27/12/2014: Geography of the Euro Area Debt Flows

The debate about who was rescued in the euro area 'peripheral' economies banking crisis will be raging on for years to come. One interesting paper by Hale, Galina and Obstfeld, Maurice, titled "The Euro and the Geography of International Debt Flows" (NBER Working Paper No. w20033, see http://www.nber.org/papers/w20033.pdf) puts some facts behind the arguments.

Per authors, "greater financial integration between core and peripheral EMU members had an effect on both sets of countries. Lower interest rates allowed peripheral countries to run bigger deficits, which inflated their economies by allowing credit booms. Core EMU countries took on extra foreign leverage to expose themselves to the peripherals. The result has been asset-price bubbles and collapses in some of the peripheral countries, area-wide banking crisis, and sovereign debt problems."

The causes explained, the paper maps out "the geography of international debt flows using multiple data sources and provide evidence that after the euro’s introduction, Core EMU countries increased their borrowing from outside of EMU and their lending to the EMU periphery."

So braodly-speaking, core euro area economies funded excesses. Hence, in any post-crisis rescue, they were the beneficiaries of transfers from the 'peripheral' economies and taxpayers.

Some details.

According to Hale and Obstfeld, "one mechanism generating the big current account deficits of the European periphery could be summarized as follows: after EMU (and even in the immediately preceding years), compression of bond spreads in the euro area periphery encouraged excessive borrowing by these countries, domestic lending booms, and asset price inflation. We further argue that a substantial portion of the financial capital flowing into the European periphery was intermediated by the countries in the center (core) of the euro area, inflating both sides of the balance sheet of the large financial institutions in the euro area core."

So, intuitively, lenders/funders of the asset bubbles should be bearing some liability. And it would have been the case were the funds transmitted via equity or direct asset purchases (investment from the Core to the 'periphery' in form of buying shares or actual real estate assets). Alas they were not. "These gross positions largely took the form of debt instruments, often issued and held by banks. Thus, EMU contributed not only to the big net deficits of the peripheral countries, but to inflated gross foreign debt liability and asset positions for nonperipheral countries such as Belgium, France, Germany, and the Netherlands – countries that all experienced systemic banking crises after 2007."

Debt, as we know it now, has precedence over equity when it comes to taking a hit in a crisis, and debt is treated on par with deposits. Hence, "the tendency for systemically important banks to increase leverage in line with balance sheet size …implied a substantial increase in financial fragility for these countries’ financial sectors."

In the short run, prior to the crisis, leveraging up from the Core into the 'periphery' had a stimulative effect on asset bubbles. "Four main factors contributed to the suppression of bond yields in the European periphery after the introduction of the euro.
- First, the risk of investing in the European periphery declined with the advent of the euro due to investor assumptions (perhaps erroneous) about future political risks, including the possibility of official bailouts.
- Second, transaction costs declined and currency risk disappeared for euro area investors investing in the periphery countries.
- Third, the ECB’s policy of applying an identical collateral haircut to all euro area sovereigns, notwithstanding their varied credit ratings, encouraged additional demand for periphery sovereign debt by euro area financial institutions, which, moreover, were able to apply zero risk weights to
these assets for computing regulatory capital. The EU’s recent fourth Capital Requirements
Directive continues to allow zero risk weights for euro area sovereign debts, even though the borrowing countries cannot print currency to pay their debts.
- Fourth, financial regulations in the EU were harmonized and the euro infrastructure implied a more efficient payment system though its TARGET settlement mechanism."

Crucially, all four factors combined to reinforce each other giving "…core euro area financial institutions a perceived comparative advantage in terms of lending to the periphery, and this would also likely have affected financial flows from outside to both regions of the euro area.

In line with the above, the authors find:
- "...strong evidence of the increase in the financial flows, both through debt markets and
through bank lending, from core EMU countries to the EMU periphery."
- "… that financial flows from financial centers to core EMU countries increased, but predominantly due to increased bank lending and not portfolio debt flows.
- "In addition, …evidence from the syndicated loan market that is broadly consistent with the core EMU lenders having a comparative advantage in lending to the GIIPS."

