Carney: Commonwealth Is Still Alive

Includes: EWC
by: Evariste Lefeuvre

With candidates like Paul Tucker, Adair Turner, John Vickers and Kate Barker left waiting in the wings, the recent announcement that Bank of Canada Governor Mark Carney will be transitioning to the role of Bank of England Governor in July 2013 came as a surprise.

With England barreling toward another recession (GDP growth in Q3 will likely be revised down this week), Carney certainly has his work cut out for him.

It may take a while before we know why Carney was chosen, but the BOE attempting to import credibility through a highly valued central banker is a possible reason.

It may seem odd at first, given the huge disparities between the economies. Canada has an open economy, and is also highly dependent on its biggest trade partner, the U.S. (74% of its exports). It also has a commodity currency, as the CAD is highly dependent on oil price fluctuations. A nearly exclusive trade relationship combined with an oil-linked currency makes the BOC's management of monetary policy very different from that of the BOE.

According to the BOC, "the cornerstone of the Bank's monetary policy framework is its inflation-control system, the goal of which is to keep inflation near 2 per cent - the mid-point of a 1 to 3 per cent target range." By contrast, the BOE has two core purposes: monetary stability and financial stability. According to the BOE: "Financial stability entails detecting and reducing threats to the financial system as a whole. This is pursued through the Bank's financial and other operations, including lender of last resort, oversight of key infrastructure and the surveillance and policy roles delegated to the Financial Policy Committee."

Should Carney be praised for his management of the crisis since 2008 and the fact that Canada did not suffer a banking crisis in 2008? To us, this is a matter of inheritance and legacy.

Inheritance: Carney inherited a banking system that is highly regulated and hence not as susceptible to systemic risk. In the paper "Why Didn't Canada Have a Banking Crisis in 2008? (NBER Working Paper No. 17312), the authors outline a simple answer: Canada set up a strong banking regulator that controlled mortgage lending, while the U.S. allowed less stable banks (and a shadow banking system) to profit without serious oversight. Financial regulation, they write, is the reason that Canadian banks have withstood the crises that the US has faced. The fact that Canada went through the crisis without bank failures may not be attributable to monetary management skills but rather to the fact that "the stability of the Canadian banking system is not a one-off event."

Legacy: Carney will join the BOE at a time when Canada is facing a major risk of housing bubble. As can be seen in the charts below, the outstanding mortgage debt is still ramping up. In addition, housing prices are levitating, while they have receded in many crisis-affected countries.

There may not be a housing bubble in Canada, but the risk of negative contribution to growth from the real estate sector in the next few quarters should not be ruled out. In addition, the banking sector might be robust enough for the real estate risk to be limited and not systematic.

There are upcoming changes in UK financial regulation that will increase the role of the BOE. The division of the Financial Services Authority (FSA) into the Prudential Regulation Authority and the Financial Conduct Authority will leave the BOE to be the single authority that will monitor the financial system. This is probably why Carney was appointed to offer a "fresh perspective" to the BOE, according to Chancellor George Osborne. The cyclical pattern, the currency fluctuations, the market expectations and the financial framework of the UK economy differ greatly from those of Canada. Carney may have been able to steer the Canadian economy through the crisis with the help of a sound (inherited) regulatory framework, but dealing with a recession-prone economy and a newly framed regulatory environment will be a huge challenge.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.