BBC News - US criticises Germany and China policies

The US has criticised Germany's economic policies, saying that its export-led growth model is hurting the eurozone and the wider global economy.

The US Treasury has blamed Germany's export-led growth model for dragging down eurozone

In its bi-annual report, the US Treasury said that domestic demand growth in Germany had been "anaemic".

It also reiterated its view that the Chinese yuan continued to remain "significantly undervalued".

The report has criticised Chinese policy before, but criticism of German economic policy is rarer.

"Germany's anaemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro-area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment," the Treasury said.

"The net result has been a deflationary bias for the euro area as well as for the world economy."

'Bit strange'

Germany, the eurozone's largest economy, has been one of its key drivers of growth in recent years.

Its importance to the 17-nation bloc has only increased since the development of the region's debt crisis, which has affected other bigger economies such as Italy and Spain.

Germany has been one of Europe's stronger economic performers and its exports prowess is seen as one of its key strengths.

It narrowly avoided recession earlier this year, but GDP in the second quarter of 2013 was driven up by demand from both consumers and businesses.

Analysts said that while Germany could benefit from boosting domestic demand, the criticism levelled at its policies was unfair.

"I think this is a bit strange," Tony Nash, vice president at IHS, told the BBC. "The eurozone has to get growth from somewhere and Germany is the most likely place for that to happen."

"And it is better for the eurozone to have a highly concentrated, efficient and skilled export powerhouse in Germany than not have any major engine of growth," he added.

Yuan concerns

In recent years, the US and many other economies have alleged that China tries to keep the value of its currency artificially low.

They say that, by doing so, Beijing gives an unfair advantage to its exporters, as an undervalued currency makes its good cheaper to foreign buyers.

For its part, China has been looking to loosen its grip on the currency as it looks to push for a more global role for the yuan.

But Beijing has maintained that a sudden and sharp appreciation in the value of the yuan will hurt its overall economy.

The yuan has risen nearly 12% against the US dollar since June 2010.

While the Treasury acknowledged that the yuan had been rising, it said the appreciation was "not as fast or by as much as is needed".

"On the other hand, the evidence that China has resumed large-scale purchases of foreign exchange this year, despite having accumulated reserves that are more than sufficient by any measure, is suggestive of actions that are impeding market determination and a currency that is significantly undervalued," it added.

However, the report did not label China as a currency manipulator.

Bloomberg News - Iceland Pushes to Become Arctic Hub After Scrapping EU Accession

Arnaldur Halldorsson/Bloomberg

A national flag is seen on the hull of a commercial fishing vessel moored in the harbor in Reykjavik, Iceland.

Iceland wants to turn itself into a hub for business in the Arctic and strike more trade accords on its own after scrapping talks to join the European Union, its foreign minister said.

“The focus of Iceland’s foreign policy is on the Arctic,” Gunnar Bragi Sveinsson said in an Oct. 25 interview in Reykjavik. The island will work for deeper cooperation within the Arctic Council and seek to provide a base in the region to help support trade with China, Singapore and South Korea, among others, he said.

The Arctic is becoming a magnet for countries seeking to benefit from new shipping routes created by rapidly melting ice in a development that will make the trip from Europe to Asia shorter and cheaper. The softening ice could also bring within reach the 30 percent of the world’s undiscovered natural gas reserves and 13 percent of its undiscovered oil that lie under the Arctic Ocean floor, the U.S. Geological Survey estimates.

The eight-member Arctic Council, which was founded in 1996, in May this year granted observer status to China, India and Japan, among other countries. Members include the Scandinavian nations, Russia, the U.S., Canada and indigenous groups.

Iceland is also considering opening a shipping port at Finnafjordur, on the island’s northeastern coast, which may be operated by Bremenports GmbH & Co. KG. The facility would be able to service companies using the northern sea route as well as oil explorers.

Own Terms

In April, Iceland became the first European country to sign a bilateral free trade agreement with China. The accord provides the island with the opportunity to sell its expertise in geothermal energy to the world’s second-largest economy. That deal followed a 66 billion kronur ($550 million) currency swap agreement with China in 2010, which was renewed in September.

The swap contract has helped Iceland obtain foreign currency as it struggles to exit capital controls put in place after its economic collapse in 2008. The deal came a year after the country began EU membership talks in 2009.

