World Finance speaks with US Chamber Center for Capital Markets Competitiveness Vice President Tom Quaadman
Year: 2015
Everyone likes negative interest rates now
“Whatever it takes”, said ECB President Mario Draghi, in answer to a question on how far he’d be prepared to go in order to save the euro. This was in 2013, before the ECB unleashed a €60bn-a-month bond-buying programme (see Fig. 1) and before the bank began to court with the once-radical idea of negative interest rates. Beginning at -0.1 percent in June 2014, the prospect of charging banks to deposit money in certain accounts is one thing many thought unworkable. That was until the ECB, alongside a fair few other central banks on the continent, stepped in to prove otherwise.
The policy stance meant that, rather than receiving interest on their deposits, customers would pay a percentage to their banks for keeping hold of their cash: such is the topsy-turvy world of negative interest rates. However, the tool remains a niche one, and we’re yet to see a world in which we all stash cash in our mattresses and seek $100 bills, for fear of the storage space required for lesser denominations.
A failed system
The unconventionality of the policy is seen by the narrowness of its use in history. Only a few banks have been known to employ it, invariably in extreme circumstances and predominantly in Europe. Resorting to negative interest rates is a sign conventional policy has failed to yield much in the way of growth or investment – and the circumstances in which the policy has been enacted in years passed show just that.
The Sveriges Riksbank in Sweden slashed its deposit rate to -0.25 percent at the height of the crisis in 2009, only to reverse the decision after no immediate benefits were detected, whereas the Bank of New York imposed a negative rate on deposits over $50m around about the same time. Silvio Gesell supported the idea of negative nominal interest rates in the late 19th century, but the issue was little talked about until Japan’s deflationary trappings towards the latter stages of the 20th century prompted scholars to re-examine his findings.
The eurozone is suffering from record levels of unemployment and at the same time is struggling to fend off deflation
Interest in the policy has since turned from academic to practical, as the financial crisis and the ensuing low to zero interest rate climate has led some in Europe to reconsider the merits of negative territory. The eurozone is suffering from record levels of unemployment and, at the same time, is struggling to fend off deflation, while negative rates could conceivably move money out of reserves and into the real economy where it’s needed most.
Switzerland kicked off the trend in mid-2012 when it lowered its certificates of deposit rate to -0.2 percent to more closely mirror the ECB and prevent the currency from further strengthening against the euro. Next up was the Swiss National Bank, which, in December, imposed its first negative deposit rate since the 1970s in a bid to temper the brakes on the waves of cash flooding in from Russia, and keep to a minimum CHF1.20 per euro exchange rate.
Later came Sweden’s Riksbank, which slashed its main repo rate to 0.1 percent in February and introduced a QE programme to coincide with the ECB’s, both in order to head off deflation and keep to a two percent inflation target. The measures, taken alongside a more-than-five-year stint of unconventional policy decisions, feed into a wider discussion about the role of negative rates and similarly radical steps in charging growth.
Mythical no more
Negative interest rates are implemented on various grounds, though the reasons-for generally centres on one of two key factors: discouraging certain investments or boosting lending. The theory holds that keeping interest rates below zero should serve to limit borrowing costs and incentivise banks to lend money more freely to both individuals and businesses.
As it stands, the tool is used only in exceptional circumstances. However, with the threat of deflation looming large over the eurozone, the population could conceivably see a time in the not-too-distant future where negative rates are commonplace. If consumer prices continue to fall – as indeed they look likely to do so – negative rates might soon prove popular among struggling European nations for whom deflation is an issue and respite hard to come by.
Still, reverting to negative rates is not as simple as it appears , and doing so asks that policy makers radically rethink our relationship with cash – not to mention the school of thought on which many of our economic systems are based. The ‘zero bound’ thesis stipulates interest rates cannot fall into negative territory, yet the aforementioned examples prove the limit can be, and has been, broken on numerous occasions. Where the prospect of zero rates was unthinkable only a few years ago, the journey into negative territory signals perhaps the next logical step in the process. While still very much a radical policy choice, the adoption of negative rates – by some estimates – proves we’ve entered into a new era wherein the zero bound thesis no longer applies and unconventional policy tools are fast becoming the norm.
The proliferation of the policy, meanwhile, does not necessarily qualify the measure as an effective policy tool; for every proponent of the system there is another whose criticisms cast fresh doubts over it.
Tested and unproven
The main criticism of negative rates is that, by punishing depositors, the system could prompt savers to keep hold of their cash, in turn stifling the banking system and, in extreme circumstances, threatening a depression. There is a case to be made for charging interest on high-net-worth accounts, but this could risk a collapse if and when the rates were reeled back into positive territory. Assuming the tool is only temporary, it’s clear negative rates can bring only limited benefits and in a short time frame, yet there are some proponents who insist it could be used, not as a short-term fix, but as a sustainable solution.
However, the policy is still a significant departure from what has come before inasmuch as charging a percentage on any deposits asks that customers attach a certain financial value to this specific service. And in a period so soon after a financial crisis, consumers are yet to reach a point where their trust is sufficient to accept negative interest rates.
Essentially, the policy has grown in popularity because of the excess liquidity banks have injected into the system. The only reason negative rates are even possible is that the attractiveness of assets has deteriorated to such an extent that the returns often dip into – or at least border on – negative territory. It would appear negative rates apart from central bank policy are fast becoming more common.
American economist and professor at NYU’s Stern School of Business Nouriel Roubini asserts that, in nominal terms, some $3trn of assets in Europe and Japan have negative rates attached to them. What’s more, an estimated 16 percent of the world’s government bonds come equipped with negative yields, so the policy stance might not be as radical as first thought.
As it stands, everyday savers are largely exempt from paying interest on their deposits, and the rate applies rather to big-ticket names such as investment funds and banks. Yet as central banks continue to embrace the once-unthinkable policy stance that is negative rates, the ‘sustainable’ solution, as was said by Goldman Sachs President Gary Cohn, could prove to be a game changer for central banks, for whom inflationary monetary policy has been the preferred option in recent years.
The circumstances that have forced central banks into introducing negative rates, however, are less than desirable, and no doubt a healthier financial climate would mean such a policy stance would not hold the same appeal. Negative rates might be the key to growth in the short term, but any party citing the policy as a sustainable solution to Europe’s many and varied shortcomings is misguided. By most accounts, a return to stability will mark a return to conventional economic policy, and negative rates would likely fall out of favour as a result.
The shipping industry turns to alternative finance
The global shipping industry is a capital-intensive business. All industry participants need capex financing as well as available credit lines to handle the large scale, daily, cash flows, which are a part of the growing concern – in the same way as investments in the future of any company are.
Traditionally, the shipping industry has relied heavily on bank financing, as limited alternatives were available or were unattractive. And so the introduction of multiple alternative financing options in the wake of the global economic crisis came in handy to those who needed it and had found nowhere else to go. The limited strings attached to bank financing make it a favourite, but the significant changes to the market conditions in many parts of the shipping industry forged new partnerships between financially interested parties and experienced shipping people.
Alternative financing has not just provided a new source of financing; we have also seen contraction among the alternatives
As the industry is currently awash with ships, earnings are depressed and that is putting pressure on loan terms. Loan-to-value covenants, as well as required cash reserves and minimum equity restrictions, are among the most widely used measurements of credit quality by lenders. This goes for traditional banks, shipping banks and alternative financing providers.
