Economic Crises

  

Three things to think about today.  If you haven’t already done so, subscribe now to my colleague Brad Setser’s blog, which provides excellent commentary on global macro issues. His most recent piece makes a compelling case for European fiscal action against the backdrop of a meaningful UK and European growth shock, a point that I very much agree with (listen also to my conversation with Jim Lindsay and Sebastian Mallaby here). I remain puzzled that this industrial country growth shock has not had a broader effect on emerging markets. Reports are that portfolio outflows from EM were minor on Friday, with some recovery this week. One view is that as long as China’s economy remains on track, commodity prices hold up, and the Fed is on hold, emerging markets should weather the Brexit shock. Conversely, the IMF has worried that declining trend growth in the emerging world reflects a rising vulnerability to globalization. The humanitarian situation in Venezuela has become critical. I have focused in past blogs on the severe economic consequences of the crisis, and the need for a comprehensive, IMF-backed reform effort, supported by substantial financing and debt restructuring. China’s recent agreement to push back debt payments due recognizes the inevitable but is unlikely to provide additional free cash flow to the government or the state energy company PDVSA. For investors, default now looks to be coming soon.  

The Venezuelan government has a $2.3 billion debt payment due this Friday. Most believe the government has the resources to make the payment, though it is hard to see a coherent economic reason to do so. The economy is descending into a deep and profound crisis—reflected in severe shortages, hyperinflation, and a collapse in economic activity. It faces a widening financing gap, and has imposed highly distortive foreign exchange controls. Debt service far outstrips dwindling international reserves. Recent policy measures by the government, including a rise in gasoline prices, fail to meaningfully address the imbalances. A default increasingly appears to be a question not of “if,” but “when.” But whether through a stubborn unwillingness to accept this reality, fear of litigation and asset seizures, or simply an effort to kick the can in the face of powerful political and economic pressures, the government has shown a strong commitment to pay as long as they can. The current regime will refuse cooperation with Western governments, but it is not too early to begin planning for a time when a future Venezuelan government is willing to take the hard measures that warrant strong and broad international support. The Numbers Are Daunting There is no doubt that the dramatic decline in oil prices has hit Venezuela hard. At $30 per barrel, oil exports will be around $26 billion this year, down about three-quarters from 2012. Subtract around $8 billion for oil-related imports, and you have export revenue woefully inadequate to meet debt service this year of nearly $20 billion on $125 billion of debt (that includes substantial oil payments due on assistance provided by China in recent years). Altogether, market commenters have estimated a financing gap of around $30 billion. Meanwhile, reported reserves are only $15 billion, and there are serious questions as to whether all of those reserves (especially the gold) are freely useable. In sum, it will take extraordinary measures to make it through the year without a default. And if the government responds by further compressing imports, popular support for the government could collapse. Change could come quickly, not because of a debt payment due but rather because of domestic conditions. Meanwhile, the economy likely declined by around 10 percent last year, and according to the International Monetary Fund (IMF) is expected to decline by an additional 8 percent this year. Inflation was officially 180 percent in 2015, though the actual number was probably closer to 250 percent, and accelerating rapidly this year. Following years of mismanagement and low investment, the state oil company Petroleos de Venezuela, S.A. (PDVSA) has seen a sharp decline in production, and while reserves in the ground are substantial, there would be material hurdles to a significant increase in production. In response, the government has invoked emergency powers through mid-March, devalued the primary official exchange rate by 37 percent, and adjusted some domestic prices—but this has done little to address widening imbalances and shortages. After this Friday’s payment, the government does not have a major international bond maturing until 2018.  