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Forex Market Analysis

Let’s Focus on the Real Deal

Weekly Update (August 6th – 10th)

Macroeconomic Outlook

Last week was intense with multiple central banks meetings, corporate results and many macroeconomic indicators. Anyway, the final outcome for the markets was mixed.

  • Good in the USA
  • Regular in Europe
  • Bad in China

Overall, after what has been happening in the last weeks, there will three key factors that will influence in the future.

  1. Protectionism from the USA and its relationship with China

Even though the comments from central banks were hawkish and the corporate results were solid along with the macroeconomic indicators, the protectionism concerns have increased with the last comments on tariffs influencing in a negative way the markets.

Trump commented how they were considering raising the tariffs from an initial 10% to 25% on Chinese goods which are worth around $200B.

–          This was what concerned the markets

–          This kind of news is impossible to anticipate

o   The key is that the tone of the conversation does not get worst

o   If this happens, markets will redirect their attention to the fundamentals will put on the side the trade concerns

  1. The second factor is the technology

There were some concerns regarding the drop from Twitter and Facebook. However regarding the reports from Amazon and Apple too, leads to thinking that what is happening is that the markets are turning more demanding and it is not worried about the valuation models.

  1. The last factor is corporate results

Not only from technology companies but from banks too, which they are turning out to be really positive.

–          Within Europe, UniCredit, Commerzbank, Adidas… will report results this week

And is it is as forecasted, it is expected that markets put aside their concerns about the USA-China relationship and focus more on the current expansive economic cycle and the strong results reported from the companies, retaking the bullish inertias.

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Forex Market Analysis

Markets’ Attention On Summer


Weekly Update (July 9th – 13th)


Macroeconomic Outlook

Summer is in focus now, and with it, the attention on the multiple factors that will condition whether it will be a good summer for the markets or a bad one.

Nevertheless, all these factors that unnerve investors are reaching a final outcome.

  • Last week, the markets performed better as the matters that block them improved slightly.
    • European policy and German politics have reached an outcome.
    • Then oil, which is still a problem.
    • And protectionism which is something more bilateral between China and USA rather than global.
      • When the market realises that, it will care less about it.

We were expecting a hard summer, however, the markets are starting to react in a positive way sooner than expected.

This week has three main references:

  • On Tuesday, the German ZEW Economic Sentiment which is expected to be negative again for the fourth month in a row.
    • It is relevant enough to watch out for but nothing especially important as the overall German economy has been increasing recently at 2.5% in the last trimester, which is really good.
  • On Thursday, there is US Core CPI which is forecasted to rebound from 2,2 to 2,3. This issue depends mostly on oil prices.
    • Over-inflated data may hurt bonds, nevertheless structurally it will not be a real matter which could be solved in 2 or 3 months.
  • And the third reference is American corporate results which start, among the big ones, on Tuesday with Pepsi Co.
    • And on Friday, three big banks publish results
      • Citi / +23%
      • JP Morgan / +30%
      • Wells Fargo / +11% and with some legal problems
    • They are expected to be really solid which will support markets.

Hence, this week looks like where a more positive sentiment towards markets can be consolidated.

  • German political turmoil looks clearer than before.
    • Even though it will come back in October with the elections.
  • Regarding oil, American pressures regarding an increase in production are graspable which will lead to Saudi Arabia producing more, and reducing oil prices.
    • This will reduce inflation related concerns.
  • Then, there is the protectionism which is mostly between the USA and China, being something more local rather than something global.
    • So that, when the market realises that along with strong corporate results, a good economic growth and a lot of liquidity, it will lead to an overall favourable economic cycle which will support the markets.
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Forex Market Analysis

Slight Change of Context

Weekly Update (June 4th – 10th)

Macroeconomic Outlook

Two main factors need to be considered initially this week-

–          Outcome in Italy

o   More expected

–          Outcome in Spain

o   Less likely to happen

  • The bond spreads of Spain and Italy have had a notable increase over the German ones

However, the midterm elections in the USA are more worrying, which are taking place in November.

–          Which means Trump will put more pressure on trade with other countries.

o   This lead to uncertainty and lower growth in global terms

o   However, also they are useful to clarify ideas

For now, we can rely on the rebound that happened on Friday, due to two things that need to happen this week.

  1. The Italian Government should be formed and avoid other elections which can be interpreted as a danger to the Euro.
  2. In Spain, the budget program should go forward, and there should not be any surprise from the government.

Anyway, we cannot rely on this too much as the protectionism will still grow. In general terms, the investment strategy should not change.

–          We should be still exposed to markets

o   We still are within an expansive economic cycle

–          We elevate the perspective looking to 2019

o   Due to the current change of context to a worst one, returns will be slightly lower but that will not change the overall direction of the markets

 

Technical Outlook

US Dollar Index


After taking profits, the US Dollar Index is hanging between the resistance it just touched and the support it previously broke. So, for now, we´ll wait until it breaks one of them and position in the right direction.

 

EURUSD


EURUSD remains in the green, and there is not any support or resistance that signals a change of trend. Hence, for now, we remain short.

 

GBPUSD


GBPUSD is hanging on a key after breaking the first resistance. Now, it is facing the second monthly resistance. In case it does not break it we´ll remain short. However, if it closes above the bearish trendline that is now facing, we might consider changing the strategy to a more bullish position.

 

USDJPY


It remains in the same situation as we left it. It is going sideways between resistances and supports. Recently it has touched the support confirming it and possibly now it can go up to the resistance. However, for now, the movements are too small to care about them, so we remain on the side, looking at how it behaves and waiting for a clear breakout.

 

CRUDE OIL


US Oil just broke a strong monthly support which creates a strong entry to join the recently formed bearish trend. We captured the initial movement and now can be a good opportunity to join again after this last breakout of a resistance.

 

DAX


As analysed in the macroeconomic outlook, the fundamentals remain solid and the technicals too. If it does not close below the support, it is now facing we´ll remain as bullish as we are now. However, if it breaks the support and retests it, we might change to short, but for now, everything is in place for a low but positive uptrend.

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Forex Educational Library

FOMC Statement- March 2018

The information received by the Federal Open Market Committee (FOMC), since its meeting in January, has shown signs of further strengthening of the labour market and economic activity has been growing at moderate but solid rates. Job gains have grown strong in recent months, and the unemployment rate has remained at low levels. Recent data shows that the growth rate of household spending and business fixed investment has grown in 2018 at moderate rates after a large growth at the end of 2017.

On a twelve-month basis, overall inflation and inflation for items other than food and energy has remained below 2%. The economic outlook has improved in recent months due to the good results evidenced throughout 2017, and since the tax reform approved at the end of the same year.

The committee expected that with gradual adjustments in the monetary policy stance, the economy would continue to behave positively in the medium term and labour market conditions would remain robust. Regarding inflation and its annual base, the committee expected that in the short term this indicator would be close to 2% and that the bank’s goal would be met.

Due to the behaviour of the labour market, the main sectors of the economy and inflation, the committee decided to raise the target range of federal funds from 1.5% to 1.75%. The committee was explicit in that the monetary policy stance would remain accommodative as long as it was necessary for inflation to return to 2%.

This decision was in line with market expectations, so there was no strong reaction from the market. In the projections of the path of the interest rate, there is still no unanimity on what the next steps of the Federal Reserve will be as some expect a stronger policy, so they expect four increases during 2018. For other analysts, the path will continue the road stipulated so they expect only three increases during the current year.

The following graph shows the main projections of the committee. This graph shows economic growth above the natural long-term rate and the rates expected since the December meeting has improved. The unemployment rate also shows a very positive behaviour and is below the long-term rate. Regarding the different inflation measures, inflation is expected below the bank’s target for 2018, but very close to the target level, and for the next two years, an optimal inflation rate is expected according to the bank’s mandate.

Graph 82.Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents, March 2018. Retrieved 23rd March 2018 from https://www.federalreserve.gov/monetarypolicy/files/monetary20180321a1.pdf

In the press conference, the president of the Federal Reserve Jerome Powell expressed that the decision to raise the target range of the interest rate marks another step in the normalisation of monetary policy, a process that has been underway for several years. But in his statements, some caution was evident and showing that the path of the interest rate considered only two more hikes in 2018.

Job gains averaged 240,000 per month in the last three months, which is a very positive rate and makes it possible for new workers to be absorbed. The unemployment rate remained at low rates in February, standing at 4.1%, while the rate of labour market participation increased.

According to Powell, that is a positive signal given that the economically active population is getting older, so this leads to the participation rate to the downside, but with the new entries this negative effect is offset by the entry of new workers.

Also, the president of the Federal Reserve has concluded that there are certain specific factors that have contributed to the greater economic growth observed in recent months and these are:

  • Tax reform
  • Ongoing Jobs Gains
  • Foreign growth is strong
  • Overall financial conditions remain accommodative

Regarding inflation, Powell was clear that inflation was still below 2% regardless of what measure was used. According to the president of the Federal Reserve, this was due to unusual price reductions that occurred in late 2016 and early 2017. But for Powell, as the months passed in 2018, these unusual events would disappear, and inflation would be very close to 2 %.

In his statements, the president of the Federal Reserve specified that, if the rates rose too slowly, this would increase the risk that monetary policy would have to adjust abruptly in the future if a shock should occur in the economy. At the same time, the committee wanted to prevent inflation from remaining below the target which could reduce the chances of acting quickly in the face of a recession in the US economy.

Finally, Powell pointed out that the reduction in the balance sheet that began in October was progressing smoothly. Only specific conditions of the economy could curb the normalisation of the balance sheet of the Federal Reserve. President Powell was emphatic that they would use the balance sheet in addition to the interest rate to intervene in the economy if a deep economic recession were to occur.

In conclusion, the federal committee decided to raise the federal funds rate as expected by the market due to the good performance of the economy which continued to grow at high rates and above the long-term level. Although inflation was not at the desired level, according to the committee, this was due to transitory effects that would fade over the months, and thus inflation would be in the target range.

As already mentioned, the economy showed good signs due to the labour market, so the bank decided to raise rates, but the committee remained cautious about the future of the economy because it was not ruled out that a recession would occur. According to the statements made at the press conference, some indecision was evident on the part of the committee as they evaluated the two possible scenarios against the interest rate.

If they raised it too quickly they could slow down the economy and thereby affect the labour market, which would lead to a drop in inflation, which would lead to a complex economic scenario as future increases would not be possible, and this would restrict the use of the monetary policy. On the contrary, If the committee raised it too slowly, a scenario could be generated where any economic shock, whether internal or external, could also affect the economic growth of the United States and limit future increases in the interest rate.

The market is still undecided if the FED will make two or three more rate hikes during the current year. Some analysts question why the Federal Reserve continues to raise rates if the inflation rate still shows no stability. For them, the central bank should be more cautious in its monetary policy because they could be in the second scenario where the economy still needs an accommodative policy so that the medium term could be limited future increases in the rate as well as the normalisation of the balance sheet.

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Monetary Policy Statements of Bank of Japan 2017

 

Category: Fundamental Analysis, Intermediate, Currencies, economic cycles, Monetary Policy, Economy, Macroeconomics, Central Banks.

Key Words: Central Banks, Monetary Policy, Bank of Japan.

Tags:  Macroeconomy, BoJ, Monetary policy, 2017.

At the January 2016 meeting, the Central Bank of Japan introduced negative interest rates, setting the reference rate at 0.1%. This negative rate meant that the central bank would charge commercial banks for some reserves deposited in Japan’s central financial institution. The measure was designed to encourage commercial banks to use their reserves to increase the supply of loans to consumers and investors in Japan, to reactivate the economy and overcome the deflation that the country was experiencing at that time.

This negative rate would not apply directly to the accounts that customers had with commercial banks so as not to affect the purchasing power of individuals or companies. It was not a measure taken impulsively since the Bank of Japan had been analysing what measures could boost the behaviour of inflation for several years.

The decision was made by the board of the bank in a split decision of 5 votes in favour of the measure, against four votes who did not agree to establish negative rates. In addition, the report issued summarising the meeting, stipulated that if it was necessary to delve into the negative rates territory, this measure would be only be implemented until the bank achieved its 2% goal.

This measure of establishing negative rates has not been common for the central banks of the world’s leading economies since there is no consensus on the possible effects of negative rates. A problem that had lasted for quite some time in Japan was the decline in the prices of goods and services so that consumers restricted their spending due to their expectations of prices in the future.

At the press conference, the governor of the Bank of Japan, Haruhiko Kuroda indicated that deflation coupled with a global economic slowdown led to an unprecedented policy for Japan. For many analysts, the decision to adopt negative rates was surprising, and it was not known how much this could influence the short and medium-term inflation rate.

The consensus for many analysts was that the Japanese economy did not grow at higher rates as well as inflation, not because of low supply of credits but because companies had pessimistic expectations about the future of the economy, so they preferred to postpone their investment decisions. Therefore, they hoped that the outlook would not change even with negative interest rates.

Specifically, the bank adopted a three-tier system in which the balance that commercial banks held in the central bank would be divided into three levels:

  • Balances with a positive interest rate
  • Balances with zero interest rate
  • Balances with a negative interest rate

This multi-level system in the balances was intended to prevent an excessive decrease in the income of financial institutions derived from the implementation of negative interest rates.