Challenges to overcome
There are multiple challenges on both sides. From the banking side, the financial crisis has brought some bad loans into the portfolio for all, as well as increased regulation. Basel III is the most prolific example of the latter. In non-professional terms, this means credit given to shipping interests is likely to become more expensive, as industries categorised as ‘high risk’ force the banks to put more money aside in reserves for each dollar they lend out. This is likely to see interest for alternative shipping finance options increase.
So far, a lot of talk has surrounded the alternative financing options given to the shipping industry, but on a larger scale, we have seen little action. Despite all the talk, the financing need of the industry has not diminished in recent years. Right after the outbreak of the economic and financial crisis in the West, a huge order book needed finance. The air was thick with uncertainty and wishful thinking: would the lack of financing cut the order book significantly down, now that money was not easy to come by and shipping demand had apparently evaporated? No, was the unfortunate answer to that question.
Who stepped in to bridge the gap then? Banks did to a large extent, but not the traditional European ones, as they were too busy dealing with existing loans (see Fig. 1). Among the new entrants into ship financing were the policy banks of China and the Export Credit Agencies in other Asian shipbuilding nations, lending support to their domestic industry, and subsequently to the global shipping industry.
Opportunistic investments
Private equity (PE) also chipped into the pot with some opportunistic investments among the small- and medium-sized enterprises, whereas some of the medium- and large-sized enterprises went to the bond market to stay clear of both banks and PE.
We have also seen shipping funds move into closer partnerships with traditional shipping companies in deals that look like financial leasing.
Alternative financing has not just provided a new source of financing; we have also seen contraction among the alternatives. The most prominent is the German KG market. Once a very successful way of providing financing primarily for containerships, today it is a tap that has run dry.
The challenges on the shipping side, in combination with those on the banking side, may see more deals actually done with the support of alternative sources in the near future. Why would that be? Because the industry for one has become more familiar with the concept; earnings are still sluggish, which in turn limits the cash flow generating ability of the industry; and high-performance management is top of the agenda, making company accounts better suited to attracting alternative financing.
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Come back later for a full transcript of this video.
An education in finance will help avoid future economic failures
Given the state of the UK economy, having the necessary knowledge to make the right financial decisions is more important than ever. But sadly, more often than not, people lack the knowhow to avoid making mistakes with their money – something that has the potential to tangle them up with a whole lot of debt and an even bigger headache. This is particularly true for young people, who after many years at home will eventually venture off to universities, where they will be left in sole control of their finances for the first time.
Once there, the temptation to overspend will inevitably kick in, and so too will the phone calls home asking for a bailout. But once the bank of mum and dad finally closes, that is when the real problems begin. Strapped-for-cash students tend to dive deep into their overdrafts. Sales teams on campuses tempt financially naïve youngsters with the allure of a nought percent student credit card, and then, when they leave to make their mark in the big wide world, many may make the mother of all debt-inducing decisions: turning to payday loan websites to cover their outgoings. In fact, in the UK, people under the age of 25 are twice as likely to turn to companies such as Wonga than they are to talk to their bank manager or even credit card provider, according to data released by the Citizens Advice Bureau late last year.
Generation Credit
“Generation Y is fast becoming Generation Credit”, says Citizens Advice Chief Executive, Gillian Guy. “The housing and money pressures on young adults are significant and… it is a big concern that so many young adults are turning to some of the most expensive types of loan to get by. Often, [these] high-interest loans end up spiralling out of control and many people in debt end up feeling they have nowhere else to turn other than a vicious circle of more borrowing.”
More than
50%
of BRITISH children aged between
10 & 17
see advertising for loans often
Source: Young Enterprise
Clients aged between 17 and 24 make up 10 percent of Citizens Advice’s serious debt cases, but the charity says they make up more than 15 percent of the cases where debt has been caused by taking out a high-cost loan, with payday loans accounting for 62 percent of the high-interest credit taken out by under-25s.
For so many young people to fall foul of such elementary errors is evidence that many simply do not have a basic understanding of how to manage their money, or even where to turn when they find themselves in their own financial crises. In order to combat this problem, Young Enterprise and the Personal Finance Education Group successfully campaigned for personal financial education to become compulsory throughout secondary schools across England. And, as a result of their combined efforts, since September 2014 financial education has been part of the national curriculum within the statutory subjects of mathematics and citizenship.
The new curriculum covers aspects of personal finance including the importance and practice of budgeting, income and expenditure, credit and debt, insurance, savings and pensions, and even how public money is raised and spent. On top of this, there is an expectation that appropriate financial contexts be provided in mathematical learning, with the intention of providing a foundation in financial education. While this represents a huge first step in helping young people become better managers of their money, as well as setting an example for other education systems around the world, according to Michael Mercieca, the Chief Executive of Young Enterprise, there is still plenty more to be do.
“This has been an important leap forward and reflects the commitment, support and hard work of many people and organisations that have helped make this a reality”, said Mercieca. “While there is now a mandate for schools to teach about money, it will not in itself be the driver. There is a need to provide schools and teachers with the guidance, advice, support and resources that they need to make financial education a reality in the classroom. We still need compulsory financial education in all primary schools, and this is something that we have committed to working towards within our 2015 manifesto.”
Some payday lenders in the UK have an annual interest of
4,000%
The cost of UK student accommodation has doubled in
10 years
with 21+ students taking out high-risk debt at
6%
Source: National Union of Students
Child’s play
Starting personal finance education at such an early age may seem a little severe to some, but a study published by the Money Advice Service claims parents and caregivers possess the power to shape the money habits of their children. Behaviours they adopt in childhood will affect financial decisions they make in their adult lives.
Authored by behaviour experts at Cambridge University, the report reveals how, by the age of seven, most children have learned to recognise the value of money and count it out; by this age they will also have come to understand that money can be used to buy goods, as well as concepts such as what it means to earn money and even understand what an income is. The study also states that seven-year-olds are capable of complex functions such as planning ahead, delaying a decision until later and understanding that choices are irreversible.
“In today’s world there are many pressures on young children and their families which make financial education increasingly important”, says the co-author of the study, Dr David Whitebread of Cambridge University. “The ‘habits of mind’, which influence the ways children approach complex problems and decisions, including financial ones, are largely determined in the first few years of life.
“By contrast, early experiences provided by parents, caregivers and teachers which support children in learning how to plan ahead, in being reflective in their thinking and in being able to regulate their emotions can make a huge difference in promoting beneficial financial behaviour.”
Taking financial education home
Another indirect benefit of promoting financial education in primary schools is the fact that what kids learn in the classroom can be taken back into the home. It has the potential to impact the way parents and other family members think about their own financial decisions, creating a positive feedback loop.
Commenting on the publication of the study, Caroline Rookes, CEO of the Money Advice Service, said: “This study really demonstrates the power of parental influences, and illustrates how much of what you learn and absorb when you are young, both consciously and subconsciously, affects the choices you make throughout the rest of your life. Over the next few months, we will be working closely with experts in education and the financial services industry to bring together a forum, and develop world-class parenting and teaching resources.
“But these steps alone are not enough – even more can be done to shape the money habits of young children, by including money education in the primary school curriculum in England.”
By fostering these types of skills and educating children and young people in this manner, the hope is that, in the long term, a new generation of young people can grow to become better, more responsible borrowers, more effective savers, and to make better informed financial decisions throughout their adult lives.
“Many young people have unrealistic expectations of the value of money and, as such, can set themselves unrealistic plans”, says Mercieca. “Financial education provides the knowledge, skills and attitudes to set achievable aspirations, as well as the means of getting there.”
