Rupinder's Musings on Economics and Development

Contagion? Possible Second Round Effects for Emerging Markets

2018-09-18T14:25:00.002+01:00

A decade on from the last financial crisis, the conventional wisdom is that that broad macro fundamentals are strong and that potential shocks from a hit on banks is a low probability event given the regulatory changes that have since beefed up capitalisation ratios for banks, coupled with new national or supranational instruments - especially in the EU - to provide backstop liquidity in case of any run on banks or general illiquidity due to shocks.

As I outlined in my last piece, the risk of EM wobblies is underway and affecting countries across all geographies, although there is a general bullishness that the scale will be limited and the impact contained.

Is this baseline valid?

Aside from basket case economies, Venezuela or Zimbabwe come to mind first, and those where credibility of policy is clearly the issue - Turkey being a case in point - it is indeed the case that the internal-external imbalances are less alarming as a genre for main EMs. Current Account deficits are not necessarily in nose-bleed territory and ditto with fiscal balances. Add to that FX reserves or months of import cover which the IMF focuses on for LDCs in particular. And a key lesson from the decade earlier and the SE Asian crisis in 1998 has been to have more flexible exchange regimes to take the brunt of adjustment. Russia's relatively successful stabilisation in recent years is a case in point.

That said, the risks of second-order impacts are under-valued.

One of the fascinating features of looking at biological equilibria models using game theory for viruses was how a seemingly salient long-lasting equilibria could be immediately and very quickly mutate into a contagion. Students of bank runs in the pre-Gold Standard era will be aware of how sentiment and confidence can turn into a riot - the herd instinct in short.

What are the potential sources of 2nd order or feedback loops?

Mr Trump. Irrespective of one's view of him personally and the fascinating never-ending soap-opera around his administration, he remains an "unknown unknown" in terms of policy predictability. Given that his tweets can move shares and markets, his spat with Turkey could, if continued, not only lead to a recession in Turkey but spillover onto neigbours and into the EU via the Western Balkans. This could also affect Turkey's position on opening refugee routes back into the EU.
China. The one emerging consistency of the Trump presidency's economic policy seems to be "correct" the modus-operandi of economic relations with China and to equalise the basis of bilateral trade and of investment policy in China that discriminates against Western investment vis-a-vis Chinese investment in the West. Mr Trump's escalation of additional tariffs on near 50% of bilateral trade with China and pressure on the likes of Apple to shift supply chains from China are examples that the pressure may not abate yet. China's tit-for-tat responses are programmed but have a limit - because ultimately its economic machine is reliant on trade surpluses, and with the US. A slowdown in external trade in China could set of a chain reaction.

China's growth rate, even accounting for a little official massaging of figures, needs to be north of 5-6% to prevent social discontent in China.
The elephant, sorry Panda, in the room is the potential spillover to the (in)stability of the Chinese financial system. The political-economy model in China means a mix of SOEs and a genuine private sector in tandem and with a legacy of bank lending to SOEs and to local authorities that could prove to be that catalyst that suddenly turns from illiquidity to mass insolvency. Whilst the Chinese could have perhaps played the US off against the other key western trading partners who also have increasing concerns about Mr Trump and his broader support for the existing post-War system of trans Atlantic system of economic and military relations, what they now find is a common position of the US+Japan+EU on this one issue.
Regional impact in Asia: any financial and/real impact on the Chinese economy would quickly ripple across onto other Asian economies through trade and financial channels. So the baseline models that project Goldilocks scenarios of sustained growth and resultant strength of equity markets in Asia may be at risk in such an eventuality.

Source: FRED using BIS data

3. Competitive Devaluations: as shown in the Figure above, the CNY:USD has devalued by around 8% since February and devaluation is an obvious policy choice although it would create further monetary headaches to deal with issues of subsequent sterilisation requirements. However, a bit like the Death Star in Star Wars, once you're in the gravitational pull, it don't matter how strong the force is with you! Asian currencies in SE Asia will do the same - as was the case in previous episodes. Moreover, it may lead to further angst from the "devil's workshop" and further Trumpian action.

4. The risk of currency mismatches on liabilities: this is where there could be some serious pain where the capital account is heavily reliant on dollar-denominated portfolio flows and domestic debtors have domestic currency assets and cashflows but possibly dollar-denominated loans.

5. I am still not fully convinced about the sustainability for the EU. OK we all now know that the pre-financial crisis baseline that Greek risk equated to EU risk and akin to Germany's turned out to be a load of moussaka! As crises from Latvia to Romania to Greece have shown in the last decade, a common monetary regime and fixed exchange rate for the entire Euro-zone means that external devaluation is not a possibility. Hence the impact of any external shock to weaker economies from any sustained EM contagion in the EU would be that much greater.

6. Political impact: a rising anti-EU tide is afoot with Sweden the latest example. With Poland and now Hungary facing Article 7 sanctions for being increasingly authoritarian and threatening the basis of fundamental EU values (Freedom of Expression, opposition and freedom of press and judiciary) and the bond market spooking in Italy when yields doubled in a few hours last week, a further move away from the centre ground of European politics of the last 30 years could yet lead to major de-stabilisation of southern and eastern EU economies.

EM wobblies: deja vu Contagion?

2018-09-13T15:01:00.001+01:00

Students of a certain vintage may recall the Junior School favourite (or not!) in the prehistoric days before the advent of mobile screens:

"Hungary was hungry, ate Turkey, slipped on Greece and broke China"

This basic kiddy whatchamacallit is one that comes to mind every so often when we experience Contagion across economies, most notably affecting EM economies in the transition, developing or LIC/frontier space. Are we again in the midst of something like 1998 when writing about the wave from South East Asia that spread to Russia and central Europe?

The world is even more inter-connected and the share of global wealth increasingly shifting towards the newly developed world and emerging economies. The transmission channels for possible vulnerability, economic shocks and volatility are therefore more synchronised than in the good old days of pre-Internet, Facebook and so-called Fake News. The pattern of increased synchronicity of business cycles across the globe means that economic policy can often be pro-cyclical in tandem across regional economies and ditto with short term external flows and a mis-match of currency exposures on national and private balance sheets, leaving economies and both private and public sectors to the mercy of a change of sentiment that can start with an isolated idiosyncratic issue and spread from one country to another.

Its clear that bad economic management has been the curse of many emerging economies although as we saw with Greece and possibly soon Italy, that this is not unique to developed economies but they at least tend have more sound governance and institutional structures - and importantly backstops from the EU and the IMF to plug finance gaps on the balance of payments and help plug gaping short-term holes on public finances.

The pains in Argentina, Venezuela and possibly South Africa obvious examples of the current geographical spread of woe. The pains of Turkey were, yes, affected by the macho stand off between Erdogan and Trump, but the increasingly authoritarian rule in Turkey with perhaps a Pretorian policy guard is in stark contrast to the more nimble approach taken by Putin in Russia where the central bank has been more orthodox and nimble in managing monetary policy.

Country specificities will always exist but common exogenous shock is the reversal of QE across the developed world. The tightening monetary stance in the US has had the most attention but the ECB and the Bank of England too are starting the unwinding of easy money that has found its way across asset classes - and to high yield investments in emerging and frontier markets.

If the taper tantrum that led to a surge in the yield of US Treasuries was the starter, we are now moving to the main course! The out-flow of funds is affecting not only the policy-wonky countries but other EM countries as confidence in the EM asset class abates and the age-old issue of the herd instinct kicks in.

As in 1998 the sudden outflow of hot money can leave countries gasping as exchange rates plummet, exposing currency mis-matches of FX borrowing and putting countries with Current Account imbalances on watch - witness the impact on India - and one that is likely to get worse before getting better.

The big unknown is the impact on commodity prices that affected developing and Low-Income countries (LICs) in the Africa-Caribbean-Pacific region (or ACP as the EU calls it in the aid jargon). Many of the poorer LICs were pounded during the 2008-09 financial crisis and needed sizeable budget support from the EU and development banks. One has to be vigilant for them.

China is a big guzzler of commodities so watch China. The considerable deceleration in broad money expansion is a positive sign to reign in dodgy lending policies, especially at a sub-national level but will put a brake on domestic demand. Add the risk of a sustained and accelerating trade tensions with the US and voila...

Transition Economies? Russia may take a further hit although it has taken plenty due to the sanctions it has faced and recent post-Soviet history shows that when Russia sneezes the CIS catches a cold. A rebound in oil prices may help to cushion the impact and neighbouring economies are not so heavily exposed to flight of international capital.

And yet and yet. There will undoubtedly yet be a few unforeseen surprises out there in terms of international bank lending. The likes of Serbia faced the music in 2009 but Venice Agreements under the EBRD helped to maintain credit lines to domestic banks reliant on external capital lines. This may be the transmission channel to watch and which oddly may well affect developed Europe and banks there.

Banks in Greece may be exposed to the Western Balkans, those in Spain to South America and those in Germany and France to Turkey. Have the ECB and other EU financial reforms in the last decade made banks sufficiently secure against the potential shocks in the offing? Time will tell.

