Thursday 20 March 2014

History Suggests Putin Is Likely To Pause At Crimea

Taking back a gift is frowned upon across the globe, except in Russia. Soviet leader Nikita Khrushchev handed Crimea as a gift to Ukraine in 1954, but 60 years later Russian president Vladimir Putin made a swift reclaim.

After spending the last few years making efforts for recognition as a prominent member of the globalized world, Russia has managed to isolate itself in a matter of days. Fittingly, the Crimean Peninsula also represented Russia’s estrangement from Europe in the 19th century. After building up favorable relations with European allies by cooperating against Napoleon, Russia abruptly alienated itself by launching an unexpected attack on the Ottoman Empire in 1853.

Assuming the role as protector of the Empire’s oppressed Orthodox Christians, Russia attempted to take control of the Black Sea during the three year Crimean War. Its efforts were thwarted after Britain and France intervened, forcing Russia to abandon its plans and accept a peace deal.

Russia no longer uses religion as a mantra for expanding its influence and instead styles itself as a guardian of ethnic Russians, regardless of their location. That was the excuse used in separating two regions from Georgia in 2008; a conflict mirroring this week’s annexation of Crimea.

While Putin targeted Crimea following Ukraine’s ambitions for European Union integration and ousting of its pro-Russian president, desires of joining NATO were the catalyst of his aggression towards Georgia. Putin still views Russia as the empire victimized by the Mongols, Vikings, Napoleon and Hitler, and reacts with alarm whenever one of its former subjects expresses a desire seek relationships with outside powers.

Like Crimea, the Georgian regions of South Ossetia and Abkhazia are primarily populated by ethnic Russians. Similarly, Russia managed to maintain a military presence in the regions following the fall of the Soviet Union. This enabled Putin to easily occupy Crimea and in 2008 helped stir up tensions in Georgia’s troubled territories.

After Georgia took a step closer to NATO membership in April 2008, Putin responded by authorizing official ties with South Ossetia and Abkhazia. The two regions had long endured uneasy relations with Georgia, but the moves from Putin amplified tensions that led to local skirmishes. This provided him with the perfect excuse to send in ‘peacekeeping’ troops to protect the ethnic Russians, emboldening the regions’ separatist movements. When Georgian troops responded to attacks from South Ossetian rebels, Putin sent his army into Georgia-proper, laying waste to any resistance over a five-day conflict that resulted in 850 deaths.

Ultimately, Russia never assumed South Ossetia and Abkhazia into its federation, but did officially recognize their independence from Georgia. The tumult was intended to send a clear message to neighbors that aspired to western relations. Yet the EU and US acted as if unaware that Russia might take action against Ukraine if it sought European integration. When Putin coerced Ukrainian president Viktor Yanukovich to reject the EU’s proposed trade deal late last year, the West stayed silent; neither voicing strong support for Yanukovich against the larger bully nor warning Russia of interference. Of course, Western leaders hoped things would be resolved quickly so that it could maintain the stability of its Russian business interests.

But when Yanukovich was chased out of power, Putin realized he had to take things another step further. The seizing of Crimea was designed to remind the new Ukrainian government that looking west brings headwinds from the east.

Today, Putin seems to be following the template from the Georgian conflict. Things have been calm since ceasefire was reached there in 2008 and Georgia remains outside NATO. As long as Ukraine does the same then Russia will not encroach beyond Crimea.

Putin is likely wary that further provocation in Ukraine could incur additional sanctions from the West, akin to the severe measures on Iran that restricted access to the global financial system and choked its economy. But Western powers will be reluctant given that Russia plays a more important role in global trade than Iran ever did. Moreover, even if sanctions are intensified, Putin’s desire for regional authority cannot be underestimated. Since the days of Peter the Great, Russian rulers have put a high value on the power of the nation, often above the health of its citizens.

