Macro and Markets

There is an interesting debate going on in Western capitals over financial support for Ukraine.  The possibility of political change, coupled with Russia’s decision to suspend disbursements on its $12 billion financial package, has created an opening for meaningful economic reforms and renewed ties with global financial bodies.  There are compelling political arguments for the West to respond with a financing program that makes it economically viable for Ukraine to choose the EU Association Agreement that it rejected last year.  But the economics make a deal hard to put together.  For now, the ball is in Ukraine’s court—tensions remain high and Western aid will require at a minimum a technocratic and reform oriented government be put in place.  But should that happen, here are five economic questions on the table. How big is the hole?  Ukraine has significant fiscal and external imbalances.  For some time, and against the advice of the IMF, the government had tried to peg the exchange rate at just over 8 hryvnia against the dollar.  Last week, with foreign exchange reserves plunging to around $17 billion (around 2 months of pre-crisis imports) and reports of significant deposit flight, the government abandoned the peg, imposed capital controls, and is now managing the exchange rate down. That is good for long-run competitiveness, but doesn’t preclude the need for substantial upfront financing.  In December, the IMF identified a current account deficit of over 8 percent of GDP and a fiscal deficit of 7 ¾ percent of GDP.  The underlying fundamentals look to have deteriorated since then.  Optimists will argue that market access would return quickly with improved policies, but there would be significant risks to any lightly funded program.  A financing gap on the order of $15 billion seems reasonable. Who pays?  Western officials are understandably hesitant to be caught up in a bidding war with the Russians over aid, but discussions look underway to try and boost the package on offer to Ukraine. Until now, the reported European package is quite small, less than $1 billion.  The EBRD should expand lending, but their exposure to Ukraine is already stretched.  Some creativity may be possible using structures that encourage private sector cofinancing.  One idea would be to expand the IFC’s A-B loan program, which provides a degree of seniority to cofinancing partners.  In addition, the IFC’s focus on trade and energy efficiency--critical issues given strained relations with Russia--should easily be scalable.  The US government should ask Congress to reprogram available funds (perhaps the "Chobani affair" at the Olympics makes that possible!).  An IMF program is a must, but will it be a large access program that could be needed to fill the financing gap? That would be a tough call for the IMF, which in their last review criticized the government’s past ownership of the reform program and argued that “arrangements with lower access focused on critical areas may have better prospects.” Russia’s role?  The financing need will depend on how Russia reacts, both in terms of trade sanctions and energy pricing (Russia is the dominant supplier of energy to Ukraine).  To the extent that market access gains can be accelerated when the EU Association Agreement is signed, they should be.  And Russia is in principle constrained from retaliation by its WTO obligations (the US and Europe should take a strong, united stand on this point).  In the end, some understanding with the Russians seems required. A sustainable reduction in subsidies?  The IMF rightly has taken a strong stance on the need for a substantial increase in energy prices, on the order of 40 percent, but how fast does that have to happen?  In my view, the increase could be done gradually, as long as there is “stickiness” in that the increases are not reversed.  It would help a lot if future increases had automaticity (e.g., indexed), a narrow safety net was constructed to protect the poor, and the policy had popular support.  That’s a tough job, but worth the effort.  Of course, a gradual adjustment requires more financing in the near term. Burden sharing?  The toughest question, and most important for markets, is whether economic assistance will be conditioned on a private sector involvement (PSI).  There is a hot debate now underway about whether the rules of the game for debt restructuring need to change, in cases where debt sustainability is uncertain.  Ukraine’s government debt is not high by international standards—on the order of 45 percent of GDP.  Instead, the case for a reprofiling of debt here rests on the old-fashioned need for financing.  If there is a residual gap, will the Europeans up their contribution so external creditors can get paid?  Should they?  If, as noted above, there are good reasons for the IMF to limit its role, attention may turn to the debt.  Over the next two years, Ukraine has around $2.1 billion in external bonds falling due, including $1 billion in June 2014.  It might be attractive to push off payments, but care will need to be given to the precedents that could be set and to managing the risks of contagion. Tim Ash has a  good analysis as to why the risk of default may be underestimated. Reprofiling that debt--perhaps with a menu of options including new money from "friends of Ukraine"--backed by meaningful reform would send a powerful message and could draw broad popular support.

