Does infinite growth exist and is sustainable development possible?

Investment rules of pension funds and savings schemes those provide tax shields and encourage chasing assets growth in long term are coincident with the believes of perpetual growth, the concept which is based on sustainable development and assumption that a comfortable retirement is in the interest of all people. However, does infinite growth really exist and is sustainable development possible?

According to the survey of the retirement-income systems in OECD and G20 countries [1], OECD pension fund assets reached USD 16.8 trillion in 2009. The US pension funds’ assets were worth of USD 9.6 trillion in 2009 those represented 57.1% of the total pension funds assets in OECD, the UK pension funds’ assets were worth USD 1.6 trillion, a 9.5% of the total. The other largest pension funds belonged to Japan with estimated assets worth of USD 1 trillion, the Netherlands - USD 1 trillion, Australia - USD 0.8 trillion and Canada - USD 0.8 trillion. The survey disclosed that in 2008 OECD pension funds experienced on average a negative return of 22.5% in real terms, equivalent to USD 3.5 trillion. Losses made in 2008 were recovered by around USD 1.5 trillion during 2009. More information about the investment performance of pension funds and public pension reserve funds in selected OECD countries during the period of 2008-2009 is available in the Picture 1 and Picture 2.

Pension funds' real net investment return in selected OECD countries, 2008-2009 (%)

Picture 1. Pension funds’ real net investment return in selected OECD countries, 2008-2009 (%)[2]

PPRFs’ real net investment return in selected OECD countries, 2008-2009 (%)

1. There are five Swedish National Pension Funds (AP1-AP4 and AP6).
2. 2009 data refer to fiscal year 2010 ending March 31, 2010.
3. AGIRC and ARRCO are unfunded mandatory supplementary plans for white-collar and blue-collar workers respectively, with reserves. More information on these plans can be found in the OECD Private Pensions Outlook 2008.
4. Data refer to June of each year.
5. 2009 data refer to the period January-March 2010.
Source: OECD Global Pension Statistics.

 Picture 2. PPRFs’ real net investment return in selected OECD countries, 2008-2009 (%)[3]

The research also revealed the information about the allocation of pension funds’ and public pension reserve funds’ assets in selected OECD countries in 2009. According to the survey bonds and equities remained the two most important asset classes, accounted for over 80% of total pension funds’ portfolio in nine OECD countries at the end of 2009. The proportions of different asset classes allocated by pension funds in selected OECD countries provided in Picture 3 and Picture 4.

Pension funds' asset allocation for selected investment categories in selected OECD countries, 2009 (As a % of total investment)

Note: The GPS database provides information about investments in mutual funds and the look-through mutual fund investments in cash and deposits, bills and bonds, shares and other. When the look-through was not provided by the countries, estimates were made based on asset allocation data for open-end companies (mutual funds) from the OECD Institutional Investors' database. Therefore, asset allocation data in this Figure include both direct investment in shares, bills and bonds and cash and indirect investment through mutual funds.

1. The "Other" category includes loans, land and buildings, unallocated insurance contracts, private investment funds, other mutual funds (i.e. not invested in cash, bills and bonds or shares) and other investments.
2. Data refer to 2008.
3. The high value for the "Other" category is mainly driven by land and buildings (11%) and other mutual funds (8%).
4. The high value for the "Other" category is mainly driven by outward investments in securities (26%), for which the split between various securities is not available.
5. The high value of the "Other" catoegory is mainly driven by unallocated insurance contracts (22%).
6. The "Shares" category includes all mutual funds' investments, as the split between various securities is not available.
7. The high value for the "Other" category is mainly driven by loans (30%) and other mutual funds (16%).
8. The high value for the "Other" category is mainly driven by private investment funds (46%).
Source: OECD Global Pension Statistics.

Picture 3. Pension funds' asset allocation for selected investment categories in selected OECD countries, 2009[4]

Public pension reserve funds' asset allocation for selected investment categories in selected OECD countries, 2009 (As a % of total investment)

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1. The "Other" category includes structured products, land and buildings, private investment funds, loans, unallocated insurance contracts, and other investments.

