survey.
Low or lower oil prices remain “the key risk for the Russian economy, despite adaptation to the shock during 2015,” said Andreas Schwabe, an economist at Raiffeisen Bank International AG in Vienna. “From that risk, an even weaker ruble and new waves of high inflation and budget problems derive.”
Further complicating the outlook are geopolitical tensions that followed the downing of a Russian warplane by Turkey in Syria last week and pushed investors to sell Russian assets. In addition to events in the Middle East, Russia also has to contend with international sanctions over the conflict in Ukraine.

Whither Sanctions

A diplomatic thaw between Russia and its Cold War-era foes in the aftermath of terrorist attacks in Paris and Egypt has stoked optimism that the improved relations will help remove the punitive measures.
Russia may get that boost in the next 12 months, with 56 percent of economists saying the European Union will ease its penalties during the period, up from 34 percent the last time the question was asked in August. Twenty percent predict the U.S. will begin relaxing its restrictions in the next calendar year, compared with 3 percent three months ago.
EU countries will probably extend sanctions for another six months at the end of January despite improved cooperation in Syria, according to three European diplomats. The bloc’s 28 leaders are set to discuss the issue at a Dec. 17-18 summit.
“Only without sanctions will the Russian economy return to GDP growth,” said Wolf-Fabian Hungerland, an economist at Berenberg Bank in Hamburg, Germany. Despite “a unique chance for a thaw between Russia and the West,” there’s “a substantial risk that this chance is not taken, implying prolonged sanctions.”

Ruble, Economy

The adjustment to the new economic reality was helped by swift changes in the exchange rate, Bank of Russia First Deputy Governor Ksenia Yudaeva said in Moscow Friday. The ruble is down almost 32 percent against the dollar since the central bank shifted to a free-floating regime in November 2014. That’s the third-worst performance among its emerging-market peers after Brazil’s real and Colombia’s peso, according to data compiled by Bloomberg.
A renewed bout of ruble weakness last summer forced policy makers to pause monetary easing in September and October after five consecutive interest-rate cuts brought their benchmark to 11 percent. Even as high borrowing costs choke investment, Governor Elvira Nabiullina in November left open the possibility of keeping rates on hold until March.

$30 Oil?

Russia has learned to live with oil near $40 and only a decline to $30 a barrel can provoke another deterioration, which isn’t the most likely scenario, Deputy Finance Minister Maxim Oreshkin said Nov. 25. The central bank estimates that in a stress-case scenario, with crude below $40 in 2016-2018, the economy will contract 5 percent or more next year and price growth may be at 7 percent to 9 percent. That would also raise risks to inflation and financial stability, according to the Bank of Russia.
GDP will contract 3.9 percent to 4.4 percent this year and may shrink as much as 1 percent next year if oil stays at $50 a barrel, the central bank forecasts.
“The second leg down in oil prices and likely further capital outflows will add more pressures to Russia’s ailing economy,” said Nerijus Maciulis, chief economist at Swedbank AB in Vilnius, Lithuania. “The next wound will open up on banks’ balance sheets -- non-performing loans are set to rise much further and will further drain public funds.”

Sunday, November 29, 2015

Fintech: The $10 billion club

Banks around the world will finally be put out to pasture in 2016 and replaced by “fintech”, as financial-technology startups dub themselves. That, at least, is the consensus in Silicon Valley, whose t-shirt-wearing denizens think of banks as the Kodaks of the 21st century: incumbents whose time is up. Twenty-somethings developing apps, often turbocharged by plentiful helpings of venture capital, are baffled as to how plodding banks even managed to muddle through to 2015. Finance, all bits and bytes, is there for the taking. Even the titans of Wall Street seem rattled. “Silicon Valley is coming,” warned Jamie Dimon, JPMorgan Chase’s boss, in a letter to shareholders in 2015.
The insurgents’ claims are exaggerated. But there is no doubt that “disruption” has at last reached finance, an industry so regulated and politically connected that it once seemed above the threat of new entrants. Some of the early stars of fintech in San Francisco, London, Stockholm or Shanghai are doing business at levels once considered the preserve of century-old firms. Around 50 are valued at over $1 billion, giving them the mythical status of “unicorn”.
But even $1 billion will start to feel old-hat in 2016. The biggest fintech outfits, in fields from lending to payments and asset management, will celebrate doing business in the tens of billions of dollars—at least if their exponential growth rates hold. A safe prediction for 2016 will be that someone will come up with a waggish moniker for such firms.
An early joiner of the $10 billion league will be Lending Club, a “marketplace lending” platform which pairs people wanting to borrow money with those who have some to spare. It is to banks what Airbnb is to hotels: an elusive rival, given that it acts as a matchmaking platform rather than a provider of services. Banks could easily dismiss the San Francisco firm in 2012, when it was arranging a mere $60m of loans a month, mostly recycling money from retail savers. Now large institutions such as hedge funds provide much of the capital loaned out. Lending Club should finish 2016 doing well over $1 billion of credit a month.
Automated wealth advisers, which aim to replace human investment advice (for example on how to squirrel away for retirement), might also cross the $10 billion mark—in this case in terms of the assets they manage on behalf of clients. Wealthfront, based in Palo Alto, and Betterment, based in New York, will both start the year managing over $3 billion each. They were once able to double assets every six months but their growth has tapered as incumbents such as Charles Schwab and Vanguard have launched competing products. A return to old ways could see them reach $10 billion each towards the end of the year. If not, they will serve as a salutary lesson into how the fortunes of fintech darlings can turn.
Venmo, a service used mainly by American teens to whizz money to each other, will be another $10 billion club member. A unit of PayPal, it has irked banks by offering free, convenient transfers of trivial sums of money, sometimes just a few cents, making banks’ own apps look clunky. It faces new competition from Facebook and Apple, both of which launched payment facilities in the last year or so. 