Iceland originally sought to enter the 28-nation bloc after the collapse of its biggest banks pushed the island’s economy into its worst recession in six decades and left it reliant on an International Monetary Fund-led bailout.

EU Snub

After exiting the IMF program, and as the economy improved, Icelanders earlier this year voted in a coalition government that has rejected continued talks with the EU.

The new administration has now decided that a referendum will be needed to move ahead with the EU accession process, though no date has been set. President Olafur Grimsson has said Iceland’s relationship with the EU worsened during the economic crisis, in part amid a dispute over bailing out Dutch and British depositors in a failed Icelandic bank.

“I hope Iceland will never join the EU,” Sveinsson said. “It’s impossible to say what will happen in 10 years or 20 years, but in my opinion the EU is moving in a direction that should make it less desirable for Iceland to join. There’s greater centralization, power is being shifted from the sovereigns to unelected bureaucrats.”

Instead, Iceland is using its bilateral ties with China and others to help boost trade. The country will also seek to build closer links to Canada and the U.S., according to Sveinsson. The cooperation will include “defense issues,” he said.

Chinese Billionaire

The new government, which ousted a Social Democrat-led coalition in April, has also said it will review a decision by the previous administration to block a property development plan by Chinese billionaire Huang Nubo.

“It’s very important for us to have a free trade agreement with China,” said Sveinsson. “The Chinese are interested in Iceland and the Arctic and naturally Iceland should utilize that interest, just like Iceland utilizes that interest among other nations. Hopefully, Iceland’s relationship with China will grow stronger. Of course, that will have to be on our terms.”

Reuters News - UK economy accelerates to fastest growth since 2010

Quarterly percentage change in UK real GDP.

Credit: Reuters/Vincent Flasseur

By William Schomberg and David Milliken

(Reuters) - Britain's economy picked up more speed between July and September, growing at its fastest pace in more than three years and building on an unexpected turnaround that has buoyed the government.

Gross domestic product rose by 0.8 percent, faster than the 0.7 percent achieved in the April-June period, Britain's Office for National Statistics said on Friday.

The quarterly growth and the year-on-year rate of 1.5 percent were in line with forecasts by economists in a Reuters poll. The numbers also made Britain, until recently a laggard among the world's rich countries, one of its fastest-growing economies with an annualised growth rate of over 3 percent.

British government bond prices initially rose, reflecting expectations among some investors that quarterly growth might have been closer to 1 percent, but quickly fell back. The pound strengthened slightly against the dollar and the euro.

Joe Grice, chief economist at the ONS, said quarterly growth could have reached 0.9 percent but for weak gas and electricity output. That was possibly a reflection of Britain's unusually hot summer this year.

Samuel Tombs, an economist with Capital Economics, said Britain's economy was unlikely to gather much more pace because of wages that are rising less than inflation, more government spending cuts and the dormant euro zone.

"But with employment growing, confidence returning and productivity still well below its potential, it seems unlikely that the recovery will fade significantly either," he said.

Britain's economy has staged a surprising recovery since early 2013 when it avoided falling back into recession.

The turnaround has given a boost to Conservative Chancellor George Osborne, who defied calls from the International Monetary Fund and the Labour Party to bring forward spending in order to get the economy off the ropes.

The government hailed the growth figures as proof that its tough approach to public spending was paying off.

"Many risks remain, but thanks to our economic plan, the recovery now has real momentum," a Treasury spokesman said.

STILL SMALLER

The growth between July and September meant the British economy expanded for three successive quarters for the first time since 2011.

Nonetheless, unlike almost all other developed economies, which have fully recovered output lost during the financial crisis, Britain's economy remains 2.5 percent smaller than its previous peak in early 2008.

Bank of England Governor Mark Carney noted on Thursday that growth was coming from a low base, so Friday's figures are unlikely to sway policy at the bank, which has suggested it will keep interest rates at their record low of 0.5 percent for three more years.

Earnings are lagging inflation, raising questions about the sustainability of the recovery and giving ammunition to Labour to attack the government in the run-up to a general election due in 2015.

Friday's data showed Britain's giant services sector, which accounts for nearly 80 percent of the economy, expanded by 0.7 percent from the second quarter and was now above its peak before the financial crisis hammered Britain.

Growth in services was driven by the private sector, while government services lagged behind, a reflection of Osborne's push to curb public spending.

