Issues that need to be addressed to reduce European sovereign risk

Normal 0 false false false EN-US X-NONE X-NONE

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Normal 0 false false false EN-US X-NONE X-NONE

European leaders face a deadline this Sunday to implement policies to help resolve the sovereign debt crisis.  A review of these issues is summarized in a recent commentary.

 

A deadline for solving a deadly Eurozone sovereign debt crisis (Guillermo de la Dehasa, VOXEU October 20^th) Time is running out for EU leaders to put an end to the Eurozone crisis.  European leaders face the following issues: 1. find a definitive solution to Greek insolvency, 2. isolate solvent countries from possible Greek contagion, 3. improve EU governance by creating a true European Parliament and 4. refocus on a pro-growth policy mix. 

 

Eurozone leaders must reach a clear and definitive solution to Greece’s insolvency without triggering a credit event.  Private sector involvement is not the best solution since “voluntary haircuts” can be an oxymoron and impede decisions.  Haircuts can be imposed on banks and a Brady-like swap program can be implemented for Greek bonds into European Financial Stability Facility (EFSF) bonds of longer maturities.  A challenge for policymakers is to isolate solvent members from contagion.  The can be implemented through a backstop for Eurozone member debt, such as a leveraged EFSF.  The guarantee is implemented in return for debt consolidation and structural reforms. 

 

Long-term, the present structure of European governance and crisis management needs to be addressed.  This issue can be resolved by amending the treaties and moving away from the current system where council decisions need unanimous approval within national governments.  Long-term, the EU needs to move to a federal system of governance by a true European parliament.  It should set up an independent European treasury to monitor states compliance to debt limits and structural reforms.  Lastly, policymakers need to implement a policy where Eurozone growth rate can exceed the real interest rate on its debt.

 

European banks will need to be recapitalized.  However, this will only be a stop gap measure without addressing the other issues.   Otherwise the concept of the euro will be at risk.    

 

The Cost of a Capital Cushion for Global Systemically Important Banks

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Recently, a number of financial institutions along with the International Institute of Finance (IIF), an industry association owned by financial institutions, have raised concerns about the economic costs for a capital cushion for global systemically important banks (GSIB).  The BIS has answered some of these questions in a recent report Assessment of the Macroeconomic Impact of Higher Loss Absorbency for Global Systemically Important Banks (BIS Macroeconomic Assessment Group, October 10^th).

Weakness in large financial institutions has often played a central role in the triggering and propagation of systemic financial crises.  The Financial Stability Board (FSB) and the Basel Committee on Banking have made a number of proposals for improving the loss absorbency of the GSIB and put together a Macroeconomic Assessment Group (MAG) to investigate the macroeconomic costs and benefits of these proposals. 

The GSIB proposal costs stem from the adverse impact on economic activity, bank policies to increase rate spreads and reduced lending to build up their capital buffers.  The 30 potential GSIBS, for the study, were based on their domestic market lending share and share of financial assets in their domestic economy.  

The initial result showed a 1% increase in the capital requirement reduced GDP by 0.06% over 8 years, or a little less than 0.01% per year.  The primary driver of this macroeconomic impact was the increase in lending spreads by 5-6 basis points.  The overall results conceal differences across countries related to role of the domestic financial system, existing capital buffers and international spillover effects.  It was found that by varying key assumptions: such as asset size, a larger bank list, a shorter implementation period or authorities altering only had a limited impact of growth. 

The MAG group looked at the full impact of implementation of all the Basel proposals and increased the capital buffer by an additional 2% for the GSIBs implemented over 8 years.  The actual results of the two components indicate reduced GDP growth by 0.04% per year while lending spreads rise by 31 basis points.  As noted earlier, different assumptions lead to different effects, while faster implementation or a weaker monetary response increasing the impact on GDP. 

The benefits for the GSIB framework relate primarily to the reduction in the exposure of the financial system to systemic crises that can have long-lasting effects on the economy and financial markets.

For more on this follow the link to the BIS:  http://www.bis.org/publ/bcbs202.htm

Wanted: An Inuit Risk Manager

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Recently while driving home from my teaching engineering students about entrepreneurship I was listening to the CBC radio program “Ideas” which had at that time a woman who studied the Inuit (the indigenous people of the Canadian arctic) language and by default its culture.  One of her more interesting discoveries is that one of the Inuit dialects has a term which best translates to X-ray eyes – in this case it is used to describe the situation a lone hunter may find themselves in when on the ice floes.  The idea is that the hunter is alone and with no form of contact with anyone and thus by necessity is forced by themselves to see through all the options that lay before them and “see” their consequences before acting. 