Crimea will never be returned to Ukraine, but further Russian expansion is unlikely. As with Georgia, Putin is probably content that his work in Ukraine is done, for now. He has conveyed a stern warning to the new leadership while invigorating the nation’s large pro-Russian population. Calm will be solidified if May’s Ukrainian elections restore power to eastern-leaning politicians; something that will bring relief to Putin, and the West.

Labeling Ukraine’s new government “legitimate” is not endorsement of democracy

The word “legitimate” is given three definitions by the Merriam-Webster dictionary, but it seems like none are known by those in the White House. Earlier this month President Obama declared that “any discussion about the future of Ukraine must include the legitimate government of Ukraine.” Illogically, he was referring to the new unelected leadership headed by acting prime minister Arseniy Yatsenyuk, who was subsequently welcomed to Washington by Obama to send a message that the US “strongly supports… the legitimacy of the new Ukrainian government.”

While the Obama administration is correct in vigorously opposing Russia’s attempt to truncate Ukraine, continually describing the latter’s new government as legitimate is a spurious and damaging pretense. Much of the media has made the same error. Inaction from Western powers allowed Russia intimidate recently-ousted president Viktor Yanukovich and saw a panicked opposition bypass democratic principles in its ascension to power. The US now looks hypocritical as a promoter of global democracy.

Let’s put the current government in the context of the dictionary’s first definition of “legitimate”: allowed according to rules or laws. Yanukovich was overthrown in a single day on February 22nd. Earlier that morning he declared in a televised address that he had no intention of resigning from power. Regardless, with Yanukovich and many of his allies chased out of Kiev, a rushed emergency session vote was held under the specter of violence in which the majority of the parliament agreed to depose the president.

The legality of the move is dubious. The Ukrainian constitution states that there are four circumstances in which a president may be removed between elections. The first three are moot in Yanukovich’s case as resignation, incapacitation and death were not applicable. The fourth, impeachment, is what the new leadership uses as its justification for the president’s removal. Yanukovich’s alleged act of authorizing troops to fire at protesters would certainly be worthy of prosecution, but the parliament alone cannot administer impeachment. A committee investigation and judgment from the Constitutional Court must also be dispensed; neither of which happened.

Even if the US chooses to ignore the legal technics, after all Yanukovich tried to tamper with the constitution for his own gain in 2010, it doesn’t seem to adhere to the dictionary’s second explanation for “legitimate”: fair or reasonable.

The day prior to his removal, Yanukovich signed into law constitutional changes that diluted his powers, formed a caretaker government and allowed early presidential and parliamentary elections in May. While these concessions didn’t bring an immediate step towards the catalyst issue of the EU trade agreement, it was a European-mediated deal expected to ease social unrest. But belligerent mobs of protesters continued to rout the city, effectively taking control of Kiev as police were forced into retreat. Yanukovich didn’t hang around and fled for Russia amid claims his car came under attack from gunfire, allowing the parliament to call the emergency session about the president’s removal. It was in nobody’s safety interest to oppose the motion.

The third explanation for “legitimate” is: real, accepted, or official. As recent years have demonstrated, mass demonstrations can result in constructive political changes. But Ukraine is not experiencing an Arab Spring. Unlike the despotic regimes of Arab nations, Yanukovich was elected to power in 2010 under conditions deemed fair by international observers from the Organisation for Security and Co-operation in Europe (OSCE). Yanukovich won 49% of the vote versus 45.5% for the incumbent Yulia Tymoshenko.

The 2010 and 2004 elections illustrated Ukraine’s political divisions, with the east of the country supporting the traditionally pro-Russian Yanukovich, while most of the west voted for pro-Europe candidates. From afar it may have appeared like there was a mass uprising against Yanukovich in recent months, but Kiev's geographical location in the Western-leaning heartland magnified the negative sentiment against him.