Net conclusion: "The concentration of peripheral risks on core EMU lenders’ balance sheets helped to set the stage for the diabolical loop between banks and sovereigns that has been at the heart of the euro crisis."

Authors quote other sources on similar: “German banks could get money at the lower rates in the euro zone and invest it for a decade in higher yielding assets: for much of the 2000s, those were not only American toxic assets but the sovereign bonds of Greece, Ireland, Portugal, Spain, and Italy. For ten years this German version of the carry trade brought substantial profits to the German banks — on the order of hundreds of billions of euros ... The German advantage, relative to all other countries in terms of cost of funding, has developed into an exorbitant privilege. French banks exploited a similar advantage, given their major role as financial intermediaries between AAA-rated countries and higher yielding debtors in the euro area.” (From Carlo Bastasin, Saving Europe: How National Politics Nearly Destroyed the Euro, Washington, D.C.: Brookings, 2012, page 10.)

Charts below summarise flows from Core markets to 'peripheral' markets

CPIS is stock of portfolio debt claims from CPIS data in real USD:

BISC is stock of total international bank claims from consolidated BIS data in real USD:

BISL Flow is valuation-adjusted flows of total cross-border bank claims from locational BIS data in real USD:

And conclusions: "Not only did peripheral countries borrow more after EMU; in addition, financial institutions in the core of the euro area expanded their balance sheets to facilitate peripheral deficits, thereby increasing their own fragility. This pattern set the stage for the diabolical feedback loop between banks and sovereigns that has been such a powerful driver of the euro area's recent crisis."

So next time someone says that 'periphery' is to be blamed for the causes of the crisis, send them here. for in finance, like in dating, it takes two to tango…

26/12/2014: Household Leveraging and Deleveraging in the U.S.

Household debt deleveraging is one of the key forces currently still working through the Western economies, suppressing investment and spending, and supporting precautionary savings. The U.S., having entered the Great Recession ahead of many other economies, armed with stronger consumer-centric systems of insolvency and personal bankruptcy, and having exited the Great Recession with more robust rates of economic growth than other advanced economies, presents a good example or a case study for this process.

One recent paper, by Justiniano, Alejandro and Primiceri, Giorgio E. and Tambalotti, Andrea, titled "Household Leveraging and Deleveraging" (see FRB of New York Staff Report No. 602: http://ssrn.com/abstract=2229366) does exactly that.

Per authors, "U.S. households' debt skyrocketed between 2000 and 2007, but has since been falling. This leveraging and deleveraging cycle cannot be accounted for by the liberalization and subsequent tightening of mortgage credit standards that occurred during the period." Quite strikingly, the authors show that financial liberalisation does not fully explain the cycle.

Instead, "…the credit cycle is more likely due to factors that impacted house prices more directly, thus affecting the availability of credit through a collateral channel. In either case, the macroeconomic consequences of leveraging and deleveraging are relatively minor because the responses of borrowers and lenders roughly wash out in the aggregate."

Of course, the only reasons for this conclusion are the factors mentioned above: the U.S. personal insolvency and debt resolution regimes are far more benign, allowing for a more orderly and less disruptive 'washing out' of adverse effects of household debt overhang.

26/12/2014: "Iceland: How Could this Happen?"

Always interesting and never ending debate about Iceland v Ireland can only be aided by the following recent paper by Gylfason, Thorvaldur, titled "Iceland: How Could this Happen? (see CESifo Working Paper Series No. 4605: http://ssrn.com/abstract=2398265).

The author "reviews economic developments in Iceland following its financial collapse in 2008, focusing on causes and consequences of the crash. The review is presented in the context of the Nordic region, with broad comparisons also with developments elsewhere on the periphery of Europe, in Greece, Ireland, and Portugal. In some ways, however, Iceland resembles Italy, Japan, and Russia more than it resembles its Nordic neighbors or even Ireland. The paper also considers the uncertain prospects for reforms and restoration as well as the possible effects of the crash on social, human, and real capital and on long-run economic growth."