As for the guidelines for money market operations, the bank decided in a vote of 8 to 1 in favour of conducting operations in the open market until the monetary base was increased annually by 80 trillion yen. The bank decided to make purchases of Japanese Government Bonds (JGB) so that the amount in circulation would increase its annual rate of around 80 trillion yen.

By early 2017, the bank confirmed that the interest rate in the short term would remain at -0.1% and for the long term it would be 0%, so the bank decided to continue buying Japanese Government Bonds to maintain the yields of the bonds at 0%. World economic growth was moderate, but the negative performance was for the emerging economies which remained lagging behind the growth of the developed economies.

The bank especially highlighted the US economy, which showed great strength in almost all its variables, ranging from household spending to exports to the labour market. Inflation was perhaps the only variable that had not shown the strength of other economic variables but was close to the objective of the FED of 2%.

Japanese exports improved, mainly by the automotive sector. Private consumption was expected to have a positive performance in 2017 due to a good performance of the labour market, and effects on wealth, given the growth of the stock index in Japan and the main economies of the world. Real estate investment also showed positive signs since the end of 2016.

Given these positive signs, the bank expected a moderate expansion of the economy in 2017 given a rise in domestic demand for goods and services, in addition to better global growth and the depreciation of the yen, which would continue to boost exports.

The committee recognised that there was a lack of strength for the inflation rate to be at 2%, so it was important for the bank to continue with its guidelines and its operations in the market in order to continue channeling inflation towards the objective set by the bank’s mandates. The committee cleared doubts about its increase in long-term rates given the rate hike that the FED carried out, being very clear that its monetary policy decisions would only be based on local inflation conditions and not on decisions of other central banks.

At the mid-year meeting in 2017, the bank decided to keep the negative interest rate of -0.1% in a vote of 7 to 2. In order to maintain the long-term interest rate at 0%, the bank decided to buy JGB at the same rate as it had already done by increasing its holdings by 80 trillion yen.

By mid-2017 the Japanese economy had returned to a moderate expansion, with a slight increase in exports as well as fixed investment in businesses. Private consumption still did not show positive signs despite a better outlook in the labour market with wages rising slightly. In terms of the consumer price index, its annual measurement was close to 0%, so the bank was far from its annual growth goal, but expectations were positive because they expected an upward trend of this indicator.

The bank said it would continue with the Quantitative and Qualitative Monetary Easing (QQE) program until inflation rises above 2% in a stable manner that would allow for a path of economic growth that is larger than expected until mid-2017.

At in the October 2017 meeting, the bank committee decided with a vote of 8 to 1 to keep the short-term interest rate at -0.1%. For the long-term interest rate, the Bank of Japan continued acquiring JGBs to keep the interest rate at 0% for the long term. In the reports, it was indicated that the vote was not unanimous because a member of the board needed more encouragement from the bank to reach the goal of 2% as soon as possible.

In the meeting held in October 2017, the bank continued with its monetary policy of negative interest rate established at -0.1%. Yields on 10-year Japanese government bonds were still zero given the intervention of the central bank. The Nikkei 225 index rose considerably during 2017 given high expectations in the corporate results of Japanese companies.

As for the yen, it depreciated against the dollar during the year due to the interest rate differential between both central banks. Regarding its parity with the euro, it did not fluctuate significantly during the year.

As in the January report, the performance of the global economy remained positive, especially in the United States, which maintained a robust growth rate with good employment rates and good dynamics in its domestic markets.

In Japan, the economy grew at moderate rates with good dynamics in the export sector that was positively boosted by world growth. Fixed investment in businesses showed signs of moderate growth mainly due to an improvement in corporate revenues, better financial conditions and a better expectation of economic growth in the following quarters.

The unemployment rate has remained at low levels between 2.5% and 3%, which has encouraged greater private and household spending. The behaviour of real estate at the end of 2017 showed flat signs and the industry showed a growing trend. Regarding inflation, the Consumer Price Index (CPI) for the main goods minus food showed figures between 0.5% and 1%, as shown in the following graph.

Graph 76.CPI Inflation Japan 2017.Retrieved 26th February 2017, from http://www.inflation.eu/inflation-rates/japan/historic-inflation/cpi-inflation-japan-2017.aspx

Although it is still not close to 2%, the behaviour of inflation has improved, and the bank’s expectations were that in the medium and long-term, inflation would be located at the bank’s target rate. It was clear to all board members that the engine of year-round growth was exports that benefited from a better global juncture.

If you compare the projections that the bank had in July and November, the projected inflation rate of prices decreased in November and was due to more pessimistic expectations about price growth and a reduction in mobile telephony, but the medium and long-term rates remained without modifications. For some members, there was still a long way to reach the goal of 2% due to an excess supply of capital and a labour market that still needed to be narrower, so that wage increases would be stronger.

In conclusion, given the behaviour of the economy during 2017, the committee determined that the economy needed monitoring continuously to achieve its goals in the coming years. The objective of inflation was met, but the board was satisfied with the macroeconomic development of Japan. For most of the members, it was clear that the monetary easing program should continue to support the different measures of inflation so that the expectations of businesses and households would change and spend more, boosting wages and prices.

There was also the concern that other banks were ending their monetary easing programs and in some cases, interest rates were rising, so this could put pressure on the yen’s exchange against other currencies. The monetary relaxation program had begun later in Japan, so the normalisation of its monetary policy could also take longer. Given these statements, it was easy to understand why the executive board still did not change the negative interest rates and its purchase of Japanese government bonds.

©Forex.Academy

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Japan’s Economic Outlook

Japan’s economic outlook

Category: Fundamental analysis, Intermediate, Currencies, economic cycles, Monetary Policy, Economy, Macroeconomics, Central Banks.

Key Words: Central Banks, Monetary Policy, Bank of Japan, Projections.

At each meeting of the bank’s board, a review is made of the state of the Japanese economy, the projections for the current year and the next two years, and the risks to which the economy is exposed both internally and externally.

In the April 2017 report, the board concluded that the economy would continue its positive trend growing above the potential stipulated by the bank, due to better internal financial conditions, some government stimulus and greater global economic growth. The bank was explicit that the expected growth in 2017 and 2018 would be higher than in 2019 due to a cyclical slowdown in fixed investment in business and an increase in the consumption tax that had already been programmed.

As global growth had generally improved, Japanese exports had shown an upward trend, contributing to economic growth. Private consumption had also been resilient due to a better outlook in the labour market with better employment rates and higher wages.

As already mentioned, the bank expected that by 2019 the local economy would slow down a little due to a slowdown in domestic demand reflecting the closing of the cycle of expansion in business investment in addition to the increase in consumption tax since that year.

Regarding inflation, the annual change in the CPI (Consumer Price Index) excluding fresh food continued to show better figures than in 2016 with a clear upward trend thanks to a better performance of the economy and an increase in expectations medium and long term. But even the price growth is not as strong as the bank would like so they followed the price index with some caution.

The annual CPI for April excluding food and energy was close to 0%, so the bank was still expectant that the price index was far from the target rate of 2%.

Regarding monetary policy, the bank indicated that it would continue to apply Quantitative and Qualitative Monetary Easing with the Yield Curve control, with the objective of using it until inflation hit 2% so that the short-term interest rate would remain in negative territory.

Inflation could reach 2% in the medium and long-term, but not in the short term due to the weak behaviour of the main price indices. It was estimated that in the medium and long term it could reach  2% due to better economic growth rates added to energy prices that have been rising in recent years. In addition, the policy of monetary easing continued to drive the supply of credit and liquidity to the market so that inflation continued to rise to the bank’s target figure.

Also, the unemployment rate continued to decrease showing figures between 2.5 and 3%, so the labour market was narrowing which could generate an increase in the nominal wages of people, which in turn could lead people to consume more and this would boost inflation. The following two graphs show the main projections of the members of the committee and the expected behaviour of the CPI until 2019.

Graph 77. Forecasts of the majority of Policy Board Members. Retrieved 27th February 2018 from https://www.boj.or.jp/en/mopo/outlook/gor1704b.pdf

 

 Graph 78. CPI (ALL ITEMS LESS FRESH FOOD. Retrieved 27th February 2018 from https://www.boj.or.jp/en/mopo/outlook/gor1704b.pdf

 

In the July report, the committee stated that the path of economic growth was still positive due to the already exposed factors of a better global panorama and incentives created by the government to stimulate the local economy.

Regarding inflation, there were negative signals that showed a weak CPI (excluding food and energy prices), being in figures between 0 and 0.5%. The bank indicated that it could be due to the caution that the companies had at the time of fixing the prices and the wages of their workers. This behaviour of the companies caused expectations to decrease somewhat on inflation in the medium and long-term. The bank stressed that for inflation to reach 2% companies had to be more determined when setting prices and wages.

What was driving inflation in recent months were energy prices due to higher global demand for fuels and the agreements reached by OPEC to sustain oil prices, which is why the bank was concerned that the other components of the prices were not contributing to the rise of the recent CPI.

Due to the weakness of inflation, the bank decided that it would continue with its policy of monetary easing until inflation was close to levels close to 2%, so that short and medium-term interest rates would remain in negative territory. In addition, the financial market continued to offer credit facilities to the market.

Despite the weak performance, in the bank’s projections, it was estimated that in the medium and long-term the inflation rate would be at 2%, but the projections had fallen slightly on this variable for the next two years.

In the October 2017 report, the bank’s committee continued to observe a positive performance of the economy due to higher exports thanks to the better performance of the world economy throughout 2017.

In terms of domestic demand, fixed investment in business had followed a slight upward trend with better profits from companies and better expectations of entrepreneurs on the Japanese economy.

Private consumption continued to grow moderately, thanks to the better performance of the labour market. There were good rates of job creation and wages rose slightly. Public investment had also had positive behaviour during the last quarter, but not spending by households that had shown flat figures throughout the year.

Looking at the financial conditions, the outlook did not change with respect to the two previously issued reports, since the short and medium-term rates remained in negative territory. Financial institutions were still willing to lend to the market, and corporate bonds were still well received by the market, so the bank continued to observe the accommodative financial conditions.

Although inflation continued to rise slightly as in mid-2017, this behaviour was mainly explained by the rise in fuel prices and energy in general. The weak behaviour of the CPI excluding food and energy was due to the little increase in prices of companies as well as wages and a mobile phone market increasingly competitive in prices.

If you compare the projections that the bank had in October with the projections at the beginning of 2017, the CPI showed a weaker than expected behaviour, but it was expected that in 2018 and 2019 inflation would have more positive figures as shown in the following graph.

Graph 79, CPI (ALL ITEMS LESS FRESH FOOD, Retrieved 27th February 2018 from https://www.boj.or.jp/en/mopo/outlook/gor1710b.pdf

 

The reasons for a better performance of the CPI for the following years should be given thanks to better conditions in the labour market, better performance of the economy in general and better market expectations. The graph shows that inflation bottomed out at the end of 2016, showing deflationary signs.

The risks faced by the Japanese economy according to the bank were:

  • New regulations implemented in the United States and economic performance will directly affect global growth
  • Geopolitical risks
  • The Brexit negotiations
  • The problem of the European debt

These factors could affect the decline of the Japanese economy due to its direct involvement in world trade. The following graph shows the bank’s projections at the October meeting.

Graph 80. Forecasts of the majority of Policy Board members. Retrieved 27th February 2018 from https://www.boj.or.jp/en/mopo/outlook/gor1710b.pdf

 

If these projections are compared with those made at the beginning of the year and July, expectations for 2017 and 2018 improved and remained the same for 2019. That shows the good performance of the economy and a slight recovery of inflation, but as the bank reaffirmed that recovery was not robust since it was mainly based on energy prices. The other components of the CPI did not yet show positive figures, so the bank expected 2019 to be close to 2%.

As long as the inflation rate was not close to 2%, the monetary easing policy would continue. That would include negative interest rates and acquisitions, and corporate bonds to provide liquidity to the market and thus achieve better growth rates. This would encourage companies to be more aggressive in its increases in prices and wages of workers, which was not as strong as would be expected from a narrow labour market, although they did rise during 2017.

The following graph shows the CPI excluding food and energy which shows that the figure during 2017 was well below 0.5% which is negative and gives the reason why the bank committee was concerned because the basic items of the index showed a very weak behaviour.

 

Graph 81. Chart 38, CPI. Retrieved 27th February 2018 from https://www.boj.or.jp/en/mopo/outlook/gor1710b.pdf

©Forex.Economy

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Organisation of the European Central Bank

Globalisation has led to an integration of the various aspects of people’s lives from consumer habits to cultural aspects. The economy has not been indifferent to this phenomenon and the relations between most countries have been internationalised so that there is more and more dependency between them and for that reason greater co-operation between governments and between the central banks of each country.

There are more and more processes of regional integration, which has led geographically close countries to eliminate barriers to trade between each other and generate an economic bloc that is more competitive with the rest of the world. But not all forms of integration are equal, there are some deeper ones that allow macroeconomic policies to be co-ordinated and create a single currency and other unions that simply reduce trade barriers between countries without going beyond a privilege in trade with certain countries.

