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Posts Tagged ‘savings’

Ochi, ochi, ochi

Banks in Cyprus are in crisis. They have many bad debts e.g. to Greece and as mortgages in a falling property market. Private-sector debts have become unsustainable for the banks. The problem is compounded by negative economic growth and large government deficits (see chart). But, as with Icelandic banks back in 2008, this means a crisis for the whole country.

The reason is that the banking sector in Cyprus, as in Iceland and Ireland too, is large relative to the whole economy – over 8 times annual GDP (second only to Ireland in the EU). Loans to Greece alone are as much as 160% of Cyprus’ GDP and Cypriot banks were badly hit by the terms of the Greek bailout, which required creditors to take a 53% reduction (or ‘haircut’) in the value of their loans to Greece. With such a large banking sector, it is impossible for the Cypriot government alone to rescue the banks.

Cyprus thus turned to the EU for a bailout: back in June 2012. This makes Cyprus the fifth country to seek a bailout (after Greece, Ireland, Portugal and Spain). A bailout of €10 billion has just been agreed by the EU and IMF. The bailout comes with the ‘usual’ conditions of strong austerity measures of tax rises and cuts in government expenditure. But what makes this bailout different from those given to the other countries was a proposed levy on savers.

The proposal was that people with up €99,999 in their bank accounts (of any type) would face a one-off tax of 6.75%. The rate for those with €100,000 or more would be 9.9%, including on the first €99,999. This would raise around €5.8 billion of the €10 billion.

Not surprisingly, there was a public outcry in Cyprus. People had thought that their deposits were protected (at least up to €100,000). There was a run on cash machines, which, as a result were set to deliver just small amounts of cash to cope with the excessive demand. There was huge pressure on the Cypriot government not to introduce the measure.

But the ramifications of the proposed levy go well beyond the question of justice to savers. Questions are being raised about its incentive/disincentive effects. If people in other countries in future financial difficulties felt that they might face similar levies, how would they behave? Also, there is no haircut being proposed for holders of banks’ bonds. As Robert Peston states in his first article below:

The Cypriot deal sets back the cause of the new global rules for bringing order to banking systems when crisis hits. Apart from anything else, in other eurozone countries where banks are weak, it licenses runs on those banks, as and when a bailout looms.

But getting incentives right is not easy. As the Buttonwood column in The Economist points out:

The problem is tied up with the issue of moral hazard. This can be applied to both creditors and debtors; the former should be punished for reckless lending and the latter for living beyond their means. The collapse of Lehman Brothers is seen as an example of the faulty reasoning behind moral hazard; by letting the bank go bust, the crisis was spread throughout the financial system. But rescuing every creditor (or intervening to bail out the markets every time they falter) is the reason we are in this mess.

One alternative considered by the Cyprus parliament was to exempt people with less than €20,000 in their accounts from the levy. But this was rejected as being insufficient protection for savers. Another is to exempt people with less than €100,000, or to charge people with between €20,000 and €100,000 at a lower rate or rates.

But charging less, or nothing, on deposits of less than €100,000 would make it harder to to raise the €5.8 billion required by the EU. Without alternative measures it would mean charging a rate higher than 9.9% on larger deposits. The Cypriot government is afraid that this would discourage inward investment. Russia, in particular, has invested heavily in the Cyprus economy and Russia is campaigning vigorously to limit the size of the levy on large deposits. But there is little sympathy for Russian depositors, much of whose deposits are claimed to be ‘laundered money’. The Cypriot government has been seeking financial support from the Russian government.

An alternative proposal being considered is to issue government bonds in an “investment solidarity fund” and to transfer pension funds from semi-public companies to the state. Also Russia may be willing to invest more money in Cyprus’ offshore oil and gas fields.

Agreement
A deal was struck between Cyprus and the EU/IMF early in the morning of 25 March, just hours before the deadline. For details, see the News Item Cyprus: one crisis ends; another begins.

