Blog

The Wall Street Alchemist
How does financial innovation impact the real economy?

by Nathan Coplin

Alchemists were known for their efforts to transmutate common metals into more valuable ones like gold. Alchemy is uncommon today, but the practice of transforming the “bad” to “good” continues, especially in the financial industry through financial innovation. It is widely accepted that innovation, in general, improves productivity and stimulates economic growth. However, it is less clear how financial innovation impacts the real economy. 

Recent research led by Thorsten Beck at the University of Netherlands focused on this issue. This research found that financial innovation can stimulate economic growth (GDP) but that it also leads to greater fragility. Financial innovations that improve the effective allocation of capital can be complementary to stability and economic growth. However, new financial products that disguise or repackage risks, particularly those associated with derivatives and speculative trading, increase volatility in the global financial system. Such volatility and excessive risk exposure can increase the likelihood and losses of economic and financial crises. This is best exemplified by the financial innovations that led to the slicing and repackaging of mortgage-backed securities that fueled the 2007-2008 financial crisis. Beck’s research revealed that firms with higher levels of financial innovation suffered the greatest losses during the crisis.

Since then, regulatory measures (Basel III, Dodd-Frank, and EMIR) have sought to reduce risk in the financial sector by requiring higher quality capital and assets – which can be used as collateral to back risky activity, such as derivative trading. This is intended to increase stability and confidence in capital markets and by extension, the broader economy. However, Wall Street alchemists are well-prepared to eschew these new measures and in the process, undermine their intended purpose. The latest financial innovation is “collateral transformation” – essentially turning risky assets (low-quality capital) into collateral (high-quality capital) that can be used to back risky derivatives trading. This may be simply viewed as compliance with new rules, but risk exposure cannot just disappear. The recent JP Morgan “London Whale” trades demonstrate this; despite crafty manipulation and deceit (see Senate Permanent Subcommittee on Investigations report). Further slicing and divvying up of risky assets – particularly complex derivatives – will obfuscate where market risks are located and impede the ability of both regulators and banks to manage them.  This is not to say that all financial innovation is destructive, but there need to be rules for how new financial products or activities can manipulate and hide risk. Without new rules, financial crises may become the new normal.

From 2001 to the 2009, innovative financial instruments helped Greece manipulate and obscure its debt from investors and European regulators. Goldman Sachs, JP Morgan and other firms were able to devise financial products that transferred cash to the Greek government in exchange for rights to future airport fees and lottery proceeds. This innovative trick kept Greece’s increasing debt off the balance-sheet (i.e. hidden) and promised government funds to owners of these financial products on Wall Street – meaning less money for healthcare, education, infrastructure and other programs that directly impact people and their livelihoods. These products are not responsible for the debt crisis in Greece, but they did amplify the problems and directly impact the real economy in the process. Unfortunately, the real economy is never part of the formula in financial engineering. In 2008, the European Union’s statistic agency reported that “the observed securitization operations [in Greece] seem to have been purportedly designed to achieve a given accounting result, irrespective of the economic merit of the operation.”

The world economy is still choking on these innovative financial products and its impact on the real economy is becoming clear. The current crisis in Cyprus is multifaceted and still unfolding, but a major factor is that the investment portfolios of Cyprus’s biggest banks contained assets that were products of financial innovation – including Greek government bonds (i.e. Greek debt disguised as a sound investment). In 2011, when the EU and IMF bailed out Greece, Greek debt was restructured and bond holders were forced to take a loss of 50 percent. Banks in Cyprus lost 4 billion euros which is more than one fifth of the country’s GNP.  This contributed to the current crisis where these same banks are now in need of a bailout. The original terms of the bailout, designed by the IMF and the EU, placed a tax on all depositors to fund the bailout – siphoning money from even low to medium income individuals. Only after vehement public protest was the bailout restructured to only tax accounts with more than 100,000 euros. This has become more politically palatable, but the large depositors to take these losses are not only wealthy Russians but also local institutions, such as the University of Cyprus. The exposure of educational and other public institutions to “garbage assets” – a product of financial innovation – have very real implications for the people and economy of Cyprus. Even with the bailout, the Cypriot economy is expected to shrink by 8.7 percent this year.

When financial innovation leads to the manipulation and concealing of risks, the consequences are clear for Greece, Cyprus and their citizens. The US and other advanced economies have also suffered economic recessions and high levels of unemployment. New financial innovations like “collateral transformation” that undermine stability and transparency will contribute to, not mitigate, future crises. Furthermore, this type of financial engineering permits more risk-taking in the derivatives markets that determine global food and fuel prices. Instability in these commodity markets impact all countries, but has hugely disproportionate consequences for the world’s poorest.

Given the recent damage and potential future consequences, the financial industry needs innovation. However, this innovation must be of a different breed – one that breaks free from pre-crisis models and the short-termism mentality. “We simply cannot have pre-crisis banking in a post-crisis world” said Christine Legarde, IMF Managing Director, earlier this week. We need new investment models not investment vehicles. To guide such a shift, the appetite for quick profits will have to be balanced by rules that encourage less-risky, long-term investing. Similar to the alchemist’s efforts to create gold from junk metals, Wall Street is trying to create profitable assets out of risky ones. Persuading Wall Street to reduce this activity will be challenging, but establishing strong incentives to discourage the creation of “fool’s gold” (i.e. garbage assets) could be a good start.

 

Cheat Sheet for the 2013 World Economic Forum (WEF):

Key points and briefings of the WEF meetings relevant

to global finance and New Rules mission

Opening Address
A New Global Economy for a New Generation, Davos, Switzerland (summary)

In her address to the World Economic Forum, International Monetary Fund’s Managing Director, Christine Lagarde believes the biggest test for 2013, will be maintaining a strong drive for reform. Lagarde points out that 2013 will be a make-or-break year for the global economy.

Lagarde lists the four pivot points in the world, namely, individual empowerment, power transition, demographic changes and environmental challenges. To tackle the aforementioned issues, Lagarde introduces three long-term priorities for the global community to accomplish, such as greater openness, stronger inclusion and better accountability.

Lagarde appeals for countries to transcend national interest and embrace global economic openness. Lagarde continues with the example of Asia regarding how trade and financial integration has benefited the whole region and remains optimistic about the future of the European Union. For a stronger inclusion, Lagarde emphasizes that inclusive growth including social and gender inequality reduction, social safety net building, job creation and public debt cutting is the core objective for policy makers.

Lagarde warns of the risks of climate change and of backsliding on necessary reforms of the financial sector, and admits that policymakers, including the IMF, have underestimated the costs of inequality.

"I believe that the economics profession and the policy community have downplayed inequality for too long," Lagarde said. "Now all of us have a better understanding that a more equal distribution of income allows for more economic stability, more sustained economic growth, and healthier societies with stronger bonds of cohesion and trust."

Lagarde continues to emphasize the importance of finishing the job of financial sector reform and goes on to list a series of risks, including a further dilution of capital and liquidity requirements, a failure to police shadow banks and derivatives, cross-border resolution and compensation.

"Ultimately, again, this is all about accountability: we need a financial sector that is accountable to the real economy—one that adds value, not destroys it,” says Lagarde.

In its updated World Economic Outlook, 2013 will be a defining year for the global economy than 2012. Essentially, Lagarde believes that accountability to not only IMF’s 188 member countries is due but also to the citizens of those countries who hold the IMF to a new standard of effectiveness.

Full speech is available here: Click here

Meetings and Events

 

1. The Global Financial Context

Key Points (to view the video, click here)

• Limits of monetary policy
• Eurozone options
• Real world impact of Basel III and Solvency II
• Future of shadow banking .

2. China’s Growth Context

Key Points (to view the complete summary, please see the Appendix below)

• China’s economy has secured a soft landing – it is now on its way to recovery.
• China’s entrepreneurs enjoy a “broader” set of opportunities than those in the United States.
• Over the past decade, the Chinese government was “digesting” the reforms it implemented in the late 1990s. Now there is a consensus that reform is again needed.

3. Global Design Challenge

Key Points (to view the complete summary, please see the Appendix below)

Creating a sustainable future

• Closing the poverty gap
• Understanding and managing complexity
• Responding to rapid urbanization

4. The Evolving Role of Business

Key Points (to view the complete summary, please see the Appendix below or click here)

• After several “trust shocks”, corporations, their leaders and business at large needs to marry profit with purpose.
• Short-term shareholder capitalism needs to be replaced with a more mature version of stakeholder capitalism (long term, inclusive).
• The next evolution of the role of business should be thought about in terms of “useful capitalism”.

5. The Latin America Context

Key Points (to view the complete summary, please see the Appendix below)

• Terms of trade have determined which countries grew in the recent past, but economic policies will determine future growth.
• Countries must implement market friendly policies that also work to reduce economic and social imbalances and that stimulate economic diversification.
• Brazil’s shift to a more interventionist approach has put it on a low growth path, but a change in policy that would restore faster growth is likely.

6. Open Forum: NGOs as New Models for the 21^st Century

Key Points (to review the video, click here)

• To whom should NGOs be accountable?
• What are their roles and responsibilities?
• Should NGOs be run like businesses?
• What are the opportunities for businesses and NGOs to collaborate?
• What are the drivers to create partnerships? 

7. The Europe Context

Key Points (to view the complete summary, please see the Appendix below)

• Divergent competitiveness levels
• Fiscal-monetary-banking system nexus
• Future of governance institutions

8. The East Asia Context

Key Points (to view the complete summary, please see the Appendix below)

• Peel back the layers of military build-up, high politics, currency fluctuation and imbalances, and one finds in the towns and villages throughout East Asia an enormous vital economic transformation.
• The China-Japan relationship has been deteriorating since 2010 when the countries began to fight over the Senkaku Islands; the territorial dispute has escalated over the past four months.
• For all the economic competition and national differences, most countries in the region share the common challenge of an ageing population, a shrinking workforce and no social safety net.
• Free trade agreements, most recently the Trans-Pacific Partnership, will continue to unite regional interests and help ease geopolitical tensions sparked by nationalistic rhetoric.

9. Global Leadership in Transition

Key Points (to view the complete content, click here)

• Facilitating international trade negotiations
• Coordinating macroeconomic policy
• Resolving territorial and maritime disputes

10. The Arab World Context

Key Points (to view the complete summary, please the Appendix below)

• Expectations have risen among Arab populations as a result of the Arab Spring. But so has unemployment as a result of the instability.
• Regional integration must move higher up the agenda as a way to boost trade and job creation.
• The Syrian conflict is at the top of the Arab world’s geopolitical concerns, but the Arab reaction has been characterized by division and inaction.