The European Union has developed a legal and political system that promotes continental integration through common policies that cover different spheres of European society, although the origin of this union is especially economic. The form of integration was a monetary union where a single currency was created to facilitate transactions between countries, but some countries belonging to the European Union avoided giving up their control over their currency and therefore did not adopt the Euro as a transaction unit.

In order to achieve monetary union, certain requirements of fiscal homogeneity need to be met in order to synchronise their macroeconomic policies, which is why some European countries have first had to meet some public deficit targets in order to be part of the integration. Being part of a monetary union, the member countries give part of their sovereignty to the European Central Bank, in charge of issuing the common currency and fixing the monetary policy of the economic union.

The countries that make up this economic agreement have:

  • Preferences among members to boost trade within their borders.
  • Elimination of trade barriers for members of the agreement.
  • Common external protection.
  • Free mobility of capital, people and productive factors
  • Economic policy coordination
  • Unique economic policy

The first historic step for the consolidation of the European Central Bank occurred in 1998, where the decision was made to build an economic and monetary union with free capital mobility within Europe, a central monetary authority and a single monetary policy within the European area. But before formally taking the decision two previous events had occurred that allowed the creation of the bank.

  1. In 1990, free capital mobility is allowed among some European countries, as well as greater co-operation among central banks, which allows a convergence in the economy of several European countries.
  2. The European Monetary Institute (EMI) was established in 1994, central banks were prohibited from continuing to grant loans, monetary policy co-ordination was further increased, economic convergence followed and the establishment of central bank independence to take the necessary measures for the good performance of the economy.

Already in 1999 stronger steps were taken for the monetary and economic union, such as the introduction of the Euro, the establishment of a single monetary policy set by the European System of Central Banks (ESCB) and the conversion rates were set.

Since the 1st of January, 1999 the European Central Bank has been responsible for conducting the monetary policy for the eurozone consisting of 19 state members. To be part of this union, each country had to comply with certain economic and legal criteria. The following chart shows the main stages of the European Central Bank.

Graph 74. Stages of the European Central Bank.

 

The European Central Bank has a legal status under international law and is considered an international institution. The Euro system is composed of the European Central Bank (ECB) and the National Central Banks (NCBs) of the countries that adopted the Euro. The Euro system and the European Central Banks system will continue to co-exist as long as there are members of the economic union who have decided not to adopt the Euro. The following chart shows the member countries of the eurozone.

 

Graph 74A. Euro Area 1999-2015. Retrieved 16th February 2018, from https://www.ecb.europa.eu/euro/intro/html/map.en.html

 

Mandate

The main objective of the bank and its monetary policy is to maintain price stability. As complementary objectives, the bank must help the economies of member countries in their growth and in the dynamics of the labour market, but without these variables diverting the main objective of keeping inflation under control.

For the bank, price stability is defined as an annual increase in the Harmonised Index of Consumer Prices (HICP) for the entire eurozone below 2% and a long-term target of 2%.

 

Organisation

The European Central Bank has four major subdivisions that make all the decisions to fulfil the bank’s mandate.

  • The Executive Board
  • The Governing Council
  • The General Council
  • The Supervisory Board

 

The Executive Board

All the members of the board are appointed by the European Council. Each member is chosen for a period of eight years without the possibility of renewing. The board meets normally every Tuesday and is composed of:

  • The President
  • The Vice-President
  • Four other members

The committee is responsible for the implementation of the monetary policy defined by the governing council and the instructions given by the National Central Banks (NCBs). It is also in charge of the daily management of the bank and prepares the meetings of the governing council.

 

The Governing Council

It is the decision-making body of the bank, composed of six members of the executive committee as well as the governors of the central banks of the 19-member countries of the Euro-system. It is chaired by the president of the ECB. They meet every six weeks and publish the minutes of the meetings with all the necessary information four weeks after the meeting. In total it is composed of 25 members with the accession of Lithuania in 2015 and there is a rotation of the votes in the meetings as follows:

 

Rotation of voting rights in the Governing Council

 

 

Graph 75. Rotation of voting rights in the Governing Council in 2018. Retrieved 16th February 2018, from https://www.ecb.europa.eu/ecb/orga/decisions/govc/html/votingrights.en.html

The responsibilities are to define the monetary policy of the euro area and in particular to establish the interest rate at which commercial banks will be given resources, in addition to the supply of Euro-system reserves.

 

The General Council

It is composed of the president of the ECB, vice president of the ECB and the governors of the 28 National Central Banks (NCBs) that belong to the European Union, where 19 countries are of the euro area and 9 countries of non-euro areas. Other members who attend the meetings, but without the right to vote are the president of the Council of the European Union and members of the European Commission.

The general council carries out the tasks assumed by the European Monetary Institute (EMI) that the ECB should execute as the last phase the economic and monetary union since not all the member states adopted the Euro. Its functions are the collection of statistical information, preparation of the annual report of the ECB among others. This body will be dissolved when all the members of the economic union assume the same currency.

 

The Supervisory Board

The supervisory board meets twice a month to discuss, plan and carry out supervisory tasks of the bank’s departments. It consists of, the president appointed for a period of 5 years, vice president elected from among the members of the executive board, four representatives of the ECB and representatives of national supervisors

In conclusion, there is a certain similarity between the way monetary policy decisions are made between the European Central Bank and the US Federal Reserve since it is done through voting by the governors of the banks that make up the central bank and take turns the votes in the meetings. The difference is that the rotation of the votes of the districts that make up the Federal Reserve is annual while the votes of the banks that make up the ECB are rotated monthly as shown in the graph above.

Regarding the mandate of the central banks, there is a greater similarity between the ECB and the Bank of England since both have to maintain price stability as its main objective, and the objective of the annual growth of inflation is 2%. Although they also worry about economic growth and the unemployment rate, these objectives are secondary. While for the Federal Reserve the three variables are equally important, so by mandate they are responsible for maintaining low unemployment rates, stable economic growth with good growth rates and an inflation rate that is close to 2%.

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Bank of Japan

The Bank of Japan is the central bank of Japan. It is a juridical entity established by the Bank of Japan Act. It has no governmental character nor is it a private corporation. The law states that the bank’s objectives are to issue banknotes, carry out monetary control and monitor the stability of Japan’s financial system. The law also stipulates price stability as the main objective of the bank which will contribute to the development of the national economy.

The Bank of Japan started its operations on the 10th of October 1882 as a central bank under the laws of that country. The original statutes were modified in 1942 due to the war situation and after this conflict ended, the bank’s regulations were modified again. In 1949 the Policy Board was set as the governing body and responsible for making the most important decisions of the bank. The law of 1942 was completely revised in 1997 and it was stipulated that the bank’s independence and transparency were fundamental pillars of the bank.

The organisation of the bank is divided as follows:

Graph 70. Organization Chart. Retrieved 15th February 2018, from https://www.boj.or.jp/en/about/organization/chart.pdf

 

The Policy Board was established as the most important bank entity for decision making. The board examines the guidelines for monetary and currency control, establishes the basic principles to carry out the operations of the bank and supervises the fulfilment of the duties of bank officials.

It is composed of 9 people. The Governor who represents the bank and exercises general control over the affairs of the bank, two Deputy Governors who assist the governor and they control some matters of the bank, and six members of the Policy Board who serve as support for the Governor and Deputy Governors. They are also in charge of other matters of the bank.

Then there are the Bank’s Officers who are made up of the Governor, the Deputy Governors, the members of the board of directors, auditors, executive directors and counsellors. These officers are responsible for managing the operations of banks, to ensure that employees comply with the required tasks and assist in the tasks of the Policy Board.

Finally, there are the Departments, Branches, Local Offices in Japan, and Overseas Representative Offices. There are 15 departments, 32 branches and 14 local offices in Japan and 7 overseas representative offices

The bank is capitalised by 100 million Yen due to the bylaws, and 55% of the capital is subscribed by the government. The law does not grant the holders of the subscription certificates the right to participate in the management of the bank and in the event of liquidation they are only granted the right to request the distribution of the remaining assets up to the sum of the paid-in capital. Dividend payments in paid-up capital are limited to 5% or less each fiscal period.

The central objective of the monetary policy of the bank is the stability of prices. It was stipulated as an objective from 2013 that the maximum rate of annual growth of prices was 2%, this rate promotes economic growth and the well-being of the population. Price stability is important because it provides the basis for the nation’s economic activity.

In a market economy where there is a diversity of markets, individuals and companies make decisions about consuming, investing or saving according to the prices of goods and services in addition to the interest rates of the financial system. When prices fluctuate beyond what is expected, it is difficult for agents to make decisions and this may hinder the efficient allocation of resources and revenues.

The Policy Board of the bank decides on the basic stance of monetary policy in its meetings, discusses the economic and financial situation and then makes an appropriate guide for monetary policy operations. After each meeting, the bank publishes its evaluations of the economic activity and the price level, as well as the position adopted by the monetary policy in the short term.

According to the guidelines stipulated by the board, the bank controls the amount of money circulating in the economy, mainly through Money Market Operations. The central bank offers funds to financial institutions through loans that are backed by guarantees given to the central bank.

The meetings of the board of the central bank are held eight times a year and each meeting takes two days of discussions. At each meeting, the members of the board of directors discuss and decide on the guidance of future operations in the money market. Monetary policy decisions are taken by majority vote of the nine members of the Policy Board.

One aspect that has become widespread but is still important is the independence of the central bank since the decisions made by the bank have an impact on the daily life of the Japanese people. The bank and its employees conduct economic and financial system research to be well informed about the most appropriate decision on monetary policy.

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Quantitative Easing in the Bank of England

The issue of the balance sheet has been discussed by a number of analysts since there is no consensus on what the appropriate size for the assets of the bank should be, and how positive it is to have a very large balance as that acquired by the main banks in the world. Some analysts believe that at present the balance sheet of the main banks in the United States, the United Kingdom and the European bank has expanded sufficiently, and the committees of these banks have wanted to materialise a change in asset acquisition policies.

Many people believe that the purchase of assets increases the balance sheet unnecessarily due to the limited scope of this measure in the real economy in terms of job creation and economic growth.

After the 2008 crisis, the Federal Reserve and the Bank of England, among others, multiplied their balance sheets several times through a quantitative easing program which consisted in the issuance of money to finance the purchase of government bonds and corporate debts. The long-term objective of this measure was to keep interest rates low in the medium and long-term in order to support the financial system and demand for loans, which would reactivate the economy.

Many analysts believe that the decision to modify the balance sheet was made due to the limited response of the economy in the short term to reductions in the interest rate after the financial crisis.

When the authorities of the main banks issued their intentions in 2014 to normalise their policy and begin to reduce their balance sheet, financial markets became more volatile due to the change in expectations of investors who expected higher interest rates in the long term. But it is not clear yet how much the balance sheets would be reduced or what the possible consequences of this policy change would be, so in the next part of the article, it will expose the main findings of Charles A. Goodhart in his paper, A Central Bank’s Optimal Balance Sheet?

The paper criticises the centralisation of monetary policy studies since it is well known what the effects are of the intervention on the interest rate, but not the study on the normalisation of the balance sheets of banks. The conjuncture of the paper was given at the moment that the FED was announcing the reduction of the size of its balance sheet by not reinvesting its internal cash flows of interest payments and the maturation of the principal.

It was expected that the announcement would come out between September and October 2017 and that some banks such as the European Central Bank (ECB) and the Bank of England would follow in the footsteps of the FED soon after. What the market had discounted is that the reduction of the balance sheet would be gradual, to be only the non-reinvestment of its cash flow instead of selling the portfolio of banks directly. But for Goodhart, what had not been discussed was what the final objectives of normalisation were and what the equilibrium balance of the banks would be.

Quantitative easing involves not only public debt assets but also the purchase of financial and corporate assets in some countries to support credit flows in weak markets. But with the normalisation of the balance sheet, the direction of the credit as its supply and demand should be determined by the market, and the assets held by the banks in equilibrium should be only public debt assets.

Although the banks have already expressed their desire to normalise their balance sheet, there are still different points of view on what the result of the normalisation policy should be. That is why the author exposes two different points of view about the people who defend the permanence of the expanded balance sheet and those who are against it.

Those in favour of a larger balance sheet mention that the payment of interest on excess reserves or offering Reverse Repos (RRPs), central banks can continue to control the official short-term rate and thus fulfil the mandate of monetary policy without having to import the size of the reserves of commercial banks and their own balance sheet.

Furthermore, according to the defenders of a large balance sheet, central banks can create additional liquidity for the benefit of the public sector since their assets generally have a higher rate of return than their liabilities, so this positive dynamic can be followed with large balances that end up contributing to the public sector.

The truth is that the optimal size of a balance sheet is unknown, and consensus may never be reached. The only thing that is not proposed is to continue increasing these balances but to maintain the current levels that, as already mentioned, would not have negative effects according to these people.

Analysts who are against the big balance sheet criticise the fact that the people who make the analysis of the quantitative easing and balance sheets of the central banks come from the central banks themselves, so they are not the most suitable and objective people to perform this work. In addition, they could be under political pressure, so it would be best for people outside the institutions to do the analysis on what is best for the banks and the economy.