Other bits of fintech will amble to dizzying heights; 2016 will be the first full year in America where companies will be able to “equity crowdfund”, giving (small) shareholdings to backers wanting to invest perhaps just a few dollars. The money-transfer business is gradually being wrested from banks and specialists like Western Union, which offered uncompetitive exchange rates: nimble online operations like TransferWise are growing fast. More and more money will be spent deploying “blockchains”, the innovative technology that underpins bitcoin. A wave of new entrants want to offer day-to-day banking through current accounts, a service where old-school banks have thus far not faced competition. Amassing retail deposits would be a fast way into the $10 billion club.
Just a rounding error?
Silicon Valley’s exuberant claims about banks’ demise should be taken with a pinch of salt. Even $10 billion is a rounding error in the grand scheme of global finance: roughly 0.4% of the total assets of jpMorgan, say. Robo-advisers manage chicken feed compared with a UBS or BlackRock. Fintech’s main effect up to 2015 has been to force banks to sharpen their game. However, if their hockey-stick growth continues in the coming year, and their prospects remain as bright, fintech champions will go from being finance’s gadflies to something altogether more substantial.

Saturday, November 28, 2015

El Nino Shrinking Rice Crop Worldwide to Spur Vietnamese Sales

Rice exports from Vietnam may increase 14 percent in the first quarter as the strongest El Nino in almost two decades shrivels crops in some countries, spurring importers to build reserves.
Shipments will jump to 1.3 million metric tons in the three months ending March from 1.14 million tons a year earlier, said Tran Tuan Anh, Vietnam’s deputy minister of industry and trade. The world’s third-biggest exporter is already seeing a spurt in demand, he said in an e-mail on Nov. 25. October rice shipments surged 43 percent to 859,000 tons from a year earlier, the highest level since July 2012, government data show.
Indonesia and the Philippines are among nations importing rice after dry weather induced by the strongest El Nino since the record event in 1997-98 hurts crops. Prospects for the event to further strengthen may prompt buyers to secure supplies before prices run up as the United Nations’ Food & Agriculture Organization predicts a decline in global rice output in the 2015-16 season with consumption surpassing production.
“Rice supply and stockpiles will decline, and demand for imports will rise because of unfavorable weather conditions,” Anh said. “The El Nino event occurring this year and prolonging into 2016 will affect production in many countries, especially Thailand, Indonesia, and the Philippines.”
Rough-rice futures on the Chicago Board of Trade have rallied 29 percent from the lowest level in more than eight years in May on concern that the El Nino will shrink global harvest. The contract for delivery in January closed at $12.13 per 100 pounds on Wednesday.

Output Decline

Production in Thailand may decline to the lowest in 19 years as dry weather may prompt the world’s top exporter to further restrict plantings to preserve water supply. The Philippines is monitoring rice production closely to see whether there’s need to import more on El Nino after purchasing 750,000 tons from Vietnam and Thailand for delivery from November to March 2016. Indonesia this month agreed to import 1.5 million tons from Vietnam and Thailand and is in talks with Cambodia and Myanmar for additional supplies, according to state-run food company Bulog.
Vietnam’s paddy rice output may increase 0.3 percent to 45.1 million tons this year, VietnamPlus reported in September, citing the Agriculture Ministry. Exports may climb to 7 million tons in 2016 from 6.2 million tons this year, according to the U.S. Department of Agriculture.
Boosting rice exports will still be a challenge for Vietnam as Thailand is looking to draw down the stockpiles it accumulated under a state purchase plan, Anh said. Major importers, especially in Southeast Asia, are also diversifying supply sources and boosting domestic production, he said.
Thailand has about 13.7 million tons of rice in state stockpiles after the military government sold 5 million tons, Chutima Bunyapraphasara, permanent secretary for commerce, said Nov. 16.

This Island Says Everything About Australia's Shifting Economy

On the largest island in Australia’s Great Barrier Reef World Heritage Area, $60 billion of liquefied natural gas terminals are helping feed China’s hunger for energy. The next major construction project may appeal to its tourists.
Four decades after his father bought a cattle property on Curtis Island, American businessman Tim Reigel is seeking government approval to turn it into a five-star holiday destination. It’s the latest chapter for the 30-by-15-mile strip, located beside the famous coral reef, which state authorities predict will become one of the world’s largestLNG hubs.
The gas-to-guests transition is a microcosm of the economic shift happening in Australia. The nation, at the tail end of the biggest resources boom since the 1850s Gold Rush, is counting on tourists, especially from China, to help soften a plunge in mining and energy investments. These days, the majority of people coming to the tropical isle are there to help build the LNG facilities, not for the pristine beaches or endangereddugongs and snubfin dolphins. Once the projects are completed, most of those workers will leave.
“LNG is a tiny part of the Curtis Island story,” Reigel said by phone from his Los Angeles home. “I don’t care how many billions they’ve spent on it. Most of the island experience is very divorced from that.”
Yellow Patch, Curtis Island.
The three LNG projects on the island, about twice as big as Martha’s Vineyard, occupy about 2 percent of the land area on its southwestern tip, a couple of miles from the central Queensland port town of Gladstone.
The island’s workforce has already halved from a peak of 14,500 people last year and will drop to a “very small number” next year, according to contractor Bechtel Group Inc. The last project, a ConocoPhillips-Origin Energy Ltd. venture, is due to begin production this month.
The exodus is hurting local businesses, such as Scotties restaurant, two blocks from the harbor, which once counted among its clientele directors of BG Group Plc, operator of the $20 billion Queensland Curtis LNG plant. The U.K. company said Wednesday that the second stage of the plant’s development is finished.
“I had three fantastic years, like everyone else, when all the big guys were coming to town -- the engineers, the executives,” owner Scott McCarthy said. “Now, it’s been going downhill at a rapid pace. What we need is another big project to be announced, but with the commodity markets being as low as they are, that’s probably not about to happen.”

Cheaper Holiday

Fresh sources of income are needed to fill the gap, said Janu Chan, an economist with St. George Bank Ltd. in Sydney. Tourism may help, especially after the Australian dollar slipped against all but three of the Group of 10 currencies in the past year, making it cheaper to holiday in Australia for most overseas visitors.
Nearby Gladstone, originally named Port Curtis, is starting to woo travelers. Carnival Corp.’s P&O Cruises is scheduled to dock there six times next year, enabling passengers to visit the reef or even take a boat tour of the LNG plants, said Mayor Gail Sellers. Still, she’s not counting on Curtis Island drawing crowds of vacationers anytime soon, she said.

