Divergence in Monetary Policy and Macro-Risks for Emerging Markets

Are we entering a great divergence between the developed world and Emerging Markets, particularly for oil-fuelled economies and currencies?

In the UK the pound has taken has fallen off its perch by 6% against the dollar in the last few weeks alone - is it the spillover from the travails of the markets or in part a response to increasing country risk amidst a rise in chatter of Brexit?I was contra-market in my projections for UK base rates for 2016 and with the continued - possibly sustained - low oil prices, the arithmetic for inflation has changed and in turn the likelihood of tighter monetary stances.

Whilst the Fed's rate rise of 25 basis points was expected and arguably sound given its inflation target of 2% the landscape in the Euroland remains positively soporific. Again, more recent data shows that a lower inflationary perspective whilst Super Mario has in recent days sought to allay fears of an end to QE.

There is a deeper question for another day whether central banks role of de facto lenders-of-last-resort is now the norm and whether markets are addicted. Or what further can policy-makers more generally do in terms of firepower and tools, at least in the developed world, given near zero (or in some instances negative) interest rates and at least in the EU self-imposed strait jacket of fiscal restraint.

And the risk that the debt overhang that began in 2007 and mutated into various forms, has yet to play out.

And the Divergence?

In part this great Divergence is - like many of the economic-cum-financial narratives of the last decade - being affected and driven by developments in the middle Kingdom. China.

Anyone with experience in transition countries and a grounding in National Accounts will tell you how data can be massaged. I suspect that real activity is probably 40%-60% of what is being officially reported. And this in turn is affecting demand for commodities and hydrocarbons despite official orders to maintain production (and more importantly politically - employment) targets although the Chinese are making fantastic efforts at Energy Efficiency and switching away from hydrocarbons.

Three Major Implications I see:

1. In the last couple of weeks we have seen a queue of oil producers, from the big cheese of them all Saudi Arabia, through to Russia, Azerbaijan, Nigeria through to Equador and even Venezuela facing huge macro-instability on the back of falling oil revenues that fuel both external and internal accounts. Saudi is talking of fiscal reforms to cut subsidies and even privatising part of ARAMCO, its oil genie. Azerbaijan is talking to the IMF for a possible support. Whilst most of these countries have followed sweet-talking consultants and set up whizzy wealth funds, these and the FX reserves will quickly deplete if authorities try to beat the markets (Soros or no). So expect tighter monetary policy, falling currencies and higher imported inflation in EM space - particularly for commodity-based economies, but with spillovers to neighbouring satellite economies (Russia and CIS par example).
2. Debt Overhangs in EM. Deja vu 1990s? EM FX loans, particularly dollar-based will mean currency mismatches, although Russia's corporate sector is largely immune following the financial sanctions (although it's still in a macro-mess that will impede Mr Putin's foreign policy aims).
3. Low Income countries haven't really had a mention but those of us who have worked across investment and risk analysis and development will be aware of the potential risk to vulnerable economies and the potential counter-cyclical hit it will have on public finances for economies most exposed. The EU successfully pushed through a package to aid 30 odd countries in 2008 in Africa and the Pacific by helping to ringfence critical public expenditure in health, education and public services - more of the same may well be required.

Forecasts, Monkeys (with keyboards) and UK Interest Rates: a case for no change

I was tickled by a comment by the RBS reported in last week's weekend newspapers - who evidently came top in the Wacky Races of would-be forecasters for 2015 for the British economy who used an apt (except perhaps to its number crunchers) riposte about "monkeys with keyboards".

With monkeys of my own in our household, I thought it only fair to get their take on the key forecasts for 2016!

Alas they were too interested in the latest I-Phone and Japanese Animes as target-forecasts than that of something called GDP or seismic developments in the FTSE 100. So we stuck to one indicator...UK interest rates.

With  that UK base rates at 0.25% for the last 7 years and most folk again writing about a definite rate rise this year, the "consensus monkey forecast" at chez nous was a dead-heat: up, down and one flat. I particularly enjoyed the outlier of the forecast for a reduction...(forecaster age 8 mind!). So the average or mean is no change.

