Zurich Insurance Company: Insurance in Latin America - Economic Growth Brings New Opportunities

[caption id="attachment_6629" align="alignright" width="211"] Santiago, Chile[/caption]

To continue its success story, Latin America will need to address a number of socio-economic challenges. Insurance has the potential to help the nations of the region to tackle such challenges. Yet insurance potential of the region remains largely untapped. Unleashing it will require a transformation of both market and regulatory structures.

Latin America has undergone a remarkable transformation after suffering through a series of major economic and financial crises in the 1990s and at the beginning of the new century. Since 2003, the region’s GDP has grown more strongly than that of the advanced economies in every single year.

Even more importantly, the region’s economic development appears to rest on far more solid foundations than it did in the past. This positive development has been driven by a strong expansion of domestic demand that was in turn supported by high prices for natural resources and food – the main exports of the region. Sound economic policies and a growing financial sector have also underpinned these improvements.

There are, however, several risks and challenges for sustainable economic growth in Latin America. Although the situation differs among Latin American countries, there are some common issues which need to be addressed. In order to maintain the current growth path there is a need to foster trade and investment.

“Since 2003, the region’s GDP has grown more strongly than that of the advanced economies.”

The region’s high exposure to natural catastrophes calls for precautionary actions as well as protection from their financial consequences. Given the decreasing, yet still high income inequality there is also a critical need to protect the growing middle class from falling back into poverty. Finally, expected demographic changes require appropriate retirement solutions. A vibrant insurance sector can help the countries of the region address these key challenges.

Fostering Trade and Investment

Latin America has gained much from increased levels of trade. However, the region’s trade patterns are not well diversified: Most revenues result from the export of commodities. An expansion and diversification of trade has the potential to make economic growth more sustainable and to enhance welfare.

Exporters face a number of risks that are inherent to their activity. These include the risk of physical loss of any products and risks during transport. As economies move up the value added chain, the risks associated with supply chains become more significant. To effectively manage the risks associated with the disruption of complex supply chains, in-depth knowledge of various risk factors and their interdependence is necessary. In addition to the trade-enhancing effects of insurance, insurers can help exporters develop and maintain resilient supply chains.

The Economic and Social Role of Insurance

Insurance plays an important economic and social role and has the potential to provide vital support to emerging economies. However, its important contributions often tend to be overlooked. Insurance performs three core economic functions:

Insurance enables risk transfer: insurance provides an efficient mechanism of risk transfer by pooling idiosyncratic risks. In technical terms, such risk pooling, based on the law of large numbers, provides value in that the premium paid by individual policyholders is smaller than the cost of an expected maximum loss occurrence.

Insurance provides risk management: By charging a premium that reflects the underlying risks, insurance provides an important signal to policyholders and the economy at large, thereby offering incentives for risk mitigation. Insurers also give risk management advice and services to individuals and companies.

Insurance contributes to efficient capital accumulation: Insurers typically invest collected premiums as reserves for future claims payments. By accumulating large pools of capital invested in real and financial assets, insurers foster capital formation. In contrast to other financial institutions, insurance assets are typically matched in size and maturity with positions on the liability side, and do not involve maturity transformation.

Through these functions, insurance enhances individual wellbeing, promotes economic activity that otherwise would not be undertaken, and protects people from falling into poverty as a consequence of an adverse event.

In order to sustain economic growth, Latin America will have to mobilize sufficient investments, in particular in infrastructure, buildings and machines. However, both domestic and international investors face a number of risks that endanger their investments. By taking on and pooling some of the risks inherent in business operations, insurance enables individuals and companies to undertake productive investments. An example is surety coverage, by which insurers take on certain risks related to large and complex construction projects. Without such coverage, these projects would not be undertaken.

In order to strengthen the resilience of their economies and to broaden the investor base, emerging markets seek to attract foreign direct investment (FDI). Yet foreign investors face uncertainties, with political risk seen as the single greatest impediment to inward investment. A global and competitive insurance industry can play an important role in the promotion of FDI. By absorbing and managing some of the risks investors typically face, global insurers make investments possible that otherwise would be too risky.

[caption id="attachment_6641" align="aligncenter" width="551"] Insurance Penetration: Premiums as a % of GDP in 2012. Source: Swiss Re, sigma No. 3/2013.[/caption]

Enhancing Resilience to Catastrophic Losses

Latin America is strongly exposed to recurrent natural disasters. The region was particularly hard hit in 2010. The earthquake in Haiti alone killed 160,000 people. The economic losses are also significant. The earthquake of 2010 in Chile resulted in economic losses of $30 billion which represents 15 percent of Chilean GDP. In fact, in 2010, the losses from natural disasters in Latin America relative to GDP exceeded loss ratios in any other part of the world. The economic losses from natural disasters will most likely further increase in years to come, as a growing population and further urbanization as well as growing wealth will expose increasing values to risk. It is expected, for example, that the population exposed to flood risk in Brazil will surge from 33 million today to 43 million in 2030.

As a large number of people are simultaneously affected by natural disasters, such risks can easily exceed the capacity of domestic insurers. To effectively protect against catastrophes, each country would have to accumulate significant amounts of savings to cover the associated economic losses. As a result of this need for savings, consumption would have to be reduced with adverse consequences for economic growth.

The international insurance and reinsurance markets provide more efficient and extensive protection against large-scale disasters by pooling risks at the global level. Following the 2010 earthquake in Chile, for example, insurers – mostly international – paid out claims equalling four percent of Chilean GDP.

Many Latin American countries rely excessively on post-event assistance as opposed to pre-event preparedness and mitigation. Poor disaster preparedness and poor construction standards are often the cause of high mortality and injury from building collapses caused by earthquakes or tsunamis. Adaptation measures, such as urban planning, building codes, drainage and hillside stabilization projects, could significantly reduce expected losses.

The lack of appropriate building standards has been identified as one of the main causes for the devastation caused by the Haiti earthquake. By way of comparison, the Chilean earthquake caused a far lower number of casualties even though it was 500 times more powerful – not least due to advanced building codes. Insurance cannot only help to cover the economic losses and contribute to a faster recovery; it can also help to strengthen the resilience to natural disasters by sharing its experience in risk mitigation and risk management.

Protecting the Growing Middle Class

While Latin America enjoys increasing income levels, it still suffers from high levels of income inequality. A large proportion of the population remains at a low income level and has only limited possibilities to build up reserves in order to protect themselves from the financial consequences of adverse events like illness, accidents or the destruction of property.

Without reserves, adverse events force people to drastically reduce their consumption. This can often have large and persistent effects on their future health and income. As a result, individuals, families or entire villages can fall into poverty and the overall economic development is challenged. Insurance can create substantial benefits for people who do not have the possibility for self-insurance. For people that managed to escape poverty, insurance provides security of assets and helps to maintain their social status.

Though the population of the region is still comparatively young, it has started to get older. According to UN forecasts, Latin America will close the gap with advanced economies within the next 50 years. The young people that start working now will be heavily affected by this development when they retire, yet, appropriate retirement solutions are still underdeveloped. They have to finance a much longer post-work life span despite the fact that there will be a much smaller part of the population that is still working and generating the necessary financial sources.

Notably the rise of the middle class will increase the demand for savings products as people strive to maintain their lifestyle beyond retirement. Furthermore, without appropriate retirement solutions there is a high risk that large parts of the middle class will fall into poverty when they have retired.

Public pay-as-you-go retirement systems will likely get into difficulties as premium payers have to finance a steadily increasing number of retired persons. This can create a high and probably unsustainable fiscal burden. Furthermore, in most countries of the region, public retirement schemes are not designed for the needs of a growing middle class, and there are no general retirement insurance and pension policies widely available. There is an important role for insurers to develop new products tailored to meet these needs.

Unleashing the Untapped Potential of Insurance

Although the use of insurance in the region has picked up over the course of the last decade, Latin America still has rather low insurance penetration rates.

Given the capacity of insurance to help address key challenges of the region and spur economic growth, its untapped potential is clearly a missed opportunity. Policymakers, regulators and market participants need to address a number of market and regulatory challenges to enable insurance to grow in the region. This includes:

Financial literacy: There is much potential in the region to enhance financial literacy and deepen awareness about insurance products and their beneficial effects. Financial education is crucial to make progress on this front, and the public and private sectors should cooperate towards this end.

Financial inclusion: Insurers can tailor the products to reduce the thresholds for efficient insurance by simplifying policy terms and collecting payments in highly scalable ways. Such tailored products can serve the needs of low-income households.

Regulation: A sound and stable policy and regulatory framework is a precondition for the development of an efficient insurance market. However, in many Latin American countries there are regulatory restrictions that limit the ability of insurers to effectively pool risks and therefore hinder the development of an efficient insurance market. There is an urgent need to reduce regulatory barriers for efficient risk pooling.

