Macro and Markets

While today’s headlines focus on the truce agreement between Ukraine and Russia, a significant economic milestone was achieved yesterday with the IMF’s announcement that its staff has reached agreement with the government on a new four-year program. The Fund’s Board will likely consider the program next month. Whether or not the truce holds, the program is the core of western financial support for Ukraine. Is it enough? The program is for $17.5 billion, representing about $6 billion in new IMF financial commitments. This is somewhat misleading, because this amount is spread over four years, as compared to the two years remaining in the existing program it replaces. It appears that the amounts the IMF will disburse this year are broadly comparable to what they were before. Similarly, the statement that total support for Ukraine will total $40 billion would seem to represent mostly a repackaging of previously announced commitments (including $2 billion in U.S. loan guarantees and a roughly similar amount from the EU). If you believe that the program will need to be revised several times even in the best of scenarios, and could need a major rewrite later this year if events on the ground continue on their current path, then the truly additional resources, or “real water” of the announcement, is minimal. Most of the additional financing for the program comes from restructuring of private debt, which will take time to arrange but will be a condition for future drawings in the program (a similar approach was used in Uruguay in 2003). Pushing back maturities at roughly current interest rates (a “reprofiling” in Fund-speak) would provide substantial relief and keep creditors engaged in Ukraine until a time when sustainability is clearer, and seems to be what the markets are anticipating. Further, given the extraordinary uncertainty associated with the conflict, and the difficulty the IMF has in taking such factors into account in their debt sustainability assessments, it is folly to think we know now what the needed relief will be. But a deeper restructuring now that also includes some reduction of principal amount can’t be ruled out. After all, debt is much higher than previously admitted and in almost any reasonable scenario it is highly likely that the official sector will decide that a deep restructuring is needed eventually, so why not do it now?  On balance, and with the focus on assuring adequate financing through a quick deal with broad participation, reprofiling looks to be the sensible choice. But either way, the decision on private sector involvement (PSI) in this deal may well be precedential for the larger, ongoing debate over the architecture of international debt policy. The financing program would seem to assume that the $3 billion Russian bond that comes due in December would be restructured or otherwise pushed back, but presumably the documents will need to be silent on this issue, as Russian consent cannot be assumed at this point. With reserves down to $5.4 billion (from $16.3 billion in May), and external financing needs of $45-50 billion over the next three years, there is little scope for debt payment in the near term. Is the program “enough?” It is hard to see this program as creating the conditions for Ukraine to grow absent an end to the hostilities. Much higher levels of official bilateral aid will likely be required in the future if the West is truly committed to rebuilding Ukraine. Still, there are important positives from the agreement, both in terms of the government’s commitment to continue its reform effort and the West’s commitment to stick with Ukraine in the face of continued Russian aggression. The upfront measures in the program—including further sizable energy tariff increases, bank restructuring, governance reforms of state-owned enterprises, and legal changes to implement the anti-corruption and judicial reform agenda—are all desperately needed over the longer run even as the pace of reform needs to be slowed reflecting the current crisis. The degree of fiscal consolidation also seems realistic. One big question relates to the hole in the banking system, which appears much larger than originally estimated; the recent sharp decline in the exchange rate no doubt made that hole even larger. Overall, while I remain highly critical of the West’s stinginess in providing bilateral economic assistance as part of its overall strategy of support for Ukraine, the Fund has done what it could do, and it is an important bit of breathing space for the Ukrainian government.

