17/2/15: Of Debt, Equity and the Wake Up Calls for the Financial Markets

My post for Learn Signal blog on the issues of debt v equity composition of the global financial markets: http://blog.learnsignal.com/?p=157

16/2/15: Euro v 'Sustainable Growth': Mythology of Brussels Economics

Euro existence has been invariably linked to the promise of a 'sustainable' prosperity. From days when it was just a dream of a handful of European integrationists through today.  Which means that we can have a simple and effective test for the raison d'être of common currency union: how did GDP per capita fare since the euro introduction.

So let's take a simple change in GDP per capita, expressed in constant prices (controlling, therefore, for inflation) across the advanced economies around the world. Chart below details annualised rates of growth achieved between the end of 1999 and the end of 2014.

Excluding the most recent addition to the euro area, let's consider the original EU12. Across all advanced economies (34 of them), average annualised rate of real GDP per capita growth was 1.57%. Across the euro area 12 it was 0.727% - less than 1/2 of the average. Average for non-euro area 12 states was 2.126% or almost 3 times the euro area 12 average.

All of this translates into a massive gap between the euro area 12 (euro 'growthology' states that supported from the start the idea of 'sustainable' growth based on the EMU) and the rest of the advanced economies. In cumulative terms - over 2000-2014, EA12 states clocked growth of 11.674% in terms of their real GDP per capita. Over the same period of time, ex-EA12 advanced economies managed to grow on average by 40.01%.

Oh dear... even if you are not Italy or Cyprus (the latter made utterly insolvent by the EU inept 'resolution' of the Greek crisis and then promptly accused of causing this disaster upon itself - just to ad an insult to an injury), even if you are the 'best in the class' Ireland... within the euro, you are screwed.

So the key question is: where is the evidence that having a common currency results in better economic outcomes? Key answer is: nowhere. 

16/2/15: Current Account, Growth and 'Exports-led Recovery': 1999-2014

There is one European economic policy/theory fetishism that stresses the importance of external balance in 'underpinning sustainable' growth. The theory works the following way: countries with external imbalances (e.g. current account deficits) need to enact 'reforms' that would put their economies onto a path of external surpluses. More commonly, this is known as achieving an 'exports-led recovery'.

Set aside the Cartesian logic suggesting that if someone runs a current account surplus, someone else must run a current account deficit. Or in other words, if someone achieves 'sustainable' growth, someone else must be running an 'unsustainable' one.

Look at the actual historical relationship between current account position and growth in income per capita, measured in real (inflation-adjusted terms).

Take the sample of all advanced economies (34 in total, excluding those that we do not have full data for: San Marino and Malta). Take total growth achieved in GDP per capita from the end of 1999 through 2014. And set this against the average current account surplus/deficit achieved over the same period of time.

Chart below illustrates:

Note: there is no point, given the sample size, to deal with non-linear relationship here.

Per chart above, there is, statistically-speaking no relationship between two metrics. Multi-annual growth GDP per capita (in real terms) has basically zero (+0.019) correlation with multi-annual average current account balance. The coefficient of determination is a miserly 0.00036.

Now, cut off the 'outliers' - four countries with lowest GDP per capita: Estonia, Latvia, Slovak Republic and Slovenia. Chart below shows new relationship:

Per chart above, there is a very tenuous relationship between multi-annual growth GDP per capita (in real terms) and multi-annual average current account balance, highlighted by a rather weak, but positive correlation of +0.41 between two metrics. The coefficient of determination is around 0.17, which is relatively low for the longer-term averages relationship across the periods that capture both - a slowdown in growth in the 2002, a boom-time performance for both the advanced economies and the global economy during the 2000s and the global crises since 2008.

I tested the same relationship for GDP per capita adjusted for Purchasing Power Parity and the results were exactly identical. Furthermore, removing the three Asia-Pacific growth centres: Taiwan, Korea and Singapore from the sample leads to a complete breakdown of the stronger relationship attained by excluding the Eastern European outliers, with coefficient of determination falling to ca 0.05. Removing these three economies from the sample with Eastern European outliers present results in a negative (but statistically insignificant) relationship between the current account dynamics and growth.