In conclusion, insurance can play a crucial role in addressing the key challenges of Latin America by protecting the assets and wealth of individuals, families and businesses and promoting economic development.

However, a lack of trust and awareness by consumers is a major impediment for insurance in playing this role. On one hand, the insurance sector needs to develop affordable and tailored products that enable consumers to build up trust in the sector. On the other, it is vital for many countries of the region to ensure that the right regulatory infrastructure exists to allow the sector to deliver the economic and social benefits that it is able to.

About Zurich Insurance Company

Zurich is a leading multi-line insurance provider with a global network of subsidiaries and offices. With about 60,000 employees, we deliver a wide range of general insurance and life insurance products and services for individuals, small businesses, and mid-sized and large companies, including multinational corporations, in more than 170 countries.

About the Authors

Benno Keller is Head Research and Policy Development at Zurich Insurance Company. He holds a PhD in Economics and Social Sciences from the University of Fribourg, Switzerland.

Christian Hott is a Senior Economist in the Government and Industry Affairs unit of Zurich Insurance Company. He holds a PhD in economics from the Technical University of Dresden and a master’s degree in economics from the University of Konstanz.

Roy Suter is a senior public policy analyst at Zurich where he also headed the company’s international government affairs operations. Prior to joining Zurich, Roy worked for the Swiss Ministry of Economic Affairs where he was in charge of managing Switzerland’s relations with various multilateral development banks. He holds a PhD in International Relations and a LLM in International Business Law.


Harbingers of Climate Doom Gear Up Over Storm

[caption id="attachment_6648" align="alignright" width="142"] Nicholas Stern[/caption]

Extreme weather events such as prolonged heat waves in Argentina, killer typhoons in the Pacific and violent storms lashing the UK are a godsend for doom-and-gloom scientists banging the climate change drum. Nicholas Stern, author of a 2006 report on the economics of climate change, is one of the alarmists. Lord Stern is a highly respected academic and president of the British Academy for the Humanities and Social Sciences.

This makes it just so much worse. In a recent op-ed piece for the Guardian, Lord Stern argues that we should cut emissions of greenhouse gases immediately lest extreme weather events, such as the storms now lashing the UK, become the norm rather than the exception.

Lord Stern lists a long series of weather events that caused mayhem and then jumps to the conclusion that these are caused by global warming due to human activities. This is precisely what the data-juggling Intergovernmental Panel on Climate Change (IPCC) finds every so often. That IPCC scientists have been found to massage the numbers to fit the politically expedient outcome they desire is – rather conveniently – forgotten.

"However, to suggest, as Lord Stern does, that we can alter the grand course of global climatic events might attribute humanity a power it does not yet possess."

So are the well-documented Little Ice Age that changed the global climate between the 16th and 19th centuries, and the Medieval Climate Optimum that preceded it. The latter anomaly warmed up the globe to average temperatures similar to those measured now.

The Little Ice Age, which IPCC scientists persistently try to downplay to an astonishing degree, cooled the earth by as much as 1.2 degrees Celsius. It left a heritage of breathtakingly beautiful paintings of wintery scenes by masters like Pieter Brueghel (Hunters in the Snow, 1565), Abraham Hondius (The Frozen Thames, 1677) and Bartholomeus Johannes van Hove (Pompenburg met Hofpoort in de winter, 1825). The icy landscapes depicted have been absent from contemporary life on like latitudes since the early 1900s.

This would indicate that the earth is warming up: A process not entirely unexpected at the close of a mini ice age. What’s more, scientists know such a change to have occurred within human memory. The Medieval Climate Optimum, a pronounced warming of the earth, also lasted for about three centuries (AD 950-1250). At that time average temperatures were but 0.03 degrees Celsius cooler than they are now. In other words: About a thousand years back the earth went through a warming cycle that produced average temperatures roughly equal to those experienced today.

This would seem to indicate that the alarm insistently sounded by Lord Stern and his colleagues is a typical case of much ado about nothing. The notion that by drastically cutting emissions of greenhouse gases, humanity may actually revert global warming bespeaks of supreme arrogance.

Through invention, resourcefulness and sheer genius, humanity has gathered a power over nature that is quite impressive. Collectively we obliterate entire ecosystems, contribute to the extinction of countless life forms and habitually mould nature to suit our needs. Sometimes we even get together in order to undo the damage done. Such was the case with the acid rain of the 1970s and with the worryingly large hole in the ozone layer above Antarctica in the 1980s. We also seem to have rescued whales from extinction.

However, to suggest, as Lord Stern does, that we can alter the grand course of global climatic events might attribute humanity a power it does not yet possess.

While the scientists’ near unanimity on climate change and its causes cannot be discarded, it does them, and their cause, no favour to argue that each and every freak weather event constitutes irrefutable proof of their theories. Donning the robes of prophets of doom who cajole humanity into obedience and compliance with fire and brimstone preaching does not suit them all that well either.

Fact is that carbon emissions at fairly elevated levels are here to stay. A green economy is not going to be legislated into existence and certainly not on a global level. China, India, and the nascent powerhouses of Africa will not boast economies run on eco-friendly principles. Imposing levies, fees and other financially punitive regulation on non-green economic activities will accomplish little else than condemning untold millions to continued poverty and deprive the up-and-coming generations of Europe and North America a fair shot at attaining a level of comfort similar to the one taken for granted by their parents.

This most definitely does not equal a conundrum. Far from it: Accept extreme weather phenomena for what they are – freak events that have occurred, one way or another, throughout history. They prove nothing other than that nature is a force to be reckoned with. Also, stop sounding the alarm as if there were, quite literally, no tomorrow. There is.

Instead, let’s collectively pursue a set of sensible policies aimed at eliminating the blight of poverty from the face of the earth without attempting to reinvent the wheel in the process. By now, we have discovered, mostly through trial and error, which economic policies deliver the goods and which ones do not. Let’s also try to cope with whatever global warming nature dishes out. We cannot possibly stop this warming trend, let alone revert it; we can, however, manage it quite well.


Wang Meng: A Champ Tumbles and Falls on Her Way to the Top

We all crash into the barricades from time to time and Wang Meng, China’s most successful winter Olympian ever, did so at the 2010 Vancouver Olympics. However, this young lady got up, brushed herself down and went on to finish the competition with three gold medals to bring home.

Short track speed skater Wang Meng, born in 1985, has been on the ice since she was nine years old. According to her American co-competitor Katherine Ruetter, “she is willing to do whatever it takes to win. It’s not just that she does a few things better than her peers; she simply does everything a good deal better than anyone else.”

Not one for false modesty, Ms Meng tends to agree and pointed out while at the Vancouver Olympics that, “unless I make mistakes, no one else will have any chance to win.” Thank goodness, she is not perfect and is as prone to falling and failing as the rest of humanity.

Ms Meng was heavily criticised at home for not showing much in the way of gratitude to either her country or its government after the Vancouver gold wins. She did, however, thank her team mates and coach. She also promised to help her parents get “a better life”. Ms Meng, perhaps wisely, refrained from denouncing China’s one-child policy or that country’s elaborate system of forced-labour camps.

“It’s really good. It’s better than what I have thought. I am happy to be competing. I hope my country will win a gold medal but I don’t care if it’s me or somebody else.”

Ms Meng crashed into obstacles yet again the following year after a brawl – including the attendant exchange of blows – with team manager Wang Chunlu who had dared question her late night drinking bouts and lack of discipline. Ms Meng ended up with an injured arm. She then went on to address the media in a rather bizarre fashion and was subsequently expelled from the Chinese team.

Interestingly, the manager was sacked as well, perhaps signalling the existence of wider issues surpassing those related to a recalcitrant athlete. In the end, Ms Meng blamed no one but herself, saying: “I ought to apologise to the Chinese people. So many lovers of short-track skating like and support me. What I did was wrong.”

Ms Meng was allowed back on the team after a year in the boondocks. She found that the competition had stiffened during her absence. She was beaten in the 500 metres – on which she holds the world record – by a Canadian skater. However, Ms Meng’s winning ways would soon return as she started working her way towards a third Olympic appearance.

If Ms Meng bags just a single gold medal at the 2014 Winter Olympics in Sochi, Russia, she will have won the most gold medals ever for a short track speed skater. Two plaques of any colour would mean a tie for most medals in this category.