Yellow Patch

Unlike the Whitsunday Islands, about 600 kilometers further north, with their white-sand beaches, azure water and dense rain forest, the island that English explorer Matthew Flinders landed on in 1802 is more rustic and rugged. Among its features are a 20-story-high sand dune, called Yellow Patch, tranquil billabongs and flatback turtle nests.
Its raw beauty may pose a challenge to resort developers, said Graham Reynolds, a Brisbane picture framer who wrote a book about Curtis Island’s history.
“Perhaps you might get clever operators who can wrest some of that latent charm out of the place,” said Reynolds, who spent part of his childhood on the island, where his uncle was a maritime pilot.
Universal Partners BV, a Dutch real estate investment company, had planned to develop the northern tip of Curtis Island, which it said was the largest freehold, or non-leased, island-property in Australia. The plan didn’t gain traction with state and local governments and was shelved almost a decade later, said Rob Johnson, a designer who worked on the project and is now based in Jakarta.

Luxury Villas

“Sooner or later there will be a resort on Curtis Island,” said Reigel, who is pushing ahead with his plans for Turtle Street Beach Resort, a A$100 million ($72 million) project featuring 177 luxury villas and apartments, tennis courts, pools, a bar and restaurant. The proposal has drawn interest from Chinese investors, he said.
If approved by the Australian government, design work could begin immediately with the first stage of construction finished by the end of 2017, according to documents that Reigel’s company, QRE Pty, filed last month with environment authorities. 
Reigel’s father, Bill, a former stockbroker, led a group of U.S. investors that acquired the cattle property, Monte Christo, in the mid 1970s with the goal of building a resort there. The proposal stalled in the 1980s, while the government considered setting up a naval base on the island.
In 1989, three years after his father died, Reigel started the effort to obtain state and local government clearance, the filing shows. The plans have been tied up in a “complex” approvals and negotiation process with government agencies since, while about 14,000 hectares have been given up for national and conservation parks.

Tourism Drive

The impetus for tourism developments is increasing. The Australian government estimates thousands of extra rooms are needed in capital cities and in Queensland state to meet its target of doubling visitor spending to as much as A$140 billion by 2020, and investors are responding. The country has the strongest hotel pipeline in more than a decade, said Karen Wales, senior investment specialist at the Australian Trade Commission.
Current projects in Queensland include the A$600 million redevelopment of Lindeman Island and plans by Aquis Group, controlled by Hong Kong developer Tony Fung, to build an A$8 billion casino-resort with 7,500 rooms on a former sugarcane farm north of Cairns.
Although industries outside minerals and energy are helping the economy, they are unlikely to plug the investment hole that resources companies have left, St. George’s Chan said. Resources-related infrastructure projects total more than A$90 billion in the Gladstone area alone.
“We’re a fly on an elephant’s behind in terms of the size and type of projects that happen around Gladstone,” Reigel said. “But the role we fill is helping to provide diversity to the industrial base.

Wednesday, November 25, 2015

China’s Macro Disconnect: Steve Roach

Structural change and rebalancing are formidable undertakings for any economy. China has been focused on these objectives for five years – seeking to transform a powerful yet unbalanced growth model based largely on exports and investment into one driven increasingly by its consumers. Success is essential if China is to avoid the dreaded “middle-income trap” – the economic slowdown that most fast-growing developing economies experience when they reach income thresholds comparable to that of China today.
The results have been mixed. China has been highly successful in its initial efforts to shift the industrial structure of its economy from manufacturing to services, which have long been viewed as the foundation of modern consumer societies. But it has made far less progress in boosting private consumption. China now has no choice but to address this disconnect head on.

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The performance of China’s services sector has been especially impressive in recent years, with its share of GDP increasing from 44% in 2010 to 51.6% in the first three quarters of 2015, according to official statistics. That is nearly double the four-percentage-point increase that was initially envisioned in the 12th Five-Year Plan, which is about to come to an end.
The gains have been particularly strong in the distribution sectors – wholesale and retail trade – as well as in finance and real estate. And China’s shift to services has only just begun. It should broaden into IT services, healthcare, domestic transportation, and hospitality and leisure, as the sector as a whole climbs toward a 60-65% share of GDP over the next decade.
By contrast, consumer-led growth has been much slower to materialize. After bottoming out at 36% of GDP in 2010, private consumption’s share of GDP inched up to 38% in 2014 – a two-percentage-point increase that is only about one-fourth the magnitude of the services-led shift in the economy’s structure.
With its prowess in central planning, China has always been adept at engineering shifts in its industrial structure – as the move toward services-led growth attests. But China apparently is far less proficient in replicating the DNA of a modern consumer culture – specifically, in altering the behavioral norms of its people.
The disconnect between surging services and lagging growth in private consumption has been accompanied by a steady rise in China’s urban saving rate to 30% in 2014 (versus 24% a decade earlier). This has occurred despite a significant increase in the personal income share of the Chinese economy, driven by services-led employment growth and the income leverage of urbanization. Chinese families have been reluctant to convert much of this newfound income into discretionary spending.
China’s high and rising urban saving rate in a climate of vigorous per capita income growth reflects a persistent preference for precautionary saving over discretionary consumption. Unfortunately, this is a rational response to the uncertain future faced by the majority of Chinese families, underscored by the lack of a reliable social safety net. Moreover, anxiety over inadequate provisions for retirement and health care is set to intensify as a rapidly aging population now enters the most vulnerable phase of its life cycle.
The good news is that the 13th Five-Year Plan (covering the 2016-2020 period), which is to be enacted in March 2016, appears likely to address these concerns explicitly. Early indications from the Fifth Plenum of the 18th Central Committee of the Communist Party of China, held in late October, suggest that the next plan will focus on the missing piece of consumer-led rebalancing: a strong social safety net.
A proposed consolidation of rural and urban plans for pensions and critical health care is particularly important in this regard, as is the authorities’ commitment to allowing workers to transfer their hukou (residency permits) – and the associated social welfare benefits – wherever they move. For China’s 270 million migrant workers, benefit portability could be decisive in shifting the balance from fear and precautionary saving to security and discretionary spending. Equally significant was the Fifth Plenum’s emphasis on using state capital to fund a more robust safety net through an increase in taxes on state-owned enterprises that was proposed a couple of years ago.
But the biggest breakthrough in reshaping societal norms was in family-planning policy – replacing the one-child limit that had been in force since 1980 with a two-child limit beginning in 2017. Aimed at addressing China’s serious aging problem, the eventual consequences of this long-overdue shift cannot be minimized. As the family unit, central to China’s Confucian heritage, changes, so will the country’s social and economic character.
Over the past 35 years, China’s powerful growth model has yielded extraordinary progress in terms of economic growth and development. But speedy implementation of the shift from production to consumption will be vital if the country is to remain on course and avoid the middle-income trap. That will require resolving the disconnect between the structural shift to services and the behavioral norms that will ultimately shape the spending habits of its people.
And that means overcoming the understandable caution of Chinese households in the face of an uncertain future. Converting fear into confidence is a daunting task for any society. China is no exception. The focus on resolving China’s macroeconomic disconnect, reflected at the Fifth Plenum, is thus very encouraging.


