U.S. Federal Reserve Balance Sheet Worries Paul Volcker

Former U.S. Federal Reserve Chairman Paul Volcker warned the Fed’s independence and credibility could be harmed by the many different sorts of assets it took on to its balance sheet to stave off a credit crisis.

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Europe and US want a stronger dollar

U.S. and European officials have come together in the belief that the U.S. dollar should strengthen against the euro, following more than a year of sharp decline.

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Rising financial protectionism

The Wall Street Journal reports on how rising nationalism has provoked a trade backlash and may hinder global environmental negotiations.

“Some of the world’s biggest new investors are government-run investment funds. In the Middle East and Russia, sovereign wealth funds are powered by oil revenue; in Asia, they’re fed by other export earnings. In all, the funds have a total of $3 trillion in revenue and have used the money to buy stakes in Citigroup Inc., Merrill Lynch & Co. and other battered Wall Street firms. While the infusions have been lauded by the U.S. Treasury and capital-short Wall Street firms, they also aroused suspicions here and internationally that the investors could have political agendas.

Now, many national governments are raising barriers against such foreign investment. The U.S., Canada, Germany, France, Japan, South Korea, Australia, Hungary and Greece are proposing or enacting restrictions on investment by state-owned firms from other countries, according to a forthcoming study by the Council of Foreign Relations. China and Russia, which have sovereign wealth funds, are staking out ’strategic sectors’ where foreign investment would be restricted, say the study’s authors, investment-law specialist David Marchick and Dartmouth economist Matthew Slaughter.”

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Oasis Economies

A new article from the journal strategy + business says Middle Eastern oil states, particularly in the Persian Gulf, are investing the proceeds of the recent oil boom more cleverly than they did the last time they reaped such windfalls.

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China’s Exchange Rate Policy

An excerpt from a new book by two experts at the Peterson Institute for International Economics looks at the main policy issues dominating discussion of China’s exchange rate.

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Delta-Northwest Deal

The Wall Street Journal reports on the agreed merger between U.S. airlines Delta and Northwest, a deal which faces resistance from regulators and employees but would create the world’s largest airline by traffic.

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Massive Chinese investment in Tibet produces few results

A report from the Economist Intelligence Unit looks at Chinese economic investment in Tibet and argues that the inflow of capital hasn’t brought the payoffs Beijing wanted.

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Swiss energy deal with Iran finances Terror

The Wall Street Journal, April 8, 2007

In an effort to draw attention to Switzerland’s $30 billion energy deal with the world’s leading sponsor of terrorism - Iran - the Anti-Defamation League (ADL) has taken out advertisements in major international newspapers and in leading Swiss dailies with a message to the Swiss government that, “When you finance a terrorist state, you finance terrorism.”

The series of ADL ads, appeared on April 8, 2008 in The New York Times, The International Herald Tribune, The Wall Street Journal  and The New York Sun.  Additional ads will appear in Switzerland in Le Matin Bleu and Le Temps and Neue Zürcher Zeitung.

ADL is concerned that Iran’s profits from the energy deal could help the regime to accelerate and complete its nuclear weapons program and provide tens of thousands of additional missiles to Hezbollah and Hamas, two terrorist groups and sworn enemies of Israel who routinely benefit from Tehran’s largess.

These concerns about the Swiss-Iran energy deal, as well as Switzerland’s foreign policy record vis-à-vis Israel, are explained in the following op-ed by Abraham H. Foxman, ADL National Director.

Swiss Err on Iran, Israel

by Abraham H. Foxman
National Director of the Anti-Defamation League
This article originally appeared in the JTA on April 7, 2008

Swiss Foreign Minister Micheline Calmy-Rey’s visit to Tehran was billed as an opportunity to deliver a stern message about the need for Iran to end its human rights violations and its threats to destroy Israel. This was according to the government’s official announcement of her March 17 diplomatic visit.

As a secondary matter, the announcement noted, Calmy-Rey would attend the signing of a gas deal between Iran and a Swiss energy company.

But Calmy-Rey herself inadvertently exposed the flimsy human rights pretext when she acknowledged on the day of her departure that she was traveling to Tehran in response to Iran’s invitation.

