Germans Brand Thee, USA, an ESG Disaster

♠ Posted by Emmanuel in at 6/06/2023 11:43:00 AM
Just one flagrant American ESG violation among countless others.

This news story from Bloomberg had me laffing so hard it hurt: Despite the action being rather novel--banning investment in US Treasuries over environmental, social and governance [ESG] grounds--it is undoubtedly true that America is an ESG disaster. Offhand, we can cite endless ESG offenses that the US has perpetuated on its citizens and the rest of the world. Among others:

  • Environmental: Being the world's second-largest carbon emitter and, historically speaking, by far the world's largest;
  • Social: Maintaining a persistent racial underclass of nearly half of blacks who have experienced inter-generational poverty despite accounting for less than 15% of the overall population;
  • Governance: Inflicting far more gun deaths annually than any other country by allowing largely unfettered sale and ownership of military-style weapons.

Now, it is not news to anyone that the US is a super-polluting, racialized and hyper-violent nation. However, it is news when others like the German state of Baden-Württemberg start calling a spade a spade... and put their money where their mouth is at:

That’s because the new environmental, social and good governance filters have resulted in US Treasuries ending up on an investing blacklist, due to America’s failure to ratify a number of treaties in areas including women’s rights and controversial weapons...

The bulk of Baden-Württemberg’s exclusions impact its equity and corporate bond portfolios. The law establishes the United Nations Sustainable Development Goals, the European Union’s Taxonomy Regulation and the Paris Agreement on climate change as the basis for future investment decisions.

Lest you think it's just one German state objecting to America, Inc., there are others:

Back in Germany, meanwhile, other states have taken similar steps. Baden-Württemberg, the only one of Germany’s 16 states with a coalition government led by the Greens, was inspired by a similar law in the smaller state of Schleswig-Holstein, where bans apply to US Treasuries as well as to fossil-fuel companies. And the pension funds of Brandenburg, Hesse and Germany’s richest state North Rhine-Westphalia are this year allocating as much as €11 billion to Paris-aligned stock indexes that exclude ESG laggards alongside Baden-Württemberg.

While I do not doubt the sincerity of these actions, I am not convinced that what international ESG-related treaties a country has ratified should constitute the basis for assigning ESG ratings to sovereign debt. Solability, for instance, has a "Global Sustainable Competitiveness Index" (GSCI) that takes into account a number of indicators similar to conventional bond credit ratings.

Ah well, I guess it's the thought that counts for these Germans.  

A Problem of Unstressful US Bank Stress Tests

♠ Posted by Emmanuel in , at 5/04/2023 04:35:00 PM

 Each day brings news of a distressed US bank about to take leave for the Great Central Bank In the Sky. Aren't US banks supposed to be safer now with the advent of greater macroprudential regulation? A common way to gauge the soundness of banks is through the use of stress tests that simulate how these financial institutions would fare in the wake of financial, well, stress. While Americans bicker about whether the 2019 loophole exempting midsize banks holding between $100 to $250 billion in assets from stress testing led to their currently precarious situation, even that may not have saved them.

Comparatively speaking, stress tests conducted Stateside may not be sufficiently rigorous in simulating scenarios that are detrimental to financial sustainability. It is fairly obvious that the higher rates we have these days are causing mismatches between what banks earn and what they must pay out. Oddly, however, recent US stress tests have not involved rising but rather falling interest rates. See the illustration above and commentary from the Peterson Institute:

But it’s not only for 2023 that this feature appears. Indeed, every severely adverse scenario used by the Fed since 2015 has the 3-month Treasury bill rate ending up at 0.1 percent. Many historic episodes of severe economic downturn have indeed been accompanied by low interest rates, as the Fed used its policy tools to support aggregate demand. But it is a bit strange that not since 2015 has a stress test involved rising interest rates.

One of the advantages of stress testing the banks every year is that their robustness to a variety of contrasting stresses can be assessed. Just repeating a broadly similar scenario year after year misses the opportunity to provide supervisors with potentially important information on vulnerabilities. It can also result in policymakers assuming that the banks are robust to more types of shock than is really the case.