11. Forum Debate: Rise of Unconventional Monetary Policy

Key Points (to view the complete summary, please the Appendix below)

• Quantitative easing helped to prevent financial crises in many countries from becoming a protracted depression worldwide.
• These policies come with long-term risks including hyperinflation, asset bubbles and financial burdens on future generations.
• Knowing when to end quantitative easing is also a challenge for today’s central bankers.
• Adjusting interest rates is also a tool to balance the impacts of quantitative easing, and some predict that the US is likely to raise rates in the coming years if the economy continues to grow.

12. G20 Outlook

Key Points (to view the complete summary, please see the Appendix below)

• As G20 president, Russia will focus on investment, financial regulation and job creation, among other priorities
• While the G20 has won legitimacy due to its crisis response and its early accomplishments, questions continue about its relevance
• To boost its relevance – perceived or real – the G20 will have to effectively address such persistent challenges as unemployment

13. Eurozone Crisis – The Way Forward

Key Points (to view the video, click here)

• Enhancing political vision and fiscal order
• Developing effective governance frameworks
• Instituting smart reforms

14. From Interdependence to Integration

Key Point (to view the complete summary, please see the Appendix below)

• Asian integration on the ASEAN group of nations, has been a success story, yielding substantial economic dividends
• Economic pragmatism is encouraging states to set aside political disputes, with China and Japan signing a Free Trade Agreement and India and Pakistan agreeing to normalize trade
• Political tensions remain investors’ key concern and the key to integration

15. Rebuilding Europe’s Competitiveness

Key Point (to view the complete summary, please see the Appendix below)

What critical steps are needed to achieve long term prosperity in Europe?

• Design the roadmap to growth
• Catalyse action among European leaders 

16. Turning Transparency into Growth

Key Points (to view the complete summary, please see the Appendix below)

• Companies believe they know in the meantime what they have to do to minimize the risk of corruption
• The challenges in many parts of the world remain formidable
• The business case of fighting anti-corruption is less obvious

17. Accelerating Infrastructure Development

Key Points (to view the complete summary, please see the Appendix below)

• The global infrastructure deficit requires an annual investment of US $2 trillion each year for the next 20 years
• The worlds “savings surplus” provides an unprecedented opportunity to address this infrastructure deficit
• Public-private partnerships (PPPs) are not a silver bullet; in many cases, bespoke solutions are required. One challenge is to overcome public resistance to pay-per-use services such as road tolls
• Governments can do a lot – including providing clear priorities for development and providing forms of limited guarantee – but the private sector also needs to step up, especially in terms of financing
• Long-term investors such as pension funds can become a significant source of capital if development risks can be mitigated or offset

18. Closing Critical Inequality Gaps

Key Points (to view the complete summary, please see the Appendix below)

• Of the world’s 3 billion workers, 800 million on the less than dollar a day, even as the rich grow ever richer – over two-thirds of GDP growth in the United States goes to less than 1% of the population
• The causes of inequality include globalization, the changing and accelerating nature of technology, rent-seeking and corruption, and taxation that favors speculators over creators of real value
• Among the solutions are turning into talent through education and entrepreneurship, reducing or eliminating rent-seeking, reforming taxation regimes, and revitalizing the labor union movement
• Its necessary to be more inventive and come up with fresh ideas to narrow inequality gaps because the technologies now in the pipeline will bring far more profound changes in the near future

19. The Secrets of Competiveness

Key Points (to view the complete summary, please see the Appendix below)

• Competitiveness, economic growth and tackling unemployment should be the focus in a post-global financial crisis landscape
• With the Doha Round stagnating and no prospects for revival, nations are pursuing bilateral and regional trade agreements to boost exports
• Examples of countries strengthening national competitiveness are found in Chile, France, Germany and Singapore
• There is much work to do to achieve innovation-based growth on the 10 pillars of competitiveness as outlined in the World Economic Forum’s Global Competitiveness Index

20. The Economic Malaise and Its Perils

Key Points (to view the complete summary, please see the Appendix below)

• Policy-makers must address the global unemployment crisis
• Services, not manufacturing, is the growth sector in China
• Economic growth can no longer rely on labor arbitrage
• Technology, particularly smart phones and in the Internet, is destroying traditional jobs, while creating opportunities for people to create jobs
• Government, business and educational institutions all have important roles in ensuring that job seekers have skills employers need.

21. Catalyzing Innovative Development Partnerships

Key Points (to view the complete summary, please see the Appendix below)

• Public-private partnerships are key to meeting today’s development challenges
• Projects driven by innovation and technology can be leveraged and taken to scale globally
• Global partnerships need funding from the public and private sectors, as well as participation from civil society

22. Creating Economic Dynamism

Key Point (to view the video, click here)

• Faced by fiscal and competitive pressures, how can governments put economies onto a path of stable growth and higher employment?

23. Investing for Impact

Key Point (to view the complete summary, please see the Appendix below)

How are investors addressing the world’s growing social and environmental challenges?

• Benefits of private equity and venture capital
• Investment policies for sustainable and inclusive growth
• Establishment of capital markets for social entrepreneurs

24. Emerging Economies at a Crossroads

Key Point (to view the complete summary, please see the Appendix below)

• Emerging markets cannot rely solely on high growth to achieve sustainable development
• While many developing economies are continuing to grow robustly, they must implement necessary structural reforms to boost productivity, competitiveness and the resilience to withstand shocks
• Developing economies of the fast-expanding middle classes and rapid urbanization

25. Open Forum: Eurozone – Solidarity or Domination?

In today’s challenging political and financial climate, the Eurozone has many trials ahead. As Europe prepares for the Eurozone 2.0, it will have to balance smart and inclusive growth with smart austerity measures. Is the European dream of Solidarity, stability and integration a broken promise?

Key Questions (to view the video, click here)

• How can we reconcile diverging interests among European nations?
• Should budgetary discipline be enforced? If so, how?
• Can Germany effectively run the Eurozone’s economic policy?
• How should the birth defects of the Eurozone be rectified to achieve competitiveness on the global stage?

26. Japan Growth Context

Key Points (to view the complete summary, please see the Appendix below)

• Business and economy confidence rose after the establishment of new ministry
• Investment in innovation is effective for economic growth, however the timeline had to be considered
• Giving freedom to the private sector and diversity management in the business sector are the keys to revitalizing the economy.

27. China’s Next Global Agenda

Key Points (to view the video, click here)

• Inbound and outbound investment
• Global and domestic financial reform
• Role in international cooperation and negotiations

28. Sustaining High-growth Markets

Key Points (to view the complete summary, please see the Appendix below)

• Simply because an economy is growing fast does not mean foreign investors will make money
• To maintain, Russia must pursue institutional reform and diversify away from reliance on oil and gas
• There are investment opportunities in Latin American in providing financial services to the poor
• China’s manufacturing sector is burdened by overcapacity. China must shift its growth model from manufacturing for export towards domestic consumption

29. An insight, An idea with Jim Yong Kim

Key Point (to view the video, click here)

• A conversation with World Bank President on his breakthrough idea on emerging trends and transformational opportunities in global development and climate change

30. The Global Economic Outlook

Key Point (to view the video, click here)

• What should be at the top of the agenda for the global economy in 2013?

31. Banks in the Real Economy

Key Points (to view the complete summary, please see the Appendix below)

• Reforms in liquidity and capital are showing positive progress
• Anxiety continues about unethical behavior by banks
• Industry has concerns about structural solutions

 

Appendix

 

2. China’s Growth Context

China’s new leadership, announced in November, is expected to begin implementingeconomic reforms that will ensure Chinacontinues to grow at roughly 8% for the next few years. These reforms will likely enhance anti-corruption measures, clarify the relationship between central and local governments, promote the development of the private sector, and reduce the income gap between rich and poor.

As China moves beyond manufacturing into a more innovation-driven economy, the new generation of entrepreneurs, and the educational system fostering them, provides a cause for optimism. People like Pony Ma, chairman of Internet giant Tencent, and Jack Ma, founder of e-commerce pioneer Alibaba, are exposed to the international community and understand corporate governance better than their predecessors. To better foster this kind of talent, some universities in China are switching from a system that favours passive learning and narrow specialization to one that emphasizes questioning received wisdom and prioritizes analysis. As a result, instead of wanting to join state-owned enterprises, college graduates are more likely to have the same dreams as Microsoft co-founder Bill Gates, Google co-founder Larry Page, and Michael Dell, CEO of the eponymous laptop company.

In the second and third quarters of 2012, China experienced lower than hoped for growth. But another promising sign, noted one panellist, is that “for the first time, consumption is leading the economic recovery”. He cited financier George Soros’ criticism regarding the Asian financial crisis in 1997 that the investment-driven growth of Asian economies was not sustainable. Consumption, and not investment, drove China’s 2012 fourth quarter growth rate.

One area where everything is not rainbows and buttercups is political reform. Changes that China’s new leaders, many of whom will be confirmed in their government positions in March, should consider include transforming from a government that “approves things” to one that “provides goods and services”. At the same time, China’s new leaders should reduce the influence of state-owned enterprises (SOEs); the government and government-run companies “hold more than 50% of current assets”, said one panellist, fostering monopolies and making it more difficult for China’s promising small and medium enterprises to grow.Other ideas for political reform bandied about included “creating some sort of checks and balances” that would strengthen China’s rubber stamp congress, and prioritizing rule of law “to protect private rights”. The real indicator of whether the administration is serious about political reform, one panellist said, is whether the government is willing to reform themselves.

3. Global Design Challenge

The aim of the session was to raise awareness of the growing importance of design and share bold ideas on how it can foster change in addressing a range of global issues in the 21st century. So, were there any “bold ideas” in the panel? Not really, but that didn't detract from a great debate. I think Sir Tim Berners-Lee’s framing of the challenge of understanding the macro fully when you design for the micro was extremely insightful. Certainly it was a diverse and honest discussion about current and future challenges on designing for global challenges and to scale.

The panel was moderated by Paola Antonelli, Senior Curator, Department of Architecture and Design, Museum of Modern Art New York, USA, now heading up the Global Agenda Council on Design Innovation. She gave the initial cue: “Design is not just cute Italian furniture or fast cars.” That became very clear when the eclectic panel spoke. Overall, I felt that it was an interesting, abstract and diverse discussion about the power of creativity. I'm not sure that any of the global design challenges are solvable as we stand, but perhaps just realizing what they are brings us closer.

4. The Evolving Role of Business

Harvard Business School Professor Nancy Koehn, interestingly enough a historian by education, charmingly led a lively and interesting debate about the role of business (which probably referred to both the role of business today in our hyperconnected and “perma-crisis” world, and the role of business in society going forward). The moderator opened with a reference to Bill Gates’ call a couple of years ago in Davos for “creative capitalism” and to John Mackey’s recent book contemplating examples of what he calls “conscious capitalism”.

There was broad agreement on the diagnosis, i.e. that business (like leadership in general) has gone through several “trust shocks” and needs to rebuild such trust and confidence in leadership and business.

