Brian Caplen discovers that market responses to concern over climate change, the risks associated with macroeconomic imbalances and the ever-present bugbear of regulation are the issues most vexing the world’s financial powerbrokers.

In days gone by, the intelligentsia went to the mountains to recuperate from illness. They stayed in sanatoriums where they sat on balconies watching the snows fall while breathing in the clear crisp air. To pass away the hours they discussed the meaning of life and the state of the world, as recounted in Thomas Mann’s classic novel The Magic Mountain.

These days the elite are in much better physical shape but they are still going to the mountains to discuss ‘the global agenda’ as set out by the World Economic Forum (WEF) at its annual meeting in Davos, Switzerland, in January. This year’s theme was ‘Shaping the global agenda, the shifting power equation’, aimed at exploring new influences on the world economy such as the emergence of India and China and the rise of new community networks. Twenty or so heads of state were in town along with delegates to bring their considerable grey matter to bear on a very rich diet of seminars and meetings that spanned issues such as depression, city living and the wisdom of youth as well as the more standard ones of economics, geopolitics and business.

Climate change

Apart from the headline-grabbing issues that impact on everybody, the key elements for finance professionals at the meeting were the climate change discussions as well as material on macroeconomic imbalances, and the risks they pose, and the ever-vexed question of regulation.

Climate change is now firmly on the corporate agenda. As well as being a serious and potentially life-threatening issue it also comes laden with business opportunities. Peter Schwartz, chairman of the consultants Global Business Network, said: “Solving the climate change problem is unusual in business terms as the benefits come before the costs. You get the upside before the downside.” He cited as an example auto companies selling ‘green’ cars before they are charged with any kind of environmental taxes.

Mr Schwartz carried out one of the key pieces of research on climate change done for the US department of defence, and he claimed that in the worst-case scenario “six million people are off the planet”.

“Climate change is a recipe for war,” he said, and other commentators at Davos noted the potential for mass migrations, wars and infectious diseases if climate change is not addressed.

But on the positive side, he added that climate change can be of real benefit to the economy because of the business opportunities.

Doing nothing is not an option

UK treasury economist Sir Nicholas Stern, who was in Davos for the meeting, has pointed out in his groundbreaking report that the cost of action is about 1% of gross domestic product, while the cost of doing nothing is potentially fatal. Given the necessity for newly industrialising countries such as China and India to increase emissions of greenhouse gases as they grow their economies, the onus is on the developed countries to cut back on theirs, says Mr Stern in his report.

The investment banks are already making money from the trading of carbon credits and the new emphasis on climate changes – evident in Davos sessions such as ‘Climate change: A call to action’, chaired by Financial Times columnist Martin Wolf, and ‘Can markets save the planet’ – is likely to lead to further opportunities.

Kevan Watts, chairman of Merrill Lynch International, said: “The climate change issue is a classic case of market failure because the public costs arising from carbon emissions are not being borne by the producers. Bringing these costs into market pricing mechanisms such as trading carbon credits is exactly the right way to go.”

Renewable energy

Credit Suisse looked at a different aspect of the environmental debate in its luncheon seminar on the future and potential of renewable and sustainable energy. Here the emphasis was on companies in the renewable energy field and the prospects for listing them on a stock exchange.

“Renewable and sustainable energy is very much an issue of the future but is increasingly becoming an issue of the present as well. You can see why it’s such a hot topic here in Davos this year and will be for many years to come,” said Brady Dougan, the new CEO of Credit Suisse, and formerly the head of investment banking. “We did our first IPO [initial public offering] for a company in the alternative energy sector in 2005 – a $500m deal for a Chinese company called Suntech – and since then we have done 22 deals. This shows that capital is becoming available through the market.”

The climate change market will be strongly influenced by regulation of course, in the way that the Kyoto Protocol kick-started emissions trading, and regulation is a topic never far away from the surface at WEF meetings. German chancellor Angela Merkel referred to the need to look at the role of hedge funds in the international capital markets (implying the need for regulation or self-regulation) in her opening address at Davos. The theme was taken up again in sessions on hedge fund transparency involving Howard Davies, director of the London School of Economics and a former chairman of the UK’s Financial Services Authority (FSA), and on regulation and financial market competition.

Regulation wary

Bankers are understandably less keen on regulation that slows down and encumbers their business – which some financial regulation does – as opposed to creating opportunities as further climate change regulation might. Last December, the Institute of International Finance (IIF) launched an initiative to improve dialogue between regulators and the industry, focusing particularly on cross-border, enforcement and anti-money laundering issues.