Manufacturing grew 0.9 percent, and construction, which has begun to recover after a sharp contraction caused by the crisis, expanded by 2.5 percent, the strongest in more than three years as house building picked up, the ONS said.

Consumers, a key engine of Britain's economy, are feeling increasingly upbeat, a separate survey showed on Friday.

A consumer confidence index compiled by market researchers YouGov and the Centre for Economics and Business Research hit its highest level this month since it was launched in April 2009.

The survey showed that expectations of higher house prices were driving the increase in confidence; homeowners expected their properties to be worth 2 percent more in 12 months' time, almost double the expected gain in July's survey.

Critics of the government's economic policies say its attempts to revive the housing market will not help bring about the long-hoped-for rebalancing of Britain's economy towards more manufacturing and exports.

The ONS's preliminary estimates of GDP are among the first released in the European Union, and are based partly on estimated data. On average, they are revised by 0.1 percentage points up or down by the time a second revision is published two months later, but bigger moves are not uncommon.

(Additional reporting by Joshua Franklin; Editing by Will Waterman)

BBC News - EU says distrust of US on spying may harm terror fight

EU leaders meeting in Brussels say distrust of the US over spying could harm the fight against terrorism.

Angela Merkel: "Once the seeds of mistrust have been sown it doesn't facilitate our co-operation... it makes it more difficult"

A statement agreed by the leaders says that "a lack of trust could prejudice" intelligence-gathering co-operation.

France and Germany are pushing for talks with the US to find a new "understanding" by the year's end.

A number of allegations against US intelligence agents have surfaced this week, including the bugging of German Chancellor Angela Merkel's phone.

In addition there have been claims that the US National Security Agency (NSA) monitored millions of French telephone calls.

On Thursday, the UK's Guardian newspaper also reported that it had obtained a confidential memo from the NSA suggesting it had monitored the phones of 35 world leaders.

The latest revelations have been sourced to US whistleblower Edward Snowden, the former intelligence contractor who fled the country earlier this year and is now in Russia.

They have overshadowed the EU summit in Brussels.

'Vital element'

The statement of heads of state or government, released on Friday, reflects the EU leaders' conclusions following their talks on Thursday.

It says the recent intelligence issues had raised "deep concerns" among European citizens.

The statement says the leaders "underlined the close relationship between Europe and the USA and the value of that partnership".

It continues: "[The leaders] stressed that intelligence-gathering is a vital element in the fight against terrorism."

And it went on: "A lack of trust could prejudice the necessary cooperation in the field of intelligence-gathering."

Talks among the EU leaders continued late into Thursday night.

Speaking afterwards, Mrs Merkel said: "We need trust among allies and partners. Such trust now has to be built anew.

"The United States of America and Europe face common challenges. We are allies. But such an alliance can only be built on trust. That's why I repeat again: spying among friends, that cannot be."

Germany and France said they were proposing talks with the US to settle the row by the end of the year.

The leaders' statement said: "The heads of state or government took note of the intention of France and Germany to seek bilateral talks with the USA with the aim of finding before the end of the year an understanding on mutual relations in that field.

"They noted that other EU countries are welcome to join this initiative."

BBC Europe editor Gavin Hewitt says the French and Germans are looking for a new set of rules with a "no spying pact" at the core.

He says this would mirror an arrangement the United States has had with Britain, Australia, New Zealand and Canada since just after World War II. That secret intelligence-sharing operation is known as Five Eyes.

EU President Herman Van Rompuy accepted the UK had "a special relationship" with the US, but said Britain was "completely on board with this text".

UK PM David Cameron has yet to comment.

But a number of other leaders have indicated their support for the French and German position.

Finnish PM Jyrki Katainen said: "We have to talk together with the Americans, and try to find some sort of code of conduct [on] how to cooperate on this kind of issue in the future."

Swedish PM Fredrik Reinfeldt said it was "completely unacceptable" to eavesdrop on the leader of an ally, a view echoed by Italian PM Enrico Letta, who added: "We want the truth."

But the BBC's Chris Morris in Brussels says that, despite the widespread anger about American spying, Mrs Merkel opposed a suggestion to suspend trade talks with the United States - and on that point, the UK will be relieved.

Mrs Merkel had raised her concerns with US President Barack Obama in a call on Wednesday.