Webcasts and podcasts
Eurozone ministers agree 10bn euro Cyprus bailout Channel 4 News (16/3/13)
Bailout is ‘blackmail’ claims Cyprus president Euronews (17/3/13)
Cyprus’s president tries to calm fears over EU bailout The Guardian (18/3/13)
Cypriot bank customers reactions to savings levy BBC News (17/3/13)
Cyprus bailout: Parliament postpones debate amid anger BBC News (17/3/13)
Cyprus parliament delays debate on EU bailout Al Jazeera (17/3/13)
Cyprus told it can amend bailout, as key vote postponed BBC News, Gavin Hewitt (18/3/13)
Robert Peston: Cyprus bailout an ‘astonishing mess’ BBC News, Robert Peston (18/3/13)
Cyprus bailout is ‘completely unfair’ BBC Radio 4 Today Programme, Michael Fuchs and Bernadette Segol (18/3/13)
Lenders ‘doing everything you should not do’ on Cyprus BBC Radio 4 Today Programme, Alistair Darling (19/3/12)
Cyprus warned over bailout rejection BBC News (20/3/13)

Articles
Cyprus becomes fifth eurozone bailout The News International (Pakistan) (17/3/13)
Cyprus bailout deal sparks run on ATMs Irish Independent (17/3/13)
EU leaders gamble in Cyprus bank bailout BBC News, Gavin Hewitt (17/3/13)
Cyprus told it can amend bailout, as key vote postponed BBC News (18/3/13)
Q&A: Cyprus bailout BBC News (19/3/13)
Cyprus’ President Defends Bailout Deal The Motley Fool (16/3/13)
Sad Cyprus The Economist, Buttonwood’s Notebook (12/3/13)
The Cypriot bail-out: A fifth bitter lemon The Economist (30/6/12)
Analysis: Cyprus bank levy risks dangerous euro zone precedent Reuters, Mike Peacock (17/3/13)
The Cyprus precedent Reuters, Felix Salmon (17/3/13)
The Cyprus Bank Bailout Could Be A Disastrous Precedent: They’re Reneging On Government Deposit Insurance Forbes, Tim Worstall (16/3/13)
Cyprus rescue breaks all the rules BBC News, Robert Peston (18/3/13)
Cyprus and the eurozone’s survival BBC News, Robert Peston (20/3/13)
Eurogroup defends Cyprus bail-out The Telegraph (17/3/13)
Cyprus eurozone bailout prompts anger as savers hand over possible 10% levy The Guardian (16/3/13)
Cyprus’s wealth tax makes perfect sense – its rich won’t escape unscathed The Guardian, Phillip Inman (18/3/13)
The tragedy of Cyprus The Real Economy blog, Edmund Conway (16/3/13)
Damage limitation in Cyprus BBC News, Stephanie Flanders (19/3/13)
The fatal flaw in the eurozone’s not-so-cunning plan for Cyprus The Guardian, Larry Elliott (19/3/13)
Cyprus plans special fund in race to get EU-IMF bailout BBC News, (21/3/13)
Cyprus says ‘significant progress’ in debt crisis talks BBC News (23/3/13)

Background information
The Banking System in Cyprus: Time to Rethink the Business Model? Cyprus Economic Policy Review, Vol. 5, No. 2, pp. 123–130, Constantinos Stephanou (2011)
European sovereign-debt crisis Wikipedia

Questions

  1. What is the justification given by the Cypriot government and the EU for imposing a levy on bank deposits?
  2. What alternative measures could have been demanded by the EU? Why weren’t they?
  3. What is the significance of Russian deposits in Cypriot banks?
  4. Compare the benefits of the proposed levy rates with the alternative of imposing levies only on deposits over €100,000, but at higher rates (perhaps tiered).
  5. Explain the moral hazard issues in bailing out the Cypriot banks.
  6. How serious is the problem that imposing a tax on deposits in Cypriot banks might have adverse affects on the behaviour of depositors in other countries’ banks?
  7. How might Cypriots behave in future in regards to depositing money in banks? What impact could this have on the economy of Cyprus?
  8. Explain “the unholy trinity of options facing indebted nations (inflate, stagnate, default)”. Compare the effectiveness of each.
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Bank rate

In March 2009, the Bank of England’s base rate was slashed to 0.5% in a bid to boost aggregate demand and stimulate the UK economy. And there it has remained for almost 2 years and as yet, no change is in sight. In the February 2011 meeting of the Monetary Policy Committee (who are responsible for setting interest rates to keep inflation on target), the decision was to keep interest rates at 0.5% rather than raise them to tackle high and rising UK inflation. Those in favour of keeping interest rates at this record low argue that any increase could damage the UK’s ability to recover and may lead to the dreaded double-dip recession. This is of particular concern given the economy’s performance in the last quarter of 2010.