Tuesday, November 24, 2015

The promise of the blockchain: The trust machine

BITCOIN has a bad reputation. The decentralised digital cryptocurrency, powered by a vast computer network, is notorious for the wild fluctuations in its value, the zeal of its supporters and its degenerate uses, such as extortion, buying drugs and hiring hitmen in the online bazaars of the “dark net”.
This is unfair. The value of a bitcoin has been pretty stable, at around $250, for most of this year. Among regulators and financial institutions, scepticism has given way to enthusiasm (the European Union recently recognised it as a currency). But most unfair of all is that bitcoin’s shady image causes people to overlook the extraordinary potential of the “blockchain”, the technology that underpins it. This innovation carries a significance stretching far beyond cryptocurrency. The blockchain lets people who have no particular confidence in each other collaborate without having to go through a neutral central authority. Simply put, it is a machine for creating trust. 
The blockchain food chain
To understand the power of blockchain systems, and the things they can do, it is important to distinguish between three things that are commonly muddled up, namely the bitcoin currency, the specific blockchain that underpins it and the idea of blockchains in general. A helpful analogy is with Napster, the pioneering but illegal “peer-to-peer” file-sharing service that went on line in 1999, providing free access to millions of music tracks. Napster itself was swiftly shut down, but it inspired a host of other peer-to-peer services. Many of these were also used for pirating music and films. Yet despite its dubious origins, peer-to-peer technology found legitimate uses, powering internet startups such as Skype (for telephony) and Spotify (for music streaming)—and also, as it happens, bitcoin.
The blockchain is an even more potent technology. In essence it is a shared, trusted, public ledger that everyone can inspect, but which no single user controls. The participants in a blockchain system collectively keep the ledger up to date: it can be amended only according to strict rules and by general agreement. Bitcoin’s blockchain ledger prevents double-spending and keeps track of transactions continuously. It is what makes possible a currency without a central bank.
Blockchains are also the latest example of the unexpected fruits of cryptography. Mathematical scrambling is used to boil down an original piece of information into a code, known as a hash. Any attempt to tamper with any part of the blockchain is apparent immediately—because the new hash will not match the old ones. In this way a science that keeps information secret (vital for encrypting messages and online shopping and banking) is, paradoxically, also a tool for open dealing.
Bitcoin itself may never be more than a curiosity. However blockchains have a host of other uses because they meet the need for a trustworthy record, something vital for transactions of every sort. Dozens of startups now hope to capitalise on the blockchain technology, either by doing clever things with the bitcoin blockchain or by creating new blockchains of their own (see article).
One idea, for example, is to make cheap, tamper-proof public databases—land registries, say, (Honduras and Greece are interested); or registers of the ownership of luxury goods or works of art. Documents can be notarised by embedding information about them into a public blockchain—and you will no longer need a notary to vouch for them. Financial-services firms are contemplating using blockchains as a record of who owns what instead of having a series of internal ledgers. A trusted private ledger removes the need for reconciling each transaction with a counterparty, it is fast and it minimises errors. Santander reckons that it could save banks up to $20 billion a year by 2022. Twenty-five banks have just joined a blockchain startup, called R3 CEV, to develop common standards, and NASDAQ is about to start using the technology to record trading in securities of private companies.
These new blockchains need not work in exactly the way that bitcoin’s does. Many of them could tweak its model by, for example, finding alternatives to its energy-intensive “mining” process, which pays participants newly minted bitcoins in return for providing the computing power needed to maintain the ledger. A group of vetted participants within an industry might instead agree to join a private blockchain, say, that needs less security. Blockchains can also implement business rules, such as transactions that take place only if two or more parties endorse them, or if another transaction has been completed first. As with Napster and peer-to-peer technology, a clever idea is being modified and improved. In the process, it is fast throwing off its reputation for shadiness.
New chains on the block
The spread of blockchains is bad for anyone in the “trust business”—the centralised institutions and bureaucracies, such as banks, clearing houses and government authorities that are deemed sufficiently trustworthy to handle transactions. Even as some banks and governments explore the use of this new technology, others will surely fight it. But given the decline in trust in governments and banks in recent years, a way to create more scrutiny and transparency could be no bad thing.
Drawing up regulations for blockchains at this early stage would be a mistake: the history of peer-to-peer technology suggests that it is likely to be several years before the technology’s full potential becomes clear. In the meantime regulators should stay their hands, or find ways to accommodate new approaches within existing frameworks, rather than risk stifling a fast-evolving idea with overly prescriptive rules.
The notion of shared public ledgers may not sound revolutionary or sexy. Neither did double-entry book-keeping or joint-stock companies. Yet, like them, the blockchain is an apparently mundane process that has the potential to transform how people and businesses co-operate. Bitcoin fanatics are enthralled by the libertarian ideal of a pure, digital currency beyond the reach of any central bank. The real innovation is not the digital coins themselves, but the trust machine that mints them—and which promises much more besides.

Is Traditional Banking Unbreakable?

