Financial Markets

A deal that would end the violence in Ukraine appears to be holding. It would produce early elections, a return to the 2004 constitution, and a national unity government. It would also set the stage for an urgent western effort to provide financing supported by an IMF program. Good news on the politics, though, does not equate to good news on the economy. Last week I blogged on the issues that would need to be confronted if the West were to put together a package. If a government is put in place that can work with the IMF, the international community will need to move fast. Experience with crisis situations and failed states suggest that economic fundamentals deteriorate quickly if unaddressed. Capital flees, growth and trade slows dramatically, and tax receipts plunge as the authority of the state activity weakens.  Exchange rate depreciation (see chart) and continued reserve loss exacerbates the risks.  Ugly surprises appear on bank balance sheets.  The longer a deal is put off, the larger the financing gap and the greater the challenge of filling it. S&P’s decision today to downgrade the sovereign on rising expectations of default highlights these risks. This suggests that the window may be short for an adjustment program that can restore confidence and market access, and is consistent with the financing available. Much depends on the IMF. How generous should a package be, and with what conditionality? In December, the IMF Board noted some achievements, but also regretted the authorities’ insufficient ownership, which undermined the program. Directors agreed that, "in view of Ukraine’s track record, arrangements with lower access and strong prior actions would be most appropriate." In plain speak, Ukraine has performed badly on past IMF programs, and a large financing program contingent on future economic reform promises is likely to fail again. Renewed funding could in fact could be counter productive. Of course, the counter argument for a large package is also easy to make. The new government is the best hope in some time for Ukraine, and deserves strong western support if there is to be a credible alternative to Russian financing and the strings attached. A large financing package from the IMF, with politically realistic conditionality, is the best hope to avoid default and chaos.  This would mean financing a large fiscal deficit (which was 7.7 percent of GDP last year) and allowing a gradual adjustment of energy prices.  This will be a tough package for the IMF (and some creditors worried about moral hazard) to accept. If the West goes in this direction, the Fund will want to see its program as catalyzing other support.  I continue to see merit in a "Friends of Ukraine" effort, involving western governments and perhaps major Ukrainian investors and businesses. Market attention in coming weeks increasingly will focus on whether the Ukraine government will pay upcoming bond maturities. But even more important will be the speed and conditionality of the package the West offers.  The contagion to other markets will likely depend on whether investors see this as a failure of the state and unique due to Russia’s role, or rather symptomatic of a broader increase in EM political risk.  So far, market commentary has been balanced on this point.  How the West responds will matter here too.

The current Economist has an article on U.S. oil and gas that repeats an increasingly common view: tight oil will make “future oil shocks less severe” since “frackers can sink wells and start pumping within weeks”. (Here’s a variant from The Atlantic last August.) That speedy response means that “if the oil price spikes, [drillers will] drill more wells”, quickly spurring new production, and taming any price spike. This is severely flawed – a point that recent experience reinforces. It is undeniably true that the time from drilling to production is far lower for tight oil than for traditional wells. But that doesn’t mean that industry can respond quickly and powerfully to oil market shocks. Imagine that a disruption in the Strait of Hormuz threatened to send oil prices up from one hundred to two hundred dollars a barrel for a span three months. How would U.S. oil producers respond? The first thing they’d do is ask themselves whether new investment would make sense over the full life of any new well rather than just over the span of the disruption. Let’s take a best-case scenario: a developer realizes that something is afoot on Day 1 of the crisis and is confident the price rise will last three months. If you assume that about 20 percent of a well’s output comes in its first year, and that production declines by about 50 percent in a straight line over the course of that year, then you end up with 6-7 percent of total production during the period of elevated prices. Wells with break-evens up to 106 or so dollars a barrel, rather than merely 100 dollars a barrel, are now in the money. This will not spur radical change. (If I was doing this carefully, I’d discount future cash flow, making the up-front revenue boost more consequential. But the basic qualitative point would still stand.) Even if you extend the crisis to six months, you get a maximum break-even of about 112 dollars a barrel, a relatively small increment. And this assumes that drillers act instantly upon a supply disruption; in reality, making a decision to drill, mobilizing resources to begin production, and actually drilling and fracking a well would delay the start of production and further blunt the slightly-above-normal returns. One can argue with the numbers I’ve used to make this point, but the basic qualitative conclusion is solid. In fact the numbers I’ve just presented overstate how strong drillers’ response would be. In the short run the number of rigs available for drilling is fixed. (I could make a similar argument about other capital and people needed to initiate production, but it’s useful to focus on one thing.) It’s true that producers can move rigs from