Why Russia Doesn’t Deserve an ‘A’

Published in The Moscow Times
By Andrey Borodin

Around the globe, there is a heated discussion among policymakers, bankers and analysts about the role of the major credit ratings agencies. This discussion was provoked after we witnessed their incompetence in rating collateralized instruments in the early 2000s. According to the U.S. Financial Crisis Inquiry Commission 2011 report, they were “key enablers of the financial meltdown” in 2007 and 2008. The discussion has been reignited recently by Standard & Poor’s decision to downgrade the U.S. credit rating. Continue reading

Why did this seem like a good idea?

In recent days, Greece, followed by Belgium, France, Italy and Spain, have banned short-selling of the shares of banks and other financial companies, receiving in response almost universal condemnation by analysts, fund managers, academics and media commentators.

So why on earth did they do it?

The symptom they have responded to is recent extreme volatility in bank stocks, around a sharp downward trend.

The underlying cause however has been investor concern about the credit worthiness of much eurozone government debt, which is held within the banking sector, and has previously been highly rated within the banks’ capital requirements. Recent action by the ECB to support the Spanish and Italian government bond markets led to brief rallies in these markets, but has not calmed investor fears that sooner or later the banks holding these bonds will need to write down their value, as has already happened with Greek debt.

Hence the investor rush for the exit.

For the authorities to try to stem this rush by banning short selling seems to display a horribly worrying understanding of market – and particularly hedge fund – mentality. Continue reading

Fed Reserve vote of no confidence in US economic recovery!

This week the US Federal Reserve announced it anticipates holding its official interest rate, the target federal funds rate, near zero, at least through mid-2013. The official statement read, ‘To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee currently anticipates that economic conditions-including low rates of resource utilization and a subdued outlook for inflation over the medium run-are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.’

What on earth were they thinking when they made this announcement? Presumably it was designed to reassure investors that they would continue to supply cheap liquidity for a prolonged period? However, well intentioned it may have been, it appears only to have confirmed how sick they perceive the economy as being!

As I have noted before, the Keynesian principal of government deficits rising as the economy slows down, to ‘pump-prime’ and re-instigate growth, has clearly failed over the last 4 years in the US, the UK and the eurozone. The underlying problem in these countries has continued to be national spending in excess of income, whether by individuals, businesses or the government. And low interest rates of course continue to encourage spending – that is what they are designed to do.

For a sustainable solution, everyone in these countries actually needs to spend less – or more accurately, a smaller percentage of their income. What would encourage this would be higher interest rates, not lower. Continue reading

The EU – Cloud Cuckoo Land

So… the European Central Bank is buying Spanish and Italian government bonds this week. Whilst that appears to have given short term relief to the bond markets, to me this is simply prolonging the inevitable agony that is bound to result eventually from continuing to extend further credit to nations that are already, quite clearly, broke.

The ECB has made it clear it is intervening in this way with extreme reluctance – it was never designed to be a lender of last resort to individual governments within the EU and it does not have any political mandate to take on such a role. But apparently it can’t bear facing the bloodbath that would have ensued in the short term had it refused.

The European Union was set up with very clear rules stating that the debt-to-GDP ratio of member states should not exceed 60% and the deficit in general government finances should not exceed 3% in any year, with the additional requirement that general government finances should be close to balance or in surplus in the medium term. Yet Eurostat figures for 2010 report that the Irish budget deficit was a whopping 32.4% of GDP, the Greek budget deficit ratio was 10.5%, and Spain’s was 9.2%. On the other measure of fiscal prudence and stability, the Greek debt to GDP ratio was 142.8% whilst Italy recorded 119.0%, although Spain came in only just above the allowed limit at 60.1%.

So why have the central bankers capitulated and allowed these ratios to grow dramatically above the prescribed limits? In many cases, the real explosion in deficits came after the financial crisis, and was permitted based on the Keynesian view of public spending working in a counter-cyclical fashion.

The trouble is that the expanding deficits have not proved to be short term, and have not obeyed the Keynesian model of bringing forth the growth in output and tax revenues that would be necessary to bring them back into line with the Treaty rules. Continue reading

China – stuck between a rock and a hard place

For many years now China and the US have been playing a dangerous game – with short term advantages to both nations, but long term risks – as the fundamental imbalances between the nations have grown, to a point where they now seem unsustainable, leaving both countries with choices between a selection of unpalatable alternatives.

The game has been chronic undervaluation of the renmimbi. From 1997 to 2005, the renminbi was kept at a fixed rate of 8.27 yuan per US dollar, but since July 2005 the currency has been fixed in a narrow band (currently 0.5%) around a rate announced by the People’s Bank of China, fixed with reference to a basket of world currencies.  This did allow the renmimbi to rise more than 20% against the dollar from mid 2005 to late 2008, but with the onset of the global financial crisis, Beijing halted the currency’s gradual rise until June 2010, since when it has once more allowed a gradual appreciation. Continue reading

How the US Debt Deal Affects Russia

The recent deal to raise the debt ceiling and avoid an unprecedented national default in the US brings significant global changes. Firstly, the world will no longer see the US dollar as a strong safe-haven currency. The dollar has now gone down to the level of other currencies, which means that many may start to question its status as the main reserve currency.

The US debt deal is helping to resolve the situation in the US only temporarily. Unless the world markets see that there are significant adjustments to the way the US economy is run, the trust in dollar will not be restored.

We all know that when America gets a cold the rest of the world gets fear. In Russia the fever will be felt immediately. Its economy remains much dollarised. An average Russian person still believes that the dollar is the most powerful currency in the world. Most people prefer dollars to rubles, just like 15-20 years ago. Even though all official transactions now are now done in rubles, the dollar still plays a very important role for black and grey market payments.

Russia’s dependency on the US dollar has been subject of a long-standing dilemma for the Central Bank of Russia. The currency policy of the Central Bank has been unpredictable so far. The exchange rate between the rouble and the dollar is not free floating. Even though the Central Bank does not acknowledge this, the exchange rate is adjusted. For these reasons, it is much more important for the Russian economy to know what the Central Bank thinks about the dollar, rather than what the world thinks about it.

I would struggle to give any assessment as to what prospects the rouble as currency faces, mainly for two reasons. Firstly, the current policy of Central Bank does not allow for a free float of rouble. Secondly, the Russian economy is very dependent on commodities prices. Currently the income from natural resources is around 60% of the total income of the Russian economy, while last year it was 50%. This increase is a worrying trend. Another worrying trend in the Russian economy is its dependency on the oil prices (currently the price is $115-120). A decrease in oil price may lead to a sharp decline in the rouble exchange rate. This demonstrates that rouble is not a strong currency and therefore strong dollar and stable US economy is so important for Russia. Continue reading