The big elephant in the room in the EU may be Italy. In the aftermath of the horrific collapse of the bridge in Genoa, Italy wants to spend big on infrastructure and this means breaking the noose of the Stability pact and expanding its fiscal deficit. The new government is hostile to the EU, an increasing common phenomena amongst the EU electorate, and already talking of withholding payments to Brussels. With yields on government debt on the up and a debt burden over 130%, it doesn't take too much effort to figure out significantly alarming tail risks.

The potential second order effects and likely impact on mature debt and global equity markets are for another day but if previous contagious episodes are to go by, this is more likely than not.

BREXIT TO Dis-United Kingdom?

2016-06-29T22:39:00.000+01:00

So here we are, the bleary-eyed evening after the long night of Referendum results. And pandemonium...in politics, financial markets and potentially about the whole EU project going forward.

The UK electorate has voted 52% to 48% to Leave the UK. What next?

I knew something was mightily afoot some weeks back when my 9-year old put down his Minecraft to ask about migrants, the then upcoming referendum - excellently presented by the BBC's Newsound for children - and then proceeded to tell me it was worse in Germany.

And some of us had outlined risk assessments on what might happen should Brexit become fact, even though the weight of opinion and expert recommendations were very much in the Remain camp. I thought it apt to review these 12 hours on from the momentous decision that sent genuine political shockwaves across the EU and economic spillovers across the world and various asset markets.

1. Political Risk

As expected PM Cameron has tendered his resignation. It was he who had engineered both the Referendum and the timing of it. Alas, for all his good work he'll go down as the PM that took the UK out of the EU. Ex London Mayor Boris Johnson was assessed to be the likely successor pending the formalities and his lodestar remains bright although other candidates could emerge, likely from the Brexit side of government.

The risk of a fresh election is now a real possibility only a year on from the last.

2. Exit Date from EU...uncertainties

Despite the shockwaves the fact remains that the UK will remain an EU Member State until Article 50 of the Treaty is exercised. This requires the UK government to submit a letter to the European Council when a 2-year period ensues to sort out the dissolution.

In practice there is a chance that a 2nd referendum may ensue and over 2 million have signed an online petition that parliament will review.

Even without any 2nd referendum, the UK Parliament must ratify the referendum and there is a chance this will not happen, again leaving it to a fresh election to confirm the mandate.

Either way, uncertainty will result. PM Cameron will leave it to his successor to do the jolly work of actioning Article 50, which in reality will not happen until after new PM is anointed by the Conservatives at their conference in October 2016, so unlikely until early 2017 most likely.

1b. Impact on Political parties

There are many factors that led to the outcome of the Brexit win. One was the Blue-on-Blue attacks within the ruling Conservative party that in effect means two groups with a differing world-view of the UK and Europe/EU and which could yet see some form of split.

Another has been the failure of the Labour leadership to explain to working class voters its position. Its leader, Jeremy Corbyn, also an outlier of a selection last year, will face pressure to resign. At the time of writing most of his shadow Cabinet has resigned.

With the pro-EU Lib-Dems essentially marginal in its impact on the Referendum, the main parties are anything but stable internally whilst essentially without any real representation in Scotland where the SNP has most of the seats.

2. Disintegration of the UK?

As expected the SNP, whose political DNA is to seek full Scottish independence, has set in motion a second referendum. The fact that Scotland overwhelmingly voted for Remain will give the SNP the springboard of legitimacy to seek a second plebiscite so soon after the first one in 2014. The risk of both a 2nd Scottish Referendum and the probability of a successful dissolution from the UK is now significantly higher.

Not expected was calls from Sinn Fein in Northern Ireland for a poll-cum-referendum on Irish unification. The risk is low but Scottish Independence would accelerate demands and support, particularly if there is a significant economic hit from the loss of EU funds coupled with an economic contraction.

And Wales. The Welsh First Minister, Calwyn Jones has already flagged concerns for the Welsh economy and jobs particularly if EU funding for farming and poorer areas ends. There is a real risk now that there will be demands for greater transfers from London.

Spain has already asked for shared management of Gibraltar which is sited on the Iberian Spain but part of the UK and that unsurprisingly voted almost 96% for Remain. Things could get prickly with Spain that in turn could be a risk to the thousands of Brits living in southern Spain.

Taken together, this raises the risk of disintegration of the UK and increasing incoherence within what then remains were Scotland to seek independence in order to remain in the EU.

3. Economic Impact

One for another time to review separately but the short term shock was partially predictable in terms of direction if not in magnitude.

Sterling has taken a hit which of itself may not be too detrimental as it improves UK competitiveness but will also mean a rise in imported inflation.

Country risk for the UK will rise and in turn the costs of borrowing and financing national debt.

The stock market has taken a massive hit although markets in the EU have not been immune.

The UK's imbalances on the Balance of Payments and the fiscal accounts remains a concern and which leaves little fiscal space that will be required for the government to weather the expected acceleration in the economic slowdown already underway prior to the Referendum.

The uncertainty will affect business decisions both in the UK and foreign investors who delay or cancel investment into the UK. The pre-referendum doomsday predictions by the Minister of Finance/Chancellor et al. may not have affected the voting but may actually come to fruition through a marked reduction in household expenditure and housing transactions.

Fiscal and monetary stances may require softening and UK interest rates may fall, although there is a tail-risk that they could in fact rise also if the pound plummets too far.

There remain a lot of ifs and buts on a range of issues such as the impact on current and future EU migrants in the UK that on balance remain a resource that has had a positive impact on the UK economy and net taxes collected.

Many of the poorer areas from Cornwall to the former mining communities in Wales and England that voted for Brexit are the ones that have benefited from EU Structural Funds and many of these regions are suddenly waking up to the potential loss of these and asking if the UK government....itself in a fiscal bind...will do so. In the short term there will be no change in flow of EU funds but it raises the spectre of further economic disparities in England and Wales in the medium term.

Of course there will be ripple effects in the EU that could lead to another wave of financial market contagion - particularly in Eurozone countries in southern Europe.

Thanks Mr Cameron.

BREXIT – Article 50 - The long goodbye?

2016-03-03T21:43:00.002+00:00

So here we go. Six months of waffle, argument, zillions of articles and oodles of persuasion ahead to the Referendum on June 23rd 2016.

A lot has already been written about the emerging taxonomy of the two sides of the argument. Whilst the elite – most of the ruling Conservatives, the opposition and those who run UK Corp and unions are on the side of the “ins”, this may turn out to be a gross oversimplification of the Island mentality that lurks a scratch below many here in the UK, particularly England.

And insurgency against the elites is very much in fashion - both in Britain with the election of Corbyn as leader of the Labour party, in the US presidential race and across the EU where the middle ground of politics is under vociferous attack from both Left and Right.

Brexit risk has already had an effect on the FX markets through a devaluation of the pound against the dollar and the Euro - which the tradeable sector will gladly take and which in effect further loosens monetary conditions in the UK - and where the likes of UBS are forecasting parity with the Euro in case of Brexit (presumably assuming the Eurozone sticks it out...)

But what if the UK votes to leave? What then?

Leaving aside the possible political, economic and military ramifications for the rest of the EU shorn of the 2nd largest donor to the EU budget and a lodestar for many of the smaller more liberally minded economies in Europe, what would it mean in practice for the UK, hmm leaving on one side the further risk of the break-up of the UK should Scotland and/or Northern Ireland decide to stick with the rump EU27?

Unlike in Greece where the Syriza government had made no plans for issuance of Drachmas had Greece been booted out of the Eurozone in the last – or the one-before-last EU crisis – there is a position paper outlined by the UK Government, at least by its laudable Civil Service.

And it all boils down to Article 50 of the Treaty of the European Union. This lays the framework for an orderly exit of a Member State but one that has not been tested as no country has exited the EU (Greenland’s exit was partial as it remains an overseas Danish territory).

The short answer is that there is a 2-year sunset period but in reality this can mutate up to a decade for trade related agreements or re-agreements. It would also require the full EU institutional structures to be in motion – the European Commission, approval of the European Parliament, of all the remaining EU Member States (particularly for an extension to the 2 years) and of the European Council. Good luck...given the European electoral cycle from 2017.

The implications for a more drawn-out exit phase means that a clinical and immediate divorce sought - and assumed - by many of the Little Englanders will be less likely than envisaged. Likely, though not impossible - anyone schooled in history will recognise that disintegrations can happen very quickly, as those old enough to recall the domino effect of the fall of the Berlin Wall in the fall of Communism in Europe from 1989.

It also lends credence to the Conservatives who have argued that a Brexit vote can be a means to a better negotiated end for the UK - through a better bargain with the EU. This view was echoed initially by the current London Mayor, Boris Johnson, and by Michael Howard - who has argued that the EU has "form" with the Danish and Irish rejections of previous referenda...although these were for boring Treaty changes rather than remaining in the EU.