Private pension system key to Peru’s future prosperity
With its private pensions system, unique credentials and rapid economic growth, Peru has been drawing in pension fund managers from across the globe as they look to capitalise on the country’s substantial potential. Nevertheless, that potential is currently being held back, with a large portion of the workforce operating informally – and thereby outside of the current pension system.
Renzo Ricci Cocchella, CEO of leading pension fund manager Prima AFP, believes the key to tapping into that potential lies in scrapping other systems to bring everyone under the private pensions system, and providing incentives to get more workers to contribute to it. Fresh from the company winning the World Finance Best Pension Fund, Peru award for 2015 (the fifth time the company has won the award), we spoke to him about what other steps should be taken to improve the system, what impact the reforms in 2012 have had in Peru, and how the country’s sector compares with that of the wider Latin American region.
What is it about Peru’s current situation that makes it attractive for pension fund managers?
Peru’s potential GDP is higher than that of other surrounding countries and our companies’ fundamentals are good. That’s drawing in new employees, in turn increasing the number of those under the pension system. Given that three quarters of the population aren’t currently part of it, the potential market is huge.
Peru’s potential GDP is higher than that of other surrounding countries and our companies’ fundamentals are good
The private pension system (SPP) has matured and is now in a position to invest in new asset classes such as alternative funds, offering attractive yields and less volatility. This is enabling pension fund administrators to increase the profitability of funds and so maximise pension payouts.
How does Peru’s private pension system compare with others in neighbouring regions?
The pension systems in Chile, Colombia and Mexico are similar to ours in that they all have individual capitalisation systems. Like Peru, all three have a number of AFP [Administradoras de Fondos de Pensión] players in the market and manage distinct types of funds with different levels of profitability and risk. The biggest differences are that Chile and Mexico don’t offer any systems outside of the private pension one, and that Colombia, unlike Peru, requires companies to make unemployment contributions to the AFPs, in Peru the unemployment contributions are administrated by banks.
In what ways has the pension system changed in recent years?
In 2012, the Peruvian State reformed the private pension system in four key ways. Given that most of the population isn’t currently covered by the system, the state ruled that all independent workers under the age of 40 would be obliged to contribute from August 2014 – a regulation which was then repealed last September.
It also focused on increasing competition, establishing a tender to encourage new entries to the AFP. The AFP that offered the lowest commission scheme won the exclusive right to affiliate all new workers to the private pension system for two years. I believe, however, that an open and free market is preferable; we’d reach more workers if all AFPs were able to affiliate them. Efficiency is also being improved, by centralising five common processes that are common to all AFPs.
Meanwhile under investment reforms, improving transparency has been a key focus; companies are now required to publish all investment portfolio results on a monthly basis. AFPs are also being made more dynamic, the eligibility of each investment instrument before allowing it to be included in a portfolio was applied to the AFP instead of the regulating entity. Most importantly, the reform has increased investment flexibility. In this context, alternative investments now constitute a new class of assets with significantly higher investment limits than before. Rules surrounding the use of derivative instruments have also been made more flexible, with parameters now encompassing relative risks, proxy hedges and unleveraged directional positions. Other changes have also been made to increase self-regulation.
What further changes should be made?
I believe there are three key changes to make. The first of those is increasing coverage, by obliging independent workers currently not saving for their retirement to start contributing to the private pension system. The state needs to educate the population and explore the possibility of providing tax incentives or other mechanisms to make this proposal more attractive.
The second focus should be on increasing replacement rates (that is, the ratio of the pension at the time of retirement divided by their recent average salary). Although this rate is increasing, efforts need to be made to ensure this ratio follows an upward trend to eventually reach 70 percent of the average salary. In order to do that, no cuts should be made to the salary percentage that workers are required to pay into pension funds. Members of the system currently contribute 10 percent of their monthly salary to their AFPs, but in the past this was cut to eight percent for political reasons.
My third recommendation is evaluating the possibility of having only one pension system: the public pension system (where affiliates contribute to a common fund) is underfunded, pensioner payouts from this system come from fiscal revenue. This amount will continue to increase over time, as Peru has a large base of young people (see Fig. 1). Sustaining the pension system will become more difficult as the population ages in the future, however. I believe a sustainable solution for future governments lies in using the private pension system alone, where members can build their funds with contributions and yields obtained by their AFPs.
What opportunities does this bring?
The changes would mean more Peruvians covered by a pension upon retirement; a bigger AFP base, which will spread out costs; increased trust in the private pension system; and healthier fiscal accounts, which will help ensure that all contributors receive a minimum pension.
What major challenges remain for those working in Peru’s private pension sector?
Other than the need to expand the pension systems’ coverage through policies, incentives and benefits that appeal to employees, people need to be educated about it. Over the past 22 years the private pension system has not communicated its benefits effectively, and we need to be more creative and proactive to build trust and satisfaction among our client base.
How has Prima AFP adapted to economic, financial and regulatory changes?
Through more flexible regulation, several changes have taken place. Foreign investments now account for over 40 percent of our total assets and should in the future reach 50 percent – compared to just 10 percent less than a decade ago. Mining investments, which used to account for a large portion of returns, now account for less than three percent of our total assets. Alternative investments were virtually inexistent a few years ago and now account for almost 10 percent of total assets. Our focus has also become far more global.
Liquidity in domestic markets has not improved in more than a decade, while assets in the pensions industry have grown five-fold. It’s now virtually impossible to manage domestic portfolios, so our investment focus has turned to more manageable areas, namely global markets.
How has Prima AFP changed its investment model to accommodate these changes?
We worked hard in 2014 to align our investment practices with those of big global players. We wanted to put in place an investment framework that was ready to take on a larger number of more complex, globally reaching assets.
We have now established long-term goals for investment returns, creating a strategic asset allocation (SAA) framework to ensure our portfolios are paying off in the long term. We have also developed our investment and risk management teams, changing their structure and hiring experienced professionals.
In terms of governance, our risk management practice – traditionally focused on regulation and compliance – has been better integrated with the investment process to ensure sensible risk-taking that’s aligned with the investment goals of each fund. We’ve also invested significantly in IT to improve risk management, front-to-back integration and other areas of the business. We believe these changes are helping to set us out as a leader in the industry – not only locally, but also in the wider Latin American region.
What advantages is this likely to have?
We expect the main advantage to be our improved ability to deliver risk-adjusted, more consistent returns to our clients over the long-term. Good investment decisions require a robust decision-making process, comprehensive information about the portfolios and its risks, and sound governance. By tackling all of these factors in 2014, we are better positioned to lead the industry’s returns in an ever-evolving regulatory framework.
Tell us a little about the companies you’ve partnered with to make these changes
We hired global consultancy Oliver Wyman – the firm appointed by the ECB to undertake the European bank stress tests – to help us identify our weaknesses and so make more effective changes. We also leveraged our strong links with Blackrock. As the world’s largest asset manager and one which has worked with a number of other Latin American pension funds, the firm was able to draw on its understanding of regional markets to help us create the SAA framework.
Finally, to help us develop our investment platform we partnered with Bloomberg – the global leader in information services for investment professionals around the world. The sophistication and reliability of these tools are helping us to develop our reporting, execution and risk management capabilities to the highest possible global standards.
A Korea of the future?
World Finance speaks with Bradley Babson, a former World Bank official, who is now the chair of the DPRK Economic Forum at the US-Korea Institute at John Hopkins on the economics of the regime.
The sustainable side of oil
“Having large reserves of oil and gas presents an economy with considerable opportunities over the short- and long-term”, read a government-sponsored proposal for a Scottish oil fund. This was a statement that came in the lead-up to last year’s in/out referendum and one that saw the Scottish Government roll out plans to establish two oil funds and make good on any surplus tax receipts derived from North Sea oil and gas.
