SMU Political-Economic Exchange

AN SMU ECONOMICS INTELLIGENCE CLUB PRODUCTION

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ISSUE 16 21 MAY 2012

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- The Green Industry: Public and Private Sector Interplay - Inflation Management in The UK - Contagion effect of Eurozone on global M&A activities
The Fortnight In Brief (8th May to 21th May)
US: Is the US in a Spring Slowdown? Dismal jobs data and a slight dip in GDP figures for the month of April seem to be a tell-tale sign of a slowdown. However, recent figures for May show a rebound in the job market against expectations and trends. There is also more good news as inflationary pressures are easing and consumer sentiment is at its highest level since 2008. In same vein, industrial production (IP) climbed by 1.1% m/m in April backed by hiking utilities output. Aprils FOMC meeting indicated that the Fed is ready to commit to further monetary policy accommodation if the recovery were to lose its momentum. Asia Pacific ex-Japan: The Chinese Drag The slowdown in China accelerates both imports and exports registered lower figures while value-added industrial production (IP) growth saw a dip to 9.3% y/y. Urban real estate investment growth, which accounts for close to 8% of the Chinese GDP, tanked from 23.5% y/y to 9.2% in April, prompting the Peoples Bank of China (PBoC) to cut the required reserve ratio. The drag seems to confirm a regional slowdown - both Taiwan and South Korea reported data that were below expectations while Indias IP saw a 3.6% contraction y/y in March and a hike in inflation to 7.2% y/y. EU: The Core floats while the Peripheries sink The Greeks are once again, in the spotlight the failure to form a unity government between President Papoulias and the New Democracy, SYRZIA and PASOK parties prompts for fresh elections in June. While a caretaker government is being installed, concerns on potential disorderly default were raised as the possibility of a majority SYRZIA (the party with a firm stance against austerity) coalition government looms ahead. Meanwhile, the Eurozone escaped a technical recession with a flat growth in Q1 2012. As expected, the core has been sustaining the Eurozone, with Germany, Austria and Belgium posting quarterly growth while the peripheries, Greece, Italy, Spain, Portugal and Cyprus slipped further and remains in recession.

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The Green Industry: Public and Private Sector Interplay

By Lisa Ho, Singapore Management University

Introduction Once an oft-overlooked industry, the green industry has, in recent years, been stirring more attention. There is no single definition of green industry. However, the United Nations Development Organisation provides a fairly good starting point: a green industry is any industry that commits to reducing various environmental impacts of its processes and products, and is actually doing so on a continuous basis. This description recognises that green industries manifest themselves in several diverse forms: renewable-energy projects, the construction of environmentally-friendly buildings and the development of pollutionreducing technologies, to name but a few. According to the United Nations Environment Programme, the world market for environmental goods and services reached US$1.3 trillion in 2008. It is expected to double over the next 12 years. As seen from Figures 1 and 2 below, demand for renewable sources of energy as a primary energy source is set to increase.
Figure 1: Projected demand for energy

Source: OECD World Energy Outlook 2011

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Figure 2: Contribution of renewable energy sources to total primary energy supply (%)

Contribution of renewable energy sources to total primary energy supply (%)

7 6 5 4 3 2 1 0 1990 1995 2000 2007 2008 2009 2010 USA Japan Australia UK

Source: OECD World Energy Outlook 2011

Private-sector Reluctance to Invest Given the high growth potential of the green industry, one would expect the private sector to be rushing eagerly to invest in it. However, government investments in green industries often outweigh private investments. Why is this so? The most important factor is the high initial capital cost involved in most green ventures: infrastructure such as plants and equipment in these industries often cost more than those of traditional brown industries. Another deterrent is the high degree of perceived risk involved in most green projects. Green technology projects are relatively untested and the lack of historical data, coupled with the long payoff period for the majority of projects, creates the perception that they have a disproportionate risk/return payoff ratio. This lowers their appeal, particularly to private investors looking for proportionate and consistent payoffs. Finally, the private sectors reluctance to invest further stems from the lack of clarity and consistency in government regulations and policies governing the green industry. Take the American Production Tax Credits (PTC) introduced in 1992. Among other things, they reduce property tax owed, hence lowering the costs of a project and increasing its appeal. These credits have been vital in securing private financing in areas such as the wind industry. However, the lifespan of each batch of PTCs fluctuate. Uncertainty over the longevity of these credits caused significant investor exit in the mid-2000s. These barriers to entry1 have traditionally deterred private investment in green ventures to a significant degree and left the government as the main driver of investment in most countries. However, depending on the public sector to fund the transition to a low-carbon economy is unsustainable. Firstly, the extent and form of support is highly vulnerable to changes in government. The priority given to funding green investment may vary according to the prevailing political agenda. For instance, retroactive cuts to feed-in tariffs2 in Spain for solar power projects 3 Copyright 2012 SMU Economics Intelligence Club