Yanukovich’s ascension to power was real, accepted, and official; adjectives that should not apply to the reigning US-supported government. Of course, a fair election does not give a leader free reign over a nation, but Yanukovich was not a Putin proxy. While depicted as a rigid puppet, last September Yanukovich forcefully vowed to his party at a private meeting that "we will pursue integration with Europe." He was originally in favor the EU trade deal but those plans were spoiled by a combination of Russian trade threats and a $15 billion investment in fragile Ukrainian debt which lessened the attractiveness of Europe’s proposal.

Yet Yanukovich attempted to appeal to both sides of Ukraine by suggesting an arrangement involving trade deals with the EU and Russia. Such notions were quickly dismissed by European Commission President Jose Manuel Barroso who indicated that Ukraine must choose between the EU and Russia. "When we make a bilateral deal, we don't need a trilateral agreement," he said. Yanukovich didn’t sign and so ensued anarchy in Kiev.

Yanukovich received no sign of US backing when Russia pressured him into rejecting the EU deal. The Obama administration only spoke out when it became embarrassingly clear that Russia felt it could do what it wanted with its neighbors. Putin’s boldness grew as the US government struggled with inertia.

Threatening Russia with sanctions, increasing NATO presence in the region and facilitating aid through the IMF will help with Ukrainian security. But while the Obama administration believes that saluting the new government will encourage stability, in reality it is appeasing one mob and breeding contempt in another. The EU trade deal that spurred the unrest was not a unanimous desire. A poll by German group GfK in November found that just 45% of Ukrainians supported the deal.

On Friday President Obama said he “supports Ukrainian democracy and self-determination”, while concurrently throwing his symbolic weight behind a government that came to power via blunt force. While it would be wrong for the US to condemn the current Ukrainian leadership, it should dial back its warmness in the public arena. At the moment the US is trying to make a strong statement to Russia, but the message to Ukrainians is that storming parliaments counts as “legitimate” democracy.

Friday 14 March 2014

Growing pains for China’s financial system

A corporate default is rarely reason to celebrate, but nor is it always a sign of impending crisis. Last week’s declaration by Shanghai Chaori Solar Energy Science and Technology Co that it could not to make a $14.5 million interest payment is bad for the company and its bondholders, but not for China. Several analysts have erroneously labeled this as the Chinese “Bear Stearns moment” whereby the failing of one entity portends a broad breakdown in the financial system.

As with most matters surrounding China, any sign of stress in the burgeoning nation is treated with fearful hysteria by sections of the Western media. That is not just the fault of the West, but also a reflection of the existential obscurity of information from China. There are reasons for anxiety about the world’s second largest economy, but the recent missed bond payment is not one of them.

While Chaori is the first onshore Chinese corporate default since the regulation of the market in 1997, many more would likely have happened by now if the government had not provided generous assistance to avoid such consequences of a liberalized financial system. But it’s not known for sure. That is why the allowance of Chaori to default should be regarded as an indicator of progress in China’s slow transition to an open marketplace.

The inability of Chaori to make payments reflects weakness with the company and China’s long-struggling solar industry. It does not indicate any weakness with the country. Moreover, the default was not a surprise to analysts. Chaori’s difficulties have been flagged for some time and problems in the sector were highlighted in the past, with China’s formerly largest solar firm, the US-listed Suntech, defaulting on bonds last year.

In a worst case scenario Chaori could default on $163 million, but that is hardly substantial given the scale of China’s $14 trillion corporate debt market. Defaults on corporate debt are not unusual. Even in 2007, before the Western world’s financial turmoil, there were defaults on agency-rated debt in the US that totaled more than $5 billion. Investors take a risk any time they purchase a financial instrument, and the inability of a struggling company to repay its debts is part of the system. It is vital that corporate defaults are allowed to occur so that markets can efficiently weed out zombie companies.

Panic is understandable when defaults become widespread, but there is no evidence of that in China. Instead, there are reasons to think that the Chaori default could strengthen China’s corporate debt process. Until now, the system had never dealt with bankruptcy proceedings or wrangled with the pecking orders of bondholders; aspects of the market that are undesirable but a component nonetheless. The default may also give reckless investors reason for pause, while other struggling companies may disclose their limitations now that it is apparent markets won’t collapse when defaults are announced.

