Labour plans for bank reforms – UK Bank market share

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Readers Question: would you be able to comment on what the Labour party’s latest proposal to break up the banks to create competition? I can see some reasons that relate to safe guarding possible failures of large banks which can prove costly if the government are needed to bail them out. However, in terms of helping to stimulate economic growth, would it help or is it like shuffling a deck of cards? I would greatly appreciate hearing your opinion on this.

Labour bank reforms include:

  1. A cap on the size of banks’ market share; this will involves splitting up large banks, such as Lloyds and RBS
  2. The introduction of two new challenger banks with an 8% market share.
  3. Refer the issue of banking competition to the Competition and Markets Authority (CMA), within one year of being elected.

Motive for bank reforms

  • The UK banking sector has become more concentrated in recent years. This has created less competition and more market power. If the government is able to reduce market concentration and increase competition, then they hope that consumers will benefit from more choice and greater price competition. If the banking sector becomes more competitive, the theory is that it will put downward pressure on the cost of borrowing, and upward pressure on saving rates.
  • The OFT found in a review of the current account market that, while the share of the four largest providers fell from 74 per cent in 2000 to 64 per cent in 2008, it then rose to 77 per cent in 2010.

bank-marketshare

  • A report by Bain & Company,  showed that the market share of the top six banks together account for 91% of retail deposits. The problem of high market concentration of retail banks is that market power leads to dominance in related financial products, such as mortgages, loans and overdrafts.
  • Reducing the size of banks helps to deal with the issue of banks which are too big to fail. After the credit crisis, the government had to bail out large banks, at a cost to the taxpayer. Reducing the size of banks means that any bailout will be less costly.

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Waterstones cafes and lessons in specialisation

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I’m a big fan of Waterstones. It’s a good bookshop. It’s not Amazon; it even pays UK taxes. I like the atmosphere of bookshops and would be sad if they disappear from the High Street to be replaced by drones delivering books from anonymous warehouses somewhere off the M4. Even though Amazon is often cheaper, I do like to buy books from a proper bookshop like Waterstones because I enjoy browsing, and don’t like being a complete free-rider (enjoying the atmosphere of a bookshop to then go and save a couple of pounds ordering online)

waterstones-cafe

I also used to spend a lot of time in the Costa coffee shops in Waterstones. It’s a good place to work and write some economics.

A while back, I noticed Waterstones were replacing Costa Coffee shops with their own brand of coffee shops. It makes sense to try it as a business idea. Selling coffee is, at least, one area free from the internet.

I don’t consider myself a coffee connoisseur like some of my Italian friends. But, I know what I like and I can tell the difference between good and bad coffee. I was interested to see how they would do because Costa Coffee have really got it down to a fine art. I though it would be really hard to improve on the coffee shop experience of Costa Coffee.

How did Waterstones get on as a coffee shop?

The first thing is that the Waterstones staff are unfailing friendly. You can tell they mean well and are trying hard. But, they don’t seem to have been on a barista course. When I ask for a ‘dry’ cappuccino they all look flummoxed. I try to explain it is a cappuccino with froth instead of milk. (It makes it more like a macchiato). Maybe I’m not very good at explaining, but they always end up making it like a traditional cappuccino. I’ve been in two Waterstone cafes in Oxford and Bradford. It’s interesting you get the same experience in both places. Also the coffee (especially first thing in morning, isn’t as hot as I would like.) At a Costa coffee I once noticed a file with a menu for all possible drinks – Costa Barista’s have to learn these menus. I’m pretty sure Waterstones staff don’t have this.

Often you get the sense that they are really trained booksellers who have been asked to make coffee on the side. Some are very frank and say “Sorry, I don’t know how to make coffee properly”.

Sincerity and honesty are very good. But, when you go to a cafe, you would prefer to be met with a confident barista who takes pride in the job.

Interestingly the former Costa manager was offered the job at Waterstones, but she turned it down because she wanted to specialise only in coffee and not also be responsible for selling books.

