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Daily Archives: July 12, 2009

Perverse incentives remain intact on Wall Street

Designing the right incentive system without jeopardizing the whole financial system and losing the talent at the same time remains to be a difficult task. The current revision in comp scheme that pays more in base salary and most in cash seems to have done nothing to change that. The perverse incentives structure is largely intact. Reports WSJ:

Congress wants to lower Wall Street bonuses, blaming them for encouraging the excessive risk-taking that helped cause the financial crisis. But the haphazard way that pay practices are being altered may yet yield the worst of all worlds, higher fixed costs and less accountability, without removing the threat of talent walking out the door.

Banks like Citigroup and Bank of America that still have funding from the Troubled Asset Relief Program are dealing with restrictions on the bonuses they can pay top employees. To keep the rank and file happy, Citigroup is raising base salaries for many of its 300,000 employees who are eligible for a bonus. Morgan Stanley also has increased base pay, from about $300,000 to $400,000 for managing directors. Even stronger performers, such as J.P. Morgan Chase, are considering raising base pay. Credit Suisse is considering all options.

The result: higher fixed costs, even as many banks continue to struggle. When guaranteed salaries rise, so do a range of juicy benefits, as well as severance packages, which are based on salaries. With banks facing increased regulation and higher capital requirements, reducing flexibility on pay could be another blow to investors.

There also is a question of whether higher cash salaries really will mean lower bonuses. The danger is that, even if the likes of Goldman Sachs Group pay out less than half of net revenue in compensation, less-profitable firms might feel forced to pay out a higher portion to keep up. Goldman said it has no plans to adjust the way it pays employees; stars will continue to receive the bulk of pay in bonuses tied to performance.

A perverse outcome of the Wall Street crisis is that compensation as a proportion of revenue could actually rise. Pearl Meyer, of Steven Hall & Partners, estimates that Wall Street pay will end up topping 60% of revenue for the foreseeable future, up from about 50% in past years. It could hit 70% at some smaller financial firms, she said.

To be sure, the "comp ratio" mightn't stay at elevated levels as revenue improves. Morgan Stanley said its payouts looked high in the first quarter because movements in the price of its debt reduced net revenue. Banks said bonuses will be trimmed to keep overall compensation about the same.

Citigroup said its changes were aimed at reducing the focus of employees on short-term results and keeping more of them at the bank for the long haul.

But salaries are paid in cash, while bonuses are usually in cash and shares that vest over time. More cash upfront arguably gives them fewer reasons to stick around or worry about the long-term performance of their firms. At the same time, bonuses aren't going away, so some traders and bankers will continue to embrace risk to try to score the highest payouts. A rise in base pay might help retain middle-performing staff, but it is unlikely to attract or retain the best traders and bankers.

The crisis should lead to a more rational pay structure on Wall Street, with pay remaining flexible and bonuses paid largely in stock that can be clawed back if necessary. Instead, as salaries rise and guaranteed bonuses start to make a comeback, Wall Street firms risk adopting a new set of bad habits.


Is China overinvesting?

Or the high growth demands a higher investment to GDP ratio?  The analysis from Economist.

China’s capital spending could soon be bigger than America’s

DESPITE falling exports, China’s economic growth has remained relatively strong this year thanks to a surge in investment sparked by the government’s stimulus measures. Official data show that fixed-asset investment leapt by an astonishing 39% in the year to May, or by a record 49% in real terms. Sowing more today should yield a bigger harvest tomorrow, but how wisely is this capital being used?

Official figures almost certainly overstate the size of the spending boom: local bureaucrats may well be exaggerating investment in order to impress their masters in Beijing. More important, the government’s figures misleadingly include land purchases and mergers and acquisitions. But even if measured on a national-accounts basis, like GDP, investment is probably growing at a still-impressive real annual rate of around 20%. This year China’s domestic investment in dollar terms is likely to exceed that in America (see chart).