Lastly, it is worth noting that the sample is most likely biased due to policy direction: during economic slowdowns and in poorer performing European economies in general, there is a strong policy bias to actively pursue exports-led growth strategies, while in non-euro area economies this is further reinforced by the pressure to devalue domestic currencies. Which, of course, suggests that the above correlation links are over-stating the true extent of the current account links to growth.

The conclusion from this exercise is simple: there is only a weak evidence to support the idea that for highly advanced economies, rebalancing their economic growth over the longer term toward persistent current account surpluses is associated with sustainable economic growth. And if we are to consider a simple fact that many euro area 'peripheral' economies (e.g. Greece, Cyprus, Portugal and Spain, as well as Slovenia) require higher upfront investments in physical and human capital to deliver future growth, the proposition of desirability of an 'exports-led' recovery model comes into serious questioning.

15/2/15: European Federalism: Principles for Designing New Federal Institutions

This week, I was honoured to have been invited to participate in a discussion panel of the Future of Europe at the Trinity Economic Forum 2015.

Here are my extended speaking notes on the subject of European Federalism and the challenges of building future European institutions: http://trueeconomicslr.blogspot.ie/2015/02/15215-european-federalism-principles.html

14/2/15: Russian Banks: Some New Stats

A very interesting interview with Jim Rogers, reprinted by Russia Insider: http://russia-insider.com/en/politics_opinion/2015/02/12/3390?utm_source=dlvr.it&utm_medium=twitter

Note the points on the threat of SWIFT sanctions against Russia and the position of China in the US-led sanctions. Both themes have been highlighted on this blog before and both remain very important to the current situation.

And on a SWIFT-related note, few fresh stats on Russian banks situation, reported by BOFIT. Latest data shows Russian banking system assets at RUB77.66 trillion at the end of 2014, up 18% y/y, and this fully accounting for Ruble devaluation. Surprisingly (or not, depending on which fundamentals you consider core drivers for assets growth forward), growth in banking assets accelerated in Q4 2014. The reason was increase in CBR funding for the banks unlocking some liquidity tightness present in Q2-Q3 2014. As the result, CBR-funded share of assets rose from 9% in Q3 2014 to 12% in Q4 2014.

In January 2015, total assets fell RUB24 billion, down 2.6% m/m, thus accelerating the decline registered in December.

Loans to non-financial private sector rose ca 13% in 2014 y/y, similar to 2013 for non-financial companies but lower for the households. In December, outstanding loans to households declined. Non-performing household loans rose ca 6% and non-performing corporate loans were up roughly 30%. Corporate lending fell 0.5% m/m in January, while household lending fell 1.3%, although these figures do not reflect changes in Ruble valuations (Ruble lost 22% vis-a-vis the USD in January after falling 14% in December).

Meanwhile, household deposits fell 2.5% y/y as dollarisation of deposits drove more household savings into 'mattress' savings. In December alone this resulted in a 1% m/m decline in household deposits - a rate, though substantial, still well below what anyone could have expected given the Ruble crisis peak around December 16-18. In part, Government doubling the deposit insurance coverage to RUB1.4 million helped reduce deposits outflows, along with a massive hike in deposit rates that in December hit ca 14% on average, with some banks offering Ruble deposit rates in excess of 20%. Dollarisation also led to a massive, near doubling, of forex deposits held by the households. Share of forex deposits rose from just under 10% at the start of 2014 to 26% at the end of last year.

Drain of household deposits was more than offset by a rise in corporate deposits as companies aggressively built up cash reserves and forex reserves to provide contingency funding for possible acceleration in liquidity squeeze in the markets. Corporate deposits were up 24% y/y and this growth was dominated by larger enterprises.

All of this means that T1 banks capital ratio fell from 13.5% to just under 12% in 11 months through November 2014. November 2014 injection of RUB1 trillion in Government-approved capital for 27 banks via the Deposit Insurance Agency will inject additional 15% of T1 capital into the banking sector.