resulted in a wave of bankruptcies of solar power companies. There was also a loss of investor confidence in the green sector throughout Europe as investors feared that other European governments may follow in Spains footsteps. Secondly, as the green industry expands, the toll exerted on public resources will increase. Even if governments were willing to increase expenditure, it comes at the expense of other policy areas e.g., healthcare. Hence, governments often attempt to encourage simultaneous private investment. Orthodox Public-sector Approaches Generally, four types of policy approaches are utilised. 1. Taxation: Some countries use tax revenue to support eco-efficiency programs while discouraging less efficient production. For example, Germany introduced a tax targeting the consumption of oil and electricity in 1999. Part of this revenue is then used to promote renewable energy.

2. Direct Expenditure: This approach takes various forms, e.g. funding, subsidies and provision of infrastructure. For instance, under Australias 2009 Green Skills Agreement, private businesses are partially subsidised by state funds when they upgrade employees skills to suit the transition of the industry into an ecologically sustainable one. 3. Regulation: These exist in many forms; the more common ones being minimum standards for energy efficiency and limits on emissions. 4. Institutional approaches: Government departments create new institutions that develop standards and recognition programmes. Japans Eco-Efficiency Awards Program, sponsored by the Ministry of Economy, Trade and Industry, provides awards designed to encourage private sector investment in the green industry.

The Worlds First the UK Green Investment Bank Unorthodox approaches have been taken as well, the most recent being the United Kingdoms Green Investment Bank (GIB). The GIB is publicly-driven, and aims to increase private investment by targeting difficulties involved in financing green projects. Its novelty lies in its focus on managing and reducing the inherent risks of low-carbon projects a significant step away from the usual method of simply providing support. Instead of being restricted to addressing market failures within the green industry alone, as has been the case with orthodox policy measures, the GIB allows the government to enter the capital market and direct private-sector money to specific green ventures that require funding. Several advantages flow from this novel solution.

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Firstly, GIB intervention in selected sectors addresses the under-provision of capital more effectively. Since it focuses on both the green industry and the capital market, it is able to build a body of financial products and information in response to changing sectorial markets. Private investors can adopt and modify these innovations to suit their circumstances. This encourages private sector investment by lowering information and transaction costs. Secondly, the GIB can indirectly reduce the future cost of infrastructure. This benefit is especially likely to materialise should there be increased flow of private capital to the research and development of existing and novel green technologies. The resulting increased body of data will contribute to lowering unit costs in the relevant sectors of the green industry. Industry clusters3 may also form, reducing unit costs through knowledge spill over. Thirdly, the GIB arguably has greater distributional efficiency than existing policy measures. Having direct contact with private-sector players allows it access to a wide range of investors; from large institutional investors to small- and medium-sized enterprises. Furthermore, all investors will be able to modify the financial instruments offered to suit their needs the level of and degree of exposure to project-specific risk, initial and/or additional capital provision via equity or debt, etc. As a result, more investors become willing to enter the green industry. Theoretically, this would enhance competition and from there, distributional efficiency. Finally, a public financial institution that has widespread exposure to green investment projects through its portfolio would signal the public sectors commitment to supporting the green industry for the long-run. This reduces the perceived risk of abrupt changes in policy supporting the green industry, creating credibility and further lowering investment risk for private actors.

Conclusion The establishment of the GIB is a novel attempt to address current market failures and barriers to entry in the green industry. By offering financial instruments that can be tailored to meet private investors circumstances and desires, the UK government can steer capital to green ventures far more effectively and efficiently than traditional, blunter instruments such as taxes or arguably unsustainable measures like subsidies. Thus, the UK GIB is an option worth exploring regarding the encouragement of private investment in green projects.
Economic, procedural, regulatory, or technological factors that obstruct or restrict entry of new firms into an industry or market.
1
2

Guaranteed wholesale prices

3 Groups

of similar and related firms in a defined geographic area that share common markets, technologies, and worker skill needs. Firms and workers in an industry cluster draw competitive advantage from their proximity to competitors, a skilled workforce, specialized suppliers and a shared base of sophisticated knowledge about the industry.

Sources: BIS UK, McKinsey & Co, OECD, The Financial Times, UNIDO, World Resources Institute. 5 Copyright 2012 SMU Economics Intelligence Club

Inflation Management in The UK

By Zhang Tengen, University College of London
The UK has historically been at the forefront of economic thought and this has been evident in the evolution of policy making in the country. As seen in the graph below, over the course of the last 50 years, the country has seen periods of volatile and stable inflation, which can be best attributed to the choice of policy to control inflation. From demand management policies to monetary aggregate targeting, the merits and flaws of each approach have refined inflation management to the inflation targeting monetary policy that it is today.

