Saturday, 29 August 2009

The Tide Turns

Two recent events have given us an important glimpse of how the future of the global economy may unfold over the next decade or so. First, the Swiss bank UBS has come to an arrangement with the US tax authorities over the disclosure of the account details of US Citizens who, it is alleged by the IRS, are secreting away their assets as part of a move to avoid – or even evade – US tax. The final agreement is something of a compromise, as the US authorities will request the details of the accounts, which will then be subject to review by a Swiss banking panel. Either way, this represents a major step forward in the process of globalisation and the establishment of a transparent banking system that a fully functioning global financial system would require.

The agreement between UBS and the US authorities removed a major source of uncertainty that had previously prevented the Swiss government from disposing its bailout stake within the bank. UBS had been highly exposed to the sub-prime lending crisis, which had led the Swiss government to purchase ChFr 6.1 billion of convertible loan notes. One day after the tax agreement, the Swiss government converted the loan notes and sold the shares into the market immediately for ChFr 5.5 billion. In addition to this, UBS will pay the Swiss government ChFr 1.8 billion to compensate for lost interest on the loan notes, which leaves a surplus of ChFr 1.2 billion for the Swiss taxpayer. This provides an annualised rate of return of 30%.

The long term importance of these events is quite significant. It shows that the public involvement in the banking system need not be permanent. Whilst the press has focussed on the cost of the banking bailout, they have conveniently ignored the nature of the transactions. Although the cost can be stated in billions – or even trillions – of Dollars, Euros, and Pounds, this cost is not an expense – it is an investment.

On the other side of the balance sheet lay the assets that have been purchased. Eventually, these assets will be sold, either through private placement or into the market. As the assets were purchased under distressed circumstances, it is not unreasonable to expect that they will be sold at a surplus (what might otherwise be called a profit). These capital inflows will, undoubtedly, be used to repay the public debt that has been incurred to purchase the banking assets. When we factor this into the equation, then it would seem that the levels of public debt arising across the OECD nations is not as bad as it might first appear.

This is an important point when considering how the rebalancing of the economy might occur. Over the first half of the next decade, there is a real chance that public sector borrowing may crowd out private sector borrowing. The real policy challenge will be to ensure that the effect is felt upon household borrowing for consumer purchases – i.e. credit card debt and household mortgage debt. This seems to be a trend at the moment, as households work to reduce credit card debt and as mortgage lending remains subdued. It is important in this phase to ensure that credit lines to business remain open. If they don’t, then the recovery will take that much longer to achieve.

There will come a point, however, where recovery reaches a point where the restoration of tax revenues and the decline in social assistance allow for public borrowing to become public repayment of debt. Once this point has been reached, private sector borrowing can be safely allowed to crowd out public sector borrowing. The proceeds of public sector asset sales will hasten this process. This effect will also be greater and faster in those economies - such as France and Germany – that rely more upon ‘automatic stabilisers’ than those economies – such as the US – which rely more upon ‘discretionary stimuli’. Our calculations suggest that, for the UK, the turning point is likely to be somewhere around 2017 or 2018.

Of course, such suggestions are subject to all sorts of unpredictable factors (e.g. exactly how generous are the pensions that will be paid to the Boomers who are now entering retirement in mass). And yet, the case of UBS does establish two things. First, the public involvement in the banking sector need not be permanent. And second, the withdrawal of the public sector from the banking sector could actually yield a surplus to public funds. In this respect, the tide has turned.

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