It is highly unlikely that Iran invited Switzerland’s foreign minister to chat about Iran’s bleak record on human rights or its belligerent statements about Israel. The real purpose of the visit, which included photo ops with President Mahmoud Ahmadinejad, was to raise the profile of a $28 billion energy deal, one that has consequences for Iran’s continued pursuit of a nuclear weapons capability.

The Swiss are not alone in signing gas contracts with Iran, but the size of the deal and its timing so soon after the latest round of United Nations sanctions will surely encourage Iran on its march toward nuclear weapons and in its defiance of international demands to stop enriching uranium.

If Switzerland were committed to ending the Iranian nuclear threat, it would join with other responsible countries to reinforce the isolation of the ayatollahs’ regime. If Switzerland were serious about supporting an effective strategy, it would join the movement to target Iran’s energy industry.

This gas deal is just the latest example of Swiss actions that are out of step with the West’s determination to confront Iran and commitment to the security of Israel.

Switzerland joined Saudi Arabia, Cuba and other dictatorships in support of the U.N. Human Rights Council resolution that condemned Israel’s reaction to the rockets from Gaza while ignoring the actions of Iran’s terrorist client, Hamas. The resolution was so biased that Canada, an international leader in human rights promotion, voted against it, and every European Union member of the council abstained.

The Swiss ambassador feebly explained that the importance of condemning Israel’s alleged wrongdoing outweighed all other considerations.

That decision logically followed from Switzerland’s apparent policy of censuring all Israeli military operations, no matter how justified. In their condemnations, the Swiss invariably invoke international humanitarian law, with which they are closely associated as the depository for the four Geneva Conventions. Missing, though, is evidence of understanding the proper application of those laws of war.

In one egregious example, Israel’s 2006 raid on a Palestinian prison in Jericho was denounced for “violat[ing] the principle of proportionality.” In that incident, Israeli soldiers had surrounded the prison, in which armed terrorists, including the assassins of an Israeli government minister, were granted free reign and permitted to communicate with the outside world.

One prisoner and one prison guard were killed in an exchange of fire, but the terrorists and other Palestinian prisoners were convinced to surrender without any further hostilities. Even that successful operation the Swiss condemned as a disproportionate use of force.

Switzerland hasn’t been content to undermine Israel’s right to self-defense. Calmy-Rey has also tried to undercut Israel’s diplomacy. Brazenly disregarding Israel’s sovereignty and democratically elected government, Switzerland sponsored negotiations between private Israeli and Palestinian individuals, known as the Geneva Accord.

Unlike the Oslo negotiations, which were backed by the Israeli government after the first couple of private meetings, the Swiss project was officially rejected by Israel and the Swiss ambassador summoned to receive a protest.

Regardless of the content of the resulting document, the Swiss action represented an inexcusable intrusion by a foreign government in the peace process and an end run around the “road map” that reflected the will of the international community and demanded an end to Palestinian terrorism as a condition of further Israeli steps.

Some of the above examples of unfriendly behavior toward Israel could be explained away as soft-headed do-goodism. But one incident in particular punctures that theory.

In December 2006, Tehran hosted its infamous Holocaust denial conference, which responsible nations condemned unequivocally. Switzerland’s reaction was different. A week after the Tehran conference, Calmy-Rey met with Iran’s Deputy Foreign Minister Said Jalili in Switzerland.

According to the Swiss government’s minutes of the meeting, subsequently leaked to the Swiss press, she proposed that “a seminar about different perceptions of the Holocaust could be organized in one of the Geneva centers.” Public outrage killed that idea, but the fact that Calmy-Rey made the proposal provided encouragement to the Holocaust deniers in Iran and elsewhere.

In the battles against the Nazi regime during World War II and communism during the Cold War, Switzerland pursued its narrow self-interest by professing neutrality.

Today the Swiss appear to be taking the same approach in the current global war against the radical Islamist threat, spearheaded by Iran, which menaces Israel’s existence and the security of the West. But neutrality isn’t an option. And for Switzerland, a country that takes pride in its liberal democracy and claims to have learned from its history, it shouldn’t even be considered.

***

Abraham H. Foxman is the National Director of the Anti-Defamation League and author of “The Deadliest Lies: The Israel Lobby and the Myth of Jewish Control.”