As signaled in recent days, President Obama’s State of the Union address puts the spotlight firmly on domestic policy. Creating economic opportunity was a major theme. In addition to a hike in the minimum wage for government contract employees, the president called for a economy-wide minimum wage increase, an extension of unemployment benefits, immigration reform, and other measures to attack income inequality. The only surprise was a new Treasury instrument, MyRA, to encourage retirement savings. Overall, the speech was pragmatic, balancing a willingness to use executive action against offers to negotiate. Some have criticized the speech as small ball, and like many State of the Union speeches the need to cover many, many issues limits effectiveness.  But it is also a realistic assessment of the hurdles he faces at this stage of his presidency. My colleague Ted Alden has a companion blog on what the president has to say about immigration, trade, and tax policy, and Heidi Crebo-Rediker discusses the message on infrastructure. Here are additional thoughts on the economic themes in the speech. Inequality, Upward Mobility and Jobs Ahead of the speech, reports signaled the president was focusing on income inequality, but last night he put the issue in more hopeful terms, highlighting the importance of expanding opportunity. "What I offer tonight is a set of concrete, practical proposals to speed up growth, strengthen the middle class, and build new ladders of opportunity into the middle class." Many of the proposals to boost middle-income jobs and welfare—e.g., early childhood education, expansion of the earned income tax credit—require legislation and it’s easy to be skeptical. If there are to be compromises, they would likely involve small initiatives “paid for” with modest entitlement cuts. More attention was focused on President Obama’s announcement that he would use his executive power to increase the minimum wage to $10.10 per hour for workers on new government contracts. Because the ruling would not apply to existing contracts, the effects will be felt only gradually, eventually affecting less than 500,000 workers according to one study. He also challenged Congress to pass a comprehensive increase in the minimum wage, a proposal that I presume is dead-on-arrival in the House of Representatives. Executive order President Obama plans to make 2014 a “year of action” with expanded use of executive power, a move sure to stir anger among Republicans. In addition to the minimum wage, reports are that we could see presidential action on infrastructure, climate change and education. From an economic perspective, executive action can have a substantial effect on individual sectors and prices, but it is hard to see it making a big difference on the overall macroeconomic trajectory of the economy. Light on Finance and Fiscal On housing reform, Jaret Seiberg of Guggenheim Securities noted that the president treaded lightly, calling for legislation but not making it a priority and not putting markers down on what it should contain. Other proposals in the financial space, including a new Treasury savings instrument for those without 401k’s and working with Congress on student loan refinancing initiatives, are unlikely to lead to major changes in the financial landscape. In last month’s speech on income inequality, President Obama declared: “When it comes to our budget, we should not be stuck in a stale debate from two years ago or three years ago… A relentlessly growing deficit of opportunity is a bigger threat to our future than our rapidly shrinking fiscal deficit.”  Indeed, what was striking about last night’s speech was how little fiscal policy mattered. A bitter war has been waged over the last three years, with multiple fiscal cliffs, threats of shutdowns (and one real shutdown), and enough drama around the debt limit to badly unsettle money markets. Both sides now are exhausted, and a truce has been called. Fiscal policy looks broadly neutral next year, with political tail risks from government shutdowns and debt limit showdowns looking much reduced. Good news for a clean passage of the upcoming extension of the debt limit.

Today we are please to have the following guest post written by Heidi Crebo-Rediker, a CFR Senior Fellow. Prior to joining CFR, Heidi served as the State Department’s first chief economist.  Infrastructure got a brief mention in last night’s State of the Union—enough to remind us that the president still cares about renewing America’s infrastructure, and that he can make a dent without legislation or new funding. But he’ll need Congress on this one. President Obama highlighted that first-class jobs gravitate to first-class infrastructure and said he’s acting on his own to slash bureaucracy and streamline the permitting process for essential projects. He will need the help of the legislative branch to finish important transportation and waterways bills this summer though, and he called on Congress to act. He did not push the National Infrastructure Bank this time around—even though he found new champions of the bank late last year in Senators Mark Warner and Roy Blunt, who introduced the BRIDGE Act of 2013, an updated 2.0 version of the BUILD Act introduced by Senators John Kerry and Kay Bailey Hutchison in 2011. The president is right to continue to keep public attention on infrastructure and the need for both investment and strategic attention. According to the American Society of Civil Engineers (ASCE), one out of nine bridges in the United States is structurally deficient, and approximately 210 million trips are taken each day across these deficient bridges in more than one hundred of the nation’s largest metropolitan areas. This problem is very close to home—we drive across these bridges everyday. ASCE’s very user-friendly report card gave America’s overall infrastructure a “D+” in 2013, noting that levees and waterways are particularly bad, and estimating that the price tag has now reached $3.6 trillion by 2020 just to bring what we have up to an acceptable state. But public attitudes of what is an acceptable state of infrastructure usually leads observers of the American predicament to quote the boiling frog analogy—that we don’t realize the situation keeps getting worse and worse until we’re cooked—or in our infrastructure’s case, a bridge collapses or train crashes. We get used to the traffic and delays. Keeping American public attention on the importance of investing in infrastructure to drive competitiveness needs all the help it can get—a recent PEW survey shows investment in roads, bridges and public transit nears the bottom of the list of what Americans care about in 2014—although the survey noted this ranking is up from the year before. Americans who travel around the world get a glimpse of life outside of the boiling pot—they take smooth rides on high-speed trains, connect seamlessly through high-tech airports, or take quick airport connections into cities that boast great public transport or roads with no potholes. They come home dismayed. But for most Americans, a reminder from the president of how important infrastructure is to our daily lives and our economic competitiveness is extremely helpful. Infrastructure investment is win-win for the country. An investment in an asset that can help businesses be more productive and efficient, provide jobs, ensure safer transit of goods and people around the country and provide greater resilience against storms should be a no-brainer. Ways to get there include overcoming permitting and red tape hurdles, providing innovative financing that can plug gaps in project capital structures across a wide range of infrastructure projects—most efficiently and effectively delivered through a well-designed National Infrastructure Bank, such as described in the BUILD Act of 2011 or BRIDGE Act of 2013—and tackling the knowledge gap that we have in the United States when it comes to engaging the private sector in infrastructure investment through Public Private Partnerships. In some of these areas the president can act alone. But in most, he will still need to rely on congressional support to move the infrastructure agenda forward.