It is a rare industry nowadays that is not at risk of being upended by digital technology. Amazon, having swept away bookshops, is now laying siege to the rest of the retail sector. In transportation, Uber is outrunning traditional taxi companies, while Airbnb is undermining the foundations of the hotel industry. Meanwhile, smartphones are transforming how we communicate and revolutionizing the way we discover and patronize businesses.
So it is no surprise that banking and financial-services companies are not safe from the immense transformations wrought by technological innovation. Indeed, for the last decade, digital startups have been penetrating areas traditionally dominated by the financial industry. But there is reason to believe that finance will prove resilient.

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Today, money can be sent to the other side of a country – or the world – simply by tapping an app, without ever interacting with a traditional financial-services company. Migrants’ remittances alone, which the World Bank estimates will total $586 billion this year, represent a tremendous growth opportunity for companies competing with banks to move money.
Meanwhile, would-be disrupters are offering opportunities to save and invest – the very heart of traditional banking institutions’ operations. Startups such as Acorns – an app that automatically allocates a proportion of everyday purchases to a pre-selected investment portfolio – are making rapid inroads into a very competitive marketplace.
Acorns, launched in 2014, already manages more than 650,000 investment accounts. The company – and others like it – are not just moving into the market; the simplified investment and savings processes they offer are expanding and transforming it. According to research by the digital ad agency Fractl, approximately 85% of millennials are saving a portion of their paycheck – a larger percentage than their predecessors.
Lending, too, is being transformed by technology. Crowdsourced funding and peer-to-peer lending schemes give borrowers the opportunity to circumvent many of the hurdles of traditional banking – including, in some cases, collateral requirements and credit ratings.
According to the research firm Massolution, the crowdfunding market has grown exponentially, from $880 million in 2010 to $16.2 billion in 2014. Global crowdfunding volumes are expected to double this year, surpassing $34 billion. In 2016, crowdfunding is expected to provide more funding than traditional venture capital.
Even financial services traditionally characterized by face-to-face dealings with clients, such as investment banking advisory services, have been affected. When Google conducted its initial public offering in 2004, it chose to bypass the investment banking industry, which traditionally underwrites the process of taking a company public. Instead, the company opted for an electronic auction in which anyone could participate. Other companies – like the financial research firm Morningstar – have followed suit. While these attempts to revolutionize the equity capital markets have yet to gain widespread traction, their very existence is evidence of the opportunities for disruption in this sector.
But it would be premature to conclude that traditional banking has yielded to new financial platforms. Many of the new entrants have benefited from advantages that would be difficult to maintain were they to scale up in size and importance.
Traditional banking is subject to intense oversight, and regulations have only become more onerous in recent years, as regulatory authorities reacted to the 2008 global financial crisis by tightening rules on leveraging ratios and know-your-customer requirements. Many upstarts in the sector have carved out a competitive advantage by avoiding thresholds beyond which they would face substantial regulatory scrutiny and requirements.
This places a significant constraint on the size and type of financial transactions these new companies can offer. By steering clear of services that might draw the scrutiny of financial authorities, digital startups face a natural limit to the size of their market. Indeed, this arrangement – albeit informal – can be viewed as the way regulators manage the systemic risk posed by new entrants.

As the digital revolution evolves, much of the financial terrain in which technology companies are making the deepest inroads will come into much sharper regulatory focus. This will favor the established players. As a result, the digital revolution’s assault on the traditional banking industry is by no means overwhelming. In finance, at least, technology firms should not be viewed simply as a threat, but as a source of productivity-boosting innovation.

