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.

Impact of the Crimean Annexation and Sanctions on Russian Growth

Whatever the narrative or counter-narrative, the annexation of Crimea by Russia is in effect.  What does this auger for Russia’s economy?

Russia’s growth was already flat-lining before the Russian-Ukrainian “conflict” with concern over the greater reliance in 2014 on hydrocarbons than in 1991 AND the increasing likelihood of a narrowing current account on the Balance of Payments in the coming years.

Did the Putin team do its sums?

Cost of Transfer of Fiscal Responsibilities To Moscow

The incorporation of approximately 2 million Crimeans represents an administrative challenge that Russia will manage although the transfer of property rights will prove more taxing whilst an asset-grab of prized real-estate or businesses has already begun.

Crimea was reliant on transfers from Kiev of around 60% of its budget of approx. $0.5 bn. Add additional (and higher) centrally managed social payments (eg pensions higher than in Ukraine) that Moscow will now have to manage and the expected reduction of both cash-payments from migrants working outside Crimea and the likely collapse – at least this year – of tourism receipts means that the net back-of-the-envelope cost to the Russian budget is around $1.5-2bn per year.

Add additional Russian transfers that will be needed to keep the Crimean economy afloat – and the total bill will be $4-5bn, equivalent to less than 0.2% of GDP for the Russian Budget.  I’m sure the boys from MinFin will have provided something along these lines in their preparatory brief to Mr Putin.

Cost of Sanctions

This is the big unknown. The Russian economy is far more integrated with the rest of the world than is often appreciated.  Even excluding the gas flows that cater for 30% of European energy consumption there is a surfeit of international connections from industry to finance that affect corporates and banks.

The combination of US and EU sanctions was scoffed at by Putin and co initially. However the very inter-connectivity of Russia to the global nexus of markets is already having a marked effect – in particular following the measures announced by the US.  Global banks will be reticent to fall foul of the US’s regulatory net by touching anything associated with the Putin Inc. clan that have been shown the equivalent of soccer’s Yellow Cards.  With regulators purportedly checking bank exposures to Russia, and with recent experience of handling and containing potential contagion, the possibility of a tail-risk event such as a gradual Iran-style financial squeeze led by the US could seriously hurt Russia.

With rating agencies such already highlighting a “negative” for Russia and reports of credit lines being cut, the initial flight of hot funds may prove to be a more lasting factor than Putin’s strategists may have anticipated in their cost-benefit analysis of the Crimean blitzkrieg.

Interbank rates in Moscow have risen over a percent over the last 48 days and the US’s clever focus on Bank Rossiya and the resultant freeze on its quarter of a million credit card holders by Mastercard and Visa will have done more to hit home to the rich upper and middle classes the potential financial impact of even a modest lock-out from the international financial architecture.

Old hands in Russia from the 90s will be aware of the  risk of mini bank runs given memories of two previous Russian financial crises since the Soviet collapse in 91 but I see this less of a risk and the Central Bank will manage any liquidity crises given its oodles of reserves.

One hopes that diplomacy at least de-escalates the situation so that the threat, in particular, of harsher German-led EU economic sanctions dissipates. If not the next round of trade and financial sanctions on Russia – and its likely reaction against foreign investments in Russia by it – will unfortunately mean a greater hit on the Russian economy.

The Putin model relies on hydrocarbon revenue and the short-term risk of say the US releasing reserves on the global market will have less of an impact than imagined as supply is based on agreed forward prices.

However if such a move affects the forward curve and at the same time presages a very likely structural shift in EU energy demand for Russian gas through say a strategic “energy security pact” to import US gas and accelerate alternative LNG and from other supply sources in the Mediterranean, then this will have a harder medium-term hit on the Putin model and its economy.

Compensation for loss of State Owned Assets to Ukraine?

Murky waters and hardly mentioned so far… but assume that Ukraine,  with western assistance, is able to get safe passage out for its military personnel.