To add, two charts of my own, really self-explanatory:

26/12/2014: Advanced Economies: Public Debt Explosion 2008-2014

Some interesting insight into the legacy of the Great Recession that we are carrying over into 2015. From the start of 2008 through 2014:

• Average increase in gross debt of all advanced economies was 27.2 percentage points of GDP, with a range from a decrease of 21 percentage points for Norway and an increase of 88.5 percentage points for Ireland. Thus, the average annualised rate of increase in government debt over the period was around 3.47 percentage points of GDP with a range of -2.76 percentage points annualised decline for Norway and a 9.48 percentage points annualised increase in Ireland.
• Average change in the gross government debt of the group of countries where debt declined over the crisis was -12.0 percentage points of GDP. There were only 3 countries in this group.
• Average increase in gross government debt of the group of countries with benign levels of increase (levels of increase consistent roughly with offsetting GDP contraction over the crisis period) was 4.8 percentage points of GDP. There were only 5 countries in this group and only two of these were in Europe, with none (at the time of the crisis onset) being members of the euro area.
• Average increase in gross government debt within the group of countries where debt rises were moderately in excess of contraction in the economy was 16.4 percentage points of GDP.
• Average increase in gross government debt within the group of countries with debt increases significantly in excess of economic contraction was 26.6 percent of GDP.
• Average increase in the government debt within the group of countries with severe debt overhang was 60.4 percentage points of GDP, with a range of increases in this group between 41.6% for the U.S. at the lower end and 88.5% of GDP for Ireland at a higher end.

Chart above summarises these facts and also highlights the extent to which Ireland's government debt increases were out of line with experience in all other countries, including Greece and all other 'peripheral' economies.

The average rise in gross government debt across all peripheral economies 2008-2014 was 56.5 percentage points of GDP (excluding Ireland), which is more than 1/3 lower than that for Ireland. Our closest competitor to the dubious title of worst performing sovereign in terms of debt accumulation is Greece, which experienced a debt/GDP ratio increase almost 1/4 lower than Ireland.

And in case you wonder, our Government's net debt position is not much better:

26/12/2014: The Empirical Evidence on Globalisation

Much has been written around the alternative, and even mainstream media about the perils of globalisation. Not to discount these arguments without a serious treatment, economics mainstream tends, on the other hand, view globalisation as a net positive force for betterment of the economy. Of course, there non-linear transmissions from economics to the broader society, and there are non-linear effects of globalisation on various social and economic agents: there are winners and losers in the process.

Here is an interesting paper that looks at the core macroeconomic consequences of globalisation. Potrafke, Niklas' study "The Evidence on Globalization" (see: CESifo Working Paper Series No. 4708: http://ssrn.com/abstract=2425513) surveys the empirical literature on globalisation focusing on the KOF indices of globalisation "…that have been used in more than 100 studies. Early studies using the KOF index reported correlations between globalization and several outcome variables. Studies published more recently identify causal effects."

The evidence shows that "globalization has spurred economic growth, promoted gender equality, and improved human rights. Moreover, globalization did not erode welfare state activities, did not have any significant effect on labor market interaction and hardly influenced market deregulation. It increased however within-country income inequality."

Worth a read. 

25/12/2014: Skilled Immigration and Employment in the U.S.

There is a persistent debate in economics about the effects of migration of the highly-skilled workers on employment prospects and careers of the natives. Here is one interesting study looking at such effects within the context of the targeted immigration programme based on skills within the particular set of sectors - the STEM, or more commonly, Science and Technology.

Kerr, Sari Pekkala and Kerr, William R. and Lincoln, William Fabius, Skilled Immigration and the Employment Structures of U.S. Firms (see arvard Business School Entrepreneurial Management Working Paper No. 14-040: http://ssrn.com/abstract=2354963) "study the impact of skilled immigrants on the employment structures of U.S. firms … [accounting for] the fact that many skilled immigrant admissions are driven by firms themselves (e.g., the H-1B visa)." The authors "find rising overall employment of skilled workers with increased skilled immigrant employment by firm. Employment expansion is greater for younger natives than their older counterparts, and departure rates for older workers appear higher for those in STEM occupations compared to younger worker."

