The Analyst Michaelmas Term 2014

ISSUE 9 | MICHAELMAS TERM 2014

MARKETS

New Leadership, New Economy in China?

Soaring to New Heights: The UK Aerospace Industry

FUNDAMENTALS The Future of Hedge Funds

INSIDE ANALYSIS Mexico: Challenging Informality

CAREERS

The Analyst Interview

FOREWORD

As the economic tides settle down once again, economies all over the world look to staying afloat in preparation for subsequent shockwaves.

This edition seeks to delve into the past to uncover the telltale signs of economic recessions. Lucy recounts the historical impact of oil shocks and how countries are steering clear of the problems arising from oil price volatility. Whereas, Alfio draws from past research in investigating the need for world economies to strike a balance with regards to holding the right amount of international reserves.

This edition also seeks to mark out the future for a selection of large economies. Yibin discusses the socioeconomic ramifications of China’s Third Plenum from which major reforms will be set into motion. Back in the UK, a special collaboration between Thorsten, Madeline and myself presents British vested interest in the aerospace industry and its role in paving the way for economic growth in the UK. We are also proud to introduce an exclusive report from our partnership with Oxford Business Group. This report sheds insight on the economic reforms underway to tackle the hefty informal economy in Mexico. In addition, Rasmus explores the nature of hedge funds and its potential in wrecking havoc on the global financial system.

For those interested in pursuing a career in finance, we have enclosed the insights of third year BSc Accounting and Finance student Emily Cheah, who has spent her summer in the Finance department at Deutsche Bank.

There is much to learn from the past, and much to foresee in the future. Through this edition, we hope that we have provided you with a perspective on the implications of major world issues.

Editor-in-Chief Terence Goh

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Editors Sherman Lim Rasmus Hogh Designer Madeline Lim Contributors Alfio Puglisi Lucy Liu Madeline Lim Rasmus Hogh Terence Goh Thorsten Kern Shu Hang Low Yibin Liu

CREDITS

05 10 15

New Leadership, New Economy in China?

By Yibin Liu

Soaring to New Heights: The UK Aerospace Industry

By Madeline Lim, Terence Goh & Thorsten Kern

The 1973 Oil Crisis: Before and During the 40 years

By Lucy Liu

FUNDAMENTALS 21 25

The Future of Hedge Funds

By Rasmus Hogh

CONTENTS

MARKETS

Global Financial Imbalances

By Alfio Puglisi

INSIDE ANALYSIS Challenging Informality 30 Mexico:

By Oxford Business Group

CAREERS Analyst Interview 34 The

By Shu Hang Low

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MARKETS

NEW

LEADERSHIP, ECONOMY IN CHINA?

By Yibin Liu The reform package agreed at the Third Plenum signaled major economic transition rather than an immediate boost.

Some analysts heaped praises upon the 60-point reform plan announced two days after the close of the Communist Party of China’s third plenum on Nov. 15 went way beyond expectations as it proposed sweeping changes across broad swathes of the economy, dealing with a comprehensive range of critical issues and challenges facing China as it reaches for the next stage of development.

Reading through the reform plan, it is true that the plan’s overarching goals hit all the right reformist notes: “The core issue is to handle the relationship between government and the market”; “In allocating resources, the market must play a decisive role”; China “must actively and steadily push forward the breadth and depth of market-oriented reforms,” and

“vigorously develop a mixed-ownership economy” – both the private sector along with state-owned – states the document, formally called the “Decision on major issues concerning comprehensively deepening reforms1.”

The major idea here is that by loosening the central government’s grip on the economy, market rules can better exercise their power. China is making its transition from a mainly state-centralized economy into a more efficient and transparent market economy.

Everyone who watches China closely can predict such a change.

The big question is to what extent the reform plan can be successfully implemented. Documents published by the government tend to set ambitious and lofty goals to achieve a “propaganda

Moran, Z.(2013, November 22). China’s Third Plenum Reform Agenda: Winners And Losers. Retrieved from http://www.ibtimes.com/chinas-third-plenum-reform-agenda-winners-losers-1481438 1

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MARKETS effect”, though they release little specific details about how these plans will be implemented.

Before we discuss further on the prospects of the reform, let us first take a closer look at the proposed changes to the different economic sectors mentioned in the plan:

The Corporate Sector

The private sector – domestic and foreign companies alike – will compete freely on a level playing field with state-owned enterprises (SOEs) in nearly all sectors. SOEs will no longer enjoy the benefits of subsidies and favorable policies, which may lead to the end of SOEs’ dominance in several crucial sectors including oil, utilities, etc.

The Financial Markets

Interest rates will be fully liberalized and largely determined by the market. Foreign financial investors will be able to access most of China’s financial assets and Chinese households will likewise have a much greater freedom to make overseas direct or portfolio investments.

Land and Other Resources

Farmers will be able to sell their non-agricultural land directly in the market, no longer requiring the local governments to convert the land into state land. Prices of oil, gas, water, electricity and telecommunication services will also now be subject to the market forces of supply and demand.

The reforms mentioned above have certainly vindicated the optimists, who have placed great faith in the new leadership meeting their lofty expectations in delivering a bold new vision. China has been growing at an average rate of 10% for around 30 years, which many analysts consider unsustainable. As such, the plan is seen as a proposed solution to the many problems that come along with such rapid growth.

Endorsing the reform, Mark Williams of Capital Economics notes that “the reforms would reduce the threat of a hard landing caused by the misallocation of capital and the resulting widespread overcapacity. Not only would average

Fiscal System

Local governments will care less about growth targets, responding to a more comprehensive evaluation system that places equal – or sometimes even greater – emphasis on social targets and risk management. The central government will both run and fund the lion’s share of the pension, healthcare, education and other social security systems. Land sale revenues will become a smaller proportion of the local governments’ revenues, with local taxes contributing a greater part. Revenue and spending will be broadly matched at various levels of the government, fulfilling the critical condition for complete abolishment of the “Hukou” system, the household registration system that restricts movements of Chinese within the country. The move will trigger a mass push towards urbanization and provide migrant workers with a full range of social services in cities away from their hometown. Direct bond issuance by local governments will be permitted and the proceeds will be used mainly for a rather selective list of infrastructure projects in order to enhance the efficiency of investment. growth be somewhat higher in a post-reform China, but risks would be lower than if reforms didn’t happen2.”

It is definitely inspirational to see that China has finally made its move into the next stage of its development. However, liberalization is a double-edged sword as the possibility of new problems and issues arising will inevitably exist.

In the first place, identifying the specific reform policies to carry out without a discussion regarding how to implement them can be extremely difficult. Furthermore, it is obvious that each reform comes with a certain cost. Some major players in the current market, namely state en-

Moran, Z. (2013, November 1). China’s Third Plenary Session Of 18th CPC Central Committee: 8 Things To Know About China’s Party Congress And Its Reform Agenda. Retrieved from http://www.ibtimes.com/chinas-third-plenary-session-18th-cpc-central-committee-8-things-know-about-chinas-party-congress.

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MARKETS terprises, local governments, banks, well-connected princelings and security authorities must suffer and make painful sacrifices for the reforms that are to take place. It is not far-fetched to say that many of these players have formed the foundation of the party itself. Economic reform will eventually have to incorporate political reform as well, if all the reform goals are to be achieved. The direct consequence is that the party’s power will be greatly diluted, something the party desperately wants to avoid. To summarize the quandary faced by the party we can see that on the one hand, China cannot continue growing the way it has been, and indeed she risks social and economic fracture if these reforms are not carried out. On the other hand, the pursuit of these reforms will dilute the party’s power in multiple ways. For instance, if lending increasingly goes through private banks, the party will lose its privileged role in controlling the purse strings of economic actors. The party’s influence will also be challenged when the private sector enters industries long controlled by state enterprises, when farmers gain greater control over their land, and when the “hukou” is loosened.

tions, all of which have been areas where government-owned companies have dominated.