The Economic Impact of Evil: James Mauldin

The world can change quickly, and last week it did. The most immediate and heartbreaking impacts of the Paris attacks were suffered by the victims themselves and their families, but from there the ripples of terror spread outward around the world.
The Paris events didn’t happen in isolation. Recent bombings in Lebanon, Iraq, Mali, and Nigeria, plus the Russian airline disaster, showed us how far evil can reach. It isn’t just ISIS: al-Qaeda is getting stronger in some places; Boko Haram continues to strengthen in West Africa; there is a resurgent Taliban in Afghanistan; and the list goes on…
In addition to the catastrophic human cost it exacts, terrorism has economic impacts. It misallocates resources, distorts prices, and prompts adverse government policies. We all feel these effects, even if we live far from the terror zones.
Terrorism is global. So is the economy. We can’t separate them. I’m sure you have spent time reading about the reaction to the terrorist attacks in Paris. I have been reading and thinking a great deal about the effects of recent events on the European Union. Much of what I’ve read seems to miss what I think is the larger context and what may be the real longer-term economic and geopolitical implications of these attacks. It should make for an interesting, and somewhat sobering, letter.
The Dysfunctionality of Europe
The European Union works marvelously as a free-trade zone of separate nations, but the visionaries who launched the EU wanted it to be a political union, not just a free-trade zone. They felt that if they could create a political union, then even though the economic problems would be immense, the member countries would eventually come together on the economic front as well. That has not happened. In fact, a fitful political union has made the EU’s economic problems worse.
Europe has three basic economic problems, which I’ve dealt with at length over the years:
  1. Capital and goods flow from the peripheral countries of Europe to the core. This huge trade imbalance has no way to resolve itself. The peripheral countries were able to borrow money at German rates for many years, while the politicians in those countries exhibited no discipline in their budgeting process and ran up huge debts and deficits. Then the bill came due.
In the modern world, the normal way to resolve trade imbalances is through currency fluctuations. But in the Eurozone there is now just a single currency, and one size does not fit all.
  1. Many Eurozone countries have run up unsustainable debts relative to their potential growth. Unsustainable, that is, under a normal interest-rate regime. After the collapse of Greece, the European Central Bank, worried about contagion effects, lowered interest rates dramatically; and countries like Italy took on large amounts of additional debt. What is now nearly a 140% debt-to-GDP ratio in Italy is manageable when interest rates are only a few points. That ratio would be a disaster at 6 to 8%, and Italy would soon be Greece. It should be noted that, even with the low rates, the Italian debt-to-GDP ratio increases each year.
As you may recall, I visited with a senior economist at the Italian central bank a few years back and confronted him about the logic of the country’s debt level and the question of potential interest rate increases. I came away with the distinct impression that the answer was “[ECB President Mario] Draghi has our back.” I remember remarking to you on the Bank of Italy’s confidence in the sustainability of what was then a 125% debt-to-GDP ratio.
Draghi gives at least one speech every few months begging the peripheral countries to reform their labor markets and fiscal budgets during this low-interest-rate regime he has given them. He knows it can’t last forever and that without market and labor reforms the peripheral nations cannot grow their way out of the debt problem.
  1. As bad as the entitlement situation is in the US, it is worse in most of Europe, especially in the problem countries (including France!). Given the demographics involved, these countries simply cannot sustain their governments’ promises. They have no room to increase taxes without severely damaging their economies even further.
The Euro: A Suboptimal Currency Union
Let’s deal briefly with the first problem: trade imbalances in the currency zone.
Many of us take our national currencies for granted, and we assume there have always been dollars, pounds, or yen. In fact, for a long time individual banks issued notes promising the holder to exchange the notes for gold upon demand. The concept of a national currency is actually one that came about very late in history.
Before the euro was created, the economist Robert Mundell wrote about what made for an optimal currency area. His work was so important that he won a Nobel Prize for it. He wrote that a currency area is “optimal” when it has
1. Mobility of capital and labor
2. Flexibility of wages and prices
3. Similar business cycles
4. Fiscal transfers to cushion the blows of recession to any region.
Europe has almost none of these. Very bluntly, that means it is not a good currency area.
As Otmar Issing, chief economist of the German Bundesbank stated in 1991, “There is no example in history of a lasting monetary union that was not linked to one State.” And that state has to be a fiscal union, which the Eurozone and the EU in general are not. Further, there are significant differences among the economies of the various countries composing the Eurozone.
The United States is a good currency union. The same currency serves just as well in Alaska as it does in Florida and as well in California as it does in Maine. If you look at economic shocks, the US has absorbed them pretty well. If you were unemployed in Texas in the early 1980s after the oil boom turned to bust, or in Southern California in the early 1990s after post-Cold War defense cutbacks, you could pack your bags and head to a state that was growing. And that is exactly what happened. That doesn’t happen in Europe. Greeks don’t pack up and move to Finland. Greeks don’t speak Finnish (no one does, outside Finland). And if unemployed Americans stayed in Texas or California, they would have received fiscal transfers – employment benefits and various forms of welfare – from the central government to cushion the blow. There is no central European government that can make fiscal transfers. So the US works because it has mobility of labo r and capital as well as fiscal shock absorbers.
There are other good currency unions around the world. China comes to mind, as does Canada. There are numerous countries that work very well as currency unions but are in fact amalgamations of various regions with historically different identities. But those currency unions evolved over time and did not simply turn up one bright New Year’s day, as the Eurozone did on January 1, 1999, an ostensible union among countries with very disparate economies and wealth.
The euro works like a gold standard. Obviously the euro isn’t exchangeable for gold, but like the gold standard, the euro forces adjustments in real prices and wages instead of exchange rates. And, much like the gold standard, it has a recessionary bias. Under a gold standard or the euro regime, the burden of adjustment is always placed on the “weak-currency” countries, not on the strong countries.
Under a classical gold standard, countries that experience downward pressure on the value of their currency are forced to contract their economies, which typically raises unemployment because wages don’t fall fast enough to deal with reduced demand. Interestingly, the gold standard doesn’t work the other way. It doesn’t impose any adjustment burden on countries seeing upward market pressure on currency values. This one-way adjustment mechanism creates a deflationary bias for countries in recession. The deflationary bias also makes it likely, at least by historical measures, that a gold-standard regime will see a higher average unemployment rate than will a freely floating currency regime.
In the Eurozone, Greece can’t simply devalue its currency, or even let the markets do it. So it suffers 25% unemployment (50% youth unemployment) as it tries to bring its trade balance back into equilibrium. The same thing is happening in Spain and the other peripheral countries. To receive the fiscal help they need, they must turn to  Germany and the other Eurozone core countries, which impose draconian austerity on the countries receiving help. As I wrote four years ago, the necessary rebalancing process will take at least a decade. Greece’s debt will be larger and more unsustainable at the conclusion of that process than it is today. The question is not whether Greece will default on its debt, but when and at what cost.
