"Have we come to the end of the squeeze in incomes and are we going to see some kind of real wage growth?" © West Midlands Regional Observatory
Prospect’s Jay Elwes spoke with Richard Woolhouse, Chief Economist at the British Bankers’ Association, for a wide-ranging interview last week. Here is the full transcript.
Read our pick of the ten key points from the interview
Jay Elwes: How would you characterise the UK recovery?
Richard Woolhouse: We’ve seen quite a lot of upside surprise in the last year and a half, in terms of growth, and whilst the sources of growth were narrowly focussed on consumption and housing we are now seeing a pattern of broadening in the recovery which I think is healthy, particularly in investment which is picking up now at close to double-digit rates, year-on-year.
There are some concerns and questions. Clearly the issue of the productivity puzzle has not been solved. I think we could see that some of it is solved by the fact that GDP data will eventually be revised up further. There’s also an element to which the employment data may be overstating the strength of employment, particularly around self-employment.
But what we’ve really seen has been a very flexible labour market in the UK and that’s been incredibly beneficial to the way we’ve recovered since the crisis and that’s enabled unemployment to be a lot lower than otherwise.
JE: You think the self-employment data is over-stated?
RW: This was discussed by the Monetary Policy Committee [in April]. If you work 16 hours a week then you are defined as self-employed. Until you get data from HMRC in terms of tax returns it’s very difficult to see what income people in that group are earning. There may be a lot of people particularly at the high end of the age range of the labour market who are self employed who aren’t maybe earning that much and are essentially under-employed but they are counted as full time. Half the growth in total employment since the crisis has been driven by self-employment.
JE: Are those self-employed workers having a downward effect on productivity?
RW: That could have been part of the puzzle in that you are overstating employment. But I think that there are one-off effects from the financial crisis that are permanent. You’ve had a big drop in financial services output itself, which is a very important sector in the economy and is unlikely to recover quickly, but also you’ve had a big fall in business investment, which fell 25 per cent. That must have affected the productive potential of the economy.
JE: You feel there’s a permanent loss?
RW: I think three quarters of the gap relative to trend is a permanent loss.
JE: So that is the output gap.
RW: And the other quarter is the spare capacity we’ve got. I think we are still operating well below capacity. There’s still plenty of scope for this economy to grow at above trend rates for the next two, perhaps three years. And that’s why I think that when we come round to discussing what’s likely to happen in monetary policy, we will see a very gradual rise in interest rates over a multi-year period.
JE: What do you see happening with wages?
RW: Clearly wage growth has been reasonably weak. I see that we are now at a point where nominal wage freezes are not the best way for companies to respond. They are raising wages for those employees they want to keep and overall, wage growth is now positive in real terms.
There are signs of skills shortages building up in certain sectors of the economy, which are concerning. But in aggregate, we are a long way away from any sort of damaging aggregate wage price dynamic. The question though is: have we come to the end of the squeeze in incomes and are we going to see some kind of real wage growth in a context in which the Bank will be comfortable? (i.e will productivity rise as well?) I think that’s what we will see.
JE: In what time frame?
RW: Two or three years. Obviously what matters if you read the depths of the Financial Stability Report is what’s going to happen to those people in the fifth, sixth and seventh income deciles. Will their incomes rise fast enough to offset whatever impact rising interest rates might have on their financial circumstances? I think there is a structural problem there to do with both international competition and capital labour transformation—the fact that technology is increasingly eating away at those jobs. That’s a problem that is with us for the next couple of decades and is something that means, as a country, we need to focus on the high value parts of the economy.
JE: So do you think that the jobs lost to globalisation and technology are not coming back and that those deciles that you pick out will continue to have it tough?
RW: Well they have been hit harder than others. I think that structural trend will probably continue. But within that you get churn, you get new industries, you get new areas and new occupations.
JE: And re-shoring?
RW: Re-shoring is very interesting. It’s certainly an area where partly because the cost advantage has been eroded significantly for off-shore locations, companies have found that it’s easier to have a higher cost base and be able to control that cost base.
JE: And as for the banks—the paradoxical situation developed where banks were on the one hand being instructed to lend, but on the other were having to deleverage. Is that still the case?
RW: A number of elements of the regulatory environment have changed the landscape. Banks are holding a lot more better quality capital. On some measures they are holding multiples of the amount of Tier 1 equity than they were prior to the crisis.
JE: Is that down to new rules from the Basel Committee?
RW: Correct, implemented in Europe by the Capital Requirements Regulation and Directive.
JE: Have these rules on capital been gold-plated by UK authorities?
RW: Although Basel III gives until 2019 for banks to progress to the higher capital requirements investors have inevitably pushed for early implementation. At the same time, the UK authorities have imposed their own tougher targets and more stringent definitions to be met over a shorter timeframe.