natural gas toward oil, but that’s happened so much over the last couple years that there isn’t a huge margin to do that today. Over time, you could see more rigs get ordered. But companies aren’t going to order a bunch of rigs that will be active for a few months and then sit idle once prices return to normal – that’s not a profitable proposition. Instead companies faced with an impending price spike will bid for a fairly fixed set of rigs. Since those rigs are newly valuable – you can now make a bit more money using each one because oil prices are higher – companies will be willing to pay more. The break-even price for a given well will therefore rise, moving some seemingly profitable but marginal prospects back into the red, and leaving them untapped as a result. This dynamic also explains why newly cash-flush producers won’t be able to blindly plow all their money back into increased production even if they were inclined to: the necessary rigs wouldn’t be there. And there’s one more constraint: transportation. Even if drillers can respond quickly, that doesn’t mean that they can get the oil they produce to market. If there isn’t sufficient pipeline or rail capacity to quickly move newly produced oil to market, companies aren’t going to produce that oil. It takes a decent amount of time, of course, to expand transport capacity. This won’t always be a big constraint, but it’s one more strike against the “tight oil production is always going to be super-responsive” line. We’ve recently had an ugly piece of real-world experience in natural gas that backs this all up. Henry Hub natural gas prices rose from $4/MMBtu to about $5.50/MMBtu over the span of a few weeks in January. They’re still elevated. So are rigs rushing toward newly profitable opportunities in natural gas? Absolutely not: the gas-directed rig count declined 4 percent last week (half those rigs went to oil and the other half were inactive) and has fallen 20 percent over the last year. This is due in part to the fact that the cold snap driving prices up right now is ultimately going to dissipate, and in part because we don’t have the right infrastructure in place to move additional natural gas production to market quickly. (It’s also because using available rigs to drill for oil remains more profitable than moving them to gas, despite the price spike.) To be certain, this story would look different if we were talking about long-term increases in the price of oil. A run-up like the one we saw in the 2000s, which unfolded over the span of almost a decade, would give drillers plenty of time to respond. (Though experience in the oil sands in the 2000s suggests that capital and labor constraints – and resulting cost inflation – would still be a major drag.) But for the sorts of oil price spikes we worry about most – those driven by sudden and intense geopolitical disruptions – the responsiveness of tight oil production is likely to do a lot less to blunt the consequences than many people seem to hope.

Antitrust law, which has evolved primarily through landmark Supreme Court cases, plays an essential role in the maintenance of efficient markets and promotion of long-term U.S. economic prosperity.

After growing to a $1 trillion asset class in Muslim countries, Islamic finance is poised for an era of globalization.

For several decades, the exciting promise of microfinance has been to provide the world’s poorest with access to financial services. But along the way, microfinance has too often become conflated with micro-credit. This is not surprising, given that most of the first microfinance institutions (MFIs) were non-profit organizations that took grants from donors and recycled them as loans. Now, however, many MFIs have reincorporated as banks with the ability to accept savings, and the full promise of microfinance is beginning to be realized. Indeed, the expansion of efficient and effective saving mechanisms and other financial services such as insurance is one of today’s most exciting developments in the effort to tackle poverty. Savings accounts and insurance can help poor people survive unexpected financial shocks brought on by events such as family illness, crop failure, or market downturn. Savings can also improve an individual’s social mobility, ability to invest, and future earning potential. According to the International Monetary Fund’s most recent Financial Access Survey (FAS), “access to commercial bank services has deepened across virtually all regions of the world, with Africa continuing to lead growth in financial access.” In addition, more and more poor people are buying life insurance and internet connectivity and online services continue to boost financial inclusion. Still, approximately 2.5 billion people -- more than half of the world’s adult population – don’t have bank accounts. And most of this unbanked population lives in developing countries. A 2011 Gallup and World Bank poll found that in high-income countries, both rich and poor individuals usually have savings accounts. This is not the case in low-income countries, where travel distance, cost, and documentation requirements hinder individuals from opening accounts. For women, gender discrimination and financial dependence on male guardians can further limit access to formal finance. Last month, I hosted Mary Ellen Iskenderian, president and CEO of Women’s World Banking, and Steve Hollingworth, president and CEO of Freedom from Hunger, to discuss these issues as part of the Council on Foreign Relations’ ExxonMobil Women and Development Series. Our discussion touched on many topics related to financial inclusion, one of which was the important difference between microcredit and microfinance. In some situations, a loan might not be the financial tool an individual needs to climb out of poverty. The World Bank’s recently-published Global Financial Development Report 2014 similarly argues that providing credit indiscriminately can lead to financial and economic instability. In addition, financial