From the point of view of countries, like Ireland, relatively open to immigration of skilled workers, but without a specific skills-based 'filter' (Irish system is open to migrants on the basis of nationality, rather than skills, but has strong selection biases into skills-based immigration due to lack of jobs creation outside the STEM categories of jobs), the above suggests that skills depreciation in the STEM sector can be a problem for the natives. As supply of younger STEM employees from abroad rises, there can be a tendency for displacement of older workers, premature termination or flattening out of careers and, subsequently, lower supply of pensions and income provisions in later years of life.

25/12/2014: Unwinding Western Excesses, Squeezing Emerging Markets

Just in case you need a scary story for the holidays seasons, here's one from economics. Some time ago, we've learned that zero bound (extremely low) interest rates in the advanced economies spell quite a disaster for the emerging markets, where the economies are now suffering from triple pressures: declining commodities prices (on which many emerging markets economies often rely for exports, declining demand for their exports of goods, and declining investment inflows from the advanced economies.

But that's just the beginning. It seems that any unwinding of the QE deployed in the West is likely to hammer the emerging markets more.

Here's a World Bank paper from earlier this year on the topic: Burns, Andrew and Kida, Mizuho and Lim, Jamus Jerome and Mohapatra, Sanket and Stocker, Marc, Unconventional Monetary Policy Normalization in High-Income Countries: Implications for Emerging Market Capital Flows and Crisis Risks (April 1, 2014). World Bank Policy Research Working Paper No. 6830: http://ssrn.com/abstract=2419786

What the authors found is that as "the recovery in high-income countries firms amid a gradual withdrawal of extraordinary monetary stimulus, developing countries can expect stronger demand for their exports as global trade regains momentum, but also rising interest rates and potentially weaker capital inflows. …In the most likely scenario, a relatively orderly process of normalization would imply a slowdown in capital inflows amounting to 0.6 percent of developing-country GDP between 2013 and 2016, driven in particular by weaker portfolio investments. However, …abrupt changes in market expectations, resulting in global bond yields increasing by 100 to 200 basis points within a couple of quarters, could lead to a sharp reduction in capital inflows to developing countries by between 50 and 80 percent for several months."

Wait, we are witnessing this already, in part, as bond prices in a number of emerging economies are following oil prices down. And worse, if the above applies to corporate yields, the same will apply to government yields. Thus, 'normalisation' in the West can yield double shock to debt markets in the emerging economies.

World Bank paper has more on the subject: "Evidence from past banking crises suggests that countries having seen a substantial expansion of domestic credit over the past five years, deteriorating current account balances, high levels of foreign and short-term debt, and over-valued exchange rates could be more at risk in current circumstances. Countries with adequate policy buffers and investor confidence may be able to rely on market mechanisms and countercyclical macroeconomic and prudential policies to deal with a retrenchment of foreign capital. In other cases, where the scope for maneuver is more limited, countries may be forced to tighten fiscal and monetary policy to reduce financing needs and attract additional inflows."

So the best case scenario, sovereign wealth reserves (if any) will be exhausted on 'normalising' the US, UK, Euro Area and Japan, while if none are present, tough luck - the emerging economies are into a tailspin. They'll have to relieve the path of austerity-driven internal devaluations. Just because the West has ramped printing presses up so much, any 'normalisation' is going to be a disaster. If that is not a case of beggar thy poorer neighbour by enriching thy stock markets strategy, then do tell me what is?

And in another paper, "Tinker, Taper, QE, Bye? The Effect of Quantitative Easing on Financial Flows to Developing Countries" the same authors looked at gross financial inflows to developing countries over 2000-2013 (see: World Bank Policy Research Working Paper No. 6820: http://ssrn.com/abstract=2417518).