But the capital rules are only one part of the picture. New rules governing recovery and resolution require banks to hold ‘loss absorbing capacity’ which can be subject to statutory bail-in requirements. That’s different to Tier 1, but again, the point is that the way banks are operating in terms of their capital structure is much safer than before the crisis. You would need a much bigger write-down of assets to see any banks come into trouble.
Also ring-fencing, which is still being worked through, is going to be a major issue for some of the UK banks in terms of separating their core retail operations from their wider activities.
All of that has led to a very different type of banking system. Whether it’s led to a safer financial system is another question. A lot of activity that was previously in the bank system has migrated to the non-bank system. That’s clearly now the agenda for the regulators, which is to move further to stabilise the non-bank system and how the two interact is a very big question. For example, who holds this bail-in debt? If that’s all being held by systemically important insurance companies, then you are just spreading the risk from one area of the financial system to the other.
JE: Will the AIFMD [Alternative Investment Fund Managers Directive] not capture a lot of this non-bank activity?
RW: Some of it, but it’s really focussed on hedge funds and private equity.
The point I would make is that an awful lot has happened in this area. There has been a big step change in the cost in terms of capital and funding that banks have to pay to make loans.
In terms of the lending side—I think the majority of the banking system in the UK has largely de-leveraged to a point where it is now starting to expand its lending. The markets are valuing these banks higher than book, which was not the case in the period during and just after the crisis for the majority of the UK banking system.
Segments of lending activity are expanding very rapidly, particularly the mortgage market, which has been driven by some policy initiatives. As for the business lending side, we are still seeing a contraction in the outstanding stock of loans, partly driven by the fact that large corporates have been re-paying bank debt and issuing on capital markets. You can see that in the data. They are swapping bank debt for bond market debt and in the SME market, we are still seeing repayments running faster than new lending.
Gross lending is picking up in both of those areas even though net lending is contracting slightly. There was a significant tension between the need to raise regulatory capital and to lend at the same time. I think the job is largely done now in terms of making the banks safer and we can now move on into a new phase of growth led by lending in the banks and expansion of the banks balance sheets. I expect net lending will grow next year to businesses as well as in terms of secured lending for households.
JE: So the situation is now that the sector is in a position to fund the return to growth.
RW: It’s a difficult one to characterise. Gross lending or new lending has continued. Essentially you have a recycling process. Banks are continuing to lend to new and growing parts of the economy while other parts of the economy themselves are deleveraging and adjusting their own balance sheets. It’s not just the banks’ deleveraging process but it’s what’s happening in the corporate sector as well. And there as I intimated before, there is a very different picture among large firms who are very profitable, holding very large cash piles and if you look at survey evidence—if you look at the Deloitte CFO survey—it is very optimistic about new investment and about new M&A activity. You tend to get M&A activity picking up first before you get new investment.
And that’s actually the majority of where the investment innovation and new growth comes from, the large firm sector. In the SME sector, clearly there are parts of it that are very dynamic. But maybe there’s more noise made in that sector relative to its economic impact.
JE: And what about the effect of the leverage ratio? The exchange of letters last year between Carney and Osborne suggested that the EU was reporting back on the technical definition of the leverage ratio at the beginning of this year. What effect would a leverage ratio have on lending?
RW: The Basel Committee finalised the definition of the leverage ratio in January but the calibration of the requirement is not due to take place until 2017. The effect will depend on this calibration. One of the challenges for global banks is a failure to co-ordinate the regulatory response in different locations. So if banks are dealing with four different types of leverage ratio in four different locations that’s going to be difficult.
JE: Would a ratio not be put in place centrally by the Basel Committee?
RW: The Basel Committee sets ‘accords’ not standards which have legal effect. Therefore it is for each jurisdiction to adopt the agreements into local law – this happens through the Capital Requirements Regulation/Directive in the EU. As such, it’s possible that differences can emerge in how countries implement the rules. The US has just updated its leverage ratio rules but these are tailored to reflect the structure of the US market. Differences in market structure can make a big difference and therefore impact calibration. For example, US banks follow an originate to distribute model where they sell their mortgage books to government sponsored underwriters. This reduces the size of their balance sheets compared to European banks. This matters because a leverage ratio views all assets as being equally risky. European banks hold large volumes of low loan to value mortgages which gross up their balance sheets. They would need to raise vast sums of new capital – or drastically reduce the scale of their activities – if this was not reflected by the final leverage rules in Europe.
JE: Is the leverage ratio a political suggestion?
RW: Yes and no. There is a justifiable regulatory desire for a backstop to risk weighted capital requirements. There is also a desire from some politicians to reduce markedly the scale of banking activity and the leverage ratio is viewed as a means of achieving this.