BOFIT comment on the situation is quite informative: "Russia’s banking sector is in different shape than during the 2008–2009 financial crisis. Banks are struggling with larger portfolios of non-performing loans and capitalisation is weaker. Economic sanctions and higher interest rates have cut off the access of banks to affordable credit and hurt their ability to intermediate credit to the wider economy. The banking sector is also more concentrated than in 2008, when the five largest banks held 43 % of total assets. Today they hold 54 %. All five banks are state-controlled, so the state’s role in the banking sector has grown further. Stricter supervision has caused over 100 small and mid-sized banks to lose their licences since summer 2013, and more banks are expected to lose their licences this year. Some 835 banks operated in Russia at the end of 2014."

Still, take a comparative to Ukraine, where Non-Performing Loans amount to close to 22% of the bank's loans. At the start of 2015, based on CBR data, non-financial corporate's NPLs in Russian banking system amounted to 4.2%. The forecast is for NPLs across the entire private sector to rise to 5.3-5.5% in 2015. NPLs rose 14.4% in January for corporate loans and by 6% for household loans.

Another telling source on the state of Russian banks is Fitch's latest report on 3 banks: http://www.businesswire.com/news/home/20150213005819/en/Fitch-Downgrades-Russian-Alfa-Bank-Lowers-Sberbanks#.VN8VyLCsVic

One thing is for sure: the banking crisis is still on-going and is likely to worsen this year, leading to accelerated consolidation in the sector.

13/2/15: January Russian imports ex-CIS down massively

Russian external trade figures for Q4 2014 show accelerating trend toward decline in both exports and imports.

According to the latest data, value of goods exports and imports in Q4 2014 fell almost 20% y/y, with December fall of 25% y/y. Russian imports from Ukraine were down some 50% and exports to Ukraine fell 70% y/y.

Oil price effects were pretty substantial as Urals price fell by almost 1/3rd in Q4 2014 compared to Q4 2013. But there was also a 7% decline in the volume of oil exports, as well as ca 30% drop in gas exports by volume. Offsetting these, petroleum products exports were up 9% y/y and other commodities exports held up pretty well and even rose.

Q4 2014 imports of machinery and transport equipment were down some 20% y/y, in line with the decline in imports of food, textiles and passenger cars.

Overall, in 2014, oil and gas accounted for roughly 70% of all Russian exports, largely unchanged on 2013. Overall value of goods exports in 2014 was down 6% (USD32 billion) on 2013, while goods imports fell 10% (just over USD22 billion).


Meanwhile, Russian trade balance posted 3.7% higher surplus for 2014, rising to USD188.66 billion compared to 2013 level of USD181.94 billion, although the surplus was still short of 2011 peak of USD196.85 billion.

Total exports reached USD496.66 billion in 2014, which is some 5.1% lower than in 2013, while total value of imports was down 9.8% y/y (to USD341.34 billion). Imports finished 2014 at their lowest level in four years. These are figures from the Central Bank of Russia.

Based on Russian Customs data, exports registered with Customs stood at USD496.94 billion in 2014, down 5.8% y/y and imports were USD314.97 billion, down 9.2% y/y. Trade balance stood at USD210.96 billion, down 0.6%. Trade balance has deteriorated in November-December 2014 very significantly, down 24.5% and 25.2% y/y, respectively. Only comparable level of deterioration was marked in February 2014 when Russian trade balance fell 23.7% y/y and in September, when it fell 24.5%.

And a 'wake up and smell the roses' moment - January data (preliminary and covering main categories of goods) for Russian imports from the trading partners excluding CIS shows imports of goods falling a massive 40.8% y/y to USD9.855 billion in January 2015, compared to USD16.65 billion in January 2014. Food imports are down 41.9%, Chemicals imports are down 35.3%, Textiles and Clothing imports are down 39.2%, Machinery and Equipment imports are down 44.6%.