 

This powerful cultural characteristic would be a very desirable trait for a risk manager (and the rest of us).  Effectively what the hunter has done is eliminating the “noise”, list the options and play them out to see which has the greatest net benefit or chance of success – be that pure survival or food.  This would be a highly desirable trait for a risk manager and the metaphor of survival (no bankruptcy) or food (profitability) is rather fitting.  

Taxation rant - Part 2

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Politicians are jumping up and down about tax evasion and blurring the lines between tax evasion and tax avoidance.  Some are saying that, although legal, tax avoidance is immoral.  Presumably this is a prelude to calls to grab more tax.  I find this tendency to be objectionable at the very least.  After all, IRA and charitable deductions in the U.S. and RRSP contribution deductions in Canada can be seen as a form of tax avoidance but are considered desirable from a personal and societal perspective.

 

What is immoral about quite properly avoid paying tax that you don’t have to?  Should people and companies voluntarily pay extra tax and if so, how much?  If there are loopholes, these can be dealt with by legislation, but many so called loopholes encourage investment and wealth creation, which might go elsewhere if plugged.  Politicians often know this but carry on spouting nonsense in any event rather than try to educate people.

Taxation rant – Part 1

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Most western countries are massively fiscally challenged.  In plain English of course that means running large and unsustainable deficits adding to already excessive debt.  And yes, I include Canada as a country that is not the worst but is far too indebted, especially when the Provinces are brought into the equation.  So governments are now under huge pressure to reduce those deficits.  Cost cutting is of necessity a major component of this effort. 

 

Taxes are close to the limit of what people will tolerate, especially here in the UK where years of Gordon Brown saw massive overall tax increases, but governments are still squeezing out extra cash from fees and stealth taxes.  

 

Another part of the effort to squeeze out every possible dollar is beefing up enforcement.  Not only will there be more audits and challenges for businesses, but there will be less (or no) leniency about imposing penalties for the most minor of infractions.  There are many existing filing requirements with new ones springing up all the time.  Many of those requirements are nothing really to do with the amount of tax to be paid but are to provide information, most of which is likely to be of no use and often people are totally unaware of the requirements.  However, they do create traps – and financial penalties for those who get caught that grab yet more of our money.

 

I have 3 examples of areas where tax departments will impose penalties

 

·         Example 1 – UK - a recent quarterly filing requirement in the form of a “Value Added Tax EC Sales List” whereby UK companies must list sales to customers in other EU countries by customer along with VAT registration numbers for each customer.  Presently total sales to EU customers have to be reported on VAT returns (Value Added Tax, which is equivalent to Canada’s GST).  Now businesses have to file this separate form quarterly. Some companies could have thousands of names to report.   This is hugely onerous and for no apparent useful purpose.  Furthermore, the form has to be filed by calendar quarter and that might not coincide with quarterly VAT reporting periods.  Of course, there are penalties for not filing the form or for filing it late.

 

·         Example 2 – Canada – Regulation 105 (which this author has written about before and would be happy to forward information to anyone who requests it) imposes a requirement for Canadian businesses to withhold 15% of amounts paid to foreign service providers, even if no withholding tax is applicable under a tax treaty.  The foreign service provider must file Canadian tax returns to recover these amounts.  There appear to be few Canadian businesses that are aware of this.  However, the penalties for non-compliance can be significant.  I am told that CRA enforcement of Regulation 105 is being stepped up.

 

·         Example 3 – U.S.A. – many U.S, citizens have lived much of their lives outside the U.S. but still have to file U.S. tax returns, even though many of them have little connection with the U.S, and owe no tax under tax treaties.  Unfortunately, the U.S. tax system is a constantly changing minefield.  One requirement is to file a Form 90-22.1 detailing accounts with foreign financial institutions if the total balance in all accounts is $10,000 or more at any time in a year.  This includes all accounts over which the person has signing authority.  This form is filed separately from tax returns.  The penalty for non-willful failure to file is $10,000 for each account.  (Fines for willful failure to file start at $100,000 and can go up to $500,000 plus 5 years in prison.)  Recently, such fines have been imposed on U.S. citizens living abroad who in good faith thought they were in compliance with all their filing requirements.  The fines were so onerous that the Canadian finance minister has even complained to the U.S. about it.  There are obviously reasons for the U.S. wanting to know about foreign bank accounts but applying such fines to honest citizens acting in good faith is not going to convince people that the tax system is fair.

