Macro and Markets

Leaders of the BRICS--Brazil, Russia, India, China, and South Africa--meet in Rio today to swap World Cup stories and launch a long-discussed "BRICS Bank." The bank creates two funds--a development lending facility (New Development Bank or NDB) backed by $50 billion in capital ($10 billion from each of the BRICs), and a $100 billion rescue fund (Contingent Reserve Arrangement, CRA) for countries suffering from exogenous shocks. There is a great deal of optimism surrounding the launch of the institution, with some seeing it as a serious political and economic counterweight over time to the World Bank and IMF. While the political motivations for the initiative are easy to identify, the economic benefits are much harder to pin down. I am skeptical that the BRICS Bank will be an effective development institution or rescue facility, and see serious risks that its good ambitions could be undermined by poor investments, bad policies, and even corruption. Here are five reasons why. 1. No obvious pot of high-quality investments. Part of the motivation for a new development bank is to meet an unfilled need for development projects the World Bank and regional development banks cannot or will not fund. The early focus of the NDB is on infrastructure, and I would fully agree that there is a critical need for more infrastructure in industrial as well as emerging economies. But there are good reasons why private investment is wary to make strategic investments in this area, and many reasons (including environmental, social, and governance related) why the official community is careful to act. Unless we are going to abandon these concerns, which I’d oppose, there will not be easy investments to fund, which could lead to excessive risk taking. 2. Limited institutional capacity. Instituting a global development agenda—identifying and implementing projects, monitoring against corruption, measuring the impact—takes extraordinary institutional capacity, something that will take decades for the new bank to develop. (Even at the World Bank, we have seen a recent shift to putting more people in country in part to support project implementation.) In the meantime, the pressure to lend will force tough choices. The NDB could piggyback on the investment expertise of others, including the World Bank and IMF, but the political imperative to differentiate will make that difficult. The NDB could of course link in with high quality private investors, but that has its own problems in a world of weak governance and may tend to lead to a narrow range of low-risk, low developmental impact projects (e.g., 5-star hotels) with an even narrower range of trusted co-financing partners. My greater concern in this case would be that the new Bank becomes captured by the finance ministries of the borrowing countries and backdoor fiscal financing for politically popular projects. Conversely, for creditor countries of the new bank, importantly China, the incentives to encourage lending that supports their overseas investment strategy could be profound. 3. Exogenous is in the eye of the beholder. Limiting emergency financing to exogenous, short-term shocks aims to protect the resources of the institution and avoid the charge that it is simply delaying needed adjustment. But of course distinguishing exogenous shocks from those requiring policy adjustment is hard, and the use of its financing to delay adjustment (and avoid the politically contentious approach to the IMF) will be hard to resist. I wouldn’t be surprised to see the CRA have some sort of rule or informal understanding linking drawings above a certain level to an IMF program, but again that limits the uniqueness and potential additionality of the arrangement. 4. Conditionality is hard. Ultimately, if lending by the bank doesn’t stem a crisis, adjustment will be needed, and it’s hard to believe that the institution will be effective at developing and enforcing conditionality. All one needs to do is recall the image of German leaders in 2010-11 telling Greece what reforms were needed, or the U.S. experience with conditionality on AID lending, to be reminded that the record of bilateral conditionality is poor. As painful as the medicine the IMF dispenses is, when adjustment is needed there is an advantage to multilateralizing policy conditionality through the IMF. While notionally this bank is multilateral, for the foreseeable future its view will be dominated by a small number of creditor countries. 5. It is still debt. My presumption is that, in the early days, the political support for the institution will ensure that it is promptly repaid, and if a borrowing country runs into trouble that it will treat its obligations to the NDB/CRA as senior. But that seniority is a de facto political outcome, not enforced by law, and if someday the borrowing countries perceive that there is limited sanction to running arrears the facilities could be quickly exhausted. Discussion of the political motivations for this effort often touch on the taper tantrum, the sharp reversal of capital flows that many emerging markets saw last year after the Federal Reserve began to discuss its exit from non-conventional monetary policies. But the BRICS Bank has been under discussion for at least five years, and the driver for its creation reflects a longer term frustration of the rising powers that its voice is not well heard in the major international financial institutions and decision making groups. In some respects, the criticism isn’t fair, as serious (if imperfect) efforts have been made to give these countries a greater voice through the G20 and other fora. Also, in important respects the World Bank and IMF’s views on policies affecting these countries have changed. For example, on capital controls, the IMF has a much more nuanced view and is willing to support controls in a wide variety of cases, even outside of crisis. The Washington consensus is far from the rigid doctrine its critics contend. Not that the major powers don’t need to do more, a message my colleague Julia Sweig hopes Washington hears. From this perspective, the failure of the U.S. Government to pass IMF reform is all the more tragic, as it fuels initiatives like the BRICS Bank. In addition, I also don’t see much harm in emerging markets in effect buying insurance against adverse shocks, or the development of new institutions as long as they coordinate effectively within the global architecture. But I am less convinced that the BRICS Bank, even if effective, is a game changer for global finance. The U.S. dollar will still be the primary reserve currency in 10 or even 20 years, and U.S. financial institutions and financial centers will continue to anchor global financial markets--as in the past, there will be tremendous inertia, or hysteresis, to the shift to an new reserve currency or financial system. The BRICS Bank may be celebrated today for accelerating that trend away from the dollar, and its intentions are good, but if it doesn’t manage the risk well it could in the end be a setback to those who would like to see a more multipolar world.