And that it seeks damages from Moscow for loss of key refineries and other assets. .. what then?

The “zero agreement” at the time of the Soviet Dissolution amicably done by the successor republics and Russia was for Russia to assume all external debt obligations but also to secure external assets – including Soviet embassies. As the takeover in Crimea is an annexation and essentially – despite Russian protestations – in violation of the Budapest Agreement it signed in 1994 that recognized Ukraine’s borders, it is highly probable that Ukraine could seek damages in almost any western country.

Summary:

1.       The nominal cost of running Crimea will be peanuts but the short term cost for Russia will reduce growth by  1/5% of GDP to around 0.5%-0.7 and lower than the 1.3% year-start forecast.

2.       Russians are feeling very proud of Mr Putin but domestic consumption will be lower as the financial squeeze from the sanctions hits home and the cost of capital rises and imported inflation rises on the back of a falling rouble.

3.       Trade will be affected – both due to the rise in country risk and delay or cancellation of cross-border projects – but also due to the significant impact on Ukrainian-Russian trade, even excluding the risk of putative economic sanctions from the EU. The Current Account could be wiped out.

4.       An escalation of tension will lead to a much higher hit on the Russian economy from the external squeeze – particularly through the financial links - but Putin's government will tap into the huge fiscal reserves to ensure growth remains at least round 0.5% of GDP.

5.       Mr Putin has in effect secured his re-election! In turn the Putin 2.0 economic model will last longer . The EU will accelerate to reduce reliance on Russian gas. Together these two factors will lower trend growth.

Ukraine, Key Political-economy Concerns and Stabilisation

There are several overarching questions and concerns that are exercising the international community, some of which include:

• How did it get to this stage with Ukraine and Russia now on the brink of war?
• What can be done to assuage Russian concerns and de-escalate the situation?
• What does it mean for the longer term for Russia’s neighbours from the Narva region in north-east Estonia through to the ‘stans in the east and even Moldova in the south-east where there are sizeable Russian populations (if not majorities as in NE Estonia)?
• And in turn for the EU that now houses several former members of the Comecon bloc and for its own energy security given the continued reliance on Russian gas and for financial centres such as London a reliable diet of Russian capital – legal or otherwise – as well as listings?
• Concurrently how can the EU utilise its very successful soft power refined during the Accession Process since the late 90s that has helped former planned economies to successfully transform into functioning, democratic, market economies?
• And the Economics: how does the putative conflict between the countries likely to affect the economies of these two countries – both over the short and medium term -  and what are the potential spillover effects onto neighbouring economies? 

As someone who has advised worked on both countries (inc. the Crimea) since the mid-90s I have my own views on these questions from first-hand experience and various writings.

In this blog entry I will focus only on the last question as it is perhaps the underlying and central cause of the current malaise. Although events over the last few months seemed to accelerate toward the end till the eventual exit of the now-former president Yanukovych, to many of us long-time Ukraine-watchers the situation had been steadily worsening with gross mismanagement of the economy and in effect a social mis-contract between the political-economic elite that are essentially the one-and-same to effectively asset-strip the state, allow rampant corruption and in effect created the disconnect and discontent that so fuelled the anger on the street.

Result: macroeconomic instability with the economy in recession since 2012 but which was buoyed previously due to demand for steel from Russia and globally, a large current account deficit, fiscal mismanagement and with FX reserves below 90-day cover.

In the last week has seen the Ukraininan currency, the Hryvna bombed and Ukrainian assets nosedived as investors rushed to the Exit doors.  The threat of bank runs has been temporarily halted through restrictions on withdrawals but the threat of meltdown remains a tail risk without external support. The necessary devaluation through an open float of the currency will push up imported inflation and further reduce real incomes and purchasing power.

Though Russia has too been hit it is sitting on a half trillion dollar reserve base inclusive of oil funds and will ride out the storm…one for another blog.