It is also clear to them that with normalisation, it is likely that short-term interests will increase which would lead to higher payments on their liabilities, while the increase in the rates that are paid to their assets would increase more slowly, which would go against the argument in favour of having a large balance. It would be the opposite because it would reduce the central bank’s liquidity by generating losses, although the magnitude of this will depend on how the bank’s balance sheet is made up.

It is clear that there will always be a continuing concern about financial stability and according to Goodhart, there is a consensus on the need to continue satisfying the demand for liquidity of the financial system in general. But that could be achieved with a great variety of assets in the system and not necessarily everything has to be done through the massive holdings of commercial bank reserves in the central bank.

Another problem that is generated by the maintenance of satiety of liquidity is that the desired level of liquidity can be altered over time, so it would not be possible to differentiate if the economy is in a stage of growth or a crisis, so an imbalance in the sizes of the balance sheets would be generated in the long term.

Perhaps the biggest problem with an excessively high balance is that the disadvantages outweigh the advantages according to Charles A. Goodhart. This is generated because the long-term interest rates remain excessively low, so it is best to reduce the size of the balance in a gradual manner. In addition, the size of the balance sheets has become so large and debt levels are generally so widespread, which implies greater sensitivity in the future to increases in interest rates so that monetary policy could face some restriction.

In conclusion, the objective of monetary policy, in general, is to provide economic stability. But with excessive quantitative easing, the opposite can happen, since in the short term this generates a monetary stimulus, but in the long term, imbalances can be created. For example, in the long term, excessive QE and a stable economy could trigger high inflation beyond what is desirable by central banks.

In addition, this excess liquidity can generate a bubble in assets due to the fact that short-term interest rates are low, which encourages the valuations of some assets to exceed their fair value. This is an issue addressed by the monetary policy committee of the Bank of England which found that in the last year many assets have excessively increased their value which can be risky in the medium and long term, as a vertiginous decrease in the values of shares and other assets could be transferred to the real sector, affecting the growth path of the economies.

There are also critics since quantitative easing may be guilty in the long run of the creation of economic cycles since this policy created liquidity to get out of the financial crisis which kept interest rates low. But this was not necessarily positive because access to credit was facilitated and it may have generated the obtaining of credits to people who are not able to pay, so if this policy is followed, it is possible that the Financial system would suffer in the future, but for the moment what generated this large amount of liquidity was an economic boom.

The opposite can happen when that large amount of money is removed in the economy because as mentioned by the writer of the paper, an excessively large balance could have generated an imbalance in the economy without certainty of what could be the point of equilibrium of the economy. It is possible that a counter-cycle of the boom is generated because the long-term rates will increase with the reduction of the balance sheets, generating a narrower credit market affecting the main motor of many economies in the world, the consumption. It is clear that this reduction in the balance will be moderate to not have a major impact on the economy, but there is no certainty as to how this will turn out.

In the case of the Bank of England, you can see the progress of the balance sheet from 2015 to the third quarter of 2015. As is evident, there has not been a decrease in the value of the balance, although in the last three instalments it has not increased drastically, although its value continues to rise. The US Federal Reserve and the European Central Bank have already given some clues as to how they will reduce the excess liquidity, but the British bank has not yet commented on this.

 

 

Graph 66. The stock of APF HOLDINGS. Data Taken from

https://www.bankofengland.co.uk/asset-purchase-facility/2017/2017-q3

 

Graph 67. Gilts. Data Taken from

https://www.bankofengland.co.uk/asset-purchase-facility/2017/2017-q3

 

Graph 68.Term Funding Scheme. Data Taken from

https://www.bankofengland.co.uk/asset-purchase-facility/2017/2017-q3

 

Graph 69. Corporate Bonds. Data Taken from

https://www.bankofengland.co.uk/asset-purchase-facility/2017/2017-q3

 

Although there is no defined route by the English bank of how it will normalise the liquidity it is evident that a large part of the assets are the Gilts that are bonds issued by the British government, so if it is taken as true the central idea of the paper A Central Bank’s Optimal Balance Sheet?, the English bank can start its reduction with corporate bonds and other assets that do not represent a large percentage of its balance. After the bank reduces or eliminates those assets, the credit market will respond to supply and demand forces as stipulated that it should be.

With the measure taken by the MPC in November 2017 to raise the interest rate, this may be the beginning of the normalisation of the balance sheet, as the meaning of this measure was to keep interest rates low to inject dynamics into the economy. But the current conjuncture of the British economy is different from the one that existed after the 2008 crisis because of the Brexit elections.

Inflation is at very high levels, so the Bank of England has decided to start raising its rates which could be complemented with the normalisation of the balance sheet since it is expected that a smaller balance will generate a reduction in the inflation indexes.

In addition, the global context is favourable to observe higher inflation rates since the world economy is growing at higher rates than expected, which may lead to higher inflation rates. The Federal Reserve has already begun its normalisation since October and it is expected that the European Central Bank will start soon, as will the Bank of England for the latest monetary policy decisions.

According to the main newspapers of the world, more aggressive increases in interest rates are expected in the United Kingdom due to the good performance of the economy in the world and in this territory. Logically, the United Kingdom has not shown the same dynamics as other countries such as the United States due to the risk associated with the United Kingdom until it is clarified how negotiations with the European Union will end.

It is likely that with a more aggressive rate hike the normalisation will also be faster, but we will wait for the next quarterly reports of the bank’s balance to observe what the pace of normalisation will be like. The composition of the assets is a determining factor since a large part of it is made up of public debt and if what is stated in the paper serves as the guidelines that banks will follow, it is first expected that banks will dispose of corporate debt and other assets, which is a small part as seen in the graphs above.

In conclusion, the Bank of England has a good profile on its balance sheet since almost all of its assets are public debt, which means that the possible effect and noise that standardisation will generate may be small. With the increase in rates, the first step towards normalisation was taken for the medium and long-term, as mentioned several times, central banks will do everything possible to reduce their balance sheets very slowly, avoiding possible undesired effects. In 2018, a more aggressive rate hike is projected due to the behaviour of inflation in the United Kingdom, although no statement has been issued such as that issued by the FED which mentions an exact date to begin normalisation.

When this process begins, it is not known to what extent an equilibrium level will be considered, as there is no consensus on how much the indicated level of liquidity in the economy is, and the level chosen by each central bank may be different. The European Central Bank has also issued statements, although it has not initiated this process. We will have to be alert to the possible effects that this will generate in the market and what decisions the Bank of England will make during the following years since by the middle of 2019 it is expected to conclude negotiations with the European Union so that normalisation could be affected if the financial system presents a marked weakness. The evolution of the balance since 2009 can be seen in the article Asset Purchase Facility Quarterly Report 2009-2017 where there have been two important moments of increases in assets and the composition of the sheet has also changed over time.

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Inflation Reports – Bank of England November 2017

In the inflation report of November 2017, the decision of the Monetary Policy Committee (MPC) was published. They decided to raise the interest rate by 0.25% to 0.5%. In the explanation of the decision, the MPC mentioned that the Consumer Price Index (CPI) had increased in September more than expected, reaching levels of 3%. But the concern according to the committee was not the figure of September and November, but the trend that it was taking as it was accelerating more than expected.

This is why the committee decided to increase the bank’s rate because they expected that after the adjustment of the economy due to the Brexit process, inflation had to progressively return to the 2% target, but this also required the help of monetary policy.

In the conjuncture seen by the bank at the end of 2017, there was high inflation, a deceleration in the main sectors and an economy growing at high rates compared to the last years, so the committee decided that the right decision was a moderate increase in rates.

The committee was very emphatic that future decisions would be determined over time since the United Kingdom was at a special juncture that could not be compared to any other situation before, so there was still great uncertainty as to how the negotiations would end with its main commercial partner, the European Union.

As mentioned in previous reports, the MPC was emphatic that monetary policy could not prevent the economic adjustment generated by the exit of the economic union since its commercial relationship could be affected due to a change in the negotiation parameters, such as tariffs and the free mobility of people and capital. But they admitted that monetary policy could help in the transition to be less traumatic for the British.

The growth of domestic consumption grew very slowly because the income of households and their purchasing power was not the same as they had before the elections. As in the May meeting, net trade had been reinforced by greater global expansion and a past depreciation of the pound sterling. Business investment was still affected by the uncertainty around Brexit, but it was growing at moderate rates due to better global demand, high profitability rates and low cost of capital.

With employment at low rates unseen since several decades ago, inflation well above the bank’s target and economic growth above the rates of recent years, the committee saw greater possibilities to strengthen its monetary policy for the long term to bring inflation to the target of 2%, without affecting the labour market and growth.

The committee in its report explained how the rate increase affected the macroeconomic variables. The first effect was a reduction in borrower flows and an increase in the loans obtained from commercial banks. The opposite effect was felt by savers who received higher rates of return for the money they had in banks in their savings accounts. An increase in the interest rate makes it more attractive to save today to consume in a later period and makes it less attractive to borrow due to the higher cost of the flows. And finally, the bank mentioned the effect of an increase in the rate on the exchange rate with other currencies and the valuation of British assets.

The committee did not expect the effects of the interest rate rise to be so drastic, since analysing with the stress test carried out by the financial policy committee, the committee observed a financial system that could be solvent in the face of challenging situations. In addition, about 60% of mortgages in the market were indexed at fixed rates so that consumers would not be affected so much by this measure, except for consumption because the interest rate rise will directly affect credit cards and other types of loans.

The bank also considered that the balance sheets of the companies were in good shape and the proportion of the profits required to meet the monthly payments of the debt fell to their lowest level during the last two decades.

In the expectations of the committee as already mentioned, it was projected that monetary policy would continue to support the economy and the labour market, but it was expected that during the next meetings the interest rate would continue to increase moderately to control the long-term inflation.

Brexit remained the main concern of the economy and the bank because without having finished their negotiations, the impact felt in the economy was strong and the economy was still accommodating by a currency that depreciated, which increased the prices of imported goods and an economy that was growing at slow rates, despite the fact that world growth was improving significantly. The following chart shows the main sectors of the economy and how they change their contribution to economic growth.

Graph 58.  Contributions to average quarterly GVA growth. Retrieved 5th February 2018 from

https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/nov.pdf?la=en&hash=950B4B1481D081CA035FC076CF9FFFFB08F658A6

In the MPC vote, it was decided to raise interest rates with a result of 7 to 2 in favour of the measure. The committee voted unanimously to maintain the sterling stock of investment-grade non-financial grade bonds at £10 billion. The committee also voted unanimously to keep the stock of purchases of UK government bonds at £435 billion.

On the international scene, the committee observed a global economic acceleration during 2017, including the G7 (excluding the United Kingdom). All measures of investor confidence and demand for products have remained robust throughout the year and have exceeded the expectations that had in committee. Despite this, the United Kingdom has not benefited from this international panorama.

This better outlook for global growth and the confidence of the markets since 2016 has been an important factor in boosting the prices of risky assets in the world and financial conditions in many countries. Despite this, the growth of the UK during the first half of 2017 was modest and investors were still very cautious with their projections about how the negotiations between the UK and the European Union would culminate.

With the volatility existing since the referendum, the pound sterling has lost about 15-20% of the values reached at the highs of 2015. In addition, the price of the shares of companies concentrated in the United Kingdom has suffered severe discounts in relation to companies from the same sector that are located in other countries. The following chart shows the behaviour of the pound sterling.

Graph 59. Sterling exchange rates. Retrieved 5th February 2018 from

https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/nov.pdf?la=en&hash=950B4B1481D081CA035FC076CF9FFFFB08F658A6

Regarding the labour market, the committee observed a drop in the unemployment rate, but a timid response of wages to this narrow labour market. An explanation to this phenomenon where there are fewer unemployed, but the salary does not increase could almost be due to the fact that there are many people who have stopped looking for a job or are underemployed, so we see an unemployment rate that should be higher. If that were the scenario of the labour market, companies could still find skilled workers without having to raise wages to attract that new workforce.

The expectations that the committee had about inflation were a little moderate because if agents expect high inflation in the future in basic goods and wages, future inflation will be high and will have persistent factors. Therefore, the committee took the decision to raise interest rates. In some surveys conducted, it was evident that agents did not believe that inflation would be in the short-range in the short term.

In conclusion, the main conclusions reached by the committee and the possible risks faced by the economy of the United Kingdom at the November meeting were:

  • Global growth remained strong and accelerated in recent months.
  • Net investment and trade supported British demand, but the growth of domestic consumption continues to show moderate rates which are consistent with the loss of purchasing power of households due to the depreciation of the pound sterling.
  • Significant upward pressure on inflation from imports and energy prices has increased the pressure on expectations for the coming quarters. Inflation has been very close to 3% between November and October and the speed for inflation to return to the target rate will depend on how quickly these pressures disappear as well as on the behaviour of domestic prices.

The following table shows the projections of the main variables by the committee.

Graph 60. Forecast summary. Retrieved 5th February 2018 from

https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/nov.pdf?la=en&hash=950B4B1481D081CA035FC076CF9FFFFB08F658A6

Compared to the projections that the bank had at the meeting in May, a lower GDP was expected due to the slow growth of the economy where the services and consumption sectors have affected growth. Inflation accelerated in the last months of the year, so the intervention of the bank was necessary, increasing interest rates. It is also possible to analyse that the labour market has continued its positive path with a significant reduction in the unemployment rate, but wages have not kept pace and it is possible that some people have left the labour market and have stopped looking for work which is not an advance of the economy.

