SMU Political-Economic Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION -A Brief Introduction to the Offshore Industry -Liquidity Matters -The LIBOR affair: A big blow to the trust in the banking industry The Fortnight In Brief (3rd July to 16th July) US: Unemployment Woes The June employment report follows weak growth in April and May, as unemployment rate remains unchanged at 8.2%. This brings the 3-month average of job gains to a tepid 75,000. This is not enough to soothe the FMOC's concerns regarding labour market weakness, opening up the possibility of further QE. The positive aspect is that private average hourly earnings grew 0.3% while hours worked increased slightly. The pace of growth in the non-manufacturing sector showed a downtick while manufacturing exports are falling sharply into contraction territory in June. Asia Pacific ex-Japan: As Growth Slows in China, the US Suffers Chinas growth fell to 7.6% in the second quarter amidst a slowdown in exports and a real estate bust. While China focuses on the thriving US export sector to claw back growth, it comes at the expense of the US which is experiencing a burgeoning trade deficit. Weakening trade figures in an election year could force the US to take a confrontational stance with China. Elsewhere, South Korean banks earnings growth are being adversely affected by increasing bad debts and more significantly, Bank of Korea slashed its rates unexpectedly due to concerns on global growth. Singapores Q2 GDP fell below consensus estimates led by contraction in retail sales. EU: Sinking Boat The ECB announced a cut of the main refinancing and deposit rate to a record-low 0.75% and 0% respectively, based on deteriorating financial conditions in the Eurozone. On July 5, Ireland managed to conduct a successful T-bill auction, raising 500 million at a 1.8% interest rate. However, this seems to be mostly a symbolic achievement and it is far from clear that Ireland would be able to attract demand for its sovereign bonds at yields that are sustainable. In the meantime, policy makers may have opened the door to allowing direct recapitalization of Eurozone banks by the EFSF/ESM, contingent on a longer-term policy change, and to empowering the ECB as the supervisor of the banking system. It is hoped that this will break up the sovereign-bank feedback loop. ISSUE 20 16 JULY 2012

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A Brief Introduction to the Offshore Industry

By Marcus Chew, University of Manchester
Alright, so most of us know how important the shipping industry is to Singapore. How many of us though, are actually familiar with the types of jobs involved and more importantly, what drives the market? This article aims to briefly explain several key services, market drivers and what the future holds for this industry. The Shipping Industry Shipping is traditionally generalized as mainly transportation of cargo on bunkers, moving goods from point A to point B to earn money or simply (in Singapores case) acting as a port to accommodate vessels - allowing them to refuel and afford the crew a location for their port of call. However, there is much more to this industry. Other shipping jobs include the utilization of vessels to conduct supply runs, to handle anchoring of ships as well as conducting towing jobs. One might be ponder the relevance such jobs has in the world today and why the industry is primed to flourish based from these jobs. The main reason would be the strong link between the offshore industry and the energy market - namely the oil and gas market. Oil and Gas Commodities

Source: WTRG Economics, http://www.wtrg.com/oil_graphs/ As shown in the graph above, since the early 2000s, oil prices has been on a general upward trajectory. Coupled with the rising oil demand since 2010, one can easily conclude that the rising demand is one of the factors of rising oil prices.

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Source: International Energy Agency

Source: International Energy Agency To further elaborate on this demand pull effect on oil prices, consider the graph above depicting quarterly oil supply. Compared with the previous graph on quarterly oil demand, we can see that oil demand is not only increasing in recent years but also increase at a rate greater then oil supply. As a result, such high oil prices will spur investors and end-users of oil (cars, planes, etc) to turn elsewhere for alternate sources of oil. Thus, this is where offshore oil supply comes into the picture. 3 Copyright 2012 SMU Economics Intelligence Club

