Macro and Markets

This week’s Annual Meetings of the World Bank and IMF will have a lot of discussion but little action.  Here are five things that I anticipate will capture some headlines. Growth is important...but what are you going to do about it?  I suspect that we will hear broad frustration from policymakers about the tepid global recovery.  Most expect a gradual global recovery to below average levels, as the scars from the financial crisis and weak policies constrain growth.  But there isn’t much on the table in terms of macro policies that can be debated and changed, and while there is a lot of structural work to be done (e.g., financial sector and labor market reform) we are unlikely to see much real progress on a growth agenda this week. Infrastructure is (a public) good.  Everyone can agree that there is a critical need for additional infrastructure, but unclear what to do about it.  Private sector projects should be encouraged, but appear limited by legal and commercial considerations, and while there is a clear case for public provision of infrastructure ("public goods"), budgets are constrained and standards (including importantly environmental standards) limit governments’ capacity to respond.  The Fund calls for more efficiency and a push by countries that have the budget space.  Beyond that, the Chinese-led initiative for an Asian Infrastructure Investment Bank (AIIB), and to a lesser extent the slower-moving BRICs Bank, will be a focus.  There appears to be a great deal of energy behind the AIIB, but it’s hard to imagine it scaling up quickly without risking a major weakening of standards, poor project selection or “capture” by borrowing countries.  Can the AIIB collaborate effectively with the World Bank and Asian Development Bank and avoid fragmentation? Is geopolitical risk a major threat to markets? As I have written, policymakers are concerned by the apparent disconnect between rising geopolitical risk and a benign market outlook.  The concern is legitimate, but there is little consensus that economic policymakers should say or do anything differently.  Still, this discussion will be an important part of the hallway debate.  There are broader questions here about the global economic architecture.  Are we headed towards comprehensive financial sanctions against Russia, and if so, would restrictions on the payments system threaten a basic “public good?” Where is the IMF going on debt policy?  The Fund recently endorsed the introduction of new clauses in debt contracts, addressing the inter-creditor equity problems highlighted by Argentina’s legal battle with its creditors and strengthening the ability of distressed debtors to coordinate with their creditors on a solution.  This is all to the good, though it arguably would have happened even without the Fund’s involvement.  The real challenge— how do we encourage the quick transformation of the existing stock of debt (which doesn’t have the clauses) into new debt—is still to be addressed.  Look for some discussion this week of ways in which the official community can provide a push to efforts to swap old debt for new debt (through market exchanges) with the improved clause. More broadly, the IMF continues to develop the case for new rules governing its lending, including a greater focus on extending the maturity of private debt when it is lending large amounts in risky situations.  I am not convinced that there is a problem in debt markets that needs solving, or that this is the solution.  The debate this week may instead focus on the so-called “systemic exemption,” which gives the major countries the ability to bend Fund rules for lending when systemic issues are in play (e.g., Greece, Ireland).   The IMF would like to constrain or eliminate that rule, and while I’m sympathetic, it is not realistic in my view to expect the major countries to tie their hands regarding how they respond to global crisis. IMF reform (still) stalled.  There is growing international frustration with the failure of the United States to pass the IMF quota and governance reform package.  My read of the environment in the U.S. Congress is that the chances of passage this year are lower than ever before, so the international community will need to begin to talk publicly about what comes next.