Michael Pettis: Markets Rationale and Volatility - The Case of China

Last month’s award of the Nobel Prize in Economics set off a great deal of chuckling because one of the three recipients, Eugene Fama, received the award for saying that markets are efficient at capital allocation and another, Robert Schiller, received the award for saying they are not. Typical is this response by John Kay (Financial Times, October 16, 2013):

 “The Royal Swedish Academy of Sciences continues to astonish the public when awarding the Nobel Memorial Prize in Economics. In 2011 it celebrated the success of recent research in promoting macroeconomic stability. This year it pays tribute to the capacity of economists to predict the long-run movement of asset prices.

People with knowledge of financial economics may be further surprised that this year Eugene Fama and Robert Shiller are both recipients. Prof Fama made his name by developing the efficient market hypothesis, long the cornerstone of finance theory. Prof Shiller is the most prominent critic of that hypothesis. It is like awarding the physics prize jointly to Ptolemy for his theory that the Earth is the centre of the universe, and to Copernicus for showing it is not.”

To me, much of the argument about whether or not markets are efficient misses the point. There are conditions, it would appear, under which markets seem to do a great job of managing risk, keeping the cost of capital reasonable, and allocating capital to its most productive use – and there are times when clearly this does not happen. The interesting question, in that case, becomes what are the conditions under which the former seems to occur.

I wrote about this in my most recent book about China, Avoiding the Fall, and I think it might be useful to recap that argument. In the book (based on articles published in 2004-05) I argue that an “efficient” market is one that has an efficient mix of investment strategies. Without such a mix, the market itself fails in its ability to allocate capital productively at a reasonable cost.

Decisions, Decisions

Investors make buy and sell decisions for a wide variety of reasons, and when there is a good balance in the structure of their decision-making, financial markets are stable and efficient. But there are times in which investment is heavily tilted toward a particular type of decision, and this can undermine the functioning of the markets.

To see why this is so, it is necessary to understand how and why investors make decisions. An efficient and well-balanced market is composed primarily of three types of investment strategies – fundamental investment, relative value investment, and speculation – each of which plays an important role in creating and fostering an efficient market.

Fundamental investment, also called value investment, involves buying assets in order to earn the economic value generated over the life of the investment. When investors attempt to project and assess the long-term cash flows generated by an asset, they discount those cash flows at some rate that acknowledges the riskiness of those projections. They are acting as fundamental investors.

Relative value investing, which includes arbitrage, involves exploiting pricing inefficiencies to make low-risk profits. Relative value investors may not have a clear idea of the fundamental value of an asset, but this doesn’t matter to them. They hope to compare assets and determine whether one asset is over- or under-priced relative to another, and if so, to profit from an eventual convergence in prices.

Speculation is actually a group of related investment strategies that take advantage of information that will have an immediate effect on prices by causing short-term changes in supply or demand factors that may affect an asset’s price in the hours, days, or weeks to come. These changes may be only temporarily and may eventually reverse themselves, but by trading quickly, speculators can profit from short-term price fluctuations.

Each of these investment strategies plays a different and necessary role in ensuring that a well-functioning market is able keep the cost of capital low, absorb financial risks, and allocate capital efficiently. A well-balanced market is a relatively stable one that allocates capital in an efficient way, maximising long-term economic growth.

“To me, much of the argument about whether or not markets are efficient misses the point.”

Each of the investment strategies also requires very different types of information, or interprets the same information in different ways. Speculators are often “trend” traders, or trade against information that can have a short-term impact on supply or demand factors. They typically look for many opportunities to make small profits. When speculators buy in rising markets or sell in falling ones – either because they are trend traders or because the types of leverage and the instruments they use force them to do so – their behaviour reinforces price movements and adds volatility to the market.

Different Investors Make Markets Efficient

Value investors typically do the opposite. They tend to have fairly stable target price ranges based on their evaluation of long-term cash flows discounted at an appropriate rate. When an asset trades below the target price range, they buy; when it trades above the target price range, they sell.

This brings stability to market prices. For example, when higher-than-expected GDP growth rates are announced, a speculator may expect a subsequent rise in short-term interest rates. If a significant number of investors have borrowed money to purchase securities, the rise in short-term rates will raise the cost of their investment and so may induce them to sell, which would cause an immediate but temporary drop in the market. As speculators quickly sell stocks ahead of them to take advantage of this expected selling, their activity itself can force prices to drop. Declining prices put additional pressure on those investors who have borrowed money to purchase stocks, and they sell even more. In this way, the decline in prices can become self-reinforcing.

Value investors, however, play a stabilizing role. The announcement of good GDP growth rates may cause them to expect corporate profits to increase in the long term, and so they increase their target price range for stocks. As speculators push the price of stocks down, value investors become increasingly interested in buying until their net purchases begin to stabilize the market and eventually reverse the decline.

Relative value investors or traders play a different role. Like speculators, they tend not to have long-term views of prices. However, when any particular asset is trading too high (low) relative to other equivalent risks in the market, they sell (buy) the asset and hedge the risk by buying (selling) equivalent securities.

A well-functioning market requires all three types of investors for socially useful projects to have access to appropriately-priced capital.

Value investors allocate capital to its most productive use.

Speculators, because they trade frequently, provide the liquidity and trading volume that allows value investors and relative value traders to execute their trades cheaply. They also ensure that information is disseminated quickly.

Relative value trading forces pricing consistency and improves the information value of market prices, which allows value investors to judge and interpret market information with confidence. It also increases market liquidity by combining several different, related assets into a single market. When demand for one asset forces its price to rise relative to that of other related assets, relative value traders will sell that asset and buy the related assets, thus spreading the buying throughout the market to related assets. It is because of relative value strategies that we can speak of a unified market for different assets.

Without a good balance of all three types of investment strategies, financial systems lose their flexibility, the cost of capital is likely to be distorted, and markets become inefficient at allocating capital. This is the case, for example, in a market dominated by speculators. Speculators focus largely on variables that may affect the short-term demand or supply for a given asset – such as changes in interest rates, political and regulatory announcements, or insider behaviour.

However they tend to ignore information like growth expectations or new product development whose impact may be revealed only over longer periods of time. In a market dominated by speculators, prices can rise very high – or drop very low – on information that may have little to do with economic value and a lot with short-term, non-economic sentiments.

Value investors keep markets stable and focused on profitability and growth. For value investors, short-term, non-economic variables are unimportant. They are more confident of their ability to discount economic variables that develop and affect cash flows over the long term. Furthermore, because the present value of future cash flows is highly susceptible to the discount rate used, these investors tend to spend a lot of effort on developing appropriate discount rates. However, a market consisting of only value investors is likely to be illiquid and pricing-inconsistent. This would cause an increase in the required discount rate, thus raising the cost of capital for borrowers.

Because each type of investor is looking at different information, and sometimes analysing the same information differently, investors pass different types of risk back and forth among themselves. Their interaction ensures that a market functions smoothly and provides its main social benefits. Value investors channel capital to the most productive areas by seeking long-term earning potential, and speculators and arbitrage traders keep the cost of capital low by providing liquidity and clear pricing signals.

Where Are the Value Investors?

Not all markets have an optimal mix of investment strategies. China, for example, does not have a well-balanced investor base. There is almost no arbitrage trading because this requires low transaction costs, credible data, and the legal ability to short securities. None of these are easily available in China.

There are also very few value investors in China because most of the tools they require, including good macro data, good financial statements, a clear corporate governance framework, and predictable government behaviour, are missing. As a result, the vast majority of investors in China tend to be speculators. One consequence of this is that local markets often do a poor job of rewarding companies for decisions that add economic value over the medium or long term. Another consequence is that Chinese markets are very volatile.

Why are there so few value investors in China and so many speculators? Some experts argue that this is because of the lack of investors with long-term investment horizons, such as pension funds, that need to invest money today for cash flow needs far into the future. Others argue that very few Chinese investors have the credit skills or the sophisticated analytical and risk-management techniques necessary to make long-term investment decisions. If these arguments are true, increasing the participation of experienced foreign pension funds, insurance companies, and long-term investment funds in the domestic markets, as Beijing has done with its QFII Programme, certainly seems like a good way to make capital markets more efficient.

“Why are there so few value investors in China and so many speculators? Some experts argue that this is because of the lack of investors with long-term investment horizons, such as pension funds, that need to invest money today for cash flow needs far into the future. Others argue that very few Chinese investors have the credit skills or the sophisticated analytical and risk-management techniques necessary to make long-term investment decisions.”

But the issue is more complex than that. China, after all, already has natural long-term investors. These include insurance companies, pension funds, and, most importantly, a very large and remarkably patient potential investor base in its tens of millions of individual and family savers, most of whom save for the long term. China also has a lot of professionals who were trained at leading US and UK universities and financial institutions, and they are more than qualified to understand credit risk and portfolio techniques. So why aren’t Chinese investors stepping in to fill the role provided by their counterparts in the United States and other developed countries?