services can be rendered ineffective without accompanying financial literacy training. As Iskenderian mentioned during our meeting, development organizations are now pioneering innovative financial literacy training programs, including educational text and voice messages that can be accessed using a cell phone. The Global Financial Development Report 2014 found that classroom-based financial education has less impact than when individuals learn through “teachable moments,” such as applying for a loan or starting a job. Popular entertainment can also be a useful tool in communicating lessons on banking and financial planning. The latest FAS report finds that financial inclusion seems closely tied to overall economic growth. In Africa, for example, there was a nearly four-fold increase in commercial bank depositors per 1,000 adults from 2004 to 2012. The region simultaneously experienced a 40 percent growth in GDP per capita. Similarly, in the Asia and Pacific region, depositors per 1,000 adults nearly doubled over the same period, with GDP per capita increasing more than 70 percent. Still, although developing countries are projected to dominate global saving and investment in years to come, that trend might not extend to the poorest populations. The Middle East and North Africa region, in particular, “has the lowest use of formal financial institutions for saving by low-income households.” The accessibility of financial services remains highly dependent on public and private sector regulation. To encourage low-income banking, governments should enact effective policies that require banks to offer low-fee accounts, allow electronic payments, and grant exemptions for documentation requirements. Less successful policies include debt relief, directed credit, and lending through state-owned banks. Financial institutions, meanwhile, should adopt new technologies such as mobile banking to make financial access easier and more secure. The African Development Bank Group and other financial organizations have already begun pioneering these types of programs. Overall, innovative programs and products that address market failures, meet consumer needs, and overcome behavioral problems can foster the widespread use of financial services. For example, financial products such as index-based insurance can mitigate weather-related risks in agricultural production and help promote investment and productivity in agricultural firms. Still, as Hollingworth lamented, widely accessible crop insurance for farmers, which would improve their financial security immensely, seems to be a long way off.

Looking back at 2013, several developments stand out for their significant potential to better the lives of the world’s poorest. Here are three that will likely reverberate for years to come: 1) The Accord on Fire and Building Safety in Bangladesh This past year saw one of the deadliest factory accidents in history, which killed over 1,100 garment workers and injured another 2,515 in Savar, Bangladesh. The incident came less than a year after the Tazreen Fashion factory fire in Dhaka, Bangladesh took the lives of at least 117 workers. In the aftermath of these tragedies and other shocking safety violations, international actors have finally come together to improve working conditions in the world’s second-largest apparel exporter and, in the process, set new precedents for labor safety in other poor countries. In May, over 100 apparel corporations, two global trade unions, and numerous Bangladeshi unions signed the Accord on Fire and Building Safety in Bangladesh, which calls for “independent inspections by trained fire safety experts, public reporting, mandatory repairs and renovations financed by brands, a central role for workers and unions in both oversight and implementation, supplier contracts with sufficient financing and adequate pricing, and a binding contract to make these commitments enforceable.” Unlike previous labor safety agreements, this one is legally binding and requires companies to reserve sufficient funds for repairs and renovations. The Accord is not perfect – and cut-throat producers will always try to exploit loop holes. Just establishing a system to organize the inspection of the country’s 5,600+ factories poses enormous logistical challenges. In the meantime, apparel companies have been criticized for not compensating or adequately helping those directly affected by the Rana Plaza collapse. But in the wake of these horrific tragedies, the pressure to follow through will likely remain and the accord provides the best basis yet on which to build positive change. The alternative for global companies concerned about their brands is to cut and run. But moving operations to another country would unfairly penalize the millions of Bangladeshi workers who have a found a semblance of middle-class life through factory work. The textile industry accounts for three quarters of Bangladesh’s exports and employs four million people, the majority of whom are women. Shutting it down would have huge economic repercussions and would take away many worker’s best shot at breaking out of poverty. A better response is for companies to make the needed investments in safety, and more broadly in infrastructure to address other supply chain problems. The Accord is an encouraging sign of progress, but its implementation will be the real test of corporate responsibility in Bangladesh and beyond. 