White House spokesman Jay Carney later said Mr Obama had assured Mrs Merkel that her phone was not being listened to now and would not be in the future.

However, his statement left open the question of whether calls had been listened to in the past.

Reuters News - ECB sets tougher bank health tests

A structure showing the Euro currency sign is seen in front of the European Central Bank (ECB) headquarters in Frankfurt July 11, 2012.

Credit: Reuters/Alex Domanski

By Eva Taylor and Jonathan Gould

FRANKFURT | Wed Oct 23, 2013 5:23am EDT

(Reuters) - The European Central Bank vowed on Wednesday to submit the euro zone's top banks to a comprehensive batch of tests next year, staking its credibility on a review that aims to build confidence in the sector.

The ECB wants to unearth potential risks hidden in balance sheets before supervision is centralized under its roof from November 2014 as part of a European banking union drawn up in response to a debt crisis exacerbated by massive bad property loans in countries like Ireland and Spain.

Setting out its plans to scrutinize the 128 top euro zone lenders, the ECB said it would use tougher new measures set out by Europe's top regulator - the European Banking Authority (EBA) - in the asset quality review it will conduct next year.

"A single comprehensive assessment, uniformly applied to all significant banks, accounting for about 85 percent of the euro area banking system, is an important step forward for Europe and for the future of the euro area economy," ECB President Mario Draghi said.

"We expect that this assessment will strengthen private sector confidence in the soundness of euro area banks and in the quality of their balance sheets," he said.

The ECB said it would conclude its assessment in October 2014, before assuming its supervisory tasks in November although some policymakers have suggested that timing could slip.

If capital shortfalls are identified, banks will be required to make up for them, the ECB said. Draghi has said a "public backstop" must also be available.

A provisional list of banks to be reviewed includes 24 German banks, 16 in Spain, 15 in Italy, 13 inFrance, seven in the Netherlands, five in Ireland and four each in Greece, Cyprus and Portugal.

The Bundesbank and Bafin, which in Germany share banking supervision, said German bankswere "already intensively preparing for the comprehensive assessment".

Detailing the measures it will use in its review, the ECB said it would use the EBA's definition which says bank loans more than 90 days overdue are non-performing.

It will ask banks in its balance sheet review for an 8 percent capital buffer. The buffer could have been higher but may still prove a challenge to some banks as they reshuffle their balance sheets to make them crisis-proof.

An asset quality review will look at "sovereign and institutional holdings and corporate and retail exposures, and both the banking and trading books will be reviewed".

The Bundesbank has pushed to reflect the varying degrees of risk attached to bonds issued by different governments.

"We are all waiting to see whether Germany has got on top of its rumored problems in the banking sector," said Sharon Bowles, who chairs the influential committee in the European Parliament that shapes economic and financial policy.

"It seems clear that banking union has not disconnected banks from sovereigns. Bank disclosures over sovereign holdings will make that even clearer," she told Reuters.

BACKSTOPS

The ECB wants a tough review so that it does not face surprises once it has taken charge, and to avoid repeating the mistakes of two earlier European-wide stress tests that failed to spot risks that led to the Irish and Spanish banking crises.

Wary of a lopsided banking union that could see it supervise euro zone banks without a common backstop in place, it has urged governments to agree on a strong single resolution mechanism (SRM) to salvage or wind down banks in trouble.

However, this second stage of the planned union is incomplete as politicians discuss how much of the costs should be shouldered by taxpayers. Plans for a third stage, a common insurance scheme, have stalled.

"For the success of the exercise, the ex ante availability of backstops is critical," the ECB said, adding that capital shortfalls should be first and foremost made up with private sources of capital.

A Morgan Stanley survey of investors this month showed between five and 10 of the banks to be tested by the ECB are expected to fail the tests and could be forced to raise up to 50 billion euros ($68.87 billion) to bolster their capital.

However, some banks may be unable to raise capital on their own and the euro zone crisis has shown that sometimes even national governments cannot afford to stage rescues. In addition to Ireland, Spain - the bloc's fourth biggest economy - had to take international help to tackle its banking problems.

Some ECB policymakers feel uncomfortable taking on the extra responsibility and have suggested spinning off bank supervision into a separate institution over the long term. But such a step would require a change of the EU treaty, which might take years.

($1 = 0.7260 euros)

BBC News - Greenspan fears US government set for more debt stalemate

Former US Federal Reserve Chairman Alan Greenspan has said that a repeat of the crisis that brought the country close to default is "perfectly conceivable".