But payments of around $6 billion are due later this year on debt owed by PDVSA. While the government does not explicitly guarantee PDVSA debt, the companies’ creditors have substantial remedies which provide protection (and a degree of effective seniority) in times of distress. There are assets in the United States that could be seized (e.g., Citgo), efforts could be made to disrupt if not to seize oil tankers and the oil in transit, and there will likely be litigation as to whether the government exercises explicit control over the company (which could expand the range of assets that could be attached by creditors to include sovereign assets). Any debt restructuring would be made more difficult by the large amount of bonds, in excess of $40 billion (mostly PDVSA debt but also some sovereign bonds), that do not have the collective action clauses now common in international bonds to bring in holdout creditors. In sum, the legal environment is complex, the interest of creditors may diverge sharply, and there are strong reasons to expect that a default on debt would be hugely disruptive. It is hard to imagine international support for a restructuring of debt by the existing government. The strong frictions between the Maduro administration and the opposition-led National Assembly pose additional political risks. The new economic czar, Miguel Pérez Abad, reportedly was named to the job when his predecessor advocated default. He may have a mandate to sell energy stakes and try for market deals that buy some breathing space for the country by pushing back debt payments. It is difficult to assess whether it is in the interest of creditors to do so when a more difficult restructuring likely lays ahead with a different government that may be quite critical of today’s deals. In any event, given the fundamental downward trajectory of the country, maturity extensions are unlikely to catalyze new private money. The China Factor China has been the primary provider of financing to the government in recent years, and while there is low transparency to these deals, it is thought that net claims are on the order of $30 billion. Many of the contracts require payment in oil, and currently Venezuela uses about one-third of its daily crude oil export to China to repay the debt. But the decline in the price of oil has dramatically increased the quantity that needs to be provided. By some estimates, full payment of the Chinese claims could consume 80 percent of the country’s daily oil export to China. Venezuela needs continuing relief from that amount, but at the same time it is not in China’s interest to be seen as providing loans under the guise of commerce that serve solely to extend the life of the current government. Even today, China’s message needs to be that it will be a critical player in a rescue package, and to that end cannot be too closely associated with the current government or policies. What International Policymakers Can Do Now For now, there is not much that international policymakers can do.  The current government is unlikely to seek help from the international financial institutions. Indeed, the IMF is operating largely in the dark. The last IMF review of the economy was in 2004, and Venezuela ceased all cooperation with the Fund in 2007. In any crisis scenario, they would be scrambling to catch up and—if past post-crisis programs are any guide—an IMF program team putting together a rescue package is likely to find that the economic crisis, the financing gap, and the damage to the financial sector are much worse than we now understand. Reserves also will need to be replenished. There does need to be a close watch for contagion to its neighbors. In recent years, trade and financial links between Venezuela and its neighbors have dropped sharply, and so one could hope that there would be limited spillovers. But the risk of domestic political and social unrest affecting its neighbors is a concern, as is the broader fear that a crisis in Venezuela would weaken market confidence in other oil-exporting countries such as Nigeria that will need to be watched. When conditions warrant, international policymakers should move fast rather than let the crisis fester. Short-term bridge financing, perhaps linked to oil, may be needed once agreement is reached on a comprehensive adjustment program. Given the likely financing needs, any future IMF package will need to include at a minimum a debt reprofiling (an extension of maturities with limited net present value loss) to provide breathing space. Whether the IMF goes further, and demands a deep restructuring because the debt is unsustainable, is hard to know given the current uncertainties. Certainly, extraordinary high debt as a share of exports suggests the need for restructuring, as would the ratio of debt to GDP (the Fund’s preferred metric) if a unified exchange rate settles near the black market rate. Further, because Venezuela’s quota is low (around $3.5 billion), the Fund’s program will require exceptional access, which under its rules calls for a high degree of confidence that the debt is sustainable if a restructuring or reprofiling is to be avoided. That seems unlikely. But any restructuring will present the difficult challenge (even more difficult than Ukraine in 2015) of deciding on the relative treatment of bilateral creditors, bonds and other creditors. China will need to contribute, through transparency about its claims on the government and a willingness to provide relief through a negotiation that leaves other official and private creditors with a sense that there is fair burden sharing.  That will be a change in how China has been operating in emerging markets, but would go a long way toward becoming a responsible part of the global rescue architecture.