The Bank of England has been consistent with the conclusions it drew at its previous meetings where it was evident that the rate hike could not be very aggressive due to weak economic growth and the lack of response from rising wages, but at very moderate rates. The bank in its two meetings prior to the November meeting had stressed that monetary policy could be adjusted in any direction since as the United Kingdom was in a special situation and there was no certainty about what the conditions of the economy were going to be at the end of the year.

The increase in rates at the November meeting is consistent with the behaviour of inflation that accelerated during the last months of 2017 reaching close to 3%, which is considered the maximum level allowed for deviation from the target range. What also helped make the decision was the good behaviour of unemployment that continues to decline to levels not seen for a while.

It is clear that the bank does not rule out future low rates depending on how the main economic variables will continue since it is the first time that the committee faces a situation of this type. But it is likely that in 2018 there will be an increase in rates by the MPC if inflation is still well above the target.

Graph 61. Averages of other forecasters’ central projections. Retrieved 5th February 2018 from   https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/nov.pdf#page=42

 

If we analyse the projections of agents that do not belong to the Bank of England, we can appreciate that the projections for the next three years are similar to the expectations that the bank had in the November meeting. The variable that most differed in the projections was the unemployment rate. As mentioned above, the British labour market has presented a strange situation showing very low unemployment rates in recent periods, but not with wages so there could be some imbalance in the labour market to explain this. This is why it is important to monitor in the future how the labour market will continue to behave in order to have an indication of what the next monetary policy decision will be.

It is also evident that inflation will be above the target range until 2019 according to surveys made to market agents and for the Bank of England, the goal will not be achieved until after 2020. This will be the most decisive factor to project future decisions of Monetary policy since by mandate the main objective of the bank is to maintain price stability. According to the inflation reports, it is expected that by the end of 2019 the Brexit negotiations will be completed, so until that moment it will be clear what the terms of trade will be between the United Kingdom and the European Union, so it is not expected that in the short term, the pound sterling will stabilise.

Graph 62. GBP/USD. Retrieved 5th February 2018 from

https://www.investing.com/charts/live-charts

If the market response is analysed after the November meeting, it can be seen from the graph that sterling continued to appreciate in the last months of the year, so it can be concluded that the markets have received the decisions of the MPC well, and expectations are no longer as pessimistic as a year ago.

But if its value is compared with the Euro, that appreciation has not been generated and remains at low levels since the decision was made to leave the European Union. So, there is still much uncertainty about what the results will be at the end of Brexit, which means that the pound sterling has not yet recovered the levels it had before the elections.

Graph 63. GBP/EUR. Retrieved 5th February 2018 from

https://www.investing.com/charts/live-charts

 

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Asset Purchase Facility Quarterly Reports 2009-2017

The Bank of England Asset Purchase Facility (APF) was established as a subsidiary of the Bank of England on the 30th of January 2009 to fulfil the mandate of the Treasury Chancellor. The mandate was then expanded to allow the fund to be used as a monetary policy tool. In order for the transactions to be transparent to the general public, the bank decided to publish quarterly reports to show the composition of the balance sheet of the Bank of England. The bank’s executive directors of markets, monetary and statistical analysis were designated as directors of the facility. These directors make recommendations on the assets that the bank will buy, and the Governor of the bank makes the final decision on acquisitions.

The Fund’s initial objective was to improve liquidity and increase the flow of corporate credit by purchasing high-quality assets from the private sector, including commercial bonds and corporate bonds. These purchases would be financed by the issuance of treasury bills. The scope of the APF of the Bank of England was determined to be delimited by the monetary policy committee to meet the 2% target for inflation.

The first meeting took place in March 2009 and the committee decided to bid £75 billion on assets financed by the issuance of central bank reserves. In order to buy this amount of assets, the bank acquired mainly debt from the United Kingdom government and, to a lesser extent, private sector assets. The objective of this measure was to stimulate the supply of money and credit, to raise the growth rate of nominal spending to a consistent level in order to reach the goal of the inflation rate in the short term.

The same decision was made at the following May meeting. In the quarterly report of May 2009, it was mentioned that the acquisition of the Gilts began on March 11. The Gilts are bonds issued by the British government in pound sterling and are generally considered low-risk bonds. The British Gilts are equivalent to the U.S. Treasury securities. The Gilts can be of two types:

  • Conventional issued in nominal terms
  • Indexed to inflation

At the end of 2009 purchases by the committee increased considerably to reach amounts of £175 billion, but as at the start of this procurement program most of the assets acquired would be from government debt. These changes in the maximum purchase limits were modified at the request of the monetary policy committee. Since the end of 2009, the bank announced that it would act as a seller, as well as a buyer of corporate bonds in the secondary market.

During the 2010 meetings, the committee voted to keep the asset acquisition cap at £200 billion. In November 2010 the bank announced a series of changes in the mechanism. The bank would give twelve months notice in advance of its intention to withdraw the Commercial Paper Facility, which reflected the bank’s better expectations regarding the economy and the British financial system and expected to sell more corporate bonds relatively. These better results were expected due to the economic recovery after the crisis of 2008, which led the economy to hit bottom in 2009, so in 2010 an economic recovery had started which moved to a better financial system.

There were no major changes until the November 2011 meeting where the committee increased the spending on assets to £275 billion. The committee stressed that the measures were taken to incentivise the growth of the nominal rate of spending and thus achieve the objective of medium-term inflation. In addition, since 2011, the service provider authorises the bank to continue conducting transactions with the private sector even if the transactions have not been met with a monetary policy goal, but it is still the smallest part of the bank’s balance sheet. At the next meeting in the first quarter of 2012, it was decided to raise the asset acquisition ceiling again to £325 billion.

From mid-2012 until the end of that year, the purchase ceiling was increased to £375 billion, financed with central bank reserves. The main objective was to influence the supply of money and access to credit so that the expense would grow in the United Kingdom to meet the inflation target. In a report issued in 2013 by the MPC, hints were given on how the path of monetary policy would be in the future.

The committee expressed that they would not reduce the stock of purchases of assets financed by the issuance of central bank reserves, so it would reinvest the cash flows associated with the maturation of its assets until the desired level of unemployment was reached. The committee concluded that the purchases of assets would continue until the unemployment rate reached rates similar to the objectives of the bank and the British government.

The next clue that the committee gave was on the 12th of February 2014, where the desired unemployment threshold had already been reached for the committee. The Monetary Policy Committee communicated that it would maintain that level of assets without major change until the decision was made to increase the interest rate up to 0.5%. In its 2014 reports, the MPC expressed its preference to use the interest rate as the main tool of monetary policy given its greater scope in the economy.

Therefore, in the 2015 report of the bank’s balance sheet, the committee stated that they would continue to maintain the amount of assets in a stable manner until they were sure what the best decision would be regarding the interest rate, without giving clues about what the direction that monetary policy would take. It is concluded that the Bank of England like many central banks see the modification of the balance sheet as a support for the main tool that is the interest rate.

On the 4th of August 2016, the MPC voted in favour of introducing a package of measures designed to provide an additional monetary stimulus with a purchase of corporate bonds for amounts up to £10 billion. In addition, a financing plan was introduced to provide liquidity in instalments for banks at rates close to the bank rate in order to reinforce the transmission of rate reductions faced by households and businesses in the United Kingdom.

In addition, the target for the stock of purchases of UK government bonds increased to £435 billion. In the next two graphs, you can see the evolution of the balance sheet of the bank since the creation of the fund and in the second you can see the variation of the most representative assets, the gilts.

 

Graph 64. The stock of APF Holdings.

 

Graph 65. Gilts

Analysing the global situation of the normalisation of the balance sheet of the banks, it was expected that at some point the acquisitions by the Bank of England would not continue. In addition, if the reports issued since 2009 are analysed, it can be observed which were the key variables that led the bank to continue injecting liquidity into the market to incentivise spending and achieve the inflation target.

  • The unemployment rate did not show figures that eased the feelings of the Bank of England
  • The financial system in the first years after the crisis showed a weak and fragile behaviour
  • In the 2014 and 2015 reports, the committee estimated that the acquisition of assets would stagnate until the interest rate increased. But in 2016 with the elections on the permanence of the United Kingdom in Europe, it was not possible to stabilise the number of assets.
  • The use of the bank’s balance sheet to affect some macroeconomic variables while determining the correct monetary policy using the interest rate.

If the comments of the committee are taken into account in the last meetings of 2017, it is observed that:

  • The unemployment rate is one of the lowest in recent decades.
  • The inflation rate is above the bank’s objective.
  • Short-term stabilisation in the economy growing at low rates, but without much volatility.
  • Increase in the interest rate at the November meeting.

With these variables, it would be realistic to expect a normalisation of the bank’s balance sheet due to the fact that the variables that have generated an increase in the acquisition of assets have normalised over time. But like other banks such as the FED, normalisation would be slow so as not to generate shocks in the economy, thus achieving results such as the reduction of inflation. But since the normalisation of the balance sheet is slower than the acquisition of assets, these types of policies will not have the same effects. In addition, with each quarterly report, investors and the market, in general, will be able to adapt to the measures taken by the central bank.

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Stress Test – Bank of England 2017

The Stress Test Report has been published annually since 2014. The report consists of taking certain variables such as unemployment, inflation, growth, among others, and evaluating what would happen to the banking system in case the greatest risks for the British economy were to materialise. Based on this report, the Financial Policy Committee (FPC) of the Bank of England is able to take the necessary measures to try to reduce or eliminate the risks to which commercial banks are exposed.

For the first time since the Bank of England issued and analysed the stress tests in 2014, no bank needs to strengthen its capital position as a result of the test. The 2017 simulation showed that banks are resistant to deep and simultaneous recessions in the UK, and to the global economy and a fall in asset prices. The economic scenario that was taken as the basis for the stress test was more severe than that witnessed by the markets in the 2008 financial crisis.

In the test, the banks’ losses would be close to £50 billion in the first two years after the economic crises happened. That scale of losses, relative to their assets, would have wiped out the common equity capital base of the UK banking system if the scenario were ten years ago. The stress test shows that these losses can now be absorbed within the capital reserves that banks have over their minimum requirements.

Capital positions have strengthened in the last decade which has given the central bank peace of mind. During the test, the bank started with a Tier 1 Leverage ratio of 5.4% and a Tier 1 capital ratio of 16% in aggregate. The aggregate common equity Tier 1 (CET1) ratio was 13.4%, which is three times stronger than a decade ago.

These capital ratios measure the financial health of banks. It puts in relation the funds with which it has to face an immediately possible crisis in the financial system of any country, with the risk assumed by the banks through the assets that they have in the balance. That is, they have taken it into account to demonstrate the solvency of capital in relation to risk assets. If these rates are very low in relation to what the regulators decide, banks will have to reinforce the quality of their capital, either by increasing it or improving it.

Even after severe losses during the test, banks would have a sufficient leverage ratio in the aggregate to continue giving credit to consumers and investors, which would boost the real economy. The bank’s main conclusion was that the financial system had continued to strengthen capital during 2017 and all banks had sufficient capital to meet the standard established by the test.

The FPC increased the system-wide UK countercyclical capital buffer rate (CCyB) from 0.5% to 1%. This measure was taken by the committee due to the losses of the banks, that they had in their assets for some credits that were not recovered. In addition, during 2017 there was a very rapid growth of rates of credit so that during the next three years the rate of loss of consumer credit could be 20% if the stress test scenario occurs.

The establishment of the system-wide UK countercyclical capital buffer rate did not require banks to strengthen their capital positions, but they were required to incorporate part of the capital they currently have in excess of their regulatory requirements in their regulatory capital reserves.

The conditions of the stress test considered a risk in the local credits at historical average levels, the global gross domestic product fell 2.4%, the product of the United Kingdom fell 4.7%, the unemployment of the UK went up to 9.5%, the real estate market down to 40% and residential property dropped by 33%, in addition to a depreciation of the pound sterling in its index up to 27%.

A domestic crisis coupled with a global economic crisis, with a fall in global assets and a depreciation of the pound would make it more difficult for consumers and investors to meet their obligations to the banks, which would decrease the value of the assets that support the balance of the bank.

Compared to stress tests from previous years, the aggregate capital ratio CET1 is lower in the 2017 test, but this is because the conditions evaluated were much more extreme. It is also important to mention that the results are different for all banks and this is due to different segments and market models, the type of risk to which they are exposed, and in some cases the degree of progress of restructuring programs.

There are two special cases which did not meet the reference levels of the capital ratio CET1 in 2016: Barclays and RBS. But by 2017 the capital structure had already improved, so after the stress test, the banks passed the quality test of their capital. Thanks to these banks improving their results, the bank committee in charge of regulating the financial system decided that no bank needed to take measures to improve the capital position for the first time since the stress tests were carried out.

In the following graphs you can see how the CET1 ratios projected in the stress scenario were, showing that the banks have solid profiles in their capital and how the evolution of the CET1 capital ratio improved between 2016 and 2017 respectively.