The first of the two funds would offset any sudden price swings and stabilise what could otherwise prove a potentially volatile revenue stream, according to the Fiscal Commission Working Group. This stabilisation fund, “into which higher than forecast oil and gas revenues are deposited, would minimise North Sea revenue volatility from changes in oil prices”, according to the Scottish Government Finance Secretary John Swinney.
The second, however, is more akin to a long-term savings fund, and would come into play only when borrowing is slow or debt high. Whether investment in the fund would come when the country ran a net fiscal surplus, a current budget surplus, or instead as a fixed proportion of North Sea revenues, the model offers a lifeline for when times turn sour.
With such widespread corruption tied to it, populations often see oil as the enemy where the resource is in
plentiful supply
The oil fund idea, though novel, is not new, and proponents of the Scottish scheme cited the success of Norway’s own Government Pension Fund Global in selling the idea to the public that North Sea oil exploits – or any fossil fuel for that matter – could bring sustainable growth.
Resource curse
Too often, the rewards tied to the exploitation of oil escape the everyman and leave countless individuals with little-to-no understanding of how the proceeds could benefit the country at large. This failure on the part of oil economies to spread the wealth more evenly is perhaps best illustrated by the ‘resource curse’ hypothesis.
Referring to the all-too-common instance whereby a plentiful supply of natural resources can bring corruption, stagnation or even economic contraction for the host nation, oil often poses more problems than it does solutions. “Managing natural resource wealth is fraught with difficulties – some economic, many political – and if not done well, can adversely impact macroeconomic performance in the short and long runs”, according to one IMF report entitled Boom, Bust, or Prosperity? Managing Sub-Saharan Africa’s (SSA) Natural Resource Wealth.
The issue of managing oil-derived revenues is clearly not the simple task many assume it is, and ensuring that the wealth is distributed to those apart from the highest few officials is a rare thing amongst those blessed with an abundance of natural resources. There are numerous examples of countries that boast a plentiful supply of natural resources though likewise rank low down on Transparency International’s Corruption Perceptions Index, having thrown away countless opportunities to boost economic and social development.
With such widespread corruption tied to it, populations often see oil as the enemy where the resource is in plentiful supply. However, Norway and a select few other countries have bucked the trend inasmuch as the governments there have recognised that any proceeds tied to oil, if managed sensibly, can set the economy on the path to sustainable prosperity. “An important factor behind the resource curse is excessive spending of the resource revenues. A sovereign wealth fund that is used to save most of the revenues for future generations, will dampen the risk of excessive spending”, says Steinar Holden, Professor of the Department of Economics at the University of Oslo.
“By putting the resource revenues into a fund, it might be easier to safeguard the money, away from politicians. Hopefully, one can also obtain a fair return on the capital in the fund. However, a fund must be combined with a prudent spending rule. One must avoid too large and/or pro-cyclical spending, for example, avoid that the spending of the resource income increases when the economy is booming.”
Established in 1990 in the hope of turning non-renewable riches into a sustainable financial instrument, the aim of the Government Pension Fund Global was and still is “to have a diversified investment mix that will give the highest possible risk-adjusted return within the guidelines set by the ministry [see Fig. 1].” Put another way, the world’s biggest sovereign wealth fund is essentially a rainy day fund for when times are hard for one of Europe’s strongest economies. Originally called the Petroleum Fund, the oil fund was renamed in 2006 and has succeeded largely in freeing space for fiscal manoeuvring in times of economic contraction, not to mention license to offset any oil price reductions.
At the beginning of last year the fund made each of the country’s five million inhabitants a theoretical millionaire, albeit in krone, when the fund’s market value crossed the five trillion mark – equivalent to over $820bn. At NOK 6,950bn, as of March, the size of the fund is equivalent to over $170,000 for each inhabitant, and lays claim over approximately one percent of all the stocks and bonds in the world.
What’s more, the pace at which the fund has grown means that the government is able to spend more ‘oil cash’ from the fund and shrink tax rates, in order to tackle an economic slowdown. The guideline however, remains that no more than four percent of the surplus is spent on public projects.
Also, in keeping with the government’s distinctly sustainable approach to spending, Chief Executive of the fund Yngve Slyngstad revealed earlier this year that the Government Pension Fund Global had divested from no less than 114 companies over the past three years on the grounds of sustainability. Acting on the recommendations set out in board meetings, the fund is fast making a name for itself as a responsible investor, and underlined this focus in February when it released its first Responsible Investment report. In it, Slyngstad said: “We recognise that there is still much to be done, and that we will encounter a number of challenges in the years ahead. Our role is to think long-term and protect value for future generations.”
David Spegel, an emerging market analyst at BNP Paribas, calculates that oil-based sovereign wealth funds like Denmark’s hold more than $5trn in assets worldwide, and are fast becoming a major force to be reckoned with. The UAE and Kuwait, for example, whose funds are valued at $800bn and $400bn respectively, have created sovereign wealth funds of their own, though the approach does not necessarily guarantee a steady stream of income without a consistency that stretches the political gamut. “There must be a broad agreement that most of the money should be saved, or, for some countries, used on socially efficient public investments”, says Holden.
No guarantees
The Canadian province of Alberta took a step in the right direction in 1976 when it pledged to stash a percentage of oil royalties in its own Heritage Savings Trust Fund. However, a reluctance to pay-out the requisite amount from 1987 onwards whether it be 30 or 15 percent, along with a tendency to dip into the savings severely handicapped the fund’s earning capacity, meaning that its value sits around the $18bn mark in a time when Norway’s own is fast approaching $1trn. Add to that debts of over $10bn and an expected budget deficit of $500m come the end of the year, and the province is proof enough that inconsistent government policy can cripple the best of intentions.
The Alaska Permanent Fund, meanwhile, created in 1976, ensures that “at least 25 percent of all mineral lease rentals, royalties, royalty sales proceeds, federal mineral revenue-sharing payments and bonuses received by the state be placed in a permanent fund, the principal of which may only be used for income-producing investments.” What differentiates the fund from others like it is that a yearly dividend is distributed directly to Alaskan citizens to supplement their earnings.
The same can also be said of Bolivia, which in 1997 set up the Renta Dignidad programme and began distributing revenue derived from oil and gas to those of 60 years and older. Looking at Alaska, the hand out last year came to $1,884 and lifted the total sum paid out over the fund’s lifetime to over $37,000 per Alaskan.
True, the idea is unlikely to catch on in any global sense, it represents a tried and tested means of transforming diminishing oil riches into a sustainable financial asset.
In this sense, both Norway and Alaska share a certain likeness, in that the fund model employed by either nation and many more like them, means that the population can hold the government more accountable for spending decisions. And by demonstrating that a sovereign wealth fund can overturn the resource curse, the pressure will build on oil economies to do the same as they seek a tried and tested means of exorcising the resource curse.
Climate change and its stormy relationship with the insurance sector
Assuming that the findings from last year’s Intergovernmental Panel on Climate Change (IPCC) are accurate, the financial ramifications of rising temperatures could number in the trillions of dollars if the circumstances are allowed to go on unchallenged. “We live in an era of manmade climate change”, said Vicente Barros, Co-Chair of the group responsible for the report. “In many cases, we are not prepared for the climate-related risks that we already face. Investments in better preparation can pay dividends both for the present and for the future.” And in an age when global warming is exasperating extreme weather conditions and inflicting major pains on affected communities, the contribution of the insurance industry should not be underestimated.
