BRICS and eurozone crisis November 2, 2011 Samir Saran, Vivan Sharan

http://indrus.in/articles/2011/11/02/brics_and_eurozone_crisis_13192.html

With their growing financial and diplomatic clout, the BRICS countries should enhance their coordination to leverage the eurozone crisis to deepen global financial integration.

The rise of the BRICS nations as new epicentres of economic activity in the rapidly evolving world order has been simultaneously accompanied by a steady decline in the relative economic strength of many of the member countries of the eurozone.

The single currency union has become essentially a two-faced beast. A North–South divide in economic fortunes is clearly visible within Europe (and the irony of this is probably lost on most Europeans). It is time for the leaders of this grouping to recognise the fact that the major rebalancing and recalibrating actions that are urgently needed within the economic and monetary union must also address the concerns of external creditor nations such as those within the BRICS grouping.

After much introspection and procrastination, the European leaders managed to pass a controversial but necessary deal on Greek debt. The deal, which calls for a “voluntary” cut on a nominal 50 percent of private sector investments of over 450 financial firms to reduce total debt burden in the economy by 100 billion euros, is a desperate attempt by policymakers to stymie the relentless bouts of selling pressures on Greek debt.  Although given the circumstances, it was extremely important for the eurozone to signal some form of cohesive multi-stakeholder action to the financial markets, the deal is built upon ambiguous foundations.

The private sector has voluntarily decided to take these ‘haircuts’ and at the same time banks have agreed to increase capital reserves to 9% to shield against an imminent market collapse in Greece. This translates into tremendous pressures on banking institutions, without much positive effect on the bond markets, with Greek bonds still yielding unprecedented rates of interest. It is clear that the projected reduction of Greek debt to GDP ratio from 160% now to 120% in 2020 is not impressing bond traders.

The European leaders have announced that they seek to increase the size of the European Financial Stability Fund (EFSF) from its current capacity of 440 billion euros to over a trillion euros.  It is not clear how they intend to do this, and whether a trillion euros (approx.) is the amount they consider to be sufficient to counter the effects of possible contagious sovereign debt defaults and banking crises in member countries. While these leaders attempt to keep kicking the can down the road with respect to how they manage the myriad financial crises that are evolving in southern Europe, it has become increasingly clear that the problem is too big to be handled without outside help.

The Chief Financial Officer of the EFSF recently told a Brazilian newspaper that his colleagues are “pleased” to see BRICS countries starting to invest in the EFSF. The composition of the investments into the EFSF is not public, and therefore there is no real way of knowing how much each of the BRICS nations have contributed to the fund so far. The EFSF was originally set up to raise money for the Portuguese and Irish bailout packages through the disbursal of loans. Although the Fund has nearly risk-free credit ratings by all the major rating agencies (AAA by Standards and Poor’s and Fitch, and Aaa by Moody’s), it can be argued that investing in Greece’s sovereign debt is a far riskier proposition for creditors to the Fund.

Many of the BRICS nations are already heavily invested in the euro. The central banks of China and India hold approximately 25% and 20% in eurozone bonds respectively and are therefore not likely to spend much more of their international reserves buying into a now suspect currency. However, much like Brazil, which is allegedly considering investing into euro debt via its Sovereign Wealth Fund (which allows greater risk taking) rather than purchasing debt through its international reserves, the economies of China, India and Russia could soon follow suit.

Given the volumes of trade between the euro zone members and each of the aforementioned nations (China surpassed the U.S as E.U’s largest trade partner in July) along with hefty direct investment flowing both ways, it is certainly not in the interest of any of the stakeholders – to let the euro collapse. The involvement of countries like China, with immense amounts of liquidity, does not fail to inspire market confidence as was seen last year in July, when China announced that it would purchase a billion euros in Spanish debt. The bond auction was oversubscribed and lead to a turnaround in market confidence in Spanish debt even though China only committed 400 million euros.