For more analysis and risk perspective please send an email.

Is the Honeymoon on Ukraine over?

2016-02-16T23:35:00.000+00:00

Is Ukraine lost? Again? Is the social contract between state and citizens fundamentally flawed?

We are now well past the "honeymoon period" of the post-Maidan street protests that ultimately led to the rather fast departure of the then president Yanikovich, who fled to Russia in 2014. Has the halcyon beacon of the EU helped to reshape the rampant political and economic corruption?

A spate of ministerial resignations at the start of 2016, an economy in dire straits and with a huge external debt overhang, having lost up to a third of its economic base from the loss of territories and ongoing conflict with Russia and being supported by western-supported IFI packages including dollops of soft EU macro-financial assistance, having witnessed a false dawn with the so-called Orange revolution in 2004 and the Maidan of 2014, which way reform?

Before I answer these questions, I invite you to view this video of a recent Cabinet meeting - it is fairly X rated... and unlike anything many who have attended any Cabinet meeting anywhere will have experienced. And it gives a flavour of the difficulties of copy-pasting a reform agenda without genuine political will and huge conflicts of interest without a fundamental reform of the current political system.

Many will have recognised a certain Georgian, Mikheil Saakashvili,who was former president of Georgia and now part of an "A Team" of former Georgian bureaucrats, fluent in Russian, brought in to help support the reform effort and given Ukrainian citizenships jousting (with glasses of water) with the Minister of Interior responsible for the police and security services, himself an "oligarch". Oh yes, the Minister of Finance is originally American and the Minister of Economy - one of the key "reformers" Lithuanian-Ukrainian.

Now back to the questions.

My starting point is to look at the data. And the picture is mixed. The odd-but-thus-far working relationship between the Prime Minister and the president has led to macroeconomic stabilisation - supported by strong western support - and important steps to liberalise the economy and reduce red tape. Global Governance indicators (that basically hoover up all available country risk indicators published) do show that Government Effectiveness has risen as shown in the figure below.

But Rule of Law?

Not so good - in fact its even worse. And the picture is the same when looking at Regulatory quality or perceptions of corruption.

Ukraine’s minister for economic development and trade, Aivaras Abromavicius, announced his resignation in early February, citing corruption levels in the state.

“Neither me, nor my team have any desire to serve as a cover-up for the covert corruption, or become puppets for those who, very much like the ‘old’ government, are trying to exercise control over the flow of public funds,” effectively saying what many have been complaining about, that there are too many bent officials trying to continue their corrupt ways - and of more significance, that things aren't really getting any better.

There is now a real political risk that the government will fall, possibly through a vote of no confidence. Polls have given it approval ratings of less than 10%. And there is scant evidence, despite a flurry of ad-hoc measures, that there is a clear roadmap of reform - which is worryingly familiar territory given previous false dawns and stabilisation plans effectively written at the IMF.

Despite a huge groundswell of popular support in what remains of Ukraine for a pro-EU direction of travel, it is not an EU candidate country forced to go through hoops and checklists to comply with the EU body of law, the acquis.

And the EU's efforts beyond financial help has led to little material effect thus far. The European Commission is great if there is a natural disaster that requires fast response or when there are longer-term structural adjustments through sector plans and the like as witnessed in the enlargements of 2004 onward for the former central and eastern European economies. Less so in dealing a country that is in need of a mix of quick-win reforms and deep reform, often painful for vested interests.

It is perhaps too early to assess if the social contract is broken. But walk past the parliament in Kiev, the Rada, and the side street and its car park are full of Bentleys, Rolls Royces and Porsches when the average salary is a few hundred dollars.

The disconnect between the elite and the rest is the effect, but the fusion of political and economic control in the hands of this narrow elite that is an unfortunate legacy in most of the ex-Soviet space is THE core root cause.

What then are the choices for the West? One for another day, but ultimately, the sad truth is that ultimately, political ownership for reform cannot be imposed. On the other hand, if there is a serious set of governance concerns and dysfunctional system that effectively limits democratic voice and accountability then a further Maidan cannot be ruled out. For the West, the EU and the US, we have to be more sanguine and realistic of expectations, but to have more targeted conditionality - political and economic.

QE2, Pyrrhic Monetary Policy and a Rise in Inequality

2016-02-05T11:49:00.001+00:00

Are Central Banks running out of firepower?

And is the second bout of QE or QE2 leading to both an arms race in competitive devaluations and more worryingly, actually accelerating inequalities?

With policy rates close to zero and years of money printing under the snake-oil terminology of "Quantitative Easing", moribund fiscal stances and private sector balance sheets in rehab zone, what more can central banks do to kick start inflation, if not growth trajectories?

No sooner had I suggested that I was against-trend in forecasting a baseline of no change in UK interest rates this year than we're faced with a change in mood music across the developed world and forecasts of more monetary easing or QE and even negative interest rates set by central banks.

Whilst the aim is to get cash to shift to production, investment and consumption by effectively taxing cash balances held by banks, in reality we are seeing plenty of unintended consequences:

a greater incidence of financial and asset bubbles as cheap dosh chases higher yields - from property to stocks and financial assets (the short term excluded). This most will go with.
this in turn is I would argue actually widening the gap between the haves and the have-nots, be it within countries and globally.
for another day...a rise in competitive devaluations: a falling Yen, a falling Chinese currency and others will follow - from SE Asia to commodity producers.

We hear plenty of research analyses that highlights a global phenomena - from the US through to the emerging economies - of an increasing inequality of wealth creation and ownership to a narrow group of economic players. Be they the kings of Silicon Valley, robber barons in Eastern Europe or the industrial titans of Asia, the pattern is uniform.

Oxfam's recent report came out with stark figures by countries but a headline one that is numbing to review - 1% of the global population have a wealth greater than that of the rest of the 99% in the world. The same conclusion came out broadly in the OECD's recent 2015 paper and notes "Income gaps are even more striking when it comes to the highest earners. In the 1980s, the top 1% of earners commanded less than 10% of total pre-tax income in every OECD country bar one. Thirty years later, their share was above 10% in at least nine OECD countries and above 20% in the United States."

There are fundamental reasons in terms of basic governance, fundamental democracy and rule of law that explain many of the fissures in developing and emerging economies that prevent citizens from having rights to education, restricted access to financial capital and in some cases, as we see in north Africa and middle East, access to education but limited opportunities to find employment. But we also see great strides by countries such as China and SE Asia on the back of growth and growth-based economic models.

Rising inequality is somewhat counter-intuitive when we think of the global reforms since the nineteenth century and following the two world wars, the rise and fall of communism and the rise of the welfare model in the post-war period. And whilst it may be less of a relative issue in the EU, rising inequality is a factor that may explain the political counter reactions from the anti-capitalist Occupy Movements in Wall St and the City as well as the drama that is the US election cycle.

What are the policy lessons?

The OECD's focus on structural issues - gender, health, education et al - is the classical development tool kit. They are longer term.
A clear lesson in today's 24-7 world is that interconnectivity is here and exponentially increasing- be it in ideas, news or alas, contagion - financial fear and medical as we witness for the Zica virus. The corollary of this that international co-ordination cannot be ignored - be it in terms of global efforts to tame disease or economies. It also means sector and country risks are subject to a wider set of risks.
Loose Monetary Policy is ultimately pyrrhic without a looser fiscal stance in an environment, as a century before, to take up slack.
Openness to innovation and growth and allied reward for risk takers cannot be compromised - but it needs to be complemented by efforts to ensure equity and fairness so that "everyone eats a bigger slice of a bigger cake" - moves in the EU to tackle the Googles, Amazons and Cafe Neros of this world on dodgy tax affairs is part of this.

Divergence in Monetary Policy and Macro-Risks for Emerging Markets

2016-01-28T00:08:00.002+00:00

Are we entering a great divergence between the developed world and Emerging Markets, particularly for oil-fuelled economies and currencies?

In the UK the pound has taken has fallen off its perch by 6% against the dollar in the last few weeks alone - is it the spillover from the travails of the markets or in part a response to increasing country risk amidst a rise in chatter of Brexit?I was contra-market in my projections for UK base rates for 2016 and with the continued - possibly sustained - low oil prices, the arithmetic for inflation has changed and in turn the likelihood of tighter monetary stances.

Whilst the Fed's rate rise of 25 basis points was expected and arguably sound given its inflation target of 2% the landscape in the Euroland remains positively soporific. Again, more recent data shows that a lower inflationary perspective whilst Super Mario has in recent days sought to allay fears of an end to QE.

There is a deeper question for another day whether central banks role of de facto lenders-of-last-resort is now the norm and whether markets are addicted. Or what further can policy-makers more generally do in terms of firepower and tools, at least in the developed world, given near zero (or in some instances negative) interest rates and at least in the EU self-imposed strait jacket of fiscal restraint.

And the risk that the debt overhang that began in 2007 and mutated into various forms, has yet to play out.