Argentina won an important contest last night at the World Cup, on a fine Messi goal.  However, while I’m a firm believer that nothing is more important than football, Argentina’s loss at the U.S. Supreme Court this morning may have larger long-term consequences. Without comment, the court rejected Argentina’s appeal of an earlier lower court ruling that required Argentina to pay holders of its defaulted bonds in full if it is to pay other creditors that had restructured their debts.  In recent months, legal scholars had speculated that the court might hear the case, delaying or even overturning the early ruling.  Anna Gelpern explains why this decision is a big deal; I have blogged on this far less intelligently as well. Argentina’s economy is a disaster for reasons unrelated to this ruling.  Nonetheless, should it now decide to default on all debts rather than pay its holdout creditors, the resultant freezing of relations with the international financial community, which the government had been working to normalize including through an agreement with the Paris Club of official creditors, will be costly and long-lasting. If Argentina can navigate the politics and its earlier commitment not to offer a better deal (before end 2014) to holdouts than those than exchanged their bonds, the economic case for negotiation seems strong. I am less convinced that the ruling has broader implications for sovereign debt markets; the government’s opposition to dealing with creditors and U.S. courts was extreme here.  Moreover, for countries that are working in good faith with their creditors, a small number of holdouts is no obstacle to a country achieving its macroeconomic objectives in an exchange. But if lenders see this as a broader risk of lending to countries that might go rogue in the future, there could be contagion and the pendulum could swing too far toward the creditor in future negotiations.  This is in part motivating a debate at the IMF and elsewhere on whether the rules of the game need to be changed.

  Petro Poroshenko’s convincing first-round victory in yesterday’s Ukrainian presidential elections, with 54 percent of the vote, is an important step toward political stability. But hard work lies ahead, as attention now returns to the even-more-daunting task of restoring economic stability. Remember that the political crisis of the last six months began as an economic crisis and had its origins in decades of failed economic policies. Massive fuel subsidies going disproportionately to the wealthy, widespread corruption, and distorted markets all contributed to the rot. These policies were reflected in an overvalued exchange rate, large sustained budget deficits, a rising current account deficit, and a falling foreign exchange reserves. Former President Yanukovych’s decision to accept $12 billion from Russia and repudiate the EU association agreement in late 2013 was an effort to delay the inevitable economic crisis that Ukraine now confronts. The IMF stepped in with a $17 billion reform package at the end of April designed to both provide emergency financing and begin the process of reform. Actions taken prior to IMF approval of its program included floating the exchange rate, an initial increase in energy prices, some other budget measures, and steps to address corruption. While necessary, the additional austerity implied by these measures represents a burden on an economy already in recession. So far, the government has sustained support for pro-Western policies despite the clear economic pain involved. Goodwill towards the new regime, and perhaps the unifying effect of the threat from Russia, have limited opposition to these measures outside of southeast Ukraine. But the new President will have to move quickly to address a number of economic challenges if yesterday’s political achievement is going to translate into a more enduring stability. These include: 1.  Reaching agreement with Russia on energy and debt.  Attention has focused on Russia’s threat to cut off gas deliveries on June 1, but equally important is the price that Ukraine pays. The IMF assumes agreement is reached with Russia on a price for gas in line with global prices at $385/mcm (thousand cubic meters).  It also assumes gas arrears and debt service are paid.  A slightly higher or lower price would be handled through an adjustment to IMF financing, but a significantly higher price for gas would outstrip Western financing and raise serious concerns about fiscal and debt sustainability. 2.  Accelerate the financial and trade flows from the West. The West has actually contributed little relative to headline promises so far, though Europe has accelerated trade benefits from the still-to-be–signed association agreement. The $17 billion pledged by the IMF is supposed to unlock a further $10 billion to $15 billion in funding from the World Bank, EU, and other individual countries, and accelerating those flows will be a critical task. 3.  “Sell” austerity at home. The new government will need to explain to the general public why deeper austerity is needed, and why the measures being taken are being done. The interim government, perhaps reflecting Russia’s threat, had maintained a low profile on economic as well as political grounds. That will need to change. 4.  Renegotiate the IMF program?  When the IMF team returns to Kiev at the end of June, it likely will find an economy far different from the rosy economic projections in the program. Anecdotally, the economy outside of southeast Ukraine looks to have weathered the crisis better than some feared, but there is no doubt that the recent turmoil has imposed material costs. The threat of Russian invasion may have receded, but the crisis is imposing continuing costs on economic activity and investment. Further, it is usually the case in cases like this that fiscal revenue falls, not just because of falling growth but also because of increased tax avoidance. The program is not asking for a lot of fiscal austerity—just two percent of GDP in measures (and the deficit actually widens in the short term with the decline in output). But activity is likely to be lower, and debt higher, than projected. The costs of the financial sector bailout are still not clear, and could be higher than the government is assuming. The new government will likely make the case that a more gradual fiscal adjustment, coupled with additional spending on social services, would be more sustainable. I have sympathy for that argument, though Ukraine’s past record of failed programs creates unsurprising skepticism. And who will pay, official creditors or creditors who may be asked to restructure their claims? The IMF is scheduled to disburse $1.4 billion as soon as July 25, and again at end September. Success will require strong governance, and substantial support from the West.  It will not come cheap, and it will take time.  But some early success may be essential to sustaining public support over a difficult coming period.