  

There are reports this morning that House and Senate legislators have included language authorizing U.S. support for International Monetary Fund (IMF) reform in the $1.1 trillion spending package funding the government for the rest of FY16.  If this language reaches the president’s desk and is signed into law, it would be an important achievement and a positive reflection on the perseverance of U.S Treasury officials and congressional leaders to get this deal done. The package—first agreed to by the Obama administration in 2010—changes voting shares and governance for the institution at a critical time, bolstering the IMF’s credibility and its ability to play a lead firefighting role at times of crisis.  Failure to pass the legislation had become a substantial irritant for U.S. influence internationally, and resolving this is a win for good global economic governance. The price the administration paid included a commitment to seek to eliminate the “Systemic Exemption”, the rule that since 2010 has allowed lending even when there was a risk that the debt was unsustainable, and that was used to support loans for the periphery countries of Europe.  I have supported the rule, which recognizes the inevitable risk involved in these large scale programs where there are broad systemic effects, but giving up the rule is a small price to pay to get IMF reform passed. Should a global crisis threaten in the future, the IMF may again need to bend their rules to respond effectively. That discussion now will begin with a clean sheet of paper, and Congress will need to be informed. The administration also has promised to report to the Congress ahead of any vote supporting a large lending program.  While these commitments add an extra layer of process, I agree with others that requiring clear explanations before and after the use of such a policy can strengthen the legitimacy of such policy decisions. The idea for this trade--IMF reform for the Systemic Exemption--originates with John Taylor, and I gave it a strong endorsement when I testified before the Senate Foreign Relations Committee earlier this year. Quietly, as a footnote to the broader budget deal, good policy is being made.

Earlier today, the International Monetary Fund (IMF) Board approved the inclusion of the Chinese renminbi (RMB) as a fifth currency in the special drawing rights (SDR), the IMF’s currency, as of October 2016.  The move was expected and IMF Board approval was never in doubt once the U.S. government signaled that it would not oppose the step. My read is that the Fund staff acted properly in arguing that the RMB now meets the test of being freely useable for international transactions by its members (though some have argued that the IMF was bending its rules for political reasons). Of course, Chinese financial markets remain significantly restricted for private investors, but the SDR’s current primary use is for transactions between members of the IMF (governments). From that narrow perspective the RMB can be judged to be widely used and widely traded because a country receiving RMB as a result of IMF transactions should be able to switch it to any other basket currency at low cost, at any time of the day or night, somewhere in the world. So too perhaps are more than a dozen other currencies freely useable by this measure, but the SDR is for now limited to the largest of those currencies by a separate (export share) measure. Consequently, next year the RMB goes into the basket with a weight of 10.9 percent (compared to today’s weights, most of China’s share comes from the U.S. dollar which will retain a 41.7 percent share; the other shares will be 30.9 percent for the euro, 8.3 percent for the yen, and 8.1 percent for the pound sterling). While some have argued that the move is a “significant” step for the international monetary system, it is more properly seen as a quite small and largely symbolic step in a long and gradual path of internationalization of the RMB, a reform process that is likely to slow following this summer’s market turmoil. Indeed, even prior to the crisis the IMF and others had warned that Chinese financial market liberalization needed to be cautious and sequenced, with a more urgent priority in bringing market discipline to large borrowers. Nonetheless, the announcement validates and perhaps reinforces the argument for expanding the RMB’s role in markets, and is consistent with measures from the Chinese in recent months to move in this direction. In this regard, the far more important announcement this week was the creation of a working group led by Michael Bloomberg aiming to provide a framework for RMB trading and clearing in the United States, as this could influence the private use of the RMB and SDR. The door for this initiative was opened during the recent state visit by Chinese President Xi, and operationally is independent of the IMF’s announcement though fueled by the same reform momentum. In the near term, the main economic impact of the inclusion of the RMB in the SDR is to raise the SDR interest rate (because Chinese interest rates are higher than rates on other currencies in the basket). Consequently, IMF borrowers will pay more, an amount that has been predicted by the IMF staff to be 27 basis points, but which could well average far more over the cycle. While this may seem small compared to normal swings in the interest rates of the major currencies during the process of normalization, it’s worth remembering that countries such as China in the process of convergence to industrial country levels of income are expected to have higher real rates than developed countries (i.e., interest rate differentials should not be expected to be offset by exchange rate moves). Conversely, if the RMB remains stable relative to the dollar, the exchange rate dynamics of the new SDR will be largely unchanged relative to the old basket. Finally, an important question will be the political impact in the United States, where Chinese and IMF-related legislation (such as IMF quota reform) already faces rough sledding.   FIGURE 1. SDR INTEREST RATE (IN PERCENT) Source: IMF "Review of the Method of Valuation of the SDR" 1/ Using proposed weighting formula