And the Divergence?

In part this great Divergence is - like many of the economic-cum-financial narratives of the last decade - being affected and driven by developments in the middle Kingdom. China.

Anyone with experience in transition countries and a grounding in National Accounts will tell you how data can be massaged. I suspect that real activity is probably 40%-60% of what is being officially reported. And this in turn is affecting demand for commodities and hydrocarbons despite official orders to maintain production (and more importantly politically - employment) targets although the Chinese are making fantastic efforts at Energy Efficiency and switching away from hydrocarbons.

Three Major Implications I see:

In the last couple of weeks we have seen a queue of oil producers, from the big cheese of them all Saudi Arabia, through to Russia, Azerbaijan, Nigeria through to Equador and even Venezuela facing huge macro-instability on the back of falling oil revenues that fuel both external and internal accounts. Saudi is talking of fiscal reforms to cut subsidies and even privatising part of ARAMCO, its oil genie. Azerbaijan is talking to the IMF for a possible support. Whilst most of these countries have followed sweet-talking consultants and set up whizzy wealth funds, these and the FX reserves will quickly deplete if authorities try to beat the markets (Soros or no). So expect tighter monetary policy, falling currencies and higher imported inflation in EM space - particularly for commodity-based economies, but with spillovers to neighbouring satellite economies (Russia and CIS par example).
Debt Overhangs in EM. Deja vu 1990s? EM FX loans, particularly dollar-based will mean currency mismatches, although Russia's corporate sector is largely immune following the financial sanctions (although it's still in a macro-mess that will impede Mr Putin's foreign policy aims).
Low Income countries haven't really had a mention but those of us who have worked across investment and risk analysis and development will be aware of the potential risk to vulnerable economies and the potential counter-cyclical hit it will have on public finances for economies most exposed. The EU successfully pushed through a package to aid 30 odd countries in 2008 in Africa and the Pacific by helping to ringfence critical public expenditure in health, education and public services - more of the same may well be required.

Forecasts, Monkeys (with keyboards) and UK Interest Rates: a case for no change

2016-01-17T22:15:00.001+00:00

I was tickled by a comment by the RBS reported in last week's weekend newspapers - who evidently came top in the Wacky Races of would-be forecasters for 2015 for the British economy who used an apt (except perhaps to its number crunchers) riposte about "monkeys with keyboards".

With monkeys of my own in our household, I thought it only fair to get their take on the key forecasts for 2016!

Alas they were too interested in the latest I-Phone and Japanese Animes as target-forecasts than that of something called GDP or seismic developments in the FTSE 100. So we stuck to one indicator...UK interest rates.

With that UK base rates at 0.25% for the last 7 years and most folk again writing about a definite rate rise this year, the "consensus monkey forecast" at chez nous was a dead-heat: up, down and one flat. I particularly enjoyed the outlier of the forecast for a reduction...(forecaster age 8 mind!). So the average or mean is no change.

Which is essentially my own personal view: ie no change in 2016 with a 70% probability and a 30% chance of a rate increase - and if so, yes by 25 basis points.

Sound UK Fundamentals but plenty of Geo Political and Economic Volatility

The consensus is that UK interest rates will go up later this year and by a quarter of a percent.

The Bank of England typically takes its cue from the trend in US interest rate setting and and the recent rise in the US Feds Funds rate by 0.25% would normally suggest a reaction this side of the "pond". Both the US and UK economies are now in a growth phase, as indeed is much of the EU. But there are lot of downside risks that suggest that the economic take-off in the UK may yet be more subdued than envisaged.

Things are extremely fluid and gittery geo-politically and are not only causing havoc in the financial markets in January but will also pose a sustained and growing risk that the consensus forecasts may not yet have fully factored in further potential volatility and resultant caution on the part of the Bank of England to hold off further monetary tightening, particularly if there will be further deflationary pressure.

Key factors

the slow-down and convulsions of the Chinese economy could yet reveal some nasty black holes (quasi-fiscal liabilities) whilst driving a general softening in external demand that will hit SE Asia and in turn is lead to what looks like more than a cyclical depression in commodities - particularly that of the black gold. With China responsible for about a third of global growth in trade in recent years, cooling external demand and in Emerging Markets will together hit external demand for the EU, including the UK.
A devaluation of the Chinese exchange rate is now likely and this in turn will continue to mean cheaper Chinese imports in the UK and elsewhere.
A Chinese devaluation may set off further devaluations in SE Asia in particular as the Asian tigers seek tor retain competitive edge in the tradeable sector...maybe good for imported inflation into the EU and the UK but also likely to add to FX risks in these countries given the increasing prevalence of dollar borrowing (deja vu late 90s?).
With investment houses now rushing to reverse previous gilded forecasts that we were living in a new normal of above USD 100 per barrel just a couple of years back, they are now rushing the other way to come up with ever lower sub-50, 40 or even 30 dollars per barrel. Whatever the macro reasons in terms of underlying demand and supply and alternatives (shale gas) and substitution effects (solar, hydro, wind et al) that explain the decline in the price of hydrocarbons, the fact is that this is clearly a positive external shock and deflationary for the UK. If it is sustained then the deflationary impact will be higher than anticipated - ie imported inflation will be lower.
Within the UK the efforts taken by both the fiscal and monetary authorities to cool down the housing market will have a pronounced effect from April 6 when a further 3% transaction tax (Stamp Duty) kicks in for anyone buying an additional property and lending criteria are further tightened by the central bank.

So, as in 2015, I'm forecasting a baseline that UK base rates remain unchanged in 2016.

Budget Support in the Western Balkans: a catalyst to the EU?

2016-01-11T22:58:00.003+00:00

“Aid modalities” to use the jargon, is a bit like men’s fashion. Rather like flared trousers and loudly coloured ties, they come around in fashion every so often. Same with the fashions in aid effectiveness.

Having sat on several national and OECD level talking shops, I now conventionally start with a quip of adding the negative…so aid effectiveness becomes ‘aid ineffectiveness’ which is often closer to the reality on the ground in recipient countries where despite well meaning declarations, foreign donors more often-than-not have their own peculiar pet ideas and vision.

One delicious example was when I came across a reasonably well designed and operational fiscal system in a particular transition economy and a certain Nordic donor insisted that its support in the area was conditional on the budget being gender based! Hmm, the average Public Finance Management expert may ask: what if budget programming is sound and based on a reasonable identification of needs and priorities?

… back to Aid (In) Effectiveness.

The EU’s aid budget is managed through its euracracy, the European Commission (EC). And in recent years there has been a marked shift to align its aid dollops through an increasing share of budget support operations or cash transfers to the national Treasury via generally its account at the central bank although they are now aimed to be 25% or so of the total aid pot.

Traditionally a tool favoured for developing and emerging nations, Budget Support has now found its way to the Aid menu for would-be accession countries of the EU’s periphery, including bits of the Western Balkans not already in the EU.

One of the interesting developments has been whether budget support operations meets the wider goals of development aid and in turn whether the tool is relevant for what is left of the Enlargement-seeking countries – relevant for either their broader development or for guiding and accelerating EU aspirations.

Leaving aside the outlier that is Turkey – it being recipient of a cool $4.8bn aid over 6 years from the EU over 2014-20 and a further $3.something bn commitments late in 2015 to Turkey “manage” Syrian refugees – the question has become focal for the Western Balkans – Albania and the 4 Yugo successor states not yet in the EU: Serbia, Montenegro, Macedonia and Kosovo.

Picture a situation where anything up to 90% or more of aid flows are from the EU into a recipient country in the Western Balkans that is earmarked to be €1.6bn in 2015. Sounds a lot but if budget support takes about a small portion of €20-40m then this is small change for the Western Balkan budgets.

So can budget support – essentially cofinance for existing budget lines for line ministries – be conducive to reform in the Western Balkans (where reforms have stalled) particularly where convergence to EU norms is concerned?

Time will tell.

One thing is for sure – Budget Support for Sector Reform is a well-meaning approach relevant for development more generally and it does in principle meet the broader aims of national ownership by allowing recipient nations to use own systems and procedures. It means funds go through the national Treasury and in effect imply a potential boost to Aggregate Demand through a rise in government expenditure.

On the other hand, anyone who has worked in EM or in other developing countries will wonder if the use of often bent national procurement systems really does lead to meaningful impact of those hard earned (and argued in austerity-hit donor countries) transfers of Euros, pounds, dollars or any other currency.

In summary, Budget Support is not a panacea in aid delivery. It is a tool or modality and one amongst a family of tools that range from classical Technical Assistance from the private sector or from national administrations in the EU (twinning as it’s called) to continued use of EU or other donor procurement systems but where the beneficiary country or authority (such as the Road Fund or Railways or Border Control Management) is given the right to make a transparent selection based on verifiable criteria.

Budget Support does make Ministers of Finance and other key ministerial folk sit up and take notice because its pure cash rather than some woolly project where foreign experts eat up most of the sum from consultancy fees. And as such policy conditionality works if the programme is well designed. Equally if it is but a substitute for a better option such as a standard Supply Contract then its impact and value-for-money will be lower.