Allan Greenspan said the eurozone needed "consolidation politically"

He told the BBC that he had not seen another situation in Washington where "compromise" seemed so far away.

Mr Greenspan confessed to sympathies with the aims of the Tea Party, the Republican faction that fought the government during debt ceiling talks.

But the former central banker said the movement's tactics were "undemocratic".

Mr Greenspan, the most powerful figure in economic policy when he ran the Fed between 1987 to 2006, spoke to the BBC's Evan Davis ahead of publication of his new book, The Map and the Territory.

In a wide-ranging interview to be broadcast on Radio 4's Today programme and the World Service's Business Daily, the former Fed chief had strong words for those who thought the eurozone crisis was over.

The crisis is likely to continue until the eurozone sees "consolidation politically. I think that's where we are going".

He said: "The culture of Greece is not the same as the culture of Germany, and to fuse them into a single unit is extremely difficult.

"The only way you can do it is by political union, like with East and West Germany, and even that is not working as well as it should be."

But he was optimistic about the UK's attempt to revive its economy.

'Shocked'

"What Britain has done with its austerity programme has worked much better than I thought it would," Mr Greenspan said.

"As far as I can judge, it [the economy] is coming out pretty much the way they [the coalition government] had expected."

Mr Greenspan also defended his record at the Fed against criticism that easy-credit policies and light-touch regulation had contributed substantially to the 2008 financial crash. He also declined to criticise the financial derivatives market.

He said: "One thing that shocked me is that not only did the Federal Reserve's very sophisticated model completely miss (the crash on) September 15th, 2008, but so did the IMF, so did JP Morgan, which was forecasting American economic growth three days before the crisis hit, going up all through 2009 and 2010."

There is a difference between predicting economic bubbles, and predicting when they might burst, he said.

He rejected suggestions that he was not clear enough in warning that the financial markets might be teetering on the edge of collapse.

However, his words of warning had to be couched very carefully in order not to unsettle the markets, he said. "I was very worried about what the impact would be."

'Worry'

Mr Greenspan, 87, who now runs his own consultancy business, also criticised a growing "crony capitalism" in the US.

He said: "Crony capitalism is essentially a condition in which… public officials are giving favours to people in the private sector in payment of political favours."

He said it was prevalent in China and Russia, but had not been common in the US or the UK. But he added: "I am beginning to worry that we are starting in that direction."

On China, he said that growth rates would begin to slow unless the country could be more innovative.

"One of the major problems with China is that its innovation is largely borrowed technology.

"There was a recent Reuters study where they listed the top 100 most innovative companies. Forty were American, none were Chinese.

"Chinese productivity is the highest in the world but the way they do it is by borrowing the technology from abroad, either by joint ventures or other means.

"What they are going to find, I suspect sooner rather than later, is that… unless they pick up innovation very specifically, their growth is going to slow down," Mr Greenspan said.

Part of the problem was that China remained a single-party state which was too conformist, and innovators there still did not "think outside of the box" enough.

BBC News - Canada and European Union agree free-trade deal

Canada and the European Union have struck a free trade agreement aimed at boosting growth and employment.

Mr Harper (left) and Mr Barroso said the deal was "of great importance" to Canada and EU member states

The deal will lower tariffs, streamline regulation, and cut red tape.

Canadian Prime Minister Stephen Harper and European Commission President Jose Manuel Barroso agreed the deal at a meeting in Brussels on Friday.

Mr Barroso said they had reached a "breakthrough in negotiations" to achieve "a great agreement for both the European Union and Canada".

The deal still requires approval by parliaments and EU member states.

Once approved, the agreement aims to make it easier for companies in Canada and the 28-member EU bloc to invest in and sell to each other.

The European Union is Canada's second-largest trading partner behind the US.

Mr Harper said the agreement was "the biggest (trade) deal our country has ever made". It will give Canada access to a market of some 500 million people in the EU, making it bigger even than the country's North American Free Trade Agreement signed with the US and Mexico.

The European Commission expects the deal to increase bilateral trade in goods and services by a fifth to 25.7bn euros ($35bn; £21.7bn) a year.

The commission is negotiating trade pacts with more than 80 countries on behalf of the bloc's members following the collapse of the Doha global trade talks.

