Is the Honeymoon on Ukraine over?

Is Ukraine lost? Again? Is the social contract between state and citizens fundamentally flawed?

We are now well past the "honeymoon period" of the post-Maidan street protests that ultimately led to the rather fast departure of the then president Yanikovich, who fled to Russia in 2014. Has the halcyon beacon of the EU helped to reshape the rampant political and economic corruption?

A spate of ministerial resignations at the start of 2016, an economy in dire straits and with a huge external debt overhang, having lost up to a third of its economic base from the loss of territories and ongoing conflict with Russia and being supported by western-supported IFI packages including dollops of soft EU macro-financial assistance, having witnessed a false dawn with the so-called Orange revolution in 2004 and the Maidan of 2014, which way reform?

Before I answer these questions, I invite you to view this video of a recent Cabinet meeting - it is fairly X rated... and unlike anything many who have attended any Cabinet meeting anywhere will have experienced. And it gives a flavour of the difficulties of copy-pasting a reform agenda without genuine political will and huge conflicts of interest without a fundamental reform of the current political system.

Many will have recognised a certain Georgian, Mikheil Saakashvili,who was former president of Georgia and now part of an "A Team" of former Georgian bureaucrats, fluent in Russian, brought in to help support the reform effort and given Ukrainian citizenships jousting (with glasses of water) with the Minister of Interior responsible for the police and security services,  himself an "oligarch". Oh yes, the Minister of Finance is originally American and the Minister of Economy - one of the key "reformers" Lithuanian-Ukrainian.

Now back to the questions. 

My starting point is to look at the data. And the picture is mixed. The odd-but-thus-far working relationship between the Prime Minister and the president has led to macroeconomic stabilisation - supported by strong western support - and important steps to liberalise the economy and reduce red tape. Global Governance indicators (that basically hoover up all available country risk indicators published) do show that Government Effectiveness has risen as shown in the figure below.

But Rule of Law?

Not so good - in fact its even worse. And the picture is the same when looking at Regulatory quality or perceptions of corruption. 

Ukraine’s minister for economic development and trade, Aivaras Abromavicius, announced his resignation in early February, citing corruption levels in the state.

“Neither me, nor my team have any desire to serve as a cover-up for the covert corruption, or become puppets for those who, very much like the ‘old’ government, are trying to exercise control over the flow of public funds,” effectively saying what many have been complaining about, that there are too many bent officials trying to continue their corrupt ways - and of more significance, that things aren't really getting any better.

There is now a real political risk that the government will fall, possibly through a vote of no confidence. Polls have given it approval ratings of less than 10%. And there is scant evidence, despite a flurry of ad-hoc measures, that there is a clear roadmap of reform  - which is worryingly familiar territory given previous false dawns and stabilisation plans effectively written at the IMF.

Despite a huge groundswell of popular support in what remains of Ukraine for a pro-EU direction of travel, it is not an EU candidate country forced to go through hoops and checklists to comply with the EU body of law, the acquis.  

And the EU's efforts beyond financial help has led to little material effect thus far. The European Commission is great if there is a natural disaster that requires fast response or when there are longer-term structural adjustments through sector plans and the like as witnessed in the enlargements of 2004 onward for the former central and eastern European economies. Less so in dealing a country that is in need of a mix of quick-win reforms and deep reform, often painful for vested interests.

It is perhaps too early to assess if the social contract is broken. But walk past the parliament in Kiev, the Rada, and the side street and its car park are full of Bentleys, Rolls Royces and Porsches when the average salary is a few hundred dollars. 

The disconnect between the elite and the rest is the effect, but the fusion of political and economic control in the hands of this narrow elite that is an unfortunate legacy in most of the ex-Soviet space is THE core root cause. 

What then are the choices for the West? One for another day, but ultimately, the sad truth is that ultimately, political ownership for reform cannot be imposed. On the other hand, if there is a serious set of governance concerns and dysfunctional system that effectively limits democratic voice and accountability then a further Maidan cannot be ruled out. For the West, the EU and the US, we have to be more sanguine and realistic of expectations, but to have more targeted conditionality - political and economic. 

QE2, Pyrrhic Monetary Policy and a Rise in Inequality

Are Central Banks running out of firepower?

And is the second bout of QE or QE2 leading to both an arms race in competitive devaluations and more worryingly, actually accelerating inequalities?

With policy rates close to zero and years of money printing under the snake-oil terminology of "Quantitative Easing", moribund fiscal stances and private sector balance sheets in rehab zone, what more can central banks do to kick start inflation, if not growth trajectories?

No sooner had I suggested that I was against-trend in forecasting a baseline of no change in UK interest rates this year than we're faced with a change in mood music across the developed world and forecasts of more monetary easing or QE and even negative interest rates set by central banks.

Whilst the aim is to get cash to shift to production, investment and consumption by effectively taxing cash balances held by banks, in reality we are seeing plenty of unintended consequences:

1. a greater incidence of financial and asset bubbles as cheap dosh chases higher yields - from property to stocks and financial assets (the short term excluded). This most will go with.
2. this in turn is I would argue actually widening the gap between the haves and the have-nots, be it within countries and globally.
3. for another day...a rise in competitive devaluations: a falling Yen, a falling Chinese currency and others will follow - from SE Asia to commodity producers. 

We hear plenty of research analyses that highlights a global phenomena - from the US through to the emerging economies - of an increasing inequality of wealth creation and ownership to a narrow group of economic players. Be they the kings of Silicon Valley, robber barons in Eastern Europe or the industrial titans of Asia, the pattern is uniform.

Oxfam's recent report came out with stark figures by countries but a headline one that is numbing to review - 1% of the global population have a wealth greater than that of the rest of the 99% in the world. The same conclusion came out broadly in the OECD's recent 2015 paper and notes "Income gaps are even more striking when it comes to the highest earners. In the 1980s, the top 1% of earners commanded less than 10% of total pre-tax income in every OECD country bar one. Thirty years later, their share was above 10% in at least nine OECD countries and above 20% in the United States."

 There are fundamental reasons in terms of basic governance, fundamental democracy and rule of law that explain many of the fissures in developing and emerging economies that prevent citizens from having rights to education, restricted access to financial capital and in some cases, as we see in north Africa and middle East,  access to education but limited opportunities to find employment. But we also see great strides by countries such as China and SE Asia on the back of growth and growth-based economic models.

Rising inequality is somewhat counter-intuitive when we think of the global reforms since the nineteenth century and following the two world wars, the rise and fall of communism and the rise of the welfare model in the post-war period. And whilst it may be less of a relative issue in the EU, rising inequality is a factor that may explain the political counter reactions from the anti-capitalist Occupy Movements in Wall St and the City as well as the drama that is the US election cycle. 

What are the policy lessons?

• The OECD's focus on structural issues - gender, health, education et al - is the classical development tool kit. They are longer term.
• A clear lesson in today's 24-7 world is that interconnectivity is here and exponentially increasing- be it in ideas, news or alas, contagion - financial fear and medical as we witness for the Zica virus. The corollary of this that international co-ordination cannot be ignored - be it in terms of global efforts to tame disease or economies. It also means sector and country risks are subject to a wider set of risks.
• Loose Monetary Policy is ultimately pyrrhic without a looser fiscal stance in an environment, as a century before, to take up slack. 
• Openness to innovation and growth and allied reward for risk takers cannot be compromised - but it needs to be complemented by efforts to ensure equity and fairness so that "everyone eats a bigger slice of a bigger cake"  - moves in the EU to tackle the Googles, Amazons and Cafe Neros of this world on dodgy tax affairs is part of this.

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.

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.