Keeping in mind their leveraged bargaining position in current circumstances, the BRICS nations should coordinate their positions and assert themselves while negotiating investments in eurozone debt. Although the BRICS nations have a diverse set of agendas and priorities, it is not hard to see a future where there is greater coordination within the nations in the grouping, especially between geographical neighbours Russia, China and India, in order to deepen global financial integration and reverse the Western narratives that have dominated the larger economic realm for the past century.

At the Sanya BRICS summit in April, the leaders put on record that the “international financial crisis has exposed the inadequacies and deficiencies of the existing monetary and financial system” and that the BRICS nations support “the reform and improvement” of this system. In order to support the troubled European economies, the BRICS countries need to devise a formal set of pre-conditions for granting bilateral loans and investing in various bailout funds. Perhaps these could be centred on some basic premises such as further trade liberalization, increased access to intellectual property and perhaps they can even be self-righteous enough to demand more friendly immigration laws.

The Europeans will no doubt be faced with some hard choices. They have to be careful to juggle two contradictory imperatives – that of enlarging existing regulatory capacities in order to strengthen and deepen European fiscal, monetary and political integration, while at the same time accepting the inevitable growing interdependence with external nations.

If the evolving debt crisis in the eurozone is viewed through a deterministic prism, it becomes immediately apparent that panaceas such as debt write downs only offer short term relief to the markets as long as structural imbalances persist. In light of this, the Europeans will be hard pressed to look for a multipronged approach to dealing with the existing problems of their southern peripheral nations.

The glory days of Western credit and forced fiscal reforms in Asia and other ‘south’ countries are far behind us, with hegemonic Bretton Woods era relics such as the International Monetary Fund struggling to find its ‘traditional’ relevance within the new political and economic realities. Although it is in no way certain that the balance of power will completely shift towards the emerging or recently emerged nations such as those in the BRICS, as they are grappling with internal problems of their own, one can be relatively certain that the growing degrees of independence – both from Western policies and from Western demand --  will provide the perfect platform for increasing economic leverage through investments in equity and debt as well as direct investments. Europe has few options left but to align economic expectations with those of the BRICS. The question that still looms large is whether there is enough political unity and substance in the grouping (BRICS and other emerging nations) to make the right kind of bargains.

Oil Supply Routes in the Asia Pacific: China's Strategic Calculations

http://orfonline.com/cms/sites/orfonline/modules/occasionalpaper/attachments/OP24_1316237026710.pdf

A Speech in Moscow

Re-thinking the New Monetary Consensus - Sharing Lessons from History

Good Afternoon. It is a privilege for me to be addressing an eminent panel such as this.

The financial crisis has caused a significant amount of confusion in the minds of policymakers. The highly integrated financial system dictates that policy experiments made in one country have rippling effects in others. And therefore, the theme of this discussion – “the possibility of coordinating positions” is extremely important in today’s context.

Given the current state of the US economy – with no job growth last month, the local positive impact of the two rounds monetary easing is in serious doubt. At the same time, there is no denying that QE1 and QE2 have had a profound global impact and the extra liquidity has still not been absorbed by the global financial system. The world as I see it now is cleanly divided into two parts. Western economies like the US, and EU are monetizing their debt and yet not experiencing any signs of inflation (and desperately clutching at straws!) while BRIC and other middle income and emerging economies are facing stubborn inflationary trends.

At the outset of course, it is not an unusual phenomenon for advanced economies to experience low inflation rates. The stabilization of output volatility with low inflation; over the past two decades before the recent crisis, had been termed “the great moderation” for precisely these attributes. A fair amount of credit had been given to central bankers – and the evolution of central banking for moderating the volatilities associated with economic cycles and trends. In fact since the 1980s, average inflation worldwide declined from 14 percent in the early 1980s to 4 percent in the early 2000s. Industrial economies achieved a reduction in inflation from 9 to 2 percent, while developing economies brought inflation down from 31 to 6 percent.