There is widespread concern that this investment boom is adding to China’s excess capacity. Investment amounted to 44% of GDP last year (compared with 18% in America), which many economists reckon was already too much. Worse still, as well as forcing state firms to invest, the government is directing state-owned banks to lend more, despite falling corporate profits. Many of those loans could turn sour. Like Japan in the 1980s, it is argued, an artificially low cost of capital causes chronic overinvestment and falling returns. If so, it will end in tears. To assess that risk you need to ask two questions. How much excess capacity was there already? And where is the new investment going?

There is certainly excess capacity in a few sectors (steel and some export industries, such as textiles). But the best measure of spare capacity for the economy as a whole—the difference between actual and potential GDP, or “output gap”—is probably only about 2% of GDP, compared with an average of almost 7% in the rich world.

The large role played by state-owned banks is bound to have resulted in some misallocation of capital, but a recent study by Helen Qiao and Yu Song at Goldman Sachs argues that concerns about overinvestment are exaggerated. A successful developing economy should have a high ratio of investment to GDP. And a rising rate does not mean that the efficiency of capital is falling; capital-output ratios are supposed to increase as economies develop. America’s capital stock is much larger relative to its GDP than China’s, with 20 times more capital per person than in China.

A better measure of capital efficiency is profitability. Profits have indeed slumped over the past year, but taking the past decade to adjust for the impact of the economic cycle, profit margins have not narrowed as one might expect if there were massive spare capacity. The argument that the average cost of capital is ludicrously low is also no longer true. China’s real interest rate is now 7%, which is among the highest in the world.

Where is the new investment going? There has been little new spending in industries with overcapacity, such as steel and computers. But the surge in state-directed investment has fuelled fears about its quality. In its latest China Quarterly Update, the World Bank calculates that government-influenced investment so far this year was 39% higher (on a national-accounts basis) than a year earlier, while “market-based” investment rose by a more modest 13%. This implies that government-influenced investment accounts for about three-fifths of the growth in investment this year, up from one-fifth last year.

The usual assumption is that government investment is less efficient and will therefore harm long-term growth. But the fastest expansion in spending has been in railways (up by 111% this year). As a developing country, China still lacks decent infrastructure; railways, in particular, have long been an economic bottleneck. Investment in roads, the power grid and water should also yield high long-term returns by allowing China to sustain rapid growth.

And the government is focusing its infrastructure stimulus on less developed parts of the country where the benefits promise to be greatest. According to Paul Cavey at Macquarie Securities, fixed-asset investment in western provinces was 46% higher in the first four months of this year than in the same period of 2008, almost double the rise in richer eastern provinces.

Some of the money being spent in China will inevitably be wasted, but it is wrong to denounce all government-directed investment as inefficient. In the short term it creates jobs, and better infrastructure will support future growth. It is certainly not a substitute for the structural reforms needed to lift consumer demand in the longer term, but it could help. After all, without running water and electricity, people will not buy a washing machine.

Talking about Asia’s consumption

Economist has a good analysis of consumption in Asia during the current crisis and how its quickly rebound means to the rest of the world. One note is that albeit the savings rate is high in Asia, the consumption is not as low as widely reported.

Can Asians replace Americans as a driver of global growth?

ASIA’S emerging economies are bouncing back much more strongly than any others. While America’s industrial production continued to slide in May, output in emerging Asia has regained its pre-crisis level (see chart 1). This is largely due to China; but although production in the region’s smaller economies is still well down on a year ago, it is rebounding in those countries too. Taiwan’s industrial output rose by an annualised 80% in the three months to May compared with the previous three months. JPMorgan estimates that emerging Asia’s GDP has grown by an annualised 7% in the second quarter.

Asia’s ability to decouple from America reflects the fact that the region’s downturn was caused only partly by the slump in American activity. In most Asian economies falling domestic demand was more important than the drop in net exports in explaining the collapse in GDP growth. The surge in food and energy prices in the first half of 2008 squeezed profits and spending power. Tighter monetary policy aimed at curbing inflation then further choked domestic demand.