It should be no surprise that eurozone finance ministers failed to agree to disburse €2 billion in bailout money to the Greek government today or to release bank recapitalization funds. Despite optimism following the recent announcement of a relatively benign program for recapitalizing Greek banks, it is hard to escape the conclusion that the Greek program again is headed off track.  The government has fallen behind its reform commitments, and a substantial number of additional end-year measures look unlikely to be met. Even with substantial forbearance from Greece’s European partners, it now looks likely that conclusion of the first review of its program will be delayed and that the promised debt relief negotiation will come only in 2016. Further, an eventual International Monetary Fund (IMF) program is likely to be small and leave a large unfilled financing gap that will further strain Greece’s relations with its European neighbors.  It is hard to predict how long Greek voters will continue to support a government that cannot deliver on its economic pledges of low debt and sustainable growth. The European Union (EU) bank audit results revealed a capital need of €14.4 billion in an adverse scenario (€4.4 billion in the baseline), which conveniently looks to be consistent with previously approved bank recapitalization funding from the Hellenic Financial Stability Fund (HFSF). While the downside scenario is not an exit scenario—the capital needs would likely be far greater if Greece were to exit the eurozone (and Greek bank capital still relies on deferred tax assets to an excessive and credibility-destroying extent), it does cover a substantial renewed recession that would result from a protracted standoff with the IMF and its European creditors. The push is now on to complete the recapitalization by year end, raising private capital to the extent possible before state aid is drawn on, before new EU rules go into effect that would require a greater haircut on bank creditors as a condition of state support (there is a certain irony in hearing policymakers celebrate the evasion of these new rules once seen as critical to the credibility of EU banking union). The next step in Greece’s reform effort is the first review of the August European Stability Mechanism (ESM) program, which is a condition for further disbursements under the package and, more significantly, required for starting the negotiation of debt relief. Reports today suggest disputes remain on a new foreclosure law, the VAT on private education, and pricing of non-generic medications, as well as on the timing and pace of pension reform.  Individually, each of these problems would appear solvable if the government has the will to move forward, but the growing list of unmet commitments has raised concerns among creditors as has the request by the Greek government for a "political decision" on the review. Much was made over the summer on the dispute between the IMF and Europe on debt relief for Greece, The United States now is also pressuring the eurozone on debt relief for Greece. While the announcement of debt relief could maintain domestic support within Greece, the ultimate success of the program is still uncertain. Whether Greece receives haircuts (what the IMF and the United States would like to see) or further deferral of interest payments (the German proposal) will only affect what Greece has to pay after 2022.  In any event, the extended window of very low debt payments to official creditors creates temporary space for private issuance, but this type of seniority-driven market access is not durable and will require repeated official debt service extensions. Despite this issuance, in the near term there would appear to be substantial funding needs for the Greek government.  The fiscal position has returned to deficit (taking into account accumulated arrears) and growth is likely to remain muted at best.  The current IMF forecast is for growth (year-over year) to turn positive only in 2017. It is easy to be critical of a reform program that contains so many reform measures, and arguably a lack of institutional capacity within the Greek government limits their capacity to move forward. But at the same time, there cannot be a return to durable growth within the eurozone without a major transformation and opening of the Greek economy, and creditors are increasingly frustrated with the slow pace of the Greek government in meeting its commitments.  Ultimately, “Grexit” will become an option again when Greek voters lose patience with the current path being charted by the government.  It is hard to predict when it will happen, but hard to imagine another result.