2. The high value for the "Other" category is mainly driven by private investment funds (17%).

3. Data refer to June 2009. The high value for the "Other" category is mainly driven by private investment funds (27%).

Source: OECD Global Pension Statistics.

Picture 4. OECD Pensions at a Glance, Retirenment-income Systems in OECD and G20 Countries, 17 March 2011[5]

Analyzing assets allocation portfolios, the survey of investment regulation of pension funds [6] which contains information about quantitative portfolio restrictions applied to pension funds in OECD and selected non-OECD countries as of December 2010, revealed that Belgium, Germany Pensionsfonds, Luxembourg’s savings companies with variable capital (SEPCAVs) and pension savings associations (ASSEPs), Netherlands had the most flexible rules to select assets for the investment portfolio. Countries mentioned above do not have portfolio limits on pension funds in equity, real estate, bonds, retail investment funds, private investment funds, loans or bank deposits and only some restrictions are applied in Australia, Canada, Ireland, United Kingdom and United States.

Even though everyone has got the same objectives to preserve savings and grow portfolio of assets, the assets allocated in pension funds and returns during the period of 2008 - 2009 are a clear illustration how much savings for the future comfort depend on the market conditions. If returns from liability matching assets, id est bonds, credit, swaps and cash collaterals are below the inflation rates and gains are equally expected as losses from the investment in equities and high yield debts those value related to the markets state, and furthermore, if perfect diversification is equal to zero, how effective is management of savings and how practical pension funds’ reliance on markets’ growth?

The answer regarding the growth of closed financial systems may be the following – the growth of the system is possible as much as it could be inflated until it burst, as long as we keep on persuading that the financial system with a constant amount of money is the system without limits.

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[1] OECD Pensions at a Glance, Retirenment-income Systems in OECD and G20 Countries, 17 March 2011

http://www.oecd-ilibrary.org/finance-and-investment/pensions-at-a-glance-2011_pension_glance-2011-en

[2] OECD Pensions at a Glance, Retirenment-income Systems in OECD and G20 Countries, 17 March 2011

http://dx.doi.org/10.1787/888932371234

[3] OECD Pensions at a Glance, Retirenment-income Systems in OECD and G20 Countries, 17 March 2011

http://dx.doi.org/10.1787/888932371234

[4] OECD Pensions at a Glance, Retirenment-income Systems in OECD and G20 Countries, 17 March 2011 http://dx.doi.org/10.1787/888932371215

[5] OECD Pensions at a Glance, Retirenment-income Systems in OECD and G20 Countries, 17 March 2011 http://dx.doi.org/10.1787/888932371215

[6] OECD Survey of Investment Regulation of Pension Funds, June 2011

www.oecd.org/dataoecd/9/1/48094890.pdf

The ECB’s conducted LTRO – could favourable borrowing conditions clean financial system?

The second European Central Bank’s tender, announced on 28 February 2012, attracted 800 participants. €530 billion will be allotted to banks according to the ECB’s policy to support bank lending and liquidity in the euro area money market. A 1% fixed rate will be applied for the conducted longer term refinancing operations with a maturity of 36 months and the option of early repayment after one year. Favourable borrowing conditions enabled banks to access cheap money; however, will the opportunity be turned to their advantage?

Mario Draghi, a President of the ECB was interviewed with The Wall Street Journal on 22 February 2012. He explained that before the first ECB’s LTRO tender, conducted in December, bank lending survey was exercised. The results revealed a credit tightening with worse circumstances in the southern regions. A 3-year LTRO allotment reached €490 billion in December; however, banks returned €280 billion shorter term credits to the ECB before the LTRO. According to the ECB’s President the net injection was only about €210 billion which most likely will cover the bank’s bonds coming due in the first quarter.