Yet pointlessly repeating a broadly similar scenario each year is exactly what the Fed has been doing, as we can show here.

Have other regulatory authorities been administering stress tests as lax and unrealistic as American ones? Thankfully for the rest of the world, the answer is no. The European Central Bank--and remember that Switzerland is not an ECB member for those thinking of a certain defunct bank--has done its homework by simulating interest rate rises just as we are experiencing now:

Overall, our [ECB]  analysis shows that the euro area banking sector would remain broadly resilient to a variety of interest rate shocks. That would hold also under a baseline scenario of an economic slowdown in 2023 with the risk of a shallow recession, such as the scenario included in the December 2022 Eurosystem staff macroeconomic projections. Profitability would increase overall, driven by [higher] net interest income. However, provisions would also increase, reflecting potential difficulties for borrowers. Results for the overall impact on solvency remain on average fairly muted with great heterogeneity across banks, within and across different business models

The same hold true for Australian banks. Down under, their stress tests have likewise gamed out the implications of higher interest rates:

Higher inflation and higher interest rates could lead to larger credit losses despite continued, albeit slower, economic growth. The stress testing model can provide insights into the magnitude of potential credit losses and how important they could be for the capital positions of large and mid-sized banks. The model applies two principal stresses to examine the resilience of the banking system to higher inflation and interest rates:

  1. Higher inflation and higher interest rates on mortgages squeeze households’ real incomes, making it more difficult to service debt, which could lead to more defaults and larger credit losses for banks. Similarly, higher input costs and higher interest rates passed onto business loans can make it more difficult for businesses to service their debts, potentially leading to higher default rates (see ‘Chapter 2: Household and Business Finances in Australia’).
  2. Higher interest rates typically reduce the prices of housing and commercial property that are held as collateral by banks against their loans, which increases LGDs as well as PDs on loans.  

Having conducted these sorts of tests well before 2023, Australian banks look to be on firming footing.

While we hope that contagion does not spread to the Eurozone and the land down under, it certainly bears questioning why US stress tests did not involve scenarios involving deteriorating financial conditions due to sustained central bank rate rises in the face of persistently elevated inflation. While the subject matter can come across as esoteric, such things do impact Joe Average since taxpayers will ultimately foot the bill for cleaning up the mess caused by unstressful stress tests giving false comfort to financial authorities about the soundness of banks they regulate.  

UPDATE 1: Also see Krishna Guha's commentary in the FT. He warns that while the ECB did conduct asset side stress tests (e.g., holding low-yielding securities), it did not test how vulnerable Eurozone banks were to depositor flight like what has happened Stateside. That said, European depositors tend not to move their money around.

UPDATE 2: Former Federal Deposit Insurance Corporation chief Sheila Bair says the same thing about the latest batch of stress tests that banks passed: They did not model rising interest rates.

The Trials and Tribulations of Friendshoring

♠ Posted by Emmanuel in at 5/03/2023 06:19:00 PM
US election sees China bashing by both parties - Global Times
At least Chinese state media's take on the topic is obvious.

Puns on the term "offshoring"--moving one's production facilities abroad, or having foreign-based concerns manufacture components for you--have proliferated. Some time thereafter came the term "reshoring" to denote moving back production to where something was once manufactured. (A US firm moving its plant back to America from China would be the most obvious example.) 

Now we have the slightly more convoluted term "friendshoring" care of Treasury Secretary Janet Yellen. Like reshoring, friendshoring concerns moving production to locales more favorable to the company in question. For instance, if you had a plant in China, you may be moving it to Mexico to avoid Communist Party persecution of foreign firms through discriminatory regulation. Hence, both reshoring and friendshoring concern moving business activities to where authorities are more favorably disposed. However, the difference is that while reshoring is moving production back to where something was once made, friendshoring does not presume moving back, and the destination can be anyplace where authorities are amicable. That is, your risk of being put out of business by some Western-hating foreign autocrat is mitigated.

