Anil Gujadhur

London Interbank Offer Rate & Interest rate fixing

Excess and Exaggeration

ANIL GUJADHUR

There was a furore last week in the British parliament. The Prime Minister David Cameron appeared outraged and that was also the case for Edward Miliband, the Leader of the Opposition. The issue was about an interest rate-fixing device adopted by some of the key banks on the market in London. Barclays was one among the few banks engaged in this market manipulation. The financial regulators of US and UK imposed a fine of $455 million on the bank for having, jointly with a few leading market players, rigged the London Interbank Offer Rate (LIBOR) which is supposed to be freely determined on a daily basis by the forces of supply and demand on the financial market. This settlement with the regulators was not enough to pacify the public.

The public is already unhappy with an uncomfortable situation in which fingers have repeatedly been pointing at the liberties taken by the huge global banks as the principal factor having brought about the world financial and economic crisis. In April, investors revolted at the compensation package of $19.5 million given to Robert Diamond, Barclays Bank’s Chief Executive but were unable to bring it down to a more decent level. It is against this charged atmosphere of a bad fait accompli that the British Prime Minister announced on 2nd July an inquiry into the British banking system.

Within a week of the banks rigging of Libor, Barclays’ Chairman Marcus Agius resigned in view of the “serious damage done to the bank’s standing” at a time he was in the chair. Everybody knows that the Chairman of the Board is far removed, at least much further away than the Chief Executive, from the counter of the bank where the drama of market rate manipulation actually plays out. The Chairman was probably taking the bullet for its Chief Executive in a bid to divert attention away from the latter’s responsibility in the matter. The latter is finding himself nevertheless in the line of fire pending a determination as to whether he was privy to this practice of manipulating this key market interest rate said to have been undertaken by some officers of the bank along with other banks’ money traders. Rumours have started floating that this market malpractice would have been carried on with tacit nods from certain quarters of as respected an institution as the Bank of England. A Treasury Select Committee of Parliament has now been tasked to establish the facts. We will see which heads will roll finally in a country which believes in the rule of law.

A “culture” of unbridled impunity

We have to understand the importance of the Libor to get a true measure of the implication of this act of manipulation being indulged in for God knows how long. This is the rate on which numerous international loans denominated in diverse major currencies are indexed. For example, when we in Mauritius resorted to international commercial borrowings in the context of the Structural Adjustment Program we adopted in the late 1970s, these loans had to be repaid with interest at a margin above the Libor rate. Not only countries, big companies like Air Mauritius or the MCB or SBM, as well, would see the international loan financing they raise being indexed to Libor. As at today, international loans amounting to $350 trillion are indexed to the Libor worldwide.

Had there not been an element of deep trust that the Libor was being objectively determined by the free interplay of the forces of supply and demand, so many governments and big companies the world over would not have committed themselves to be bound by its daily movements. It is this element of trust that has been breached, as is witnessed by one of the mail exchanges between bank traders in which one trader is asking the other as to what should be the correct level to set it up for a particular day. It appears movement in the key rate was being timed to coincide with God knows what! Actions like this sap the sense of confidence with which we should be regarding international norms and standards laid down for the sake of good governance.

Situations like this would have led Alan Greenspan, the former Chairman of the US Federal Reserve Bank (US Fed) to refer to the “irrational exuberance” of markets. That was in 2001. It was the time when Board of the US Fed which he was presiding actually accelerated the market’s irrational drive into voluminous unproductive derivative trades by bringing the US key repo rate to ground level. We know the consequences. Exaggerated volumes of derivative trades instigated by the prevailing cheap borrowing rates, fuelled up a record number of house mortgage loans at cheap interest rates. The construction boom was reinvigorated.

At first, this caused house prices to soar by fuelling successive waves of demand for mortgage credit as home buyers could easily pay away their previous housing loans by selling their previous acquisitions at higher house prices which got jacked up in successive rounds of easy financing by the banks and finance houses. Then came the crash of house prices and of the construction boom once it was found out that a mountain of irrecoverable debt of undue proportions was lurking behind, without the backing of liquidity from the financial institutions. Borrowers no longer had the means to honour their debts, not only for housing but even for credit cards they had abusively borrowed on to support an unsustainable lifestyle. Banks that had been at the source of the credit boom crashed in the face of huge bad debts. As this enormous bad debt wiped out their capital, the world financial system was suddenly seen tottering on its feet.

It is this same “culture” of unbridled impunity and not-to-be-accountable-for market conduct that we’ve just seen in the recent case of the Libor’s manipulation by Barclays and others. The world may not have emerged after all from the shoddy misbehaviour of its “prime” institutions despite the huge bailouts pumped into those systemically all-important financial institutions by western governments to avert the threat of intensification of the economic catastrophe looming on global markets since 2008.