The recent recovery in industrial production reflects the end of destocking by manufacturers as well as the large fiscal stimulus by most governments. But the boost from both of these factors will fade. Meanwhile, export markets in developed economies are likely to remain weak. So the recovery in Asian economies will stumble unless domestic spending, notably consumption, perks up.

Consumers’ appetite to spend varies hugely across the region. In China, India and Indonesia spending has increased by annual rates of more than 5% during the global downturn. China’s retail sales have soared by 15% over the past year. This overstates the true growth rate because it includes government purchases, but official household surveys suggest that real spending is growing at a still-impressive rate of 9%. In the year to May, sales of household electronics were up by 12%, clothing by 22% and cars by a stunning 47%.

Elsewhere in the region, spending has stumbled, squeezed by higher unemployment and lower wages. In Hong Kong, Singapore and South Korea real consumer spending was 4-5% lower in the first quarter than a year earlier, a much bigger drop than in America. But Frederic Neumann, an economist at HSBC, sees tentative signs that spending is picking up. Taiwan’s retail sales rose in May for the third consecutive month. Department-store sales in South Korea rose by 5% in the year to May.

It is often argued that emerging Asian economies have large current-account surpluses—and are thus not pulling their fair weight in the world—because consumers like to save rather than spend. Yet this does not really fit the facts. During the past five years consumer spending in emerging Asia has grown by an annual average of 6.5%, much faster than in any other part of the world. It is true that consumption has fallen as a share of GDP, but that is because investment and exports have grown even faster, not because spending has been weak. Relative to American consumer spending, Asian consumption has soared (see chart 2).

In most Asian economies, private consumption is 50-60% of GDP, which is not out of line with rates in countries at similar levels of income elsewhere. China, however, is an exception. Private consumption there fell from 46% of GDP in 2000 to only 35% last year—half that in America. In dollar terms, spending is only one-sixth of that in America. (Singapore’s consumption is also low, at just under 40% of GDP.)

This explains why China’s government has recently taken bolder action than others to boost consumption. Over the past six months the government in Beijing has introduced a host of incentives to encourage households to open their wallets. Rural residents get subsidies for buying vehicles and other goods such as televisions, refrigerators, computers and mobile phones; urban residents get a subsidy if they trade in cars and home appliances for new goods; tax rates on low-emission cars have also been cut. There is huge potential for higher consumption in the countryside as incomes rise: only 30% of rural households have a refrigerator, for example, compared with virtually all urban households.

The government has also introduced several measures this year to improve the social safety net, such as spending more on health care, pensions and payments to low-income households. On June 19th it ordered all state-owned firms that had listed on the stockmarket since 2005 to transfer 10% of their shares to the National Social Security Fund to shore up its assets. The short-term impact is likely to be modest but if such measures ease households’ worries about future pensions and health care, it could in the long term encourage them to save less and spend more.

Another way to boost consumption is to make it easier to borrow. In most Asian economies household debt is less than 50% of GDP, compared with around 100% in many developed economies; in China and India it is less than 15%. South Korea is the big exception: households have as much debt relative to their income as Americans and their saving rate has fallen over the past decade from 18% of disposable income to only 4%. In many other Asian economies financing for consumer durables is virtually nonexistent. Promisingly, the Chinese bank regulator announced draft rules in May to allow domestic and foreign institutions to set up consumer-finance firms to offer personal loans for consumer-goods purchases.

These measures are a modest step in the right direction. But a bigger test of Asian governments’ resolve to shift the balance of growth from exports towards domestic spending is whether they will allow their exchange rates to rise. A revaluation would lift consumers’ real purchasing power and give firms reason to shift resources towards producing for the domestic market. But so far, policymakers have been reluctant to let currencies rise too fast.

Asian spending is already an important engine of global growth. Even before the crisis, emerging Asia’s consumer spending contributed slightly more (in absolute dollar terms) to the growth in global demand than did America’s. But it could be even bigger if Asians enjoyed the full fruits of their hard labour, rather than subsidising Western consumers through undervalued currencies. It is time for an even greater shift in spending power from the West to the East.