Or is it? There are a number of viewpoints out there regarding whether friendshoring is actually beneficial. The consulting firm Korn Ferry cautions that this practice may instead create enemies among countries you have chosen to leave. It boils down to the extent to which companies want to involve themselves in international politics:

“Friend-shoring can be extremely risky,” says Tom Wrobleski, co-leader of Korn Ferry's Supply Chain Talent Optimization practice. “You’re picking sides and can unintentionally forge bad blood with other countries.” In the long term, this could backfire if the country your company relies on—for lithium for batteries, say, or precious metals for computer chips—feels alienated...

The puzzle grows still more complicated when it’s infused with values and politics, says Wrobleski, who says these considerations play an important role in the decision-making process. “There must be balance between political alignment and the actual reason for doing business in a particular country,” says Wrobleski. 

Speaking of politics, the Wall Street Journal adds that the wider effect of firms choosing sides by classifying the world into friends and foes through their location decisions could result in the fragmentation of global supply chains. "Unfriendly" countries may feel antagonized and choose to keep to themselves more. In so doing, key commodities and burgeoning markets that were previously open for business may become increasingly unavailable.  This situation may partly explain the higher inflation being experienced worldwide nowadays. In economic jargon, diminished global economic integration increases trade frictions and therefore the ease and cost of doing business worldwide. 

Weighing matters, Raghuram Rajan urges us to "just say no" to friendshoring. Insofar as many poor countries are led by authoritarian figures who may come across as business unfriendly to Western firms, development may be hampered:

The benefits [of trade between rich and poor countries] are obvious. Final products are significantly less expensive, so even the poorest people in rich countries can buy them. At the same time, developing countries participate in the production process, using their most valuable resource: Low-cost labour. As their workers gain skills, their own manufacturers move to more sophisticated production processes, climbing the value chain. As workers’ incomes rise, they buy more rich-country products...

If any forthcoming friend-shoring mandates were to apply such a broad categorisation, they would have devastating effects on international trade. After all, friend-shoring will typically mean trading with countries that have similar values and institutions; and that, in practice, will mean transacting only with countries at similar levels of development...

The benefits of a global supply chain stem precisely from the fact that it involves countries with very different income levels, allowing each to bring its comparative advantage to the production process, PhD researchers from one, for example, and unskilled assembly-line workers from another. Friend-shoring would tend to eliminate this dynamic, thereby increasing production costs and consumer prices. While some labor unions would welcome the reduced competition, the rest of us would regret it.

On top of diminished trade benefits, Rajan reiterates that friendshoring may encourage protectionism among those being discriminated against. What is a global supply chain manager to do? I'll have more to say about this topic in the future, but for now, it's safe to say that each company will need to weight the benefits of more predictable supply chains with likely costlier production in friendlier locations and the potential loss of market access to aggrieved "unfriendly" countries. 

PS: If you have doubt the admittedly unwieldy term "friendshoring" is real, the IMF is already observing greater FDI among geopolitically aligned countries. The IMF further estimates potentially large efficiency losses due to this phenomenon. 

ARM Holdings IPO: Ditch UK, Flee to US

♠ Posted by Emmanuel in , at 4/29/2023 09:32:00 PM
Masayoshi Son, chairman and CEO of Softbank, ARM Holdings’ parent company, gives the keynote speech at SoftBank World 2016 in Tokyo in July 2016. Photo: VCG
SoftBank-ARM was a fine idea at the time; now it's a brilliant mistake.

Hard as it may be to believe given how downtrodden it is now, Japan's SoftBank was once regarded as a formidable presence on the global technology stage. Sure, it always carried a fairly high level of debt, but its principal Masayoshi Son was regarded as an Asian tech visionary in the mold of a Bill Gates or Steve Jobs. Just as Japan, Inc. gorged on buying US properties in the 1980s, SoftBank gobbled global tech shares in the 2000s, culminating in the creation of Vision Fund for venture capital. Launched in 2017, the Vision Fund's losses have dragged down Softbank as of late. Casting such a wide net, some purchases were bound to be successes (like Alibaba) while others were duds (like WeWork). Unfortunately, it seems SoftBank has had more of the latter than the former. 