One Aspect of The Offshore Industry This brings us back to the main topic of the article. Offshore oilrigs have been around for ages and are not an uncommon sight. Drilling has been done close to shores in many parts of the world Indonesia, Thailand and Vietnam - just to name a few, and in recent times, the presalt basin found in Brazil. This is an exciting time in this little known industry, because now that the oil resources closer to shore has been largely developed, the next step is to focus on deep sea drilling which involves bringing oilrigs much further out into deeper waters. As one can deduce, the connection to the offshore industry and the uses of the abovementioned jobs are all related to the new position of the rigs relative to the shores, as well as providing supplies to the rigs for them to continue their daily operations. This includes not just the conventional rigs but also drill ships, as well as their supporting cast of FPSOs. From a report provided by RS Platou ASA, a leading international ship and offshore broking company, there has been a general increase in rig activity around the world over the past year. SBM Offshore, a Dutch-based global company offering services to the offshore oil and gas industry, has publicly stated their confidence in the strong growth of the demand for FPSOs in the next 5 years, citing high oil prices per barrel as one of the main reasons. E&P Magazine, citing a study, Oil: The Next Revolution. The Unprecedented Upsurge of Oil Production Capacity and What It Means For The World, by Harvard Kennedy School research fellow Leonardo Maugeri, estimates more than USD $600 billion will be spent on oil exploration and production in 2012. This is expected to yield an approximate 20% increase in oil production, resulting in a steep drop in oil prices within the next 8 years. Astrup Fearnley, a global shipping services company, has published a market report forecasting the imminent growth in the size of the global FPSO fleet in order to match the demand for exploration and production. It estimates an extensive growth of approximately 300%. Given that supply and towing vessels are a complementary good in relation to oilrigs and FPSOs, there is little doubt that such a substantial increase in the fleet of FPSOs would therefore lead to an increase in demand for services of these vessels. As such, depending on expectations, vessel owners are able to charge a higher term rate for each operation as compared to before, hence generating larger revenue. In conclusion, the offshore maritime industry is growing into an attractive investment prospect, given that it is still in its infancy. Increase in projected global demand for oil, as shown in earlier graphs, will continue to drive oil prices up if supply is unable to match demand. In addition, deep water exploration will definitely affect the landscape of the market. At this moment however, the increase in exploration and production operations will definitely require more offshore resources in various forms and hence I expect this industry to have solid growth for many years to come.
1Oilrigs:

Structures with the equipment for drilling and servicing of an oil well

2Pre-salt:

A deep layer of salt formed off the coast of West Africa and Brazil. A supply of oil and natural gas is thought to be present under this layer (approx. 200m deep). Pre-salt refers to the resources being present before the layer of salt was formed.
3FPSOs:

Floating production, storage and offloading vessels are vessels that possess the equipment to process as well as store oil or gas. Sources: International Atomic Agency, WTRG Economics, relevant company reports 4 Copyright 2012 SMU Economics Intelligence Club

Liquidity Matters
By Wong Hong Wei, Singapore Management University
Ex-President of the SMU Economics Intelligence Club and current intern at the Government Investment Corporation of Singapore, Hong Wei presents his first piece on SPEX sharing a deep and insightful look at the true causes and unintended effects of the Euro-zone crisis. Enjoy. History has shown us time and again of the importance of liquidity look no further than the 1997 Asian Financial Crisis, 1998 Long-Term Capital Management Crisis and 2007 Global Financial Crisis. On top of triggering extreme price movements, the lack of liquidity hampers the efficient incorporation of news into prices, and impacts daily life through higher funding costs to households and corporate entities. With the current European crisis still being played out, in the following, this article will identify some of the causes driving recent issues of liquidity. Causes of illiquidity
Asset and liabilities cash flow mismatch - When liability payments outpace money inflows, the

difference in cash flow can be damaging, especially to highly leveraged entities. During the recent European Crisis, the mismatch of funding longer-term assets with shorter-term liabilities exposed European banks to cash demands. Banks were forced to liquidate and deleverage1 their assets when investors pulled out. This had a vicious effect as cutbacks in trading and market making activities provided by the bank reduced market liquidity further.
Weak economy can strain liquidity - Liquidity is also tightly linked to the health of economies.

Even when banks still have capital adequacy, the anticipation of adverse feedback loop of weak macroeconomic activity and deteriorating bank asset quality could reduce lending and resilience of the financial system.
Insolvency causes loss of confidence - A different source of difficulty arises when concerns

exist regarding solvency. This could be triggered by a downgrade in credit rating by major agencies or by perceived loss of confidence in the creditworthiness of the institution. For example, when Dexia, a Franco-Belgian bank, and MF Global, a US broker-dealer, reported a large amount of losses, they could no longer find sources of funding and had to go under. In such instances, borrowers find difficulty in rolling over debt.
No lender of last resort in USD - Another point to note is the large number of trades completed