When it came to remedies, the panel ultimately circled a lot around the discussion of the perceived dichotomy whether more non-financial reporting/transparency or more value-based individual leadership is the prime prerogative. I believe both. 

Ultimately – and the panellists would agree with that – we need to move on from short-term shareholder capitalism to long-term stakeholder capitalism. A movement also from the single bottom line via the “triple bottom line” back to a “new single bottom line”. In the long term and in an inclusive view, this is what business is about. Such a concept would include social and environmental “externalities”. 

In private conversations, I have recently started coining the term “useful capitalism”. Corporations need to be long term and “net useful” for society at large. This goes far beyond talk of licenses to operate or CSR reporting. If and when (and that holds true through history, as Nancy Koehn would probably agree) they are useful, they make money. 

Actually, the most useful companies to their stakeholders at large are often the most financially successful in history. And then people (consumers, employees, long-term shareholders, governments) will trust corporations and leaders again. Capitalism can and should be that simple, that useful.

5. The Latin America Context

Latin America is currently divided into two economic blocs: countries such as Mexico, Chile, Peru, Panama, and Colombia that have embraced more market-friendly policies; and those such as Venezuela, Argentina, Bolivia and Cuba that follow more state-centred and interventionist policies. Brazil’s policies put it between these two blocs.

The different policies between these blocs have not been significant for per capita income growth in recent years. Countries with divergent policies, such as Argentina and Chile, are at the top of this measure, while other countries with divergent policies, such as Mexico and Venezuela, are at the bottom. Instead, terms of trade have determined success. Countries such as Mexico that compete with China in export markets have suffered, while raw material producers that provide supplies to China have benefited.

However, in the future, the difference in policies will determine economic and income growth. Countries such as Argentina and Venezuela are stagnant and on the verge of crisis, while the future looks promising for countries with market-friendly policies such as Chile, Colombia, Peru, Panama, and Mexico. 

Countries that have already achieved macroeconomic stability must work to reduce social and economic imbalances. Countries dependent on raw material exports must adopt policies to diversify their economic base and strengthen manufacturing, thereby integrating the Latin American urban worker into the global economy. But the policies used to encourage diversification should not be too interventionist. Rules that require a certain percentage of domestically produced content in resource extraction or infrastructure projects may backfire, reducing investment and growth. Fiscal reforms, including a reduced dependence on payroll taxes, and increased investment in education and research, are better ways to reduce economic imbalances. Efforts to reduce bureaucracy, lower import tariffs, welcome qualified immigrants, and invest in infrastructure will also spur growth. 

Brazil implemented a series of modernizing reforms between 1994 and 2006, but then the structural reforms stopped. The government has adopted a more interventionist path, including in state-controlled companies such as Petrobras, which has seen its market value punished as a result. Brazil’s exchange rate is no longer floating, inflation has been above the official target, and fiscal restraint has been eased. As a result, investor confidence has fallen, investment rates are seeing zero or even negative growth rates, and the economy is on a low-growth path. But the government is showing signs of having learned from its mistakes, and the country will likely resume the policies that can increase growth, though it may go through a few painful years first. 

7. The Europe Context

The mood this year was markedly more upbeat about Europe – a case of a glass half full, especially from the perspective of business leaders on this panel. There was little talk of crisis or concerns about a potential euro break-up; and, perhaps more remarkable yet, there was consensus on what Europe should do. First, deliver on what it promised, by creating a true single market, especially in areas such as services, where local regulations inhibit innovation and cross-border activity. Second, do away with the protection of incumbents and inflexibilities of all sorts, especially in the weaker and more gridlocked countries of the South. Third, re-focus on the real issues: innovation, productivity and education (more vocational training than ivory tower), thus tackling unemployment and inequality. This, after all, is what will assuage the markets and allow for funding to return to Europe.

Latvia was used as the poster child of what other troubled European countries should do: Bite the bullet, face the truth, and then turn an 18% contraction into the fastest growth rate in Europe. It all hinges on credibility in attracting investments, which can then drive employment growth and allow for the social state to function. Positive signals, especially from Asian investors, were used to confirm the guarded optimism in the room.

With cost of labour having already declined, and with quality of people and technology being an important part of the equation, some (but clearly not all) European countries may take back some of the industrial production they offshored. Of course, challenges remain. With new banking regulations in place, European banks have to reduce their lending. This might not be an issue for the larger corporates, but SMEs, especially in countries where funding traditionally came from banks, are finding it difficult to access financing.

Underneath this guarded optimism, though, lie deeper problems. Europe has not quite resolved its own governance structure, nor has it managed to shift its focus from “being the best place to live”, to “being the best place to work, invent, explore”. There are lots of differences in the EU, with some countries, sectors or regions doing well, and others not, and the disparity (and the pressures this poses to the euro) does not seem to decline. The efforts to engage in reform are often held back by local politics or diluted by an administration that does not want to change; and countries such as Greece, undergoing a managed reform progress, are suffering from poor implementation and limited progress. And, much as capital may “wait in the wings”, it does require stable infrastructure to return, especially in more troubled areas.

So, what we need to address are the hard questions: the implementation of structural reforms is tough, and Europe has not, yet, become a “governance union”, with members with stronger accountability and discipline helping upgrade the skills and structures in their weaker peers. Yet, if we want this continent with 7% of the world’s population and 25% of global GDP to punch its weight, we’ll have to address these issues head on. In this sense, for all of its risks, David Cameron’s challenge might even help the European debate, for all the risk that this might have for the United Kingdom and its economic future. Without doubt, 2013 will be a crucial year.

8. The East Asia Context

When a panellist asserted favourably that East Asia is transitioning towards a bipolar world between China and the United States, others disputed this hypothesis. They argued that China never has been nor will be a political hegemon in the region; interference in the internal dynamics of another country is neither in its cultural DNA nor in its long-term economic interest. The region, rather, is becoming multipolar.

While all expressed concern over the potentially explosive nature of the recent territorial dispute, tensions over the Senkaku Islands appear the exception to the rule of decades of happy coexistence in the region. Leaders in both China and Japan appear equipped to resist pressure from their bellicose domestic power bases and to pursue a more peaceful course.

Resolving these issues, said a panellist, leaves two approaches open. Either modern revisionism might change the map of the world within the framework of nationalism, perhaps through hard power. Or postmodern revisionism could transcend the era marked by the Treaty of Westphalia and seek through soft power to make the East Asian community more like the European Union, where everyone can prosper together.

Outside forces could give heads of state more room to negotiate towards the latter approach. One force is resurging competitiveness. It is in Japan’s long-term interest not only to join the Trans-Pacific Partnership, a free trade agreement, but also to leave the door open to China joining down the road. Another dynamic is the United States. The US State Department has taken the position not to favour any party’s claims, and maintains strict neutrality, but it also made clear its support for Japan’s national security. Still, Japan cannot overplay its hand, or provoke confrontation, lest it find itself isolated.

A third force for regional stability, paradoxically, may be nuclear deterrence. A panellist argued that just as Pakistan and India became less likely to go to war once they both demonstrated nuclear capacity, so it is, he argued, with China, Korea and, indirectly, Japan.

Underscoring foreign dynamics, a panellist argued, is prosperity at home. Restless constituents from the Arab Spring to East Asia are speaking up to demand better long-term stewardship. It’s all about money, affirmed one panellist, and that calls for a smart, stable and transparent regulatory framework that encourages competition and builds investor trust. In that respect, an ageing workforce and not enough jobs for a smaller pool of younger workers are a concern.

One discussion focused on the future of peaceful coexistence on the Korean peninsula. One participant suggested security could spread through vigorous pressure by both China and the United States to erase the border and merge the two countries, as happened with Germany two decades ago. But most countered that reunification is entirely a domestic issue requiring a referendum from the people of North and South Korea, regardless of outside foreign influence.

10. The Arab World Context

Unemployment was one of the underlying issues of the Arab Spring, along with the demand for political rights. Legions of unemployed educated youth with high expectations drove the initial revolutions in Tunisia and Egypt. They still have high expectations, but two years on, regional economies have not rallied to meet them. Unemployment has risen. Overwhelmingly, the region’s population is young – 70% of the population of Saudi Arabia, for example. Panellists largely agreed that the economic and stability ramifications of the Arab Spring, especially the conflict in Syria, will get worse before they get better.

Several Gulf states, such as Saudi Arabia and Qatar, sought to meet the challenge with public-sector pay rises and stimulus packages. But some panellists pointed out that since sustainable, long-term growth must be the goal, government handouts are not the answer. Indeed, graduates should be discouraged from dependence on getting a public-sector position. Creating jobs and fighting corruption are crucial. Many Arab states have made strides in establishing accessible, quality education. But even in those countries, panellists and audience members believed much more must be done to tailor training to employers’ needs. An entrepreneurial spirit should be instilled earlier to enable graduates to create their own opportunities.

Governments must manage popular expectations, in large part by being more transparent about the problems they face. That holds particularly true for countries such as Egypt and Tunisia, where sweeping change has encouraged demands for jobs and better living standards just as the political process has entered unchartered territory. Instability has kept investors away and joblessness has risen. Necessary political debate has been diverted, in Egypt and Tunisia, to discussions of Islamic Sharia law and its implementation, disillusioning the more secular. Another breaking point could easily be reached.

But Arab world challenges cannot be blamed on economic factors alone, one panellist warned. Unemployment does not occur in isolation. Political inclusiveness enables governments to deliver its plans effectively. Only a government with a clear vision can attract investors. And only if the system is functioning can the private sector create useful jobs in any quantity.

Greater regional integration would also create jobs and boost regional economies, and panellists agreed it must rise up the agenda. Some examples exist, and the Gulf countries particularly absorb many Arab workers. But boosting regional trade could create significant opportunities.

Syria dominated the discussion of geopolitical tensions. Now two years old, the conflict has embroiled major regional players such as Turkey, Qatar and Iran. More than in any other Arab uprising, sectarianism has exacerbated the crisis. Paralysis at the United Nations Security Council has stymied international action.

Asked about finding Arab solutions to the problem, panellists admitted to being at a loss. Some said Arab powers would like to intervene, but have insufficient capabilities. That drew an audience member to question the point of billions of dollars-worth of Gulf arms purchases. Others asked why insurgents fighting the regime of Syria’s president, Bashar Al-Assad, remained poorly armed given widespread Arab support, particularly from the Gulf. Many expressed regret over Arab inaction and the deep divisions within the region over how to stem the bloodshed.

11. Forum Debate: Rise of Unconventional Monetary Policy

In the face of the recent financial crisis, many central banks around the world looked to quantitative easing as a strategy to minimize economic damage. Often referred to as “unconventional” monetary policy, it allows central banks to alter the relative price of secure assets and encourage investors to take greater risks. By going beyond traditional interest-rate adjustments, central banks were able to intervene to prevent a more serious cascade of defaults during the financial crisis.