As above, authors found evidence "for potential transmission of quantitative easing along observable liquidity, portfolio balancing, and confidence channels. Moreover, quantitative easing had an additional effect over and above these observable channels, which the paper argues cannot be attributed to either market expectations or changes in the structural relationships between inflows and observable fundamentals. The baseline estimates place the lower bound of the effect of quantitative easing at around 5 percent of gross inflows (for the average developing economy), which suggests that of the 62 percent increase in inflows during 2009-13 related to changing global monetary conditions, at least 13 percent of this was attributable to quantitative easing. The paper also finds evidence of heterogeneity among different types of flows; portfolio (especially bond) flows tend to be more sensitive than foreign direct investment to our measured effects from quantitative easing."

So broadly-speaking, QE is impacting bond/debt flows and unwinding QE can be a costly proposition for the emerging markets.

25/12/2014: Ruble Crisis: Stage 1 Capital Controls

In a recent post on Ruble Crisis (http://trueeconomics.blogspot.ie/2014/12/23122014-simple-math-russian-default-or.html), I have promised to post my comments that were forthcoming in Portuguese Express. Here they are, in English:

Q: Did Russian Government impose capital controls last week?

Yes. Both de facto and de jure, the new requirement on state-owned companies and a softer request for larger private companies to reduce their foreign exchange holdings constitute capital controls. However, the reduction is relatively benign and will not present a material risk to these companies' operations. 

The reason for this is that the benchmark holdings set at October 1, 2014 levels of reserves mean that the new restrictions cover primarily build up in foreign exchange reserves accumulated during the acceleration of the currency crisis. In a sense, these were precautionary accumulations of foreign exchange that have little to do with operational demands of the companies involved. A more material restriction could have been limiting reserves to a fixed proportion of revenues. In the 1998 crisis, Russian authorities forced exporters to convert all foreign exchange earnings in rubles. This time around, an intermediate measure, in severity ranking between the 1998 case and this week's announcement, would have been requiring exporter to convert, say 50 percent of their earnings into rubles. However, Moscow held back such a measure and opted for a weaker version, benchmarking reserves to October 1 positions. 

As is, the measure will likely increase supply of US dollars into the market by about USD50 billion - roughly the amount that has been accumulated in precautionary reserves. And this comes on foot of the new currency swap agreement with China that can inject up to USD24 billion into the markets.

The new restriction is voluntary in nature, in so far as companies can continue to accumulate reserves, but in reality, only those companies facing significant bond redemptions in 2015 will be allowed to do so. Barring the latter exemption, we would have seen moratorium on debt redemptions for larger Russian companies by mid-Q1 2015.

Overall, the new measure introduced by the Russian Government is, effectively, a bid to avoid introducing full scale capital controls and to enhance the Central Bank of Russia's firepower in the forex markets. This has already been reflected in the markets via a dramatic rebound in the Ruble valuations and an equally significant decline in the volumes of short ruble contracts which fell from this week's high of just under 70,000 to below 50,000.

Updated: here is the link to the article http://expresso.sapo.pt/rublo-valoriza-gracas-ao-controlo-suave-de-capitais=f903997

24/12/2014: Amnesty International: food aid blocked in Eastern Ukraine

Pretty strong language from Amnesty International on the situation with blocked food aid destined for Eastern Ukraine: http://amnesty.org/en/news/eastern-ukraine-humanitarian-disaster-looms-food-aid-blocked-2014-12-23.

Amnesty has been very neutral in its criticism of both sides in the conflict, so this is an objective source, in my view. For example of Amnsety's balance see: http://www.amnesty.org/en/news/eastern-ukraine-both-sides-responsible-indiscriminate-attacks-2014-11-06. In contrast, I have not spotted any reporting of the above problem in the mainstream Western media.