Central banking has indeed come a long way from the “stop and go” mechanisms that were used to manage cyclical price trends. With the adoption of tools like inflation targeting – central banks in advanced economies, at the outset, seemed to have done a good job of managing inflation. As a result, most of the world achieved a working consensus on the core principles of monetary policy and how this policy can be used to manage inflation expectations. This general agreement amongst economists by the latter half of the 1990s – has been termed the “New Monetary Consensus”.

It can be argued that the genesis of the consensus was in the 1970s – with Milton Friedman’s assertion that “inflation is always and everywhere, a monetary phenomenon”. The first bit of evidence they gathered to prove this was that across the world long term sustained inflation is always associated with excessive money growth. Thereafter they showed that control on money supply is both necessary and sufficient to control inflation trends.

Even though the monetarists did a good job of accumulating evidence and building credible theoretical foundations – the actual basis for the Monetary Consensus, and the way monetary policy is conducted in many countries today, was achieved because of Paul Volcker – the Chairman of the Federal Reserve in the turbulent 1980s. Volcker was dogged in his pursuit to tame inflation – and was willing to forgo creation of jobs and economic growth to achieve his cause - by associating himself closely with the key monetarist idea – that inflation could be controlled without imposing price or wage controls. He let the short-term interest rates rise dramatically and the US economy immediately went into recession. Public support for inflation control and the political support from the incoming Reagan administration were key elements that let Volcker continue his experiment with the US economy. By 1984 he was able to control inflation with causing a dramatic drop in economic output.

It can be argued that the stubbornness and sacrifices made by the US government, the Federal Reserve and the American society as a whole – together contributed to the successful anchoring of inflation expectations in the country. It is also important to remember that this happened within the context of an already developed economy with efficient policy transmission mechanisms. Alan Greenspan took Volcker’s inflation sensitive policymaking trends forward into the 1990s and beyond – and simultaneously the world came to achieve the New Monetary Consensus which emphasised the control of inflation at all costs.

A result of this renewed focus on inflation has been the introduction of “inflation targets” by countries around the world. Starting with New Zealand in 1990 and Canada the year after, countries around the globe started declaring explicit inflation targets in a hope to anchor people’s inflation expectations. The European Central Bank is one of the bigger monetary authorities which declares inflation targets these days – but this phenomenon has also caught on in smaller emerging market economies.

The Central Bank of Russia has also published many documents over the last couple of years that have indicated an imminent switch towards an inflation targeting strategy. In its most recently published Guidelines for Single State Monetary Policy, the CBR has explicitly and repeatedly stated that both inflation targeting - and less interventions in the foreign exchange market are on the immediate agenda.

I quote from the CBR’s document: “The exchange rate policy to be pursued by the Bank of Russia in 2010-2012 will aim to cushion sharp fluctuations of the rouble exchange rate against the major world currencies. The Bank of Russia will seek in this period to create conditions for the implementation of the monetary policy model based on inflation targeting by gradually scaling down its interventions in the rate-setting process.”

I do not think that a completely free floating exchange rate is a viable or credible strategy for Russia as long as oil remains a dollar denominated resource; but the switch to inflation targeting is definitely on the cards given that there seems to be little by way of opposition to the idea in Russia. Furthermore, there seems to be a distinct attempt by the CBR to try to present its monetary policy as a modern one to foreign investors.

On some contextual analysis of inflation targeting and the idea behind central banks being solely responsible for managing inflation, there are many issues that I feel the CBR should find worth considering and indeed, many of these have been faced by the central bank of India – the RBI. Hence I would like to share our concerns in this regard.

According to monetary policy theory, central bank independence – both operational and organizational is a prerequisite for inflation targeting. That is independence is a prerequisite for establishing credibility. In India, in the earlier part of the last decade, the RBI was considering switching to an inflation targeting regime. As is usual in countries like ours, a few good men from the International Monetary Fund were trying to drive this shift in policy.