So, could long term refinancing operations relieve market tensions and clean financial system? A lot depends on mutually beneficial solutions. Banks have got an opportunity to borrow from the ECB for a 3-year period at fixed 1% interest rate, so they may repurchase outstanding debts with higher rates and reduce interest expenses. Moreover, in pursuance of higher profitability banks may have intentions to buy sovereign bonds with higher yields. Consequently, banks may expect higher interest incomes as well as increased demand to purchase sovereign bonds could reduce their yields. However, ongoing structural reforms in euro area will take time and high risk of uncertainty still remains.

According to the European Banking Authority’s press release published on 8 December 2011, the EBA recommended to strengthen banks capital positions by building up an exceptional and temporary capital buffer against sovereign debt exposures to reflect market prices as at the end of September. Moreover, banks will have to reach a 9% of the Core Tier 1 capital ratio by the end of June 2012. The reported identified capital shortfall amounted €114.7 billion.

So, will stability targets be entrenched successfully beside profitability goals?

What could be expected from reduced Chinese banks’ reserve requirements?

Liquidity shortage in China will be reduced by cutting banks’ reserve requirements. Authority’s decision announced in November, 2011 will come into effect on Friday, February 24, Reuters reported on February 20. The same day Bloomberg noticed that the proportion of cash Chinese banks must set aside will drop half a percentage point and more capital will be available for loans. This announcement was made by the central bank on its website on the 18th of February. The amount of additional capital, according to Australia & New Zealand Banking Group’s estimation, may reach 400 billion yuan ($64 billion). Economy stimulation policies define further stakeholders’ actions, so what could be expected?


According to the Statistical Communiqué of the People's Republic of China on the 2011 National Economic and Social Development published by National Bureau of Statistics of China on February 22, 2012 [1], the completed investment in fixed assets (excluding rural households) of the country in 2011 was 30,193.3 billion yuan, up by 23.8 percent over the previous year. Detailed information about fixed assets investment and its growth by sector is available in table 1. [1]

The actually utilized foreign capital increased by 9.7 percent and amounted 116.0 billion US dollars in 2011. The value of direct investment in non-financial sectors and the growth rates in 2011 is provided in table 2.[1] 

The other important aspect is China’s international trade. According to the statistical data imports comprised 1.743,5 billion yuan, exports amounted 1.898,6  billion yuan. The main trade regions and growth rates in 2011 are provided in table 3.[1] 

More information about the main export and import commodities is available in the table 4 and table 5[1] 

 

So, it is likely that the message about the reduced Chinese banks’ reserve requirements will stimulate trade; however, the additionally released capital of 400 billion yuan ($64 billion) comprises only 1.3 percentage of total investment in fixed assets made in 2011. Additionally, according to the above information, China’s trade surplus  amounts 155,1 billion yuan in 2011 and presents 0.5 percentage of total investment in fixed assets. Moreover, isn’t the shortage of liquidity a sign of financial risk?

[1] Statistical Communiqué of the People's Republic of China on the 2011 National Economic and Social Development, National Bureau of Statistics of China, February 22, 2012, http://www.stats.gov.cn/english/newsandcomingevents/t20120222_402786587.htm



How much does oil cost?

Financial crisis, recession, deterioration of assets... Alongside that, an assumption regarding Iran’s pursued nuclear programme and evoked protest. Geopolitical sanctions against Iran involve oil embargo which may disturb oil supply and push higher crude oil prices. So, could we add the energy crisis beside the issues that burden recovery?

In general, market prices of crude oil are forecasted by the consumption demand of oil and the capacity to supply oil that meets the economy growth. However, I would rather start from the available world oil reserves. According to the Annual Statistic Bulletin (2010/2011 edition) of the Organization of the Petroleum Exporting Countries, OPEC share of proven world crude oil reserves comprised 1193 bn. barrels id. est. 81.33% of total proven crude oil reserves and Non-OPEC countries possessed 274 bn. barrels of crude oil reserves that amounted 18.67% of total proven crude oil reserves. Statistical data represented at the OPEC website shows that Iran is the third largest oil reserves country in the world with the 151.17 bn. barrels of proven crude oil. Hence, the rest of the world strongly depends on oil produced by the OPEC unless we compare proven oil reserves versus recoverable and unconventional world oil reserves.