24/12/2014: House of Rubles: Bulgaria's Capital on Ruble Crisis

Here is an article in Bulgarian Capital on the subject of the Russian currency crisis, with comments from myself: http://www.capital.bg/politika_i_ikonomika/sviat/2014/12/19/2442567_kushta_ot_rubli/. My original comments in English:


1. What triggered the acceleration of the rouble crisis and why the drastic raise of the interest rates didn't help?

In a currency crisis, raising interest rates usually has little effect on currency valuations because the motives for dollarisation or a switch away from the domestic currency rest outside the scope of deposits and savings.

Russian crisis has been driven by rapid collapse of oil prices and by the growing demand for dollar and euro liquidity from banks and companies forced to repay foreign borrowings due to lack of access to the foreign credit markets.

Several larger Russian firms, facing billions of dollars of debt redemptions in Q4 2014 have moved into the market in the last 10 days, buying up dollars and using ruble loans from the Central Bank to fund these purchases. In addition, new estimates that came out last week showed Central Bank of Russia witnessing accelerated rate of capital outflows suggesting that Q4 outflows will match those in Q1 and that the total volume of outflows will total $134 billion, matching 2008-2009 crisis peak. This triggered a run on the Ruble that started on Monday and continued through Tuesday. Tuesda run was further exacerbated by the dollarisation of the household deposits, with many Russian households rushing to convert Ruble savings into dollars and euros.

In a way, 10.5 percentage points hike in interest rates enacted by the Central Bank added fuel to the fire. Firstly, it signalled to the markets that capital outflows are reaching crisis proportions. Secondly, it increased the demand for loans from the households trying to secure credit before rates rise even higher, and also drove more companies and households toward conversion of their deposits into dollars.

In the short run, the interest rate hike also led to a more aggressive shorting of the ruble, especially by algorithmic trading programmes, by acting to suppress supply of dollars out of Russian deposits into ruble trades, while leaving external supply of dollars available for backing shorts unaffected. The short-term nature of such strategy was evident in the abrupt reduction in net short positions in the market.


2. What options do Russian authorities have now to deal with the situation? Will Russia need to use capital controls?

So far, Russian Central Bank spent around USD10 billion on foreign currency interventions (through the first two weeks of December). The ministry for finance further openly committed to injecting additional USD7 billion. Simultaneously, the CBR adopted measures to ease balance sheet pain for the banks. The CBR also dramatically expanded its repo operations. All of this had an effect of calming the markets down - the effect witnessed on Wednesday.

However, the underlying causes of the crisis remain unaddressed and the current reprieve can be temporary, unless the CBR and the Russian Government adopt more drastic measures. One measure that will be effective in dealing with the underlying drivers of the crisis is limited capital controls. These can reduce dollarisation of the domestic household and corporate deposits and also restrict, in part, outflows of funds abroad. However, the second problem - mounting weight of debt redemptions by sanctions-impacted banks and companies - requires a different solution. One possible solution could be freezing redemptions for entities directly covered by sanctions, allowing ill up of interest to avoid outright default. Both measures are what we can term the 'nuclear' solutions and to-date the Russian Government has balked at adopting them. However, the Government is already applying pressure on Russian companies to stop hoarding foreign currency. The Government is also diverting 10% of the Russian National Pension Fund receipts toward supporting domestic banks.

Should the crisis regain momentum, even the 'nuclear' - in economic terms - options are going to be on the table.


3. How close is Russia to a repeat of the 1998 crisis?

The 1998 crisis was very different in nature and causes, so the parallels to it are tenuous at best. In the 1998 crisis, Russian Government was carrying unsustainable levels of external debt and it was running huge deficits. The country external balance of payments was in a persistent deficit. None of these factors are present today. Russian Government fiscal surplus is in excess of 2 percent and devaluation actually improves the Federal Government position in the short term. Current account is in a surplus and even with oil going to USD50/bbl, current account position is well-supported in the short run by collapsing imports. The entirety of Russian Government debt redemptions for 2015 is just over USD2.8 billion.

On the other hand, Russian economy today is in the same structural cul de sac as in 1998. Core driver for growth - high energy and commodities prices - is gone and it is unlikely to return any time soon. Consensus forecasts suggest oil price averaging around USD80/bbl in 2015, so at the very best, Moscow can expect moderate improvement in pressures compared to current situation.