It is ironic that during the first ten years after the creation of the euro, the European periphery experienced large increases in wages and prices compared to the core. While prices and wages were stagnant in Germany, they grew rapidly at the periphery. This dynamic made the periphery very uncompetitive relative to Germany and the rest of the core. The result? Peripheral countries imported a lot more than they exported and ran large current account deficits. The only way to turn this trend around is through real cuts in wages and prices, resulting in internal devaluations and deflation. This approach is hugely contractionary and has clearly created tremendous problems in the European periphery, starting with massive unemployment. Because there was no available “quick fix” of actual currency devaluations, the process has been long and ugly, especially if you are a worker in a peripheral country.
All these pressures have created an intense political debate over the policies that should be adopted. In numerous countries we are seeing rising political parties on both the right and the left begin to take “market share” from the more centrist parties that have been in control for decades. Portugal seems to be in outright revolt, as was Greece for a period of time.
My friend and geopolitical expert George Friedman is pessimistic about the viability of the Eurozone and has said for a long time that he thinks immigration issues will be the final wedge that splits the union. I have been somewhat more sanguine, because the political leadership of Europe, both left and right, is very committed to the idea of a political union. They will do, as Mario Draghi has said, “whatever it takes.” I think the European Union still has a chance, if only a small and expensive one, to be viable.
The European Union is a wonderful political idea but not a good economic idea. It was politics that created Europe, and it is politics that holds Europe together. The EU’s political leaders and other elites are committed to holding it together. Understand, the idea of a United Europe is an article of faith, imbued with all the ferocity and fervor of any religious belief with which I’m acquainted.
There are many True Believers in a vision of a United Europe. I believe that, to hold their union together, the leaders at the core will ultimately be willing to absorb all the debts of all the various member nations and put them on the balance sheet of the European Central Bank, basically nationalizing all the debt. They will then be willing to sacrifice their individual countries’ fiscal autonomy on the altar of the European Union.
All of the problems I mentioned above can be solved by political decision making, but it must be understood that the solutions will come at an unimaginably high cost, running to many trillions of euros. The longer Europe puts off the day of reckoning, the bigger the bill will be. Whatever the ultimate bill is, the euros to pay for the transition will not exist, so they will have to be manufactured; and ultimately the value of the euro itself will be considerably reduced on world markets, just as the current manufacturing of Japanese yen is diminishing that currency’s value. If you are a True Believer, you might be willing to pay the price.
Either the Eurozone will be re-forged as a true political union, or it will break up. When you come to the end game, there is really no middle ground. Oh, I suppose that Mario and his successors can print and monetize for another decade, but they can’t do so without the euro’s suffering a large reduction in value. There are going to have to be major reforms, or the euro will continue to “adjust.” Right now, Europe seems quite comfortable with the idea that the euro will eventually fall to parity with the US dollar. But what happens when the euro is at $.80 to the dollar? Does Europe want to go down that rabbit hole another 25%?
Into that volatile mix of politics and economics, let’s now throw in terrorism, immigration, and the refugee crisis.
The Economic Impact of Evil
I saw a report referenced on Bloomberg last week that said 2014 was the costliest year for terrorism since 2001, in both financial terms and human lives lost. That assertion seemed remarkable, so I went to the source. The Institute for Economics and Peace is an Australian nonprofit think tank. I can’t vouch for their expertise, but their “Global Terrorism Index” is still interesting.
Their report calculates that the worldwide economic cost of terrorism was $52.9 billion in 2014, an all-time peak. That’s the GDP of a small country, gone up in smoke (literally).
IEP arrives at that number by adding up property damage along with medical costs and lost income for victims. They do not include the indirect costs of preventing or responding to terrorist acts.
How much money does the world spend to cope with the mere possibility of terror attacks? The US Transportation Security Administration’s 2014 budget was $7.4 billion. TSA is only one of several agencies focused on terrorism, and the US is only one country.
Think about all the private security guards, construction costs of hardening office buildings, executive and staff time spent dealing with the inevitable headaches and delays, and much more. Pick a very large number. Whatever that number is, you can bet the cost will go much higher after what happened last week. For instance, how much did it cost to shut down Paris for a weekend?
Merkel’s Gate, Redux
Looking back at my past newsletters is always interesting (and frequently humbling). It’s a bit like entering a time machine. Reading what I said in the past underlines how the world has changed in the meantime.
Only two months ago (Sept. 20), in “Merkel Opens the Gates,”a I looked at Europe’s refugee crisis. Germany’s Angela Merkel had just promised to accept 800,000 refugees this year, and was pushing other countries to help.
I don’t often quote myself, but the following excerpt from that letter helps set the stage for what we will discuss below.
And while Merkel says Germany can take 800,000 immigrants, notice that they are instituting border controls to stem the flow. It’s is all well and good to say you can absorb nearly a million immigrants, but where you going to put them? How will you feed them or school them? That effort takes planning and time, planning and time that have not been much in evidence the past few years in Europe.
Just as the Grexit crisis showed us the underbelly of European monetary integration, the refugee crisis highlights the huge difficulty of political integration. Hungarians, Slovaks, and Czechs do not want Brussels telling them how many Syrians they must admit and support. I don’t blame them.
Ambrose astutely points out that Europe must now deal with an east-west split on immigration along with the still-unbridged north-south economic chasm. Yet EU leaders push blithely on, thinking they can roll right over their opposition. To them each crisis presents another opportunity to impose structure and an artificial unity from the top down.
Read that last sentence again. Have we seen EU leaders pushing top-down solutions to the ISIS-inspired attacks? No. We see the opposite. Countries all pledge cooperation, but they want it on their terms. The EU central command all but disappeared in the aftermath of the Paris attacks. I think this is significant, like “the dog that didn’t bark” in the venerable Sherlock Holmes story.
European unity was already wearing thin before last week. Just two months ago, Merkel’s German government, along with the EU authorities, thought they could impose their desire to accept more immigrants on the entire union. Eastern European states (and many individuals all over Europe) didn’t like that idea at all. They refused to cooperate.
Look what happened next. The German public’s initial generosity faded quickly as people grasped the magnitude of the task. Merkel’s political allies began peeling away. Her grip on power started looking shaky.
Elsewhere in Europe…
  • Protests again erupted in Greece over EU-imposed austerity measures.
  • A left-wing coalition brought down a euro-friendly Portuguese government just two weeks after it took power.
  • Spain’s Catalan region moved forward with its secession effort.
  • “Brexit” sentiment grew in the UK.
The “European problem” was not improving even before Paris. Then the shooting started.
Hollande Shuts the EuroDoor
You might think all the minor issues would fall by the wayside in a true crisis. Francoise Hollande’s first impulse was to reach out to his EU neighbors for help, right?
Wrong. Within hours, he issued orders to close France’s borders with its EU neighbors. There was real fear that more attacks would follow, and Hollande essentially decided that France would stand alone. And indeed, there are reports from the hacker group Anonymous that ISIS plans to strike all over the world today [Sunday].) Yes, Hollande subsequently relaxed, but his initial reaction tells us something important. So does the way Merkel and her EU friends blended into the woodwork when Paris was hit. This isn’t what you expect to see in a healthy alliance.