In developing countries, where the dangers are most acute, the annual price tag attached to climate change-induced damages could soon tip the $100bn mark, as rising seas lay waste to coastal communities and other such areas without the requisite defences. True, the risks are well documented and the costs of inaction clear, yet under-threat areas and industries – not least insurance – have been slow to stem the losses, for want of a better understanding about where exactly their focus should lie.
False assumptions
Businesses can no longer assume that their day-to-day operations will perform uninterrupted, and the increased risk of climate shocks, described at length in the IPCC report, means that affected parties must make certain concessions or risk collapse. Of the industries exposed to climate change, few can match the seriousness of the situation facing insurance, and the circumstances here have prompted key names to make often-fundamental changes to their strategies and operating models, if only to survive the coming storm.
In developing countries, where the dangers are most acute, the annual price tag attached to climate change-induced damages could soon tip the $100bn mark
“Climate change represents one of the greatest long-term risks of change for the insurance industry”, says Ernst Rauch, Head of Munich Re’s Corporate Climate Centre. “There is uncertainty about the dynamics of these changes and where they will occur. To adapt and manage to these profound changes of the risk landscape, detailed data and deep expert knowledge is key as well as the development and application of risk modelling tools, reflecting changing patterns of weather catastrophes.”
However, although the changes made so far are noticeable, they stop short of the necessary transformation. “While the insurance industry is concerned about climate change, we have noticed that our clients, mainly insurers and reinsurers, have become more concerned about the continued upward trend in losses that largely results from exposure growth”, says Jayanta Guin, Executive Vice President of the risk modelling software and consulting services company AIR Worldwide. “Because most insurance policies are written for a short term (often one year), they are in some sense more concerned about the view of risk in the next few years, and less concerned over climate change that will occur over the next several decades.”
Without first recognising that climate change warrants attention on a global scale, or acknowledging that the industry has an important part to play in informing policy on climate change, insurers will fall flat. True, climate change may have found a way into risk modelling, yet the relationship is worth little if not explicitly stated and acted upon.
Learning by example
Hurricane Katrina, for example, illustrates just how much damage so-called extreme weather events can inflict on the industry, and shines a light on what inaction and oversight can bring. Although almost half of the affected population had no flood insurance, the $25bn in claims for those who did still managed to bankrupt the federal flood insurance programme. The programme, which was born of a desire to bail homeowners out of a crisis and protect taxpayers from shelling out additional funds, failed on both fronts, to the point where the government was forced to cough up an added $15bn to meet the costs. The shortfall still represents only a fraction of the overall costs tied to the catastrophe, and Swiss Re figures show that Hurricane Katrina was responsible for the loss of 1,836 lives and $71bn in insured losses. Statistics cited by the Insurance Information Institute also tell a story of how the hurricane then generated the largest single loss in the industry’s history, with over 1.7 million claims totalling $41.1bn and stretching six states. The takeaway from the disaster, however, is not necessarily that natural disasters can wreak havoc on any given location, but that climate change is something that warrants action if insurers are to survive the not-too-distant future.
“Because the very concept of climate change is that the past will not fully predict the future, the insurance industry has been, and must continue to be flexible to make operational changes as needed”, says Lindene Patton, Global Head of Hazard Product Development for CoreLogic Insurance and Spatial Solutions. “The operational fundamentals remain the same – using underwriting, actuarial science and natural catastrophe modelling. But the marketing, regulatory negotiations and consumer environment interaction must change. To date, those changes remain elusive.”
Though 2005 caught the eye, it was 2011 that really set the world alight, with insured losses relating to natural catastrophes costing upwards of $127bn (see Fig. 1). Unfortunately, the record-breaking year served only to highlight just how slow the industry had been to react to what remains a priority concern. One Ceres report released in 2013 showed that in the year after only 23 of 284 companies surveyed had a strategy for action on climate change. “Every segment of the insurance industry faces climate risks, yet the industry’s response has been highly uneven”, said Mindy Lubber, Ceres President in the report foreword. “The implications of this are profound because the insurance sector is a key driver of the economy. If climate change undermines the future availability of insurance products and risk management services in major markets throughout the US, it threatens the economy and taxpayers as well.”
With temperatures rising, developing and developed countries alike run the risk of increased floods and drought, and World Bank findings show that large coastal cities could face combined annual losses of $1trn by 2050 as a result. True, major names are funnelling more money towards finding creative solutions and defences are much improved on generations passed; yet the threats facing insurance are huge. Whereas weather-related losses averaged at some $50bn annually in the 1980s, the same amount today is close to $200bn. What’s important for the industry today, therefore, is that major names hone their focus on risk modelling and recognise climate change as a priority.
Catastrophe modelling
“Given the prevalence of catastrophe models in insurance and the rising cost of extreme weather events, the accuracy of modelled outputs is a key interest for insurers”, according to a recent Lloyd’s report, entitled Catastrophe Modelling and Climate Change. “The potential for climate change to drive changes in the severity and likelihood of extreme weather events could have implications for the accuracy of natural catastrophe models.”
Once a standalone spreadsheet, catastrophe modelling has evolved to the point where it today resembles an all-encompassing risk management approach. Rather than taking a very limited standpoint on the issue of climate change, the strategy looks to big data and scientific analysis for answers, and by opening up these platforms, the industry has been able to more easily share and strengthen data on the subject.
“We believe that, even today, climate change in many regions is already having a definite impact on weather related losses”, says Rauch. “We therefore have to factor these changing loss patterns into pricing models in our industry. Since the influence of climate change increases with time, the insurance industry must recognise, quantify and make allowance for these developments in good time in the form of risk-capital and risk-price adjustments.” And by taking a proactive approach to mapping the financial risks posed by climate change, the industry can more easily understand and so resolve the risks knocking at their doors.
“The framework of catastrophe models lend itself nicely to incorporating and quantifying uncertainties associated with climate change”, says Guin. “Our clients are increasingly being asked by regulators and rating agencies to explain what they are doing to manage climate risk and, in turn, our clients are looking to us to keep them apprised of the current state of the science and to educate the regulators and rating agencies on what the catastrophe models currently capture.”
In fact, the industry’s contribution to climate change mapping has been so great that many have labelled insurance perhaps the most important link in tying together the many facets of a low carbon economy. Broken down into its simplest parts, insurance is a risk management tool, and if the industry can arrive at a working set of solutions for mapping climate change, all businesses in all nations can operate with more assurances about the future.
“The modelling data and analytic solution set is available to address the risk of climate change and is being applied by the industry, but it’s not merely a question of access”, says Patton. “Additional steps are needed to underscore the importance of investing in risk management to the customer base through an appropriate means of addressing the question of ‘who should pay?”
Settling debts? Show all your assets
World Finance speaks with corporate investigator Daniel Hall to find out if this is illegal and where the loopholes are.
World Finance: Daniel, hiding assets – is it illegal?
Daniel Hall: Structuring your own affairs is not illegal. It’s like anything, you can have a debt and you can choose not to pay. I think you shouldn’t look away from how it would work in a small claims court almost. If you have a dispute with one of your friends and you owe them £1000 and you choose not to pay, that’s not illegal. They just then have remedies against you, and frankly you scale that up and you’re talking about billions of dollars with sovereign states.
It’s a very profitable enterprise for many facilitators, accountants, lawyers, people who help their clients effectively judgement-proof themselves.
World Finance: Well you specialise in recovering assets that have been hidden by accountants or lawyers of their clients, often sovereign states or multinational corporations, to avoid them having to pay the full costs of litigation arbitration. So who are the main culprits?