  The Greek elections on Sunday returned the Syriza-led coalition government, a modest surprise following polls showing a close race that might have left a deadlocked parliament. Most commenters took the result as positive for Greece’s reform effort.  Certainly, the government now has a strengthened mandate to implement the program that it agreed to in August.  The program’s first review, now likely in November has some tough issues (e.g., pensions, banking recapitalization) but disagreements are likely to be navigated, setting the basis for a negotiation on debt relief and the terms of an International Monetary Fund (IMF) program.  Most importantly, the ongoing European immigration crisis and other pressures on European decision making (e.g., “Brexit”) likely have reduced the appetite of even Greece’s toughest critics for a confrontation with the government.  All this points to the needed forbearance to keep the program on track. There are a few reasons for caution, which provide perspective on why I still believe that ultimately “Grexit” remains the most likely outcome and the best chance for Greece to restore growth over the longer term. Pensions and banking.  First review of the European Stability Mechanism (ESM) program will see the government pushed to take further steps on pension reform, one of the toughest areas politically for the Tsipras government.  On the banking side, there are significant differences over the size of the bank recapitalization (the IMF reportedly would like to see a larger recapitalization than what the Greek government has called for, hoping to provide a buffer against future downside risks). Fiscal slippages and financing.  While anecdotally, there has been a pickup in tax collection, the August data shows that revenue remains 11.9 percent below target.  Fiscal targets are being met overall, through a massive reduction in spending that is unlikely to be sustainable.  Part of this improvement, further, relies on cash-basis accounting, and the likely continued accumulation of arrears flatters the books. Given the economic carnage associated with the showdown with creditors this summer, there likely will be slippages from what was assumed and there will be a difficult debate over whether Greece should be required to take additional austerity measures. Official creditor disputes.  If Greece is not required to take additional fiscal measures, and as a result the financing required for the program exceeds the predicted €86 billion, then who will pay?  The IMF has already signaled their willingness to lend depends on “explicit and concrete” debt relief from other official creditors, an argument that I have linked to a desire to limit their own financing.  Without a long moratorium on repayments, perhaps of 30 years, or a reduction in the value of the debt, the burden will become unmanageable, the IMF has argued. But even if European creditors meet the IMF demand, there could be a residual financing need in excess of what the IMF is comfortable providing. While the agreement in principle calls on the Europeans to meet any financing shortage, the risk in having the IMF go after the debt relief deal is that it becomes the de facto lender of last resort. In sum, Sunday’s election eliminates one set of risks facing the Greek effort to return to growth in the eurozone.  Harder tests remain.

Yesterday, John Taylor and I testified on the Greece crisis before the Senate Foreign Relations Subcommittee on Europe and Regional Security Cooperation.  A summary of my testimony is here (including a link to my written statement), and the full video of our discussion is here. I continue to see Grexit as the most likely outcome, as we are at the very early stage of a complex adjustment effort that will face serious economic and political headwinds in Greece, and will be extraordinarily difficult to sustain. But whether Greece is ultimately better off in or out of the euro, a competitive and growing Greece is an objective the United States shares with our European partners. A number of decisions concerning Greece will be made in the coming weeks that could be decisive in deciding Greece’s economic future. Specifically, I argued that (i) A European financing facility (ESM) on the order of €50 billion is needed to ensure that the IMF is not left with an unreasonably large financing gap; (ii) European creditors should give explicit commitments on debt relief (conditional on economic performance), in line with the recommendations of the IMF, and consideration be given to a "Paris Club" for Europe; and (iii) The recapitalization and restructuring of the banking system needs to be prioritized if growth is to be restarted.  I also noted that the challenges in Greece highlighted the need for a sufficiently large and flexible IMF that can respond pragmatically in the face of hard-to-quantify risks.  This makes it all the more important that the Congress rapidly pass IMF quota reform, and John and I discussed some ideas for getting this done.    