JE: Do you think that there is a residual political threat to banks? Vince Cable has been talking about pay levels recently.
RW: Not just Vince Cable but also what Ed Milliband has been saying about market share caps. I think there is still a significant amount of political risk and I think there’s still a misunderstood narrative. We can talk about competition in retail banking. But there’s also this question about the wholesale financial markets; people don’t understand how important they are to the UK economy. London’s location as a capital market head quarters and all the high value added professional services that go with that are vitally important. So [it is concerning] when European banks are having difficulty hiring people who have the option of working in New York or Singapore.
That’s very different from the retail banking side, where we have had a lot of mistakes in terms of mis-selling. It’s time we moved on from that. There is far more competition in the retail market than people recognise and technology is making a big difference to the way in which retail banking is being conducted.
JE: So you do not think that the high street is too concentrated?
RW: I don’t, not if you look segment by segment. If you look at mortgages, credit cards, personal loans and the number of offers and pricing, I think it’s difficult to say there isn’t a lot of competition in those markets. We have four or five big high street banks in charge of the current account market, the SME market. We also have four or five supermarkets. It’s very difficult to say that supermarkets aren’t competing very aggressively with each other. We have areas of the technology sector where we have huge market shares but companies are still competing with each other. It’s how contestable those markets are that really matters. Whether you can enter and switch and there has been an awful lot done on that in the banking system. You have seen the seven day switching service introduced and customers are now able to move around between banks if they wish.
JE: Are technology companies themselves going to become more involved in banking and finance?
RW: They already are. If you look, there are things like E-wallet on the payments side and also for international payments there is obviously Paypal. Also Google and Facebook are entering this space. They will start to encroach on elements of the payments system first, but in the medium to long term it’s a big threat to what the banks have because essentially the banking industry is entirely digitisable.
JE: So—the Bank of England, interest rates, large numbers of people who have taken out high-LTV mortgages at the bottom of the interest rate cycle. Can Mark Carney ever raise interest rates?
RW: I think he can. There are a couple of questions here. One is the fact that you have to remember that incomes are now growing. So when you look at the affordability issue, a 1 per cent rise in interest rates is not actually huge for an average mortgage relative to real personal disposable income.
What tends to happen is when interest rates rise, and we saw this in 1993 with the Fed, we saw it in every typical post-war cycle. Rates rise because the Fed got behind the curve, or the Bank of England got behind the curve on inflation and they had to rise quickly to get in front of the game. But this is a different cycle: it’s a financial crisis-led cycle, which has led to this process of de-leveraging that you talked about at the beginning. What I think we will see now is a very gradual rise in rates to a level—and the Bank is signalling this—to a level that is much lower than historical averages. The problem is that markets will draw a straight line between where we are now and where the historical average is and infer that we will get there faster. That is why the Bank is trying very hard to manage expectations and if you look at the strip curve we are still looking at 2.5 per cent rates towards the end of 2017, so it’s a very gradual rise that is priced in. The other point is that the Bank has other tools now. We now have a Financial Policy Committee, with a mandate to lean against the wind, if you like, in areas where there is concern about financial stability and obviously one of those areas might be the housing market.
I would not be surprised to see the Bank moving on housing regulatory measures designed to constrain activity in the economy before they move on interest rates.
JE: It has already done that.
RW: It has already shifted the Funding for Lending Scheme away from supporting mortgages to just supporting businesses. Next we will see some of the stress testing around mortgages, where people will have to do affordability tests contingent upon higher rates. The Bank has other options. Problem is, we have never done this before and we have still got to ask the question of whether the Bank can take the punchbowl away while the party is still going, and whether they have a political mandate to do that
I think the issue is: will Carney raise interest rates once, before the election? And I think he will. He has been there before in Canada and I think he is saying that he will do it. The narrative from the Coalition government will be “rates are rising and that’s fine because the economy is pretty robust”. You will see a very gradual move in interest rates.
JE: Twenty-five basis points?
RW: Yes and maybe we move fifty, seventy-five and wait and see what that does.
JE: Can he do that while inflation is still falling?
RW: He wants to get back to something that gives him a little bit of leeway. But inflation is unlikely to be falling in a year’s time. We are off the charts here. We have been at the zero bound for five years. We have £375bn of asset purchases. He would like to begin to normalise the position of monetary policy. But I think he will do that in a very gradual way, test the water, see how that works. But you know we have seen a significant comeback—and going back to your point about the economy and why we have seen growth, we have seen a significant loosening of monetary conditions. In terms of mortgage rates across all LTV buckets, they are down by 150bps since the summer of 2012. A lot of that’s because of the end of the euro crisis and the fact that funding costs for banks have fallen. But Funding for Lending has helped to reduce the cost of credit.