The answer lies in what kind of information can be gathered in the Chinese markets and how the discount rates used by investors to value this information are determined. If we broadly divide information into “fundamental” information – which is useful for making long-term value decisions – and “technical” information – which refers to short-term supply and demand factors – it is easy to see that the Chinese markets provide a lot of the latter and almost none of the former. The ability to make fundamental value decisions requires a great deal of confidence in the quality of economic data and in the predictability of corporate behaviour. However, in China there is little such confidence.

How to Develop the Investor Base

Regulated interest rates and pricing inefficiencies make it nearly impossible to develop good discount rates. Also, a very weak corporate governance framework makes it extremely difficult for investors to understand the incentive structure for managers and to be confident that these are working to optimize enterprise or market value.

And yet, when it comes to technical information useful to speculators, China is too well endowed. Insider trading is very common in China, even while illegal. Corporate governance and ownership structures are opaque, which can cause sharp and unexpected fluctuations in corporate policies. Markets are illiquid and fragmented, so determined traders can easily cause large price movements. In addition, the single most important player in the market, the government, is able – and indeed likely – to behave in ways that are not subject to economic analysis.

This has a very damaging effect, undermining value investment and strengthening speculation. In the first place, unpredictable government intervention causes discount rates to rise because value investors must incorporate additional uncertainty of a type that is difficult to evaluate or quantify.

Second, it puts a high value on research directed at predicting and exploiting short-term government policies, and thereby increases the profitability of speculators at the expense of other types of investors. Even credit decisions must become speculative, because when bankruptcy is a political decision and not an economic outcome, lending decisions are driven not by considerations of economic value but by political calculations.

Chinese authorities are attempting to improve the quality of financial information in order to encourage long-term investing, and are trying to make markets less fragmented and more liquid in the process. But although these are important steps, they are not enough. Value investors need not just good economic and financial information, they also require the existence of a predictable framework from which to derive reasonable discount rates. And here China has a problem.

There are several factors, besides the poor quality of information, that cause discount rates to be very high. These include market manipulation, insider trading, opaque ownership and control structures, and the lack of a clear regulatory framework that limits the ability of the government to affect economic decisions in the long run. This forces investors to incorporate too much additional uncertainty into their discount rates.
As a result, Chinese value investors employ high discount rates to account for high levels of uncertainty. Some of these doubts represent normal business uncertainty. This is a necessary component of an economically efficient discount rate, since all projects have to be judged not just on their expected return but also on the riskiness of the outcome. But Chinese investors must incorporate two other, economically inefficient, sources of uncertainty. The first is the uncertainty surrounding the quality of economic and financial statement information. The second is the large variety of non-economic factors that can influence prices.

This is the crucial point. It is not just that it is hard to get good economic and financial data in China. The problem is that, even when information is available, the number of non-economic factors that affect value, force the appropriate discount rate so high as to price value investors out of the market.

Speculators, however, are much more confident about the value of the information they use. Because their investment horizon tends to be very short, they can largely ignore the impact of high implicit discount rates. As a result, it is their behaviour that drives the entire market. One consequence is that capital markets in China tend to respond to a very large variety of non-economic information and rarely, if ever, respond to estimates of economic value.

Confidence Misplaced

During the past decade, Beijing was confident that an increase of foreign participation in the domestic markets would improve their functioning by reducing the bad habits of speculation and increasing the good habits of value investing and arbitrage. But it has since become pretty clear that this faith was misplaced: The market is as speculative and inefficient as ever. This should not have come as a surprise. The combination of very weak fundamental information and structural tendencies in the market – such as heavy-handed government interventions and market manipulation – reward speculative trading and undermine value investing. This forces all investors to focus on short-term technical information and to behave speculatively. In China even Warren Buffett would speculate.

Investors in Chinese markets must be speculators if they expect to be profitable. As long as this is the case, investors will not behave in a way that promotes the most productive capital allocation mechanism of the market, and such efforts as bringing in foreigners will have no meaningful impact.

What China must do is something radically different. It must downgrade the importance of speculative trading by reducing the impact of non-economic behaviour from government agencies, manipulators, and insiders. It must improve corporate transparency. It must continue efforts to raise the quality of both corporate reporting and national economic data. Finally, it must deregulate interest rates and open up local markets to permit arbitragers to enforce pricing consistency and to allow better estimates of appropriate discount rates.

If done correctly, these changes would be enough to spur a major transformation in the way Chinese investors behave by permitting them to make long-term investment decisions. It would reduce the profitability of speculative trading and increase the profitability of arbitrage and value investing, and so encourage a better mix of investors. If China follows this path, it would spontaneously develop the domestic investors that channel capital to the most productive enterprise. Until then, China’s capital markets, like those of many countries in Latin America and Asia, will be poor at allocating capital.

When Efficient Markets Become Inefficient

But this is not just an issue for China. In the US there have been times when markets seemed efficient and rational, and times when they clearly were not. Of course this cannot be explained by the disappearance of the tools needed by value investors. For example the market for Internet stocks seemed rational in the early 1990s and clearly became irrational during the latter part of that decade. This did not occur, I would argue, because fundamental investors were suddenly deprived of their analytical tools.

What happened instead, I would argue, is that conditions that led to a too-rapid expansion of liquidity at excessively low interest rates changed the environment in which fundamental investors could operate. As excess liquidity forced up asset prices, the likes of Warren Buffet found themselves unable to justify buying assets and so they dropped out of the market. As they did, the mix of investment strategies shifted until the market became dominated by speculators.

This, I would argue, made the US stock market of the late 1990s “irrational”, not because they are fundamentally irrational or inefficient but rather because they can only function efficiently with the right mix of investment strategies. When the mix was altered, the markets stopped functioning as they should.

Perhaps what I am saying is intuitively obvious to most traders or investors. However, it seems to me that the argument about whether markets are efficient or not misses the point. There are certain conditions under which markets are efficient because the tools needed for each of the various investment strategies are widely available and are credible. When those conditions are not met, markets cannot be efficient.

About the Author

Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. He has taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is also Chief Strategist at Guosen Securities (HK), a Shenzhen-based investment bank.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.

Pettis has been a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.

He can be contacted at michael@pettis.com


United Nations Office for Project Services (UNOPS): Sustainable Results in Challenging Environments

[caption id="attachment_6671" align="alignright" width="230"] Myanmar[/caption]

From building shelters in Haiti or helping to improve the school system in South Sudan, to buying medicines in Myanmar or equipment for clearing the snowy passes of Afghanistan – UNOPS provides sustainable infrastructure, project management and procurement services in some of the most world’s most challenging environments.

As an operational arm of the United Nations, UNOPS works on behalf of the UN family, national governments, donors and others. Its goal is to support development, humanitarian and peacebuilding projects that make a difference for people in need.

Interestingly, while UNOPS, like other UN bodies, is not-for-profit, it is also fully self-financing, supporting itself by charging a small fee on any project it implements. In order to remain operational it has to convince partners of the value of its services.

At present UNOPS is proving its value, implementing around $1 billion worth of projects annually and with operations in more than 80 countries. More than 6,000 people currently work for the organization.

United Nations Secretary-General Ban Ki-moon commented on the organization: “UNOPS plays a critical role in providing management services for our life-saving, peacebuilding, humanitarian and development operations. I have seen many examples of how these activities help suffering people in troubled parts of the world. UNOPS is setting countries on course to a more stable future by helping them build roads, schools, clinics, remove landmines, prepare for democratic elections, and much else besides.”

Well-Placed to Offer Support

With a clear mandate from the United Nations General Assembly, the organization is well-placed to support its partners. However, in the middle of the last decade there were questions about UNOPS unique business model. In the wake of the fall of the Taliban regime in Afghanistan, UNOPS had expanded rapidly to cope with the demand for its services in the country. In doing so it over-stretched, and while it was able to implement complex projects quickly, financial and management controls were not able to keep up. The organization was in trouble.

“UNOPS is setting countries on course to a more stable future.”

In 2006, a new management team was brought in and quickly identified the weaknesses. The team set about implementing the structures, controls and processes needed to run a global organization that operates in some of the toughest environments imaginable. A culture of accountability, transparency and quality was embedded.

The turnaround has been remarkable, and while the organization is now financially strong and has been recognized for high standards of transparency and effectiveness, the climate of innovation and change is being maintained. Now the emphasis is on increasing the organization’s focus, excellence and the sustainability of the way it works and the results it contributes to.

Focus means the organization needs to concentrate its activities in areas where it has a clear mandate and expertise: Infrastructure, project management and procurement. This is allowing UNOPS to build a catalogue of specific products and services and then to work on improving each these.