However, due to the dovish pro investment policy followed by Alan Greenspan under George Bush, the RBI struggled to sterilize capital inflows. As a result the exchange rate for the rupee came under immediate threat - and the government faced protests from the exporting sector. (By the way – one of our biggest exporting sectors – the textile sector, employs the 2^nd highest number of workers after the agriculture sector)

The policymakers in the RBI realized that there was an inherent contradiction in wanting to project independence and using government guaranteed bonds to sterilize the inflows to control the Rupee’s sharp appreciation. Consequently the RBI abandoned aspirations of switching to inflation targeting. Given that Russia faces similar problems managing capital inflows, in my view it makes little sense to switch from discretionary policy to explicit inflation targeting.

The second major challenge that advanced economies in the developed world are experiencing with regard to inflation targeting is the failure of such policy to overcome deflation. After all, it was only recently that the Federal Reserve went about injecting liquidity into the American economy in a frenzied fashion due to deflationary scares. Even after almost 3 trillion dollars were indirectly injected into the American economy – inflation is still very low. There is even talk of the US becoming more and more like Japan everyday – inadvertently caught in a long term liquidity trap.

Another problem is that countries like Russia and India are structurally prone to more inflation than Western counterparts – and it is the volatility of inflation that is to be more seriously countered rather than overall inflation. It is significant to note that inflation targets in various advanced economies are rather arbitrarily declared at low levels – between 1.5 to 2.5 percent in nominal terms. The structural set up in Russia and India dictate that the optimal levels of inflation lie between 4 and 7 percent. 

In countries like ours, policy transmission mechanisms are not as efficient as in advanced economies in the West. The ECB has estimated that there is about a 4 quarter lag between policy change in the form of interest rate movement and expected outcome in the euro zone. It would be overly presumptuous to think that the transmission lag in Russia would be any less than in the euro zone.

Furthermore, much like India, Russia is a country where the existence of asymmetric and imperfect information in the financial markets is a well known problem – therefore invalidating, the efficient market theories on the assumption of which the New Monetary Consensus style of central banking has evolved. This clearly causes more contradictions for inflation targeting regimes.

One of the projected advantages of inflation targeting is increased accountability of the central bank. However, on careful observation of Western models, it is certainly not obvious that accountability has increased. The recent market interventions in the sovereign bond markets by the ECB or the complete disregard by the Federal Reserve of accepted regulatory and supervisory roles in the mortgage markets - leading to the collapse of the financial markets, certainly do not inspire confidence in such theoretical models.

For Western central banks, these turbulent times contrast sharply against the extraordinarily smooth period they enjoyed in the years before the crisis. With inflation low and real economic growth strong and stable, and risk spreads in financial market increasingly compressed, managing monetary policy had become an unexpectedly easy task. As we are all aware the situation in the West has now reversed. As Mr. Nikonov pointed out in his opening statements yesterday – the three most unstable zones in the world today include the US and the euro zone!

Central Bankers in the West face similar challenges to those that were experienced by less developed financial systems in the past – that is they are not longer finding it easy to separate monetary and fiscal prerogatives. The precarious economic situation in the US and euro zone dictate that the Federal Reserve and the ECB are increasingly forced to make fiscal decisions. This is ironic given that the central tenets of the New Monetary Consensus demand that monetary and fiscal management of economies be conducted separately. 

It is clear to me that monetary policy has reached a crossroads. The question now is whether the inherent hypocrisy of central banking policy of the West is recognized and the New Monetary Consensus re-evaluated by the relevant stakeholders; or whether Western models of monetary policy will continue to be projected as a panacea for inflation throughout the globe – much like following the Washington Consensus was projected for decades by institutions like the IMF and World Bank as the only way for policymakers in the developing world - to ensure positive and sustainable economic growth trajectories in their respective countries.

In the end I would like to say that it is time for Russian policymakers to ask themselves some hard questions:

Is the signalling value of projecting a consistent and conservative monetary regime to their countrymen and perhaps more relevantly, to the international investing community - truly worth sacrificing logical and optimal adaptive policy for? Do Russian policymakers believe that the discretionary learning by doing policy responses to supply and demand scenarios followed in both our countries for many years now, need to be reversed? And do they believe that explicit policy rules should be followed without paying attention to history or to the observable changes in the global financial and economic architecture?