While an immediate financial crisis was averted, the long-term effects of these policies remain unclear. Hyperinflation is often cited as a risk; however, panellists argued that central bankers can still raise interest rates to counter this threat. Greater emphasis was placed on the risk of asset bubbles, as recently occurred in real estate markets. Quantitative easing could drive an increase in commodities prices and fuel the demand for scarce resources, which could distort markets.

Quantitative easing also places a burden on future generations to pay off today’s borrowing. By delaying the time in which deleveraging takes place, these policies allow much of the world to continue to enjoy economic growth. However, future consumption must be used to service this borrowing, which could drag down long-term GDPs.

Given the relative newness of quantitative easing and uncertainty about its effects, a number of questions remain about how to “wind down” such programmes. Some financial experts have argued that policy should be pegged to specific targets, such as a date or a measure of inflation rates or unemployment. Such a structure would signal that quantitative easing is a temporary policy response. Others argue that verbal commitments will never be convincing and that central bankers retain a range of tools, including raising interest rates, to respond dynamically to changing economic conditions.

Moral hazard remains a serious problem of quantitative easing. As central banks in many parts of the world have intervened to offset the most damaging effects of the financial crisis, some experts worry that behaviour in the private sector has been altered. The effects of overleveraging and taking excessive risks have been minimized. In the pessimistic view, the severity of crises has increased as the problem of moral hazard has been compounded with central banks’ intervention.

The consequences of failing to employ quantitative easing polices could have been much more severe, according to the policy’s advocates. Further, these unconventional monetary policies could be phased out if economies that have employed them continue to recover.

12. G20 Outlook

The global economic recovery has been weak, with unemployment a continuing challenge, said Dmitry Medvedev, Prime Minister of the Russian Federation. As it takes on the presidency of the G20 and leads efforts to bolster the global economy, Russia will pursue an agenda focused on investment, the global currency regime, financial regulation, further reform of the International Monetary Fund, job creation, promoting innovation and infrastructure development. The group will continue to counter protectionism, he assured participants. Medvedev also said that, to bolster the G20’s legitimacy and effectiveness, Russia would aim to make the G20 process as transparent as possible and would maintain the now customary consultations with non-member governments. “As chair of the G20, Russia will make every effort to look for fresh solutions to global economic problems,” Medvedev pledged.

The G20 agenda is broad and ambitious, yet it labours under questions about its legitimacy and relevance. In the midst of the crisis, when the global economy was on the brink and trade was collapsing, the G20’s emergence as the prime platform for managing international financial and economic affairs was welcomed as a major breakthrough in the recasting of the global system. Now, as the threats have subsided, the organization has shifted from crisis response to long-term reform.

But can this cooperative fusion of developed and developing economies work coherently? Russia’s task this year, following Mexico in 2012, is to ensure that it does. “Somebody has to conduct that orchestra,” explained Ngaire Woods, Dean, Blavatnik School of Government, University of Oxford, United Kingdom. “And not only does the G20 [president] need to conduct that orchestra, but it has to ensure that all members of that orchestra perform well.”

To be sure, the G20 is not without major accomplishments: coordinated fiscal stimulus, financial system reforms, recapitalization of the IMF, an anti-corruption action plan, and pledges to resist protectionism. The G20 is credited with pulling the world back from the abyss. This feat won it widespread legitimacy, though some countries that are not members have argued that, while it is more representative than the G8, it is still not representative enough.

More pressing is the question of the G20’s relevance. As the international community moves back from the edge of the cliff, it is natural that the tight embrace of collaboration, forced by the crisis, should loosen. How relevant the G20 is – or how relevant it is perceived to be – will depend on how effectively its coordinated measures drive growth and bring down unemployment, especially among young people. Addressing joblessness will be a particularly difficult challenge. “The old theory is that if you get growth, then jobs will come,” reckoned John Evans, General Secretary, Trade Union Advisory Committee to the OECD, France. “Now you have to break into that confidence trap. There is no certainty of government policy. A third of the world’s unemployed are under 25. It’s a social time bomb.”

One way to stimulate job growth would be to create favourable conditions for entrepreneurs, suggested James S. Turley, Chairman and Chief Executive Officer, Ernst & Young, USA. If the G20 provides regulatory and policy certainty across countries, entrepreneurs will move, he argued. The G20 can also take collective action on the economic empowerment of women, immigration and the fight against corruption.

To secure its relevance, the G20 should also promote global economic stability through further financial reforms and regulation (such as the full implementation of the Basel III banking standards), recommended Fernando Aportela Rodríguez, Undersecretary of Finance and Public Credit of Mexico. It can also broaden and deepen its anti-corruption efforts, said David T. Seaton, Chairman and Chief Executive Officer, Fluor Corporation, USA.

The G20 has evolved significantly from being an information-sharing group to being an organization with a set of processes and mechanisms that “if used well can work well,” remarked Gordon de Brouwer, Associate Secretary, Domestic Policy Group; G20 Sherpa, Department of the Prime Minister and Cabinet of Australia. “Implementation is always imperfect. But don’t mistake imperfection with complete failure.”

But the process will not guarantee results. There is a danger that the G20 could be caricatured in the same way as the G8 – as an ineffective organization of grand gestures and plans that are not implemented. Outreach and transparency could help people to understand the G20 better and boost its perceived relevance. The G20 could find creative ways to make its initiatives more effective. For example, instead of counting on national implementation, it could pursue some of its programmes at the city level, Turley proposed. Expanding the G20 process could also help. For a few years now, the business sector has been integrated into the discussions through the G20 Business Summit, or the B20. This year, labour and finance ministers will hold a joint meeting for the first time.

The fact is that, with the urgency of the crisis having subsided, consensus decision-making will be much more difficult, especially across a broad agenda, said Ksenia Yudaeva, Chief, Presidential Experts’ Directorate; G20 Sherpa; Office of the President of the Russian Federation. “We are at the stage where easy solutions are not on the agenda anymore.”

14. From Interdependence to Integration

Asian integration has gathered pace in the past few years, focused on the Association for Southeast Asian Nations (ASEAN). Participants in this session were unanimous in their view of ASEAN as a success story, which has yielded substantial economic dividends and closed gaps between Asian countries. Growth in Malaysia, Thailand and Vietnam, for example, averages 5%-9%. International investors have been drawn to the region and intra-Asian investment is also growing, such as Singaporean investment in Malaysia and South Korean Hyundai and Samsung’s presence in India. ASEAN cooperation has also yielded political dividends, speakers said, with economic growth helping political stability and vice versa.

Asia’s economic potential is unequalled worldwide, participants argued. One reason is the complementary nature of the various economies, which include service centres such as India, manufacturing centres such as China and commodities centres such as Australia. More effective cooperation between the various types could yield “fantastic opportunities”, one speaker pointed out. One reason for ASEAN’s success, a participant argued, is that it avoids interference in sovereign affairs, and relies on consensual decision-making rather than the unanimity required by the European Union.

Political tensions remain the main concern for big business. One participant warned that territorial disputes in the South and East China Sea risk clouding the otherwise positive outlook for the region. Another risk, he warned, is corruption, which could prevent Asia’s middle-income countries from completing their growth trajectory and breaking through the threshold to achieve rich-nation status. Another risk may be beyond the control of Asian nations, one participant said. He feared the region could increasingly become the arena for an international contest for supremacy between China, Japan, Russia and the United States.

But as integration has snowballed, economic pragmatism has increasingly trumped political rivalry. China, Japan and South Korea launched a Free Trade Agreement in 2012 despite long-standing disputes. Those three countries have also partnered with ASEAN as part of the ASEAN Plus Three grouping. ASEAN Plus Six, which adds Australia, India and New Zealand, is also, in the view of one speaker, making slow but steady progress despite what he felt was Washington’s diagnosis to the contrary. FTAs outside the ASEAN umbrella are multiplying; India has now signed 23, with a further 44 in the pipeline.

Only South Asia has bucked the upwards trend, being the least integrated region not only in Asia but the world, one speaker said. Two factors account for the difference. The first is India and Pakistan’s historical adversity, stretching back to independence. Second, the countries of the sub-region long pursued inward-looking policies, only opening up to free trade and investment flows in the 1990s. However, 2012 saw a historical agreement between India and Pakistan to normalize trade relations even in the absence of political rapprochement. One speaker expressed optimism that such pragmatism could eventually enable South Asia to follow the footsteps of the rest of the region.

Despite the rosy picture, participants felt there was room for further progress and that searching for philosophical and cultural common ground could help to build a sense of Asian identity. Asian countries must also learn to put aside narrow national interest so that they can work together to overcome some of the problems affecting them all, such as climate change, health pandemics and terrorism.

15. Rebuilding Europe’s Competitiveness

This is a well-worn topic, but in true World Economic Forum fashion new ideas and great energy meant that a new perspective was achieved.

The most surprising moment was when participants were asked if Europe citizens properly understand the challenges facing them. Only five hands went up, including three finance ministers; the politicians believed in their electorate while the business folk were not so confident. But, when presented with a scenario of what Europe will achieve by 2020, radical ideas flowed and there was confidence in Europe’s ability to get there.

One group had to imagine the success and the other failure by 2020. Both groups came up with the same issues: a sustained reform programme over many years; reinvented institutions; fairness and gaining the trust of the people; catalysing the young catalysers; and making change irrevocable. These were the keys to success.

Some radical concrete ideas emerged – all non-EU students who completed degrees in the EU could have the right to live and work there; universities needed to escape from state control so they can be entrepreneurial; far more continuous professional development; retaining and abolishing entry restrictions into professions; and changing bankruptcy laws to encourage risk taking.

Perhaps the most surprising theme was that there had to be an ethical and social component to any reform programme. It was not just that the enemies had to be chosen carefully (rent seekers, tax evaders), but also that the losers had to have skin in the game. Markets could not work without the trust of the people and a sense of fairness. All agreed that it was vital not to underestimate the challenge and to invest heavily in gathering political consent right at the start, while making sure that a burning platform provided the driving force for the acceptance of change.

There was debate on whether to start big and go for the great prize, or build momentum from smaller beginnings. But all agreed that opening markets had to come before institutional reform, and going for early wins avoiding legal complexity was key.

The session had begun with the Forum presenting its new report, “Rebuilding Europe’s Competitiveness”, which showed there was a big gap between the EU and the US (and even South Korea and between the north and south in Europe).

Participants agreed with the big conclusions that we need multistakeholder partnerships, sustained leadership, a sense of urgency and clear communications. And it all depends upon entrepreneurship, innovation, mobilizing talent and making markets work.

Encouragingly, most people in the room seemed to think that Europe can do it by 2020.