Collaborative Approach

Improvement at UNOPS involves taking a collaborative approach with headquarters and the field, by using discussion boards and other online tools to capture the lessons project managers are learning about how best to implement projects in challenging environments. Typical UNOPS discussions might centre on the best way to earthquake-proof a new school or ideas for helping suppliers to offer more green options. Ideas gained from practical experience are debated throughout all levels of the organization before being turned into policy and applied consistently. At the same time, different offices are leading specific drives to become certified to international standards.

This is the excellence aspect of the UNOPS approach – benchmarking services against internally recognized best practice – to ensure they not only share learning within the organization, but also benefit from pre-existing standards. A major step on this route was making UNOPS fully ISO 9001 compliant. It is, in fact, the first UN organization to have its global quality management systems certified at this level.

This commitment to quality is intended to help UNOPS complete its partners’ projects on time, within budget and in line with their expectations. By implementing projects to these exacting standards, UNOPS increases the likelihood of their success – for example a road which lasts longer, a hospital which is more accessible, or a national park which is better protected.

The certification was the culmination of several years of work to ensure that UNOPS follows business practices that reflect international standards. UNOPS has followed the same route to achieve prestigious external certifications in procurement and project management, as well as in worker safety and environmental management on its construction sites.

These skills make it easier to ensure that sustainability is central to everything the organization does. UNOPS is one of many UN organizations trying to translate the rhetoric surrounding sustainability into real action on the ground. Indeed, it is the sustainability of UNOPS work and the organisation’s ability to support national capacity that will have the longest term impact on communities in need.

Dimensions of Sustainability

UNOPS Executive Director Jan Mattsson explains what balancing the economic, social and environmental dimensions of sustainability means for the organization: “For example, managing the construction of a hospital sustainably means identifying and consulting stakeholders on their requirements, using the local workforce while providing decent working conditions and training, and using the best possible design, the right materials and cutting waste. It means, among other things, that the completed hospital should be disaster-resilient and energy efficient, and that future operation and maintenance have been considered.”
The overall goal of all of these changes, alongside creating a robust organization that can provide real value to its partners, is to be able to truly enhance the capacity of developing countries to manage such initiatives themselves in the future. For example in the hospital scenario Mr Mattsson described above, UNOPS could support national capacity in many ways, from raising awareness on building standards and promoting access for people with disabilities, to training local suppliers to compete for international tenders.

UNOPS in Post-Earthquake Haiti

When all the above comes together, UNOPS can help its partners make a real difference, as an ongoing project in post-earthquake Haiti demonstrates. This project was launched in 2011 to shut down six post-earthquake relief camps and resettle those living there into sixteen newly rehabilitated neighbourhoods, with funding from the Haiti Reconstruction Fund. Known as the 16 Neighbourhoods / 6 Camps (16/6) project, it is being jointly implemented by the United Nations Development Programme (UNDP), the International Labour Organization (ILO), the International Organization for Migration (IOM), and UNOPS – with leadership from the Government of Haiti.

Due to UNOPS construction experience, the organization was selected to design and implement low-income housing and other infrastructure works in eight of the neighbourhoods, with a budget of over $16 million. In addition to producing the agreed outputs, UNOPS trained the home-owners in construction techniques to help them continue to maintain their own houses in the future, in line with the local culture.

As some of the neighbourhoods suffer from gang violence, UNOPS also helped make residents feel safer by installing hundreds of solar streetlights and constructing the new houses in accordance with good public space management, to help alleviate social problems. To improve local acceptance of the project, UNOPS and its partners kept residents involved during project design and implementation through door-to-door surveys and community meetings. In order to enhance capacity, UNOPS hired 95 percent of its workforce from the local community and worked with ILO to train more than 150 construction workers.

UNOPS is committed to learning from its past successes and challenges in order to make each project it implements that much more effective and sustainable. Often working in areas where conflict, poverty and natural disasters have created suffering and need, the organization is a central resource for the United Nations, supporting communities and governments to find their own sustainable solutions.


Jesse Lauriston Livermore: The Boy Plunger

Playing the stock market in order to make a bundle is not a pursuit deemed suitable for the faint of heart. For every story starring an investor who struck it rich, there are countless others of poor souls who lost everything but the shirt off their back. And then there was Jesse Lauriston Livermore who made and lost a fortune on Wall Street several times over.

The Great Bear of Wall Street – or the Boy Plunger – was a master at short selling stocks. He made his first millions shorting stocks on the eve of the Panic of 1907 when share prices tumbled over 50% as liquidity was sucked out of the system after a failed attempt by the United Copper Company to corner the market. When the Knickerbocker Trust Company – New York’s third largest trust which had financed the ill-conceived scheme – collapsed, panic spread across the nation.

Curiously enough, the crisis was exacerbated by the growth of unregulated bucket shops where investors could place bets on the movements of stocks without actually buying them – choking liquidity even further. It was precisely at these shops that Jesse Livermore started trading at age 14. Within a year he had accumulated over a thousand dollars ($23,000 in today’s money) and a little while later was banned from most bucket shops whose proprietors refused to accept his unfailingly accurate bets.

“The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the person of inferior emotional balance, or the get-rich-quick adventurer. They will die poor.”

– Jesse Lauriston Livermore

Mr Livermore was a day trader way before the slightly derogatory term was coined. He left later generations of security traders a basic philosophy that places heavy emphasis on increasing the size of any given position that is headed in the right direction while cutting any losses immediately and ruthlessly.

Mr Livermore would later expand on his securities trading practices further in a book still considered mandatory reading at business schools in the US and elsewhere – How to Trade in Stocks: The Livermore Formula for Combining Time Element and Price (McGraw-Hill, ISBN 978-0071469791).

Jesse Livermore also had a hand in the writing of the book Reminiscences of a Stock Operator (John Wiley & Sons, ISBN 978-0470481592) by his journalist friend Edwin Lefèvre who may, as is widely suspected, have regularly planted stories in the press with an eye to influencing the market and allowing for lucrative day trades.
Mr Livermore knew little if any caution when trading on a hunch, a planted story or a nugget of insider information: He’d go all-in, kitchen sink not excluded. This is the only way to either make a fortune, or lose one, trading stocks. He did both. Caution and moderation are enemies of success. However, this does not imply that traders should act irrationally.

In fact, Mr Livermore lost the $3 million he made on the back of the Panic of 1907 on a cotton trade gone awry. He violated many of his own prescriptions for success: He listened to the advice of others and kept adding funds to a losing position. In the years following the crash, Jesse Livermore would continue to lose money in the now mostly stagnant market. By 1912, he was a million dollars in debt and declared bankruptcy.

His fortune turned with the World War I bull market and the downward trend that followed. Not only did his creditors get paid, Mr Livermore recouped the millions he had lost and went on to live to good life with fully-staffed mansions in the US and Europe and a private yacht to shuttle back and forth across the Atlantic. To keep him company, Jesse married Dorothy, one of the Ziegfeld Follies showgirls and 23 years his junior.
By 1929, Mr Livermore saw a market afflicted by the same ills that caused the Panic of 1907. He moved fast and started shorting stocks left, right and centre. He kept adding to his positions as share prices continued their slide. The strategy paid off handsomely. While nearly everybody lost huge amounts of money with the Wall Street crash of 1929, Jesse Livermore made a cool $100 million (today $2.3 billion) after raking in his short-selling profits.

In the years following the Crash of 29, Jesse yet again lost most of his money. Precisely how he squandered his fortune is still one of Wall Street’s enduring mysteries. By March 1934, Jesse was declared bankrupt and suspended from trading.

A year earlier, Dorothy had filed for divorce. Jesse then married 38 year old Harriet Noble who had already survived four husbands. They all committed suicide and Jesse’s fate was to prove no different. In November 1940, Jesse shot himself in the cloakroom of the Sherry Netherland Hotel in Manhattan leaving a hand-scribbled note to his wife: “I am a failure and tired of fighting. There is no other way out.” i


World Bank Group: Financial Inclusion - Banking on Low-Income Households

[caption id="attachment_6687" align="alignright" width="225"] Author: Douglas Pearce[/caption]

Financial exclusion restricts economic opportunity and constrains poverty reduction. Yet today there are an estimated 2.5 billion adult people worldwide who go about their lives without any formal financial services such as bank accounts. According to the World Bank’s Global Findex Survey, almost 80 percent of those living on incomes of less than $2 per day are financially excluded. Low-income households and women are disproportionately affected, which further holds back poverty reduction and ultimately limits economic growth.

The aspiration of universal financial inclusion is increasingly prominent on the global economic agenda in recognition of its importance. More than fifty countries have set national targets to expand financial inclusion. Innovative models to extend financial access have generated a buzz around transformational business models. Examples of these models include China’s Alibaba which focuses on SME finance and is based on ‘big data’ and supply-chain relationships; and, M-Pesa and Equity Bank in Kenya. The former processes payments through mobile phones while the latter welcomes low-income clients through alternative delivery mechanisms.