Arguably SoftBank's crowning purchase was the UK's ARM Holdings for $32 billion in 2016. Based in the college town of Cambridge, ARM licenses leading-edge microchip designs used in almost all of today's smartphones. Such licensing revenue is huge. However, ARM has been shopped around for a number of years now to help resuscitate its parent company's finances. 

From an international political economy standpoint, what is interesting is that ARM has chosen not to make its initial public offering (semantically a re-offering) on the London Stock Exchange where it was listed prior to SoftBank's 2016 purchase. Spurning national pride, it has chosen to list in the United States. So much for UK government entreaties to lure ARM back home, at least financially

“After engagement with the British Government and the [Financial Conduct Authority] over several months, SoftBank and Arm have determined that pursuing a U.S.-only listing of Arm in 2023 is the best path forward for the company and its stakeholders,” Arm CEO Rene Haas said in a statement. Arm did not completely rule out the possibility of listing in London in the future, saying it was “proud of its British heritage” and may consider a subsequent listing in the U.K. at a later date. It provided no further details.

The decision comes despite intensive lobbying efforts by the British government to persuade the chip designer to list its shares in the U.K. capital. With 6,000 staff globally and 3,000 based in the U.K., Cambridge-based Arm is widely regarded as the jewel in the crown of the British tech industry.

The company is a major force in the semiconductor market, licensing its microchip designs to some of the world’s largest consumer tech manufacturers. Around 95% of smartphones globally, including the Apple iPhone, contain Arm-based processors.

London has relaxed its listings rules in an effort to attract leading global tech companies to go public in the U.K. It faces barriers, with venture capitalists complaining of a lack of understanding of often loss-making tech ventures.

Although the soon-to-be defunct Softbank-ARM linkup has many interesting angles to it, there are two of particular note here: The fall of Masayoshi Son who though the world was his (tech) oyster is one. Another is the London Stock Exchange's inability to attract tech IPOs. With many of its listings consisting of traditional industries like energy and finance, the UK reputation as an investment destination for technology could literally have received a shot in the ARM. But alas, it has just been announced that ARM will soon list Stateside a few weeks after the UK was spurned:

SoftBank Group Corp's chip maker Arm Ltd has filed with regulators confidentially for a U.S. stock market listing, Arm said on Saturday, setting the stage for this year's largest initial public offering. The IPO registration shows that Softbank is pressing ahead with the blockbuster offering despite adverse market conditions, after saying in March that it planned to list Arm in the U.S. stock market.

U.S. IPOs, excluding listings for special purpose acquisition companies, are down about 22% to a total of just $2.35 billion year-to-date, according to Dealogic, as stock market volatility and economic uncertainty put many IPO hopefuls off.

Arm plans to sell its shares on Nasdaq later this year, seeking to raise between $8 billion and $10 billion, people familiar with the matter said. In a statement, which confirmed an earlier Reuters report on the planned IPO, Arm said the size and price range for the offering has not yet been determined.

The Matthew Effect is alive and well in tech, I guess. Given the UK's self-inflicted harm over Brexit, it is not unexpected that one of its national champions would prefer to list in the capital- and tech-intensive United States which already has many of tech's top firms. Maybe the UK will get a consolation prize of a secondary listing a few years down the road, but for now, it has come up empty.

5/19 UPDATE: The ARM sale probably couldn't come sooner as the SoftBank Vision fund has just announced a scarcely believable $39B loss.

The IMF, Team Transitory & You

♠ Posted by Emmanuel in at 4/26/2023 07:27:00 PM

I have a confession to make in being on board "team transitory", or the belief that the recent (global) increase in inflation is due to largely temporary factors. As these factors fade, we are set to resume the previous economic environment of relatively benign inflation. On the demand side, these temporary factors include increased demand for consumer goods as people stayed more at home due to the pandemic. Economic stimulus provided by rich countries to their citizens further fueled this demand. On the supply side, disruptions in goods production, transportation and retail also arose due to the pandemic. More demand + less supply = inflation.