2) Rise of Internet and Smartphone Use in Africa In Africa, internet and smartphone usage continues to expand: the continent now has 16 percent internet penetration, 167 million internet users, 67 million smartphones, and $18 billion internet contribution to GDP. By 2025, Africa is expected to have 50 percent internet penetration, 600 million internet users, 360 million smartphones, and $300 billion internet contribution to GDP. A 2013 McKinsey report attributes this growth to “significant infrastructure investment—for example, increased access to mobile broadband, fiber-optic cable connections to households, and power-supply expansion—combined with the rapid spread of low-cost smartphones and tablets.” The implications of the spread of internet technology in Africa are huge. In education, affordable tablets and e‑books can cut costs and improve quality of instruction and teacher training. With Internet access, farmers can find and share valuable information on crop management, finance, pest control, and weather. Internet access can also improve government transparency, efficiency, and productivity. Lastly, e-commerce promises to boost the continent’s overall economic growth, potentially adding an addition $75 billion in annual revenue. All this adds up to a revolution for the continent, and especially for rural communities and public service providers previously unable to access critical innovations and information. 3) Expansion of Payment Networks in East Africa Technology has profound implications for financial services and aid delivery as well. In Kenya, M-Pesa has revolutionized how people spend and move money. Mobile banking is expected to grow even more in the coming years, with international heavy-weights Paypal, Google, and Huawei (a Chinese telecommunications company) joining other companies, such as Obopay, Ericsson, Western Union, MasterCard, Airtel, and Visa already developing and investing in African mobile payment systems. PayPal’s new partnership with Equity Bank in Kenya, for example, will allow Kenyans to access the global PayPal network and could “further transition East African economies away from cash, allowing business to better integrate into the global marketplace.” East African banking has been further transformed by the implementation of the East Africa Payments System. Championed by central banks in the region’s top economies, the EAPS speeds up commercial transactions and allows Kenyans, Ugandans, and Tanzanians to make and receive payments in real time. Rwanda and Burundi are expected to join the EAPS and even help establish an East African monetary union once their economies are more developed. The expansion of mobile banking enables aid organizations to efficiently reach more rural communities and boost economic growth overall.

I recently wrote a memo titled “Banking on Growth: U.S. Support for Small and Medium Sized Enterprises in Least-Developed Countries,” which argues that it is in the United States’ interest to invest in small and medium enterprises (SMEs) in the world’s toughest and poorest economies. Investing in such businesses has diplomatic and financial dividends: it would spur economic development, accelerate progress towards international health and education development goals, and boost stability in fragile economies -- all of which furthers U.S. foreign policy goals. According to the International Finance Corporation (IFC), small and growing businesses account for about 90 percent of businesses worldwide and contribute nearly 30  percent of formal GDP in lower-income countries. Accounting for more than 50 percent of employment globally, these enterprises are key drivers of job creation and market innovation, both of which strengthen economies in societies vulnerable to political and social instability. Yet despite growing evidence that SME investment yields positive economic, development, and security benefits, the United States currently lacks the ability to deploy the full weight of its entrepreneurial knowhow on behalf of entrepreneurs and SME-owners. The Overseas Private Investment Corporation (OPIC) comes the closest to filling this role, but OPIC’s efforts are constrained: it has to work with a U.S. bank when investing in the private sector and cannot offer technical assistance or equity investments. An American development bank that expands and builds upon OPIC’s efforts would give the United States the flexibility to invest in SMEs abroad with fewer restrictions. And it could be done at no cost to taxpayers: for each of the last 36 years, OPIC has actually returned money to the government – most recently $426 million. Some of this money could be deployed to expand OPIC’s capabilities and scope. In the memo, I suggest that the U.S. government do three things in order to effectively invest in SMEs and women entrepreneurs:   1. Invest in and create a new American development bank that would build on OPIC’s framework and provide a "one-stop shop" solution for entrepreneurs in lower-income countries.   2. Encourage the American development bank to invest in locally owned small businesses in order to demonstrate that the SME sector – which investors often view as high-risk – is vital to economic growth and stability. Women entrepreneurs would be a focus of such a development bank given the development benefits of investing in women. 3. Collaborate with others already supporting SMEs, including governments, civil society organizations, private sector entities, UN agencies, international NGOs, and other development finance institutions.   Women entrepreneurs would be a critical focus of the American development bank. There are around 8 to 10 million women-owned SMEs in the formal economies of emerging market countries, and millions more in the informal sector. Women face all the challenges of growing businesses in risky environments that men face, and more. Seen as high-risk clients, investors are usually reluctant provide women with access to the capital, networks, and support they need to build and expand their businesses. By serving women, an American development bank would help female entrepreneurs contribute more to local economies, and in the process help create more prosperous and financially secure communities. The U.S. government stands to reap substantial gains from launching an American development bank that could invest directly in entrepreneurs in lower-income countries. Doing so would help the United States get far more from its aid dollars and address important national security risks associated with weak economies and unstable societies.