Daniel Hall: There’s no single answer to that. There’s a confluence of factors that the reason the world is as it is. I think that what tends to happen is, commercial disputes arise, things change, governments change, and perhaps the new administration doesn’t want to deal with the legacy of the old guard.
World Finance: Does this differ jurisdictionally?
Daniel Hall: Not really, I think what you tend to find if you are, for example, going after the assets of a sovereign state, is some sovereigns are much more amenable to paying their judgements because they want to interact with the capital markets of the world. There are some sovereigns who are perhaps less amenable to doing so, and one has to pursue them and pursue their assets.
World Finance: So can you give me examples of the types of recoveries you’ve worked on?
Daniel Hall: I can’t obviously go into too much detail, but I can kind of broadly describe how one goes about doing this. So for example, if you’re interested in recovering against a sovereign state, what is sometimes a worthwhile enterprise is to understand how it interacts with the real world, and do things that perhaps will cause it political problems which will make it actual kind of, frankly, settle its debts.
So going after various Eastern European countries, what you’re trying to do is identify joint ventures they’re perhaps involved in, where you have assets which sit outside of sovereign immunity, they’re used for commercial purposes, but actually the mere act of freezing, for example, bank accounts or manufacturing interests has a political knock-on effect which means that they have to, as I say, settle their debts.
World Finance: But you’ve actually recovered some unusual things, shall we say. Give me examples of those.
Daniel Hall: Polo ponies in Argentina. Yachts attached to docks. What’s quite interesting when you’re doing asset recovery is you have to learn to play the man as well as playing the ball. So you have to understand your counterparty, you have to understand what’s important to it, and then act accordingly.
I had a fun case going after a technology entrepreneur who was a billionaire, and was more then capable of paying the $100m judgement that my client had, but he had no intention of doing so until we discovered that he was very much interested in yachting, he’d paid a lot of money to become a member of the Monaco Yacht Club, and so when he came out to race one day and found, effectively, bailiffs on the docks requisitioning his yacht in front of all of his new buddies, it brought him to the settlement table fairly quickly.
World Finance: So when hidden assets are recovered, what then happens? Are they just forced to pay or do they have further penalties?
Daniel Hall: No, it’s always a challenge. I suppose in any asset recovery exercise there are three prongs. There’s locate, fix, repatriate. The challenge is typically understanding where the assets are, how they’re structured, and how one can then pursue them. Sadly, something we’re encountering day in day out is it’s one thing knowing where they are, it’s another thing having the requisite legal system to actually be able to freeze money or halt a manufacturing business.
It’s a challenge, but there’s a bunch of things that one can do to ensure that you bring them to the negotiating table effectively.
World Finance: So how common exactly would you say this type of thing is, and what’s the knock-on effect, who else does it affect? Does affect in terms of taxes, that sort of thing?
Daniel Hall: 30-40 years ago was a different place in the sense of people wanted to settle their debts, and I think people now see it as a debt they now don’t necessarily have to pay because most of the time, corporate transactions are usually set up with Special Purpose Vehicles, and actually if something does go wrong people are sitting there thinking “well what are they going to do pursuing my Seychelles company without any assets?”
Does it have a knock-on effect? Yes, enormously. I think people get put out of business by an inability to collect on debts due to them.
World Finance: If somebody is awarded something in court, and then their opponent, as you say, is hiding assets, they then have to pay you and if they can’t pay that they’re just going to lose out. Is that how it works?
Daniel Hall: That’s one of the biggest problems historically with asset recovery, is you tend to have someone who is usually out of money or at least litigation fatigued, facing the prospect of what is in effect yet another lengthy trial, and I think the offering that Burford have where we’re effectively doing it at risk, we are assessing the judgement scenario or the arbitral award and saying “this is something that we will deploy our own capital, we will fund the recovery.”
Structuring a deal for the judgement holder gets as much money back as possible, we get a return on our investment and ultimately the protagonist loses out.
World Finance: Well you’ve called for greater accountability of accountants and lawyers, but aren’t there already regulations in place for this?
Daniel Hall: Yes, there are regulations where lawyers and accountants and other professionals frankly cannot act illegally or unethically. However, I would like to see things go further. I know of, I won’t reveal them now, of law firms who are currently acting for sanctioned individuals from Russia, for example.
There’s a way of gaming the system, effectively, and I would like to see people cracked down upon harder, because I think that as soon as you do that it won’t become as easy for protagonists to effectively hide their assets in a way that we shouldn’t be doing.
World Finance: So where are the loopholes that need to be addressed?
Daniel Hall: The clearest analogy for you to have in your mind is the one with international tax regulation. There are many parallels with asset hiding becoming effectively tax-structured. It’s a form of jurisdictional arbitrage where what works in one jurisdiction will not work in another, and you have effectively global players who can position themselves accordingly. So they are playing by the rules of each individual jurisdiction but it has an overall holistic effect in making them nearly impossible to pursue.
North Korean migrant workers vital source of foreign income
World Finance speaks with Bradley Babson a former World Bank official who is now the Chair of the DPRK Economic Forum at the US-Korea Institute at John Hopkins on how much the regime relies on these labourers.
One Acre Fund empowers Africa’s farmers
If the world is really serious about ending poverty in Africa, then it needs to create market-based solutions. Simply increasing aid to the continent year-on-year is not enough. There is an answer, however, and it lies with Africa’s farmers. By supporting them to improve their harvests, they can pull themselves and their communities out of poverty with dignity.
The One Acre Fund, which represents Africa’s largest network of smallholder farmers, helps provide the necessary tools and financing they need to grow their way out of hunger and poverty. World Finance spoke to Eric Pohlman, the organisation’s country director in Rwanda, to learn how he and his team are better serving local farmers, so that they can create long-term solutions for escaping poverty for good.
What motivated you to become a senior partner in the One Acre Fund?
Having lots of opportunities growing up, I felt an obligation to give back. Originally, I thought I would do that through public service in the US, but, by chance, I ended up studying abroad in Senegal and that changed my worldview. Spending a semester at the Cheikh Anta Diop University in Dakar. I saw a lot of opportunity in Africa, there is certainly an entrepreneurial buzz.
Senegal itself has an amazing culture and it captivated my interest. So I shifted my studies at university and started looking at traditional development studies. Eventually I gravitated towards more business-based approaches. After school, I spent two years in the Peace Corps in Cameroon in the Extreme North province and then joined One Acre Fund immediately after that, which was back in 2007, and I have been with the programme since.
One Acre Fund sustainability: Total Farmer Loan Repayments, USD
1.5m
2010
5m
2011
13.7m
2012
14.4m
2013
22.8m
2014
Source: One Acre Fund
What does One Acre Fund do?
Our fundamental goal is to make farmers more prosperous. We serve smallholder farmers in East Africa as they face a number of common problems – mainly basic market failures in the region. Many farmers do not have access to information or training, and often impactful technologies do not reach rural areas. This includes everything from seeds and fertilisers to solar lamps. But even when farmers do know about these products or have received training through public extension, they often do not have the money needed at the start of the season to invest.
So what we do at One Acre Fund is develop a basic market bundle that offers a complete package tailored for the smallholder farmer in East Africa, which aims to address these shortfalls. It all starts with training through a field officer who is based in the community. We then develop a delivery system to get impactful products like seeds and fertiliser out to farmers before planting. We provide these services on credit, so farmers can pay back slowly over six to nine months, which better fits the household revenue flows. And then, finally, we have some post-harvest solutions that help farmers store their harvest at the end of the season.