This in turn opens up perhaps the critical path for potential reform. Via the budget.

The share of government in Western Balkan economies remains relatively high and so fundamental reform in key sectors will be credible only if the piles of donor funded sector plans and fancy Medium-Term Expenditure Frameworks (MTEFs) are subject to genuine Public Finance Management through much improved budget programming, better expenditure management and improved financial accountability.

Having designed the one main General Budget Support package for Serbia in 2009-10 and a pilot Sector Budget Support in the Western Balkans in the last two years, I remain cautiously optimistic about the potential of the new modality as a conduit to more effective governance, rule of Law and government finances.

The latter three tick boxes toward the Copenhagen criteria that defined the initial basis of meeting the entry requirements to the join the EU.

That said, the Jedi Knights of the Acquis Communautaire may wonder if the Force is really with them if this does not lead to meaningful real convergence at the geek-level EU Chapters….from statistics to agriculture and veterinary control to financial control.

For this and more see my blog, www.aid-finance.com

Western Balkans: Public Finance Management in Kosovo, Policy Concerns and Risk

2016-01-06T09:26:00.002+00:00

With focus during 2015 in Europe on the continuing challenges with Grexit-cum-Brexit, the refugee crisis and the political spillovers across Europe, what of the Western Balkans and long-stated hopes of EU accession?

Inevitably, the yellow-brick road to the EU remains of keen interest to citizens of the Western Balkans if not their erstwhile politicians and policymakers who are happy with the current models of existence. Barring major economic and resultant political turbulence this modus-operandi is changing little.

From the EU the same broadly applies. The European Commission’s Directorate General is no longer DG Enlargement but rather DG Neigbourhood and Enlargement (DG NEAR) that takes in countries around the EU periphery from Belarus in the East via Jordan, Turkey and then across the southern Mediterranean to Morocco.

The EC’s reduced focus on Enlargement in the Balkans echoes the political mood music in the EU more generally about fear of further flows of economic migration and taking on board economies that remain unprepared in terms of basic principles of governance, political accountability and economic freedoms.

Yours sincerely has had the opportunity to work on macro-PFM-advisory issues with governments in recent years and the one State I had not worked on was Kosovo. So what was my experience and assessment following several visits from late 2014 and 2015?

Kosovo, formerly bang in the centre of Yugoslavia and now a nominally independent State but quite yet fully recognised by the international community, made some fantastic strides in setting up market based institutions…but much of it was setup under the auspices of the UN agencies in control and without the legacy of state institutions that have often proved to be the limiting factor to change and subsequent implementation of reforms.

Impact of the Crimean Annexation and Sanctions on Russian Growth

2014-03-21T23:35:00.000+00:00

Whatever the narrative or counter-narrative, the annexation of Crimea by Russia is in effect. What does this auger for Russia’s economy?

Russia’s growth was already flat-lining before the Russian-Ukrainian “conflict” with concern over the greater reliance in 2014 on hydrocarbons than in 1991 AND the increasing likelihood of a narrowing current account on the Balance of Payments in the coming years.

Did the Putin team do its sums?

Cost of Transfer of Fiscal Responsibilities To Moscow

The incorporation of approximately 2 million Crimeans represents an administrative challenge that Russia will manage although the transfer of property rights will prove more taxing whilst an asset-grab of prized real-estate or businesses has already begun.

Crimea was reliant on transfers from Kiev of around 60% of its budget of approx. $0.5 bn. Add additional (and higher) centrally managed social payments (eg pensions higher than in Ukraine) that Moscow will now have to manage and the expected reduction of both cash-payments from migrants working outside Crimea and the likely collapse – at least this year – of tourism receipts means that the net back-of-the-envelope cost to the Russian budget is around $1.5-2bn per year.

Add additional Russian transfers that will be needed to keep the Crimean economy afloat – and the total bill will be $4-5bn, equivalent to less than 0.2% of GDP for the Russian Budget. I’m sure the boys from MinFin will have provided something along these lines in their preparatory brief to Mr Putin.

Cost of Sanctions

This is the big unknown. The Russian economy is far more integrated with the rest of the world than is often appreciated. Even excluding the gas flows that cater for 30% of European energy consumption there is a surfeit of international connections from industry to finance that affect corporates and banks.

The combination of US and EU sanctions was scoffed at by Putin and co initially. However the very inter-connectivity of Russia to the global nexus of markets is already having a marked effect – in particular following the measures announced by the US. Global banks will be reticent to fall foul of the US’s regulatory net by touching anything associated with the Putin Inc. clan that have been shown the equivalent of soccer’s Yellow Cards. With regulators purportedly checking bank exposures to Russia, and with recent experience of handling and containing potential contagion, the possibility of a tail-risk event such as a gradual Iran-style financial squeeze led by the US could seriously hurt Russia.

With rating agencies such already highlighting a “negative” for Russia and reports of credit lines being cut, the initial flight of hot funds may prove to be a more lasting factor than Putin’s strategists may have anticipated in their cost-benefit analysis of the Crimean blitzkrieg.

Interbank rates in Moscow have risen over a percent over the last 48 days and the US’s clever focus on Bank Rossiya and the resultant freeze on its quarter of a million credit card holders by Mastercard and Visa will have done more to hit home to the rich upper and middle classes the potential financial impact of even a modest lock-out from the international financial architecture.

Old hands in Russia from the 90s will be aware of the risk of mini bank runs given memories of two previous Russian financial crises since the Soviet collapse in 91 but I see this less of a risk and the Central Bank will manage any liquidity crises given its oodles of reserves.

One hopes that diplomacy at least de-escalates the situation so that the threat, in particular, of harsher German-led EU economic sanctions dissipates. If not the next round of trade and financial sanctions on Russia – and its likely reaction against foreign investments in Russia by it – will unfortunately mean a greater hit on the Russian economy.

The Putin model relies on hydrocarbon revenue and the short-term risk of say the US releasing reserves on the global market will have less of an impact than imagined as supply is based on agreed forward prices.

However if such a move affects the forward curve and at the same time presages a very likely structural shift in EU energy demand for Russian gas through say a strategic “energy security pact” to import US gas and accelerate alternative LNG and from other supply sources in the Mediterranean, then this will have a harder medium-term hit on the Putin model and its economy.

Compensation for loss of State Owned Assets to Ukraine?

Murky waters and hardly mentioned so far… but assume that Ukraine, with western assistance, is able to get safe passage out for its military personnel.

And that it seeks damages from Moscow for loss of key refineries and other assets. .. what then?

The “zero agreement” at the time of the Soviet Dissolution amicably done by the successor republics and Russia was for Russia to assume all external debt obligations but also to secure external assets – including Soviet embassies. As the takeover in Crimea is an annexation and essentially – despite Russian protestations – in violation of the Budapest Agreement it signed in 1994 that recognized Ukraine’s borders, it is highly probable that Ukraine could seek damages in almost any western country.

Summary:

1. The nominal cost of running Crimea will be peanuts but the short term cost for Russia will reduce growth by 1/5% of GDP to around 0.5%-0.7 and lower than the 1.3% year-start forecast.

2. Russians are feeling very proud of Mr Putin but domestic consumption will be lower as the financial squeeze from the sanctions hits home and the cost of capital rises and imported inflation rises on the back of a falling rouble.

3. Trade will be affected – both due to the rise in country risk and delay or cancellation of cross-border projects – but also due to the significant impact on Ukrainian-Russian trade, even excluding the risk of putative economic sanctions from the EU. The Current Account could be wiped out.

4. An escalation of tension will lead to a much higher hit on the Russian economy from the external squeeze – particularly through the financial links - but Putin's government will tap into the huge fiscal reserves to ensure growth remains at least round 0.5% of GDP.

5. Mr Putin has in effect secured his re-election! In turn the Putin 2.0 economic model will last longer . The EU will accelerate to reduce reliance on Russian gas. Together these two factors will lower trend growth.

Ukraine, Key Political-economy Concerns and Stabilisation

2014-03-04T22:06:00.000+00:00

There are several overarching questions and concerns that are exercising the international community, some of which include:

How did it get to this stage with Ukraine and Russia now on the brink of war?
What can be done to assuage Russian concerns and de-escalate the situation?
What does it mean for the longer term for Russia’s neighbours from the Narva region in north-east Estonia through to the ‘stans in the east and even Moldova in the south-east where there are sizeable Russian populations (if not majorities as in NE Estonia)?
And in turn for the EU that now houses several former members of the Comecon bloc and for its own energy security given the continued reliance on Russian gas and for financial centres such as London a reliable diet of Russian capital – legal or otherwise – as well as listings?
Concurrently how can the EU utilise its very successful soft power refined during the Accession Process since the late 90s that has helped former planned economies to successfully transform into functioning, democratic, market economies?
And the Economics: how does the putative conflict between the countries likely to affect the economies of these two countries – both over the short and medium term - and what are the potential spillover effects onto neighbouring economies?