using the USD. However, there is no lender of last resort for USD out of the US. Trade finance, in particularly, is affected by US dollar funding shortages. This brings about vulnerabilities in the system when supply shocks occur.
Financial contagion exacerbates problems Lastly, liquidity shortages on a global scale take

place due to financial contagion. When Lehman Brothers collapsed, overnight lending rates and interest rates soared. One contributing factor of the liquidity shortage in the European crisis is attributable to the interconnectedness of nations and banks. When one country faces a flight of capital, its banks may call in the loans lent to another country. The implication is that interdependent banks will find their sources of funding reduce. The second basis is when an affected country is a major trading partner of the other countries. Its imports will fall and adversely affect the GDP of its trade partners. Both reasons bring about the destabilization of 5 Copyright 2012 SMU Economics Intelligence Club

the other countries, especially if they were already performing poorly. Anticipating this, a loss of confidence in investors would bring about higher rates of interest, which intensifies the problem. Figures 1 and 2 below capture the extent of bank loans and trade in a few of the affected European countries. Loans extended to country as % of lending countrys GDP Greece Ireland Portugal Spain Italy France Greece 0.20% 0.10% 0.10% 0.20% 0.70% Ireland 0.50% 1.50% 8.10% 7.80% 9.00% Portugal 4.20% 9.00% 10.50% 1.20% 3.20% Spain 0.10% 0.90% 6.30% 23.0% 2.00% Italy 0.30% 0.80% 0.30% 1.70% 2.20% France 2.50% 1.80% 1.30% 6.60% 18.20% Figure 1: Loans Extended through banks as % of GDP Bank

Trade Greece Ireland Portugal Spain Italy France

Exports as % of GDP Greece Ireland Portugal Spain Italy 0.10% 0.10% 0.20% 0.80% 0.30% 0.40% 2.60% 2.10% 0.10% 0.10% 5.30% 0.80% 0.20% 0.10% 1.70% 1.80% 0.40% 0.10% 0.30% 1.50% 0.20% 0.20% 0.30% 1.80% 2.00% Figure 2: Exports as % of GDP

France 0.30% 3.50% 2.30% 3.30% 3.00% -

Source: Washington Post Government actions and regulations Several propositions were put in place to reduce the occurrence of future financial crises and impact of liquidity risks.
Basel III - Basel III was formulated post-crisis to enhance the existing framework to tackle

banking risks. By increasing capital ratios and adding cyclical factors to improve the robustness of the systems, the severity and frequency of sudden liquidity withdrawals are reduced. Liquidity coverage ratios were also specifically targeted, with higher capital charges on off-balance sheet items.
Solvency II and Volcker Rule - Solvency II, with similar regulations as Basel1, is slated to be

passed and come into effect on 1st Jan 2014. This will target the insurance companies, and is hoped to correct the underlying solvency issues, and in the process mitigate liquidity risks. The past crises demonstrated the need for stability in the banking system. For example, a loss of confidence resulting from the failure of multiple banks during the financial crisis severely impacted liquidity. As such, the U.S. authorities have responded by laying out the Volcker Rule to reduce the incentive to invest in risky assets which endangers the money of depositors. 6 Copyright 2012 SMU Economics Intelligence Club

Deposit guarantees and Bailouts - To restore confidence in the banking systems, governments