The problems faced by monetary policymakers are paralleled in the other areas of economic and financial policy making. And therefore I feel that it is the right time for us to think seriously about alternative policy making strategies to those advocated for the last few decades by various Western stakeholders. In this regard – I feel that there is enormous scope for India and Russia to coordinate positions and adopt reasonable and practical monetary and fiscal stances rather than subscribe to theoretical and rigid policies promoted by the US, EU and various inherently interventionist international organizations.

Ladies and gentleman, I thank you once again for giving me an opportunity to express my personal views, and the view from India, to this very important forum.

Whose Debt is it Anyway?

On Tuesday, the United States Senate passed the budget deal, averting what could have been, the first debt default in its history. The debt bill has now become a law, with the Senate voting 74-26 in favour raising the nation’s debt ceiling by almost 2.5 trillion dollars. This is the largest increase in the debt ceiling ever. Indecision on increasing the limit by 2^nd August would have created an apocalyptic scenario for the financial markets, and therefore the signing of the deal by President Obama, was largely anticipated.

Although the successful signing of the deal has lead to widespread relief in the country, the looming question of how the close to 15 trillion dollars in accumulated debt is ever going to be repaid still remains unanswered. The accumulated debt now adds up to approximately 50,000 dollars per person – and the markets have not failed to take notice of the unsustainable trajectory that the economy has been propelled into. The S&P 500 index plunged over the last two days, recording negative gains for the year on Tuesday. The plunge of over 100 points from the year highs is indicative of the shift in market sentiment. 

Until a week back, it was uncertain whether the financial markets were in fact in a slow summer phase – much like last year, where gains were hard to come by. Many market bulls dismissed the whole double dip debate pointing towards the strong performance by equities, especially blue chip stocks. However, with the major indices, all turning their backs on these eternal optimists over the last few days, exacerbated by the flimsy nature of the debt deal, few would have the courage to call the anaemic 1.3% growth rate in the second quarter signs of a recovery. This is ironic given that at the beginning of the year, the situation was assessed to be complete opposite – few would dare to call a bear market in 2011!

The total agreed upon cuts in discretionary spending add up to around 917 billion dollars over the next 10 years. This is unequivocally seen to be a token amount, considering that the country is going to spend 817 billion dollars in discretionary spending over the same period of time. Continuing along this trajectory, social security programmes will be bankrupt by 2036. If interest rates go up, the day is not far, when the United States Government will have to pay a trillion dollars a year, just to repay its debt obligations. This will exceed entitlement payments, as well as defence spending.

Over the past year, Obama has been constantly emphasising that economic growth is America’s ticket out of the current gloom, and justifying discretionary spending to create momentum. Having spent the allocated money for the second round of quantitative easing, it is not clear what the drivers of this envisioned growth are going to be (a third round of easing perhaps?). Manufacturing data released on Monday indicated that the economy is slowing considerably, with numbers being lowest since mid 2009 levels. The job market is not picking up pace either, and with marked slowdowns in consumer spending, it is not clear either, where the consumption demand is going to be generated from.

Although the Republicans technically control one half of one third of the government, they have leveraged their bargaining positions due to the ongoing faltering recovery and the constant dithering amongst the Democrats. Obama cannot possibly expect to leave any mark he can call his own, in the rest of his days as President. He has already expressed that he feels like he has been “left at the altar”, and it is certain that his decision making going forward, is going to be conservative and bipartisan, that is – not his own.  However, it should be conceded that the pendulum swings in his position on the economy are hardly his own fault – this is a complicated situation that even his team of economic advisors have not been able to crack.

 Obama’s top economic advisor, Austan Goolsbee, resigned in June this year to go back to his teaching post at University of Chicago. It is debatable whether his decision was spurred by the university’s handbook of rules, which state that leaves of absences should not exceed one year, or whether he decided to abandon a sinking ship at the opportune time – before the situation got palpably worse. What is clear is that nobody in Washington is ready to own up to the debt, and at a time when the country most requires a real sustainable economic game plan, there is none.