Recall the credit derivative loss of $ 2 billion of JP Morgan that suddenly came in the news in May last; the current reckoning is that the loss may actually be closer to $7 billion. This is a big difference. The stark difference between the two figures may be showing a trail towards management of public opinion against the excessive liberties still being taken by banks’ executives in the good old rotten style. Jamie Dimon, CEO of JP Morgan, may end up keeping his job but that will not bring to an end the huge amount of liquidities the European Central Bank and the US Fed, along with governments, have to keep pumping since those days in 2007 into financial institutions that went berserk.

It will not be surprising that part of the funds so pumped by the monetary and government authorities into salvaging their affected economic and financial system would have found their way into safe assets outside the productive sectors of the west. Part of the money has gone into real estate in emerging countries. While the west was busy bailing out its institutions in a bid to restore domestic growth and employment, there has taken place simultaneously a construction boom nearly everywhere else in the world. The added liquidity must have partly flown out away from its initially intended objective, which was to save domestic economies that were floundering.

FDI, real estate and class divide

We have ourselves benefited from this outflow. Our real estate sector has been one of the main beneficiaries of record flows of FDI in the past years. The villas are safe assets for their foreign owners but they are not investment of the productive type such as those that enable us to pan out sustainably a greater volume and wider range of exports of goods and services to external markets as we’ve done since so many years by growing our manufacturing base. Nevertheless, it must be said that the value of our export of international services has increased from Rs 21 billion in 2007-08 to Rs 23 billion in 2010-11 even though the causal link between the FDI inflow and growth of services is not directly established. What must be stated in no unclear terms however is that the swell of our FDI has helped us pay up for the substantial current account deficits we’ve been accumulating on our balance of payments for years.

On the other hand, housing prices have been shooting up locally. This situation mirrors the high prices foreign investors in real estate are able to afford along with the monumental spike local property prices have assumed during the past 5 years by conversion from agricultural to residential use. This factor has a sweeping effect over all asset prices and not simply on the high value villas acquired by foreigners.

Consider the case of a two-room apartment in the Sodnac newly created residential area from previous agricultural land. The property up for sale is located at a site strategically bordering a newly established public leisure park. The apartment is currently being put up for sale at Rs 3.9 million. This means that an acquirer of the property, at say an interest rate of 10% pa, will have to fork out monthly interest payment of no less than Rs 32,000. If you add principal repayment of say Rs 7,000 per month, that comes to a total monthly debt repayment of Rs 40,000. This situation not only tells a story about affordability and access. It also speaks about the scale of debt and debt servicing it invites decent local house owners into and what amount of remuneration they should be earning on average to make sense.

This cost escalation will necessarily feed into our local salary structure. Hopefully, we’ll remain competitive internationally. Property price surge is also pointing to the fact that we are moving irretrievably towards a class divide which hopefully will be sustainable without serious social dislocations. The price factor unmistakably creeps into the entire structure and that includes the scale of provision of state support to the less well-off in terms of decent living quarters now and into the future.

Capitalism and market forces are irretrievably intertwined with exaggerations. Unless controlled, they can wreak irreversible havoc, as we are seeing currently with global climate change. One of the objectives of government is to achieve a balance of risks over time. It does so by guiding stakeholders to a path of discipline and reining them in to act in accord with a code of governance for the sustainable good of one and all. This is why we pay for the upkeep of numerous national institutions.

As the late financial market events demonstrate, it is not enough to let the markets operate with a totally free hand. Lawmakers typically leave gaps in rules and regulations that are exploited to the detriment of society as a whole by a few seekers after wealth to the maximum. It is important not only to make laws and rules but to see to it that they are actually being implemented correctly and in the right spirit. Those in charge should not satisfy themselves with general routine compliance with rules of good conduct laid down; they should do so with a view to keeping the trust in the orderly and purposive working of public institutions alive at all moments. If at all it was necessary, recurring disruptions are proving that not many are actually conducting their charge in this deeper sense, a fact to which successive disrupting events are drawing our attention from time to time.

The consequence is that we are left each time to go for remedial action to do damage control past the event as the full-scale investigation set in motion following the Libor manipulation by the reputed high street banks is showing. Those who are wilier than the rest are walking away with the spoils while the victims of the situation have to foot the bill for the rest. This distorting situation ends up in important social and public costs that have not been repaired nearly half a decade since the last international crisis was set off.

ANIL GUJADHUR

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