have stepped in by guaranteeing deposits. In Europe, the Deposit Guarantee Schemes was rolled out to reimburse a limit of deposits in the event of a bank failure. Similar guarantees were also rolled out even in countries with sound banking systems, such as Singapore, to bolster deposits and liquidity. During the nadir of the financial crisis, policymakers bailed out several banks to stem the loss of liquidity and to return the economy to growth. In the U.S., under the Troubled Asset Relief Program, there were further steps to bail out corporations. Central bank interventions - Problems underlying the economy have prompted central banks to act. Swap lines2 were established or boosted to overcome foreign exchange liquidity issues. Many have resorted to quantitative easing through open market operations or interest rate cuts. And in Europe, the European Central Bank intervened through Long Term Refinancing Operations (LTRO) and provided direct liquidity through cheap loans to banks. Unintended consequences While the policies of governments and regulators aim to prevent or mitigate liquidity issues, there could be unintended consequences. Slower economic growth - Although policies, such as holding capital, should help to mitigate risks, they are costly to do so given that capital that could be put to economic uses is kept as a buffer. The Institute of International Finance, a bank lobby group, estimated that banks have to raise US$700 billion to satisfy the requirements of Basel III and other measures. The Financial Stability Board and the Basel Committee has also concluded that every 1% rise in capital ratio will reduce growth by 0.2% over a 4 year period. Increased regulations decreases number of regulated - The increased regulatory requirements could also push segments of the existing banking systems out of the regulated segments to avoid the harsh penalties. As the shadow banking segment is lightly regulated and cannot be effectively monitored, the implemented policies could worsen the situation. Moral hazard - The bailouts of banks, although potentially solves a part of the problem, could result in the need for a larger number of bailouts in the future. This is because a too big to fail attitude could be developed they assume government will provide guarantees in the event of insolvency. With skewed incentives, these financial institutions can place larger bets which further destabilize the banking system. Consequences of liquidity abundance - The lack of liquidity has severely impacted the global economy. However, it should not be forgotten that the easy credit condition following the burst of the dotcom bubble is one of the causes of the 2008 global financial crisis. Similarly, the ease of access to low-cost funding also precipitated the Eurozone crisis when economies with weak fundamentals spent beyond their means. This is something for central banks to consider while they pursue low interest targets and inject huge amounts of liquidity.

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The act of paying off interest-incurring liabilities, such as debts.

The regulatory framework is made up of 3 pillars. Pillar 1 requires the insurer to hold a stipulated amount of capital. Pillar 2 guides the governance and risk management of insurers. Pillar 3 sets out the structure of disclosure.
2

A temporary reciprocal currency arrangement between central banks an agreement to keep a supply of country's currency available to trade to other central banks at the going exchange rate. It is meant for overnight and short-term lending only. This keeps liquidity available for central banks to lend to their private banks to maintain their reserve requirements. This liquidity is necessary to keep financial markets functioning smoothly.
3

Sources: Washington Post

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The LIBOR affair: A big blow to the trust in the banking industry
By Myat Thiha, Singapore Management University
With the world economy in a gloomy state, the banking industry is now in one of its darkest periods. With JPMorgans embarrassing loss of an estimated US$5.8 billion spreading in the headlines over the past few weeks, the LIBOR-manipulation scandal , have adulterated the trust that people put in banks. Recently, while many big banks are under probe into fixing the LIBOR, Barclays has been fined a total US$450 million by the Financial Services Authority (FSA) in Britain and Americas Department of Justice for its attempts to manipulate the LIBOR. Some analysts say that it could be the financial industrys Tobacco moment. The London Inter-Bank Offered Rate LIBOR can be roughly defined as an interest rate at which individual banks can borrow funds, in marketable size, from other banks in the London interbank market. LIBOR, published daily by Thomson Reuters, is calculated by taking the average of the 25th to 75th percentile of interbank offer rates submitted by the contributing banks at 11:00 AM London time. The chart below, taken from The Economist website, shows the submissions of sixteen contributor banks for the three-month LIBOR rate between September and December 2008. As shown in the graph below, the LIBOR is calculated for 10 currencies, each of which is from reputable contributor banks. Almost all financial instruments, estimated at about US$840 trillion, are based on this rate. For every 0.01% move, the LIBOR can generate profits as large as a few million dollars. Therefore, it is extremely important to keep the LIBOR accurate, lest it cost billions of dollars for victims of trading by rigging LIBOR a few percentage points off its true value.

Figure: Submissions of 16 contributor banks for the three-month LIBOR rate between September and December 2008 9 Copyright 2012 SMU Economics Intelligence Club