In order to keep the One Acre Fund supporting farmers, how do you make the business profitable?
In order to serve more farmers, we are really focused on being as efficient as possible. So right now, farmers fund 70 percent of our core programme operations. The other 30 percent is coming from donors and over the years as we scale up, we will benefit from some efficiencies in delivery. We hope to see our subsidy go down over time, with the ultimate goal to be entirely farmer funded. But we are in new markets, we are in riskier places, so it is appropriate as a young start-up we are not financially sustainable at this point.
What are some of One Acre Fund’s greatest achievements so far?
Just a few weeks ago in the programme, we delivered farm inputs to our 100,000th customer, which is a big milestone for the programme here. Right now, we are serving 280,000 customers across East Africa, so it is a big farming population. We have lit over 100,000 households with solar lamps, which is really exciting. Most of our clients that we serve are off grid, so when the sun goes down their homes are dark or lit by kerosene.
Another big accomplishment of the programme is that we have started to demonstrate that farmers have a strong willingness to pay for good services. We’ve lent over $20m, and to date we have a 98 percent repayment rate, which is pretty impressive, considering the context that we are working in. We hope that we can act as an example for other micro-finance institutions and other businesses to start treating farmers not as beneficiaries, but as customers. These are all great accomplishments for the organisation, but really, I think our greatest victories are found in the individual stories of the farmers we serve.
One of our clients is a mother of six and, like many of our clients, she had never used improved farm inputs [seeds and fertiliser] before we started offering services in her village. But in her first harvest using improved farm inputs, she saw a huge increase. She then invested that surplus in buying a new cow. That was three years ago, and today, that cow has given birth to two other cows and upon visiting her recently you can see the pride in her face that she has started to become prosperous and self-sufficient.
On average, the programme that we offer creates about $120 of new income for farmers per year. That may not sound like a lot of money, but it is often the difference between whether you choose to educate your kids or not; whether you decide to go to the hospital or not; and whether you decide to invest in another productive asset. That really is the difference between subsistence farming and wealth creation. It’s those farmers’ stories where we see our biggest accomplishments.
How does the work at One Acre Fund provide a better solution to the problem of poverty?
I think that a lot of food aid follows a giver-recipient model. This kind of model puts all the power in the giver’s hands and none in the recipients. This model is only appropriate in crisis scenarios, like in the event of a massive natural disaster or huge population displacement caused by a violent conflict in the region.
In those scenarios, the decision is very clear; people need support and they need it fast. It works in the short-term. But the giver-recipient model cannot handle any type of complexity or development or market creation. It is a brain-dead approach. It makes one person the decision-maker and the millions of recipients turn off their agency over themselves, losing their voice in the process.
What we need is market-based solutions, where you basically turn the giver-recipient model on its head. You empower the recipient by turning them into a customer, so they’re the ones making decisions. The giver then becomes an innovator. They have to figure out what works and what doesn’t. Together that combination is powerful. It is where long-term solutions come from.
What is your opinion of farming subsidies?
I can understand a government’s desire to support farmers. Farmers are the most important profession in any given community. They create the food we eat, and food is the single largest determinate of health. Farmers have the ability to grow surplus, and surplus is what originates a market economy. It is what allows, in the initial stages, for a vibrant economy to develop.
On one hand, I get where governments are coming from. Rwanda has a farm subsidy for its farmers and in less than seven years it has helped shift the country from a net food importer to a net food exporter. There is now food security here for the first time. That is an example of an effective farm subsidy. On the other hand, there are a lot of farm subsidies that are not farmer first. If you look at a number of farm subsidies in the US like maize or soy for example, these deflate global prices and put farmers in parts of the world at a competitive disadvantage. They pervert the economy.
Is there any way to balance the concerns of maligned farmers in both developed and developing nations?
I think that we need to reorient [farm subsidies] in developed countries. In these countries, one percent of the population work as farmers, so a subsidy that artificially deflates the price of food is probably good for the economy. But we live in a globalised world and that artificial cost to produce maize or soy for example, negatively impacts most of the African continent, where 90 percent of the population is engaged in farming.
How do we balance that? Well, I think it is unlikely that farm subsidies, given their political history, will change. But I do think that reorienting subsidies in developed countries, so that we re-incentivise farmers to plant a more diverse crop base and to serve local and regional communities’ food needs would build a much stronger society, as well as having the secondary benefit of making communities in developed countries healthier.
What other challenges need to be confronted in order to reduce poverty in Africa?
One, we need a lot more investment in the region. I would focus first on agriculture (see Fig. 1), because I believe it is the foundation for any vibrant economy. I read recently that 33 percent of Africans expect within the next one or two years to start their own business. There is a lot of entrepreneurial drive there. If we can match that with appropriate investment, then I think we will start to see many more innovative market-based solutions.
We also need good governance and better infrastructure. Those help to create the environment necessary for a vibrant economy. It is hard for that to happen without both of those. There are a number of bright spots across the continent where things are working. Rwanda is one of the best case studies, where good governance and really smart investments in infrastructure have made it one of the fastest growing corners of the world right now.
What are some of the more common misconceptions about poverty that are most harmful?
I think the biggest is that farmers are not capable or unwilling to pay for services and products that are going to make their lives better. That misconception perpetuates the giver-recipient model. It makes micro-finance institutions scared to work in rural areas or increase their agriculture-lending portfolio. Micro-finance has largely focused on urban areas where they have higher population densities. You see very few banks out in rural areas where it is more expensive to serve customers.
So I think that misconception is pretty harmful and we have a lot of evidence to the contrary. In the past eight years, we have seen over a 98 percent repayment rate, with hundreds of thousands of farmers. The difference is, farmers are willing to pay for stuff that works, so it is on the plate of every company or social enterprise to figure out what works for their customers and provide services they want to buy.
What does the future have in store for you and the farmers that you serve?
I intend to serve farmers well into the future. Rwanda is my home. It is one of the most exciting places in the world right now, so I want to keep doing what I am doing. For One Acre Fund, as a whole, we are going to keep growing our impact and keep innovating new ways to better serve farmers. And for the farmers we serve, their future will hopefully be full of big harvests, healthy children, and educated families. These farmers are the keystones to building prosperous communities across Africa.
China-Russia relationship intensifies
On May 8, Russia and China signed various new deals for finance, trade, transportation and energy, with the purpose of strengthening their economic partnership. A cooperation decree has also been signed to bring the recently-formed Eurasian Economic Union into the fold.
“The integration of the Eurasian Economic Union and ‘Silk Road projects’ means reaching a new level of partnership and actually implies a common economic space on the continent,” Russian president Vladimir Putin is reported as saying after a meeting with Chinese Premier Xi Jinping.
China has pledged to invest $5.8bn into the project, which is estimated to cost over $20bn
One of the schemes agreed for collaboration is the 800km long Moscow-Kazan High Speed Railway that will connect the two countries though Kazakhstan. According to The Moscow Times, a top speed of 400km per hour can be reached on the new line, which will cut the current 14-hour journey time by over 10 hours. China has pledged to invest $5.8bn into the project, which is estimated to cost over $20bn.
An energy contract was also signed between the largest gas suppliers of the two nations – China National Petroleum Corporation and Gazprom. The state-owned companies have agreed upon the provision of 30bcm of gas to China per annum, via what is known as the Western route – the Altai. Once the project is complete, China will become Russia’s biggest customer for gas, considerably outstripping the 40bcm it currently supplies to Germany each year.