16. Turning Transparency into Growth

In a lively debate, four chief executive officers and a Central Bank governor tackled the issue whether there was a chance of turning transparency and anti-corruption into growth. Representatives from emerging economies were very outspoken about the high levels of corruption going hand-in-hand with the high growth rate of their economies. They deplored the weakness of the justice systems and rampant impunity in their countries. They demanded stiff law enforcement action against “big fish” in order to demonstrate to the public-at-large that these states were serious about fighting corruption

The CEOs stressed (reputational) risk and cost. They talked about the increasing cost of non-compliance. They also mentioned the cost of compliance. On the business case for anti-corruption, the actual topic of the event though, they were fare less outspoken. Only after prompting from the audience, they did mention collective action of competitors and/or the public sector as a creative solution.

Finally, in the course of the debate, it was mentioned that following the money trail to financial havens was indispensable.

17. Accelerating Infrastructure Development

In recent decades, rapid economic and demographic growth, coupled with severe under-investment in infrastructure, has created an infrastructure deficit that some estimate would require an annual investment of over US$ 2 trillion each year over the next 20 years.

At the same time the world faces a “savings surplus”, providing an unprecedented opportunity to address this infrastructure deficit.

What is needed are better mechanisms to match the funds with viable infrastructure projects.

Governments around the world are trying to position their countries as recipients of funding in their efforts to bridge the infrastructure gap.

Ukraine, for example, has focused its development plan on improving infrastructure. Coming off its success in hosting the UEFA Euro 2012, the country is undergoing deregulation and creating incentives for investors to come in. For instance, the enormous oil and gas sector has been partially privatized, with joint-stock companies created to allow private investors to participate.

In Asia, total infrastructure needs are estimated at more than US$10 trillion over the next 10 years, more than double the spending of the previous decade. Asian governments do not have the financial capacity, know-how or technology to develop these projects alone – strong private sector involvement is required. Though true progress will take time, PPP projects in the Philippines, Vietnam and Indonesia show great promise.

Africa continues to face serious infrastructure challenges. Infrastructure investments bore the brunt of post-crisis reductions in public expenditure on top of dramatic declines in private investment. This has had an immediate negative effect as high growth rates in Africa have been driven by infrastructure development and progressive policies. Improvements in ICT infrastructure, for example, were a strong contributor to the region’s improved growth performance over the period 1990 to 2005, and responsible for adding almost one percentage point to per capita growth rates.

Panama provides a compelling example of how infrastructure can be one of the main drivers of an economy. The country’s GDP growth has averaged 10% in recent years on the back of large projects such as the Panama Canal expansion as well as smaller metro, road and hospital building projects.

There are many things governments can do to address the infrastructure deficit. First, provide clear lists of priority infrastructure projects. Second, provide transparent, stable tariff structures. Third, shift the mindset away from government projects to PPPs. Finally, enhance risk mitigation via guarantee structures or innovative mechanisms to de-risk investment during the development phase.

18. Closing Critical Inequality Groups

To close inequality gaps, it is important to first understand what they are and their causes. Inequality in income is the most obvious gap, with 800 million of the world’s 3 billion workers living on less than a dollar a day. Most of the rest are doing only marginally better – even as the bosses in multinationals, banks and other large companies earn 500 times more than they do.

There is also inequality in opportunities, where those with no access to education, for example, are denied the chance to rise from the bottom. When there is inequality in resources, those who have no access to capital are unable to start and nurture their own businesses or otherwise improve their skills, knowledge and marketability in the workplace.

There have always been inequalities among segments of the population, particularly in the wake of disruptive developments such as the Industrial Revolution. However, the inequalities we see today are unprecedented in their magnitude and speed of expansion. Given instant communications, social media and the Internet, they pose the single biggest risk to social stability across the world.

Globalization is one cause of inequality, as capital and production migrate from one country to another in search of the most cost-efficient way to manufacture and sell goods and services. Rent-seeking is another cause – this is the act of obtaining gains through manipulation of the political and economic environment around economic activities, rather than creating those economic activities.

One panellist placed the blame squarely on the supposed abdication by employers of their responsibility to their workers, and the lack of restraint at the top about rich compensation packages while those at the bottom are nickeled and dimed. This assertion was refuted somewhat by a participant in the audience, who pointed out that small business owners like himself have no access to capital and suffer from competition with multinationals and large local companies, forcing them to cut corners whenever they can.

While agreeing that globalization and rent-seeking are major contributors to inequality, another panellist observed that technology is actually the key cause of the gaps. For example, manufacturing in China continues to expand at a rapid clip, but there are now 25 million fewer people employed in those factories. That is because automation is eliminating many repetitive jobs. A robot that works almost round-the-clock is “paid” only US$ 4 per day today; that cost can fall exponentially in the future.

Over 65% of employees in the United States are now information workers, with most of the rest needing to work with technology in their daily tasks. Transforming labour, understood as referring to manual, repetitive tasks, into talent (workers with high-level skills and knowledge who typically work in services) is one of the proffered solutions. This means giving everyone access to good quality education from an early age. Training and funding for entrepreneurship are also important, along with the provision of social safety nets that would encourage people to take on the risks of starting their own business.

Eliminating or reducing rent-seeking will also help, but this requires political will that may be difficult to find in many societies. Governments should wield the power of taxation to discourage speculation and trading of value and promote real economic activities. Again, political will is required – there will undoubtedly be strong pushback in raising taxes on the earnings of hedge fund managers, for example, described by one panellist as “speculators who create zero value”.

One panellist made a passionate plea for eliminating the fear and insecurity among workers in many countries and companies by lifting the restraints on the labour union activity and giving workers a voice in setting pay and working conditions.

Another panellist noted that all these courses of action are useful, but there is also a need to be more inventive and come up with fresh ideas. Computers and the Internet are already allowing goods, services and talent to be replicated and disseminated to billions of consumers at little cost. New technologies in the pipeline will accelerate this trend and bring more changes.

19. The Secrets of Competiveness

Many participants at the World Economic Forum’s Annual Meeting believe the worst of the global financial crisis is over. If so, public and private sector actors can now focus on boosting competitiveness, kick-starting economic growth and tackling burgeoning unemployment. Participants debated how to strengthen national competitiveness and whether lessons learned can be transferred regionally and globally. 

Chile has benefited from an open trade policy for 40 years. Today, the country has 60 free trade agreements, which makes it an attractive foothold for companies wanting a gateway to Latin America and beyond. The government is focusing on enhancing competitiveness by better managing state resources, which includes reducing labour absenteeism in the public sector, controlling the use of extra time, recovering medical insurance claims for public employees and paying suppliers within 30 days. Chile’s economy depends on copper. Therefore, running fiscal policy to cushion the economy and compensate for wild swings in exchange rates means spending according to permanent revenues – i.e. saving in boom times and spending in down times. Chile’s public sector is a net creditor by about 9% of GDP, but it placed US$ 1 billion on a 10-year sovereign bond in New York. The government did not need the money, but wanted to set a benchmark for interest rates for the private sector, which helps Chilean companies to raise money and invest in the country and the region.

Eight months into France’s new government, major reforms are underway to tackle public finance challenges, including a legacy of sovereign debt that doubled over 10 years and a deficit hitting historical rates. Austerity measures include regaining France’s sovereignty towards capital markets to better control interest rates it pays, raising taxes on higher contributors and lowering taxes for small businesses and low-income individuals. The government intends to spur growth through its National Pact for Growth, Competitiveness and Employment, which offers lower taxes and business costs, access to funding, greater incentives, and supports innovation, rolling out high-speed broadband throughout the country and a streamlined and stable regulatory, administrative and tax environment. Other measures are: reducing payment delays, which are particularly painful to small and medium enterprises (SMEs); and reducing labour costs by 20 billion euros annually. France’s labour markets are viewed as rigid, but an agreement between government and trade unions could pave the way for more flexibility. 

A social market economy and a division of labour between business and government are the fundamental principles driving the economic environment in Germany. In this division of labour, the government establishes the framework for competitiveness by establishing efficient, effective supply chains across a range of sectors, a sound financial framework, a balanced budget, low unit wage costs, affordable energy and flexibility in the labour market. Attempts are being made to streamline bureaucracy and pursue privatization. Germany’s robust SME sector is given freedom to do what it does best – business. Striking the balance is a challenge – when the state intervenes, the balance shifts. Now that the Eurozone crisis is over, the EU can get back to business and turn to the objective of the Lisbon Agenda, which focuses on making Europe the most competitive knowledge economy by 2020 by building innovation and strengthening competitiveness.

Singapore is a small country with no natural resources, yet it ranks as second only to Switzerland in the Forum’s Global Competitive Index. Singapore’s success is driven by flexibility, competitive hard and soft infrastructure and a total commitment to an open labour market. The country must continuously question what it is doing to attract investment and listening to what business needs; productivity and innovation remain major challenges to competitiveness. 

From the private sector’s perspective, the question to ask is: If you could be anywhere, where would you be drawn to set up a business? Who is “punching” above and who is “punching” below their weight, and who is using its natural advantages? Competitiveness factors include:

The rule of law – Can investors recover their investment? Can investors sue in local courts and get justice? Can investors sue a local company or sovereign and get justice?

A fair tax system 

An educated population

Good housing and schools

English has a competitive advantage because in today’s world it provides people with “liquidity” to go more places and interact with more people

A flexible labour force – a business should be able to withdraw without heavy penalties; if an investment is “illiquid” for example in manufacturing and production, the returns must be higher

A welcoming, diverse cultural environment

With the Doha Round stagnant and little signs of revival, nations are pursuing bilateral and regional trade agreements. This is critical and will help open markets. Germany, for example, depends on open markets for its supply chains – 60% of its trade is with the EU and 40% of that is within the Eurozone. More than 95% of Chile’s exports are to countries with which the country has free trade agreements. An import tariff of 1% makes Chile an attractive place to do business.

The Forum’s Global Competitiveness Report 2012-2013 assesses the competitiveness of 144 countries across 10 pillars and provides insight into the drivers of their productivity.To view the report, please click here.

20. The Economic Malaise and Its Perils

With the banking and financial crises subsiding, the focus of this session was on continuing high employment. Spain announced recently that unemployment hit a record 26%, with a destabilizing rate of 55% among young people. Guy Ryder, Director-General, International Labour Organization (ILO), Geneva, said: “The Spanish numbers are appalling and there is no light at the end of the tunnel. But we have a global jobs crisis. While the financial crisis is abating, jobs losses continue. Policy-makers need to tackle the jobs crisis.”

However, things are not bleak in East Asia. Mohd Najib Bin Tun Abdul Razak, Prime Minister and Minister of Finance of Malaysia, noted that Malaysia enjoys essentially full employment. “After the crisis of the 1990s, Asia came up with a new economic model that created new investment”, he said.