13/2/15: Data: Don't Bank on Sanctions Triggering Political Change in Russia

A very interesting insight into the interaction of politics and economics in public perception of political power distribution and public satisfaction with political life from the Pew Research: http://www.pewglobal.org/2015/02/12/discontent-with-politics-common-in-many-emerging-and-developing-nations/

Here are some numbers:

Political satisfaction in Russia in the above chart is quite telling and coincident with public approval ratings for the Government (though these are always lower than the approval ratings of President Putin). In fact, Russian public satisfaction with political situation is the highest in the entire sample of countries. The data covers Spring 2014, so it is somewhat dated and does not reflect subsequent economic and geopolitical developments.

In the context of Russia and Ukraine, the above chart maps public perception of the power of oligarchs. Not surprisingly, Russia comes out much more favourably than Ukraine. Notice that Russian perception of power concentration in the hands of the wealthy is on par with Asian median. As chart below shows, Russian perceptions of power concentration in the hands of the wealthy is actually consistent with Higher Income countries median at both ends of the opinion spectrum.

And for the last, a fascinating plot of relationship between economic environment and satisfaction with political system:

Again, note Russia's position in the above, which appears to be statistically below the correlation line, implying significantly higher satisfaction with political system component to be unrelated to economic environment/conditions than sample average.

All of the above reinforces the argument that in Russia's case, economic environment is much less important in driving public attitudes toward political system than in other countries, which, of course, reinforces the argument that economic sanctions and economic warfare against Russia are unlikely to deliver the results expected under the traditional assumptions of the close links between economic performance and political satisfaction. In other words, don't bank on sanctions and/or economic hardship triggering regime change in Moscow. At least not in the short- to medium-term.

13/2/15: TEF 2015: Challenging Our Conventions

Today is the first day of the Trinity Economic Forum - a students-led venue for discussing current and future trends in economics, economic policy and related issues, such as the future of Europe, social policies and so on.

TEF is a superb venue for an open and intelligent debates and TEF organisers are really doing a stellar job helping to inform and develop a new crop of European and Irish leaders - intellectual, engaged, crossing business, Government, social and other lines.

Check it out: http://trinityeconomicforum.ie/

I asked the organisers for a quick comment on the forthcoming event and they told me:

"TEF was set up in 2012 to promote student engagement in the economic policy-making process. Since then TEF has gone from strength to strength and has become a truly national forum, welcoming students from universities across Ireland. We hope that this year's forum will once again demonstrate the valuable contribution students have to make to shaping Ireland's economic future."

While the lineup of speakers and panels participants is superb, the real value of the TEF is actually students - their participation, engagement, enthusiasm, thinking, knowledge - all remind myself as to why teaching is such a rewarding job: it keeps us, old foggies, on our toes, shaping ourselves to constantly keep up with the speed and depth of our students testing our conventional 'wisdoms'.

Best of luck to all of us who are sitting / standing today on TEF stages.

12/2/15: Ruble Crisis in a Historical Perspective

A neat comparative of the extent of the recent Ruble crisis in a historical context (note: this prices Ruble devaluation at ca 58%, presumably to the USD, is for the peak crisis, while current valuations imply y/y devaluation of 47%).

Source: @jamesrickards

12/2/15: IMF's Latest Ukraine 'Package'... It's Political

As expected, the IMF announced a revised package of loans for Ukraine today. Below is the statement with some comments.

Top line conclusions:

1. IMF Extended Fund Facility Arrangement gives Ukraine more breathing space (three years at a shorter end of debt repayments) and avoids significant repayments due this year under the old arrangement.
2. Nonetheless, the new package is still too short in its maturity - Ukraine will need closer to a decade to rebuild the East and own economy, and to implement reforms, while allowing reforms to take hold and start delivering on growth. 
3. IMF funding comes with expectations of European funding and will probably (at this time it is uncertain as no details have been released yet) imply Fund participation to 2/3 of the total package.
4. Ukraine needs not more loans, but a Marshall Plan with loans:grants ratio of 1:1 or close and total package volume of USD60 billion and duration of at least 10 years. In ignoring the grim realities of Ukrainian economy, the IMF has once again gone for a political compromise instead of a real solution.