Ukraine will, however, need rapid stabilisation and to their credit the big guns in the form of the IMF and the EU are already making preparations for rapid-response loans and budget support using the experience from recent years in the Eurozone and elsewhere.

The key question beyond short term plugging of financing gaps will be whether Ukraine will be willing and able to undertake genuine reforms to ensure sustainability. This in turn will depend on how the Russo-Ukrainian spat plays out – the longer the duration, the more costly the impact and the reconstruction/redevelopment efforts.

It will also depend on political will and all the bonhomie rhetoric from some western capitals about the Ukrainian parliament being the people’s senate ignores the rather unsavoury truth  that it does unfortunately retain the reputation of being a Members Club for crooks. Whether this group in the Rada has the courage or willingness to sanction broad-based reforms remains to be seen, particularly difficult reforms to balance the fiscal books through necessary but potentially difficult political amendments to the energy deficit that has been soaking close to 8% of GDP in subsidies.  A fresh election may well be required to give the new government a genuine mandate.

The so-called Orange Revolution in 2004-05 was pyrrhic and a gross disappointment for those that saw it as a precursor of a fundamental redress of governance in Ukraine. Unfortunately, and despite significant good-will and dollops of western assistance thereafter there was little real appetite in Kiev to modify the status quo and despite some sterling efforts to kick-start reform at a regional levels.

Hopefully, the penny has dropped for many of these rent-seeking members of the elite that political stability and effective economic governance go hand-in-hand….and hopefully the sabre-rattling from Moscow will cease….and the hit on the RTS, the rouble and share prices in energy stocks in Russia may well catalyse this.

The debate on Scottish Independence and the EU

The arguments for hearts and minds of Scottish voters went into overdrive in the last few weeks, from PM Cameron’s speech, a choreographed doomsday scenario by the 3 main parties at Westminster and now the departing president of the European Commission, Manuel Barroso , putting his oar into the debate.

I have commented previously on the debate in 2012 when I looked at the country risk and macro aspects of the independence debate and pretty much all those points remain valid. The pro campaign’s economic case is on the whole somewhat weak. That said, sovereign dissolutions in Europe since the Second World War have been political in nature even though the economic dislocations were catalytic – from the dissolution of the USSR signed off by the presiding heads of the soviet republics in 1992 to the velvet divorce of the former Czechoslovakia in to the resultant Czech and Slovak republics in 1993 and the economic impact that hit and ultimately dismembered Yugoslavia.

So the debate about a currency union post-independence in Scotland, pooled fiscal policy and the like are indeed important but miss the point somewhat. Ultimately if the Scots want independence a solution will be found to these economic issues as it always is. Connoisseurs may recall the IMF’s advice to Estonia to retain the rouble in 1992 but the latter did pretty well with its Kroon that ultimately sailed into the Euro-zone in 2011.

So why my angst?

As an economic liberal I fully support the rights of the Scots for quasi self-determination that is at stake in the debate even though I don’t see the economic case for it. If the Scots gain independence and see a Norwegian style oil economy they will also suffer the boon-curse conundrum of rising real exchange rates as echoed in the 2012 blog.

And if East Germany could be absorbed into the EU through a union with West Germany despite the huge structural differences and if the Czech and Slovak Republics are now merrily back in the bosom of the EU then why cannot an independent Scotland be a successful part of the EU, of which it has been a de facto member through the UK’s membership since 1973? Does Scotland not explicitly, if not implicitly, already comply with the EU’s body of law – the acquis communautaire – which the would be accession states are busily internalising? And would an independent Scotland really not be more in line with economic convergence with the EU than say Serbia or Montenegro let alone new Member States like Bulgaria and Romania that joined in 2007?

Moreover the pro-independence waffly goal is precisely akin to the EU geek-speak of “subsidiarity” implied by granting political, economic, fiscal and administrative functions to the lowest level. So why did Mr Borosso get involved?