Reuters News - For hedge funds, debt crisis largely business as usual

The U.S Capitol Building is pictured at sunset in Washington, October 11, 2013.

Credit: Reuters/Jason Reed

By Svea Herbst-Bayliss and Katya Wachtel

BOSTON/NEW YORK | Wed Oct 16, 2013 6:51pm EDT

(Reuters) - Hanging tough seems to have been the right strategy for a good number of money managers now that it appears a stop-gap deal to avoid a federal debt default and reopen the U.S. government is on the verge of passing.

Hedge fund manager David Tawil said that, after living through the collapse of Lehman Brothers, many on Wall Street are now well-versed in telling a real financial crisis from one that is more of the smoke and mirrors variety and much more easily fixed.

The manager of the $60 million Maglan Capital, which trades mainly stocks, did not do anything particularly different with his portfolio during the three weeks Republicans and Democrats battled over a plan to reopen the federal government, and come up with an agreement for lifting the nation's debt ceiling.

"Those of us who invest on the basis of assigning probabilities to various outcomes, essentially gave this one a zero," said Tawil of the prospect of Congress not raising the country's borrowing ability and letting the federal government default on its debt obligations.

Tawil's hang tough strategy made a lot of sense with his fund up 34 percent this year, compared with a 5.6 percent gain for the average hedge fund.

Other money managers also said the political theatrics of the past few weeks were more of a nuisance than a real threat.

Some of that is because managers have already been through a series of politically provoked fiscal crises beginning with the 2011 debate to raise the debt limit, the battle to raise taxes on the wealthy and the more recent fight over sequestration and automatic budget cuts. In all of these situations, Wall Street saw a potential crisis averted by a last-minute deal hammered out by the political parties.

Others, meanwhile, said there were simply few opportunities to make money off the drama so it simply made more sense not to make big changes to their investment strategies.

Sander Gerber, chief investment officer for Hudson Bay Capital Management, a $1.6 billion hedge fund firm, said there had been worry, but not panic, about a possible default. He said there was more concern about a debt default in 2011.

During the current fiscal crisis, Gerber said his firm, which invests in stocks, bonds, convertible debt and merger arbitrage strategies, did not dramatically change its positions apart from adding some extra hedges to protect in the event of a default.

"The majority of the fund world thought it was utterly inconceivable that the U.S. would default on their debt," Gerber said.

He said more damage was done to portfolios, in particular investments in bonds, by this summer's spike in Treasury yields prompted by fears the Federal Reserve would bring a quick end to its $85 billion in monthly bond purchases.

The Fed's bond purchases have helped stock prices all year by forcing investors into riskier assets. Even with a stopgap measure in place, talk about the Fed tapering those bond buys might be put on hold.

On Tuesday, Richard Fisher, the hawkish president of the Federal Reserve Bank of Dallas, told Reuters the fiscal standoff means even he would find it difficult to make a case for scaling back bond purchases at the Fed's policy meeting on October 29-30.

"My personal opinion is that it's not in play," Fisher said. "This is just too tender a moment."

And some on Wall Street are thinking tapering may get pushed even further out into next year.

Jason Ader, whose Ader Investment Management allocates money to a number of small hedge funds, said most of the money managers trying to gain a tactical advantage in the fiscal crisis were short-term traders. He said an indication that most managers were not particularly worried about a government default is that so-called crash protection on Standard & Poor's future contracts was still priced relatively low as of Wednesday.

Even as the hand wringing continued in Washington, Wall Street kept moving ahead, with the Standard & Poor's 500 gaining 3.6 percent in the last five days driven largely by the ups and downs in Washington with little regard to corporate earnings. On Wednesday alone, with a deal almost done, the S&P 500 rose 1.38 percent and the Dow Jones Industrials was up 205 points, or 1.36 percent.

Wall Street's fear factor, as measured by the CBOE Volatility Index, also remained in check, hovering around 15 on Wednesday, the middle of the typical 10 to 20 range when markets are calm.

But even as markets looked relatively placid, some fund managers took pains to describe to investors that they were not just doing nothing.

So while there was not a dramatic exit from stocks, some managers who did not want to be identified said they noticed some rotation into more defensive stocks. This helped names such as Johnson & Johnson rise nearly 4 percent and Procter & Gamble Co go up 2.68 percent in the last five days.