Since its annexation of Crimea in 2014, Russia has actively sought closer political and trade relations in Asia, as well as with neighbouring states. Similarly, China is also making moves to consolidate its influence in the region, including the formation of a closer alliance with Pakistan and laying the foundations for the Asian Infrastructure Investment Bank – the region’s first development bank that is independent from the World Bank and IMF – explicitly, the first of its kind that is free from Western control. With both powerful states now moulding a landscape in the East that is economically integrated and autonomous from the West, it would seem that the international arena soon faces a rebalance of power that is gradually tipping away from the current status quo.
Thaioil: how to navigate plunging oil prices
Back in May 2014 Brent crude was being sold for around $110 per barrel, but that soon changed, with the price sitting at nearly half its previous value at just $56 per barrel, as of March 2015. A number of factors played a part in the commodity’s decline: one is a reduction in global demand spurred by Europe and China. Another is the US’ energy independence, something made possible through the controversial process of fracking, which permits the extraction of large shale oil and gas reserves deposited deep underground. Finally, there has been a distinct lack of noise coming from the world’s largest oil cartel, OPEC. Many thought that it, or one of the states that comprises it, would have stepped in and cut back on supply in order to push up the price of oil. But nothing happened. Instead, OPEC seems happy to engage in a price war with US shale oil producers.
This is all great news for net importers of the commodity; as consumers in those countries can enjoy a reprieve when they go to fill up their cars at the pump. The opposite is true for net exporters like Russia, whose economy relies heavily on its energy exports, and now, combined with the economic sanctions imposed on it by the US and EU, sees its economy teetering on the brink of collapse. But managing oil’s fall from on high has been a bit of a mixed bag for some. Thailand still relies heavily on imports in order to sustain its rising fuel demand (see Fig. 1), and, therefore, the plummeting price of oil is seen as a bit of a double-edged sword.
30%
Fall in the number of US oil rigs since peak level in October 2014
Price plunge
As a result of oil prices plunging by over 50 percent since mid-2014 amid unprecedented supply from both non-OPEC and OPEC producers, domestic refinery Thaioil, a company recognised globally as having one of the best track records for sustainability, has seen its business affected in two major ways.
First of all, its gross refinery margin (GRM) has become much healthier compared with previous years, which enhances Thaioil’s competitiveness against imported petroleum products. The underlying rationale being, that the dramatic drop in the outright price of Dubai crude has boosted its GRM, which serves as the key input or cost of production of the refined petroleum products. In fact, the cost of crude oil accounts for 70 percent of the total cost of oil production.
“As a result, the cost of production is becoming much lower for the business and subsequently enhances refining profitability”, says Atikom Terbsiri, CEO and President of Thaioil. “Additionally, refinery margins had also been bolstered by the fact that the petroleum product spreads had not fallen as rapidly as crude prices. Nevertheless, there is also a downside effect to Thaioil’s profitability in terms of the stock loss of crude reserves.”
This is due to the fact that it is legally mandatory for refinery businesses in Thailand to reserve crude inventory as a tool to enhance energy security for the nation. The current proportion of legal reserves is six percent. If the event arises that will impact oil supply such as unrests in oil producing countries or obstacles of transporting oil to Thailand; the reserves ensure that the country will still have some tucked away, which can be exploited for approximately 43 days.
“It is, therefore, inevitable to confront such a stock loss as we had to initially reserve the crude oil at high prices last year”, says Terbsiri. “But despite this, we are certain that Thaioil’s profitability can be partly cushioned by the remarkable GRM. Not to mention the fact that low oil prices stimulate domestic demand by elevating consumers’ purchasing power, so even in the middle of such difficulties there lies opportunity. The company also has the added benefit of over THB 40bn [$1.22bn] to cushion the business amid any sudden crisis.”
Crude surplus
The surplus of crude oil worldwide – around nearly two million barrels – persistently pressures oil prices. The IEA recently published its medium-term outlook for the oil market by forecasting that the US will remain the main contributor of non-OPEC supply growth up until 2020. The IMF has also revised its GDP growth forecast for January 2015 to just 3.5 percent (down from its earlier figure of 3.8 percent). On the back of such bearish forecasts, the price of oil is unlikely to soar above $100 per barrel any time soon.
There is, however, a notable harbinger that low oil prices start to adversely affect the oil drilling and investment plans. Major international oil companies (BP, Chevron, Conoco Phillips, Royal Dutch Shell, Apache and Total) have begun scaling back investment by reducing capex on oil production projects. As a result, US oilrig counts have fallen by over 30 percent, compared with the peak level in October 2014 (1,019 rigs as of 20 Feb 2015). However, the impact is lagged since it takes some time for the decline to register and have an impact on actual oil production.
“With the expectations of continual deceleration of non-OPEC production growth, we may be able to see the slight recovery of oil prices in the second half of 2015”, says Terbsiri. But despite his optimism he admits that there are real challenges ahead – the main being oil’s price volatility. “Even though there is an initial rise of oil prices in 2015, along with global markets on optimism over eurozone crisis, prices continue to be volatile and could soften due to the worry of crude markets oversupplied, especially in the US, where inventories are at record highs”, says Terbsiri. “Even though Thaioil Group has strong net cash margin, due to strong gross integrated margin (GIM) from our integrated refinery, aromatics and lube base oil configuration together with relatively low cash operating cost, there are a number of new large and complex refining capacities that would be pressure GIM in the coming years.”
The real challenge for oil producers, however, is the constant advancement of technology. While the breakthrough in shale gas and oil production processes may have a positive impact in term of crude availability, and create a higher oil demand from oil prices remaining low, advancement in alternative and renewable energy such as solar and liquid hydrogen may lead to a downward trend of petroleum demand for transportation, especially gasoline. In addition, alternative and renewable energy promotion from governments around the world may cause structural change in future domestic petroleum products demand.
To mitigate the effects of the markets volatility and overcome the challenges it faces from alternative energy sources, Thaioil has chosen to embark on a strategy of organic growth, with projects to improve efficiency. Such projects include the Emission Improvement Project, HVU-2 revamp and CDU-3 energy efficiency improvement. The company is also planning to strengthen its value chain integration through Sriracha terminal, LAB project (LAB stands for Linear Alkyl Benzene, a surfactant product categorised in downstream fine chemical and a major ingredient in fabric and homecare business) and SPPs projects, which are expected to be completed over the next 1.5 years. Thaioil also plan to strengthen its value chain through logistics capability, building higher value products and extension of products and services toward end customers.
“Thaioil is aiming towards international business expansion, focusing on three key countries, Indonesia, Vietnam and Myanmar, and leveraging on our core competency, which is refining skills and capability”, says Terbsiri. “For [the] long term, in light of more competitive new refining capacity, we will need to consider upgrading investment for its main refining and petrochemical business, enhancing competitiveness through our ability to upgrade low value to higher value products and flexibility to process diverse crude types. In addition, with the changing trend of energy consumption, we have set up an innovation and R&D team to study and develop new energy business opportunities. These strategies would support Thaioil to cope with challenges we are facing.”
Net winner
Despite the challenge the dramatic price drop of oil poses for producers like Thaioil, the country as a whole stands to benefit from the 50 percent dip. The lower cost of fuel is great news for consumers, who can take advantage of cheaper gasoline. Due to rising domestic demand, Thailand has had to spend much of its foreign exchange reserves buying oil, but because of the recent drop in price, the government can now funnel that money elsewhere, at least for the time being.
Experts believe that while the oil’s price will remain depressed for at least the next two quarters, such prices are simply unsustainable. In the meantime, consumers in net importing countries can enjoy a moments respite from inflated prices, while producers will not have to wait too long until they see profits return.