Which is essentially my own personal view: ie no change in 2016 with a 70% probability and a 30% chance of a rate increase - and if so, yes by 25 basis points.

Sound UK Fundamentals but plenty of Geo Political and Economic Volatility

The consensus is that UK interest rates will go up later this year and by a quarter of a percent.

The Bank of England typically takes its cue from the trend in US interest rate setting and and the recent rise in the US Feds Funds rate by 0.25% would normally suggest a reaction this side of the "pond". Both the US and UK economies are now in a growth phase, as indeed is much of the EU. But there are lot of downside risks that suggest that the economic take-off in the UK may yet be more subdued than envisaged.

Things are extremely fluid and gittery geo-politically and are not only causing havoc in the financial markets in January but will also pose a sustained and growing risk that the consensus forecasts may not yet have fully factored in further potential volatility and resultant caution on the part of the Bank of England to hold off further monetary tightening, particularly if there will be further deflationary pressure.

Key factors

1. the slow-down and convulsions of the Chinese economy could yet reveal some nasty black holes (quasi-fiscal liabilities) whilst driving a general softening in external demand that will hit SE Asia and in turn is lead to what looks like more than a cyclical depression in commodities - particularly that of the black gold. With China responsible for about a third of global growth in trade in recent years, cooling external demand and in Emerging Markets will together hit external demand for the EU, including the UK.
2. A devaluation of the Chinese exchange rate is now likely and this in turn will continue to mean cheaper Chinese imports in the UK and elsewhere.
3. A Chinese devaluation may set off further devaluations in SE Asia in particular as the Asian tigers seek tor retain competitive edge in the tradeable sector...maybe good for imported inflation into the EU and the UK but also likely to add to FX risks in these countries given the increasing prevalence of dollar borrowing (deja vu late 90s?).
4. With investment houses now rushing to reverse previous gilded forecasts that we were living in a new normal of above USD 100 per barrel just a couple of years back, they are now rushing the other way to come up with ever lower sub-50, 40 or even 30 dollars per barrel. Whatever the macro reasons in terms of underlying demand and supply and alternatives (shale gas) and substitution effects (solar, hydro, wind et al) that explain the decline in the price of hydrocarbons, the fact is that this is clearly a positive external shock and deflationary for the UK. If it is sustained then the deflationary impact will be higher than anticipated - ie imported inflation will be lower.
5. Within the UK the efforts taken by both the fiscal and monetary authorities to cool down the housing market will have a pronounced effect from April 6 when a further 3% transaction tax (Stamp Duty) kicks in for anyone buying an additional property and lending criteria are further tightened by the central bank.

So, as in 2015, I'm forecasting a baseline that UK base rates remain unchanged in 2016.

Budget Support in the Western Balkans: a catalyst to the EU?

“Aid modalities” to use the jargon, is a bit like men’s fashion. Rather like flared trousers and loudly coloured ties, they come around in fashion every so often. Same with the fashions in aid effectiveness.

Having sat on several national and OECD level talking shops, I now conventionally start with a quip of adding the negative…so aid effectiveness becomes ‘aid ineffectiveness’ which is often closer to the reality on the ground in recipient countries where despite well meaning declarations, foreign donors more often-than-not have their own peculiar pet ideas and vision.

One delicious example was when I came across a reasonably well designed and operational fiscal system in a particular transition economy and a certain Nordic donor insisted that its support in the area was conditional on the budget being gender based! Hmm, the average Public Finance Management expert may ask: what if budget programming is sound and based on a reasonable identification of needs and priorities?

… back to Aid (In) Effectiveness.

The EU’s aid budget is managed through its euracracy, the European Commission (EC). And in recent years there has been a marked shift to align its aid dollops through an increasing share of budget support operations or cash transfers to the national Treasury via generally its account at the central bank although they are now aimed to be 25% or so of the total aid pot.