Last week, a United Nations expert panel issued a harsh report expressing concern over the construction of a $12 billion steel project in Odisha, India, financed by the South Korean steel conglomerate POSCO. The project reportedly threatens to forcibly displace over 22,000 people and disrupt the livelihoods of many thousands more. The forests and fields now claimed by the Indian government to build the sprawling project have long been occupied by locals, who rely on the land for their livelihoods. As I demonstrated in my Brooklyn Journal of International Law article last year, the tension between aggregate economic growth and the property rights of vulnerable groups is a longstanding development challenge. Often, growth-enhancing land acquisitions financed by foreign investors forcibly displace the original resource users and ignore their property rights claims, intensifying property insecurity and resource scarcity—even while bringing macroeconomic growth. Legally, governments should protect the rights of all their citizens—rich and poor. But the customary rights of subsistence local resource owners are too often ignored by elites, who sometimes even pocket kickbacks from the transnational investments that displace these local resource users.. In India, residents of Odisha decry government ineptitude and corruption for jeopardizing their property rights and livelihoods. POSCO likewise criticizes the government for not effectively resolving land disputes, which have delayed construction for almost eight years. If rights were fairly recognized and adequate compensation granted to current users, then both local owners and aspiring investors who want to play by fair rules would be better off. Raquel Rolnik, UN Special Rapporteur on adequate housing, stressed that “forced evictions constitute gross violations of human rights,” in her statement regarding the Odisha steel project. But what can be done when governments fail to protect human rights and global companies like POSCO stand to benefit? International investors finance these projects and own the companies that develop them, so will profit from their success.  These global investors therefore have an ethical obligation to ensure that the rights of all affected communities are respected, in order to promote economic development that is inclusive and sustainable, and not just beneficial to a wealthy few. In the case of the steel project in Odisha, POSCO’s international investors include ABP, Norges Bank Investment Management, Bank of New York Mellon, Blackrock, Deutsche Bank, and JPMorgan Chase. Fortunately, some of these leading investors already have a framework to safeguard environmental and human rights norms for the projects in which they are invested.  The Equator Principles -- currently followed by 78 financial institutions, covering over 70 percent of international project finance debt in emerging markets -- codify norms for human rights, labor rights, and the environment. The principles also reflect a consensus among multilateral development banks and other development finance institutions regarding environmental and social standards. These principles should be extended to cover all private sector investments, not just project finance, so that they would apply to cases like POSCO’s proposed steel plant, which now threatens thousands of poor rural residents. In addition, the principles need to be strengthened to prevent free riding by member companies seeking to boost their reputations without taking the trouble of actually complying with the principles. An independent monitoring mechanism should be established to ensure that all Equator Principle signatories are really playing by the rules. When voluntary measures fail, mere UN reports, however harsh, are not enough to change the facts on the ground. Impacted communities need advocates to represent their interests in complex legal disputes, which entangle investors from many countries. As I have argued elsewhere, mobilizing international corporate lawyers to represent marginalized communities around the world would level the playing field, and would help ensure the rules of the global economy work for everyone, not just the rich and powerful.