As someone who has advised worked on both countries (inc. the Crimea) since the mid-90s I have my own views on these questions from first-hand experience and various writings.

In this blog entry I will focus only on the last question as it is perhaps the underlying and central cause of the current malaise. Although events over the last few months seemed to accelerate toward the end till the eventual exit of the now-former president Yanukovych, to many of us long-time Ukraine-watchers the situation had been steadily worsening with gross mismanagement of the economy and in effect a social mis-contract between the political-economic elite that are essentially the one-and-same to effectively asset-strip the state, allow rampant corruption and in effect created the disconnect and discontent that so fuelled the anger on the street.

Result: macroeconomic instability with the economy in recession since 2012 but which was buoyed previously due to demand for steel from Russia and globally, a large current account deficit, fiscal mismanagement and with FX reserves below 90-day cover.

In the last week has seen the Ukraininan currency, the Hryvna bombed and Ukrainian assets nosedived as investors rushed to the Exit doors. The threat of bank runs has been temporarily halted through restrictions on withdrawals but the threat of meltdown remains a tail risk without external support. The necessary devaluation through an open float of the currency will push up imported inflation and further reduce real incomes and purchasing power.

Though Russia has too been hit it is sitting on a half trillion dollar reserve base inclusive of oil funds and will ride out the storm…one for another blog.

Ukraine will, however, need rapid stabilisation and to their credit the big guns in the form of the IMF and the EU are already making preparations for rapid-response loans and budget support using the experience from recent years in the Eurozone and elsewhere.

The key question beyond short term plugging of financing gaps will be whether Ukraine will be willing and able to undertake genuine reforms to ensure sustainability. This in turn will depend on how the Russo-Ukrainian spat plays out – the longer the duration, the more costly the impact and the reconstruction/redevelopment efforts.

It will also depend on political will and all the bonhomie rhetoric from some western capitals about the Ukrainian parliament being the people’s senate ignores the rather unsavoury truth that it does unfortunately retain the reputation of being a Members Club for crooks. Whether this group in the Rada has the courage or willingness to sanction broad-based reforms remains to be seen, particularly difficult reforms to balance the fiscal books through necessary but potentially difficult political amendments to the energy deficit that has been soaking close to 8% of GDP in subsidies. A fresh election may well be required to give the new government a genuine mandate.

The so-called Orange Revolution in 2004-05 was pyrrhic and a gross disappointment for those that saw it as a precursor of a fundamental redress of governance in Ukraine. Unfortunately, and despite significant good-will and dollops of western assistance thereafter there was little real appetite in Kiev to modify the status quo and despite some sterling efforts to kick-start reform at a regional levels.

Hopefully, the penny has dropped for many of these rent-seeking members of the elite that political stability and effective economic governance go hand-in-hand….and hopefully the sabre-rattling from Moscow will cease….and the hit on the RTS, the rouble and share prices in energy stocks in Russia may well catalyse this.

The debate on Scottish Independence and the EU

2014-02-25T21:55:00.001+00:00

The arguments for hearts and minds of Scottish voters went into overdrive in the last few weeks, from PM Cameron’s speech, a choreographed doomsday scenario by the 3 main parties at Westminster and now the departing president of the European Commission, Manuel Barroso , putting his oar into the debate.

I have commented previously on the debate in 2012 when I looked at the country risk and macro aspects of the independence debate and pretty much all those points remain valid. The pro campaign’s economic case is on the whole somewhat weak. That said, sovereign dissolutions in Europe since the Second World War have been political in nature even though the economic dislocations were catalytic – from the dissolution of the USSR signed off by the presiding heads of the soviet republics in 1992 to the velvet divorce of the former Czechoslovakia in to the resultant Czech and Slovak republics in 1993 and the economic impact that hit and ultimately dismembered Yugoslavia.

So the debate about a currency union post-independence in Scotland, pooled fiscal policy and the like are indeed important but miss the point somewhat. Ultimately if the Scots want independence a solution will be found to these economic issues as it always is. Connoisseurs may recall the IMF’s advice to Estonia to retain the rouble in 1992 but the latter did pretty well with its Kroon that ultimately sailed into the Euro-zone in 2011.

So why my angst?

As an economic liberal I fully support the rights of the Scots for quasi self-determination that is at stake in the debate even though I don’t see the economic case for it. If the Scots gain independence and see a Norwegian style oil economy they will also suffer the boon-curse conundrum of rising real exchange rates as echoed in the 2012 blog.

And if East Germany could be absorbed into the EU through a union with West Germany despite the huge structural differences and if the Czech and Slovak Republics are now merrily back in the bosom of the EU then why cannot an independent Scotland be a successful part of the EU, of which it has been a de facto member through the UK’s membership since 1973? Does Scotland not explicitly, if not implicitly, already comply with the EU’s body of law – the acquis communautaire – which the would be accession states are busily internalising? And would an independent Scotland really not be more in line with economic convergence with the EU than say Serbia or Montenegro let alone new Member States like Bulgaria and Romania that joined in 2007?

Moreover the pro-independence waffly goal is precisely akin to the EU geek-speak of “subsidiarity” implied by granting political, economic, fiscal and administrative functions to the lowest level. So why did Mr Borosso get involved?

The on-going peace dividend following the end of the Cold War in Western Europe, at a time of increasing global technological connectivity, is seeing a part resurgence to the pre-industrial revolution sense of European regionalism over nation states – and the spectre of an independent Scotland therefore raises temperature in Madrid (fear of Catalonia saying adios to Spain proper let alone the regular feast of El Clásico football matches between Real Madrid and FC Barcelona) or the north of Italy doing the same or even the possible break off in Belgium where the EU institutions are housed.

I don’t expect the Yes-campaign to win but what chances that there won’t be demand for another one within the decade – particularly if the rest of the UK continues – at least politically if not at the street level - to project an anti EU-and an anti-Johny Foreigner mentality driven by UKIP.

The somewhat bizarre sight of Messrs Cameron and Barroso playing from the same hymn sheet is a reflection of a common political goal to stop a possible rise in demand for splitting existing EU states. Bizarre because of the Cameron-led Conservatives have been pushed by UKIP to a more antagonistic stance toward all things EU (except for the Single Market that is).

The real story in the early 21st century EU, especially post-financial crisis, will be what shape and form the EU will develop as regards further economic, fiscal and political integration – now that financial and monetary integration are so developed. And that in turn smacks of what form federalism will take, to allow so many member state countries to work as a cohesive economic group.

So one hopes the debate in October after the likely failure of the yes campaign turns to how to provide even greater fiscal autonomy in the UK, where so much remains centralized and defeats the often well-meaning structural programmes by successive governments in various sectors as there is no real incentive for reform where purse strings are almost fully based on central transfers.

And that in turn could help to invigorate the direction and vision of the EU that remains such a lodestar for the likes of those outside such as Ukraine where it – or rather the EU’s prevailing requirement of standards of democracy, governance and rule of law – remains such a beacon.

Sochi Games and Russia

2014-02-10T21:28:00.000+00:00

There is something pyrrhic about witnessing an opening to the Sochi Winter Olympics – and the related cost of a jaw-dropping $50bn – set against the prevailing economic headwinds facing the Ruuski economy…itself set against the cyclical turbulence afflicting the emerging economies more generally.

The front cover of this week’s The Economist with Mr Putin’s face pasted onto the ice-skater with his arms aloft whilst his partner (Russia) is on her backside was apt.

The Sochi Olympics is a showcase for a re-emerging Russia and the wonderful opening ceremony showcased the country’s history, pride and ability for grand engineering.

And yet it remains a project, a grand expensive project at that. Like the London 2012 Olympics it will no doubt inject a degree of feel-good factor in the host country. But the real feel-good driver for Russia in the medium term will remain the price for hydrocarbons that continues to fuel the Putin’s economic model.

And here we return to the fate of Mother Russia or more humbly the Russian economy. What does the Olympics signify for Russia’s ambition to be a major global player in international economics and politics?

A lot has been written about the costs and related corruption on a grand scale. Is any major tournament really that different – particularly in emerging economies? And are decisions to award say the FIFA World Cup to Qatar (without a football league and summer temperatures in excess of 40 degrees centigrade) based on a truly unbiased fair selection? The Russians will do a fab job, and with 1 squaddie for every local denizen in Sochi, it will be well-protected also.

The decision to go for a big international project is akin to a coming of age for a country and signifies confidence in itself, ability to finance the games and to organize it. Witness the World Cup in South Africa, the putative Games and next FIFA Cup in Brazil and even the slightly wonky Asian Games in India.

Mind you it will be interesting to see how many of these EM countries put their hat for such show-case events in the ring now that the US-tapering has commenced and capital has started to leave these states.

So why pyrrhic?