Traditionally a tool favoured for developing and emerging nations, Budget Support has now found its way to the Aid menu for would-be accession countries of the EU’s periphery, including bits of the Western Balkans not already in the EU.

One of the interesting developments has been whether budget support operations meets the wider goals of development aid and in turn whether the tool is relevant for what is left of the Enlargement-seeking countries – relevant for either their broader development or for guiding and accelerating EU aspirations.

Leaving aside the outlier that is Turkey – it being recipient of a cool $4.8bn aid over 6 years from the EU over 2014-20 and a further $3.something bn commitments late in 2015 to Turkey “manage” Syrian refugees – the question has become focal for the Western Balkans – Albania and the 4 Yugo successor states not yet in the EU: Serbia, Montenegro, Macedonia and Kosovo.

Picture a situation where anything up to 90% or more of aid flows are from the EU into a recipient country in the Western Balkans that is earmarked to be €1.6bn in 2015. Sounds a lot but if budget support takes about a small portion of €20-40m then this is small change for the Western Balkan budgets.

So can budget support – essentially cofinance for existing budget lines for line ministries – be conducive to reform in the Western Balkans (where reforms have stalled) particularly where convergence to EU norms is concerned?

Time will tell.

One thing is for sure – Budget Support for Sector Reform is a well-meaning approach relevant for development more generally and it does in principle meet the broader aims of national ownership by allowing recipient nations to use own systems and procedures. It means funds go through the national Treasury and in effect imply a potential boost to Aggregate Demand through a rise in government expenditure.

On the other hand, anyone who has worked in EM or in other developing countries will wonder if the use of often bent national procurement systems really does lead to meaningful impact of those hard earned (and argued in austerity-hit donor countries) transfers of Euros, pounds, dollars or any other currency.

In summary, Budget Support is not a panacea in aid delivery. It is a tool or modality and one amongst a family of tools that range from classical Technical Assistance from the private sector or from national administrations in the EU (twinning as it’s called) to continued use of EU or other donor procurement systems but where the beneficiary country or authority (such as the Road Fund or Railways or Border Control Management) is given the right to make a transparent selection based on verifiable criteria.

Budget Support does make Ministers of Finance and other key ministerial folk sit up and take notice because its pure cash rather than some woolly project where foreign experts eat up most of the sum from consultancy fees. And as such policy conditionality works if the programme is well designed. Equally if it is but a substitute for a better option such as a standard Supply Contract then its impact and value-for-money will be lower.

This in turn opens up perhaps the critical path for potential reform. Via the budget.

The share of government in Western Balkan economies remains relatively high and so fundamental reform in key sectors will be credible only if the piles of donor funded sector plans and fancy Medium-Term Expenditure Frameworks (MTEFs) are subject to genuine Public Finance Management through much improved budget programming, better expenditure management and improved financial accountability.

Having designed the one main General Budget Support package for Serbia in 2009-10  and a pilot Sector Budget Support in the Western Balkans in the last two years, I remain cautiously optimistic about the potential of the new modality as a conduit to more effective governance, rule of Law and government finances.

The latter three tick boxes toward the Copenhagen criteria that defined the initial basis of meeting the entry requirements to the join the EU.

That said, the Jedi Knights of the Acquis Communautaire may wonder if the Force is really with them if this does not lead to meaningful real convergence at the geek-level EU Chapters….from statistics to agriculture and veterinary control to financial control.

For this and more see my blog, www.aid-finance.com

Western Balkans: Public Finance Management in Kosovo, Policy Concerns and Risk

With focus during 2015 in Europe on the continuing challenges with Grexit-cum-Brexit, the refugee crisis and the political spillovers across Europe, what of the Western Balkans and long-stated hopes of EU accession?

Inevitably, the yellow-brick road to the EU remains of keen interest to citizens of the Western Balkans if not their erstwhile politicians and policymakers who are happy with the current models of existence. Barring major economic and resultant political turbulence this modus-operandi is changing little.