 

Graph 51. Projected CET1 capital ratios in the stress scenario. Retrieved the 3rd of February 2018, from https://www.bankofengland.co.uk/-/media/boe/files/stress-testing/2017/stress-testing-the-uk-banking-system-2017-results.pdf?la=en&hash=ACE1E2FB54482F5DC3412864C6907928B622044A

Graph 52. Evolution of CET1 capital ratios in the 2016 and 2017 tests. Retrieved the 3rd of February 2018, from https://www.bankofengland.co.uk/-/media/boe/files/stress-testing/2017/stress-testing-the-uk-banking-system-2017-results.pdf?la=en&hash=ACE1E2FB54482F5DC3412864C6907928B622044A

The quality of consumer credit portfolios is a very important determinant to analyse the ability of banks to withstand low economic cycles. This is due to the fact that non-compliance with loans increases in economic recessions and it is on these occasions that banks must test the quality of capital they have in order to continue lending, and thus support economic growth.

Defaults in consumer debt have decreased in recent years, and cancellation rates decreased from 5% to 2% between 2011 and 2016. This is a reflection of how credit quality has improved in recent years since the financial crisis. It is also evidence of a change in the distribution of consumer loans to borrowers with less risk of default.

But, not only this can be attributed to a better distribution in the loans, it is also true that banks have enjoyed a better economic situation with a better rate of job creation, low-interest rates by the Bank of England, as well as new financial innovations. The Prudential Regulation Committee (PRC) concluded that some banks have underestimated the risks exposed in the stress test because they think that the best credit quality is due to policies implemented by them and not by the economic conditions, which may be risky if the exposed risks materialise.

In the test scenario, the effects of an increase in the Bank’s interest rate on the economy were evaluated. Although the increase in the rates does not directly influence the depth of the crisis, some effects that the rate hike could generate were observed. Higher rates would put more pressure on borrowers, which could lead to higher loan default rates of up to £10 million.

The prevalence of short-term mortgages shows that households are particularly exposed to the volatility of the interest rate. Nearly three-quarters of the mortgages were fixed in short-term contracts, or with variable rates which could have a negative effect on other markets such as real estate. In addition, in a pessimistic scenario, the crisis could deepen if it combines higher unemployment rates with higher values of mortgages, which would put borrowers under greater pressure.

In conclusion, stress test report carried out by the Bank of England shows the strength of the British financial system, given that all the banks analysed in the area could withstand very adverse situations in the economy, being able to continue lending to the money market which could be important for an economic recovery if the economy is in a recession. Banks are expected to see 26% deterioration rates on credit cards, 14% on personal loans and 17% on unsecured loans such as cars and overdrafts, among others. It is important that the Prudential Regulation Committee has reached the conclusion that the financial system is robust given the multiple risks that the British economy faces, so it is necessary that the system is prepared by the multiple paths that Brexit can take.

©Forex.Academy

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Inflation Reports – The Bank of England May 2017

The Inflation Report is a quarterly report issued by the Bank of England, which analyses many variables such as internal consumption, the growth of countries that are important in the international sphere, projections, among others. With the inflation report, first, we have a panorama for the agents in the economy about the current situation of the economy and second, we can have some clues about the decision of monetary policy that the bank could take, since the priority by mandate of the Bank is inflation, although it also tries to influence the growth and the labour market.

In the May report, the bank had prospects that economic growth and inflation would continue to be influenced for the rest of the year by the response of households, businesses and financial markets to the expectations each had about the United Kingdom leaving the European Union. The behaviour of agents in the economy has been very volatile due to the behaviour of Brexit expectations since at the beginning of 2017 consumers were pessimistic about the negotiations for an organised exit. But according to the Monetary Policy Committee (MPC) that pessimism was reduced throughout the year to May.

According to the committee, the expectations of the agents improved due to moderate growth of the economy and a rebound in inflation. Sterling began to appreciate in the middle of 2017, possibly reflecting expectations of a more orderly Brexit process. The pound sterling appreciated 2.5% between February and May, but still below 16% of the highest level seen in November 2015. Due to the rise in inflation, real incomes of people fell so that the growth of consumption was reduced more than the bank predicted, but it was expected that in the last months of the year this variable would recover.

In the February projections of the MPC, it was expected that economic growth in the second quarter would stabilise in rates observed in previous periods and that at the end of 2017, the growth would be 1.9%, and in the following years would be close to 1.75%.

But at the meeting in May, we observed better global economic growth and better conditions in the financial markets, which led to better rates in the exchange between countries and orders of capital goods. There was also evidence of improvements in global demand which generated a rise in the prices of global assets, especially stocks.

The combination of stronger projections worldwide and the depreciation of the pound sterling led the MPC to improve its expectations on the net trade of the United Kingdom. This scenario, coupled with less uncertainty and better global growth rates, led the committee to expect better rates of capital investment so that exports would be able to respond to more robust demand.

Regarding inflation, the Consumer Price Index (CPI) was above the Bank’s target of 2% due to the strong depreciation of the pound sterling, which was transferred to the basic goods consumed by households, in addition to a moderate increase in local goods. The negative aspect for people was a lower than expected increase in salaries which ended up affecting the real income of households.

The MPC expected inflation to continue to rise above the target in 2017, even reaching levels above 3% in the fourth quarter. As already mentioned, the expectations of high inflation were great because, since 2015, the pound sterling had depreciated sharply due to the negotiations for the UK exit from the European Union and the due restructuring of the economy after this happens.

The trend of wage growth softened in recent years despite high growth rates in job creation. Some factors that could generate this weak growth of wages were:

  • Weakness in worker productivity growth.
  • The uncertainty of the negotiations of the exit of the European Union by companies, for which they were not willing to increase salaries until they knew what the result of the negotiations would be, because this directly influences their cost function.

But the MPC expected these factors to dissipate over time, which would lead to better rates of wage growth over time since the unemployment rate was falling to rates close to those considered to be an equilibrium.

The committee was aware that monetary policy was not enough to influence the real adjustment of the British economy, as it was a necessary and inevitable adjustment that the economy had to go through. In addition, there was no certainty of what the conditions of trade were going to be after the negotiations were concluded so that low growth combined with high inflation rates was normal.

If the bank will try to fully compensate for the effect of the depreciation of the pound sterling on inflation, higher unemployment rates and even very weak growth would be generated. That is why, despite the fact that the mandate of the bank is to have inflation close to its 2% objective, it is considered that in exceptional circumstances the committee must analyse and balance the macroeconomic variables so that imbalances are not generated in the economy.

That is why in the May meeting they decided to leave monetary policy unchanged to respond to the situation in which the British economy was. In a vote of 7 votes in favour and 1 against, it was decided to keep the rates at 0.25%. In addition, the committee voted unanimously to maintain the sterling stock of investment-grade non-financial grade bonds, financed by the issuance of central bank reserves at £10 billion. The vote was also unanimous to maintain the stock of purchases of government bonds of the United Kingdom.

The committee made it clear that the monetary policy would respond in any direction depending on the economic perspectives so that in the long term it would be possible to locate inflation at acceptable rates. In general, the committee considered that, if the economy followed the estimated projections, the monetary policy could be hardened in the future. The bank’s projections depended mainly on three aspects:

  • That the low level of the pound sterling will continue to stimulate the price of consumers beyond the projected period.
  • That the wage increases that remained modest will accelerate in the projected period.
  • That the more moderate growth in household spending will be balanced by a rise in other components of demand.

In terms of the global panorama, as already mentioned, there was a better situation in several countries such as the United States, where, like the United Kingdom, unemployment rates were at levels similar to those observed before the 2008 crisis, but not in the Euro Area.

On the other hand, the committee expected global inflation to rebound especially due to the rise in fuel prices thanks to the OPEC agreement and stronger demand for raw materials, but still, there were special cases such as the United States where the behaviour of inflation was weak.

In conclusion, for the bank’s inflation expectations, it was presumed that for the rest of 2017, inflation would continue to rise due to the increase in food and energy costs, down to the fact that they are one of the most sensitive components of the CPI. In addition, the fact that the price of fuels has increased worldwide, the depreciation of the pound has meant that inflation also rises for this reason as it is more expensive for the British people, due to their reduction in purchasing power. The path of inflation in the following quarters of 2017 depended on how fast companies could pass the increase in external costs to the consumers.

Another problem that has generated high inflation is a slowdown in the economy because it has affected the purchasing power of households so that their consumption has been reduced and the devaluation was expected to cause inflation to be above that of the bank’s target range in the next three years.

Also, within the projections of the committee, a good dynamic of exports was expected for a better global demand for goods and services, and a devaluation already exposed that would serve as a boost to make their products more competitive. The following chart shows the main projections that the committee had at the May meeting.

 

Graph 53. Forecast summary. Retrieved on the 3rd of February 2018, From https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/may-2017.pdf?la=en&hash=92BA13788FBF71CBC9D800DDCD0EA3D217008867

Analysing what was stated in the inflation report by the Bank of England, it can be seen that the bank raised its rates in the meeting of November 2017. This was in line with what was stated in the report because it was not ruled out, tightening the monetary policy if the macroeconomic variables allowed it.

Throughout the year, the bank faced a trade-off between its main objective inflation and other important variables such as employment and economic growth. Inflation was above the target level of 2% imposed by the government due to the weakness of the pound sterling, which was a reflection of the uncertainty that the market had against the United Kingdom since 2015 when it was decided that it was going to start negotiating the exit from the European Union.

The uncertainty was generated due to the possible paths that the negotiations could take from stable commercial relations, without major sanctions such as tariffs on British exports or restrictions on capital flows, until the slow and clumsy negotiations that would generate an unwanted scenario on the part of the UK, and of the countries belonging to the economic union.

Since the fall of the pound sterling at the end of 2015, levels have not been achieved in its index with respect to other currencies seen before the Brexit results, which led to an increase in the cost of goods and services, which translated into a high inflation and a reduction in the consumption of the inhabitants of the UK.

During 2017, moderate economic growth was observed with low unemployment rates, but without a rise in wages. The following graph shows the behaviour of the unemployment rate in 2017. Based on the inflation report, it can be seen that the bank was correct in projecting lower unemployment rates at the end of the year.

 

Graph 54. UK Unemployment Rate. Retrieved on the 3rd of February 2018, From. https://tradingeconomics.com/united-kingdom/unemployment-rate

The following chart also shows how inflation continued to rise until the end of 2017, reaching levels close to 3%, which made it logical for the bank to raise interest rates due to the behaviour of inflation

 

Graph 55. CPI ANNUAL RATE. Retrieved on the 3rd of February 2018, From https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/l55o/mm23

The aspect that was not so positive was the economic growth due to the fact that it continued presenting moderate rates of growth.

 

Graph 56. Gross domestic product. Retrieved on the 3rd of February 2018, From https://www.ons.gov.uk/economy/grossdomesticproductgdp/timeseries/ihyq/pgdp

A few months after the May meeting, it was observed that the content of the inflation report was right for the British economy, and they decided to raise interest rates due to inflation that was increasingly growing and far from its objective. The behaviour of the market after the inflation report and meeting of the MPC in May can be seen in the following graph.

 

Graph 57 GPB:CUR. Retrieved on the 3rd of February 2018, From https://www.bloomberg.com/quote/GBP:CUR

You can see that sterling continued to appreciate since the May meeting so it is clear that investors have relaxed a bit more and are no longer so pessimistic about the UK situation. This appreciation has also helped households to recover a bit of the purchasing power lost since the Brexit elections, where a sharp drop in the pound sterling began and even after several years failed to reach levels seen before the crisis.

Following the foregoing in the inflation report, it can be concluded that the sterling trend continued since the beginning of the year and, as the committee mentioned, this is evidence of the change in expectations of the investors who expected smooth negotiations between the United Kingdom and the European Union, which would allow trade and capital regulations not to undergo drastic changes and the economy could grow at rates seen before the elections. In addition to the change in expectations, the November rate hike was also important because this shows signs that the committee sees a stronger economy.

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Report of the Financial Policy Committee June-November 2017

The Financial Policy Committee (FPC) was established in 1998 and amended in 2012. The main objective of the committee is to ensure the financial stability of the United Kingdom, which is one of the fundamental pillars of the Bank of England. In addition to supervising the health of the financial system, it must also aim at the good development of the economy by supporting other committees and the objectives of the Crown that are based on growth and employment. The responsibilities of the committee are mainly to identify, monitor and take necessary actions to remove or reduce the systematic risks of the financial system of the United Kingdom.

The Financial Policy Committee (FPC) has the objective of ensuring that the financial system of the United Kingdom is resistant to the various risks and situations that they may face over time. The FPC evaluates internal and international risks and is always monitoring variables such as credits, mortgages and others so that they are within an acceptable range for the committee.

In recent years in the UK, consumer credit has grown rapidly. The conditions for access to a mortgage have become more accessible so it is easy to think that there are negative incentives for bankers who often prioritise their economic benefits and profits of the banks before the security of the financial system.

Another concern of the committee is Brexit. This event has generated much uncertainty in international markets and is still unclear on what will be the conditions of the departure of the United Kingdom from the European Union. This is a concern because it is clear that the financial system will be affected when Brexit is completed.