4. Is now a deep recession a certainty for Russia in 2015? And how much worse can things get?

It is most likely that the Russian economy will slip into the recession over Q4 2014 - Q2 2015. The only question is - how deep the recession can be. Based on USD60/bbl assumption for the price of oil, the Central Bank estimates that Russian economy will contract 4.5-4.7% in 2015. At USD80/bbl, the contraction is likely to be closer to 0.8-1%.

The former is a heavy toll on the economy, while the latter is relatively mild and consistent with Euro area experience in 2012-2013. And beyond that, 2016 is also promising to be a tough year. Russian economy desperately needs two things: investment for developing non-extraction sectors, modernising the capital and technological bases; and structural reforms, reducing red tape, corruption, arbitrary enforcement of laws, reducing bureaucracy and altering labour markets. It will be extremely hard to deliver investment boost in current financial conditions and in the presence of sanctions. It will be virtually impossible to deliver reforms with current power brokers' so heavily dependent on continuation of the status quo of power and wealth distribution. But, at least reforms are a function of internal will.

There are added risks to the downside of the above forecasts, however. If capital outflows remain at peak levels consistent with Q1 and Q4 2014, interest rates will have to rise even further. Meanwhile, devaluation of the ruble will require offsetting nominal increases in spending on pensions, social supports, as well as investment in imports substitution. The result will likely be even more severe recession than forecasted above.


5. Could the rouble crisis shake Putin's grip on power?

At this stage, it is very hard to imagine any significant shift in the power balance in Moscow. The reason for this is two-fold. There is no momentum for such a change in the electorate and amongst the elites. Most recent public opinion surveys show steady 80% and higher support for President Putin and similar broad approval ratings for the Government.

Economic hardship is something the Russian society endures when it is faced with geopolitical adversity. Sanctions, in a way, are reinforcing current balance of power in favour of President Putin. The Crimean Euphoria effect is now almost gone. Eastern Ukraine offers much lower support base within the Russian society, with roughly 60% of population approving Russian Government providing support for the separatists there. But the juxtaposition of Russia vis-a-vis the West is now forming the main basis for President Putin's popularity. Whether we, in the West, like it or not, Russians do feel that their interests are not being served by cooperative engagement with Nato and the West. And much of the fault for this antagonism is based in both sides actions and rhetoric.

In addition, Russia lacks viable alternative to the current power balance. Existent opposition is even more vested into nationalist rhetoric and represents more extreme positions both in economic policies terms and geopolitical outlook. Opposition currently visible outside Russia has no support base within Russia. It is a power vacuum, absent the current Presidency. And, frankly, I cannot convincingly say that external opposition offers anything other than Putinism 2.0. The head of state change is not equivalent to structural reforms and so far, democratisation rhetoric from the Western-based Russian opposition is shallow, unbacked by any serious proposals for reforms and offering no alternatives to the 'power vertical' systems put in place from ca 1995 on, from the late Yeltsin era through today.

That said, if the crisis persists beyond 2015, we are likely to see growing pressure on the President and the emergence of potential challengers. Whether they will offer any serious prospect of reforms, while providing pragmatic road map for stability and governability is another question altogether.


6. What is more likely now - the economic agony to make the wounded Russian bear even more belligerent, or to force Putin to soften his position and to seek lifting of the sanctions?

In my view, the current situation is very volatile and highly unpredictable. We can certainly hope that the crisis is going to move both Russia and the West toward reconciliation of their respective positions. We need a constructive dialogue across a range of geopolitical issues. And we need Russia to be a strong, but cooperative participant in this process. The core point here is that it takes two to tango. The West needs to moderate its position on sanctions and Nato, Russia needs to be offered a way out of the Ukrainian crisis, while Ukraine's independence and territorial integrity must be preserved. Russia, in return, must step away from brinksmanship in both Ukraine and vis-a-vis Nato. The former is a disastrous strategy that will not deliver on Russian longer-term objectives and will continue to antagonise the Ukrainian population, moving the country away from any future good will-based cooperation with Russia. The latter is a tragedy waiting to happen - close calls in fly-bys between Russian military aircraft and civilian airlines in the Baltic Sea region are the proof of this.