Syriza’s victory in Greek elections yesterday, and the announcement this morning that they would rule in coalition with the right-wing Independent Greeks party, all but ensures a confrontation between Greece and its European creditors over austerity and debt. While Greek markets have continued their sell-off on the result, 10-year yields near 8.9 percent are still down from earlier this month and well below earlier crisis levels. In line with these numbers, most market analysts believe a deal is likely that would avoid a Greek exit from the eurozone, noting some moderation of Syriza’s rhetoric in recent days and upcoming meetings with creditors. But what would such a deal look like? Greece and its creditors are so far apart, their perceptions of their negotiating leverage so different, and time so short to reach an agreement, that the risk of failure seems higher than implied by market prices.  A few points. First, Syriza has promised a substantial fiscal expansion, a greater role for the state, and demanded relief from its unsustainably high debt (most of which is now owed to the public sector). I am quite sympathetic to the need for less fiscal austerity and debt relief for the periphery. And there are some interesting proposals for how that could work. But a fiscal expansion, even if it can boost growth for a bit, will only make consensual debt relief more difficult in the long run. All of these ideas have been firmly rejected by Germany and by other European creditor countries, and it is likely that any debt relief offered would involve a reduction in interest rates and payment deferrals, not cuts in nominal debt, and conditional on reforms that would make relief distant at best.  Further, the precedent such a deal would set makes it very difficult for creditor governments to agree, at least in the time frame required for Greece to stay current on its obligations. Second, any compromise agreement would need to allow the incoming government to issue new debt that would primarily be purchased by already-stretched Greek banks. That would require an extension and modification of Greece’s debt program, which expires at the end of February, and expanded ability for Greek banks to finance these purchases directly or indirectly through the European Central Bank (ECB). Such forbearance will be tough politically at a time when Greece, in word if not in deed, is repudiating its past commitments. Even if the ECB continues to extend credit on Greece’s intention to negotiate, the government would likely run out of money in July or August when some substantial debt payments come due. Markets would likely move the ’zero date’ forward if negotiations lag. The fiscal position apparently worsened sharply in the run-up to elections, as tax revenues plunged and spending rose, resulting in a smaller-than-expected primary surplus in 2014 and a deficit in early 2015. That is both good and bad for a deal. On the positive side, it allows for a fiscal path that tightens later this year but is still far less austere than the 5 percent of GDP primary surplus target under the current program—everybody wins. On the down side, it brings forward the date that the government runs out of cash and makes it harder for other European governments to endorse.  Further, it raises government debt levels well above the current level of 175 percent of GDP, clearly unsustainable absent substantial debt relief. Can the IMF support this path?  Navigating these issues will take a delicate balancing act, and a lot of near-term financing. Finally, short of a eurozone exit, but absent an extension of its IMF-backed program, Greece could finance itself through arrears and, eventually, capital controls to prevent capital from fleeing. Payments, including debt payments, would be delayed. This may well be the most likely scenario in the near term. Many point to the example of Cyprus, and note that, while still in the eurozone, there would be a de facto separation—a euro in Athens would not be the same as a euro in Berlin. However, the Cyprus program was based on the (controversial) assumption that it could adjust and exit the controls with a competitive economy, a story far harder to tell in Greece. Even in the best of circumstances, controls are hard to remove. Unless you believe that, with time, a fiscal-driven boost to growth is all Greece needs to achieve longer-run competitiveness and sustainability, there would not be a path to normalization that did not involve a significant markdown of Greek debt. If that “unilateral” debt restructuring was unacceptable to the rest of Europe, it is easy to imagine that exit, even if delayed, would be the end result of the process. My bottom line is that the new government can produce a temporary growth surge inside or outside the eurozone, but that the main scenarios for doing so make consensual debt relief harder, not easier to achieve. Whatever the longer-run consequences of the new government’s plans, an eventual exit from the eurozone seems more likely than not. While Europe is better prepared than 2010–12 for such an event, the substantial losses that would result with either exit or capital controls would have broad repercussions. Moreover, any growth in Greece will embolden anti-austerity parties elsewhere in Europe. In a year, the debate may be over whether the rest of the periphery should copy Greece, not the other way around.

My thoughts on the ruble’s collapse are here. Three points to highlight in particular: Sanctions are a force multiplier. While oil is the dominant factor behind the ruble’s fall (see figure 1), western sanctions have taken away the usual buffers—such as foreign borrowing and expanding trade—that Russia relies on to insulate its economy from an oil shock. Over the past several months, western banks have cut their relationships and pulled back on lending, creating severe domestic market pressures. The financial system has fragmented, and any doubts that the central bank fully backs bank liabilities will lead to a run. Nonetheless, political pressures on the central bank remain intense. In fact, it was news of a central bank bailout of Rosneft that apparently triggered the most recent round of turmoil. Meanwhile, trade and investment have dropped sharply. These forces limit the capacity of the Russian economy to adjust to any shock. Perhaps Russia could have weathered an oil shock or sanctions alone, but not both together. Analogies to 1998 are too simplistic. Conditions in Russia and the global economy were much different in 1998, as global financial markets were dealing with the legacy of the Asian financial crisis and emerging strains in major money markets, so we shouldn’t overdraw the lessons from that time. Similarly, the fact that sanctions have caused western financial institutions to pull back from Russia makes the west less leveraged, less interconnected, and therefore less vulnerable to contagion than was the case in 1998. Therefore, I am not surprised to see a modest reaction in U.S. markets so far, with the exception of energy companies that are affected by the global energy shock. Further rate hikes are likely to be counterproductive. The central bank has already hiked interest rates to 17 percent and intervened (see figure 2). While they have produced a bounce in the currency, the sense of panic remains. I don’t think further rate hikes are helpful in the current environment. I expect capital controls are the next step, even though the history of controls in Russia is that they are usually ineffective. Evasion is simply too easy. But Russian policymakers need to do something. The real test of whether sanctions work starts now. I have for some time believed that it would be an upturn in inflation, and a deep recession, that would be the real test of whether sanctions would create conditions for peace, not a move in Russian stocks and bonds alone. That is because it is only now that the broader Russian public is feeling the costs of President Putin’s policies. No doubt the Russian’s searing experience with hyperinflation in 1998 still resonates with the Russian public. History also reminds us of the fragility of confidence. When crisis happens, exchange rates will move far and fast. Figure 1: The Ruble and the Price of Crude Oil Source: Bloomberg; Central Bank of Russia Figure 2: The Ruble and Official Central Bank Currency Intervention* Source: Central Bank of Russia *Note that this figure shows only officially reported intervention by the Central Bank of Russia and does not include unreported intervention or intervention carried out by other entities, including the Ministry of Finance.