Hence the role of private enterprises is to be expanded and strengthened. However, on the other hand, the proposals do not really seem to directly challenge the privileged positions held by the state enterprises, revealing that it may not be the party’s intention to give up its control of the essential sectors. Indeed, much language was expended in the document explaining how Beijing could better strengthen state enterprises so that they would better maintain their dominant positions:

This quandary probably explains why the party gives out a lot of seemingly contradictory and equivocal statements throughout the documents published after the third plenum. While it wants to move boldly with reforms to transform and give new life to its slowing economy, it displays hesitance in truly giving up control, evident from the partial and piecemeal policy reforms suggested. This becomes abundantly clear when you start to look closely at what is proposed in each of the reform areas, and is perhaps most apparent when it comes to stateowned enterprises.

“We must unswervingly consolidate and develop the public economy, adhere to the dominant position of public ownership, with the state-owned economy to play a leading role, and constantly enhance the vitality of the state economy, its dominance and influence… [And the party must] promote state-owned enterprises to improve the modern enterprise system3.”

On one hand, the party points out that only competition can enhance the competency of state enterprises. Prices are to be liberalised in oil, gas, power, transportation, and telecommunica-

The party and its people see the economic reform differently. While both recognise the promise of more sources of growth to China and a build-up towards a more market-based economy, the party sees a document that will also help them maintain their grip on power, which is the core idea implicitly made. That rationale was made clear in a long explanatory note by Xi Jinping, released in tandem with the reform “de-

Peter,C. (2013, November 21). As Xi Jinping Reforms China, Expect Power Consolidation, Not Democracy. Retrieved from http://mobile.businessweek.com/articles/2013-11-21/as-xi-jinping-reforms-china-expect-power-consolidation-not-democracy 3

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MARKETS cision” on Nov. 15. He makes the argument that economic reform is a necessary tool to ensure the longevity of the present political system, and cites Deng Xiaoping’s famous “southern tour” to Shenzhen almost two decades ago, where Deng – then widely regarded as China’s “paramount leader” – tried to resurrect the then-flagging reform, to make his point.

“In 1992, during Comrade Deng Xiaoping’s speech in the south, he said: ‘We cannot adhere to socialism, without having reform and opening up. If economic development does not improve people’s lives, we will only reach a dead end,’” writes Xi. “Looking back, we can remark on Comrade Deng Xiaoping and reach a deeper understanding. Therefore, now we can say that only socialism can save China and only reform and opening up can develop China, socialism and Marxism4.”

painful, revolutionary, and risky reform to sustain its growth which may result in catastrophic results. It is the age of wisdom, when coming up with the appropriate policies and balancing the interests of major players in the market calls for skills and wits. It is the age of foolishness, as China’s communist party may foolishly lose its control over the country undertaking this reform.

It is now time to test the party and the Chinese people.

It is the best of times, as three decades of amazing growth has transformed China into the second largest economy in the world. It is the worst of times, as China has to experience a Dexter, R (2013, November 18). The Trouble With China’s Reform. Retrieved from http://www.businessweek.com/articles/2013-11-18/the-troublewith-chinas-reform-plan.

4

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MARKETS

SOARING TO NEW HEIGHTS

The UK Aerospace Industry

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By Madeline Lim, Terence Goh and Thorsten Kern The global aerospace industry is one that exhibits massive growth potential in the coming years. Due to the rising affluence of populations in emerging markets, orders for commercial aircraft have reached an all-time high. It is also one of the few industries that continued growing during the recent recession, and provides high research and development spillovers to offer higher rates of social return.1 As a result of the favourable prospects, countries all over the world are looking into strategically placing their own aerospace industries for success.

At present, the United Kingdom (UK) holds one of the top 5 largest global market shares in the world together with the United States, France, Japan and Canada. Emerging economies such as China, Russia and India are also growing their aerospace sector at a fast pace.

MARKETS

The UK is well-placed to reap the profits of increasing demand for aircrafts with strong brands such as Rolls-Royce, BAE Systems and Bombardier. The UK also has the largest small and medium sized enterprise (SME) base in Europe making up 55% of civil aerospace sales in 2010.2 The strong position of the UK aerospace industry can be largely attributed to the large investments made in research and technology over the past few decades, especially during the 1970s and 1980s. Companies such as Rolls Royce, who invested heavily in engine research and development in the 1990s, have seen investments pay off as the company continues to enjoy the success of its Trent engines.

In more recent years, despite the hollowing out of the heavy manufacturing base to overseas countries, UK companies have managed to remain relevant by adapting and repositioning themselves by concentrating on specific areas in which they have a competitive advantage in, such as landing gear, avionics, fuel and power supply. UK companies such as GKN Aerospace and Senior, producing metallic and composite material supplies and turbine engine parts respectively, continue to grow and have favourable dividend yields for investors.3 There has also been a shift in focus towards fuel efficiency and green technology, in which the UK has significant expertise in. Aircraft such as Bombardier’s new CSeries, which reduces

Great Britain. Department for Business, Innovation and Skills, (2012). Industrial Strategy: UK sector analysis (URN 12/1140). Retrieved from website: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/34607/12-1140-industrial-strategy-uk-sector-analysis.pdf 2 Great Britain. UK Trade & Investment, (2012). UK aerospace. Retrieved from website: http://www.ukti.gov.uk/uktihome/item/280120.html 3 Great Britain. Department for Business, Innovation and Skills, (2012). Reach for the skies: A strategic vision for UK aerospace (BIS/12/954). Retrieved from website: http://www.bis.gov.uk/assets/biscore/business-sectors/docs/r/12-954-reach-skies-strategic-vision-uk-aerospace.pdf 1

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MARKETS emissions and noise, contains significant UK content, primarily through its advanced composite wings. These wings incorporate highly complex Resin Transfer Infusion technology and are manufactured by the Bombardier Aerospace in Belfast, therefore boosting the company’s growth and broadening the UK’s customer base.4

Leading Environmental Technology). This initiative, led by Rolls-Royce, will investigate new manufacturing processes aimed at increasing productivity and making the best use of available resources.6 Such continuous and heavy investments into research and development have allowed the UK aerospace industry to constantly innovate and remain at the top of its game.

In addition, the industry has received strong support from the government, in terms of funding and the starting up of new initiatives. The Aerospace Growth Partnership (AGP), established in 2010, is a collaborative effort between the government and the industry to map out long-term strategies to maintain the UK’s leading position in the industry. In 2012, the government announced a £60 million investment to create a new virtual centre in the UK for aerodynamics, on top of a further £120 million to support industry research into new engine manufacturing techniques and low-emissions engine technology.5

Despite the UK’s strong position in the aerospace industry, there are various problems inherent in the industry that would require greater focus on. Firstly, the industry faces various problems with their labour workforce. The high-technology sector requires highly-skilled and competent workers to enable the UK to maintain its current position in the industry, but the industry is facing problems filling up job vacancies. As much as 30% of firms in the aerospace sector have a vacancy, equivalent to 2% of the sector’s direct employment, and lower proportions of young people are currently working in aerospace than in manufacturing as a whole.8 It is estimated that more than 8,000 people could retire from the sector within the next 8 years, but only 5,000 young people are likely to be fill those vacancies based on current employment

In addition, further funding was announced to support various collaborative research and technology projects, under SAMULET II (Strategic Affordable Manufacturing in the UK through

Figure 1. (Source: BIS, 2012)7 Great Britain. Department for Business, Innovation and Skills, (2013). Lifting off: Implementing the strategic vision for UK aerospace (BIS/13/723).

Retrieved from website: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/142625/Lifting_off_implementing_the_strategic_vision_for_UK_aerospace.pdf 5 Bardens, J., & Rhodes, C. Great Britain. Parliament. House of Commons, Economic Policy and Statistics. (2012).The aerospace industry (SN/ EP/00928) 6 Great Britain. Department for Business, Innovation and Skills, (2012). Reach for the skies: A strategic vision for UK aerospace (BIS/12/954). Retrieved from website: http://www.bis.gov.uk/assets/biscore/business-sectors/docs/r/12-954-reach-skies-strategic-vision-uk-aerospace.pdf 7 Great Britain. Department for Business, Innovation and Skills, (2013). Lifting off: Implementing the strategic vision for UK aerospace (BIS/13/723).

Retrieved from website: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/142625/Lifting_off_implementing_the_strategic_vision_for_UK_aerospace.pdf 8 Ibid.

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MARKETS trends.9 Moreover, the skill levels of existing staff are below requirements, which will pose companies with the major challenge of upgrading the skills of such a large percentage of the workforce.These problems may pose a greater challenge in the future as competition from other aerospace nations who are investing heavily in skills and human capital intensifies.

gineers and improve future research.12 Therefore, the ATI and the additional masters’ places will increase the UK’s competitive advantage in research and development as highly trained and skilled engineers will be educated in newly built facilities, while getting involved in real-world design problems at ATI through the various industry-backed programmes.

Secondly, the aerospace industry has one of the most complex supply chains and the one with the longest lead time. As such, without an integrated supply chain, supply-side problems such as delivery delays and the increased incidence of supply chain disruptions can arise. Currently, many companies encounter problems in aligning their operations to real time fluctuations in consumer demand, as well as determining supplier performance in terms of risk, reliability and quality, and hence face significantly less visibility into their supply chains, rendering them unable to become leaner and more cost efficient.10 In order to counteract the existing problems within the industry, as well as secure their position as the world’s second largest in global market share, various changes will take place in the near future. The UK Aerospace sector will be shaped by an improved, more focused education system, better supply chain management and opportunities in the emerging markets.

To improve the origin of one of the UK aerospace sector’s competitive advantages, research and development, the government created the new UK Aerospace Technology Institute (ATI) in cooperation with the industry. Each party is planning to commit £150 million by 2014/2015 to the ATI for a seven-year period.11 Furthermore, 500 new aerospace Masters places were created which award students government- and industry-backed bursaries for an Aerospace Masters Scheme, aimed to create better aerospace en-

The second area which intellectual and monetary investments focus on is improving the competencies as well as the production of suppliers and optimizing the supply chain. The government currently backs a £110 million programme, Sharing in Growth UK Ltd.13, to improve the capabilities of important aerospace suppliers in the six core areas of lean production systems, manufacturing capability, strategy and finance, supply chain management, value improvement, and capability assessment.14 In addition, 21st Century Supply Chain (SC21) aims to improve the quality performance of the UK Aerospace sector’s supply chain by achieving common industry development and performance plans.

These tactics are derived from a common supply chain development framework which aims to improve inter-company communication, promoting collaboration with openness, honesty, integrity, and trust.15

Ibid.

KPMG, (2012). 2013 Global aerospace and defense outlook (130278). Retrieved from website: http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/aerospace-defense-outlook-2013.pdf 11 Great Britain. Department for Business, Innovation and Skills, (2013). Lifting off: Implementing the strategic vision for UK aerospace (BIS/13/723).

Retrieved from website: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/142625/Lifting_off_implementing_the_strategic_vision_for_UK_aerospace.pdf 12 Ibid.

13 Smith, M. (2013, October 16). £110 million fund for uk’s aerospace supply chain. Business Reporter. Retrieved from http://business-reporter. co.uk/2013/10/110-million-fund-for-uks-aerospace-supply-chain/ 14 What is sharing in growth?. (2013, October 31). Retrieved from http://sig-uk.org/what-we-do/ 15 ADS, (2010). 2010 UK aerospace industry survey. Retrieved from https://www.adsgroup.org.uk/pages/52590578.asp 9

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MARKETS Overall, improving the supply chain and strengthening the suppliers will enhance the capabilities of the UK’s Aerospace sector in the future and it will help expand its competitive advantage further.

UK’s Aerospace Industry will observe additional, fast-growing demand from emerging markets in the future and might be able to outsource some of its services to these countries. China, India, and Russia are expected to purchase more than 3500 planes over the next two decades, representing approximately 15 percent of the global demand in this period.16

of labor is on average three to five times lower in the emerging markets, the complexity of the industry’s technology does not allow major outsourcing in the manufacturing process. However, labor-intensive maintenance and repair services could potentially be outsourced. Large customers such as India would appreciate close proximity to low-level maintenance and repair services, while the aerospace industry could use these savings to fund more education programmes. Thus, the imminent demand increase from the emerging markets offers the opportunity to sell more and strengthen the industry’s position in the world.

The demand originates in the need for capable, technologically advanced airplanes. Most of these countries do not have access to the needed technology to produce similar airplanes in the short- or mid-term and are, thus, demanding vast numbers. Because the UK Aerospace industry is protecting its intellectual property in critical areas such as aircraft engine design, most of the airplanes’ important parts are manufactured in the UK. Even though the cost

As a key strategic sector of UK’s economy, it is imperative for the government, research institutions and industrial players to cooperate in solving skilled labour and supply chain problems that plague the aerospace industry. In view of the imminent threat of cheap labour in emerging markets, the UK must maintain its technological advantage in manufacturing processes and green technology so as to remain relevant and competitive.

Bédier, C., Vancauwenberghe, M., & van Sintern, W. (2008, April). The growing role of emerging markets in aerospace. Retrieved from http://www. mckinsey.com/insights/travel_transportation/the_growing_role_of_emerging_markets_in_aerospace 16

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the analyst | 14 Clients First

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MARKETS

Before and during the 40 years

By Lucy Liu The Rise of Oil Ever since ground-breaking innovations of a series of internal combustion engines in the late 19th century, petroleum, or more generally, oil, has been developing into one of the most important energy sources to people’s daily life.

Upon that, the rise of industrial organic chemistry has enabled all kinds of chemical synthetics such as plastics, fertilisers and pesticides to be continually provided to form our modern lifestyle. Without doubt, this increasing significance and dependency of oil, has magnified the fear of any types of oil shortages.

Reviewing the 200 years of modern history of oil, numerous shortages due to various reasons have taken place which have caused impacts of different levels on the global economy. And among these, it is commonly agreed that the 1973 oil crisis was the most detrimental one that has ever happened before or after1. This article will be assessing the persisting economic effect of this crisis and its historical significance.

THE 1973 OIL CRISIS A great picture: who produced oil and who consumed it?

First of all, it is essential to look back in time and evaluate from the historical perspective.

Since the last century, oil has become an increasingly important natural resource in industrial and commercial production. And in order to satisfy expanding demand for oil, developed economies such as North American and West European countries had been exploring oil reserves all around the world. In addition to their own domestic reserves, scientists and oil experts were sent to potential foreign regions like Latin America, Africa, East Asia and Middle East to discover both new onshore and offshore reserves, as a result of which, abundant reserves of oil were found in Middle East area. This, certainly, had made the area a focal point. In 1960, the proven crude oil reserve in the Middle East was reported at 183,060 million barrels, about 62.9% of the world total back then2.Despite its natural advantage, however, the Middle Eastern states preserved nearly no powers over the extraction of this valuable commodity on their

Perron, P. (1988, November). The Great Crash, the Oil Price Shock and the Unit Root Hypothesis. Econometric Research Program, Princeton University Princeton, New Jersey. Retrieved from http://www.princeton.edu/~erp/ERParchives/archivepdfs/M338.pdf 2 OPEC Research Division, Data Services Department & Public Relations and Information Department. (2013).OPEC Annual Statistical Bulletin .

Retrieved from website: http://www.opec.org/opec_web/static_files_project/media/downloads/publications/ASB2013.pdf 3 Perron, P. (1988, November). The Great Crash, the Oil Price Shock and the Unit Root Hypothesis. Econometric Research Program, Princeton University Princeton, New Jersey. Retrieved from http://www.princeton.edu/~erp/ERParchives/archivepdfs/M338.pdf 1

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MARKETS own land. The trade agreed between western monopolistic or oligopolistic oil companies and local authorities were considered as inequitable by those states. The general payment to them by large oil companies was about $3 per barrel3 whereas the synthetics produced by western factories and sold back to oil exporters were priced at hundreds time more.

All these made the year of 1960 a crucial year in the history of world oil production. The founding of Organisation of the Petroleum Exporting Countries (OPEC) by 12 major exporting nations (Mid-East and Non-Mid-East) enabled their aim of gaining control over petroleum production.

OPEC cartels started to nationalise their domestic oil industries by gradually acquiring oil subsidiaries of western conglomerates. Saudi Arabia, for example, began by buying up Aramco leading other OPEC states to follow suit. By early 1970s, a unified block of oil supplier had formed against western demand which, become a relatively strong back force for the coming-up oil embargo in 1973.

One matter worth noticing is the end of Bretton Woods System in 1971. Since the US dollar was no longer fixed to gold price which it used to be under Bretton Woods, a number of central banks increased their currencies in volume causing the US dollar to experience depreciation as a result4. The effect upon the oil exporters was negative as the oil was quoted in US dollar. Oil producers, especially OPEC states, underwent a period of substantially lagged real-income growth.

Trigger, Chaos and Instantaneous Effect In spite of all causes that generate the situation above, the real trigger of the oil crisis in 1973 was the Yom Kippur War. Territorial conflicts known as the fourth Mid-East between Arab nations (Syria and Egypt) and Israel pulled western countries’ stakes into the action as well. The U.S.’s support to Israel in the form of arms and weapons resulted in full retaliation of oil embargo by Arab Nations of OPEC (OAPEC)5. Oil shipments from OAPEC states to the U.S. were suddenly restricted and crude oil price soared drastically. Below is a chart from BP Statisti-

Figure 1. (Source: BP Statistical Review of Global Energy 2013)6 Hammes, D. & Wills, D. (2005). Black gold: The End of Bretton Woods and the Oil-Price Shocks of the 1970s.The Independent Review, IX(4), 501511.

5 Responding to crisis. (2010, April 26). Envhist.wisc.edu. Retrieved from http://che.nelson.wisc.edu/cool_stuff/energy/crisis.shtml 6 Crude oil prices 1861-2012, world events. (2013, November 30).BP Statistical Review of World Energy 2013. Retrieved from website: http://www. bp.com/content/dam/bp/pdf/statistical-review/statistical_review_of_world_energy_2013.pdf 4

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MARKETS cal Review of World Energy 2013, for crude oil price with clear indications of important world events during the period of 1861-2013. There is a notably high peak in 1973 at the time of Yom Kippur War and a rising trend after that point. In fact, by 1974, crude oil price quadrupled from $3 per barrel to $12 per barrel and consequently caused huge chaos in the market3.

A shock to industrial and non-industrial sectors across the western world was a matter of course. Countries like the U.S., Canada, Japan as well as Western European states could no longer continue with their annual 5% increasing pace of oil consumption. Amongst the chaos, one of the immediate effects was on motor vehicle industries. There were alarming shortages in most of the petrol stations in the U.S. as oil companies were charged higher payments by oil producers. Their cost of production also increased substantially which forced a rationing system of gasoline to be executed. Truck drivers and motorists suffered the most - they had to face long queues at petrol stations during the summer of 1973. It was also reported that in the last week of February 1974 about 20% of American gasoline stations had nothing but empty fuel stock for long lines of customers3.

To prevent the situation from getting worse, different measures were taken with the aim of easing tensions. The governments of some states in the U.S, for instance, required people not to put up Christmas lights, and to a more drastic extent, Oregon even banned commercial lighting. Odd-Even rationing was implemented as well where vehicles with odd-numbered license plates were only allowed to be fuelled up on odd-numbered days of the month and the same applied to the even-numbered7. In Europe, the impact was also felt by nearly all the countries.

Ted Heath, the UK Prime Minister at the time, asked Britons to only heat one room up in their houses during the winter for saving purposes.

Sweden also rationed gasoline and heating oil3.

Moreover, activities such as boating, flying and driving were banned on Sundays in many Euro-

pean countries8.

What is the Aftermath? Macroeconomic Implications and Global Reaction Although the crisis gradually eased after the negotiation at the Washington Oil Summit, March 19749, the effect lasted throughout the rest of the 1970s. Oil prices rose to over $50 per barrel in the following years after 1973. On a macroeconomic scope, influence of the 1973 oil crisis was also profound and lasting, in both the positive and negative aspects.

First of all, the sharp and hard negative shocks on the Western economies were immense. The U.S. and Canada experienced slowed industrial development and therefore macroeconomic growth, periods of excessive cost-push inflation, lower productivity, and disrupted market functionalities. The UK also suffered a period of disrupted industrial production as coal miners and rail workers were carrying out strikes at the same time of oil embargo10. The Japanese economy was greatly undermined since it was a net oil importer and a great proportion of its industries relied on imported oil from around the world - mainly the OPEC countries.

Furthermore, the failure in adjustments on interest rates by some central banks in order to target at slowing economies became another factor that dragged down the growth rate8. For oil importing economies, current deficits on the Balance of Payments Account were becoming more common. This was because there was more money outflow, demanding for more expensive crude oil which was essentially the blood of the economy.

The landscape of the global economy shifted as well. Regionally, the rise of OPEC attracted a long-term capital stream into oil-producing economies. Oil exporters who acquired power over this vital commodity accumulated vast wealth during this period of increasing oil price, thanks to the reversion of traditional flow of capital. This contributed substantially to both local and national economic growth. Consequently,

Shortages: Gas fever. (1974, February 18). Time Magazine. Retrieved from http://content.time.com/time/magazine/article/0,9171,942763,00.html Dhawan, R., & Jeske, K. Federal Reserve Bank Of Atlanta, Research Department. (2006). How resilient is the modern economy to energy price shocks?

9 Oil Embargo, 1973–1974. (2013, October 31). U.S. Department of State, Office of the Historian.Retrieved from http://history.state.gov/milestones/1969-1976/oil-embargo 10 Slavin, B., Freudenheim, M., & Rhoden, W. C. (1982, January 24). The world; British Miners Settle for Less.The New York Times. Retrieved from http://www.nytimes.com/1982/01/24/weekinreview/the-world-british-miners-settle-for-less.html 7 8

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MARKETS over the time, the living standards of people in oil-rich nations, especially the Middle East, gradually escalated.

In industrial sectors, economies like Japan which had developed many oil-intensive industries shifted their focus towards less energy-consuming sectors such as electronics and financial services. Apart from this capital flow from heavy to light industries, more investments were directed into research and development (R&D) of more petrol-efficient and cleaner motor vehicles. This trend, to some extent, helped the Japanese car manufacturers expand their market shares in America and Europe which were troubled by oil shortages then. Many other countries also sought solutions to the energy shock. In North America, more human and monetary inputs were diverted to the exploration of new oil reserves. Countries such as Brazil implemented mixing gasoline with ethanol. Cleaner power resources were also gradually promoted which paved the way for renewable nuclear and solar energy.

The 1973 oil shock gave a warning signal to all oil-consuming economies that being largely dependent on importing energy sources would make its economy vulnerable and unstable. Therefore, many countries initiated oil stock schemes where large amounts of oil were stockpiled in order to cope with any harmful economic emergencies and also provide fuel for national defence. In the U.S, the project titled ‘Strategic Petroleum Reserve’ (SPR) started in 197511.

What Does It Mean Today?

It is worth making some comparative analysis between this oil shock and the other two subsequent big crises - one happening in 1979 due to the Iran-Iraq War and one in 1990 as Iraq invaded Kuwait. The 1973 oil crisis was considered the most detrimental as it lasted the longest and impacted the world the most significantly.

One reason is that it was the first time ever that the oil-consuming economies suffered from oil shortages, which led to the realisation of the

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significance and danger of putting themselves in vulnerable positions of great oil dependency.

Another reason is that although the other two crises also raised the international oil price substantially, both lasted for a much shorter time, mainly due to the effect of SPR schemes and increased commercial storage. Since countries are more likely to ease any shortage situations using its storage as a buffer, they are provided with a powerful coping mechanism whenever a disruption in commercial oil supplies threatens their economy. The U.S. has currently the largest SPR stock with a capacity of 727-million-barrel11.

Looking back at history, oil crises have brought not only negative economic influences but also a positive transformation of world economies from energy-dependent to technology-dependent production methods. In the long term, the global energy frame was changed significantly.

MARKETS Over the past few decades, more capital has flowed into oil-exporting nations, which has effectively driven up their quality of living. High-technology sectors have been placing increasing emphasis, and enormous amount of investment has joined in those expanding markets such as the Internet and mobile industries. Furthermore, energy-efficient vehicles are increasingly favoured by consumers along with the development of renewable and green energy encouraged by the government.

Most importantly, the continuing inspection and exploration of new oil reserves in non-OPEC nations has decreased the Middle East’s share in global oil production. The recent shale oil/gas revolution is an evident example of a more even distribution of oil production around the world. The pie charts below illustrate this shift of oil reserve percentages:

Figure 2. (Source: BP Statistical Review of Global Energy 2013)12

From 1992 to 2012, it is clear that the Middle-East’s share of global oil reserve has remarkably decreased whereas the Americas have seen considerable increases in its oil reserve.

Nevertheless, as the R&D of new and clean energy or other alternatives is a costly and long-term process, in the short-run, volatile oil prices will still account for one of the most impactful risks to the growth of all the economies.

U.S. Department of Energy, (n.d.). Strategic petroleum reserve. Retrieved from website: http://energy.gov/fe/services/petroleum-reserves/strategic-petroleum-reserve 12 Distribution of proved oil reserves in 1992, 2002 and 2012, percentage. (2013, November 30). BP Statistical Review of World Energy 2013. Retrieved from website: http://www.bp.com/content/dam/bp/pdf/statistical-review/statistical_review_of_world_energy_2013.pdf 11

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FUNDAMENTALS

THE FUTURE OF HEDGE FUNDS Hedge Funds can be enigmatic to outsiders. They have retained many of the operations that now face much greater regulatory scrutiny elsewhere. They are regulated lightly compared to other financial institutions. Their business model is seemingly unchanged even after the financial crisis. I will be exploring what lies in store.

By Rasmus Hogh

What is a hedge fund?

A hedge fund is a pooled investment vehicle, which is commonly structured as a limited partnership with a general partner. In order that they don’t have to register their securities with regulators, such as the SEC, Hedge Funds only allow “Accredited Investors”1 to invest money with them. These include banks, insurance companies, etc.

used to define them, namely Equity, Fixed Income, etc.

The strategies that Hedge Funds employ can be broken into 4 main categories: 1. Global Macro – Wider economic picture 2. Directional – Trends and market movements 3. Event Driven – Consolidations, acquisitions, liquidations etc.

4. Relative Value or Arbitrage – Differences in pricing between asset classes The assets that Hedge Funds trade are also

Why are Hedge Funds significant?

As of the 2nd Quarter 2014, total assets under management for the hedge fund industry was $2352.6 billion2. The largest Hedge Funds have several billion dollars in assets under management (AUM), and as a result have an ability to influence markets just through their sheer size of trades. The asset allocation and sizes thereof may be of particular interest:

1 2

Hedge fund fees are high when compared to other investment vehicles such as mutual funds.

These are split into a management fee – typically 2% of assets managed – and an incentive fee – anywhere between 10% and 50% of fund profits.

Accredited Investors, U.S. Securities and Exchange Information. Retrieved from http://www.sec.gov/answers/accred.htm Assets Under Management , BarclayHedge. Retrieved from http://www.barclayhedge.com/research/money_under_management.html

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FUNDAMENTALS

Table 1: Allocation of hedge fund AUM (Source: Barclayhedge)2

The potential for wealth creation at Hedge Funds as a successful investment manager is huge, which attracts attention from ambitious money managers and scrutiny from politicians.

Interestingly, regulators and politicians have for the most part focused on banks, exploiting an obloquy born out of the financial crisis.

Are their leverage ratios sustainable?

Hedge Funds use leverage – borrowing money, trading on margin or using derivatives – to be able to invest a greater amount than the capital provided by investors. Leverage can increase potential returns, but can also exacerbate losses. Leverage ratios also determine how much a hedge fund can lose before they have lost the entire value of their original capital. For example, if a hedge fund is leveraged 10 times, then only losses of 10% can be incurred before the entire value of the capital has been wiped out.

So leverage leads to a higher risk profile.

Interestingly enough, leverage ratios of Hedge Funds are on average lower than investment banks at 1.5 to 2.5 compared with 14.23. By this metric, Hedge Funds are not particularly risky and one could assume that the leverage ratios are sustainable. Taking a leverage average of 2, then a hedge fund would have to lose 50% to

lose their entire capital. One would think that it difficult for a manager to lose this high a percentage without action taken by the hedge fund executives. However, there are over 10,000 active Hedge Funds4, so this figure of leverage may not be representative of the most important Hedge Funds. Also, there is no regulatory limit to the amount of leverage used by Hedge Funds, so as a result, the amount of leverage may change dramatically depending on the transaction. This is not taken into account in the average figure.

What are absolute returns?

Absolute returns are the returns that a hedge fund achieves, unrelated to an index or benchmark. There is pressure to achieve as high a positive absolute return as possible. This is both to produce a positive return on the investment by clients but also to increase the performance fee to the investment manager. There is a tendency for short-termism, which is not conducive of a sustainable business model.

There is an asymmetry between profits and losses, which is very important when considering long-term sustainability. A positive absolute return for the fund leads to profits for the investment manager through the performance fee, but a negative absolute return leads to a fall in the

Ang, A., Gorovyy, S., & Van Inwegen, G. (2011). Hedge Fund Leverage. Nber Working Paper Series. Retrieved from http://www.nber.org/papers/ w16801.pdf 4 Growth in the number of hedge funds worldwide from 2000 to 2012, Statista. Retrieved from http://www.statista.com/statistics/273844/growth-ofthe-number-of-hedge-funds-worldwide/ 3

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FUNDAMENTALS value of the AUM. This loss is not shared with the manager and indeed the manager will still be paid the management fee regardless of performance. Warren Buffett, who believes that they create incentives for high-risk investment management, is a critic of these5.

How transparent are Hedge Funds?

At present, Hedge Funds are exempt from many of the standard registration and reporting requirements because they ingeniously only accept accredited investors. Also, they only accept a certain number of these investors to keep the number of total investors below a threshold, of 100 in the US, which would require them to disclose asset allocations. Each so-called accredited investor may represent thousands of smaller investors that have invested in the accredited investor’s fund or investment vehicle, so the total number of investors with indirect exposure to Hedge Funds is actually very large.

Performance statistics for individual Hedge Funds are difficult to obtain, as the funds have historically not been required to report their performance to a central repository and restrictions against public offerings and advertisement have led many managers to refuse to provide performance information publicly. However, summaries of individual hedge fund performance are occasionally available in industry journals and databases. Hedge fund indices are available, however, since they are actively managed, it is very difficult to track them on an individual basis.

Hedge Funds can use something called a “Side Pocket” to stow away illiquid assets until market conditions improve. It is essentially a technique to make it more difficult for investors to withdraw capital and was used during the 2008 crisis amid a large amount of withdrawal requests.

The practice of using side pockets can decrease losses in the short term by not registering writedowns on assets and keep assets from being withdrawn. Their use is very opaque and can be easily abused.

Is regulation catching up?

The Dodd-Frank Act of 2010 introduced additional reporting requirements for Hedge Funds,

however in reality they are still very lightly regulated compared to banks. The major danger for Hedge Funds is through the penalties for fraud.

These are very strict, compared to the low filing, reporting and disclosure obligations. The SEC settlement with the hedge fund SAC for a total of $1.8 billion shows the potential severity for fraudulent actions such as insider trading, for which there may be a propensity given the expectations of such high positive returns6. Since Hedge Funds have been able to adapt to regulation in the past to retain the benefits of flexibility, it is entirely possible that they will continue to do so in the future, limiting the effects of regulatory oversight.

What next?

Hedge Funds like all market participants have a propensity to be a part of a “herd mentality” which exacerbates swings in the market. The best Hedge Fund managers will try to remove themselves from this effect. Due to human nature, this is difficult and is not always possible.

Hypothetically, if many asset classes become correlated, a large fall in these could adversely affect most market participants, especially Hedge Funds if their exposure is greatest. Combined with leverage, such an event could be devastating. These unpredictable events happen infrequently but they do actually happen, and so cannot be written off entirely.

Until such a point, if it were to occur, Hedge Funds can continue to be a very successful business model. This is due to several reasons.

Firstly, the compensation structure will continue to draw in the most ambitious and/or the most talented money managers who see an opportunity to earn a greater percentage of profits.

Secondly, investment in Hedge Funds can add diversity to an investor’s portfolio, and thus are attractive to investors. Nevertheless, there are other ways to diversify risk in such a portfolio.

This financial crisis resulted in sweeping changes to banking and the financial services sector, but left hedge funds largely unscathed. Could it be possible that the next crisis will primarily affect hedge funds?

(2010, October 26). 5 Reasons Why Warren Buffet Is Wrong About Hedge Funds. Retrieved from http://www.businessinsider.com/warren-buffetwrong-about-hedge-funds-2010-10?IR=T&http://www.businessinsider.com/warren-buffet-wrong-about-hedge-funds-2010-10 6 Rothfeld, M. (2013, November 4). SAC Agrees to Plead Guilty in Insider-Trading Settlement. Retrieved from http://online.wsj.com/news/articles/SB 10001424052702303482504579177602847708162 5

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FUNDAMENTALS

GLOBAL FINANCIAL IM BALANCES The cost of developing countries holding a high level of international reserves – does it stimulate or strain the economy?

By Alfio Puglisi Introduction With the advent of global perfect capital mobility, there has been an increase in international capital flows, especially within emerging markets such as China and India. Due to the higher capital remuneration offered compared to that of industrialised countries, other countries have also followed suit to capture the investors’ appetite for emerging markets. This article aims to elucidate – through close examination of financial literature – the recent reserve accumulation in emerging markets, its positive and negative aspects, and its implications from the standpoints of monetary policy and trade balance.

Accumulation and holding of reserve: motivations, costs, and benefits Reserve management has changed during the last decade. Philip Wooldridge of the Bank of International Settlements (BIS)1, upon analysing the data on reserves placed in banks by monetary authorities, notes that although managers have maintained a cautious stance towards diversification in the past twenty years, the composition of reserves has changed dramatically.

Reserve managers have increasingly oriented tools to more profitable yet riskier assets. Furthermore, the share of other reserve currencies invested has varied significantly over time, though they continue to be invested mainly in U.S. dollars and euros.

Over the last year there has been a great accumulation of foreign exchange reserves by

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FUNDAMENTALS emerging markets economies. According to Madhusudan Mohanty and Philip Turner of the BIS2, for some countries with an accommodative monetary stance, having a steady interest rate has kept inflation under control, thus simplifying the dilemma between supply- and demand-side policymaking faced by central banks. Nevertheless, a substantial and sustained accumulation of reserves can still create other risks beyond inflation in the short term. These risks include high costs of intervention, monetary imbalances, overheated credit markets and activities, high liquidity and probable distortion of banking systems, among others.

The transformation of many developing countries into net exporters of capital contradicts the conventional view that flows of capital should be from rich countries to emerging and developing countries. Developing countries offer investment opportunities characterised by higher potential returns. But with benefits, come costs

as well. In addition to the foreign trade management needs, it is imperative for a country to hold official reserves to protect themselves from the currency risk. In fact, international reserves are essential tools to support the economy when foreign capital inflows are interrupted (Tweedie, 2000)3.

Many empirical contributions have shown that the probability of a debt crisis – as well as transaction costs of borrowing (Chan Lau, 2004)4 – decreases with increasing accumulated reserves. They are, in fact, the primary essential tools to allow the Central Bank to intervene when needed. Accumulated reserves can play the role of “lender of last resort” in the presence of a high percentage of loans in foreign currency, reducing the run bank risk5 (Diamond and Dybvig 1983)6. Recent studies (Dooley, Folkerts - Landau, Garber, 2004)7 support the view that the increasing accumulation of reserves can also be linked to the pursuit of export-led growth

Figure 1. (Source: Reserve Bank of India, 2006)8 Philip Wooldridge “The evolution of trading activity in Asian foreign exchange markets”, Emerging Markets Review, December 2008.

Madhusudan Mohanty & Philip Turner, 2010. “Banks and financial intermediation in emerging Asia: reforms and new risks,” BIS Working Papers 313.

3 Tweedie, A. IMF, (2000). Annual report. Retrieved from website: http://www.imf.org/external/pubs/ft/ar/2000/eng/pdf/file5.pdf 4 Chan- Lau, J. A. (2004). Reserve Holdings and Sovereign Default Risk. International Monetary Fund.

5 A run bank risk occurs in a fractional reserve banking system when a large number of customers withdraw their deposits from a financial institution at the same time and either demand cash or transfer those funds into government bonds, precious metals or stones, or a safer institution because they believe that the financial institution is, or might become, insolvent. Diamond, D. W., (2007). Banks and liquidity creation: a simple exposition of the Diamond-Dybvig model. Federal Reserve Bank of Richmond.

6 Diamond, D. W., Dybvig, P. H. (1983). Bank Runs, Deposit Insurance, and Liquidity. Journal of Political Economy, 91, 401-419.

7 Dooley, M. P., Folkerts-Landau, D. and Garber, P. (2004). The revived Bretton Woods system. Int. J. Fin. Econ., 9: 307–313.

8 Summer, L.H, (2006). Reflections on global account imbalances and emerging market reserve accumulation. Reserve Bank of India. Retrieved from website: http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/69527.pdf 1 2

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FUNDAMENTALS strategy. The huge stock of reserves would then be the result of actions taken by central banks in the currency markets, as it aims to maintain an exchange rate weak enough to support export-led growth.

The economic cost of holding international reserve It can be argued that the U.S current account deficit is unsustainable and hazardous for the global economy. It is also alarming that developing countries are holding huge reserve accumulations beyond their monetary financial sustainability, in what is called a ‘saving glut’. The diagram below shows reserves accumulation at high levels and growing sharply at several hundred billion dollars per year. It is interesting to note that the real return of earnings in domestic terms is likely to be zero. This indicates a substantial opportunity cost. If the external wealth earned and the accumulated reserves were invested in domestic investment like developmental infrastructure or in long-term investment plans in the international market, “6% would not be an ambitious estimate of what could be earned. The resulting gain would be close to $100 billion a year. Aggregating the 10 leading holders of excess reserves, the opportunity cost of these reserves comes to 1.85% of their combined GDP” (Summer, L.H, 2006)9.

On the other hand, this figure is comparable to the gains achievable in a number of countries with trade liberalisation, global foreign aid, or spending on key social sectors. Moreover, reserve adequacy should be judged within money supply.10 Low yielding reserves in the developing world is an important start point to counter problems that have been concentrated on creating an international financial system. From the establishment of the International Monetary Fund (IMF) to the foundation of the Special Drawing Right (SDR) through conferences of expanded SDRs during the 1990s, the main concern was finding low cost ways of manufacturing to ensure that reserves could be handed over to capital-importing developing nations.

Positive arguments for reserve accumulation in emerging markets There are some arguments in favour of accumulation of reserves. In countries where the economy is growing at sustained rates – most notably China11 – the accumulation of foreign exchange reserves can drain liquidity from the domestic economy and curb inflationary pressures. In addition, international reserves can be used to ensure against unexpected shock such as the recent financial crisis.

However, in the financial context of increasing integration, many economists attribute the decreasing efficacy of this form of protection to exogenous shocks.

International reserve accumulations, with an appropriate and strict monetary control on inflation, play an important role in absorbing economic shocks from unpredictable variables.

These shocks represent one of the main causes of economic volatility for emerging countries, especially for those whose economical performance depends strictly on the raw materials and resources like oil commodities. The exchange rate volatility is three times larger in emerging markets than in industrialised countries.12 Reducing the problem of volatility would allow policymakers to mitigate the impact of the reversal of global financial cycles.

Fiscal and monetary policies, like keeping inflation rates stable and steadying interest rates, that are recently implemented by emerging markets reflect their ambition to reduce the problem of exchange rate volatility and achieve a stable economic status.

The effect of economic reserve stabilisation is particularly significant in oil-exporting Asian countries. This is evident in a less volatile real effective exchange rate, which measures the real competitiveness of the economic system, for countries that have higher levels of international reserves. For each percentage point of improved terms of trade, for example a permanent increase in the commodity exports price,

Ibid.

Rodrik, D. (2006). The Social Cost of Foreign Exchange Reserves. International Economic Journal, 2(3), 253–266.

11 Aizenman J., Rear-Crichton, D. (2008). Real exchange rate and international reserves in an era of growing financial and trade integration. The Review of Economics and Statistics, 90(4), 812-815.

12 Hausmann, R. et. al. (2006). The Long-Run Volatility Puzzle of the Real Exchange Rate. Journal of International Money and Finance, 25(1), 93-124.

9

10

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FUNDAMENTALS

Table 1: Excess Reserves Beyond Greenspan-Guidotti Rule (Source: Reserve Bank of India, 2006)15

the exchange rate of balance appreciates in value by 2% ceteris paribus. This implies that a reduction in these economies’ competitiveness through, for example, the reduction in the growth of export volumes would slow the growth of GDP by about 1% per year. In this context a level of international reserves equal to 100% of GDP completely eliminates the impact of exchange associated with price shocks and a level of 50% reduces the impact of the half.13 Arguments against international reserve accumulation There is a lack of consensus among economists and policymakers regarding the usefulness of high levels of international reserve. Indeed, there are negative effects on emerging economies that have large reserve accumulations denominated in dollars. On the one hand, it exposes them to risks of fluctuations in the exchange rate – the U.S. trade deficit remains high and is likely to be 6.5% of GDP14, therefore the possibility of a depreciation of the dollar is high. This would lead to capital losses for countries that have accumulated high levels of assets in this currency in recent years. On the other hand, for some of these countries, reserve accumulation tends to maintain artificially undervalued exchange rates compared to market levels, contributing to an increase in global financial imbalances.

Are current reserves excessive? How much reserve should countries hold?

The IMF board discussed a rule of thumb for reserve adequacy incorporating short-term foreign currency debt as shown in the table below. It is termed the Guidotti-Greenspan rule after policymakers Pablo Guidotti and Alan Greenspan who proposed the idea in 1999, in which the former proposed a rule of thumb that accords sufficient reserve to cover amortisation up to 1 year to each emerging markets.

Conclusion It is understandable that international reserves are held by emerging markets, and important that they can support and finance the overall banking system. International reserves also help avoid extreme currency depreciation and play a significant role in determining exchange rates as well as influence economic ties among countries. However, much like the current US-China trade relationship, countries maintaining high levels of international reserves and investments in developed markets are contributing to an economic vicious cycle between the government, industry and central bank.

Ibid.

Summer, L.H, (2006). Reflections on global account imbalances and emerging market reserve accumulation. Reserve Bank of India. Retrieved from website: http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/69527.pdf 15 Ibid.

13 14

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INSIDE ANALYSIS

CHALLENGING INFORMALITY: Special Report from Oxford Buiness Group

In line with reforms pertaining to energy, education and telecommunications, Mexico is also amending its tax system. In late 2013, President Enrique Peña Nieto signed the new reform into law, which was thereafter approved by Congress. The reform aims to reduce dependence on energy revenues and to boost tax collection through a series of measures, including higher taxes for the wealthy and additional levies on a variety of different products.

However, a big part of making the taxation system more efficient will depend on the government’s ability to reach Mexico’s massive informal sector. To do this, authorities are easing access to social benefits as a way to enhance the attractiveness of operating in the formal economy. This arguably remains one of the biggest challenges for the current administration but one that could have an enormous impact on the state’s fiscal position over the near future.

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Increased expenditure on infrastructure and the need to improve health and education services are putting pressure on government finances, while a large proportion of the country’s economic activity takes place outside of the tax system’s reach.

Successive governments have had little effect on curbing on curbing the number of people working informally, leaving the country’s fiscal machinery unable to tap into a considerable amount of income.

According to the National Institute of Statistics and Geography (Instituto Nacional de Estadística e Geografía, INEGI), Mexico’s key statistics bureau, six out of 10 workers operate in the informal sector. In 2013, labour minister Alfonso Navarette Prida said that the Mexican economy was losing between 3% and 4% of GDP because of its inability to collect taxes from such a

INSIDE ANALYSIS large proportion of the working population.

The problem has an impact on the government’s ability to capture resources that are needed to improve its infrastructure and boost competitiveness. Mexico has the lowest level of tax collection among the 34 countries in the OECD. The Tax Administration Service (Servicio de Administración Tributaria, SAT) has reported that of Mexico’s 53m economically active people, some 29.6m of those work informally. Besides the lower tax collection, there is also a relevant opportunity cost in terms of competitiveness.

“This has consequences for the economic growth, since the productivity levels of the informal segment are much lower than those of formal firms. Informality has a negative impact on productivity, thus reducing income levels and economic well-being,” Luis Videgaray Caso, Minister of Finance and Public Credit, told OBG. Despite the daunting challenge, the government is hoping that a series of reforms and legal instruments can better channel informal operations into the country’s tax system. Mexico’s informal economy woes are deeply connected to economic patterns. Although growth has meant that the level of unemployment has dropped, this has mostly impacted the informal side of the country’s economic structure. This dynamic was clearly visible in the last quarter of 2013. According to INEGI, unemployment was reduced to 4.6% in the fourth quarter of 2013, compared to 4.9% two months earlier. This represented an increase of more than 75,000 in the number of employed people in the formal sector. However, over the same period of time, INEGI also estimated that the overall percentage of informal workers reaches 58.8% of the active population, totaling approximately 29.6m people. However, their distribution depends on the sector of activity.

According to INEGI figures for 2013, the agricultural sector employed more than 6.2m informal workers as of December 2013, and an additional 2.2m are employed in paid domestic work. Furthermore, 7m workers are employed in formal companies, government positions and institutions, but are not registered in the social security system. The biggest slice of Mexico’s informal economy is made up of people working entirely in informal business, mainly using

home-based resources, which are not legally constituted as companies, amounting to around 14m people.

Small and medium-sized enterprises (SMEs) will be one of the main targets for the government’s inclusion objectives.

The tax reform is putting in place a new Fiscal Incorporation Regime (Régimen de Incorporación Fiscal, RIF) in order to encourage informal enterprises and workers to enter the system.

SMEs with annual revenues less than MXN2m ($155,400) will be able to receive tax breaks and discounts in social security payments in exchange for sharing transaction information with the tax authorities. Additionally, the government will also offer training programmes and credit lines as further encouragement. The plan is to reduce benefits to firms entering the new regime, but also to offer enough of an incentive that these informal businesses will see the real benefits in joining the formal economy. In early March 2014, SAT announced that approximately 1.1m workers had already started the process to join the new incorporation system.

The benefits are designed to promote modernization and efficiency increases, allowing companies operating outside the system to exchange informality for the possibility to upgrading their businesses. This, the government hopes, will translate into better-operated and more profitable businesses in the long run, coupled with an enlarged tax base for the fiscal system. “People in the informal economy do not have access to credit to boost their businesses or social security coverage, training or new technology,” Videgaray Caso told OBG. To achieve the goal of reducing informality from the current 60% of workers to roughly 50% by the end of the presidential term in 2018, the authorities will need to clearly tilt the cost-benefit equation of operating under the law towards the side of formality.

Other more localized programmes are helping to stem informal commerce at the city level. For the past two years the Mexico City Chamber of Commerce, Services and Tourism (Cámara Nacional de Comercio, Servicios y Turismo de la Ciudad de México, CANACO) has been running

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INSIDE ANALYSIS a pilot programme to upgrade small shops, by providing shop owners with training and equipment to improve inventory management and promote formalization of businesses. The programme is being tested on 2000 vendors in the capital, and CANACO is hoping to expand it to thousands of Mexico City’s commerce owners over the coming years.

Facilitating contact between citizens and the state will also help to encourage businesses and individual workers to formalise. A study by INEGI in 2013 found that about 31% of Mexican citizens had to wait “several hours” to pay their taxes, and more than 60% of those surveyed noted that they had been asked to pay a bribe to tax employees in order to accelerate the process.

Technology is already proving a good way to bring more companies into the system and speed up processing times. Tax payment is currently only possible through the internet, and although some businesses still chose to do it via professional accountants, the move towards digital payment has facilitated a greater audit trail. Since the beginning of 2014, digital business invoices have become mandatory, helping authorities get a better grasp of business activity by private companies. However, strengthening collection will also be dependent on the economy’s ability to develop formal job opportunities across the country, especially outside major urban centres. According to 2013 figures from the Ministry of Finance and Public Credit, about 60% of the country’s informal workers live in rural areas, many of who are employed in agriculture or small informal commerce operations.

Lack of sufficient formal employment options in some regions will continue to push workers towards parallel economic activities.

Despite the government’s focus on reducing the weight of unregistered economic activity, some parallel measures included in the current fiscal reform might have counter-productive effects.

One example is the government’s goal to establish a new unemployment fund that, by 2015, might allow workers who lost their jobs to receive a minimum salary for a period of six months.

The fund does not include a mechanism for the large amount of Mexicans working outside the tax system. Although this might encourage informal workers to try to secure legally registered work, the creation of the unemployment fund

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might also discourage formal business owners that employ informal workers to channel them to full legal status for fear of increased social benefit charges.

Implementation of a new unemployment benefit system will thus depend on how the government fine-tunes the details to ensure it remains an additional encouragement to reducing informal work. The current fiscal reform has the potential to give much-needed impetus to Mexico’s economic growth. The objective to increase the country’s overall tax base will help the authorities to better channel fiscal resources in support of development. Further, it will also assist Mexico’s mass of underpaid and informal workers to access social benefits and better-paid employment options. To succeed then, the government will need to make it more advantageous to work inside the tax system.

The experience stays with you

Layo at PwC’s More London office

Assurance Actuarial Consulting Deals PwC Legal Tax Technology All degree subjects Voted employer of choice by students in The Times Top 100 Graduate Employers survey for eleven years running.

Opportunities with the UK’s number one graduate employer Offices across the UK » Join spring, summer or autumn Your career is just that; yours. You choose it. You live it. You make it happen. To get the best from it, you need the best opportunities. That’s why opportunities are at the heart of a career with us. Opportunities to grow as an individual, to build lasting relationships and make an impact in a place where people, quality and value mean everything. For Science graduate Layo, that meant exploring the business world on our Tax Summer Internship – and like many of our talented interns, she was offered a job with us at the end. Now she works on major tax projects, helping the employees of some of the world’s biggest companies manage their complex tax affairs. Join PwC – we’re focused on helping you reach your full potential.

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Diverse people make us stronger

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CAREERS

THE ANALYST INTERVIEW

By Shu Hang Low Tell us a little bit about yourself and your internship experience.

My name is Emily Cheah and I’m in my third year in a BSc Accounting and Finance degree. Last summer, I had the opportunity to gain a better insight on the Finance department within Deutsche Bank through a summer internship. The internship lasted for 9 weeks, but it felt short.

Every day was a new learning experience with greater exposure on the dynamics of the financial industry.

to Global Valuation Group (GVG) whereby the division functions primarily to perform independent price valuation on portfolios.

What is the function of the division you interned in?

The Finance department serves generally to be a control mechanism of the bank to ensure accurate and timely financial information is delivered. However, there are various desks with different functions within Finance department itself: ranging from analytic, process to valuation functions. During my internship, I was assigned

What was the most challenging aspect of your internship?

It was definitely a technical role that requires a solid foundation in Finance. It was, at first, difficult to grasp the methods and approaches to evaluate the portfolios as there is no true and accurate method of valuating the portfolios. The Finance intern role, however, does not require a Finance degree as a prerequisite (even with my

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What were your responsibilities?

As part of my role as an intern, I assisted in preparing monthly variation reports for two portfolios, namely Commercial Real Estate, and Pension and Risk portfolios. Hence, I performed cash flow trend analysis, risk sensitivity test analysis and recovery projectile of the portfolios.

CAREERS degree of BSc Accounting and Finance, I was unable to understand all the concepts). My team was very supportive in helping me understand my function and roles. In fact, my manager also provided several one-to-one sessions on educating me on Derivatives.

What is the most valuable insight into the industry that you gained?

This internship definitely provided me with valuable insights into the functions of the Finance department while giving me an exposure on the Investment Banking sector. My main take-away from my internship experience is the network skill gained. Undeniably, I have acquired stronger analytical and valuation skills, but this experience also highlights the importance of networking skills. Through networking, I was able to exchange knowledge with other divisions and departments, while fostering good professional networks.

Any advice you would like to give students wishing to apply for an internship?

The application process is the most difficult part.

It is always advantageous to prepare in-depth for the interview and assessment centre.

Any advice for students starting their internship the coming summer?

An internship is a golden opportunity to learn more about the nature of the division you are interning, and the working culture of the bank.

Be eager to learn and understand as much as possible, while being able to accept constructive criticisms.

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Deutsche Bank db.com/careers

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Agile minds think there’s never been a better time Global Graduate Programs Given the current climate, it’s tempting to think there’s little future in finance. However if you step into Deutsche Bank, you’ll soon discover no shortage of opportunities.

We need graduates from all kinds of backgrounds and with all kinds of talent – to help us in Markets, Corporate Finance and Group Technology & Operations to name just a few. Graduates with the intelligence and energy to contribute to our continued stability and growth, and to help us drive change in a global market.

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