IMF statement (select quotes):

"February 12, 2015: Nikolay Gueorguiev, Mission Chief for Ukraine, issued the following statement today in Kyiv: “The mission has reached a staff-level agreement with the authorities on an economic reform program, which can be supported by a four-year Extended Fund Facility, in the amount of SDR 12.35 billion (about $17.5 billion, €15.5 billion), as well as, by considerable additional resources from the international community. The staff level agreement is subject to approval by IMF Management and the Executive Board. Consideration by the Executive Board is expected in the next few weeks, following the authorities’ implementation of decisive front-loaded actions to achieve program goals."

So the total package extended to Ukraine is now in the region of USD40 billion. This might be enough, if the hostilities in the East end in the next month or so, and assuming post-hostilities ending, Ukraine regains the regions as a part of at least some Federal structure. Barring that, if the regions gain significant autonomy from Kiev, it is hard to see how the Ukrainian economy can sustain a loss of ca 15-20 percent of its GDP and still fund the debt it will be carrying.

“The policies under the new arrangement, developed by the Ukrainian authorities jointly with Fund staff, are designed to address the many challenges confronting the Ukrainian economy. Economic activity contracted by around 7-7½ percent in GDP in 2014, weighed down by the conflict in Eastern Ukraine, which  has taken a significant toll on the industrial base and exports, undermined confidence and ignited pressures on the financial system. The economic reform program focuses on immediate macroeconomic stabilization as well as broad and deep structural reforms to provide the basis for strong and sustainable economic growth over the medium term."

It is worth noting that in October 2014 WEO, IMF estimated 2014 GDP decline of 6.5% and forecast growth of 1% in 2015, followed by 4% in 2016 and 2017. At an upper reach of the latest estimate, the Ukrainian economy was shrinking at an annual rate of 1.5 percent in Q4 2014. Which is quite surprising as prior to that it was falling by 2.0-2.2 percent per quarter. Meanwhile, EBRD and others are forecasting for Ukrainian economy to shrink 5% in 2015 (a swing of difference of 6 percentage points compared to the IMF dreaming).

Ukraine's “…2015 budget initiates an expenditure-led adjustment to strengthen public finances within the availability of resources. This required bold, but necessary, measures, including keeping nominal wages and pensions fixed. The budget is supported by revenue reforms, including increasing the progressivity of the personal income tax and streamlining the tax system. The authorities are committed to medium term reforms of the civil service and the important health and education sectors, aiming to improve quality and efficiency, as well as widening the tax base and improving customs and tax administration. Fiscal consolidation would continue over the coming years which together with the debt operation envisaged by the authorities will strengthen debt sustainability."

All of this sounds benign, until you think about the impact of these reforms on Ukrainian power base (oligarchs), and foreign investment (sensitive to taxation regime). In addition, behind the 'widening of the tax base' rests a push to increase effective tax burden on general population. Now, consider this: inflation is running at close to 13% pa, hrivna is devaluing, taxes are rising (both in terms of enforcement and rates and breadth of applications), while nominal wages are fixed. And that in a country with GDP per capita (adjusting for PPP) at $8,240.4 in international dollar terms (for cross-referencing, comparable figure is $24,764.4 in Russia). So how soon will there be social unrest boiling up?

Again from the IMF release: “The authorities are firmly committed to deep and decisive measures to reform the critical energy sector. They have developed a comprehensive strategy aiming to foster energy efficiency and independence, increase domestic gas production, and restructure Naftogaz. As part of this strategy, and to rehabilitate Naftogaz while eliminating its drain on the budget, the authorities have decided to implement frontloaded gas and heating price adjustments aiming to reach full cost recovery by April 2017, while protecting the poor through revamping social protection schemes and allocating sufficient budgetary resources. At the same time, efforts are under way to improve Naftogaz’s corporate governance, as well as the framework for payment compliance and recovery of receivables."

What the above means is that cost of energy to middle classes and above will rise and it will rise dramatically. Note two things in the above: one part of this increase will come from eliminating energy subsidies these classes currently receive.  But another shock will come from "eliminating [Naftogaz] drain on the budget" which means that supports for low income earners and the poor in the form of subsidies will have to be loaded onto the rest of the population if Naftogaz were to be a cost-recovery vehicle.