The success in holding an international Sports Day (or days) does not change the overall context of the challenges facing Russia and its economy. And there are more parallels with the Soviet Union’s 1980 Games when Russia’s predecessor USSR was in a downward economic spiral than with many of the other EMs that have seen greater structural changes and a more balanced share of wealth.

Unlike the other above-mentioned EMs (and ignoring basket cases such as Argentina and Venezuela) Putin’s Russia is more centralized, less democratic and more reliant for employment on the state when compared with the early 90s…and where the state itself is even more reliant on oil and gas revenue that account for ¾s of all exports.

Whereas the Beijing Games were genuinely regarded as confirmation of China’s return to global influence politically and economically, one hopes the Sochi Games don’t instead presage the parallels with the economic malaise that subsequently afflicted the Soviet Union.

Russian Medium-Term Growth and Policy Implications

2013-11-13T00:11:00.000+00:00

The IMF had barely taken off from Sheremetyevo Airport and the Ministry of Economics was already busy modifying its medium-term forecasts for 2030 down from the government’s 4.5% figure it held to during negotiations with the Fund’s and MicEc now forecasts a 2.5% trend to 2030 (the IMF 3%).

So what has happened for this stark posited change in the Russian fundamentals? And what does this mean in the short term as regards economic policy?

In practice nothing has fundamentally altered for the Russian macro-economy. The medium-term structural challenges remain the same as before whilst the external outlook is, if anything, a wee bit more positive than a few months back – both for the underway cyclical rebound of developed economies critical for external demand for Russia’s hydrocarbons and over the longer-term the expected continual rise in global demand for oil in a world that is going to have more oil-guzzling middle-income consumers.

My guess therefore is that this rather staid, less-than-rosy medium-term scenario for Russia for 2030 highlights that the economists in government are beginning to put down realistic markers for Putin Inc. and using the IMF discussions as justification for the downward adjustments.

While policy makers-cum-politicians see the long term to be the next election, the bureaucrat-cum-politician-cum-Putin chum axis in Russia means that the 2030 scenario may have more policy traction in terms of at least genuine acknowledgement of structural challenges and medium-term fiscal vulnerabilities that would be the case in many other Emerging Economies where these documents tend to be donor-driven strategies…but the real test will be if there are credible measures to unlock the Russian growth potential.

Recent monthly and Q3 data have not changed the expected growth trajectory for 2013 that is now more likely to be closer to 1.7% rather than the 2-3% range anticipated just a month or so back.

Nominally the economy is at full pelt (the output gap is close to zero) with unemployment close to a record low. This in turn limits the potential lasting impact of policy easing on either the monetary or fiscal fronts without risking cost-push inflation. And why external agencies ranging from the IMF to the EBRD are helping to push the message that the adjustment requires a significant shift on the supply side where Russia does so badly relative to EM peers: from labour market reforms to ease of doing business.

So what does augur for policy?

Fiscal loosening to boost Investment in 2013-14 is likely if external demand remains weak. This may involve fancy footwork to comply with the new Fiscal Rule through off-budget operations or (dodgy) securitisation of loans from the reserve funds to State-Owned investment projects.
No change in the monetary stance that is shifting toward full-fledged Inflation Targeting (IT) by 2014-15
The policy rate will remain unchanged: i) for the simple reason that the central bank recognizes that the transmission channel remains weak for it have any real impact on lending ii) inflation remains above or close to its headline inflation target and iii) given tight labour market and high capacity utilization

Serbia’s Incomplete Transition and Country Risk: Mind the Gap

2013-11-04T22:02:00.000+00:00

Serbia is one of those CEE States that is an enigma. A Serb friend who was in both the Federal Yugoslav government and in the post-Yugo declining rump into the Serbia bit once Montenegro had gone its own way in 2006 reminds me regularly that Yugoslavia had negotiated 80% of the acquis for EU Membership during the 80s.

And as a kid growing up in Berkshire, I would often play football in the park against Yugoslav kids so travel was not an issue for a country seen as a half-way house breaching both sides of the iron curtain. Indeed taking the train from Yugoslavia to Trieste for your jeans to flog off back home or to proudly wear was essentially the stamp of adulthood!

Fast forward three two decades.

Whilst the grand air of the capital of the Balkans remains (even the Slovenes come to party at weekends in Belgrade) in substance a lot has changed. Aside from the Cyrillic alphabet and proximity of languages there are similarities – but also key differences – with another city coming to terms with loss of empire, Moscow.

For a start Belgrade lost a major trump card that Moscow retained by not retaining its high-calibre Federal civil service. Yes the EU annually rubber-stamps that the Serbian government has good administrative capacity, but drill down into actual mechanics and you’ll find a lot of bright well educated cadres but lack of a joined up government. Meaning decisions often lack clear strategic thinking or where – as for say for macro-stabilisation there seems to be some semblance of grey matter – alas it is often on the back of external conditionality (DC or Brussels).

And there tend to be a lot of governments… where each new minister brings his mates along for key positions in the civil service. Meaning a continuous dilution of capacity and institutional memory in the ministries. Again, not so in Moscow.

Russia remains a good risk but faces real challenges of how it reaches the nirvana of a broad-based economic landscape that often escapes resource rich economies. Serbia on the other seems often to be on the cusp of another macro shock, often due to failure to keep to terms on the previous stabilisation programme, and lacks any real resource endowment.

Whilst CEE watchers no doubt review the macro numbers and compare with other EM economies, what they often miss is the transition gap it still has to overcome, certainly relative to the CEE economies in the EU.

Although Serbia underwent a rapid transformation in the immediate period after the ousting of Milosovic in 2000 (cherry picking reforms that had worked elsewhere as someone from the World Bank once said) there has been not much reform since the early 2000s and Serbia rode the long cyclical wave of benign global and CEE growth when it was all about convergence plays.

Whilst the new EU Member States had to go through (some) hoops, Serbia had no such external anchor. And whereas the likes of Estonia or even Slovenia saw themselves very much in the western European family (if only to get away from the Ruuski bear), Serbia has until recently remained very agnostic if not plain disinterested (again the post-empire blues that also affected Britain’s initial two-fingers at the EU before its eventual entry in 1974 – although the fingers haven’t quite descended!).

Result: an economy with enormous structural issues, a bloated civil service, massive unemployment, fundamental issues for the business environment, an uncompetitive trade sector and economic growth that has relied on domestic absorption, often on the back of credit – where a lot of the bank credit is owned by a coterie of banks from the Euro-risk economies of Greece, Austria, Italy and to a lesser extent France – and where there is a high FX-debt profile through Euro-isation of loans.

Can Serbia manage the transition and macro-fiscal challenges? I helped put together the EU’s Emergency Budget Support for Serbia in 2009 and worked on budget reform prior to that and whilst I have confidence in the Central Bank that sits on reasonable reserves I am less convinced about political will beyond short-term fixes on the fiscal side.

The country’s metrics on transition are often only beaten to bottom by Kosovo or Bosnia. I am also not entirely convinced about the magnetism of the EU despite promise of greater aid flows. Serbia is surrounded by the EU so has no choice but to integrate although it can affect the speed of convergence. But one wonders if the spectre of the EU of the 2020s that is moving toward a more German-led model of an integrated federation will be palatable to the Serbian politicians – although the same could be said for the Hungarians or Romanians.

But at least the latter are in the EU club. And with it have the implicit EU-put that entails through soft EU loans or via Structural Fund transfers.

What does this mean for Serbian investors and Serbian country risk?

1. There is a fat tail risk on the downside, despite recent IMF-led efforts for fiscal consolidation announced last week and the likelihood of another Eurobond issue or putative loan from Manchester City…sorry UAE.

2. From past experience, the fiscal plan will be implemented in part but then fade away

3. With the real exchange rate still 1/5^th overvalued and continuing current account pressure there is a risk of further devaluation that the authorities will want to prevent from becoming excessive, even with the reserve buffer which in turn will feed into higher imported inflation

4. The US taper-risk will lead to EM differentiation and which will affect Serbia dis-proportionately when it happens in 2014.

5. Getting back to the tube-metaphor, Serbia risk is under-priced. Mind the Gap.

Russia’s Fiscal Options: Trick or Treat?

2013-10-31T21:37:00.001+00:00

Yup, its Halloween Day! The thing about trick-or-treat is that someone opening the door will ask to see the trick before the kids get the treat. As many a little one found out this evening!

Faced with slow growth and anaemic private demand policy-makers often opt for the treat to assuage their voters: we’ll spend our way out of the downturn.

Russia is at least one of those economies that has had genuine “fiscal space” and discretion for Putin and co to press on the accelerator.

And which makes the current situation in Russia very much the Trick or Treat scenario. With domestic demand flat and external demand – with oil in particular the major driver – keeping the trade and current accounts close to balance (together with a deepening services deficiet and increased interest payments to pesky foreigners), “what do we do?” or perhaps “Что мы делаем?” is the big macro-cum-political question in Moscow.