The Anti-Defamation League, founded in 1913, is the world’s leading organization fighting anti-Semitism through programs and services that counteract hatred, prejudice and bigotry.

Showdown on U.S.-Colombia Free Trade Agreement

United States House of Representatives Speaker Nancy Pelosi has signaled she will take the unusual step of changing House rules to effectively stop the 90-day clock on the Colombia free trade deal after President George W. Bush had submitted the measure for action.

The Brookings Institution examines the showdown on Capitol Hill over the U.S.-Colombia free-trade pact and says Colombian leaders may react sharply if the deal is shot down by the U.S. Congress.

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The Top 10 Risks for Business

A new report from Ernst & Young surveys the top ten “strategic risks” for U.S. companies, including emerging market pressures, energy shocks, and cost inflation.

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Shirakawa to head Bank of Japan

The Wall Street Journal reports on the new nominee to run Japan’s central bank, Masaaki Shirakawa. The article says Shirawaka is likely to be a candidate the country’s opposition can tolerate, potentially ending a political standoff that has lasted weeks.

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Index of State Weakness in the Developing World

A new report written by Susan E. Rice from the Brookings Institution and Stewart Patrick from the Center for Global Development ranks 141 countries on economics, politics, security, and social welfare - as well as twenty other “sub-indicators” - and derives an “index of state weakness”.

“This paper presents the Index of State Weakness in the Developing World (hereafter, the Index), which ranks all 141 developing countries according to their relative performance in four critical spheres: economic, political, security, and social welfare. We define weak states as countries that lack the essential capacity and/or will to fulfill four sets of critical government responsibilities: fostering an environment conducive to sustainable and equitable economic growth; establishing and maintaining legitimate, transparent, and accountable political institutions; securing their populations from violent conflict and controlling their territory; and meeting the basic human needs of their population.”

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Credit crunch and opportunities for corporate banking in Europe

A new article from the McKinsey Quarterly examines the credit crunch with an eye toward possible opportunities it opens up in Europe’s corporate banking sector.

“Continuing turmoil in global capital markets after the credit crunch of mid-2007 has clouded the short-term outlook, especially in investment banking. We believe, however, that corporate banking in Europe will benefit from several profitable growth areas over the next 18 months and that shrewd players should position themselves accordingly.”

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Iran “central banker of terrorism”

At a hearing of the United States Senate’s Finance Committee, a senior official in the US Treasury Department has called Iran “the central banker of terrorism”.

Outlining some of what Iran is known to be doing to support anti-American and anti-Israeli fighters, the under-secretary for Terrorism and Financial Intelligence, Stuart Levey, said Iran “uses its global financial ties and its state-owned banks to pursue its nuclear and ballistic missile programs, and to fund terrorism.”

He also told lawmakers that Iran used front companies and “cut-outs” to “engage in ostensibly innocent transactions that are actually related to its nuclear missile programs.”

“We have seen Iran’s banks request other financial institutions take their names off of transactions when processing them in the international financial system. This practice, which is even used by the central bank of Iran, is intended to evade the controls put in place by responsible financial institutions and has the effect of threatening to involve those financial institutions in transactions that they would never engage in if they knew who or what was really involved,” Levey said.

Levey heads the Office of Foreign Assets Control (OFAC), which is responsible for tracking money being filtered into terrorist groups. In all, since June 2005, the OFAC has identified 51 entities and 12 individuals as proliferators of weapons of mass destruction, of whom 36 entities and 11 individuals were tied to Iran, nine entities and one individual were tied to North Korea and three entities were tied to Syria. Levey told senators that efforts to cut off money to Al Qaeda had shown success - especially in the last 18 months. He cited senior al-Qaeda leaders’ complaints that they had suicide bombers ready to go but no money to finance operations.

Click here to read the full statement.

United States presidential election, 2008: Herbert Hoover’s Ghost Haunts Markets

In a her Bloomberg column, Amity Shlaes finds that Bear Stearns evokes the crash of 1929 and the Great Depression that followed it.

“Within 24 hours, Representative Rahm Emanuel, an Illinois Democrat, was weighing in with his own 1930s comparison. Roosevelt had pulled a country out of Depression and united it; President George W. Bush was doing the opposite, he said.