The on-going peace dividend following the end of the Cold War in Western Europe, at a time of increasing global technological connectivity, is seeing a part resurgence to the pre-industrial revolution sense of European regionalism over nation states – and the spectre of an independent Scotland therefore raises temperature in Madrid (fear of Catalonia saying adios to Spain proper let alone the regular feast of El Clásico football matches between Real Madrid and FC Barcelona) or the north of Italy doing the same or even the possible break off in Belgium where the EU institutions are housed.

I don’t expect the Yes-campaign to win but what chances that there won’t be demand for another one within the decade – particularly if the rest of the UK continues – at least politically if not at the street level - to project an anti EU-and an anti-Johny Foreigner mentality driven by UKIP.

The somewhat bizarre sight of Messrs Cameron and Barroso playing from the same hymn sheet is a reflection of a common political goal to stop a possible rise in demand for splitting existing EU states. Bizarre because of the Cameron-led Conservatives have been pushed by UKIP to a more antagonistic stance toward all things EU (except for the Single Market that is).

The real story in the early 21st century EU, especially post-financial crisis, will be what shape and form the EU will develop as regards further economic, fiscal and political integration – now that financial and monetary integration are so developed. And that in turn smacks of what form federalism will take, to allow so many member state countries to work as a cohesive economic group.

So one hopes the debate in October after the likely failure of the yes campaign turns to how to provide even greater fiscal autonomy in the UK, where so much remains centralized and defeats the often well-meaning structural programmes by successive governments in various sectors as there is no real incentive for reform where purse strings are almost fully based on central transfers.

And that in turn could help to invigorate the direction and vision of the EU that remains such a lodestar for the likes of those outside such as Ukraine where it – or rather the EU’s prevailing requirement of standards of democracy, governance and rule of law – remains such a beacon.

Sochi Games and Russia

There is something pyrrhic about witnessing an opening to the Sochi Winter Olympics – and the related cost of a jaw-dropping $50bn – set against the prevailing economic headwinds facing the Ruuski economy…itself set against the cyclical turbulence afflicting the emerging economies more generally.

The front cover of this week’s The Economist with Mr Putin’s face pasted onto the ice-skater with his arms aloft whilst his partner (Russia)  is on her backside was apt.

The Sochi Olympics is a showcase for a re-emerging Russia and the wonderful opening ceremony showcased the country’s history, pride and ability for grand engineering.

And yet it remains a project, a grand expensive project at that. Like the London 2012 Olympics it will no doubt inject a degree of feel-good factor in the host country. But the real feel-good driver for Russia in the medium term will remain the price for hydrocarbons that continues to fuel the Putin’s economic model.

And here we return to the fate of Mother Russia or more humbly the Russian economy. What does the Olympics signify for Russia’s ambition to be a major global player in international economics and politics?

A lot has been written about the costs and related corruption on a grand scale. Is any major tournament really that different – particularly in emerging economies? And are decisions to award say the FIFA World Cup to Qatar (without a football league and summer temperatures in excess of 40 degrees centigrade) based on a truly unbiased fair selection? The Russians will do a fab job, and with 1 squaddie for every local denizen in Sochi, it will be well-protected also.

The decision to go for a big international project is akin to a coming of age for a country and signifies confidence in itself, ability to finance the games and to organize it. Witness the World Cup in South Africa, the putative Games and next FIFA Cup in Brazil and even the slightly wonky Asian Games in India.

Mind you it will be interesting to see how many of these EM countries put their hat for such show-case events in the ring now that the US-tapering has commenced and capital has started to leave these states.

So why pyrrhic?

The success in holding an international Sports Day (or days) does not change the overall context of the challenges facing Russia and its economy.  And there are more  parallels with the Soviet Union’s 1980 Games when Russia’s predecessor USSR was in a downward economic spiral than with many of the other EMs that have seen greater structural changes and a more balanced share of wealth.

