Global Market Perspective | A Fisher Investments Blog

Not-so-New Two-Speed Europe

Setting aside the British political debate over David Cameron’s decision to veto a Lisbon Treaty change at last week’s EU summit, here are some thoughts on the idea of a “two-speed Europe .”

Recent quotes by Nicolas Sarkozy and other continental leaders suggest Cameron created a two-speed Europe by opting the UK out of the new agreement on tougher budget oversight. However, if one defines a two-speed Europe as an EU where Britain opts out of some broad agreements, then a two-speed Europe has existed for decades. Cameron’s veto is just the latest instance of the UK not adopting an otherwise EU-wide measure. Here’s a brief historical recap:

 

·         In 1984, Margaret Thatcher negotiated a partial rebate of farm subsidies paid by the UK to continental Europe . The so-called “Thatcher rebate” is still in force.

·         Britain and Ireland are exempt from the Shengen agreement, which governs cross-border travel. The Shengen Agreement was first signed in 1985 and was later folded into the Amsterdam Treaty. Britain still maintains its own entry policies.

·         The UK doesn’t fully participate in the area of freedom, security and justice.

·         Britain did not adopt the Lisbon Treaty’s Charter of Fundamental Rights.

·         As we all know, the UK officially declined to adopt the euro during Maastricht Treaty negotiations, so neither that treaty’s “conditions for convergence” nor the Stability and Growth Pact apply to Britain . This is key, considering the budget pact agreed by the remaining 26 EU states is, essentially, a dressed up version of the Stability and Growth Pact.

Perhaps the divide between Britain and the continent seems wider because the stakes appeared so much higher this time around. But if you put Cameron’s decision in historical perspective, it seems to be more of the same.

For a longer take on this topic, check out my new column on MarketMinder.com, “In Defense of Britain.”

Football and Taxes

Earlier this month, the British government denounced the EU’s proposed financial transactions tax. In his speech to fellow EU finance ministers, Chancellor George Osborne said the UK couldn’t support a tax that would harm its standing as a global financial center (around 80% of European financial activity is based in the City of London ). Quite right, too—generally, increasing taxes on any good or service decreases the amount sold, so levying a surtax on financial transactions in Britain would likely cause some capital markets activity to shift from the Square Mile to a country with no such tax. Financial services comprise a large share of Britain ’s economy, so the tax would likely have negative economic consequences.

After the Chancellor’s speech, German and French officials—staunchly pro-tax—expressed disappointment in the UK’s stance, which effectively prevents the tax from taking effect on an EU-wide basis (all 27 nations must approve it). The rhetoric subsequently heated up, however, with these words from one member of German Chancellor Angela Merkel’s government:

“I can understand that the British don’t want [the transactions tax] when they generate almost 30% of their gross domestic product from financial-market business in the City of London. Only going after their own benefit and refusing to contribute is not the message we’re letting the British get away with.”

Tough words from one Volker Kauder! However, it’s not Germany’s, France’s or any other country’s place to determine British tax policy. The UK has every right to set policies it believes are in its best interest—other nations can complain, but they can’t force changes. For instance, earlier this year, some European nations urged business-friendly Ireland to raise its corporate tax rate, saying Ireland’s 12.5% rate gave it unfair advantages over the rest of the union. Ireland demurred, which is perhaps not surprising considering the country is ranked the world’s 10^th best nation for ease of doing business, according to the World Bank. Germany is 19^th. France is 29^th.

Which raises the question: Why do some European nations insist on their neighbors playing down to their level? Think of football. Manchester City sits atop the Premier League and also won last season’s title. Three years ago, however, the club couldn’t compete with stalwarts Chelsea, Liverpool, Arsenal and Manchester United. Instead of complaining about unfairness or demanding concessions from other clubs, the owners chose to improve their own competitiveness, signing several high-profile players in 2009 and 2010.

Just as Man City harmonized its talent with the other top clubs, Germany and France may consider harmonizing their own policies with Ireland’s, Britain’s or whomever’s. After all, the UK can “get away with” its current tax policies no matter how much other nations grumble.  Instead of arguing the UK should handicap itself, perhaps Germany and France would do better to find means of increasing their own economic competitiveness. 

 

China’s Counterfeit Crackdown

Days after being taken to task by Western officials for its lax enforcement of intellectual property rights, China recently made a high-profile counterfeiting crackdown in Shanghai. Five people were arrested for making and selling fake iPhones. The Guardian has the scoop here.

It’s tough to tell whether this is the start of a tougher approach to counterfeiters, an isolated bit of pandering to the West, or an attempt to soothe Apple following the discovery of several fake Apple stores in China in July and August. Meanwhile, piracy continues unchecked elsewhere in the country. In Hunan Province, a theme park based on the wildly popular Angry Birds game opened on September 1^st…naturally, without any licensing agreements with the game’s Finnish creators. If China’s serious about ending infringement on Western copyrights, it has its work cut out for it. 