Time will tell whether new sanctions on Russia announced by the United States and European Union last week will be a game changer. The most significant development concerns oil, as the new measures go much further than previously understood to shut down ongoing exploration and production of new Russian supply. While triggered by events on the ground in Ukraine, from a policy perspective this is a catch-up action, closing loopholes and bringing market practice more in line with the harsher intent of earlier measures. As such, I view the steps as an incremental, if logical, next step in the effort to punish Russia for its actions in Ukraine. Still, compared to what some energy companies thought they would be allowed to do, the new measures look to be material in terms of their effect on ongoing exploration, development and investment in securing new oil. Descriptions of the new measures are here and here. A few points 1. The Russian invasion of Ukraine, and continued efforts to at a minimum create a frozen conflict, should be seen as the primary trigger for the sanctions. Both U.S. and European officials have stated that these sanctions could be removed if the current peace process takes hold—a 12-step plan that would involve the complete removal of Russian troops and hardware from Ukraine. But few are optimistic on this score. 2. U.S. and E.U. energy sanctions do differ in scope and definition, but the core principle is to make clear that sanctions affect the provision of technology, goods or services for exploration and production of new deep-water, arctic or shale oil. An existing well can still pump, but efforts to develop new sources of oil are broadly affected. The U.S. also goes further than Europe in requiring that U.S. operations affected by the sanctions be wound up in 14 days, and since no major EU companies are drilling in the Arctic it seems the U.S. rules are of central importance. 3. Several commentators have noted that U.S. energy companies had been seen as sidestepping earlier sanctions, and in particular continuing exploration efforts that began prior to sanctions. Exxon’s continued and highly publicized joint venture with Rosneft in the Arctic Circle may have raised the ire of policymakers (apparently, because the rig was already in place, they earlier were able to provide services for the drilling to start—now it appears that is ruled out), but it’s not the primary reason for additional sanctions at this time. 4. The new financial measures look modest. The U.S. catches up with Europe in sanctioning Sberbank, the largest Russian bank, and both the U.S. and Europe have extended the ban on new debt and equity to include energy companies directly (not just their banks). It also may be meaningful that the term of allowed finance is reduced to 30 days (from 90 days). I continue to believe that comprehensive financial sector sanctions are where we are (and should be) headed, which would include exclusion from the payments system. That action would cause substantial and upfront pain on Russia, and have systemic implications for global markets, but we are a long way off from that. 5. Russia will help affected energy companies with limited financing from its sovereign wealth fund (subject to a cap on fund investments that is low relative to the investments affected) and the central bank will spend reserves defending the exchange rate. Still, it’s reasonable to expect further market disruption and ruble depreciation as these sanctions sink in. Analysts expect Russian oil production to slip as soon as 2015. 6. There remains inevitable momentum for additional sanctions, both to deal with evasion and because events on the ground will provide triggers for harsher action. Sanctions are “working” in the sense of imposing long-term costs on Russia, and these measures could add significantly to the cost. However, there continues to be a disconnect between a sanctions approach that aims to impose long-term costs and events on the ground that are moving at a much faster pace. At the same time, the Ukrainian IMF-backed program is veering off course and a widening financing gap is emerging that even debt restructuring may not fill. This creates a tension for policymakers that these measures do not resolve.

Should we be worried by how well global markets are performing despite rising geopolitical volatility? I think so. In my September monthly, I look at the main arguments explaining the disconnect, and argue Europe is the region we should be most worried about a disruptive correction. Here are a few excerpts. • Far Away and Uncorrelated. Much of the market commentary has stressed that the risks that most worry political analysts—for example Russia, ISIL and Syria, Syria, an Ebola pandemic—are not necessarily central to global growth and market prospects. But small (in GDP terms)and far away does not mean inconsequential. As the debate over financial sanctions has shown, its Russia’s leverage and interconnectedness, rather than its global trade share, that makes comprehensive sanctions so powerful and potentially disruptive. • A Sea of Global Liquidity. There is little doubt that the highly accommodative monetary policies of the United States, eurozone, United Kingdom, and Japan have provided an important firewall against geopolitical risk. Looking ahead, global liquidity will remain ample, but with the U.S. and U.K. beginning to normalize, and the BOJ and ECB going in the other direction, the divergence of monetary policies creates conditions for increased market volatility. Foreign exchange markets in particular appear vulnerable, as history suggests these markets are often bellwethers of divergent monetary policies. • Confident Oil Markets. A stable and moderate global expansion that has limited demand, as well as the revolution in fracking and other technologies, has allowed Saudi Arabia to maintain substantial spare capacity, thereby limiting the potential for a supply disruption to roil markets in the near term (though the longer-term buffering effects on market prices from these developments can be overestimated). But it is hard to imagine that broad based turmoil in the middle east, and the possible rewriting of borders, can be achieved without a material disruption to supplies at some point. • Europe as the Weak Link. I see Europe as the channel through which political risk could reverberate in the global economy. The standoff with Russia, or a hard landing in China could significantly affect exports, particularly in Germany. Significantly, though, Europe also faces these challenges at a time of economic stress and limited resilience. Growth in the region has disappointed and leading indicators have tilted downward. Further, concern about deflation is beginning to weigh on sentiment and investment. The persistence of low inflation is symptomatic of deeper structural problems facing the eurozone, including an incomplete monetary union, deep-seated competitiveness problems in the periphery, and devastatingly high unemployment. Homegrown political risks also threaten to add to the turmoil, as rising discontent within Europe over the costs of austerity is undermining governing parties and fueling populism. The result is a monetary union with little capacity or resilience to defend against shocks. The ECB has responded to these risks with interest-rate cuts and asset purchases, and is expected to move to quantitative easing later this year or early next, but the move comes late, and is unlikely to do more than address the headwinds associated with the ongoing banking reform and continued fiscal austerity. Overall, a return to crisis is an increasing concern and political risks could be the trigger that we should be worried about.