Unlike the other above-mentioned EMs (and ignoring basket cases such as Argentina and Venezuela) Putin’s Russia is more centralized, less democratic and more reliant for employment on the state when compared with the early 90s…and where the state itself is even more reliant on oil and gas revenue that account for ¾s of all exports.

Whereas the Beijing Games were genuinely regarded as confirmation of China’s return to global influence politically and economically, one hopes the Sochi Games don’t instead presage the parallels with the economic malaise that subsequently afflicted the Soviet Union. 

Russian Medium-Term Growth and Policy Implications

The IMF had barely taken off from Sheremetyevo Airport and the Ministry of Economics was already busy modifying its medium-term forecasts for 2030 down from the government’s 4.5% figure it held to during negotiations with the Fund’s and MicEc now forecasts a 2.5% trend to 2030 (the IMF 3%).

So what has happened for this stark posited change in the Russian fundamentals? And what does this mean in the short term as regards economic policy?

In practice nothing has fundamentally altered for the Russian macro-economy. The medium-term structural challenges remain the same as before whilst the external outlook is, if anything, a wee bit more positive than a few months back – both for the underway cyclical rebound of developed economies critical for external demand for Russia’s hydrocarbons and over the longer-term the expected continual rise in global demand for oil in a world that is going to have more oil-guzzling middle-income consumers.

My guess therefore is that this rather staid, less-than-rosy medium-term scenario for Russia for 2030 highlights that the economists in government are beginning to put down realistic markers for Putin Inc. and using the IMF discussions as justification for the downward adjustments.

While policy makers-cum-politicians see the long term to be the next election, the bureaucrat-cum-politician-cum-Putin chum axis in Russia means that the 2030 scenario may have more policy traction in terms of at least genuine acknowledgement of structural challenges and medium-term fiscal vulnerabilities that would be the case in many other Emerging Economies where these documents tend to be donor-driven strategies…but the real test will be if there are credible measures to unlock the Russian growth potential.

Recent monthly and Q3 data have not changed the expected growth trajectory for 2013 that is now more likely to be closer to 1.7% rather than the 2-3% range anticipated just a month or so back.

Nominally the economy is at full pelt (the output gap is close to zero) with unemployment close to a record low. This in turn limits the potential lasting impact of policy easing on either the monetary or fiscal fronts without risking cost-push inflation.  And why external agencies ranging from the IMF to the EBRD are helping to push the message that the adjustment requires a significant shift on the supply side where Russia does so badly relative to EM peers: from labour market reforms to ease of doing business.

So what does augur for policy?

1.  Fiscal loosening to boost Investment in 2013-14 is likely if external demand remains weak. This may involve fancy footwork to comply with the new Fiscal Rule through off-budget operations or (dodgy) securitisation of loans from the reserve funds to State-Owned investment projects.
2.  No change in the monetary stance that is shifting toward full-fledged Inflation Targeting (IT) by 2014-15
3. The policy rate will remain unchanged: i) for the simple reason that the central bank recognizes that the transmission channel remains weak for it  have any real impact on lending ii)  inflation remains above or close to its headline inflation target and iii) given tight labour market and high capacity utilization 

Serbia’s Incomplete Transition and Country Risk: Mind the Gap

Serbia is one of those CEE States that is an enigma.  A Serb friend who was in both the Federal Yugoslav government and in the post-Yugo declining rump into the Serbia bit once Montenegro had gone its own way in 2006 reminds me regularly that Yugoslavia had negotiated 80% of the acquis for EU Membership during the 80s.

And as a kid growing up in Berkshire, I would often play football in the park against Yugoslav kids so travel was not an issue for a country seen as a half-way house breaching both sides of the iron curtain.  Indeed taking the train from Yugoslavia to Trieste for your jeans to flog off back home or to proudly wear was essentially the stamp of adulthood!

Fast forward three two decades.

Whilst the grand air of the capital of the Balkans remains (even the Slovenes come to party at weekends in Belgrade) in substance a lot has changed.  Aside from the Cyrillic alphabet and proximity of languages there are similarities – but also key differences – with another city coming to terms with loss of empire, Moscow.