You get the picture: Bush is like Hoover, the do-nothing. Democrats are like Roosevelt, the activist. It’s worthwhile to go back to that Depression period to see what people actually did or didn’t do and who resembles whom. The reality differs from the cartoon.”

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Asia’s Achilles Heel

In a article for Newsweek, David Victor argues that the big challenge in the coming century may not be the strength of Asia’s emerging economic powers but rather their weakness.

Victor shows how China’s recent power crisis was caused by the tensions between China’s burgeoning free-market sector and its residual state-owned and regulated industries. India faces a similar problem: Its state-owned power utilities are supposed to be run for a profit, but incessant political meddling with electricity prices has pushed most into bankruptcy. In both China and India, dynamic economic growth has masked these governance problems. But the power sector conveys a warning: Vestiges of the statist tradition can still obstruct progress.

“Market reforms are making Beijing less and less relevant to what’s really going on in the economy, threatening to turn China into a ‘weak state.’ And it’s not just China - India, too, is having trouble regulating its industry and economy. The phenomenon is a dark cloud on the Asian century.”

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Paulson plan to combat credit market problems

The Wall Street Journal reports that U.S. Treasury Secretary Henry Paulson today will announce a broad proposal to overhaul regulation of U.S. financial markets. The article says the reforms could eliminate or merge major institutions - including the Securities and Exchange Commission - and might seek to strengthen the authority of the U.S. Federal Reserve.

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Demons On Wall Street

Top columnist and macroeconomics expert Sebastian Mallaby writes in  the Washington Post that modern financial engineering has become harder to defend in the wake of Bear Stearns.

March 24, 2008
Washington Post

“One year ago, with spectacular timing, a Wall Streeter named Richard Bookstaber published a book on financial engineering. He called it A Demon of Our Own Design, and his argument was that a new breed of ‘quants’-or ‘quantitative’ number-crunchers like him-had created a system too complex to be manageable. The risks embedded in swaps and options were understood by only a handful of math geeks, and a miscalculation in one corner of the markets could send shock waves globally. Until a week ago, Bookstaber seemed unduly glum. But in the wake of Bear Stearns, modern financial engineering has become harder to defend.

Bookstaber seemed too pessimistic because he understated the ability of Wall Street players to check and balance one another. Yes, modern finance had an alarming tendency to load debt upon debt, so the effect of a mistake was magnified. But the financial engineers who created these tottering cash towers had an incentive to stop building before the whole thing keeled over. If a bank borrowed too much, lenders would shut off the taps and clients would refuse to buy its swaps, options and synthetic bonds: Nobody wants to do business with a bank that is one shock away from bankruptcy. So financial engineers would certainly take risks. But scrutiny from fellow engineers at other firms would prevent them from overdoing it.

Even a year ago, reasonable people disagreed about whether these checks and balances were sufficient.”

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Latin American Drugs: Losing the Fight

A report from the International Crisis Group says cocaine production in the Andes region appears to have set new records in 2007 and questions how policymakers can improve counternarcotics policy in a way that doesn’t jeopardize regional stability.

“Coca leaf and cocaine production in the Andean region appear to have set new records in 2007. Cocaine trafficking and use are expanding across the Americas and Europe. Despite the expenditure of great effort and resources, the counter-drug policies of the U.S., the European Union (EU) and its member states and Latin American governments have proved ineffective and, in part, counterproductive, severely jeopardising democracy and stability in Latin America.

The international community must rigorously assess its errors and adopt new approaches, starting with reduced reliance on the measures of aerial spraying and military-type forced eradication on the supply side and greater priority for alternative development and effective law enforcement that expands the positive presence of the state. On the demand reduction side, it should aim to incarcerate traffickers and use best treatment and harm reduction methods to avoid revolving and costly jail sentences for chronic users.

Well-armed, well-financed transnational trafficking and criminal networks are flourishing on both sides of the Atlantic and extending their tentacles into West Africa, now an important way station on the cocaine route to Europe. They undermine state institutions, threaten democratic processes, fuel armed and social conflicts in the countryside and foment insecurity and violence in the large cities across the Americas and Europe. In Colombia, armed groups derive large incomes from drug trafficking, enabling them to keep up the decades-long civil conflict. Across South and Central America, Mexico and the Caribbean, traffickers partner with political instability.”