From the EU the same broadly applies. The European Commission’s Directorate General is no longer DG Enlargement but rather DG Neigbourhood and Enlargement (DG NEAR) that takes in countries around the EU periphery from Belarus in the East via Jordan, Turkey and then across the southern Mediterranean to Morocco. 

The EC’s reduced focus on Enlargement in the Balkans echoes the political mood music in the EU more generally about fear of further flows of economic migration and taking on board economies that remain unprepared in terms of basic principles of governance, political accountability and economic freedoms. 

Yours sincerely has had the opportunity to work on macro-PFM-advisory issues with governments in recent years and the one State I had not worked on was Kosovo. So what was my experience and assessment following several visits from late 2014 and 2015?

Kosovo, formerly bang in the centre of Yugoslavia and now a nominally independent State but quite yet fully recognised by the international community, made some fantastic strides in setting up market based institutions…but much of it was setup under the auspices of the UN agencies in control and without the legacy of state institutions that have often proved to be the limiting factor to change and subsequent implementation of reforms.

See also: www.aid-fnance.com

An assessment was carried out on Public Finance Management in Kosovo in 2015 for a major donor that looked at the entire scope of PFM from budget formulation, strategic planning through to treasury management, financial control, public procurement and internal and external audit functions. The aim was also to assess the current PFM stance in Kosovo in early 2015 as it affects Kosovo’s potential access to the EU Budget Support.

One key finding was that despite Kosovo’s heavy aid dependency over the last decade, formal donor co-ordination in PFM has been largely absent, meaning that the potential leverage of combined external aid and World Bank development financing has been sub-optimal. That said, this is not dissimilar to the situation in other Western Balkan states – or indeed elsewhere where donors are often more focussed on meeting commitment targets for meeting aid targets from national capitals.

Overall, the impact of EU aid in PFM reform was assessed to positive but affected by the lack of available administrative and absorption capacities as well as by the lack of genuine demand or political will to implement fiscal and PFM reforms. Impact and sustainability was found to be highest where there has been clear and full ownership – most clearly for the external audit function at the Office of Auditor General – the external audit function in  Kosovo.

Budget planning was assessed to be fairly advanced in terms of classifications, use of a budget calendar, Single Treasury Unit /cash management and a number of IT systems.

For Internal Audit and Financial Control a key challenge has been a lack of genuine ownership.

The picture was similar for Public Procurement in that the binding constraint has been the degree of ownership and political will rather than the design of aid projects. The projects made modest progress in helping to raise knowhow and improve the legal framework that was found to augur well should the recent signs under the new government in mid-2015 prove to be sustained.

Overall, the picture was essentially on par with the rest of the Western Balkans with perhaps the exception of the very advanced external aid function – although the latter was largely due to the efforts of the UN and then EU support and led until late 2014 by a senior former external auditor from Scandinavia but with increasing risk of the function becoming weakened as a true independent channel to assess accountability and value-for-money of public finances. As in most transition and emerging economies the accountability in parliament through budget and Public Account Committees (PAC) was found to be very weak – with but enormous upside potential, particularly in terms of syncing the external audit reports…aka the way the UK’S PAC has often worked hand-in-glove with reports from the National Audit Office.

Capacity limitations and political will to implement far-reaching fiscal reforms are key limitations in Kosovo. Capacity limitations weaken the potential of over-sexy IT systems for budget planning and perversely mean that there is more actual discretion in shifting appropriations between budget lines than perhaps the case in other legacy-Yugoslav states.

This in turn opens a range of questions about what exactly is the best avenue to target external funds in development aid, the modalities of aid and whether there is sufficient leverage or conditionality to force reform. The headline macro numbers hide some basic vulnerabilities including a bloated size of the state that is acting as a de-facto employer of last resort for a large cohort of workers – often politically driven – and in large part due to a lack of sufficient development of the private sector to absorb excess labour. The true unemployment rate, particularly among the youth is very high, real wages relatively low and this in turn has led to an outflow of migrant workers in search of better life in Germany via Serbia that in early 2015 reached a reported 50 -70000, although some of these will now be returning home following the German decision to not recognise citizens from the Western Balkans as refugees.