By its definition, LIBOR can simply be calculated by the accurate estimates by banks with good rules. Theoretically, these estimates should be authentic due to the market size and the banks ability to best estimate what is going on in the market. However, in reality, things are much more complicated. The first reason is that the LIBOR is based on the estimate of banks, while the real prices that banks pay for lending and borrowing money would most likely be different from the LIBOR. No one knows what is actually going on in the market as the transactions are hardly reported. The second reason is that the poorly performing banks, which tend to obscure their performance, would twist their estimates by reducing the rates even if they know they would have to pay more in the real world. In a nutshell, it is ultimately tragic that the LIBOR is being manipulated by Barclays and other reputable banks despite the peoples faith and the huge amount of financial instruments, ranging from complex derivatives to simple mortgage loans, whose prices are based on the LIBOR. Two types of incentives for price-rigging Currently, the evidence shows that there are two types of price-rigging. The first one is to manipulate the LIBOR in order to increase trading profits. The traders at Barclays requested their counterparts at other contributor banks to submit manipulated prices. By manipulating the LIBOR, the traders could increase their profits or reduce their losses on various derivative products. This type of price-rigging is similar to price fixing for higher returns for the company through trading profits. The second type of price-rigging is more ambiguous as it concerns most banks. Also shown in the graph in the previous page, this LIBOR-rigging dates back prior to the time of the 2008 Financial Crisis when the banking industry was at the mercy of greedy bankers and traders. During the financial crisis, people had less confidence in the financial strength of banks. As a result, financially weak banks lowered their submissions for LIBOR-rates, effectively artificially shoring up their financial strength and restoring public confidence. Recently, Barclays released evidence that included a note about the conversation between its ex-CEO Bob Diamond and a senior official at the Bank of England at the end of October, 2008. The evidence highlighted that the Bank of England tacitly allowed Barclays and other banks to lower the submission rates. However, this was promptly denied by the central bank soon after. Amidst all the accusations, it is worthy to note that in times of financial crisis, when governments attempt to restore public confidence in banks, a possible response would be skepticism about banks trustworthiness by the public. Ultimately, only time will tell the truth, when pending investigations are completed. Looking to the future For the next few months, investigations would go on and we are not sure which banks would be involved in the scandal until the investigations are over. However, it would take some time to restore the confidence that people had in the financial and banking industry. Some systematic changes need to be done. One change should be that LIBOR and other inter-bank offered rates, such as the EURIBOR and TIBOR (Tokyo Inter-bank Offered Rate), should be based on the actual rates that banks have to pay for lending and borrowing and not based on estimates. Moreover, in situations where the market becomes illiquid and there is little borrowing and lending capacity, there should be a regulation to ensure that banks submit accurate interest rates and not hypothetical interest rates, as this increase the risk of human error due to profit maximization motives. There should be outside regulators to monitor the submissions of each bank and verifying data across different banks. For example, actual rates banks borrow for can be referenced with rates that were originally put forth in the calculation of the LIBOR. In addition to these changes, there should be stricter regulations imposed on banks to restrict their actions. The world has witnessed several price-fixing scandals in the 10 Copyright 2012 SMU Economics Intelligence Club

banking industry and this toxic tradition of banking should be changed if we want to restore the acerbated reputation of the banking industry. Only through lawsuits, prosecutions and tighter regulations would the finance industry improve its image and regain the trust that has been forfeited. __________________________________________________________________________________ Tobacco moment refers to the lawsuits and settlements that cost Americas tobacco industry more than $200 billion in 1998. A financial security that derives its value from an underlying asset. A situation whereby selling an asset is difficult due to a lack of buyers, or there is a lack of funds available. Sources: Bloomberg, The Economist, Financial Times, CNBC

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The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large- cap common stocks actively traded in the United States. It has been widely regarded as a gauge for the large cap US equities market The MSCI Asia ex Japan Index is a free float-adjusted market capitalization index consisting of 10 developed and emerging market country indices: China, Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand. The STOXX Europe 600 Index is regarded as a benchmark for European equity markets. It represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

Correspondents Shane Ai Changxun (Vice President, Publication) changxun.ai.2010@smu.edu.sg Singapore Management University Singapore Herman Cheong (Vice President, Operations) Wq.cheong.2011@economics.smu.edu.sg Singapore Management University Singapore Fariha Imran (Marketing Director) Farihaimran.2010@economics.smu.edu.sg Singapore Management University Singapore Randy Lai (Editor) Tw.lai.2010@smu.edu.sg Singapore Management University Singapore Marcus Chew marcus.chew@student.manchester.ac.uk University of Manchester Myat Thiha Kyaw tkmyat.2010@business.smu.edu.sg Singapore Management University Ben Lim (Vice President, Publication) ben.lim.2010@smu.edu.sg Singapore Management University Singapore Tan Jia Ming (Publications Director) jiaming.tan.2010@smu.edu.sg Singapore Management University Singapore Vera Soh (Liaison Officer) Vera.soh.2011@economics.smu.edu.sg Singapore Management University Singapore Seumas Yeo (Editor) Seumas.yeo.2010@smu.edu.sg Singapore Management University Singapore Wong Hong Wei Hongweiwong.2009@business.smu.edu.sg Singapore Management University

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