Financial inclusion provided two of the proposed indicators in the UN High Level Panel’s report for post-2015 development goals.

World Bank Group President Jim Yong Kim has laid down a marker in terms of vision, stating that universal financial access should be achievable by 2020. At the World Bank-IMF Annual Meetings this year, he made the case that “universal access to financial services is within reach – thanks to new technologies, the use of ‘big data’ transformative business models and ambitious reforms.” He noted that “as early as 2020, such instruments as mobile wallets and other e-money accounts, along with debit cards and low-cost regular bank accounts can significantly increase financial access for those who are now excluded.”

Payments as a First Point of Access

The initial point of entry to financial access for many low-income households is the receipt of wages, benefits or remittances as an electronic payment credited to a card (which may or may not be linked to a bank account), mobile wallet or any other form of e-money account, or to a regular bank account.

“Innovative models to extend financial access have generated a buzz around transformational business models.”

The growth of electronic payment products – which can be used through the expanding networks of relatively low-cost access points such as ATMs, point of sale terminals, non-bank correspondent agents and mobile phones – is therefore significantly expanding financial access. World Bank data show that these transaction instruments are generally growing faster than deposit accounts at commercial banks. In those countries home to the vast majority of the unbanked, payment cards are growing every year at more than twice the rate as regular bank accounts do.

Bank Accounts as a Gateway to Financial Inclusion

The ultimate goal is to achieve full financial inclusion – in other words, the ability of all adults and firms to access and use a range of financial products and services that fits their particular needs. To achieve financial inclusion, improving access to financial services is only the first step.

An important next step toward financial inclusion is a savings or checking account at a regulated financial institution, such as a bank or credit union. This can open up access to savings (which evidence shows is directly linked to poverty reduction), credit, and insurance (to buffer the poor against the risks of sickness and catastrophic events) – thus reaching far beyond transactions and payments processing only.

The commitments to ambitious reforms made by more than fifty countries to expand financial inclusion can accelerate the expansion of access to such regulated accounts. Barriers that limit the power of investment, technology and innovation to reach the unbanked with financial services can thus be dismantled.

[caption id="attachment_6689" align="aligncenter" width="562"] Map 1: Adults with an Account at a Formal Financial Institution. Source: Global Financial Inclusion Database, World Bank.[/caption]

Government actions – such as shifting government-to-person (G2P) payments from cash to electronic methods and depositing these payments directly into accounts – can help kick start the design and rollout of new business models and products. For example, India is in the process of building an entire platform for payments around its new biometric-based national identity program. This promises to offer huge cost savings and allows for shifting payments to electronic transfers directly into accounts.

Bank accounts with lower entry requirements, fewer fees and a streamlined product offering can enable many more low-income individuals to open and benefit from regulated deposits, as well as payments and transaction services, and potentially also credit and insurance. Countries such as Brazil, South Africa and the United Kingdom have introduced such accounts in order to open up access to the unbanked. Many other countries are now following suit.

The Economics of Accounts for Low-Income Consumers

Data is increasingly available to assess the business case for serving low-income households and microenterprises, and to develop accounts and other financial products for that un-served, or under-served, demographic. This includes information on price and fee sensitivity, available cash flows, and the relative viability of delivery models. Such data has been developed by the World Bank, the World Savings Bank Institute (WSBI), the Bill & Melinda Gates Foundation and others.

The WSBI’s Doubling Savings Accounts Programme, funded by the Bill & Melinda Gates Foundation, has supported low-income account pilots through savings and postal banks in ten countries since 2009. The findings from these ongoing pilots offer valuable insights into the economics of low-income bank accounts. The pilots have demonstrated that making the products work for banks may be as important as designing products that appeal to the unbanked and low-income target groups[1]. The three main lessons learned are:

Traditional bank branches will not reach the majority of the unbanked, and alternative financial service access points are needed. While a full branch needs a minimum market size of 9,000 clients, the minimum viable number of clients for an agent (such as a retail store) is only 700, while for an ATM kiosk it is 2,000. For a mini branch the figure is 4,000[2]. In some countries like Tanzania or Indonesia, locations that can support a full branch or a bank agency would only reach a quarter of the whole population. Banks therefore need to partner with outlets that can extend their reach, such as mobile money operators.

Simplified or basic bank accounts with clear and affordable pricing can spur adoption. Simplified product design, proportional know-your-customer requirements and clear marketing messages can all induce greater client take-up. Banks should also look to price their services at a level that is affordable in order to develop a future customer base. In the ten pilot countries studied, the amounts that customers spend on fees can equal a full day’s cost of living. Banks should therefore target about 60 cents per month in least-developed countries and a dollar a month in middle-income countries, for customers to conduct two or three transactions per month.[3]

Services provided should be sustainable for the bank. WSBI argues that sustainability should be possible, although challenging, even at the sub-$25 monthly balance level typical of the poor. The key is to charge a monthly fee that can be paid out of the household budget, and to provide service at sufficient scale in order to cover overhead. A significant increase in the customer base is therefore critical to success.[4]

What Is Needed to Bring the Private Sector Fully on Board?

If banks and other financial institutions see financial inclusion reforms and other public-sector actions as out of step with their market realities – or if they view targets and strategies as a top-down imposition to be avoided or managed – then the potential impact of these actions will be watered down. Serving low-income households profitably is challenging, as the WSBI pilots illustrate.

Well-intended initiatives by policymakers often fall short of achieving their potentially transformational impact. For example, introducing basic – i.e. simplified and accessible – bank accounts, or opening new accounts for recipients of benefits, has in many cases not yet had the intended boost to financial inclusion. Many of those accounts remain under-used. Only about one in five (22 percent) of accounts in low- and middle-income countries are used frequently (more than three times a month for withdrawals), compared to 72 percent of accounts in high-income countries, according to the Global Findex Survey.

To address this challenge of dormancy or under-use of accounts, account-related costs need to be made affordable, financial awareness levels may need to increase, and access to accounts needs to be made as convenient as possible, as the WSBI pilots also indicate. Low levels of usage and limited uptake by consumers can be linked to financial institutions often not viewing new, lower-income consumers as an attractive business proposition, and therefore not developing sufficiently attractive and tailored products for them. Low uptake may also be due to account-design parameters being too strict and inflexible, if regulators have intervened to set or control those parameters.

Financial-service providers such as banks, credit unions and (where permitted) telecom companies therefore need to be engaged in informing and taking shared ownership of financial inclusion targets and strategic priorities. The momentum in many emerging markets to quickly draft and launch financial inclusion strategies with top-down targets may need to be adjusted, and processes may even need to be re-started, if the prize for doing so is private sector buy-in and a better likelihood that targets will be achieved and surpassed.

Achieving the right balance between the private sector participation in setting financial inclusion targets and prioritizing reform measures – while ensuring that financial-service providers truly rethink business models and financial products to fit low-income households and microenterprises – will be central to the achievement of the targets set. Similarly, regulators and policymakers need to balance financial inclusion targets with stability, competition, integrity and market-conduct priorities, to ensure that financial inclusion is fully beneficial to the economy, to the financial sector, and to low-income households.

About the Author

Douglas Pearce is the manager of the Financial Inclusion & Infrastructure Practice at the World Bank. He previously served at DFID, the United Kingdom’s development agency, as the leader of the financial sector team and deputy head of the Growth and Investment Group. Here he also chaired the Steering Committee of the Financial Reform and Strengthening Initiative (FIRST). Prior to that, Mr Pearce served as a senior financial sector specialist at the Consultative Group to Assist the Poor (CGAP), and set up and managed a microfinance institution, among other roles. Sarah Fathallah and Christopher Colford, both of the World Bank, contributed to this article.

References:

[1] WSBI Note: 18 Months after the launch of the "Doubling savings accounts" project: What lessons have we learned? March 2011.

[2] WSBI Working Paper: Mapping proximity – Bringing products and services close enough to the poor to be meaningfully usable and still keep them sustainable for WSBI partner banks. April 2013.

[3] WSBI Presentation: WSBI programme to double savings accounts at members. June 2013.

[4] WSBI Note: What makes pro-poor service delivery sustainable for WSBI partner banks? August 2012.


OECD: Time, Trade and Trade Facilitation

Time is money and a lot of money and opportunities are being lost due to painstakingly long customs procedures, waiting times at ports and long lead times. Although “time is money” is a universal idiom, few have looked into how time is related to money in international economics.