Retail Price Index (%)

30 25 20 15 10 RPI (%) 5 0 -5 1 9 5 0 1 9 6 0 1 9 7 0 1 9 8 0 1 9 9 0 2 0 0 0 2 0 1 0

Source: UK Office of National Statistics

Demand Management Policies After the Second World War, policy making in the UK shifted towards Keynesianism, as labour market rigidities prevented efficient policy, together with direct controls in the form of Prices and Incomes Policy, was used to combat inflation and unemployment in post-war UK. However, in the two decades after the war, the flaws of demand management policies became apparent as the effect. This created series of demand policies that were pro-cyclical, which increased the amplitude of fluctuations instead of stabilising the economy. Another key caveat about Keynesian economics is its inability to explain and resolve seemingly contradictory problems of rising unemployment and inflation, which prompted the shift away from this approach to monetarism. 6 Copyright 2012 SMU Economics Intelligence Club

Monetary Rule The oil shocks in the 1970s proved to be the litmus test for policy robustness. Also, the failure of demand policies to address the dual problem of inflation and unemployment created a period of stagflation in the UK. By the late 1970s, all hopes were pinned on the new Thatcher government to bring down inflation and unemployment with their Monetarist policies. Under monetarism, the key focus of policy making was to engage in supply side measures instead of demand side policy. The most crucial aspect of the Thatcher era involved targeting a monetary aggregate as the monetary rule, which aimed to lower inflation expectations and hence inflation. Although this doctrinaire approach towards inflation successfully reduced inflation by 1982, the relationship between the monetary aggregate and inflation soon broke down. The reason for this was that the monetary aggregate chosen was subject to Goodharts Law. The choice of targeting M3, which previously bore an observable trend with inflation, as target for policy caused it to cease being a good indicator for inflation, thereby invalidating the monetary rule. Other problems also arose as a result of tight demand side policies. Tight control over monetary and fiscal policies put upward pressure on interest rates, leading to an appreciation of the sterling pound, which created a self-induced recession in the export sector. This coincided with the North Sea oil going on stream, thereby increasing demand for the pound, leading to further appreciation of the currency. As a result, the recession in the UK was worsened. With inflationary pressures easing, exchange rates became a major policy issue again and by the mid-1980s, monetary aggregate targeting was effectively abandoned, shifting focus from monetary policy towards inflation targeting. Inflation Targeting Money is at the heart of the inflationary process, and it would be bizarre for a central bank not to pay careful attention to the behaviour of the monetary aggregates. However, there is no time-invariant link between the change in a given monetary aggregate and the subsequent change in inflation. Instead of using monetary aggregates as a target for inflation, monetary policy after 1992 focused on targeting inflation directly. The use of an inflation target does not mean that there is no intermediate target. Rather, the intermediate target is the expected level of inflation chosen to allow for the lag between changes in interest rates and the resulting changes in inflation. The reason for announcing and following an intermediate target is to convince private sector agents that the authorities will not spring inflation surprises on them, and that the inflation target is credible. By setting monetary policy based on inflation targets, this embodies the view that inflation is the ultimate objective of monetary policy. Where next? Following the adoption of inflation targeting monetary policy, the UK enjoyed a decade of NICE years from 1997-2008. During this period, typical economic indicators signalled a healthily growing economy with low and stable inflation that supported constant long-term growth alongside a low rate of unemployment. However, the build-up of sector imbalances eventually ruptured the European economy and given the close links UK has with Europe, the British. With the advent of the Eurozone crisis that is engulfing many European countries, the way inflation is managed may once again evolve. The pursuit of price stability is an endless 7 Copyright 2012 SMU Economics Intelligence Club

marathon, not a sprint for the line. As Alan Greenspan once said, You never reach the point where you shut up shop and break out the champagne. Nor should you.

1 Stagflation:

Stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high. It raises a dilemma for economic policy since actions designed to lower inflation or reduce unemployment may actually worsen economic growth. Goodharts Law: Goodhart's law states that once a social or economic indicator or other surrogate measure is made a target for the purpose of conducting social or economic policy, then it will lose the information content that would qualify it to play that role.
3 The

total amount of money in an economy in a specific period of time.

NICE: Non-inflationary, consistently expansionary.