Despite talk of a current malaise, Li Daokui, Head, Department of Finance; Director, Center for China in the World Economy (CCWE), Tsinghua University, People's Republic of China, urged participants to keep sight of the big picture. “In recent decades, billions of people’s lives have improved. Technology, particularly smart phones, is creating a quiet revolution.”

Li Daokui acknowledged that the Chinese economy is slowing down from double-digit growth rates, but the slowdown is healthy, to a sustainable 7%-8%. China created 12 million new jobs last year, with private enterprise becoming more active in the services sector. “Services, not manufacturing, is the growth sector”, he said.

Jim Hagemann Snabe, Co-Chief Executive Officer, SAP, Germany, pointed out that global economic growth can only go so far relying on labour arbitrage – transferring jobs to cheaper labour markets. The technological revolution is automating many jobs, but it is also providing the opportunity for “people to create their own jobs”, he said.

Iceland has recovered more quickly from the financial crisis than many countries. Olafur Ragnar Grimsson, the President of Iceland, said this was because Iceland rejected the IMF’s traditional advice, let its banks fail, and devalued its currency. Rather than focusing on saving banks, Iceland focused on helping people and creating jobs. Unemployment in Iceland is now at about 5%, significantly lower than in much of Europe. “Iceland proves that recovery is possible in Europe. The problem is wrong policies,” Grimsson said.

He added: “New technologies allow even uneducated people to participate in global markets. Everyone can talk, even if they can’t read. These technologies give power to poor people.”

Ali Babacan, the Deputy Prime Minister for Economic and Financial Affairs of Turkey said: “Confidence-building is at the centre of Turkey’s economic policies.” He said Turkey chose to reduce deficits, but promote high growth rates through private investment. The government provides incentives for private sector employment by paying social security contributions for new workers, paying for training of new workers and subsidizing transportation. Through these targeted employment promotion policies, Turkey leads in unemployment reduction, according to the ILO, Babacan added.

Panellists addressed the critical need to match skills with employers’ needs if unemployment, particularly youth unemployment, is to be reduced. SAP has programmes to retrain young people to provide them with needed skills, Snabe said. “Both educational institutions and business have a role in training employees. The concept of apprenticeships should be revived,” Ryder added. The Turkish government covers the costs of vocational and practical on-the-job training. “The costs of these bridging processes are minimal compared with the number of jobs created,” Babacan said.

Panellists also considered the impact of social welfare systems on employment. Li Daokui argued that these systems must be designed to give people incentives to work rather than live on welfare. In Europe, welfare systems are too generous, while in China they are too weak, he suggested. Grimsson observed that the Nordic countries have the highest levels of social welfare, but also some of the most competitive economies. “Businesses see the value of having good social welfare programmes,” he said.

21. Catalyzing Innovative Development Partnerships

Today’s massive development challenges can be met through public-private partnerships that engage civil society and focus on projects driven by innovation and technology. These projects can be implemented in an evidence-based local community context and, if successful, leveraged and taken to scale globally. 

Participants discussed successful and highly visible public-private partnerships, including the Global Fund to Fight AIDS, Tuberculosis and Malaria (GFATM). GFATM is undoubtedly a success. Its model of innovation is a wheel with four spokes:

Technology and science – new vaccines, new drugs

Applying old things in new ways – for example, medical male circumcision as an important strategy for HIV prevention

Implementation innovation – this takes place at the national and local levels by people who know how to get the job done.

Civil society – to help overcome non-health factors such as cultural and social norms; for example, many women will not go to a prenatal clinic to receive care and treatment because their mothers did not

Other successful partnerships include the Global Alliance for Vaccines and Immunization (GAVI), which is making significant inroads in saving the lives of millions of children in developing countries who do not receive vaccines. At a CEO breakfast in Davos during the Annual Meeting 2013, the GAVI Alliance announced an additional US$ 25 million in matched pledges from three private organizations, significantly expanding private sector involvement in saving lives. The pledges bring the total raised so far to US$ 78 million.

An innovative public-private partnership launched the United Nation’s Weather Info For All initiative to improve Africa’s weather monitoring network in the face of the growing impact of climate change. This network has saved the lives of thousands of people, including those who used to set out to fish on Lake Pretoria without weather information. Today, they receive weather news via community radio and text messages on mobile phones.

However, despite the obvious benefits of partnering with the private sector, there are many innovative public-private partnerships waiting to happen. Several participants pointed out that the money is there, but there is a lack of funding and political will. For example, the Green Climate Fund, designed to scale up long-term financing for developing countries by raising US$ 100 billion per year in pledges, is empty. But a climate change tax levied on each tonne of CO2 emitted worldwide would certainly help.

There is an urgent need for an agriculture fund for smallholder farmers in developing and least-developed counties. The public sector must step up with more funding – the private sector cannot do this alone. At the same time, many governments are grappling with “old fashioned” official development assistance, but it is time to start innovating using credit, loans and guarantees within public-private partnerships.

The Earth is on a collision course with planetary boundaries on many fronts. Making economic growth compatible with sustainability is an unprecedented challenge. The most important issues to address as the world careens towards explosive population growth and climate change include extreme poverty, low-carbon energy and sustainable food supply.

We are living in a time of unprecedented scientific revolution – the Digital Age.

Technologies exist to completely transform the world and address the most pressing issues. The tools are there, but they are not being used effectively. Where is the political will? Technology can be used for disaster management, early warning systems and knowledge dissemination. It also is key to developing and scaling up renewable energy sources and creating healthcare systems that deliver.

A spinoff of the digital revolution is the messaging around development. In the past, it was positioned as “the helper and the people to be helped”. This is no longer the case. With a population of 7 billion, communication is 7 billion multiplied by one because the technology exists to learn and listen. In this way, individual voices play a part in innovation.

Unleashing the creative power of young people will entail eliminating illiteracy. Every young person should have access to cost-free education. This creative power is at work in social businesses being created around the world. These non-dividend companies solve social problems. This is a development model that can be scaled up.

23. Investing for Impact

Mainstreaming impact investing has been a multi-year initiative of the World Economic Forum. Through ongoing workshops, working groups and research, the Forum has initiated a dialogue based on the premise that confidence in impact investing starts with a widely agreed upon definition. 

Forum working groups have defined impact investing as investments that are motivated by the intention to create social or environmental good with measurable results.

Panellists during the Annual Meeting 2013 session, , highlighted several challenges to mainstreaming impact investing, including an early-stage ecosystem, small average deal sizes, how the strategy fits into traditional asset allocation frameworks, fiduciary hurdles, education and uncertainty around metrics, as well as how to measure impact or “what is socially/environmentally good”.

Solutions to these challenges include supporting intermediaries that are creating metrics, educating the industry, supporting scalable business models, and emphasizing transparency and accountability.

Top areas of interest mentioned during the session were:

1. Studying how investors make portfolio allocation decisions, and what role impact investing should play in the portfolio
2. Comparing financial returns of impact investors with market returns
3. Sharing best practices in impact investing, as well as the importance of looking at opportunities and barriers in emerging markets

24. Emerging Economies at a Crossroads

In the aftermath of the global economic crisis, emerging markets, particularly the BRICS – Brazil, Russia, India, China and South Africa – have been touted as the new drivers of global growth. China, India and, to some extent, Brazil had already been on investors’ radar screens for some time. More recently, with the developed economies still weak, growth in the larger emerging markets has also flagged. China slowed down to 7.5% last year, while India’s fell below 7%. Other big rising economies – the so-called Next 11 (including Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, Turkey, South Korea and Vietnam) – have grabbed the spotlight.

It is not possible to generalize about all emerging economies. China, for example, is in a class of its own because of the size of its economy and its population, while South Korea is among the world’s most developed economies. Still, the question is whether emerging markets have been more hype than substance – are they new poles of growth for the global economy?

Among the emerging economies, there is no lack of enthusiasm and certainty that they will continue to step up. “If we move up the value chain, we can achieve double-digit growth and sustain it,” Sanusi LamidoSanusi, Governor of the Central Bank of Nigeria, said. With a low base of infrastructure and other growth enablers, his country was already managing to grow at 7%, he said. 

Brazil, for its part, has simply paused to put a lid on an overheating economy, said Alexandre Tombini, Governor of the Central Bank of Brazil. In recent years, buoyed by the dividend gained from China’s demand for its natural resources and energy, the Brazilian economy has made significant strides in reducing poverty and creating employment. Brazil has been transformed, Tombini observed. The country’s leadership is thinking long-term and focusing on increasing productivity and competitiveness by implementing structural reforms, such as the reduction of payroll taxes. It is also investing in infrastructure to unlock new growth.

Mexico, too ,is cultivating its own garden by focusing on addressing its law-and-order situation and boosting economic productivity. According to Luis Videgaray Caso,Secretary of Finance and Public Credit of Mexico, security is still a problem but the country’s new president is taking a more forceful approach. “Mexico is not just about violence,” Videgaray insisted. Like Brazil, it is pursuing reforms that will put it in a good position to take full advantage of a recovery in the US.

Meanwhile, China is aiming to transform its economy from one dominated by manufacturing for export and fixed-asset investment to one more broadly based, with growth driven by domestic consumption. The expansion of urbanization and the rise in Chinese people’s incomes will drive this crucial transformation, said Yi Gang, Deputy Governor, People’s Bank of China, People’s Republic of China. “We are focusing in the quality of growth and will pay more attention to energy efficiency and environmental protection. We have to continue reforms and the open-door process to make structural adjustments.”

It is not only the developed economies of Europe or America that need to restructure to rebound. Emerging markets can no longer expect consistent high growth without themselves building resilience by implementing targeted reforms. Those that are serious about achieving sustainable growth will without doubt continue to attract investors. Emerging markets will continue to be key drivers of global growth, especially with their growing middle classes, reckoned Muhtar A. Kent, Chairman of the Board and Chief Executive Officer, The Coca-Cola Company, USA. He noted that innovations are now coming out of these developing economies, including “frugal innovations” such as a beverage bottle made out of plants that his company is sourcing in India.

For Carlos Ghosn, Chairman and Chief Executive Officer, Renault-Nissan Alliance, France; the emerging markets, notably the BRICS, are where business growth will be for some time. China, he noted, is already the largest car market in the world. His group is also making moves in India with the low-end marque Datsun aimed at capturing consumers who currently ride motorcycles, he said.

26. Japan Growth Context

After Shinzo Abe became Japan’s prime minister for the second time in December 2012, the Japanese economy entered a new phase of revitalization. Panellists shared their views on the strategic shifts and transformational issues shaping the growth context in Japan. 

Some of the interesting highlights included:

New economic growth policy: Revitalizing the Japanese economy and breaking away from deflation is the target. The implementation of the “Three Arrows” economic policy – based on agile fiscal management, bold monetary policy and growth strategy – has received a positive response. Structural reform by deregulation, especially in the business sector, is another key factor to achieving economic revitalization; breaking down barriers at the ministry level would influence this achievement.