Can 2015 be the year when we see some positive changes in these directions? I certainly hope so. But the indications are, we will see escalation of the crisis, before we see resolution being put forward.

23/12/2014: A Simple Math: Russian Default or Not

A simple math:

• Russia's total external debt, stripping out cross-holdings of corporate entities and banks (debt owed by Russian subsidiaries to foreign parents, debt owed by Russian companies to Russian investment vehicles registered off-shore, debt owed by Russian JVs to foreign partners, etc) is around USD500 and USD600 billion, based on various estimates. Note: official estimates put gross external debt in foreign currency at USD540 billion at Q2 2014, of which we can net out around 15 percent for cross-holdings by (ultimately) Russian entities, implying gross external foreign currency-denominated debt net of cross holdings at ca USD460 billion.
• Of this, roughly USD101 billion matures in 2015
• Russian GDP is slightly over USD2 trillion
• Thus, total external debt of Russian companies, households and the Government net of cross-holdings amounts to 25-30% of its GDP.  By World Bank data referencing this runs at around USD23% of GDP.
• By the end of 2015, if the repayments take place, and factoring in dim sum new debt issuance, it will be around 22-27% of GDP or by World Bank methodology - around 20% of GDP.

By the above, Russian economy is nowhere near any significant risk of defaults, save for the risk of default induced solely by two forces (should they continue on the current trend):

1. Oil price collapse, now increasingly looking as being caused by the combination of shale output surge and Saudi Arabia's response to that, and
2. Western sanctions that effectively imposed external capital controls of extreme severity on Russian economy.

You can blame President Putin for many things, and rightly so. But for any, even nascent capital controls Russia imposes (I will post my thoughts on these in a couple of hours, once my comment to a journalist goes to print) you really should blame President Obama & the House of Saud.

23/12/2014: RTE Finance: Money Grows on NTMA Trees

Oh dear, dear... Irish State Broadcaster is clearly in the need of some cash for training... or else, they are geniuses of the unimaginable proportions. Either way, RTE has discovered nothing more, nor less than a genuine money creation principle of the Irish Government Promo Notes.

Don't believe it? Read here: http://www.rte.ie/news/business/2014/1223/668729-central-bank/

Let me summarise the logic:

• Anglo & INBS went bust (we know).
• Government created IBRC to 'close off' Anglo & INBS, funded by the Promissory Notes (government debt issued to government-owned agency)
• Government created a swap to 'close off' IBRC: NTMA issued a bunch of 'IBRC' bonds (government debt) that were swapped for IBRC Promissory Notes (government debt).
• The 'IBRC bonds' were given by NTMA to the Central Bank of Ireland which is obliged to sell them.
• NTMA, at the same time, on the sideline as a part of its normal business borrowed cash from the private markets. It stuffed this cash into Irish banks as deposits, getting paid nada on the euro and paid interest on this cash to the private markets, which amounted to a lot more than nada.
• NTMA then 'bought' back some of the IBRC bonds from the CBI, paying with cash it borrowed from the markets on which it paid interest and will continue paying interest.
• RTE described the above as a 'costless' transaction, cancelling the debt.
• In reality, debt is still there right were it was, except if before interest on IBRC bonds was payable to the Central Bank it is now payable to... drum roll... the private lenders who lent money to NTMA.

That last bit is something RTE just couldn't spot with the Hubble Telescope of Financial Wisdom they deployed in the above link.

Which brings us to the Nobel Prize-worthy breakthrough at the RTE: money grows on trees or locates itself at the end of a rainbow or something of the sorts... but in the end, money is free for the State Broadcaster that truly does get 'free' money (aka taxes)...

Oh dear...

Two twitter reactions: