Monday, June 21, 2010

The People's Bank of China Announces Increased Currency Flexibility

People's Bank of China: Further Reform the RMB Exchange Rate Regime and Enhance the RMB Exchange Rate Flexibility
Financial Times: China Vows Increased Currency Flexibility
Financial Times: New Renminbi Looks Like Deft Political Move
Financial Times: Renminbi Unchanged Despite Policy Shift
Wall. St. J.: China Says it Will increase Yuan’s flexibility
Wall. St. J.: PBOC: No One-off Adjustment of Yuan

A week before the G20 Summit, a conference that many believed would be a “showdown over the level of the Chinese currency,” and amid increasing worldwide criticism over its tightly controlled exchange-rate regime, China announced that it will introduce more flexibility into its exchange-rate. Over the past 20 months, due to the financial crisis, China adopted a fixed exchange-rate policy, that effectively pegged the foreign exchange rate at 6.83 yuan per dollar. However, on June 19, the People’s Bank of China (PBOC) announced that it will make the yuan’s exchange rate more flexible without providing details of the exact size, timing, or shape of a possible revaluation.

Even though the details of the change are unknown, some commentators have praised China’s move. Some have even gone as far as saying that the move marks “the beginning of a new era.” These individuals believe that the new policy will “make a positive contribution to strong and balanced global growth” and increase competitiveness in international trade. Additionally, the change could benefit China's economy by increasing Chinese household income. These beliefs are valid if there is significant appreciation. However, other commentators believe that the announcement is a political ploy and that rapid appreciation of the yuan is unlikely.

Commentators have rightly characterized China’s move as a “canny” and “deft political move” for numerous reasons. First, the announcement by the PBOC came one week before the G20 Summit where many expected the focus to be on China, its undervalued currency, and its large current account surplus. Second, there is no concrete plan of action for implementation of the change. Third, and most significantly, in a follow-up statement one day after China announced that it would introduce more flexibility, China stressed that substantial appreciation in its currency was not in its best interest and that the exchange rate would remain “basically stable.”

Thus, the announcement that China is introducing flexibility into its exchange rate likely had only one effect: shifting the focus off of China at the upcoming G20 summit in Canada.

1) Is there any indication that this was more than a well-timed political move?
2) If China did succeed in shifting the focus of the G20 summit off of its currency, what do you believe will be the new "hot topic" of discussion?

Tuesday, June 15, 2010

Is Basel III “Doomsday” for Banks and Economic Growth?

Financial Times: Bankers Warn of Basel III hit to GDP
Financial Times: Bankers’ ‘doomsday scenarios’ under fire
Financial Times: Basel Chief hits back at growth curb claim
Financial Times: Digesting the Basel Reforms
Bloomberg Businessweek: Geithner Meeting Barnier on Basel III Presses Banks
Wall St. J.: G-20 is Nearing Accord on New Capital Rules
Bank for International Settlements: History of the Basel Committee and its Membership

The Basel Committee on Banking Supervision (Basel Committee) sets global banking standards, which national regulators then implement. In 1988, the Basel Committee introduced a measure of capital called the Basel Capital Accord (Basel I) requiring a minimum capital of 8%. In 2004, the Basel Committee issued a revised framework, commonly referred to as Basel II, which refined the standardized rules set forth in the Basel I.
Among other things, Basel II lowered capital requirements and allowed the largest and most sophisticated banks to use internal models to calculate risk of their assets in determining the capital charges against them. Basel II is the minimum standard for international banks and many countries have adopted it in some form.

While Basel II sought to improve on Basel I by aligning regulatory capital requirements more closely to banks’ underlying risk, many have criticized it. In the wake of the global financial crisis, criticism of Basel II has not waned, but has actually increased. In fact, many critics such as Charles Goodhart, a former Bank of England policy maker and professor at the London School of Economics, have gone as far as saying “that Basel II failed.” Therefore, regulators are trying to fix Basel II through a financial reform dubbed “Basel III.”

Basel III will still rely on the banks’ risk models, but will call for tighter control of what goes into the calculations. There will be a narrower definition of what counts as capital and higher capital charges against riskier holdings such as derivatives. Basel III may also impose a cap on the amount of assets a bank can have in relation to its equity. Put simply, Basel III would require banks to keep enough money in reserve to insulate them against future crises. Not surprisingly, these proposed changes have not been without criticism.

As you may surmise, the loudest criticism of Basel III comes from the banking industry. Banks are claiming that the increased capital requirements will significantly reduce their profitability. Moreover, the world’s leading banking industry group has warned that economic growth in the eurozone, the U.S., and Japan will be cut by three percentage points between now and 2015 if the proposed changes come into force. Another group warns that this would lead to 9.7 million fewer jobs in those countries. Thus, according to the banking industry, the combined effects of Basel III will have a disastrous effect on the worldwide economic recovery.

Proponents of Basel III believe that these worries are unwarranted. Banks are assuming the “maximum impact of the maximum change with the minimum behavioral change.” Banks’ business models are not static and can be changed to deal with the new regulations. Furthermore, if Basel III is applied with equal force to all banks, there is no reason why banks could not maintain their profitability by passing the costs of increased capital to their customers without adverse impact on business. However, it is not clear that they would necessarily do so.

Due to the differing views regarding the effects of Basel III, the Basel Committee and the Financial Stability Board have given a mandate to the Bank for International Settlements to assess the economic effects of the Basel III reform. The estimates are still in progress, but the study shows that the costs “aren’t huge” and the “improvements to the resilience of the financial system will not permanently affect growth—except for possibly making it higher.” However, even if the reforms do slow economic growth, many proponents believe that it is a price worth paying for a stable financial system worldwide.

Even though the banking industry contends that the effects of Basel III will be disastrous, it is debatable whether Basel III truly is doomsday for banks and economic growth. Indeed, if there are costs, they may be a small price to pay for global financial stability going forward.

1) If Basel III does reduce banks' profitability, how do you think banks will deal with it (pass it on to customers, find a loophole, more innovation, etc.)?
2) Even if Basel III slows economic growth, do you think it is a price worth paying for a stable financial system?