Sources: Institute for Fiscal Studies, Centre for Economic Studies @ LSE, Towers Watson, UK Office for National Statistics

Contagion effect of Eurozone on global M&A activities

By Benjamin Ong, Singapore Management University

Volatility is the word of the day, when it comes to the events surrounding the Eurozone these few weeks Hollandes ascension to presidency and the backlash of the Greeks. These events prove to put pressure on the German-led cure for the debt crisis austerity. As the solution to the Eurozone debt situation, the turn of events over the past few days seemed to suggest that Hollande had the backing of the US, France, and the EU with regards to sharing his antiausterity views on growth. With Germanys Merkel backed into the corner in isolation, the next few weeks would dictate the pace and level of uncertainty that surrounds the region. In 2010, the EFSF1 was formed to address the sovereign debt crisis. The concept was simple: in exchange for lending money to certain countries in Europe, austerity measures and restructuring were demanded. The austerity pill is difficult to swallow and runs contrary to the Keynesian theory, which rests on one mantra: Spending by the government overcomes recessions. The occurrence of the above two events stand to act as a catalyst for uncertainty sparking off another roller coaster ride in the Eurozone as we see a potential switch in growth measures of the region. As a result of the volatility surrounding the Eurozone, merger and acquisition2 (M&A) activities in Europe have deteriorated significantly, unsurprisingly. Target deal count in Europe Middle-east and Africa (EMEA) region decreased fourteen per cent year-on-year on the whole, with Eastern Europe (-64%) and France (-60%) taking the biggest hit. What 8 Copyright 2012 SMU Economics Intelligence Club

exactly though, is holding investors back from the Eurozone, and what effects are presented from this decrease in M&A activities? Because companies grow via organic and inorganic growth, cross-border M&A activities serve as one of the many indicators of economic activities within the region. According to a survey by Mergermarket, debt financing and deal closing are ranked as the top two aspects of the M&A process that have become more difficult in the crisis. With resulting volatility, valuations of companies tend to widen greatly. This coupled with the drying up of credit due to reluctance from banks to finance, have led to a substantial decrease in M&A activities. Companies need to be extra cautious when performing due-diligence of such cross-border acquisitions. Concerns may include: If the country mentioned leaves the Eurozone, how will it affect operations, activities with relevant stakeholders? The extent to which the revenues, bottom line and scale of the operations dependent on the region? How will the debt arrangements be affected in the event of a fall out of either the country in question, or that of its partners? The shut-down of debt financing has dampened investor confidence and the volatility of the Eurozone has incited a general trend of cash-hoarding amongst companies across the various economies. On a year-on-year comparison, there was a general increase of seventeen per cent in cash on the balance sheet in 2011. Most notably, within the Asia Pacific region, corporates have increased their balance sheet cash significantly Singapore (+72%), China (+57%), and Hong Kong (+47%). With fairer and more realistic valuations abound, it is expected that acquisition via the use of cash is likely to be the driver behind M&A activities in 2012. This view is also in line with a recent survey conducted by Bloomberg on 2012 M&A outlook (see figure 1). A majority of respondents (>60%) of the survey have raised expectations of an increase in the pace of Asia Pacific deal making, as compared to the Americas and EMEA. Figure 1: Expected increase in the use of cash as mode of financing

Deal Financing
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Cash Equity Debt

2011
Source: Bloomberg

2012

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On the flip side, we expect that the twin occurrence of cash hoarding and lower valuations to spark off an increase in hostile take-overs3 in 2012. Strategic buyers with large cash reserves will continue to make unsolicited bids to capitalize on growth opportunities and push for a sale, even with an unwilling seller. The events caused by the Eurozone are likely to take a round-about turn back to the Eurozone, as we see companies looking elsewhere for investment and acquisitions, or holding back altogether. Pursuant to the cash-hoarding trends triggered by the overall cautious approach, management would feel pressured to put the cash to good use. As a result, crossborder activities might be diverted to non-Eurozone regions, sparking a downward spiral in the Eurozone situation as the uncertainty drags on.
The European Financial Stability Facility set up as a special purpose vehicle (SPV) by the European Union with the objective of raising funds through the issuance of debts and redistributing the funds to financially troubled institutions and governments in the Eurozone.
1

Merger refers to the consolidation of two companies to form a new company while acquisition refers to the purchase of one company by another with which no new company is formed.
2 3 The

acquisition of a target company through direct transactions with target companys shareholders without the agreement from target companys management. It is termed hostile as the target companys management is usually not in favour of the takeover arrangement and wishes to challenge and oppose the acquisition.

Sources: Allen & Overy, France 24, Bloomberg, Mergermarket Group

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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 Lisa Soh Lisa.ho.2010@law.smu.edu.sg Singapore Management University Singapore Benjamin Ong Benjamin.ong.2009@business.smu.edu.sg Singapore Management University Singapore 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 Zhang Teng En tengenzhang@gmail.com University College London Manchester, United Kingdom

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