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China-U.S. Relations: Current Issues and Implications for U.S. Policy

A new report from the Congressional Research Service gives an overview of China-U.S. relations and questions the implications of developments in Tibet and Taiwan on U.S. policy toward China.

“U.S.-China relations were remarkably smooth for much of the George W. Bush Administration, although there are signs that U.S. China policy now is subject to competing reassessments. State Department officials in 2005 unveiled what they said was a new framework for the relationship - with the United States willing to work cooperatively with China while encouraging Beijing to become a ‘responsible stakeholder’ in the global system.

U.S. Treasury Secretary Henry Paulson in December 2006 established a U.S.-China Strategic Economic Dialogue with Beijing, the most senior regular dialogue yet held with China.

But other U.S. policymakers have adopted tougher stances on issues involving China and U.S.-China relations. They are concerned about the impact of the PRC’s strong economic growth and a more assertive PRC diplomacy in the international arena; about procedures to assure the quality of Chinese pharmaceuticals, food, and other products being imported into the United States; and about trade practices and policies in China that contribute to a strong U.S.-China trade imbalance in the latter’s favor.”

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The U.S. Federal Reserve New Alphabet Soup

by Vincent R. Reinhart, former director of the Federal Reserve Board’s Division of Monetary Affairs (2001-2007)

Over the past few weeks, the Federal Reserve added to its alphabet soup of new facilities to deal with ongoing strains in financial markets. Taken together, these programs represent a clever gamble to provide large institutions some time to get their financial houses in order. Fed officials have effectively rewritten the rules on the role of a central bank in a market economy.

First, the mnemonics. On March 14, 2008, the Federal Reserve extended access to its discount window to a non-depository, Bear Stearns, for the first time since the 1930s. (The discount window is the Fed’s lending facility, where loans are made at a rate above the federal funds rates and can be secured with a wide variety of collateral.) According to the Federal Reserve Act, lending to such an individual, partnership, or corporation (an IPC) requires the affirmative vote of five of the governors of the Federal Reserve Board.

Moreover, the Federal Reserve must attest that there are “unusual and exigent” circumstances and that failure to lend would impair the economy. On March 16, 2008, the Federal Reserve granted other investment banks access to its lending facility.

On the prior Tuesday, the Fed had introduced a new program called the Term Securities Lending Facility (TSLF), under which it will loan some of the Treasury securities currently on its balance sheet to key financial market participants in return for other securities as collateral. The term of these transactions is 28 days, and the fee paid for the loan of Treasury securities will be set in an auction.

For the past few months, the Fed has been holding regular auctions for depositories of its discount window credit, also for a term of 28 days. This is referred to as the Term Auction Facility (TAF), in which depositories bid for credit. Earlier this month, these auctions were bumped up to total $100 billion per month. To put that sum in perspective, the amount of discount window loans outstanding this month will likely be nine times the previous monthly record from 1919 to the inception of the TAF (see the nearby chart). And if the TAF continues at its recent pace through June of this year, the Federal Reserve will have extended a greater volume of loans over the first eight months of the program than it had cumulatively lent over the prior 90 years.

Last but not least, the Fed also announced that it will loan another $100 billion in the form of 28-day term repurchase (RP) agreements. RPs are the bread-and-butter of a central bank’s open market operations. In the typical RP, the Fed lends money to its dealer counterparties for a fixed term, taking collateral in the form of Treasury securities or the debt and mortgage-backed securities of the government-sponsored lenders, Freddie Mac and Fannie Mae.

If we tally up all these new programs, the Federal Reserve appears willing to commit almost one-half of its balance sheet, around $400 billion, to promote the renewed health of financial markets.. Given its open-ended invitation for investment banks to follow the Bear Stearns route and tap the Fed’s discount window, it may wind up committing even more.

Why do Fed officials think these programs will work? To households, mortgages are the obligations that make home purchases possible. But to financiers, mortgages are collateral. Those loans are pooled together so that their combined payments provide a steady stream of income in a variety of mortgage-related securities. The problem is that mortgage defaults of the magnitude we are now experiencing even dry up payments to “safe” securities. Some of those securities are quite complex and difficult to price. Even worse, they are held in part on balance sheets of financial institutions that are opaque and difficult to understand.