Meanwhile, critics of the idea that high inflation is transitory argue that there have been changes in the world economy which contradict the transitory idea such as the emergence of a major war on the European continent--the first since the end of WWII--causing strains in the availability of commodities like energy and grains. Also, prices of not only goods but also services should be factored in since the latter have increased, too. In other words, inflation is becoming entrenched and is not a temporary phenomenon. 

Little-noticed in this debate is the International Monetary Fund (IMF) weighing in recently with its most recent take on the matter. According to the IMF, there were longstanding economic phenomena well underway before the pandemic that point to lower inflation whose momentum will be very difficult to overcome. These include: 

  • Total factor productivity falling significantly, which lowers economic output;
  • Demographic changes resulting in fewer persons of working age (and more retirees), which also reduces economic output;
  • For developed countries at least, inflows of capital from developing countries in search of more secure returns. 

While there too are factors pushing up rates such as running sizable national budget deficits (that have to be funded by offering higher returns to lenders), the overall picture in the developed world is of declining rates, on the balance. Here is another IMF chart:


Absent some unforeseen modern-day productivity boom or baby boom, you would generally expect rates to trend downward in the developed countries. As they become older--like China whose population is already falling outright--developing countries should follow the same path. Add in other factors the IMF found also lead to lower rates such as elevated and rising inequality--rich people tend to save more and spend less--as well as the decreasing labor share of income--leaving workers with less disposable income--and the picture for rate moderation is compelling. 

On this matter at least, I think this IMF research is spot on, with some caveats. We are not quite sure when current (transitory) inflation pressures let up precisely, but they will eventually be swamped by stronger factors favoring lower rates. Aging and diminished productivity along with a handful of other factors will lead us back to a low rate economic environment once more. You have to be brave to bet otherwise.

Geo/Econ Challenged: UK in CPTPP?

♠ Posted by Emmanuel in ,, at 3/31/2023 01:27:00 PM
Second CPTPP Commission Meeting Logo
The UK will soon join this group, but does it really matter?

It has somehow come to pass that the UK has now joined an Asia-Pacific trade agreement. OK, so the free trade agreement in question is not the US-led Trans Pacific Partnership, but rather the US-absent Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP). Moreover, the Pacific is vast: the world's largest ocean is said to contain over half the world's waters. Still, an undeniable fact is that the UK is not in the Pacific. (The last time I checked, it also belonged to this group called the "North Atlantic Treaty Organization".)

Chalk this oddity up to the Brexiteer pledge that leaving the European Union would somehow leave it better off by signing up to FTAs worldwide, and not just with the UK's neighbors. There are a few things to unpack before getting to the significance of this announcement, so here's a quick recap:

  • The trade-averse US government has continued post-Trump, meaning the US seems to have no intention of (re-)joining CPTPP. 
  • Lacking a firmly "Western" prestige partner, the remaining CPTPP countries likely decided to allow negotiations to proceed with the UK anyway.

Now, to the crux of the matter: are there significant economic benefits to be reaped by the UK from this agreement? The UK government estimates that their economy will gain 0.08% as a result over 10 years. 0.08%. To me that seems to be a rounding error instead of a significant gain. Put it down to the UK already having existing FTAs with most CPTPP members and trading far less with these Asia-Pacific nations than with its European neighbors:

The Comprehensive and Progressive Agreement for Trans-Pacific Partnership - or CPTPP - was established in 2018, and includes Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore and Vietnam. Membership of the CPTPP loosens restrictions on trade between members and reduce tariffs - a form of border tax - on goods.

However, the gains for the UK from joining are expected to be modest. The UK already has free trade deals with all of the members except Brunei and Malaysia, some of which were rolled over from its previous membership of the EU. And even with some gains in trading the government only estimates it will add 0.08% to the size of the economy in 10 years. The Office for Budget Responsibility (OBR), which provides forecasts for the government, has previously said Brexit would reduce the UK's potential economic growth by about 4% in the long term.

Simply put, joining CPTPP would only claw back, oh, 2% of the economic output lost from leaving the EU. It's as close to non-news as you can get in the economic realm.