JE: A recent paper by an economist at Fulcrum Asset Management worried about the threat of deflation from the Eurozone, saying that the closer you get to the zero lower bound, the greater the downward pressure on inflation, which seems to be born out by the inflation numbers coming out of the continent at present.
RW: I think yes, the last print was very surprising. We came in at 0.5 per cent and will see another Eurozone inflation number very shortly.
JE: What is happening?
RW: A lot of that is being driven by fuel and energy. Nearly every model I have seen does suggest that there is fuel and energy in there as a one off. A working assumption that Europe’s inflation will rise now back up to 1 per cent is what I would certainly be thinking. You are right about the risk of deflation, as clearly there is a big cliff edge there. There is a non-linearity where if you fall into deflation and it starts to have a behavioural response, a la Japan, it has very bad implications for debt dynamics. I don’t think we are close to that in Europe. I think that the IMF making noise about it has steeled the ECB to continue to make noise itself about doing more unconventional monetary policy. I don’t think they will do that. But that rests heavily upon this assumption that core inflation goes back up again.
I don’t think the European crisis has been solved. I think what Draghi did bought them time and there’s no doubt that the pendulum has swung an awful long way. Spanish yields trading near US yields looks silly to me. It’s interesting to note how the UK Treasury’s position on Europe has changed to “we will support whatever it takes to make the monetary union work”. Everybody knows that the monetary union was incomplete when it started, that fiscal and political structures were not in place to support the monetary union. There is a game being played between markets and policymakers.
The two things that will drive reform of Europe are, first, fiscal reform, mutualisation of debt and reform of structures at the centre, which the German people are not ready for and I do not think they will be ready for a number of years.
And second, structural reform on the periphery, which you have seen quite a lot of in Spain—in Italy, less so—but we have seen elements of structural reform. We need both of those things together because we need faster growth in the periphery and we need elements of the burden sharing to be built in. What I have seen so far with the banking union has not been enough. We have a mechanism of a banking union that has been put in place because we needed to break the death spiral between sovereign and bank debt dynamics. But it doesn’t have any elements of burden sharing. It does just about say we will work up a fund over a decade in the end.
JE: But the bail-out elements of the banking union are to be welcomed.
RW: They are. I think that when we complete it, I don’t think the mutualised deposit guarantee stuff will happen, but the resolution mechanism and cleaning out the decks in terms of what’s going to happen with the Asset Quality Review that the ECB is conducting this summer…
JE: The stress tests—
RW: …the stress tests, yes, will hopefully go a way towards restoring investor confidence in the financial system and banking system in Europe. But the litmus test is whether it will do enough to really solve the financial fragmentation that you have got in Europe. You have got lending spreads between the periphery and the core to SMEs now at 250pbs, despite the fact that bond yields have come back in. And that’s the critical question and I am not utterly convinced that we have solved it with the banking union. We bought time. I think that the UK corporate sector has expunged the thought that there is remaining tail risk. But I wouldn’t be surprised if we see another crisis in the euro area between now and the next five years. No doubt.
JE: What’s the knock-on effect for the City if this union goes ahead?
RW: We need to ensure that the development of the banking union does not undermine the single market in financial services. The City has a very important position as Europe’s capital market and the strength of that is very difficult to replicate elsewhere in Europe. We need to make sure that there is coordination between the Bank of England and the ECB. There are other institutions like the European Banking Authority which will be very important in ensuring that we don’t get moves which disadvantage London’s position relative to the Euro area and the banking union. We had this debate when we were discussing entering the euro back in 2003. London has captured a significant market share of euro-related activity since then. So I don’t see it as being incompatible that we have Europe’s capital market outside of the banking union.
JE: Do you see a risk coming from a Chinese slowdown?
RW: Well China was bound to slow to 5-6 per cent growth. I lived in China—in Hong Kong—in 1997 and 1998 and found that a little bit of knowledge about China is a very dangerous thing. The point about China is that clearly the expansion of credit in the non-bank sector over the last five years has been enormous: about 100 percentage points of GDP. Depending what you assume about that, that’s going to cost about maybe 25 per cent of GDP to sort out. But the government has the fiscal flexibility to do it and it has the tools—the levers—to mandate change in the way that it wants. So as long as they stick to the course and there is not a run on the financial system they can probably do it. But the point about he longer-term trajectory of China’s growth—it had to slow. Whether the official figures will show it slowing to 6 per cent that quickly, we don’t know.
JE: Will there be consequences for global confidence from a Chinese slow-down?
RW: I think that has already been discounted. Look at commodity markets and how they have responded in the last year and a half. You cannot run an economy with a 50 per cent investment share of GDP for very long. What can’t go on forever will surely end at some point. China needs to save less, invest less in infrastructure and rebalance its economy that way. But it will end up on a path that’s more like 6 per cent rather than 8 per cent.