After months of standoff, the Ukraine government appears to be making halting progress towards an agreement restructuring its external private debt. On hopes of a deal, and ahead of an IMF Board meeting next week to review its program, the government reportedly has decided that it will make a $120 million payment to creditors due tomorrow. It is possible that decision to repay will be seen as a signal of good faith and create momentum towards an agreement, but I fear it’s more likely we have reached a point where continuing to pay has become counterproductive to a deal. Absent more material signs of progress in coming weeks, there is a strong case—on economic, political and strategic grounds—that a decision to halt payments and declare a moratorium gives Ukraine the best chance of achieving an agreement that creates the conditions for sustainable debt and a growing economy in the medium term. What’s at stake? The move to restructure followed the announcement earlier this year that the IMF had made a debt operation a condition of its lending. The IMF decision, as in Greece, was justified by reference to a debt sustainability analysis showing debt rising above 100 percent. A comprehensive restructuring, including a 40 percent haircut to the nominal value of the debt, was seen as needed to reduce debt to a sustainable level (a target of 71 percent). But the timing of the decision had more to do with financing, the result of inadequate bilateral assistance from Ukraine’s main partners that left a gap that was too large for the IMF to fill. The restructuring targets cash flow relief of $15.3 billion over the next four years. Since the spring, talks have moved forward in fits and starts, and while there have been a flurry of meetings this month, significant differences remain. Most contentious appears to be the call for upfront nominal principal haircuts. Creditors rightly note that, given the extraordinary unknowns associated with the war with Russia, the size of the relief needed is uncertain and there is a case for a two-stage approach, with cash flow relief now and a subsequent restructuring discussion when there is more certainty on the economic and political future of Ukraine.  Indeed, IMF research in recent years has made a compelling case for “reprofiling” when there is significant uncertainty, albeit in cases (unlike this one) where the good outcome does not require a subsequent restructuring. But the Ukraine government, and the international community more generally, are united in their belief that there are significant benefits to a comprehensive debt deal that includes haircuts. Among the benefits are assured financing and a strong political signal to the population that there is light at the end of the tunnel. If, however, creditors doubt their resolve, or hope for much smaller levels of haircuts, and creditors are receiving payments in the interim, the negotiation becomes a game of chicken, difficult to conclude. That seems to be where we are now. This morning, there were reports that the two sides would not meet as scheduled this week, allowing technical talks to continue but suggestive of a lack of progress in recent days.  A September amortization payment of $500 million appears to be a harder deadline for the negotiations, as the government has clearly stated that it has neither the will nor the resources to make that payment.  So unless a deal is concluded soon, a moratorium is likely, if not now, in September. To be clear, a moratorium cannot be an excuse to not reach an agreement.  The form of the agreement can vary--there have been suggestions that interest rates could step up after a period of time; that the government could provide extra payments if the economy grows (although GDP warrants traditionally haven’t performed well in markets raising questions whether the government will get good value for them); or that there could be a menu of choices that included different combinations of debt relief.  All these ideas deserve examination. Markets appear to be betting on a deal, or at least on there being sufficient progress toward a deal to justify continued payment (see chart). Prices this morning were steady at around $0.55 on the dollar, up around 6 cents on the month.   The case for a moratorium Debt policy is always trying to find a balance on the issue of default. There needs to be strong incentives for countries to try and repay their debt, even at times of stress; otherwise risk premium will soar and financing for essential development needs will be squeezed out in non-crisis periods. From this perspective, Ukraine was right to make an extraordinary effort up to this point to remain current on its debt. But, when a restructuring becomes necessary, it cannot be too hard to get it done, and there needs to be strong formal and informal mechanisms for collective action to ensure the broadest possible participation. Continuing to pay while negotiations proceed can be an act of good faith; but it can also allow reserves and fiscal resources to drain to unnecessarily low levels. In that context, paying until the last minute provides little additional benefit to market access and if continued payment is seen as coming at the expense of those who are restructuring later—could in fact complicate the negotiations. Far more important for the government is the reduced debt and financing uncertainty, ahead of fall elections and a difficult effort to raise new bilateral financing for 2016. The announcement of a moratorium will no doubt bring down prices, and it is often argued that it will delay Ukraine’s return to market.  Unfortunately, international bond market access is a distant hope for Ukraine in the current environment. Imposing a debt moratorium would imply a default (after a 10-day grace period) and trigger cross-default clauses on Ukraine’s other eurobonds.  But the default would be cured when the restructuring is completed. The IMF is scheduled to complete its first review of its Extended Fund Facility (EFF) arrangement with Ukraine next week, following passage of legislation including banking and judicial reform. To complete the review, the Fund’s Board will need to waive the usual requirements of assured financing (as the restructuring is not complete) and that is more easily justified absent arrears. But that should not be a reason for delay, if Ukraine is acting in good faith and committed to negotiating a fair deal. The Fund should not be willing to lend indefinitely in the presence of arrears, but should be willing to do so now if it helps get a deal done. The government’s main concern with announcing a moratorium may be that anti-Ukrainian elements could seek to capitalize on the default, comparing Ukraine’s actions to the crisis in Greece for example. Any default can create domestic concerns about financial stability, and a bank run at this point would be damaging. Still, these concerns should be manageable. In this regard, the international community needs to provide a strong message of support for the government’s action, emphasizing the importance of an agreement and the significance of this step towards a solution, not an intensification, of the economic crisis facing Ukraine.