According to the U.S. Geological Survey World Petroleum Assessment 2000 which was cited in 2003 by Bill Kovarik, Ph.D formerly a journalist and editor of publications such as Energy Resources and Technology and Latin American Energy Report (Professor of Communication at Radford University, Virginia Tech and the University of Western Ontario), identified total world reserves comprised 1103.2 bn barrels and recoverable reserves presented additionally 2272.5 bn barrels. The more accurate pictures of proven versus recoverable an unconventional world oil reserve are available below.



Picture 1. Proven oil reserves [1]



Picture 2. Additional Figures from the US Geological Survey those represent recoverable and unconventional oil reserves. [2]

Even though it is difficult to estimate the conventional oil reserves they are proven as following. Petroleum engineers estimate the costs of drilling and connecting new wells into a reservoir as well as calculate operating expenses per well and cost per barrel extracted. The initial daily output of oil declines and the cost of extraction rises. When the costs become equal to the market value of output, production reaches its “economic limit” and extraction stops. The estimated aggregated output of the new wells over time is known as the “proved reserves added” or “reserves booked”.

However, beside conventional reserves, petroleum may be refined from Heavy Oil reserves, Tar Sands or Oil Shale. Consequently, dependence on oil supply from the Middle East may be reduced. Moreover, the head of the world's largest oil company, Saudi Aramco, in 2006 acknowledged:

“We are looking at more than four and a half trillion barrels of potentially recoverable oil. That number translates into 140 years of oil at current rates of consumption, or to put it another way, the world has only consumed about 18 percent of its conventional oil potential. That fact alone should discredit the argument that peak oil is imminent and put our minds at ease concerning future petrol supplies.”
 
Considering the cost of oil production which was obtained from traders and industry analysts and published by Reuters in July 28, 2009, Saudi Arabian crude oil is cheapest because of its location near the surface and the size of fields, which allow economies of scale. The operating cost (excluding capital expenditures) of extracting a barrel was estimated around $1-2 and the total cost including capital expenditures comprised $4-6 per barrel. Similar total costs of oil extraction are estimated in Iraq and United Arab Emirates. Oil Extraction from mature and deep water offshore fields is more expensive. It was estimated that production in ultra-deep water fields in Nigeria reached $30 a barrel compared with onshore costs of around $15. The other comparison by the region: operating and capital costs in Algeria, Iran, Libya, Oman and Qatar were estimated around $10-15 per barrel, in Kazakhstan around $10-18, in Venezuela, where fields tend to be mature and small, costs reached $20-30, in the mature British North Sea, where the remaining oil is difficult to access, the costs could be around $30-50.

According the International Energy Agency World Energy Outlook 2008 the statistical data of estimated production costs were the following:

So, if estimated recoverable and unconventional world oil reserves are twice as large as proven oil reserves and if it is possible to extract oil under the $60 per barrel how much consumer should pay for the crude oil? According to the World Oil Outlook 2011, prepared by the OPEC, it is assumed that prices will stay in the range of $85-95 per barrel for the next decade and will reach $133 per barrel by 2035. Different world events may significantly affect the crude oil prices as it is showed in the picture 3. However, high oil price volatility also depends on the futures speculation.




Picture 3. World Events and Crude Oil Prices 2007 - May 20, 2011Recessions and Oil Prices [4]

Notes:
[1] Peak Oil is wrong. THE OIL RESERVE FALLACY Proven reserves are not a measure of future supply By Bill Koyarik http://www.radford.edu/~wkovarik/oil/


[2] Peak Oil is wrong. THE OIL RESERVE FALLACY Proven reserves are not a measure of future supply By Bill Koyarik http://www.radford.edu/~wkovarik/oil/

[3] "The Impact of Upstream Technological Advances on Future Oil Supply" - Mr. Abdallah S. Jum'ah, President & Chief Executive Officer, Saudi Aramco, address to OPEC, Vienna, Austria, Sept. 13, 2006

[4] Oil Price History and Analysis  http://www.wtrg.com/prices.htm

How far unsolved repayment of Greece's debt lead? Straight to the abyss

A joint EU’s and IMF’s financial support similarly imposed even higher burden to Greece. A €110 billion EU/IMF bail-out package approved in May, 2010 followed by the Eurozone’s €12 billion bail-out package in June, 2011 and extra €109 billion support in July, 2011 were agreed in exchange of accepted severe austerity measures those involved spending cuts, tax increases and privatization of public assets. Passed proposed measures without taking a recovery plan into consideration shrank Greece's economy into deeper recession.


According to the remarks mentioned at the IMF’s conference called on Greece in December 13, 2011, the representatives of the mission revised the Greece’s GDP growth down to -6% in 2011, and -3% in 2012. So, could anything worse be expected than deteriorated Greece's economy and increased Greek default probability?

Credit Default Swaps were invented by Wall Street as credit insurance to reduce risks and facilitate issuance of debt securities. However, it may appear that banks, investment banks or hedge funds those issued the Greek Treasury CDS do not have enough collateral to compensate the insured for his loss if Greece default on its debt. If the above is possible then a voluntary private sector involvement in 50% nominal haircut proposed in October 2011 may also be treated as an agreement designed to avoid the collapse of insurers. It is expected that voluntary accepted write-down of Greek debt will not trigger CDS compensation and at the same time will reduce the Greece's sovereign debt by €100 billion. An extra €100 billion support to Greece could reduce its debt to 120 % of GDP till 2020.

However, the success of such agreement which is aimed to minimize losses depends on the proportion of Greek bonds holdings and issued CDS. According to the information published at the New York Times in January 10, 2012, it was estimated that a few months ago about €200 billion of Greek bonds were held at large European banks. But as talks have dragged on, many big holders in France and Germany sold their holdings to London Hedge Funds and other independent investors. Hence, a voluntary private sector agreement to accept a 50% haircut may be harder to achieve if an entity which possess Greek bonds is not an issuer of the CDS.
On the other hand, if an agreement of a voluntary 50% haircut is available then what a purpose and a future of the credit default swaps? According to the BIS quarterly review issued in December, 2011, a notional amount of outstanding credit default swaps was $32.4 trillion in June, 2011 with a gross market value of $1.35 trillion.

What bilateral agreements do markets accept?

Germany sold 4.06 billion euros of the bonds on the 4th of January with the average yield of 1.93% on 10 year government bonds. France sold 7.9 billion euros of bonds on the 5th of January with the average yield of 3.29% on 10 year government bonds. It is supposed that Italy’s and Spain’s borrowing in the markets this week could be facilitated as well due to the ECB’s injected liquidity through 3-year refinancing operation worth of 500 billion euros and expectations that the ECB’s Governing Council will cut interest rates on the January 12 meeting. However, despite the European sovereign debt crisis and broken markets’ confidence, China, Japan and South Korea move forward to closer financial cooperation.


After the Asian financial crisis in 1997-98, the leaders of East Asian Countries agreed to promote the Chiang Mai Initiative (CMI) which aimed to create a network of bilateral swap arrangements (BSAs) among ASEAN+3 countries to tackle short-term liquidity issues and to supplement the existing international financial arrangements.

Under the above mentioned initiative, the $120 billion crisis fund was established. In 2001 Finance ministers of ASEAN+3 agreed to exchange data on capital flows bilaterally on a voluntary basis in order the effective policy dialogue was facilitated and in 2005 Finance ministers agreed to enhance the effectiveness of the CMI by (1) integrating and enhancing the ASEAN+3 economic surveillance into the CMI framework, (2) clearly defining the swap activation process and the adoption of a collective decision-making mechanism, (3) significantly increasing the size of swaps, and (4) improving the drawdown mechanism. Moreover, developed bond markets under the same initiative reduced the dependence on short-term foreign currency-denominated financing and helped to mitigate the vulnerability caused by the currency and maturity mismatches aroused due to the volatile short term capital movements.

Japanese Prime Minister Yoshihiko Noda visited the Chinese Premier Wen Jiobao on the 25th of December in 2011 and discussed a bilateral package of financial agreements. According to the Bloomberg, Japanese government-backed entity will sell yuan-denominated bonds in China to deepen China’s domestic capital markets and other measures will be applied to facilitate the trade among Chinese and Japanese companies in their domestic currencies. These actions should reduce trade costs as measures are designed to eliminate the usage of the US dollars in exchange of currencies. Moreover, those agreements will ease the entrenchment of the Chinese yuan as a reserve currency.

However, China’s one-way determined exchange rate’s policy puzzles the most. If Japan, South Korea, US, European and other trade partners decide to set the domestic currencies and China’s yuan exchange rates then who will be right.

Security’s Beta – an indicator of systematic risk

Assessment of creditworthiness of financial institutions or financial instruments is one of the supervision measures. Standard & Poor downgraded the long-term credit rates for major financial institutions including Bank of America, Goldman Sachs, Barclays and HSBC on 30 November. On16 December, Fitch reported the rating cuts for seven largest banks: Bank of America, Goldman Sachs, BNP Paribas, Barclays, Deutsche Bank and Credit Suisse and Citigroup. Even though the downgrades reflect the assessment of the enhanced rating methodologies those involve systematic risk analyses based on macro indicators, industry and regulatory environment, will the valuation reinforce the discipline of the financial performance and reduce systematic risks?

According to the Rating Methodologies for Banks prepared by the Frank Packer and Nikola Tarashev and published in BIS Quarterly Review, June 2011, the assessed tolerance of complex financial instruments, evaluated trends of credit growth and the increase of asset prices as well as greater focus on high quality capital would have provided an important information about the stability of entity during the pre-crisis period. As the intermediation role of banking sector is significant and financial stability is essential for economy’s development, public authorities commit to support banks by additional capital injections, asset purchases or liquidity provisions. Consequently, rating agencies use “stand alone” and “all in” ratings those reflect the financial strength of the institution without the support and with the sovereign and international institutions interventions.

Capital strengthening through the retained earnings is one of the most efficient ways to enhance the resilience of financial institutions during financial shocks. However, financial institutions commit to dividend payments as long as retained earnings are essential to attract investors.

The Goldman Sachs Group, paid dividends on all series of preferred stock on the 10th of November for the following series of its non-cumulative preferred stocks: $239.58per share of Floating Rate Non-Cumulative Preferred Stock, Series A; $387.50 per share of 6.20% Non-Cumulative Preferred Stock, Series B; $255.56per share of Floating Rate Non-Cumulative Preferred Stock, Series C; and $255.56per share of Floating Rate Non-Cumulative Preferred Stock, Series D.

Barclays paid 1p per ordinary share and 4p for America Depository Security which represents 4 shares on 9 December 2011.

Bank of America Corporation announced about regular quarterly dividend of $18.125 per share on the 7.25 percent Non-Cumulative Perpetual Convertible Preferred Stock, Series L.

HSBC declared that the third interim dividend of $0.09 per ordinary share will be paid on 18 January, 2012, the dividend of $0.45 per American Depositary Share, which represents five ordinary shares will be paid on 18 January 2012, the dividend of $0.3875 per Series A American Depositary Share was paid on 15 december, 2011.

The Board of Directors of Credit Suisse most likely will suggest dividends for financial year 2011 with the results of the fourth quarter of 2011 on February 9, 2012.

Moreover, majority of banks were downgraded because of the challenges in the financial sector, id. est. systematic risks those affect financial stability. Security’s Beta describes the sensitivity of its return to the systematic risk, the average change in the return for each 1% change in the return of market portfolio. Deutsche Bank’s Beta is 2.20, Beta of Bank of America is 2.19. So, those banks are more vulnerable that HSBC, Credit Suisse and Goldman Sachs. Beta of HSBC presents 1.19, Beta of Credit Suisse amounts 1.38 and Beta of Goldman Sachs is 1.39.

Consequently, securities’ Beta should be involved in the assessments of systematic risks and factors those reduce securities sensitivity to the portfolio fluctuations could be explored further.