For a start Belgrade lost a major trump card that Moscow retained by not retaining its high-calibre Federal civil service. Yes the EU annually rubber-stamps that the Serbian government has good administrative capacity, but drill down into actual mechanics and you’ll find a lot of bright well educated cadres but lack of a joined up government. Meaning decisions often lack clear strategic thinking or where – as for say for macro-stabilisation there seems to be some semblance of grey matter – alas it is often on the back of external conditionality (DC or Brussels).

And there tend to be  a lot of governments… where each new minister brings his mates along for key positions in the civil service. Meaning a continuous dilution of capacity and institutional memory in the ministries.  Again, not so in Moscow.

Russia remains a good risk but faces real challenges of how it reaches the nirvana of a broad-based economic landscape that often escapes resource rich economies. Serbia on the other seems often to be on the cusp of another macro shock, often due to failure to keep to terms on the previous stabilisation programme, and lacks any real resource endowment.

Whilst CEE watchers no doubt review the macro numbers and compare with other EM economies, what they often miss is the transition gap it still has to overcome, certainly relative to the CEE economies in the EU.

Although Serbia underwent a rapid transformation in the immediate period after the ousting of Milosovic in 2000 (cherry picking reforms that had worked elsewhere as someone from the World Bank once said) there has been not much reform since the early 2000s and Serbia rode the long cyclical wave of benign global and CEE growth when it was all about convergence plays.

Whilst the new EU Member States had to go through (some) hoops, Serbia had no such external anchor. And whereas the likes of Estonia or even Slovenia saw themselves very much in the western European family (if only to get away from the Ruuski bear), Serbia has until recently remained very agnostic if not plain disinterested (again the post-empire blues that also affected Britain’s initial two-fingers at the EU before its eventual entry in 1974 – although the fingers haven’t quite descended!).

Result: an economy with enormous structural issues, a bloated civil service, massive unemployment, fundamental issues for the business environment, an uncompetitive trade sector and economic growth that has relied on domestic absorption, often on the back of credit – where a lot of the bank credit is owned by a coterie of banks from the Euro-risk economies of Greece, Austria, Italy and to a lesser extent France – and where there is a high FX-debt profile through Euro-isation of loans.

Can Serbia manage the transition and macro-fiscal challenges? I helped put together the EU’s Emergency Budget Support for Serbia in 2009 and worked on budget reform prior to that and  whilst I have confidence in the Central Bank that sits on reasonable reserves I am less convinced about political will beyond short-term fixes on the fiscal side.

The country’s metrics on transition are often only beaten to bottom by Kosovo or Bosnia. I am also not entirely convinced about the magnetism of the EU despite promise of greater aid flows. Serbia is surrounded by the EU so has no choice but to integrate although it can affect the speed of convergence. But one wonders if the spectre of the EU of the 2020s that is moving toward a more German-led model of an integrated federation will be palatable to the Serbian politicians – although the same could be said for the Hungarians or Romanians.

But at least the latter are in the EU club. And with it have the implicit EU-put that entails through soft EU loans or via Structural Fund transfers.

What does this mean for Serbian investors and Serbian country risk?

1.       There is a fat tail risk on the downside, despite recent IMF-led efforts for fiscal consolidation announced last week and the likelihood of another Eurobond issue or putative loan from Manchester City…sorry UAE. 

2.       From past experience, the fiscal plan will be implemented in part but then fade away 

3.       With the real exchange rate still 1/5^th overvalued and continuing current account pressure there is a risk  of further devaluation that the authorities will want to prevent from becoming excessive, even with the reserve buffer which in turn will feed into higher imported inflation

4.       The US taper-risk will lead to EM differentiation and which will affect Serbia dis-proportionately when it happens in 2014. 

5.       Getting back to the tube-metaphor, Serbia risk is under-priced. Mind the Gap.