One of those few is David Hummels, an economics professor at Purdue University in the US. He found that one day in transit is equivalent to a tariff rate of 0.8%. He arrived at this number by comparing air freight rates to ocean freight rates for similar products on similar routes and estimating the trade-off between money and time saved by using ocean and air freight respectively.

According to oceanschedules.com, the journey from Shanghai in China to Long Beach in California takes between 12 and 48 days depending on the carrier and as such corresponds to a tariff rate of between anywhere 11 and 34%. This compares to an average tariff on US imports of about 3.4%. Clearly time in transit adds vastly more to trade costs than do tariffs.

Some time for transit is of course inevitable, but as we shall see, time for exports and imports vary substantially across countries even when only the domestic leg of the journey is taken into account. And such differences matter not only for trade volumes, but also for what kind of products are traded.

“Bringing down lead times and lead time variability is therefore essential for firms located far from the major markets.”

Just-in-time organization of production was a critical factor behind the success of Japanese management in the 1980s and beyond. It implies that parts and components arrive at the work station where they are being used at the precise moment they are needed. This saves storage expenses and reduces downtime to a minimum. It is one of the factors that explain why upstream suppliers tend to locate close to their customers. Nevertheless, better, faster and more reliable international transport, communications and supply management tools have made it feasible to combine international fragmentation of production with lean production technologies.

Trade-Off

The sourcing of intermediate inputs involves a trade-off between transaction costs and production costs – notably labour costs. Nearby suppliers may have higher labour costs, particularly in rich OECD countries, but may also be more flexible and reliable as far as timely delivery is concerned. With new technologies that improve labour productivity – think robots, 3D printers and sophisticated production monitoring and control software – the balance is now shifting towards locations close to the market.

[caption id="attachment_6708" align="aligncenter" width="514"] Table 1: Time (days) and cost (USD per container) to export and import. Source: World Doing Business (IFC, World Bank).[/caption]

Bringing down lead times and lead time variability is therefore essential for firms located far from the major markets. To make up for their narrowing unit labour cost advantage, they need to reduce lead times even more than their better located competitors. There are, however, limits to what a firm can do if its goods are stranded in ports or waiting for customs clearance. Firms working under such circumstances may be unable to enter international supply chains or they may have to rely on trading less time-sensitive products that are often also in less dynamic sectors or market segments.

The average time it takes for a product from the factory gate of the exporter till it is loaded on a ship; the time it takes for the ship to make landfall at its destiny and till the product arrives at the premises of the importer; and the cost in US dollars per container by region are depicted in Table 1.

The time and cost of ocean freight is not included in these numbers. We note that it takes three times as long and costs 70% more to export from South Asia as it does from high-income OECD countries. The numbers are similar for imports. Within these regional averages there is large variation. The best performers are Denmark, Estonia, Hong Kong, Singapore and USA with 6 days for exports, while the worst are Afghanistan and Kazakhstan with 81 days.

It is likely that the longer the time for exports or imports, the less predictable is the time of arrival of the goods at their destination. With more variability in lead times, more storage is required – something lean manufacturers have already cut to the bone.

It is therefore practically impossible for firms located in countries where it takes more than a month to export, import, or both, to become suppliers to downstream manufacturers using lean production technologies – or to lean retailers for that matter. Notice that both time for import and time for exports matter for the lead times of a company since being part of the supply chain to lean multinational manufacturers implies importing parts for further processing and exporting.

Fashionable Socks or Plain Ones?

Some products are more time-sensitive than others. Intermediate inputs to firms using lean production technology can be expected to be more sensitive to lead times and lead time variability than raw materials. And plain vanilla socks and towels are less sensitive to time than, say, a fashion retailer’s summer collection. So how does time for exports and imports affect who trades what with whom?

[caption id="attachment_6710" align="aligncenter" width="595"] Figure 1: Time (days) for trade and logistics performance.[/caption]

We explored this question by comparing how sensitive different categories of intermediate inputs are to time for trade, to the average for total trade. On average we find that a 10% reduction in the time for exports and imports increases overall trade values by about 1%.

Trade in intermediate inputs is, however, much more sensitive to delays, and trade in parts and components in the transport equipment sector is most sensitive to delays. In this sector 10% reduction in time for trade raises trade by 4% - four times more than the average. This is the sector that made just-in-time management famous, and it still appears to be the leanest broadly defined sector.

For other intermediate goods, a 10% reduction in time for exports and imports is associated with 3% more trade. These estimates add up to significant numbers. For example, it takes on average three times as long to export or import from South Asia than it does from high-income OECD countries. This difference in time for trade is associated with between 90 and 120% more trade in parts and components among OECD countries, taking into account differences in market size, income levels and geography.

Infrastructure and Procedures

The time it takes to trade across borders is determined by the quality of infrastructure and infrastructure management; the competitiveness of the transport sector; and, the administrative procedures related to customs and other border crossing procedures. Among the relevant factors for which comparable data across countries are available, the World Bank’s Logistics Performance Index (LPI) has the strongest effect on time for trade.

The LPI index takes values between 1 and 5 – the latter number representing the best performance. It is plotted against the time it takes for exports plus the time it takes for imports in Figure 1. The chart demonstrates that the better the logistics connectivity, the shorter time for getting goods across the border. We also see that the variation in time for trade among countries is much smaller for the high performers on the LPI index than for those with a low index, suggesting that a low LPI index is symptomatic for wider problems related to getting goods across a border.

Other factors that we found to be strongly related to the time for exports and imports were internet access, which facilitates effective and rapid customs clearance through secured internet portals. The quality of ports and the burden of customs procedures as measured by the World Economic Forum (WEF) indices were also important. Finally, rich countries tend to possess better infrastructure and better institutions that affect the efficiency at ports as well as the inland transport leg of the journey from exporter to destination. Thus, countries tend to have shorter time for exports and imports the richer they are.

A Low Fruit to Pick

For developing countries, upgrading infrastructure at ports as well as road and rail networks may be expensive. It often remains a long-term objective. But reducing the burden of customs procedures and improving the use of existing infrastructure through better and less onerous regulation would be a low-hanging fruit for developing countries to pick and could make a substantial difference, allowing local firms to become more reliable as far as lead times are concerned. This could in turn make it worth the while for firms to invest in better quality that satisfies the requirements of downstream customers in international value chains.

While individual governments can shorten the time for exports and imports considerably by streamlining customs procedures, clamping down on cartels at ports, and liberalize transport and logistics services unilaterally, cross-border cooperation is also important. For example most of the countries in which it takes more than two months to export, import, or both, are land-locked low or middle-income countries. Their performance clearly depends on the time and cost of transit through neighbouring countries. But effective customs procedures in any country to some extent depend on the quality and timeliness of processing the necessary documents at both ends of a trade transaction.

Trade facilitation is one of the policy areas for which there are high hopes of a substantive agreement at the Bali WTO (World Trade Organisation) Ministerial Conference in December 2013. The agreement aims at reducing the cost in terms of time and money to cross borders. To quote the WTO website, the purpose of the trade facilitation agreement is to “….further expedite the movement, release and clearance of goods, including goods in transit”. A successful outcome and its implementation would clearly reduce time for exports and imports and thereby create a better environment for entrepreneurs to invest in becoming suppliers of more sophisticated but time sensitive parts within international value chains.

All countries would gain from this agreement, particularly when combined with domestic reforms. The countries where its implementation would make the largest difference are those with considerable industrial capacity but that perform badly on the WEF (World Economic Forum) indicators of customs and port quality and which have long time for exports and imports.

In such countries entrepreneurs may not have sufficient incentives to invest in quality, since the price premium associated with the upgrading only materialises if goods are reliably delivered on time, all the time. Among the countries that fit this description best are Russia, Ukraine, South Africa, Venezuela and Kenya.

About The Author

Hildegunn Kyvik Nordås joined the OECD in 2005 where she leads a project on services trade restrictions, their measurement and impact.

Before joining the OECD she worked at the research division in the WTO Secretariat, and she has held positions as senior researcher and research director at Christian Michelsen Institute, Norway.

Her areas of research and analysis are international trade, economic growth and economic development.

She has published a number of journal articles and book chapters in these fields. In addition she has led a number of projects providing technical assistance and policy advise in developing countries, including developing a macroeconomic model with the Planning Commission of Tanzania.

She has taught international economics and development economics at the University of Bergen, Norway, public finance at the School of Government at the University of Western Cape, South Africa, and she has been a visiting scholar to Stanford University, USA. Ms Kyvik Nordås holds a Ph.D. in economics.

References

Nordås, H.K (2014) “Time as a trade barrier”, Chapter 20 in Waters, D. (ed.), Global Logistics and Distribution Planning, seventh Edition, London: Kogan Page, forthcoming.