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Indian economy in 2014

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I have quite a few readers in India, so I’d like to have a brief look at the Indian economy and it’s prospects for the coming year. After spending so much time looking at the (rather depressing) economics of austerity in Europe and UK, it makes a welcome change to look at a developing economy with a different set of challenges and problems.

China_india_gdp GDP per capita (in 1990 Geary-Khamis dollars) (data range 1950-2003)

Indian economy in summary

For those not familiar with the Indian economy. In the post-independence era, 1947 – 91, India was a mixed economy with a high degree of state intervention – including nationalisation and price controls. The economic performance was mixed but generally disappointing. Since 1991, the economy has pursued a general approach of free market liberalisation and greater investment in infrastructure. This helped the Indian economy to achieve a rapid rate of economic growth and economic development. The economy has become more open, with significant growth in exports and imports. The economic growth has led to a boom in investment, real estate and a growth of the financial sector. To many, India is the second China and the economy has the potential to become one of the largest in the world.

However, at the present time, the Indian economy faces several challenges.

  • In the past couple of years, there has been a fall in the rate of growth causing concern that the period of high growth is coming to an end. (growth fell to a low of 4.4% in 2013 – bear in mind, India’s rising population mean GDP per capita is less impressive than just real GDP growth)
  • India has struggled to keep inflation low. In 2013, inflation was nudging near 10%, hurting the living standards of the poor who are particularly vulnerable to the price of food. High inflation is also harming confidence for investment.
  • Current account deficit. India’s growth has been at the cost of a persistent current account deficit (which reached over 6% of GDP in 2012). India needs to import crude oil, machinery and many other raw commodities. Its export sector has struggled to match the growth of imports.
  • Rupee devaluation. The large current account deficit has caused the Rupee to fall, despite very low-interest rates in the US and Europe.
  • Inequality / poverty. Parts of the Indian economy have made rapid growth, but it has proved difficult for the fruits of economic growth to filter through to all areas of the economy, especially isolated rural areas where there is poor infrastructure.
  • Government budget deficit. Despite years of economic growth, the government has found it difficult to balance the budget. The budget deficit is 4.8% of GDP in the year 2012–13. Public sector debt is 68.05% of GDP, one of highest for a developing economy. Tax collection is still limited by tax evasion and corruption (tax collection only accounts for 9% of GDP – one of lowest in the world). The government is committed to reducing the budget deficit, but this may be at cost of social welfare programmes.

More detail on the Indian economy

Economic growth

Indian economic growth is predicted to be around 5% by March 2014. From European standards, this sounds very impressive. But, is much lower than the rate of nearly 10% achieved in much of the recent decade. Growth of 5% reflects the fact there is much spare capacity and scope for improvement. Without a high rate of growth, the concern is that it will lead to unemployment and discourage future investment. Politicians have been predicting upturns in the rate of economic growth for a long time, hoping it would come in the next quarter. Unfortunately, this has raised and then broken expectations. However, growth did finally pick up to 4.8% in Q3 2013. (higher than previous quarter of 4.4%)

Inflation

Inflation is a real problem for the Indian economy. It has proved stubbornly high. Inflation reached 11.24% in November 2013 – the highest for years. Inflation did fall back to 9.92% in Dec, but there is concern about the stubbornness of high inflation, despite the relatively sluggish growth. The chief of the Reserve Bank of India, Raghuram Rajan has made control of inflation his highest priority and has increased interest rates twice since his appointment in September. Rajan argues that price stability is key to India’s long-term prosperity. However, the concern is that inflationary pressures tend to be due to supply side factors (e.g. rising vegetable prices) and the use of monetary policy may be limited in solving this. For Rajan to tackle cost-push inflationary pressures using interest rates may damage prospects for growth without tackling the underlying inflationary causes. To tackle supply constraints which are behind the cost-push inflation will prove much more difficult.

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UK economy in 2014

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After faltering for several years, the UK economy shows signs of real recovery, with rising spending, investment, exports and even manufacturing growth. At the start of 2014, there seems to be a virtuous circle of falling unemployment, falling inflation, and rising GDP.