On the other hand, in the June report, the Committee observed that many of the global risks had not materialised which was a relief to the financial system and the economy of the UK, but they continued to observe vulnerabilities in the Chinese financial system, so they were still analysing the situation in China. For the FPC, market volatility measures and the valuation of some assets such as corporate bonds and UK real estate did not seem to show signs that investors had these global negative projections within their valuation models, in addition to very low interest rates which affected long-term assets.

To maintain the soundness of the financial system and avoid possible future risks, the bank decided to increase the UK countercyclical capital buffer (CCyB) rate to 0.5% from 0% Also, the FPC expected to increase the rate to 1% at its November meeting. The countercyclical capital buffer (CCyB) is a tool that enables the FPC to adjust the resilience of the banking system. The FPC increases the CCyB when they consider that risks are building up. The bank forces commercial banks to have more capital reserves to face possible economic or financial shocks, absorbing the losses which makes a stronger financial system and prevents bank failures.

The bank performs multiple stress tests of the economy, taking different scenarios to analyse what the response of banks and the financial system would be in general, to study what possible measures can be taken to reduce the risks to which the system is exposed. The bank’s annual stress test assesses the banks’ resistance to consumer credit risks. Due to the rapid growth of consumer credit in the last year, the FPC began to perform stress tests analysing what the possible losses of the banks could be if a problem was found in the local economy.

Credit card debt and personal loans were the main variables that increased rapidly. But the committee noted that the losses in consumer loans were low and the loan environment was good so there was a large number of loan offerings. The downside is that the maturity of the loans was very short, so the quality of the loans could go down drastically and very quickly.

The Brexit negotiations had already begun before the June meeting and the bank had very broad expectations about the possible paths that the negotiation could take, so there was no clarity about the possible steps to follow. To be prepared, the FPC had a contingency plan to reduce the financial risks derived from Brexit as much as possible.

Spreads on sovereign bonds in the Eurozone had declined due to the resolution of some political uncertainties. In China, the outflow of capital had stabilised but the economic growth of the country was still based on a very rapid expansion of credits, which made it a risky scenario due to possible problems in the financial system. In the UK, yields on 10-year government bonds were close to -2% and in general, in the G7, long-term interest rates were low, which was evidence of negative growth expectations in addition to the uncertainty of the investors. The above can be seen in the following graph.

 

Graph 48. International ten-year real government bond yields. Retrieved 27th January 2018, From https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2017/june-2017.pdf?la=en&hash=F7350AAAC8F5F268B43FE25A9CE0CDADAB8A2E79#page=9

 

It is evident in the FPC reports that the main local concern is Brexit. This is because there are many companies and banks that could leave and stop operating in the UK because of the regulation changes after the negotiations, there could be changes in the rules which would affect the margins of the companies, make contracts again or relocate resources which could be costly. The withdrawal of the United Kingdom from the European Union has the potential to affect the economy through the supply, demand and exchange rate channels.

In global financial markets, the uncertainty measures implicit in the prices of the options were low. In June, the VIX measure of implied capital volatility derived from the prices of the S&P 500 stock index options had reached its lowest level since 1993. The Committee noted that, often in periods of low volatility, the risk increases, and then they become evident.

As previously mentioned, long-term risk-free interest rates in advanced economies remained low, which is consistent with pessimistic growth scenarios and a great uncertainty of the global situation is perceived. As for short-term expectations, they improved in the last period despite the fact that world average growth was lower compared to the pre-crisis period.

The committee argued that the prices of global assets were vulnerable due to possible increases in long-term interest rates or adjustments in growth expectations. Regarding the exposure of the UK banks to the real estate market, positive signs were found because the exposure to this market was reduced to half of the figures seen before 2008, making the financial system more robust, at least in this aspect.

The UK banking system continued to strengthen its capital positions due to the valuation of different metrics in addition to the results of the stress tests, so the committee concluded that the system was well capitalised, with good liquidity and good financing coverage.

The June report concluded that the recovery capacity of the UK financial system had strengthened significantly since the crisis and is capable of absorbing shocks to the real economy. The future of the economy was expected to be full of risks due to events such as, risks in China, negative expectations and mainly due to uncertainty about the completion of the Brexit talks, but the FPC promised to carry out all the possible studies to have greater clarity about what awaited the UK after leaving the European Union, and taking the necessary measures to maintain a robust financial system and good growth rates.

The following graph shows the comparison of the main debt metrics, market conditions and the balance sheet of the bank. As it is observed, the values up to the June meeting did not show high risks being within the values seen historically.

Graph 49. Core indicator set for the countercyclical capital buffer. Retrieved 27th January 2018, from https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2017/june-2017.pdf?la=en&hash=F7350AAAC8F5F268B43FE25A9CE0CDADAB8A2E79#page=9

 

At the November meeting, the FPC raised the UK countercyclical capital buffer rate from 0.5% to 1%. This measure was taken by the bank due to the results obtained in the stress test where some risks were observed, so it was decided to raise the rate as a precaution.

In November, the FPC continued to observe Brexit as a major risk, some risks in the domestic economy and global risks were due to some erroneous asset valuations. But despite these risks, after the stress test of the financial system, the FPC concluded that the system was robust and could support the economy in case of a disorderly Brexit that would lead some variables to show negative trends such as employment, the real estate market and even an aversion to UK assets. If the worst-case scenario were to occur for the British economy, the financial system would have the strength to support economic recovery and not collapse.

The conjuncture that could generate a crisis in the banking system would be a messy Brexit and a severe global recession. In this scenario, it would be possible to generate a credit restriction for new loans because the capital of the banks would be threatened, so the financial system would not be able to support the economy.

Regarding local conditions, it was observed that the main variables were within normal parameters without any excessive risk, although the committee must continue to monitor the system, especially due to the high level of indebtedness in the economy. The credit growth rate was above the nominal GDP growth, but there was no evidence of excessive risk at the moment. The following graph shows that consumer credit was not at alarming levels.

 

Graph 50. Outstanding consumer credit to income. Retrieved 27th January 2017, From https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2017/november-2017.pdf?la=en&hash=8CB2A5526478872DE14D531254B948BB6FD47793#page=9

As already mentioned, if after Brexit, investors stop acquiring British assets, this could affect the financial system which would reduce the number of loans granted to people, which would have an impact on the economy and could affect the economic growth of the country in the short term.

Regarding external factors, the committee explained that the current account of the UK has been in deficit persistently since 1999 and has increased since 2012 reaching 4.6% of GDP in the second quarter of 2017. It has been increased mainly by lower profits from foreign direct investment.

Long-term global interest rates have remained near historically lower levels. This has been evidence of structural factors such as demographic changes and expectations of low inflation despite solid but moderate growth. As in June, the committee observed worldwide investors have placed an excessive weight and optimism in current economic conditions, and have not correctly assessed the medium-term risks which have created a risk in the global financial markets, which in future may come to affect the British financial system.

In the corporate bond market, spreads were at levels seen before the financial crisis with a more compressed high yield, compared to historical levels. This has come along with greater leverage of companies in the United States. In the UK, there is a high risk that economic growth will be weak, so the UK’s risk-free rates have been falling since mid-2016 compared to other economies.

Short-term expectations have improved in terms of global economic growth with better prospects for the IMF by the end of 2017. The better prospects were given by better behaviour in the Eurozone, Japan, China, Russia and emerging Europe. Despite these better prospects, the FPC observed some vulnerabilities in some financial systems and markets due to a significant increase in the debt of non-financial sector companies as part of the GDP at previous levels of the 2008 crisis, especially in China where the debt has grown about 60% in the last 5 years. Finally, on the international scene, the government confirmed its intentions that by the 29th of March 2019 the United Kingdom must have completed its negotiations to leave the European Union and establish trade negotiations after it no longer belongs to the economic union.

In conclusion, the Financial Policy Committee is very explicit about which risks will be faced by the financial system and how the committee is prepared to face them by taking the respective measures. In the last two reports, the committee focused on the same risks at the local and international level, taking the Brexit negotiations as the main risk for the United Kingdom, which could lead the financial system to limit its offer, which could affect British growth. They also emphasise that the interest rates of developed countries have remained low due to not so optimistic expectations of the countries, in addition to the fact that inflation has remained low. This is a recurring theme in the reports of the central banks of the United States and England because they have not seen entirely positive behaviour in inflation and in growth, so when they have been making monetary policy decisions they have been very cautious.

Based on the FPC report it is also evident that there is an optimism among investors worldwide that has prioritised current conditions but has not valued the global economic risks such as excessive Chinese companies’ debt and some geopolitical conflicts, whereby markets and financial systems are exposed to a risk given the overvaluation. This represents a threat to global economic growth and especially to the United States where the large rise in stock market shares has generated households with greater wealth. This has encouraged consumption and in turn, this has boosted economic growth, but the overvaluation of assets could affect the economic growth since it affects the main engine of the economy.

China also represents a global risk because it is the second-largest economy, so if a crisis occurs in the financial system, domestic consumption would decrease drastically and exports around the world would be affected. It is perhaps the most latent risk internationally for developed countries that could trigger other risks such as falls in stock market indices and contagion in global financial systems.

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The Bank of England

Bank of England

The Central Bank of England is in charge of dictating the monetary policy of the country through a specialised committee. In addition to ruling the monetary policy of England, it also serves as the central bank of the government of the United Kingdom. Although it belongs to the European system of central banks, it has full autonomy from monetary policy due to the non-adoption of the Euro as a national currency. It is located in London.

The governor of the Bank of England is the most important position within the Bank of England as it belongs to the monetary policy committee and therefore has a predominant role in the orientation of national economic and monetary policies. The bank of England is the UK’s central bank. The mission of the central bank is to promote the good of the people by maintaining monetary and financial stability. The bank of England has four basic functions:

  • Regulate other banks
  • Issue banknotes
  • Set monetary policy
  • Maintain the financial stability of the system

One of the most important tasks of the central bank is to design and print banknotes. Only the central bank of England can issue banknotes in England and Wales, but seven commercial banks can issue them in Scotland and Northern Ireland. The Bank of England is responsible for keeping the UK’s economy healthy through an adequate monetary policy. The bank has two main tools to intervene in the economy by moving the interest rate (formally known as Bank Rate) and in special circumstances using Quantitative Easing (QE). Decisions on monetary policy are made by the Monetary Policy Committee (MPC) eight times a year.

Also, the Bank of England is responsible for the surveillance of the financial system. The Financial Policy Committee (FPC) identifies and monitors risks in the financial system and intervenes to reduce or remove these risks. Among other tasks that the bank has, it is responsible for conducting studies and research on the state of the economy, regulate and supervise other financial institutions.

The governors of the Bank of England perform at one of the highest levels of the executive team and are jointly responsible for the bank’s policy committees to achieve the bank’s mission of providing stability to the British economy and its population. The governor together with various committees and the court of directors are responsible for studying the behaviour of the British economy and making decisions depending on the tasks of each committee.

The Court of Directors acts as a unitary board setting the strategies of the bank’s organisation and budget, in addition to making key decisions about the appointments in the bank and the resources of each area and committee in the bank.

The Court is required to meet at least seven times a year and has five executive members of the bank and up to nine non-executive members. All members of the court are appointed by the crown and one of the non-executive members is selected by the chancellor to preside over the court. The governor serves the court for a term of eight years, deputy governors for five years and non-executive members for up to four years.

In addition to the meetings of the directors of the court, the court is assisted by other committees each with specific tasks that they have to comply with and assist the court in the management of the bank. Since the foundation of the bank in 1694, the directors of the bank have met regularly to discuss various issues related to the administration and operations of the bank. Since 2012 the financial service minutes mandated the board of directors of the court to publish the minutes of the meetings a few weeks after each meeting they held.

Although the mandate was established in 2012, minutes of the meetings have been kept in the bank’s archive since the first one in 1694 in London. To access the minutes of previous meetings the bank decided to digitise minutes dating from the late twentieth century thus facilitating the investigations of investors and academics on the decisions taken by the central bank.

One of the aspects that most worries central banks in the world is the behaviour of inflation because this variable affects transactions, the wealth of households and often also determines the behaviour of the labour market. Inflation is calculated by the central bank through a team of specialists from the national statistics office, which collects price information from the goods and services market, forming a basic consumption basket. That basket of goods is used to calculate the consumer price index (CPI). The statistical office publishes the change of this index every month.

The central government of England is the one that dictates what will be the annual inflation target that the Bank of England should sustain in order to achieve the proposed goals regarding the number of employees and the welfare of the population. The government has set the target at 2%.

To achieve this goal of 2% there is a committee in charge of dictating the monetary policy called the Monetary Policy Committee (MPC). This committee is in charge of changing the bank’s official interest rate. This is the rate that the central bank pays for maintaining the reserves of commercial banks and generally the change of that rate is transferred to consumers. When the rate goes up by the central bank, commercial banks pay more for people’s savings, but they also raise the cost of loans and other financial products such as credit cards.

The logic of the bank is that if inflation is above the target level, interest rates are raised so the loans and credit card consumption is reduced, affecting consumption by the people, which will lead to inflation decreases. The same happens in the opposite case, if it is necessary to encourage greater consumption so that inflation rises, the rates are lowered to encourage spending by households and businesses. There is a mandate from the bank where if the rate of inflation at the end of the year is above 3% or below 1%, the governor of the Bank of England must deliver a letter written to the chancellor explaining why the bank failed in its goal of 2%, and what measures will be taken to meet the goal the following year.