Jack Flaherty, an investment Director in the Fixed Income Investment team at GAM, which manages $123 billion, said managers who were trying to prepare for the worst were mainly buying put options on the S&P500, betting the index would decline at some point. If a deal does happen, investors would likely lose money on those put options, but probably not much.

"The actual outlay is not that much," Flaherty said. "A lot of the ‘shorts' in the market are of that nature, so it's not going to hurt anyone horribly when a deal is finally consummated."

One hedge fund strategy that might profit from market anxiety about a debt default, especially if a deal does fall apart at the last minute, are so-called volatility funds, which use complex trades to take advantage of pricing discrepancies caused by gyrations in global financial markets.

These funds earn big returns when volatility is high and bleed money when markets are calm.

But so far, volatility funds have not done well this year, not even in the weeks leading up to the debt ceiling deadline. To date, an index by brokerage Newedge that tracks 10 volatility funds is down about 2.5 percent for the year.

And today, with a deal almost at hand, volatility funds may have been hit particularly hard with the CBOE Volatility Index, or VIX, falling 21 percent, the biggest daily drop since August 2011.

(The story was refiled to fix typographical errors.)

(Reporting by Svea Herbst-Bayliss and Katya Wachtel.; Editing by Matthew Goldstein)

Bloomberg News - Central Banks Gaming Out U.S. Default as Deadline Nears

Central banks have begun making contingency plans on how they would keep financial markets working if the U.S. defaults on the world’s benchmark debt.

Policy makers discussed possible responses when they met at the International Monetary Fund’s annual meetings in Washington over the weekend, said officials who spoke on condition of anonymity because the talks were confidential. The discussions continued as policy makers headed home.

“Because in the past it’s always been sorted out is absolutely not a reason to fail to do the contingency planning,” Jon Cunliffe, who joins the Bank of England as deputy governor forfinancial stability next month, told U.K. lawmakers yesterday. “I would expect the Bank of England to be planning for it. I’d expect private-sector actors to be doing that, and in other countries as well.”

The initial response from the world’s central banks would likely echo their actions after the collapse of Lehman Brothers Holdings Inc. in 2008. Back then, policy makers pledged they would provide ample liquidity, eased the collateral they lent against and boosted dollar swap lines with each other to ensure supply of the currency.

The $12 trillion of outstanding U.S. government debt is 23 times the $517 billion Lehman owed when it filed for bankruptcy on Sept. 15, 2008.

Time Short

“The bank has at its fingertips a range of tools to ensure the system operates properly, that liquidity conditions remain normal in all sorts of eventualities,” Bank of Canada Governor Stephen Poloz told reporters in Washington on Oct. 11. He declined to talk about specifics.

Central bankers would have had a chance to discuss the threat of default when U.S. Federal Reserve Chairman Ben S. Bernanke hosted a lunch of counterparts on Oct. 12 during the IMF meetings.

Time is running short for U.S. lawmakers as they try to end a stalemate that risks pushing the nation into default if the government’s borrowing authority isn’t raised before Oct. 17. Senate Democratic and Republican leaders were working yesterday on the details of an accord that would prevent the nation from breaching the debt ceiling and end a partial government shutdown now entering its 15th day.

‘Tremendous Progress’

“We’ve made tremendous progress,” Senate Majority Leader Harry Reid, a Nevada Democrat, said yesterday as the chamber adjourned, adding that he hoped a deal could be announced as soon as today. His Republican counterpart, Senator Mitch McConnell of Kentucky, said there was “substantial progress.”

While policy makers from Japan to Saudi Arabia have expressed faith in the ability of the U.S. to pay its bills, a default would put the world in uncharted territory.

Central bankers have spent the past six years expanding their toolkit for dealing with a financial crisis that began in August 2007 when tremors in the U.S. subprime mortgage market began reverberating worldwide. That turmoil deepened with the Lehman failure and was then extended by Europe’s fiscal woes.

“You want the plumbing of the financial sector to keep working even with the main benchmark in default,” said Rob Wood, an economist at Berenberg Bank in London and a former official at the Bank of England. “You want to avoid a firesale of U.S. assets.”

Lines Extended

The Fed opened what eventually became 14 swap lines in December 2007 to provide the global financial system with dollar liquidity as the subprime mortgage crisis stirred doubts about the quality of assets on bank balance sheets around the world. They were boosted as markets froze the following year.