And Russia has ample public resources, taking into account both fiscal and monetary reserves. The two fiscal reserves each have $86bn or a combined fire-power equivalent to 8.5% of GDP. And FX reserves at the central bank another $0.5 trn or 26% of GDP. A bag of treats indeed.

The trick? Capital expenditure ain’t easy: shovel-ready projects don’t materialise and take time to plan.

And anyone familiar with the economics of the Soviet Union – and by implication the source DNA of current politician-policy makers in Russia – will attest to the massive failure of past investments in terms of rate of return (a Sahay and Fischer paper from the Fund comes to mind) that in part led to its ultimate bankruptcy and dissolution.

So what to make of the current appetite for grand projects or counter-cyclical expenditure in the jargon?

The structural adjustment in Russia or the lack of remains the biggest hurdle to medium-term growth. This means the rule of law, bankruptcy and creditor rights and ease of doing business and a major clamp down on corruption. A checklist that – unless you’re a Georgian – is unlikely to be fast-tracked in Russia, whatever Putin 2.0 stands for.

The Ministry of Economy has proposals for 3 major projects – a new ring road III, a high speed rail-link and railway upgrade as well as for high tech and aerospace projects . Gosplan back in action?

To be fair these are the same ideas coming out of western capitals and lets be fair, there have been many a white elephant project in the EU. But there tends to be greater feasibility analysis and accountability of expenditure assignment (just look at the airtime our Public Accounts Committee in the UK has or the sterling work of the National Audit Office, its erstwhile cousin) – needed when you ain’t flowing in hydrocarbon manna.

So Trick or Treat?

I expect a rebound in external demand to push growth above the 1.5% the IMF was projecting (now oddly 2.5% although hidden away in the tables of its Article IV Report) and at or above the 1.8% the government expects so the demand for increased capital spend will decline
MinFin has a good cadre of bureaucrats and I expect them to win the initial turf war with MinEc – barring a further tail-off on growth into 2014. And in fact the budget submitted to Duma, all 15Kg of it, is more about expenditure restraint than expansion.
The de facto securitisation model proffered by MinEc has significant flaws. Briefly, the idea that the lucky companies for the new capital expenditure will issue bonds to MinFin backed on future cashflows lacks credibility – remember many of these companies remain state entities and subject to price controls and quasi-fiscal liabilities.

No trick, no treat.

Russia and Tapering, continued...

2013-10-27T19:17:00.000+00:00

And yet?

Purveyors of the short-term will no doubt home in on the solid country-risk fundamentals that I highlighted in my last blog. In short, the Russia-story since the 90s has been of a transition economy transforming itself from plan to market, backed by an oil-bonanza helped with some semblance of co-ordinated government under Putin after the volatility of the Yeltsin era.

This broad-sweep narrative remains essentially unchanged. And yet the concerns that Russia’s reliance – and therefore vulnerability – to oil continue to be key to understanding the policy framework, and market risks, on Russia.

Two decades after the Soviet collapse Russia is a less diversified economy than in 1991. Put another way it is more vulnerable to a demand shock for hydrocarbons (principally for oil but also gas in a world of ever increasing shale gas) and terms of trade shocks through falling prices for the hydrocarbons.

The data on growth for the year is likely to show growth between shy under 2%. The IMF’s 1.5% has ruffled feathers in Moscow and expect a little bit more of monetary and fiscal easing to help tick along GDP toward the 2% mark to at very least blow a big raspberry towards the Fund. A positive tail-risk of upside to EU growth should also help propel external demand even though the rest of domestic demand will remain moribund.

From a policy perspective the 2-decade concern about the Dutch-disease effect of a rising real exchange rate remains a longer-term concern even though it has been less of an issue in 2013 given the devaluation of the RUR and Central Bank interventions to defend it to the its target range…sorry inflation target!

The fall in the Current Account this year – and the Trade balance in particular – has been ostensibly around the falling oil revenues. Russia’s budget is based on a $115 barrel of oil and where 1 in 4 jobs is in the public sector. And the reduction in external demand has directly affected the exchange rate – through both the current account decline and increasing volatility on the capital account including a large dose of capital flight but also partly due to a rise in access to the Russian bond market for outsiders – see below.

The large size of the share of the public sector in GDP and employment means that the cyclicity of growth on the back of hydrocarbons is much greater than would otherwise be the case. And explains a much greater focus in the last few months on structural aspects of growth – including statements by the president, PM and the minister of Economy to improve business environment more generally.

Whether we can expect anything of substance I’ll comment upon separately.

As regards the short-term impact on investment in Russia and the impact of the tapering discussion,

Russia’s greater inclusion in the EM space is more prevalent following the change in law in February that allows for greater participation of foreign investors - central securities depositories Euroclear and Clearstream were given permission to participate directly in trading of ruble-denominated paper. The Central Bank has grumbled about keeping its beady eye on the situation given greater potential volatility on the domestic bond market and the exchange rate – and I concur: Russia will be hit by the financial wave of portfolio outflow from EM.
But also expect a reversion of flows once the dust settles and country segregation amongst the EMs resurfaces– simply on the back of fundamentals over the herd-instinct impulse to bunch Russia to the rest. Its $7bn Eurobonds were 4-times over-subscribed on the back of a strong sovereign balance sheet.
I don’t expect the half-baked ideas floating in Moscow for de facto rise in public investment to make a serious dent on fiscal policy (again worth a separate piece).
And monetary side? The key interest rate (repo rate) will not change – the talk has been to ease financing for SMEs but with exchange rate wobblies of late the CBR will not do this. Instead the CBR has been busy putting in place a batter of interest rate tools to allow it move toward full-fledged inflation target by 2015 and a slight uptock to a 5% inflation target and this will take effect once rubber-stamped by the Duma.

Tapering, CEE and Russia

2013-10-24T20:23:00.005+01:00

Please click here or see below

A taste of the would-be portfolio shifts was given some flavour following suggestions in May that the Fed’s de-facto QE programme might be coming to a halt – aka tapering – before the volte-face in September. Yet the flow-of-funds data – particularly for cross-border bank flows – shows that central and Eastern Europe remains below the levels of late 2008 whilst LatAm and Asia are 80% and 40% up over the period.

The strong flow of funds into LatAm and Asia has in turn helped fuel the stellar growth in these regions relative to the rather sedate growth seen in the CEE region since 2008. It also provides a good gauge for the reversal of flows from EM and the likely amplitude of effects across the EM space when the US tapering ends, itself probably now put back following the delayed release of the US Payroll data on October 23rd, and for the eventual rebooting of conventional monetary policy in the mature economies.

The CEE region is less exposed and vulnerable to any outflows related to portfolio adjustments globally on the back of expected and actual adjustment of the direction of US monetary policy. Part of the explanation for the higher country risk has of course been the wider impact of the on-going sovereign/Euro/bank crisis in the Eurozone that has essentially torn up the song-sheet on a Single EU-wide market for capital and banking in particular – worth a separate focus.

With signs of green shoots in Germany and pukka growth in the offing in Britannia, CEE growth is likely to tag along, particularly given the strong supply-chain links with Germany in central Europe – even without a return to the pre EU-accession convergence plays and oodles of capital into these newer economies.

That said, I remain queezy about a couple of the CEE block – I’m not entirely convinced on the 3 not-so-new EU Member States: Hungary, Slovenia or Czech Republic and remain deeply concerned about the situation in the Balkans, particularly Serbia.

Russia’s economic situation is a fascinating case study…not least for anyone following the economy since the fun-days of the Yeltsin era. The country retains strong fundamentals that make it a good credit risk – ample reserves of a half a trillion dollars, an oil-fuelled fiscal stance with ample goodies in the bag through a wealth and reserve funds each with a touch over $80bn in the kitty each. And yet…and yet…tbc

BRICS and the Missing G spot

2012-10-11T21:14:00.003+01:00

Please click here or on the link below:

http://www.aid-finance.com/brics-and-the-missing-g-spot/

For more information or requests for advsiory mandates please contact rupinder@aid-finance.com

A Tale of Two Cities: Minsk and Tbilisi

2012-10-05T15:05:00.000+01:00

Please click here or on the link below:

http://www.aid-finance.com/minsk-belarus-and-tbilisi-georgia-a-tale-of-two-cities/

For more information on CEE economies or additional reports please contact rupinder@aid-finance.com

Emerging Markets: CEE and Vulnerabilities

2012-09-21T13:07:00.001+01:00

Click here or on the link below:

http://www.aid-finance.com/cee-and-vulerabilities/

Effect of Russia's WTO Accession..Belarus

2012-09-14T16:24:00.001+01:00

See here or click below:

http://www.aid-finance.com/effect-of-russias-wto-accession/

Belarus and trade with Russia

2012-09-14T10:39:00.002+01:00

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http://www.aid-finance.com/238/

Putin 2.0:The Hunt for Goldilocks Growth

2012-09-14T10:38:00.002+01:00

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or http://www.aid-finance.com/putin-2-0-the-hunt-for-goldilocks-growth/