The monetary policy committee is responsible for making decisions about how and what tools to use to achieve the inflation target. Historically the Bank of England has used the interest rate, but recently the bank has tried to use quantitative easing to stimulate the economy and reach the target inflation rate. Reaching the inflation rate proposed by the government is the main objective of the monetary policy, but there are also other objectives such as serving as support to the government objectives in terms of economic growth and the unemployment rate.

The monetary policy committee (MPC) is composed of nine members: the governor, the three deputy-governors for monetary policy, financial stability and markets and banking, a chief economist and four external members appointed by the chancellor. These external members are appointed to ensure that the MPC has a diversity of thoughts and experience of members who do not belong to the bank.

Also at the meetings of the MPC is a representative of the HM Treasury who cannot vote on the decisions of the committee, but can discuss what would be the best decisions they could make in monetary policy. MPC members serve by fixed terms and after their cycles are completed they are replaced or re-elected.

In conclusion, the objective of the MPC is to maintain price stability within the United Kingdom and to support government policies to encourage growth and good job creation rates. The bank has several tools such as the interest rate and the volume of purchases of assets financed by the issuance of bank reserves and exchange intervention. The MPC has no responsibility with respect to the risk profile of the Bank’s balance sheet, that responsibility falls on the Court of Directors, or the Court may delegate it to the Governor and the Bank Executive.

The MPC has no responsibility with respect to the provision by the Bank of financial assistance to financial institutions. That responsibility also falls to the Court of Directors (or may be delegated by the Court), although the Financial Policy Committee may make recommendations on the Bank’s provision of collective assistance.

The Financial Policy Committee (FPC) identifies, monitors and takes the necessary measures to eliminate or reduce systemic risks to protect and improve the financial system of the United Kingdom. The financial policy committee was established in 2013 as part of a new regulatory system that was imposed to improve financial stability after the global financial crisis that occurred in 2008. The financial committee normally has thirteen members. Six members are staff of the Bank of England, the Governor, four deputy governors and the Executive Director of Strategy and Financial Stability Risk. In addition, there are five external members who are selected for their experience in, and knowledge of, financial services.

Another committee of the Bank of England is the Prudential Regulation Committee (PRC). The PRC makes the prudential regulation authority’s most important decisions. The PRC is made up of twelve people. It is chaired by the Governor of the Bank of England and the other four members are Bank England Deputy Governors. A positive aspect of the committee is that the majority of the members came from outside the bank.

In addition to the aforementioned committees, the Bank of England has a network of twelve agencies located throughout the United Kingdom. These agencies play an important role in linking businesses, people and local economies with those in charge of monetary policy and other committees belonging to the bank in London. The agencies are responsible for the central bank to ensure that its economic prospects are correct because they are more in contact with the market than the bank is.

Each agency is composed of four agents and an administrative team. These agents have face-to-face conversations with people, businesses and some industries located near each agency, as well as attending local events to find out what the agents’ perspectives are on the economy.

Each agency has a network of contacts with those who can talk regularly but who belong to organisations from all sectors of the economy, so they have contact with a wide range of companies, ranging from small companies to multinational companies with each agency.

After these meetings with each major agent in each area, the agencies share their information with the Bank of England to take these reports into account at the monetary policy meetings, the financial policy committee and the prudential regulation authority. In addition to this good organisation, each agent can schedule meetings with local agents with the people belonging to each committee so that they can hear the information first-hand.

The bank publishes the agents’ findings eight times a year, but they do not necessarily share the opinion of the agents, just as the committees do not always act solely based on these reports. In recent years each agency has been collecting greater amounts of information for the bank to be more efficient in its mandates and try to create a more robust and more stable system.

There is evidence that indicates that these agencies have been efficient in their work in terms of information that has managed to warn the bank of risks in the corporate credit market, and abnormal conditions in the real estate (housing) market.

Finally, it is important to clarify what the role of the HM treasury member is and to identify why they are always present at the meetings of the MPC and in the monetary policy decisions. The HM Treasury is the government’s ministry of economy and finance and tries to control public spending, direct the economic policy of the United Kingdom and make decisions that help sustain strong economic growth.

As already mentioned, this entity oversees:

  • Public expenditure: departmental expenses, public sectors and pensions
  • Financial services policies: Regulation of financial and banking services, financial stability and ensuring the competitiveness of the system
  • Strategic supervision of the UK tax system

The priorities of the committee are to achieve a strong and sustainable economic growth, reduce the deficit of the trade balance of the economy, ensure good management of taxes, try to have an efficient and simple tax system, among others.

In conclusion, the Bank of England is one of the most efficient banks in the world due to its different committees and agencies that allow its governors and directors to be in permanent contact with market agents and the perspectives of people who face the local conditions daily. In addition, in its committees, there are members external to the bank which allows adding more knowledge to the discussions and different perspectives of the internal members of the bank, so there are different profiles in the members of the committees. In addition, the bank is independent of the government as is the case for most of the central banks of the world which gives greater flexibility when acting.

©Forex.Academy

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Forex Educational Library

Globalization and its Risks

Abstract

Globalization is an inevitable process that has been accelerated with the current means of communication and transportation, which help to trade more due to better access to foreign products. Globalization is not only economic, it also covers social and cultural aspects. But since globalization is a process that involves several aspects of society many people see it as a threat to local customs and producers, so they prefer to put some barriers to this process. But it is a process already in development that will be almost impossible to stop so the best thing that each country can do is take advantage of this for their benefit by being more competitive.

 

Globalization is a process that has spread to different areas in all countries, from cultural to economic aspects. For many economists, globalization has allowed the economic development of many countries to be driven by dependence on international trade and technological advances that not only stay in one country but also expand rapidly as well as new knowledge. But beyond the benefits of globalization, there are many people who question the effect that globalization has on different cultures in the world.

For many people, the values of their culture are very important to value and exchange them for more global ones, which is why some people are still reticent to see a total globalization of all aspects. There is a great debate that persists over time about how, and how much, politicians should intervene in this process of globalization and preserve their own identity or how much the economy of foreign goods should be protected.

Globalization has been formally defined as the phenomenon of acceleration and intensification of economic interaction between people around the world, companies, and governments of the countries involved in this effect, although today there is no country that has not been influenced for globalization. But globalization not only involves economic interactions, political and cultural effects have also been evident, which has led to the study of all areas of society and to encourage debate about the positive and negative effects of globalization.

The globalization of the production and distribution of goods and services has been well received by some people who can now access foreign goods of better quality and in some cases at better prices than local production. But the opponents of globalization show their concern about the local producers of each country and their standards of living after the expansion of international trade. In addition to increasing trade and allowing access to new products, globalization allows the exchange of cultural features, customs such as music and other determinants of daily life such as music and literature.

Exposure to the exchange of goods and services brings changes in the customs, values and local traditions of a country. This is also a point of debate since some believe that globalization eliminates the traditions of a country making it universal but at the cost of the loss of knowledge and traditional customs of a country which is not positive for some aboriginal and indigenous communities that can see this change in their traditions as something threatening.

One of the criticisms, in general, is the Americanization of culture and economy. The most powerful companies belong to the United States, as well as the richest people and in turn, many traditions and festivities that come from North America are exported and celebrated in other countries. This has been a high point and a great debate since many people, especially in underdeveloped and poor countries, see this Americanization as a threat, criticizing consumerism and certain values that are handled in that country. But this leader of globalization, as seen in the United States, has several elements that make it the leader of said globalization.

The first element that makes the United States one of the predominant countries in recent decades is the size of its market which represents about 300 million people. This makes it attractive for multinationals as well as generating economies of scale which means that as companies increase their production costs per unit produced are reduced making their operation more profitable. An important aspect of this large market is the wealth of the population since there are countries with similar or larger population sizes such as China and India, but the wealth between these three nations is not compared since the United States has about 25% of global production.

In addition to the importance of the United States market is the element of language because most people in North America speak English and it is a universal language that allows transactions to be made easily. It is not the only country that has contributed to the process of globalization, but it is one of the predominant countries in this process. The following graph shows the magnitude of the US market in urban areas

US market in urban areas

Graph 22. Urban population. Data taken from the World Bank.

The people who are in favor of globalization argue that contrary to what some people think, globalization supports local cultures through technology by allowing better communications through computer telephones and other elements that facilitate the exchange of opinions. In addition, they preach that through television and other visual artifacts, cultural elements can be displayed so that people who see it within each country feel more identified with their culture.

Another positive aspect of globalization is the new awareness of people that are currently being created – better educated with a broader knowledge and a global notion of different cultures. This type of people are the drivers of current economic processes, they have a more cosmopolitan than rational thinking, speak several languages, travel internationally and they have more developed skills with better education standards, so they have better living standards than the people who lived before.

Globalization in the economy is the most known and studied fact by people since it is vital to understand how this effect has an impact on people’s daily lives. Economic globalization involves the reduction or elimination of business and trade barriers between countries, which will encourage exports and imports to increase in each country. Therefore, globalization is the economic unification of different countries including the different types of investments that occur in each country. It is crucial that each country is seen as a piece of a puzzle and that each country will be very important for the good economic development of all countries.

Globalization is not a new phenomenon. It goes back more than  2000 years, during which time trade, traditions, ideas, and other elements have been exchanged between different countries and empires. In the last 200-300 years this unifying process has accelerated, leading to greater specialization in the production of goods and greater interdependence among economies. But what is not clear is that the pace of unification of the economies has not been constant, but has increased rapidly since the end of the Second World War. The following graph shows how trade in goods and services has increased in recent years, where globalization has accelerated.

 Exports of goods and services

Graph 23. Exports of goods and services. Data taken from World Bank.

 

Some of the consequences that globalization has left are:

  • The relaxation of government controls to let the market act independently thanks to the forces of supply and demand.
  • Efficiency in means of transport and communication which helps to make business faster and easier.
  • New technologies that contribute to the quality of life of people. Technological advances have been achieved thanks to the dynamism of trade and skilled labor which has contributed to the progress being made less and less time.
  • Greater dynamism in investments since resources can be easily moved from one country to another without the need to be in several countries to make such investments.
  • Better quality of life for a large part of the population. A better quality of life is achieved with globalization and international trade, consumers can acquire a greater variety of products of good quality and at better prices due to competition between multinationals and local companies.

In addition, globalization reduces labor costs because companies can be in the country that is most beneficial in terms of costs, where there is specialization depending on production and the intensity of capital used. That is why lower prices can be seen in goods and services since with globalization countries have managed to reduce their costs by specializing in countries with economies of scale and with good competitiveness in terms of costs.

Another consequence of globalization is access to the natural resources of different countries. This is an advantage for countries that do not have access to good resources due to their geographic location that determines the climate and their access to seas or not. In addition, there are countries that have better access to mineral resources such as oil or coal. Globalization intervenes in the fact that the multinationals depending on the location and resources of each country decide to locate themselves in a certain area to extract these resources, but also generating benefits for the local communities. The negative aspect of globalization at this point is to what extent it is positive to extract and exploit natural resources of a foreign country since it can destroy nature and many projects will be made for political interests rather than the possible economic benefits.

At this point in the article, we will analyze a determinant of investments in the globalized world that currently exists. Country risk is one of the most important variables when analyzing how risky investment is in a country given its political and economic factors and its relationship with other countries. The formal definition is the risk of an investment due to specific factors common to a specific country. It can be analyzed as the average risk of investments made in a country.

A country can see its risk increase if a country faces difficulties in paying debt acquired as bonds. The factors that may affect the payment of a country’s debt depend on economic, social, political conditions or in some cases due to natural disasters such as earthquakes. Any assessment of the risk of each country will express the level of probability of suffering a loss in the value invested and depending on the level of that country risk the investors will demand a return on an investment since in the finances if greater risks are incurred, it will be claimed better returns that demonstrate that it is a good idea to invest in that asset. In the following graph, you can see the percentage of country risk that some places had in 2016.

Market Risk Premium

Graph 24. Fernandez P., Fernandez I. and Ortiz A. (2016, May 9). Market Risk Premium Used In 71 Countries In 2016. Retrieved November 17, 2017, from http://www.valuewalk.com/2016/05/market-risk-premium-used-71-countries-2016-survey-6932-answers/

Country risk analysis is a predominant component of the specialized risk management departments of banks, insurance companies, risk rating agencies, and financial system regulators. In some cases, country risk includes the risk of payment transfers, confiscation and expropriation, and risks of internal and external wars.

The debtors of these investments can be stated sovereigns, or they can be private agents such as banks and companies that issue debt to obtain financing for their commercial operations. In general, any country or private agent can issue debt and be subject to country risk assessment and each agent that issues debt will be analyzed differently because almost no company or state will face the same determinants in the risk of their investment.

The country risk can be materialized to the extent that there may be a payment crisis and the result of this is the non-payment of the debt by the agents, whether private or state. This debt default occurs especially in countries with high debt or without good access to external debt. Also in cases where the debtor is a state agent, it is determined the number of foreign reserves that a country has since these can be used as payment by the creditors at a specific time. In the following graph, you can see the external reserves of different countries.

Total reserves. Data taken from World Bank

Graph 25. Total reserves. Data taken from World Bank.

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