China-Japan relationship: The relationship with China is critical; exports to China have fallen due to the reignited and ongoing dispute over ownership of the islands last year.

Innovation: Although investors remain confident about innovation, the timeline has to be considered, as profits coming from new research sometimes take decades to realize due to a complex application process.

Diversity: Furthering female employment is a key to success for the GDP growth. Japan is ranked 101 out of 135 countries according to the Forum’s Global Gender Gap 2012 report, and improvement is needed, especially in the business sector. According to the research of Goldman Sachs, Japan’s GDP would rise by 15% if there were gender equality for employment.

28. Sustaining High-growth Markets

This session considered the views of asset managers with expertise investing in high-growth markets in Russia, Asia and Latin America. They described risks and opportunities in those markets.

Simply because an economy is growing fast does not mean that foreign investors will make money. The key is to find companies with management that will look after the interests of minority investors. Good management is more important than the legal framework.

Russia has seen spectacular growth in recent years, but there are massive challenges to sustaining it. Large infrastructure investments are needed. Governments are financially constrained; public-private partnerships will be required. The challenge is how to attract private investment. Russia must pursue institutional reform and diversify away from reliance on oil and gas. The Russian oil and gas sector is likely to be adversely impacted to some degree by growing shale gas production in North America.

Foreigners wishing to invest in Russia are well advised to invest with Russian partners and with downside protection. Corporate governance in Russia must be improved if foreign investment is to increase substantially.

Emerging market economies will continue to grow fast because of high percentages of young people in their populations, most of which are at the bottom of the economic pyramid. These segments of the population need goods and services and aspire to have them, but presently cannot afford many of them. These people lack access to financial services provided by traditional banks. Providing financial services to the “unbanked” poor presents great opportunities. To do so requires a regulatory environment that fosters inclusion of the poor, technology capable of handling high volumes of small transactions, and an understanding of the market segment to be served. The best opportunities for investment in financial services for the poor in Latin America currently are found in Mexico and Peru. Finding profitable investment in Latin American is challenging because there are very few listed companies.

China has enjoyed extremely high growth rates for two decades, but investors have lost money. Some Western investors believe that the only predictable way to make money in China is through investment on the Hong Kong stock market. China’s growth has been fuelled by very high savings rates and reliance on exports. This model is unsustainable. China must shift towards growth based on much greater domestic consumption. As the current adult generation reaches retirement and the next generation – smaller due to the impact of the one-child policy – enters the work force, savings rates will fall.

China’s growth rate has declined from double digits over many years to 7.8% in 2012. This decline occurred in the manufacturing sector that is plagued by overcapacity. For example, there are an estimated 157 car manufacturers in China and 25% overcapacity. Thus, even though China is experiencing explosive growth in car sales, investment in the Chinese car industry is not profitable.

Each panellist provided some investment advice that included the following:

• Look for individual companies that have some unique attraction such as market share or regulatory protection. Avoid companies in commodity sectors or subject to overcapacity. The banking industry in China is attractive because the spread between deposit rates and loan rates is fixed by the government. China remains a most attractive investment destination.
• Consumer finance for the unbanked bottom of the pyramid is attractive in Latin America.
• The Russian government is actively seeking to attract foreign investment. Infrastructure investments with downside protection are attractive.
• India is an attractive investment destination. The banking sector is attractive, particularly big bank stocks in emerging markets.

31. Banks in the Real Economy

Basel III is not a perfect system, but reforms specifically in liquidity and capital are showing positive results. Banks are operating with two to three times the capital available to them before the global financial crisis.

There is a need to restore market discipline and transparency. The crisis was partly attributable to regulation failure, but behaviour and lack of supervision were equally culpable. Controversies such as the LIBOR-fixing scandal have resulted in a crisis of trust between the public and the banking sector. There are no quick solutions for this. It requires better governance and an absence of missteps from the banks.

Banks must also make greater efforts to connect customer expectations with outcomes. The adoption of staffing policies which reward ethical behaviour as part of performance reviews is another tool being adopted by banks to supervise behavioural standards.

Traditional banking regulation has focused on the institutions rather than the interconnection between the institutions. In this context, microprudential policies are no substitute for macroprudential regulation. 

by Nathan Coplin

Nearly five years after the financial crisis, trust and confidence in financial institutions are weaker than ever – according to a recent study “What’s Inside America’s Banks” by Frank Partnoy and Jesse Eisinger published in the January issue of the Atlantic. This should not be a surprise, as the activities and disclosures (e.g., annual reports or financial statements) of large financial institutions are increasingly opaque and esoteric.  The study finds that the complex financial statements and disclosures woven together by finance lawyers and accountants have created a curtain too thick to unravel – even for sophisticated investors. Partnoy and Eisinger report that “disclosure obfuscates more than it informs.” The authors arrive at this position by closely examining the disclosures – which are supposed to serve to inform investors – of one particular bank: Wells Fargo.

They selected Wells Fargo because it has a history of stability, dedication to costumer trust and conservative behavior - a reflection of one its largest shareholders, Warren Buffet. However, what they found (from what was discernable) was that Wells Fargo is heavily involved in risky trading. Wells Fargo’s annual report revealed a $377 million loss from the trading of Collateralized Debt Obligations (CDOs). Although this loss is relatively small compared to the bank’s capital reserves of $148 billion, the authors emphasize that the actual loss reveals nothing about the bank’s actual exposure to risk. In fact, they discover that Wells Fargo’s risk exposure is incredibly worrisome and in the trillions of dollars in notional value.

Equally worrisome is the opaque and convoluted manner in which these risks are disclosed. Partnoy and Eisinger find that sophisticated investors, former bank executives and regulators all agree that bank disclosures and financial statements are difficult to decipher. They closely inspect some of the non-interest income activities (trading activities) of Wells Fargo, such as “customer accommodation” activity. Although this activity sounds benign, it can be linked to giant bets in the derivatives markets. Partnoy and Eisinger discover that these activities expose Wells Fargo to risk amounting to $2.8 trillion in notional value. Wells Fargo’s exposure is miniscule compared to other banks like JP Morgan whose activities are exposed to around $72 trillion. That is five times the size of the US economy.

Furthermore, there is no meaningful public disclosure of banking assets and activities related to commodities and energy – one of the riskiest trading areas. Goldman Sachs reports commodities under its business segment called “Institutional Client Services” – another deceptive category. In addition to misleading categorization or veiled disclosure, some commodities activities go unreported altogether. Banks only report what is part of commodity trading and do not report activity related to physical commodities – which contains immeasurable risks, such as legal liability, financial loss, geopolitical risk and reputation damage in event of industrial accidents, oil spills, or other environmental damages.

With risk exposure of this magnitude, mitigating future crises and reducing instability in the current financial system will require complete, accurate and non-misleading disclosures. Partnoy and Eisenger suggest simplifying the rules and ensuring that CEOs and CFOs pause to sincerely reflect on the consequences when signing off on financial statements and disclosures. However, with over 30,000 pages of Dodd-Frank rules and continued impunity for banking executives, these remedies will be slow-coming.

Moreover, bank disclosure of risk is not only a problem within the borders of the United States. The Financial Stability Board (FSB)[1] has acknowledged this as a global challenge – establishing the Enhanced Disclosure Task Force (EDTF) in May of 2012. The EDTF was charged with developing principles for enhanced disclosure and to identify best practices. These are important first steps toward improving disclosure; however, the membership of the task force consists entirely of representatives from large global banks and rating agencies (member list available here). This creates a conflict of interest. Although the expertise and experience of large global banks is necessary for developing better disclosure policies, there is a strong motivation to subject oneself to a minimal amount of reform. Recommendations for enhanced disclosure need to be the product of a broader consultation. If banks write their own rules, neither risk disclosure nor risk management is likely to improve.  Hopefully the FSB country authorities will be alert to the gross conflict of interest as they review the recent recommendations from the EDTF.[2]

 

Read more »

Need for Sovereign Debt Restructuring Mechanism becoming more apparent

Since Argentina defaulted on its debt in 2001, most of its creditors have agreed to some restructuring. However, a few have not. And according a court ruling last November, that is the problem. The New York court ruled that Argentina must repay in full the bondholders which have not agreed to restructuring (New York hedge funds Elliot Associates and Aurelius Capital). In addition, the court ruled that if Argentina does not repay them, then it would be illegal for Argentina to fulfill its commitments to creditors that did restructure. If the original bond agreements would have included collective action clauses (CACs), the majority of bondholders could have required the "holdouts" (e.g., Elliot Associates and Aurelius Capital) to accept a restructured agreement. Without CACs, one bondholder can block any agreement to restructure a country's debt obligations.

However, CACs will not serve as a panacea for sovereign debt problems. Collective action clauses would only apply to new bond issuances and do not cover other debt instruments, such as bank loans, trade credits, or any official sources of credit. A stronger remedy would require a Sovereign Debt Restructuring Mechanism (SDRM) that would help resolve existing and future sovereign debt problems. In 2002, the IMF proposed a change to its articles of agreement to create a global SDRM that would address all forms of credit to sovereign debtors:  private, bilateral and multilateral.  Civil society organizations objected to the SDRM because one of the creditors (the IMF) would serve as the “judge,” thereby violating a core principle of bankruptcy workouts.  The US, holding sufficient votes to veto any initiative at the IMF, eventually opposed the SDRM, as did most middle-income countries (MICs) - Mexico being the most vocal.  The MICs were concerned that any support for the SDRM would be interpreted by creditors as an indication that they were anticipating default or might choose to default in the future.  The immediate outcome for MICs would be higher interest rates for their bonds. Today, emerging and developing economies may be similarly apprehensive. Agreeing on a global SDRM will be challenging and slow-going, but it is clear that the current approach to sovereign debt workouts is inadequate and problematic. What is imperative in the short term is that all creditors respect the current debt workout arrangements, otherwise all past debt workouts are put in jeopardy.

The Financial Times has published several stories and editorials on this issue. Below is the most recent article:

The Way the World Manages Insolvencies Needs Fixing

Protests are rippling from Wall Street to all parts of the globe, and the ongoing effects of the financial and economic crisis have brought home to people worldwide the intrinsic connection between financial regulation policies and the social contract in any given society.

This is in stark contrast to the two particular myths prevailing before the financial crisis. The first was that private financial firms could be trusted to exercise self-regulation. By seeking out their own self-interest, it was argued, the firms would inevitably end up pursuing the behaviors that were optimal, ultimately, for society as a whole. Government regulation was seen as an intrusive attempt to second-guess the outcome that market forces in their free interplay would achieve. Another prevailing myth was that the framing and design of financial regulation must be reserved to certain trained experts, only ones qualified for the job because of their understanding of the technical complexity of financial markets. Technocracy was to rule the market, not the rest of democratic society.