In between sessions and meetings at Davos, the IIF’s managing director, Charles Dallara, said: “What has become clear over the past year or so is that some high-level principles can be sketched out, such as the need for better mutual trust and relationships [between regulators and the finance industry], the need for more efficient cross-border co-ordination of regulation and the need for proportionate enforcement. We have taken these issues as ones for immediate concern but we see this as a long-term dialogue.

“The proposals have been well received by the regulatory community and that is crucial because this is not something you can get done on your own as a banking association.”

With the advent of Sarbanes-Oxley in the US as well as the failure of the US to unify its regulation, there was a lot of talk in Davos of New York losing ground as a financial centre to London because of the heavy hand of regulation. In separate sessions, Thomas Russo, vice-chairman of Lehman Brothers, and John Thain, CEO of the New York Stock Exchange, bemoaned New York’s fate.

Mr Russo said: “New York is losing ground and that is giving us an opportunity to look at the silo-based regulatory structure and to consider moving from a rules-based system to a principle-based system and make us comparable with the rest of the world.

Mr Thain added: “The truth is that London has been very successful in developing as a major financial centre because of the regulatory environment and the structure of the FSA.” He also cited the problems of getting work permits and visas for foreigners to work and visit the US.

But for Greg Fleming, president of global markets and investment banking at Merrill Lynch, it is the litigation aspect rather than the regulation that is the major source of disquiet.

He said: “The US class action litigation system reduces the competitiveness of US markets. All responsible companies accept the concept of full and honest disclosure and rigorous regulatory enforcement, but no one wants to be subject to massive class action litigation that often has little to do with the merits. Outside the US, such litigation is virtually non-existent and the markets still function very effectively. Issuers have a choice about where to raise capital and many now avoid the US in significant part because of class actions.”

Risky business

The WEF would not be complete, of course, without some discussion about macroeconomic imbalances and the general risk environment. This year’s meeting was no exception. Indeed, the founder and executive chairman of the WEF, Klaus Schwab, in his opening remarks listed a number of pressures impacting on the global situation, such as the increasing prominence of emerging economies, the rise of new multinationals, the stronger role of consumers over producers, the increasing leverage of commodity suppliers and the growth in influence of hedge funds and private equity.

For bankers, the two key issues are the outcomes in any unwinding of global imbalances and a sudden reappraisal of risk in the capital markets. At present, China is running a current account surplus of 7% of GDP while the US has an equivalent current account deficit. China’s reserves have traditionally been invested in US treasury bonds, but the government has indicated that it wants to direct more of its financial resources into domestic development. The question is what impact this will have on the global economy.

William McDonough, a former president of the New York Federal reserve and chairman of the Basel Committee, said: “It will be a challenge for both countries [to adjust their current accounts]. China’s economy is growing very quickly but the central government has enough influence to push for more production of goods and and services for domestic consumption. It’s still going to be a formidable export machine. The challenge in the US is largely a political one but it seems as if it is now firmly on the agenda.” Mr McDonough is currently a vice-chairman and special advisor to the chairman at Merrill Lynch.

cp/18/pxiaolingwu.jpg
At a session called ‘Can central banks manage global financial risks?’, the deputy governor of the People’s Bank of China, Wu Xiaoling, pointed out that the average growth rate of China was 10% a year, while inflation was holding at 3%. “The Chinese government doesn’t think it is good to have such a fast growth rate and there is a question of whether it’s sustainable. We have constraints in terms of the environment as well as energy resources. We want a balanced approach, not only a focus on growth,” she said, in remarks that reflected the general tone at Davos.

Wu Xiaoling: the deputy governor of the People’s Bank of China pointed to constraints on Chinese growth in terms of the environment as well as energy resources

But she also indicated that adjustments, such as to the exchange rate, would be gradual, the long-standing position of the Chinese government.

At the same session, the president of the European Central Bank, Jean-Claude Trichet, made the headlines by indicating that the current benign environment of low interest rates and spreads in which all shocks seemed to be absorbable may only be temporary.

“It might be due to phenomena that are transitory,” he said, such as emerging economies producing surpluses and companies spending more on risk protection than on investment in their own businesses. The oil price rises have created forced savings, he said, and that meant that capital was chasing investment all over the world. “These are elements that are unsustainable in the long run and you have to be prepared for a reappraisal of risk.”

That could very quickly switch the topics of discussion at next year’s meeting from climate change back to an immediate crisis.

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