The swaps were closed in February 2010 and re-opened three months later amid a squeeze in dollar funding due to the euro area debt crisis. Last December, the Fed extended the lines with the Bank of Canada, Bank of England, the European Central Bank and the Swiss National Bank (SNBN) until February 2014. The swaps allow the central banks to borrow in dollars from the Fed and then auction them at home.

With less room to cut interest rates now than in 2008, when major central banks did so in unison, a U.S. default would prompt officials to first focus on pumping cash into the financial system, said Stewart Robertson, an economist at Aviva Investors Ltd in London, which has about $438 billion under management.

“There are other measures they can take, such as easing liquidity strains,” Robertson said. “They might actually find that easier than after Lehman. At that time there was really a worry about who was holding billions and trillions of toxic waste. With this, you know more what’s happening.”

‘Not Forget’

Sri Lanka unexpectedly cut its two main interest rates by 50 basis points today to protect economic growth from the risk of a U.S. default. Congress’s failure to clinch an agreement has been “very, very difficult for us to understand” and “something we will really fret about in the next few months,” central bank Governor Ajith Nivard Cabraal said in a Bloomberg Television interview today.

“Even if the U.S. were to get their act together and get past the debt ceiling, I think the fact that the global economy has been put under so much stress, is something that many policy makers would not forget,” Cabraal said. That’s going to lead to “various changes in the way central banks will perceive the safety and quality of investments,” he said.

Policy Band-aid

While they could utilize swap lines and keep accepting Treasuries as collateral, central banks would probably hold back on easing monetary policy because they would bet the U.S. would quickly end the default once markets turned volatile and recession loomed, said Wood of Berenberg Bank.

“It’s only if you think the default will be extended and politicians won’t react enough that you would engage in significant monetary policy,” he said. “Would you buy oodles more bonds if you expected lawmakers to act?”

To be sure, not even the world’s most powerful central banks have the weapons to counter the potential fallout of even a so-called technical default, finance executives say.

“It will be like putting band-aids on a gaping wound,” Deutsche Bank AG co-Chief Executive Officer Anshu Jain said at a panel discussion hosted by the Institute of International Finance in Washington on Oct. 12.

‘Irrevocable’ Aspects

Jain said the bank’s analysis of the consequences of even a “technical default” found that “there are aspects to that which are irrevocable.”

“Once you miss payment on U.S. Treasury debt, we don’t want to go into all of it but I’ll give you a little taste,” said Jain. “Things like tri-party repo, the underpinning of the collateral system, there are legal ramifications which we believe are probably incurable.”

JPMorgan Chase & Co. (JPM) CEO Jamie Dimon said at the same event that his bank has calculated it probably processes about six or seven billion dollars a week in benefits such as Social Security, food stamps and veterans benefits. “We were going to fund it, despite the fact that we weren’t being paid by the government, because those people have to eat,” Dimon said.

A default, however, would be tougher to prepare for, he said.“You don’t know the effect and the ripple effect of that through money market funds, people start drawing down revolvers, people don’t know if collateral is good,” he said. “We can’t have a debt default.”

For those reasons, global financial policy makers maintain that a default is unlikely.

“It’s unthinkable that an agreement won’t be found,” European Central Bank President Mario Draghi told reporters in Washington. Japanese Finance Minister Taro Aso told Bloomberg Television’s Sara Eisen that “there’s no other way than for the U.S. government itself and the U.S. Congress to sort it out.”

What Happens When the Money Runs Out?

Treasury Secretary Jacob J. Lew has said the U.S. government will exhaust its ability to borrow more on Oct. 17, triggering a possible default on federal obligations. Though no precedent exists, a study by the Washington-based Bipartisan Policy Center suggests that the government may attempt to pay some or all of its bills under one of two scenarios.

PUBLISHED OCT. 15, 2013

1 – Payments to providers 2 – Active military and veterans benefits

3 – Unemployment/Housing and Urban Development (HUD)/Temporary Assistance for Needy Families (TANF)

Source: Bipartisan Policy Center

GRAPHIC: DAVE MERRILL / BLOOMBERG VISUAL DATA

To contact the reporters on this story: Simon Kennedy in London at skennedy4@bloomberg.net; Jeff Black in Washington at jblack25@bloomberg.net; Jennifer Ryan in London atjryan13@bloomberg.net