“Monetary policy will be geared toward returning inflation to single digits in 2016 within a flexible exchange rate regime. To strengthen confidence in banks and improve their ability to intermediate credit and support economic activity, the authorities are moving ahead with a multi-pronged strategy to rehabilitate the banking system. The regulatory and supervisory framework will be upgraded, including through measures to address above the limit loans to related-parties; banks’ balance sheets will be strengthened, where needed, following a prudential review of banks; and measures will be undertaken to enhance banks’ asset recovery and resolution of bad loans."

Banking reforms are desperately needed in the Ukraine, as banks are running non-performing loans to the tune of 20 percent and that is before any losses taken on Eastern Ukrainian operations and before we take out foreign lenders who face lower NPLs due to more selective lending to larger enterprises and foreign companies. But driving inflation down to single digits by 2016? Any one can pass the IMF folks a reality pill? Driving inflation down to these levels will require a massive deflation of demand and money supply. Which will cut across bot the above reforms in taxation and wages moderation, and across the banks reforms too.

“Structural reforms will aim at improving business climate, attracting investment and enhancing Ukraine’s growth potential. To this end, the authorities are advancing efforts toward deregulation and judicial reform and implementation of the anti-corruption measures.  They will also proceed with state-owned enterprise reforms, to minimize fiscal risks and improve corporate governance structures and de-monopolization."

All is fine. Except we have no idea what any of it really means. Still, major risk to Ukraine on this front is what will it do replace lost Russian (and other CIS) investments and remittances?


In short, so far, we have very little to go on the IMF latest package fundamentals, but plenty indications that Ukraine is in for some serious, serious social and economic pain in years to come. This pain is necessary. But what is highly questionable is whether this pain is feasible over the 4 year horizon of the new programme. Should Ukraine get some real help: a Marshall Plan with, say at least 50:50 grants to loans ratio and a package worth around USD60 billion over 10 years instead of 4 year loans that only shore up redemptions of other debts?

11/2/15: Baltic Dry Index: Another low...

Readers of this blog would be familiar with the Baltic Dry Index and with its importance in flagging up trends in global trade and, especially, in European trade.

Well, today, BDI has hit a historical low...

Source: @MktOutPerform

Good luck digging up any good news in that one...

9/2/15: Sanctions: "poisoning the public water supply in the hope of killing some enemies"

An excellent article on the effectiveness of economic sanctions as a tool in geopolitical conflicts: http://www.capx.co/sanctions-against-russia-are-dangerously-defeating-in-a-globalised-economy/

Quick quotes:

"Research by the Peterson Institute for International Economics in 1997 showed that, in instances where the United States imposed economic sanctions in partnership with other nations, between 1945 and 1970 they were successful in 16 cases and failed in 14 – a success rate of 53 per cent. Between 1970 and 1990, when sanctions were applied more prolifically, they succeeded in 10 instances and failed in 38, reducing the success rate to 21 per cent. ...Unilateral US sanctions had a high success rate of 69 per cent between 1945 and 1970, tumbling to 13 per cent in the period 1970-90."

Meanwhile, "in economic terms they carry a cost. …the reality is that Russia is the European Union’s third largest commercial partner and the EU, reciprocally, is Russia’s chief trade partner. Who thought it was a good idea to subvert this arrangement?"

"Economic sanctions have the same credibility as poisoning the public water supply in the hope of killing some enemies. Sanctions are not a weapon that can responsibly be used in a globalised economy."

Yep. On the money. Though I am not so sure that "killing some enemies" is even an attainable goal here: so far, sanctions have been hitting predominantly smaller enterprises (via cut off of credit supply) and ordinary people (via supporting currency devaluations). As per oligarchs and Government-connected elites, for every instance where their property abroad has suffered, there are tens of thousands of instances where devalued ruble has made their forex holdings and forex-denominated portfolios of investments increase in purchasing power. So be prepared to see more concentration of economic power in Russia in their hands over the next 12 months.