However, one group that will certainly not be happy is the savers. With instant-access savings accounts paying on average just 0.84% before tax and with inflation at 3.7%, savers aren’t just not gaining much interest, but are actually seeing the value of their money in real terms fall. Howard Archer of HIS Global Insight said:

“For now, we retain our view that the Bank of England will hold off from raising interest rates until the latter months of the year. Even if interest rates do rise in the near term, the likelihood is still that they will rise only gradually and remain very low compared to past norms.

Monetary policy will need to stay loose for an extended period to offset the impact of the major, sustained fiscal squeeze. Consequently, we retain the view that interest rates will only rise to 2pc by the end of 2012.”

Following some speculation that the Bank of England may succumb to the pressure of inflation and hike up interest rates (markets had priced in a 20% chance of a rate rise), sterling did take a hit, but after the decision to keep rates at 0.5%, sterling recovered against the dollar. There is a belief amongst some traders that rates will rise in May, but others believe rates may remain at 0.5% until much later in 2011, as the country aims to avoid plunging back into recession. Of 49 economists that responsed to a poll by Reuters, three quarters of them said that rates would rise by the end of 2011, with median forecasts predicting a rise around November. This is certainly a space to watch, as it has implications for everyone in the UK and for many in countries around the world.

BOE leaves bank rate unchanged at 0.5% at Feb meeting Automated Trader (10/2/11)
Economists predict interest rates will rise in November Telegraph, Szu Ping Chan (11/2/11)
UK May rate hike view holds firm after BOE Reuters, Kirsten Donovan (10/2/11)
Interest rates: What the economists say Guardian (10/2/11)
Fixed rate mortgages becoming more expensive BBC News (10/2/11)
Bank rate: savers’ celebrations on hold Telegraph, Richard Evans (10/2/11)
Inflation fears turn up heat ahead of bank rate decision City AM, Julian Harris (10/2/11)
Sterling takes BOE in its stride, higher rate talk aids Reuters, Anirban Nag (10/2/11)
Bank of England holds interest rates of 0.5% Telegraph, Emma Rowley (10/2/11)

Questions

  1. Why are interest rates such an important tool of monetary policy? Think about which variables of aggregate demand will be affected by the Bank of England’s decision.
  2. What is the relationship between interest rates and inflation?
  3. What explanation is there for the fall in the value of sterling following speculation that interest rates may rise? Why did sterling recover after the Bank of England’s decision?
  4. How has the recent speculation affected fixed rate mortgages?
  5. What does the Telegraph article about “savers’ celebrations on hold” mean about the ‘real value’ of money and savings?
  6. What are (a) the arguments for keeping interest rates at 0.5% and (b) the arguments for raising interest rates? Who wins and loses in each case?
  7. Are there any other government policies that could be used to combat inflation, without creating the possibility of a double-dip recession? Why haven’t they been used?
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Greece 2: This time it’s Ireland

It doesn’t seem that long ago when Greece was in the news regarding its deficit and need for bailing out. Back then, countries such as Spain, Portugal and Ireland were being mentioned as the next countries which might require financial assistance from the EU. It is now the Irish economy that is in trouble, even though the Irish government has not yet requested any financial help. The EU, however, is ‘ready to act’.

The Irish economy experienced an extremely strong boom, but they also suffered from the biggest recession in the developed world, with national income falling by over 20% since 2007. Savers are withdrawing their money; property prices continue to collapse; and banks needed bailing out. Austerity measures have already been implemented – tax rises and spending cuts equal to 5% of GDP took place, but it has still not been enough to stabilise the economy’s finances. All of these problems have contributed to a large and unsustainable budget deficit and a significant lack of funding and that’s where the EU and possibly the IMF come in.

If the Irish economy continues to decline and experiences a financial crisis, the UK would probably be one of the first to step in and offer finance. As our closest neighbour and an important trading partner, the collapse of the Irish economy would adversely affect the UK. A significant proportion of our exports go to the Irish economy and, with Irish taxpayers facing troubled times, UK exporting companies may be the ones to suffer.

One thing that this crisis has done is to provide eurosceptics with an opportunity to argue their case and blame the euro for the collapse of Ireland. With one monetary policy, the Irish economy is tied in to the interest rates set by the ECB and low interest rates fuelled the then booming economy. The common currency also increased capital flows from central European countries, such as Germany, to peripheral countries, such as Ireland, Spain and Portugal. In themselves, capital flows aren’t a problem, but when they are used to fund property bubbles and not productive investments, adverse effects are inevitable, as Ireland found to its detriment.

As prices collapsed and banks simply ran out of money, the government stepped in and rescued not only the depositors of Irish banks, but also their bondholders. Unable to devalue their currency, as it’s the euro, the Irish economy was unable to boost exports and hence aggregate demand and in turn economic growth. Although, the Irish government has not requested any financial help, as the French Finance Minister commented about a potential bailout: “Is it six months or a few days away? I’d say it’s closer to days.” The following articles look at this developing situation in Europe.

EU plays down Irish republic bail-out talks BBC News (17/11/10)
Ireland bailout: the European politicians who will decide Telegraph, Phillip Aldrick (17/11/10)
Don’t blame the Euro for Ireland’s mess Financial Times, Phillipe Legrain (17/11/10)
Britain signals intention to help Ireland in debt crisis New York Times, James Kanter and Steven Erlanger (17/11/10)
Ireland will take aid if ‘bank issue is too big’ Irish Times, Jason Michael (17/11/10)
Irish junior party says partnership strained Reuters (17/11/10)
Ireland resists humiliating bail-out as UK pledges £7 billion Telegraph, Bruno Waterfield (17/11/10)
Markets stable as Ireland bailout looms Associated Press (17/11/10)
The implausible in pursuit of the indefensible? BBC News blogs, Stephanomics, Stephanie Flanders (16/11/10)
Ireland bailout worth ‘tens of billions’ of euros, says central bank governor Guardian, Julia Kollewe and Lisa O’Carroll (18/11/10)
The stages of Ireland’s grief BBC News blogs, Stephanomics, Stephanie Flanders (18/11/10)
Q&A: Irish Republic finances BBC News (19/11/10)
Could Spain and Portugal be next to accept bail-outs? BBC News, Gavin Hewitt (19/11/10)

Questions

  1. Why will the UK be affected by the collapse of the Irish economy?
  2. If Ireland were not a member of the eurozone, would the country be any better off? How might a floating exchange rate boost growth?
  3. The Financial Times article talks about the euro not being to blame for the Irish problems, saying that ‘tight fiscal policy’ should have been used. What does this mean?
  4. Why is the housing market so important to any nation?
  5. What are the arguments (a) for and (b) against the euro? Would Ireland benefit from leaving the euro?
  6. Should the UK government intervene to help Ireland? What are the key factors that will influence this decision? What about the EU – should Ireland ask for help? Should the EU give help?
  7. Austerity measures have already been implemented, but what other actions could the Irish economy take to increase competitiveness?
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Cautious British households continue to consolidate

Each month the Bank of England reports on the amount of net lending by households. This is the amount that households have borrowed from financial institutions (gross lending) less any repayments households have made to financial institutions. In March, net lending to households was £643 million, down from £2.43 billion in February. Of the £643 million, £318 million was net secured lending (i.e. mortgage lending) and £325 million net unsecured lending (i.e. lending through credit cards, overdrafts and general loans).

Now, you might think that net lending of £643 million means that the stock of debt owed by households grew by £643 million. Well, not quite; some debt is ‘written off’ by financial institutions. When bad debts are taken into consideration we find that the stock of debt actually fell in March by £2.682 billion to stand at £1.460 trillion. Of this stock of debt, £1.239 trillion is secured debt and £221.65 billion is unsecured debt. Put another way, 84% of household debt is secured debt and 16% unsecured debt.

One of the interesting developments of late has been the decline in the household sector’s stock of unsecured debt. It has now fallen for 10 months in a row and in 16 of the last 18 months. Interestingly, in only 7 of these months was net unsecured lending actually negative. However, historically low sums of net unsecured lending combined with the writing-off of unsecured debt has meant that the stock of unsecured debt has fallen by £14.975 billion over the past 18 months. Over the same period the total stock of debt increased by £2.379 billion.

Patterns in net lending by households and in the growth of the stock of household debt reflect, on one hand, the willingness and ability of lenders to supply credit and, on the other hand, the demand by households for credit. On the supply-side, the financial crisis continues to restrict lending by financial institutions. But demand has been affected too because households as well as banks are looking to rebuild their balance sheets. Furthermore, the economic downturn, lower asset prices, including, until of late, lower house prices, as well as a sense of economic uncertainty have all contributed to a more precautionary mind-set amongst households.

This precautionary mind-set has impacted on the housing market. Housing market activity can, at best, be described as ‘thin’. Even though the seasonally-adjusted number of mortgage approvals for house purchase rose by 4.3% in March to 48,901, this is almost half the 94,043 seen on average each month over the past ten years. A further demonstration of the household sector’s precautionary behaviour is the sector using housing as a vehicle for saving. We observed in our blog article Saving through housing: households build firmer foundations that since the second quarter of 2008 additional housing investment (i.e. money spent on moving costs, including stamp duty, the purchase of newly built properties or expenditure on major home improvements) has been greater than net secured lending. This is known as negative housing equity withdrawal (HEW). In other words, the household sector’s stock of secured borrowing has increased by less than we would have expected.

In the 12 months to the end of March, the stock of secured debt rose by only 0.9% compared with an average annual growth rate of 9.8% over the past 10 years. Of course this doesn’t mean that households have simply been using some of their own money to fund housing investment, but that they have also been paying-off some of their existing secured debt. This, coupled with the 4.3% decline in the stock of unsecured debt, demonstrates the extent to which the household sector has been looking to consolidate. It would be something of a surprise if this consolidation was to stop any time soon.

Articles
Weak mortgage lending set to undermine house prices Independent, David Prosser (5/5/10)
Mortgage lending down almost 90% from 2007 peak Guardian, Katie Allen (4/5/10)
Mortgage approvals still sluggish, figures show BBC News (4/5/10)
Mortgage lending stalls this year Telegraph, Harry Wallop (4/5/10)
Lending dip fuels house price fall fears Press Association (4/5/10)

Data
Lending to individuals Bank of England
Monetary and Financial Statistics (Bankstats) Bank of England (See Tables A5.1 to A5.7, in particular)
Housing equity withdrawal (HEW) statistical releases Bank of England

Questions

  1. What do you understand by the term net lending? What would a negative net lending figure indicate?
  2. Illustrate with examples what you understand by secured and unsecured debt.
  3. What factors might explain why the household sector’s net secured lending has been less than the amount of its housing investment (e.g. the household sector’s purchase of new houses or its spending on major refurbishments)? Does this mean that stock of secured lending has been falling?
  4. What factors might explain the recent historically low levels of net unsecured lending?
  5. Does net lending have to be negative for the stock of debt to fall? Explain your answer.
  6. As well as the household sector, which other sectors might need to rebuild their balance sheets? How might such behaviour be expected to impact on the economy?
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The market for gold – a credit crunch-free zone?

Times of economic uncertainty often lead to people seeking what they consider as ‘safe havens’ for their money. Traditionally gold has been one of these safe havens. This financial crisis has been no exception and the price of gold has risen, but there has also been a rapid growth in demand for gold bullion and gold coins and dealers have found themselves besieged by people looking to protect their savings. ATS Bullion, a London gold bullion dealer, has even seen queues: something quite unprecedented for them.

There’s gold in them thar’ shops: the rush is on Guardian (2/10/08)
Austria witnesses new gold rush BBC News Online (12/10/08)
Gold rush as investors pile into bars Financial Times (3/10/08)
Market turmoil sparks gold rush to specialist funds Times Online (13/10/08)

Questions
1. What the main determinants of demand for gold coins and gold bullion?
2. Using diagrams as appropriate, show the changes that have taken place in the market for gold coins in recent months.
3. Discuss the extent to which the supply of gold bullion is likely to keep up with the rapid growth in demand
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