Investors have withdrawn from the entities they fear are tainted by these losses. But because they cannot pin down precisely who bears the brunt of the losses, the retreat from risk taking has been spread across a broad front. As a result, there is no effective market price for some of these securities-because the market has disappeared.

Losses across large financial firms could mount considerably beyond what has already been announced. If so, those firms will have to retrench to conserve their capital. Credit will be more expensive and harder to get.

Ultimately, the industry needs more capital. That infusion may come from elsewhere in the private sector: possibly from hedge funds and long-term investors, or from official sources abroad. (Here another mnemonic comes to mind-SWF, or sovereign wealth funds.) But if it does not come from those sources, it will likely require government intervention, which is the way banking crises around the world are often resolved.

The Federal Reserve is using its balance sheet as a safe harbor for the financial industry until that capital arrives. It is doing so by transforming mortgage - related securities - for which there is currently no effective market-into something useful. Financial institutions can now pledge them with the Federal Reserve in open market operations (via RPs) or at the discount window (via the TAF and IPC lending). Or, they can swap those securities for Treasury securities via the TSLF. For 28 days, those firms get better assets on their balance sheets, which allow them to postpone the unloading of their mortgage-related holdings.

Let’s be clear: the Federal Reserve is accepting an unprecedented degree of credit risk.

If one of its counterparties fails in the 28-day window of an outstanding transaction, the Fed will potentially be left holding illiquid mortgage paper. Such unusual policies cannot be extended indefinitely. Financial institutions have to come to grips with their losses, and their management has to swallow hard and find more capital, which is likely to be very costly. They should not use the Fed’s largesse as an excuse to delay.

Reprinted with kindly permission of The American Enterprise Institute.

France and UK to press banks over more transparency

French President Nicolas Sarkozy and British Prime Minister Gordon Brown made a joint push for greater regulation of European banks, calling for “full and immediate disclosure” of potentially bad debts.

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India is the best bet for foreign investment

The Economic Times interviews the head of Morgan Stanley India, Narayan Ramachandran, who says the country’s prime brokerage sector is due for a boom if politics in the country liberalize.

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Public Finance in China: Reform and Growth for a Harmonious Society

A report from the World Bank looks at public finance in China and examines the challenges facing Beijing’s government as it seeks to manage economic growth while using funds to promote a “harmonious society”.

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Kenya - Agriculture and Export Markets

A recent paper from the Harvard Business School uses case studies in Kenya to question why farmers in the developing world often insist on growing crops for domestic consumption when export markets are readily available to them and potentially more profitable.

“Why do farmers continue to grow crops for local markets when crops for export markets are thought to be much more profitable? Several answers are possible: missing information about the profitability of these crops, lack of access to the necessary capital to make the switch possible, lack of infrastructure necessary to bring the crops to export outlets, high risk of the export markets (e.g., from hold-up problems selling to exporters), lack of human capital necessary to adopt successfully a new agricultural technology, and misperception by researchers and policymakers about the true profit opportunities and risk of crops grown for export markets.”

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Société Générale: Why managers fail to do the right thing

Jean Dermine, a professor at the French business school INSEAD, examines the scandal surrounding a rogue trader at the French bank Société Générale and questions how European regulators can better protect financial institutions against further such incidents.

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Private Profits, Public Risks

In an op-ed in The Wall Street Journal, former White House counsel for President Reagan, Peter J. Wallison, says government-sponsored enterprises (GSEs) have contributed to the turmoil in the mortgage market.

“The fall in housing prices and mortgage values has exposed a serious flaw in the idea that private, shareholder-owned, government-sponsored enterprises (GSEs) can be effective instruments of government policy.

Two such GSEs, Fannie Mae and Freddie Mac, were chartered by Congress decades ago to create and operate a secondary market in residential mortgages. Initially government corporations, they were sold off to shareholders (Fannie was privatized in 1968, Freddie in 1986) in order to prevent their purchases and sales of mortgages from affecting the federal budget. This limited privatization created a unique hybrid enterprise: a shareholder-owned company that was supposed to act like a government agency.”

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