 

Chinese Laundry

Last week, China and the West engaged in a rather public debate over China’s role in the global economy. The story began when rumors surfaced that China and Italy were working on an investment deal that could give Italy a boost as it grapples with its ongoing deficit issues. Many hoped China would buy up troubled debt in Spain, Portugal and Greece as well, essentially shoring up Europe’s periphery in one go. However, China said it isn’t interested in investing heavily in Europe unless it’s granted “market economy” status by the World Trade Organization (WTO). In other words, China seems to be using the European periphery’s debt troubles to leverage its own position.

China wants to be recognized as a market economy because the WTO allows trading partners to charge substantially higher import taxes on goods from non-market economies, which drives up the prices consumers pay and, by extension, lowers demand. According to the Wall Street Journal, the US and EU have used China’s status to inflate duties levied on Chinese goods by 60 percentage points on average. If China’s status is improved, these extra taxes will likely vanish.  

When China joined the WTO in 2001, it agreed to keep its non-market status until 2016. Should it qualify for market status early? Investopedia defines a market economy as “an economic system in which economic decisions and the pricing of goods and services are guided solely by the aggregate interactions of a country’s citizens and businesses and there is little government intervention or central planning. This is the opposite of a centrally planned economy, in which government decisions drive most aspects of a country’s economic activity.” For much of the 20^th century, China’s economy was centrally planned: The government determined how resources were allocated, how money was spent, what people could and couldn’t buy. This started changing 30 years ago, when Deng Xiaoping began implementing economic reforms, and China has come a long way.

A Chinese Commerce Ministry official, as quoted in The Telegraph, asserted that China’s economy has evolved enough to merit the status upgrade. Yet an editorial in last Wednesday’s Wall Street Journal makes a sensible case for the counterargument. While China is more open to foreign trade, and it does have fledgling capital markets, much of its domestic development is still planned from on high, and its financial system remains insulated from the rest of the world. For example, the government refuses to let the yuan trade freely, and as a result the currency’s relative value is most likely weaker than it otherwise would be. China also has almost no private or intellectual property rights, and the latter makes some Western companies wary of manufacturing goods there given the heightened risk of piracy. Additionally, China heavily restricts foreign investment.  

European and US officials appear to agree China must make significant reforms before getting the recognition it craves. Last Tuesday, the US Ambassador to China made fresh calls for a more open Chinese economy. Meanwhile, and perhaps proving the ambassador’s point, China launched an impassioned defense of its tariffs on American chickens the next day. For now, it appears heavy reforms aren’t on China’s agenda, which makes a status change in the near future seem unlikely.

To learn more about some of the reforms needed in China’s financial system, see our recent Research Analysis piece on Fisher Investments MarketMinder, “China: Bank Bailout Rumor.”

 

Euro Rich, Cash Poor

Last week, five central banks joined to announce a plan to grant European banks easier access to US dollars. At least in the near term, this should help relieve some of the pressure on European banks, which have found it increasingly hard to borrow dollars over the past year.

European banks still have plenty of capital (as Fisher Investments explained recently in this article on The Street), but much of it is in euros and other assets. Since a good deal of international business is conducted in dollars, European banks need an ample supply of dollars for lending and other normal operations. Historically, they have borrowed significant amounts of these dollars from U.S. domiciled money-market funds, using euros as collateral.  However, as US lenders have grown increasingly concerned in recent months about the eurozone periphery’s ongoing debt problems, they’ve been less willing to accept euros as collateral.  This in turn has driven up interest rates for dollar loans collateralized by euros, making these loans more expensive for European banks.

These dollar funding difficulties have caused some to speculate about the potential for an oncoming self-fulfilling prophesy: If a bank can’t access funding, it may be perceived as too risky to lend to, and it may not receive the capital it needs to continue doing business, which could cause a liquidity shortage. If this happened many times in a short period, Europe could find itself in a banking crisis.

No one wants this, and the central banks believe they have a solution. In a coordinated action, the US Federal Reserve and European Central Bank, along with the central banks of Britain, Switzerland and Japan, will provide unlimited dollar liquidity for any bank that asks for it. The central banks will swap dollars for other eligible collateral, with terms of approximately three months, at a low fixed rate. This will happen three times, on October 12, November 9 and December 7.

Though this move won’t solve Europe’s peripheral debt problems, it should help ease lending risk in the near term, which is a positive development. Additionally, it demonstrates financial leaders’ resolve to help global capital markets function as smoothly as possible while European leaders continue working on a solution, which could boost the market’s confidence.