Nordås, H.K (2006), “Time as a trade barrier: implications for low-income countries”, OECD Economic Studies, No. 42/1, 137-167.

Nordås, H.K, M. Geloso-Grosso and E. Pinali (2006), “Logistics and time as a trade barrier”, OECD Trade Policy Working Paper no 35.


KPMG: India - Banking on New Banks

India’s financial sector has tons of questions to ask since the Reserve Bank of India (RBI) spelled out the new bank guidelines and allowed new entrants onto the market.

Is there a need for new banks?

Will these be able to compete with pioneers in the industry or will history repeat itself?

How will they impact current banks’ balance sheet?

In boardroom discussions all across the country the same unknowns dominate the agenda as industry leaders are trying to complete the jigsaw puzzle with their own answers. The truth may lie somewhere in between the many different answers to these same questions.

“The country also has a relatively low domestic credit-to-GDP ratio.”

Currently, the Indian banking system is made up of 26 public-sector banks, 20 private-sector banks and 43 foreign banks. Most banks have a country-wide presence and are complemented by another set of banks/credit institutions that work on a much smaller scale and mostly cater to niche clients such as the 61 Regional Rural Banks (RRBs) and the more than 90,000 credit co-operatives [Profile of Banks 2012-13, Reserve Bank of India].

Despite the impressive strides made by the Indian financial sector in business expansion, profitability, RoA (Return on Assets) and competitiveness, vast segments of the population remain untouched by banks and credit co-ops. This gives rise to questions regarding the need to bridge the gap between the privileged and under-privileged sections of society. RBI Deputy Governor Kamalesh Chakraborty mentioned the following facts in his recent speech on Financial Inclusion and Financial Literacy – The Indian Way:

145 million is the number of households still excluded from banking

50% percent of the population does not have a bank account

Only 34% of the population is engaged in formal banking

Only 17% of the population has any credit exposure

Out of 600,000 villages, only 30,000 (5%) have a commercial bank branch

Only 10% of Indians have life insurance while just 9.6% have any non-life insurance coverage

Until now, financial inclusion was the sole responsibility of public-sector banks. However, by using inclusive growth as a condition for the issuance of new licenses – new banks are required to locate one out of every four branch offices in rural communities – the RBI has now split the onus equally between public- and private-sector banks. As one can see from the table below, publically-owned banks currently have more branches than any other bank group in rural and semi-urban areas.

Apart from the introduction of financial inclusion as a parameter for new bank licenses, the regulator also nudges the sector toward consolidation. The RBI would not be opposed to mergers and acquisitions in the financial industry of the country and would like to see large Indian banks emerge that can compete globally.

The Attractiveness Index

What precisely is attracting the 26 applicants for new bank licenses to the Indian financial sector?
India is of course one of the Top 10 economies of the world by size. The country also has a relatively low domestic credit-to-GDP ratio and as such provides great opportunities for growth to financial institutions. In fact, the Indian banking sector is widely expected to become the world’s fifth largest by 2020 and its third largest just five years after that. Banking credit is likely to grow at about 17% annually over the medium term (from FY12-FY17) resulting in a significantly increased credit penetration [KPMG in India Analysis].

Currently, the banking sector is facing tremendous pressure on its profitability and struggles with the quality of its assets. While total business grew at an average annual rate of 17.16% to INR 133,092 trillion over the past five years, profitability decreased. This was primarily caused by a sharp deterioration in asset quality which in turn may be ascribed to the economic slowdown.

[caption id="attachment_6719" align="aligncenter" width="581"] Table 1: Number of branches of scheduled commercial banks on March 31, 2013. Source: Department of Financial Services, June.[/caption]

However, if we are to believe the statistics, the future looks bright. The emerging middle class has an evolving appetite for debt and is becoming a big driver of growth in retail banking and the mortgage business. Moreover, the profile of India’s rural economy is changing fast. This long-dormant sector is now getting increasingly diversified and has started moving to beyond mere agriculture. The share of agriculture in the overall GDP has declined from approximately 30% in 1990-91 to less than 15% in 2011-12 [Indian agriculture-performance and challenges, press information bureau, Government of India].

New Banks or Mirror-Images of Existing Ones?

Once the aspiring entrants to banking have been awarded their licenses, what will they do to succeed? How will they differentiate themselves and establish brand recognition?

Past experience shows that not all new banks possessed the grit and determination required to scale business. New banks may at first go for a niche market or limit operations to a well-defined geographical area. While setting up shop, new banks also need to create a profitable and a viable business model as they too have to adhere to a regulatory regime – that may ultimately affect their access to credit – just like the pioneers of the industry did. The regulator is unlikely to give any leeway to new banks and would expect them to maintain their SLR (Statutory Liquidity Ratio) at 23%, a CRR (Cash Reserve Ratio) of 4% and comply with all Basel-III norms. In due course, these banks are also expected to meet the 40% PSL (Private Sector Lending) standard.

New banks cannot hope to survive by just being a mirror-image of any other bank. They have to harness their specific knowledge of – and expertise in – the financial needs and requirements of specific industries. This deep understanding of the inner workings of well-defined economic segments most new banks accumulated as non-banking financial companies (NBFCs). However, the successful transition from an NBFC to a full-fledged bank will depend, as usual, on strong management armed with foresight as they move their businesses into uncharted risk areas.

Good customer service is a given in the industry. New banks have to deliver on that parameter but what would really set them apart is to find – and claim – the gaps between saturated markets – MSME (Micro, Small and Medium Enterprises), women-only businesses, traders and middlemen in agriculture, wholesale banking, markets not yet served focused on unorganized professions or corporate banking. Different operating models are required in order to reach customers in these niche markets.

Last but not least, the new banks must also find a way to maneuver into rural areas with cost-effective operating models and develop strong alliances with MFIs (Micro Finance Institutions) and BCs (Banking Correspondents). Proper governance control, coupled to local market knowledge, might spell success for these start-up banks.

Industrial Houses as New Banks

A few voices have expressed concern regarding the issuance of bank licenses to industrial conglomerates. The main reason the RBI discouraged these groups from applying for bank licenses in the past was a perceived shortcoming of corporate governance. However, this time there are a few good reasons to allow some of these large corporations into the banking sector. Industrial conglomerates come with deep pockets and these are a welcome addition to the RBI’s policy of financial inclusion.

[caption id="attachment_6724" align="aligncenter" width="562"] Figure 1: Indian banks - performance at a glance. Source: A profile of banks 2012-13, Reserve Bank of India.[/caption]

Many of the conglomerates now admitted into the banking sector already possessed other financial services businesses and are well aware of their customers’ needs. The regulator has put a number of safeguards in place such as the proposed non-operative financial holding company (NOFHC) structure which is expected to ring-fence the regulated financial service entities of these corporate groups – including their new banks – from other businesses owned by the same conglomerate.

The RBI will gladly hand out bank licenses to industrial groups as long as strong governance and risk management processes are in place. New banks are required to adhere to solid risk management processes in order to ensure that there are no lapses in the adherence to regulatory norms. This also reduces systemic risk in the entire banking system.

The Road Ahead for the Banking Industry

The regional spread of banking services has remained skewed over decades. There is a pronounced mismatch between the aggregation of deposits and the deployment of credit with Southern India at one end and the North-East at the other. It would be interesting to watch the regulator’s policy on regional and sectorial disparities take shape and see how the new banks fit into that strategy.

The regulator now mulls the possibility of the future issuing of differentiated bank licenses. These could help new banks focus on niche lending which might then also entail them receiving a distinct regulatory treatment. Some countries already have such a differentiated bank licensing regime where permits are issued precisely outlining the limited range of activities the licensed entity can undertake.

For example, Singapore has five different kinds of bank licences – full bank, qualifying full bank, wholesale bank, offshore bank, and representative bank – while Hong Kong has a three-tier structure based on fully-licensed, restricted-licenced, and deposit-taking companies.

The Indian regulator is also considering a move to make bank licenses available on tap, rather than opening this window for a limited time only. The coming changes brought to the banking landscape by the arrival of all these new kids are sure to be a topic of continued interest and discussion.

The new bank licenses now granted constitute just a single aspect of wider financial sector reforms. The government, along with the new RBI governor, is committed to this reform agenda and significant discussions on policy and direction may shortly be expected. Questions remain on the need for sectorial consolidation, the presence of foreign banks, and on the future outlook of the entire banking sector. The reform agenda is designed to eventually lead to the implementation of a four-tier banking structure comprised of:

Large Indian banks with both a domestic and international presence;

Mid-size banks including niche banks;

Old private sector banks, Regional Rural Banks, and multi-state Urban Cooperative Banks;

Small privately-owned local banks and cooperative banks.

By KPMG Team