That’s because the EU is not a healthy alliance. Different countries have radically different views of national sovereignty and responsibilities. If they can’t put their heads together on handling refugees and fighting terrorism, how can they possibly cooperate on fiscal policy? How can they maintain a common currency? Or maintain enough political support from very nervous voters?
On Monday, Hollande formally invoked the European Union Treaty’s “mutual defense” clause, which says member states must help any other member facing armed aggression. What does this mean? No one knows. This is the first time any EU member asked for aid.
It does not sound as though EU leaders are anywhere near a united European response. They have simply agreed to talk about the problems. Meanwhile, ISIS is planning its next attack. This is why Hollande acted alone that first chaotic night – and why the euro currency is now several steps further down the path wending toward oblivion.
A Disunited Europe
George Friedman sent around some private thoughts last week. I convinced him to let me share them as an issue of Outside the Box, which you can read here. I think George’s assessment of European unity, or lack thereof, is right on the money. The immigration crisis was already coming to a boil ahead of the Paris attack. Here’s George:
Had Europe been functioning as an integrated entity, a European security force would have been dispatched to Greece at the beginning of the migration, to impose whatever policy on which the EU had decided.
Instead, there was no European policy, nor was there any force to support the Greeks, who clearly lacked the resources to handle the situation themselves. Instead, the major countries first condemned the Greeks for their failure, then the Macedonians, as the crisis went north, then the Hungarians for building a fence, but not the Austrians who announced they would build a fence after the migrants left Hungary.
Between the financial crisis and the refugee crisis, Europe had become increasingly fragmented. Decisions were being made by nation-states themselves, with no one being in a position to speak for Europe, let alone decide for it.
Exactly. This is Europe’s core financial problem as well as its political barrier. The EU nominally speaks for the whole alliance, but it never says much because it takes forever for all the members to decide anything. All it takes is one holdout to bring the whole apparatus to a halt – and someone always holds out.
ISIS is not, as Obama said, the JV team. They are the real deal. All the talk I’ve read about dislodging ISIS is just that – talk. They have 100,000 battle-hardened soldiers, are relatively well-financed, and are remarkably adept at utilizing social media. Paul Kagan estimates that it would take 50,000 troops to create a safe zone for Syrian refugees in Syria and simply to contain ISIS to the territory it holds today.
I think that estimate significantly underestimates the zealotry and ambition of ISIS. They are intent upon establishing a caliphate. They recruit additional psychopathic soldiers every week. They have a functioning government, albeit one that we don’t like and one as barbarous and backward as any government the world has seen for centuries. Seriously, they have published manuals explaining that it is perfectly within their religious law to have sex with pre-pubescent girl slaves. And to stone women for offenses against Sharia law, etc. etc.
That Obama said we have contained ISIS is now almost laughable. They may not be growing their territory, but they are not ceding any, either. Twenty thousand pairs of US boots on the ground would not even come close to being enough. And the ability of ISIS to strike deep into the heart of Europe has not been contained at all.
Let’s turn to the US for a moment. The exchange between Senators Rand Paul and Marco Rubio in the last Republican debate was illuminating. There is a very clear divide on what military budget priorities in this country should be. There are lots of ideas, but none of them are palatable.
Let’s examine just one notion. There are several Republican candidates who would like to arm the Kurds. Okay, let’s say we create an army of 250,000 Kurds that is as well-armed as any group in the Middle East. They would be a formidable force; and with US intelligence and airpower, along with that of the rest of our allies in the Middle East, they could lead the attack to roll back ISIS. Seems like a simple enough plan, right?
Well, not exactly. Turkey and Iran would be extremely uncomfortable if not outright hostile to such a scheme. Iraq, such as it is, would be rendered completely incapable of keeping the Kurds from forming their own country and then beginning to absorb more of what we now think of as Iraq. At that point, what’s to keep them from absorbing the part of Syria that is Kurdish? Can we even assume that the Kurds would give up any of the territory they took from ISIS? There are large parts of Turkey and Iran that are heavily Kurdish. How would those countries be affected? In addition, there are severe divisions among the Kurds themselves. Arming the Kurds sounds good in theory, but in practice it could be like arming the Taliban in the 1980s to fight the Russians. Then again, it might be a brilliant idea. No one really knows.
Donald Trump wants to stand off and bomb the hell out of ISIS. Okay, that doesn’t cost a great deal of US blood, but how many videos of women and children being killed along with ISIS troops are this country and the world willing to stomach? How much blood and treasure are we willing to spend to go back into the Middle East? The free world was willing to go along with massive bombing of mostly civilian cities in World War II, but I doubt there is anywhere near that much resolve today. Most of the cities occupied by ISIS – they are sometimes characterized as “strongholds” – are actually heavily civilian, and the citizens have no option to relocate.
There are no good solutions, or at least no attractive ones, for dealing with ISIS. And that reality means they and their terrorist cohorts around the world will continue to be free to operate. Hollande can talk about massive reprisals, but I’m not sure reprisals will solve France’s problem of homegrown terrorists.
We should recognize that the “terrorists” in the recent Paris attacks were basically French citizens growing up in the Muslim ghettos (let’s call them what they are), where youth unemployment is 40 to 50%.
The reality is that there are going to be more terrorist attacks in Europe, and every one of them is going to make more European voters increasingly uncomfortable. With each terrorist act, voters are going to grow increasingly restless and increasingly willing to listen to politicians who will promise to control borders and make people safe.
There is already a great deal of economic distress in Europe, and a great deal of political unrest as a result. Throw in a few more terrorist acts, which are almost a certainty given homegrown terrorists and the porous nature of European borders, not to mention the refugee issue (which is going to be massively expensive in the short term), and we may see the centrist parties lose control of the political process. It is no longer outside the realm of probability that anti-EU political parties will take control of major countries in Europe. Marine Le Pen is riding high in the French polls.
If Marine Le Pen is the answer, France is asking the wrong question. I wonder what kind of working partner she would be with Angela Merkel. And that’s assuming that Angela Merkel can stay in power. I have to wonder where the political leader who will take the EU forward is going to come from.
Please understand that I am actually pro-immigration, for economic reasons, leaning against the grain of many of my political friends. Europe actually needs immigration, but the kind of immigration they are getting is making their citizens very uncomfortable.
The problems in the Eurozone are already massive and can be managed only with considerable political coordination. There has been precious little political coordination and agreement in the European Union lately. Toss into the mix the current refugee and terrorist crises, and it becomes significantly more difficult, if not impossible, to achieve positive outcomes in Europe. I have no particular love for any of the centrist parties in Europe. And they may well deserve to be voted out. Then again, look how well that turned out for Greece. And the center-right doesn’t appear to be doing all that well in Portugal, either.
I don’t see how the situation in Europe ends well. And that is sad, because Europe, the Europe I know and love, deserves better.