 

It seems that tax departments are aggressively seeking out little known and apparently innocuous filing requirements to grab more of our hard earned cash.  Creating what many may view as absurd filing requirements that only dedicated tax practitioners can hope to keep up with, and imposing stiff penalties for non-compliance may be viewed as confiscation by some, but there is not much we can do but be aware and beware.  The taxman is sharpening his fangs.

Central banking post-crisis: What compass for uncharted waters?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The global financial crisis has shaken the foundations of the deceptively comfortable pre-crisis banking world.  Central banks face a threefold challenge: economic, intellectual and institutional.  Claudio Borio in a paper for the Bank of International Settlements, notes the changing environment that central bankers face going forward; operating in a more hostile economic environment, the current economic benchmarks paradigms and models have failed and central banks will need to adjust their policy framework to maintain their independence. 

Policymakers will look for a new compass that should have the following characteristics: (1) tight interdependence between monetary and financial stability; (2) a greater awareness of the global, as opposed to purely domestic, dimensions of those tasks; and (3) the autonomy of central banks will need to be protected and strengthened. 

Borio notes three lessons that central banks learned from the crisis.  The first is that low and stable inflation does not guarantee financial and macroeconomic stability: monetary policy may have contributed to the crisis’s severity.  This is especially true during a period of prolonged easing.  The use of monetary policy to clean the post-crisis debris can be costly.  Interest-rate policy may not the right policy tool for the nature of the crisis: it is not optimal during a balance sheet recession.  There are times when a disagreement on policy may be as good as consensus.

Borio proposes the compass include adjustment to policy regimes, including the tighter integration of monetary policy and financial stability, adjustment for financial imbalances, consideration of monetary policy response to financial busts, the operational independence of central banks and a keener awareness of the global dimensions of these tasks.    

The key challenges for the implementation of the compass: the operational independence of central banks is likely to come under growing pressure and the need for greater international policy coordination.  A compass for central banks is needed as they sail into uncharted waters.

Please see the attached link for more details.  http://www.bis.org/publ/work353.htm

IMF Fiscal Monitor – Progress on Deficit Reduction

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

According to a recent IMF report, governments are making progress in addressing fiscal policy issues, but downside risks remain elevated as 2011 growth prospects are reduced.  The rising public debt levels in advanced countries are projected to top 100 percent of GDP in 2011.  A large portion of the increase came since 2007 from a drop in GDP, lower revenues and elevated spending damaging government balance sheets.

Overall, fiscal adjustment in advanced countries has declined by over 2% of GDP since 2010.  The improvement in most cases was at or better than expectations.  Progress in fiscal adjustment is better than expected. 

For Europe, the challenge is to sustain fiscal consolidation while minimizing the growth fallout.  Europe needs to focus on crisis resolution mechanisms to help resolve the solvency issues and limit contagion.  Overall, the deficits in the euro area are expected to decline by 2% of GDP this year and 1% next year.  The speed and severity of the spread of financial pressures in the euro should serve as a lesson for the United States and Japan. 

In the United States, a focus is needed on entitlement and tax reforms as well as measures needed to raise revenues and broaden the tax base.  The U.S. deficit is projected to decline by 1% of GDP to 9.6% for 2011.  For Japan, disaster relief and reconstruction are short-term objectives, but more detailed medium-term planning is needed to focus on reducing the debt and budget deficit ratio and raising tax revenues through reforms. 

Emerging markets emerged from the crisis in relatively good shape, with continued progress expected on deficit reduction.  A few countries could be vulnerable to shift in capital inflows.  Low-income countries survived based on buffers built-up in good times, but need to address social spending and their vulnerability to rising food and commodity prices.

However, despite the IMF’s relative slightly optimistic view markets remain concerned about growth prospects.  The IMF noted two risks in the outlook: that public sector insolvency and/or that excessive fiscal tightening are not sources of instability.  The optimal policy is to reduce the deficit in a timely manner without severely impacting growth.

For more on this click on the link to the IMF site:  www.imf.org/external/pubs/ft/fm/2011/02/fmindex.htm