The financial collapse and its aftermath represent a moment of awakening about the interdependence of financial regulatory choices with a broader set of public interests.

Read more »

August 22, 2012

Since the overthrow of autocratic leader Hosni Mubarak, investor confidence and economic growth in Egypt has been stymied. To relieve downward pressure on its currecny and cover government expenditures, Egypt has been borrowing from the local market at expensive rates. The country has also depleted its foreign reserves to the point that it can only afford about three months of imports. As a result, Eygpt has seen its bond yields increase to unsustainable levels - around 16 percent. These conditions have led many to assert that an injection of foreign funds is necessary to stabilize Egypt's economy. 

Since June 2011, the IMF has been engaged with Egypt to negotiate a new loan. As of today, Egypt has formally requested $4.8 billion.

Negotiations with the interim government were unproductive. The IMF stipulated that there be broad political consensus on Egypt's economic plan before a loan would be approved - a comlex task for a post-revolutionary state. In February 2012, the first economic plan was rejected by the Muslim Brotherhood-led parliment. And in June, a Mubarak-appointed judge dissolved parliment. Political consensus was scarce. 

However, since the election of the Muslim Brotherhood's presidental candidate, Mohamend Morsi, the IMF has begun to re-egage with Egypt. The IMF managing director, Christine Legarde, traveled to Egypt on August 22 to discuss the loan with President Morsi. It seems now that the IMF is willing to accept the democratically elected government as a "broad political consensus." Without a functional parliment, Morsi's new government might be the closest thing to consensus in Egypt. Given that Morsi was democratically elected, their is hope that he will push for a different set of arrangements with the IMF than his predecessor. In fact, there is some evidence this might happen. Abdallah Shehata, economic adviser to President Morsi, told an Egyptian paperthat "The new [economic] program will have more focus on social justice, it will be a fresh start for talks with the IMF." 

However, the degree to which the economic plan tilts toward social justice will depend on negotiations. It seems the IMF plans to loan to Egypt through its Stand-By Arrangements (SBA), which means disbursements will be conditional on quantitative performance criteria. Therefore, the Morsi government will need to develop quantitative indicators for its social objectives that will be approved by the IMF technical team arriving in September. The other option is for the IMF Executive Board to waive the criteria for the SBA. 

Either way, given the critical problems facing Egypt right now - namely, unemployment and security - it is time for the IMF to support a new economic plan.

 

 

 

Paulo Nogueira Batista Jr. 

March 2012


1. The staff’s paper on Quota Formula Review – Initial Considerations (SM/12/29) is a very
useful contribution to the review of the quota formula. As we all know, the comprehensive
review of the formula by January 2013 is an important element of the 2010 quota and
governance agreement.

2. Staff reminds us in the first paragraph of the paper that this agreement includes as one
of its key elements: “Continuing the dynamic process aimed at enhancing the voice and
representation of emerging market and developing countries, including the poorest, through a
comprehensive review of the quota formula by January 2013 to better reflect the economic
weights; and through completion of the next general review of quotas by January 2014”, as
stated by the G20 Leaders in their Seoul communiqué. Some Executive Directors seem anxious
to stress that we should not prejudge the outcome of these reviews. It is undeniable, however,
that the Board is not starting from a clean slate. We are obliged to abide by the commitments
our authorities have signed up to.

3. The G20 and the IMFC have also agreed, and reiterated this guidance more than once,
that the distribution of quota shares should reflect relative weights of Fund members in the
world economy. Lest this be misinterpreted, I draw attention to the fact that the link between
quota shares and relative weights is invariably accompanied by the observation that these
relative weights “have changed substantially in view of strong growth in dynamic emerging
market and developing countries”. Thus, there is only one way to understand the commitments
made by Leaders, Ministers and Governors: quota shares should be derived from relative
economic weights with the latter corresponding to shares in world GDP. I attach to this note
the language on quotas and quota formula agreed to by the G20, the IMFC and the Board of
Governors since the last review of the quota formula in 2008.

4. Based on these commitments, GDP should be at the center of the review of the quota
formula. In my view, the quota formula should be streamlined so as to basically retain a
compressed blend GDP variable. This would align the ranking of calculated quota shares with
the ranking of economies by size, i.e., by their relative weights in the world economy, while
providing at the same time some protection to the small countries. We could also consider
raising the share of GDP-PPP in the blend from the current 40 percent. The compression factor
should be maintained in the formula, and possibly increased, to reduce the dispersion of quota
shares and especially to favor the smaller members.


5. At this stage, the Fund should discontinue work on variability and openness. These are
fundamentally flawed variables and their weaknesses have been widely recognized inside and
outside the IMF. I favor dropping both from the quota formula and increasing pro tanto the
share of GDP.

6. Variability is supposed to be a measure of the potential need for Fund resources. In the
current report, staff recognizes the many conceptual and measurement flaws of the variable. In
recent years, several attempts to redefine variability have led us nowhere. Moreover, the
relation between quotas and access to Fund resources became tenuous. Last year’s paper on
Quota Formula Review – Data Update and Issues (SM/11/226) showed that GDP, rather than
quota, has been a better gauge of potential access to Fund financing in exceptional access cases
since the Mexican crisis in 1995. For these and other reasons, I welcome staff’s appraisal that
there is a case for dropping variability from the quota formula.

7. Unfortunately, staff falls short of making the same appraisal regarding openness,
despite similar or even worse problems. As currently measured, openness results in double or
multiple counting because of the use of a gross measure. This problem is increasing over time
reflecting greater vertical integration and trade in intermediate goods. Measuring openness on
a value-added rather than gross basis could, in theory, mitigate double counting. However, staff
indicates, once again, that this is not feasible due to data availability constraints.

8. The traditional rationale for including openness in the formula is flimsy. Presumably,
countries that are more open to trade and financial flows have a greater stake in promoting
global economic and financial stability and should, therefore, be rewarded with higher quotas.
As staff notes, however, some have argued that larger economies tend to be more closed but
still have a major stake in international stability. The whole reasoning is essentially arbitrary. It
could also be said, for instance, that open economies more easily “export” their domestic
imbalances and shocks, especially through financial channels, and should thus be punished with
lower quotas. If we continue down that route, we will find all kinds of sophistic propositions to
justify our preferred quota variables.

9. I see little value in further discussing alternatives ways of measuring financial openness
and including it directly in the formula. The staff paper shows abundantly that there are several
obstacles to moving in this direction. Including financial openness as a separate variable or
increasing its weight inside the openness variable would distort the distribution of quota
shares, favoring a few international financial centers, tax havens and jurisdictions with lax
regulatory frameworks. Severe data availability constraints stand in the way of using the
International Investment Position (IIP) as a way of measuring financial openness. The existence
of large data gaps and significant measurement challenges, partly due to the complexity of


international financial transactions, lead staff to conclude that on balance IIP is not suitable for
inclusion in the quota formula.

10. As a proxy for financial openness, investment income also presents significant
measurement issues, as explained by staff, and is already included in the openness variable as
currently defined. The use of investment income flows would leave unaddressed the issue of
how to treat international financial centers. Indeed, the presence of financial openness in the
quota formula tends to reward countries that have large international financial centers relative
to their size, including those that attract financial institutions by adopting low taxes or soft
regulation and supervision.

11. Similarly, the discussion on ways to capture financial contribution in the quota formula
can be seen, at best, as a mere distraction. Staff highlights one key difficulty: financial
contributions to the Fund come in many different forms (bilateral lending, participation in the
FTP and NAB, funding of the PRGT, funding of technical assistance, and charges and fees
associated with borrowing from the Fund, among others). Any attempt to aggregate these
different types of contribution would be arbitrary.

12. There is, however, a more fundamental issue. Including financial contributions in the
quota formula would amount to putting up quotas for sale. We might as well auction off quotas
going forward. Is it not obvious that this approach would tend to crystallize the institution as a
“rich man’s club”? High-income members would gain automatic advantage vis-à-vis the rest of
the membership, especially the poorer countries. Therefore, and given the arguments that staff
itself presents in the report, I see no reason to continue to explore the inclusion of financial
contributions in the quota formula. This sort of proposal flies in the face of the commitment to
reform the institution and make it more credible, legitimate and representative.

13. I continue to support the update of the classification of advanced and emerging market
and developing countries to mirror the World Economic Outlook.




ANNEX

G20, IMFC and Board of Governors
Agreed Language on Quotas and Quota Formula Review (emphasis added)


1) September 25, 2009, G20 Leaders, Pittsburgh

“Modernizing the IMF’s governance is a core element of our effort to improve the IMF’s
credibility, legitimacy, and effectiveness. We recognize that the IMF should remain a quota-
based organization and that the distribution of quotas should reflect the relative weights of its
members in the world economy, which have changed substantially in view of the strong
growth in dynamic emerging market and developing countries.”

2) October 4, 2009, IMFC, Washington DC

“Quota reform is crucial for increasing the legitimacy and effectiveness of the Fund. We
emphasize that the IMF is and should remain a quota-based institution. We recognize that the
distribution of quota shares should reflect the relative weights of the Fund’s members in the
world economy, which have changed substantially in view of the strong growth in dynamic
emerging market and developing countries.”

3) June 27, 2010, G20 Leaders, Toronto

“We recognize that the IMF should remain a quota-based organization and that the distribution
of quotas should reflect the relative weights of its members in the world economy, which
have changed substantially in view of the strong growth in dynamic emerging market and
developing countries.”

4) October 23, 2010, G20 Ministerial, Gyeongju

[The IMF quota and governance reforms include:] “Continuing the dynamic process aimed at
enhancing the voice and representation of emerging market and developing countries,
including the poorest, through a comprehensive review of the quota formula by January 2013
to better reflect the economic weights; and through completion of the next general review of
quotas by January 2014”.

5) November 10, 2010, Board of Governors Resolution submitted to the BoG by the IMF
Executive Board

“The Executive Board is requested to complete a comprehensive review of the formula by
January 2013.”


“The Executive Board is requested to bring forward the timetable for completion of the
Fifteenth General Review of Quotas to January 2014. Any realignment is expected to result in
increases in the quota shares of dynamic economies in line with their relative positions in the
world economy, and hence likely in the share of emerging market and developing countries
as a whole. Steps shall be taken to protect the voice and representation of the poorest
members.

6) November 12 2010, G20 Leaders, Seoul

[Consistent with our commitments at the Pittsburgh and Toronto Summits, the IMF quota and
governance reforms include:] “Continuing the dynamic process aimed at enhancing the voice
and representation of emerging market and developing countries, including the poorest,
through a comprehensive review of the quota formula by January 2013 to better reflect the
economic weights; and through completion of the next general review of quotas by January
2014”.