After one of the longest and deepest recessions on record, these signs of economic growth are definitely welcome, yet it is far from a return to normality. Real GDP is still 2% below its 2008 peak, and the economy is being propped up by zero interest rates, quantitative easing and a strong housing market. Stagnant wages and poor productivity growth have led to one of the most prolonged periods of declining living standards in memory. Although there is economic recovery, there is still a fear that the recovery is unbalanced, and that the UK economy could be derailed by problems in the Eurozone and future government austerity measures.

Economic growth

economic growth more on economic growth

The ONS have recently revised annualised economic growth to indicate an annual growth rate of 1.9%. Still below trend rate, but welcome after the several years of falling GDP. For 2014, the OBR forecasts economic growth of 2.4% (BBC link)

real-gdp-00-13q3

 A difficult question is how much of an output gap the UK has. Since 2008, GDP has fallen away from the trend rate of growth. In theory, with output much lower than potential GDP, we would expect a rapid recovery to ‘catch up’ the lost GDP. However, we are unlikely to see this. The great recession has unfortunately led to a permanent loss in real GDP. Economists debate how much spare capacity the UK has. But, for the moment growth rates of 2.5% are unlikely to cause any significant inflationary pressure.

Inflation

cpi-inflation

more on inflation

It is ironic that now we are experiencing economic recovery, headline inflation is finally falling closer to the government’s inflation target. of 2%. During the great recession, inflation was often above target due to cost push factors, such as depreciation, rising oil prices and higher taxes. But, now these cost push factors have evaporated, inflation has fallen to 2.1%. Given the nature of the economic recovery, inflation is likely to stay low in 2014, helped by low inflation expectations.

UK Unemployment

total-unemployment-2007-present

Unemployment

Compared with the rest of the Eurozone, UK unemployment could almost be considered a success story. Unemployment has fallen to 7.4% (2.39 million). There is a record number of people in employment (over 30 million for the first time)

However, whilst this unemployment rate is relatively low compared to Europe and also compared to previous recessions, there are other aspects which make less positive reading. Low unemployment has been helped by a rise in part-time employment, temporary contracts, greater job insecurity and falling productivity. (see  UK Unemployment mystery) Also, there are pockets of high unemployment, especially in the north, inner cities and amongst the young. Unemployment of 2.39 million is still a serious social problem, and it will need a considerable period of economic expansion to help reduce to more manageable levels.

Nevertheless, temporary work is still better than no work. Flexible labour markets have many drawbacks, but it is quite interesting that during the shallower recessions of the 1980s and 90s, unemployment rose to a much higher level. There are also promising signs of firms hiring more workers in areas such as, marketing, sales and business development (FT link) which indicate sign of optimism.

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What happens if China sells its dollar assets?

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Readers Question:

“As for the argument that China can always use its foreign exchange (forex) reserves to provide further stimulus to prop up the economy, the people who purport this have little knowledge of basic economics. 

If China were to use substantial forex reserves in this way, it would become a large net-seller of U.S. Treasury bonds. To prevent a spike in interest rates, the U.S. central bank would have to significantly step up purchases, funded ultimately by private citizens savings. Less of these savings would dampen U.S. consumption and ultimately, Chinese exports to the US.. In other words, a move by China to substantially cut forex reserves would not only be a disaster for the developed world but for China itself.”

China has built up substantial dollar assets, (US treasuries) China has done this for various reasons, including:

  • It wants to make use of its current account surplus.
  • In the past it has sought to keep the Chinese currency undervalued. Buying dollar assets keeps the Chinese currency weak, making Chinese exports more competitive boosting Chinese economic growth. (see: Chinese currency manipulation)

It is estimated that China has over $3.6 trillion of foreign reserves (Bloomberg). Approximately, 60%, of these are in dollar assets. This includes $1,294 trillion of US Treasuries (US government debt). China is the biggest foreign creditor to the US.

However, China has signalled that it will be seeking to hold less foreign reserves and reduce the % of reserves held in dollars – diversifying into other currencies.

Now, the question is what will happen to US / Chinese and Global economy if they start selling these dollar assets.

Impact on Chinese economy of selling US Treasuries

  • Appreciation in the Yuan and depreciation in the US dollar. If China sold US assets and held more of its own currency, it would cause an appreciation in the Yuan and fall in the value of the dollar. This would reduce the competitiveness of Chinese exports, leading to lower Chinese economic growth, and possible higher unemployment.
  • Reduction in Chinese current account surplus.

    In the past few years, we have seen a reduction in China’s current account surplus, a sell off of dollars assets would reduce this deficit by even more.
  • Selling foreign assets could be used to boost domestic demand by financing state investment. This could help offset the likely fall in exports. However, the concern would be whether the state could satisfactorily invest the large foreign currency reserves. It may be more inefficient that the private sector exports affected by the appreciation.
  • Reducing inflationary pressures. An appreciation in the Yuan will reduce inflationary pressure in China.

How would the sale of dollar assets affect the US economy?

China holds considerable amounts of US debt. If China stopped buying US treasuries, it would cause a few effects:

Upward pressure on US interest rates. If there is less demand for US Treasury bonds, this will push up interest rates. Making it more expensive for the US to borrow. If China became a big sellers, it might also adversely affect confidence in US Treasuries causing other investors to demand higher rates too.

Higher interest rates on government bonds may push up general interest rates, and may cause lower economic growth in the US. Higher rates increase the cost of borrowing and discourage investment and spending.

However, it is important to bear in mind Chinese holdings of US debt is sometimes exaggerated.
Oct 2012, China holds $1,169 out of a total foreign holdings of $5,526 (20%) (US Treasury) It is less than 8% of total US debt. Therefore, the impact on US interest rates is not necessarily critical if China reduces demand for US Treasuries.

10-year-treasury

It should be remembered US interest rates are close to an all time low (see above). Higher interest rates are not necessarily the end of the US economy. As long as domestic demand is reasonably strong, the US can cope with higher interest rates on US Treasuries.

Also, if China did sell US Treasuries, you may see the Federal Reserve delay its tapering and reversal of Quantitative easing. The US Treasury could absorb some of these Chinese sales by delaying its tapering programme.

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Happy new year 2014

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Firstly, happy New Year 2014. I took an extended break from blogging over Christmas. Firstly, because I was on holiday in Portugal. Secondly because in Portugal, I got knocked off my bike by a crazy dog. I just about managed to hobble home, then the next morning fell over my front door step causing grazes …

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The recession is over but not the depression

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Some thought provoking analysis from NIESR. Firstly, they define recession and depression in an interesting way.

  • Recession – a period of time where output is falling.
  • Depression – The period of time where output is below it’s peak.

The UK economy is now growing, at a decent pace (0.8% in Q3). However, output is still significantly below the old 2008 peak. This means that the recession is over. But, with output still below the 2008 peak, the prolonged period of depression is still not over, according to this definition.

Also, if we compare this ongoing economic downturn (2008-2013) with other periods of serious economic stagnation, the UK economy is performing worse now than even the 1920s or 1930s.

NIERS - UK output
Source: NIERS

The NIERS don’t expect the 2008 GDP peak to be regained until 2015. Meaning, we will have a 7 year period of stagnating real GDP. An unprecedented length of economic stagnation. See also: more on comparison of different recessions

But, it doesn’t feel like a depression?

There are no commonly agreed definitions of what constitutes a depression. Most definitions tend to emphasise a significant fall in real GDP or a prolonged fall in GDP for a period of over 3 years. For example, if real GDP falls by over 10%, that would be classed as a depression. A depression also implies a very high rate of unemployment (perhaps greater than 15%).

The UK unemployment rate is relatively low by the standards of other recessions (helped by falling productivity and flexible labour markets) Therefore, with economic growth, and ‘reasonably’ low unemployment, it feels a different climate to the great depression of the 1930s.

On the other hand, although unemployment could be much higher, there has been a widespread fall in living standards, which is unprecedented in the post war period. Figures show UK living standards have dropped to their lowest in a decade after average real incomes fell a further 3 per cent last year.

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