Above all, China’s comfort with the default indicates a growing confidence in opening up its own system. The government didn’t feel the need to offer a bailout and is content to live with the consequences of corporate defaults and the accompanying media hype. Beijing’s acceptance of Chaori’s difficulty coincides with a tolerance for greater exchange rate fluctuations in its formerly rigid currency. The renminbi, which has historically moved within tight ranges, has been allowed to trade with increased volatility over the past month, likely indicating a recent acceptance for market forces.

Of course, as with many aspects of Chinese policy the extent of the government’s role in market operations cannot be determined with certainty. But there is little doubt that some improvement has been made in opening up to outside influences, and it is important than these transitions are done gradually. The government is in the midst of undertaking a profound shift in its economic model, transitioning from a reliance on exporting cheap goods to sustainable consumption in which growth is generated by domestic spending.

Changing an economic model presents challenges and in China’s case they are clearly evident. To rely on domestic consumption, the nation’s finances must be in a healthy position. However, there are signs of an over-reliance of borrowing, with China’s total debt-to-GDP level jumping more than 80% since 2008. The level now stands at 210%, a number lower than many advanced economies, but its rapid increase is cause for concern. History has shown that similar credit expansions in emerging nations have resulted in financial crises as the floods of investments inefficiently distort asset prices.

But there has never been a test case like China. It can be argued that it has the infrastructure and resources to cope with the swathes of borrowed money. This seems to be the attitude of China’s policymakers, as reports this week indicated the central bank was prepared to cut reserve requirement ratios for banks if growth shows signs of falling below its 7.5% target toward a 7% annual rate. If implemented, banks would have to keep less in reserves and will be free to lend more. Facilitating more credit must be done carefully, but the current reserve requirement of 20% is relatively conservative and any cut figures to be limited. Moreover, aside from spurring additional economic activity, this move also aims to dampen demand for the sizeable shadow banking sector.

Encouragingly, China also has plans to liberalize interest rate markets, effectively allowing banks to offer savers more attractive yields. The imposed ceiling is currently 3% annual interest for benchmark one-year household deposits and just 0.35% on demand deposits. Allowing banks to introduce more competitive rates should boost saving and further lessen the shadow banking reliance.

Moving towards open markets is a delicate process that needs incremental steps while trying to maintain a difficult balance between economic growth and sustainable reform. Along with the Chaori default, there will be plenty more hiccups along the way as the increasingly liberalized financial system matures and adjusts to market forces. Some of the obstacles could be potentially damaging, but a missed $14.5 million payment in a $14 trillion market is not one of them.

Wednesday 12 March 2014

Fannie and Freddie reform is necessary, but not at expense of private sector investment

Private investors and the government don’t always make easy bedfellows and nothing exemplifies this more than the case of Fannie Mae and Freddie Mac. After verging on collapse in 2008, the government-backed mortgage groups are now turning significant profits, but investors are not happy.

Since their inception, the structure of Fannie and Freddie has been a point of contention. Established by government charter, the entities are owned by private shareholders and guarantee the vast majority of US mortgages, buying and selling loans from financial institutions to provide money for the banks to facilitate lending to home buyers. For much of their existence the groups’ configuration has drawn criticism as private investors enjoyed the profits while losses were felt by taxpayers. Things have changed since then.

Even after receiving a $188 billion government bailout during the height of the financial crisis in 2008, the future of Fannie and Freddie seemed precarious. The common shares of both entities, which traded at $60 in 2007, declined sharply and were delisted from the New York Stock Exchange in 2010. By mid-2012 shares were worth just $0.14. But some investors had faith in the companies and as loan delinquencies declined and house prices rose, profits were generated.

Fannie and Freddie shares have now jumped more than 1,000% over the last 12 months. Fannie had a net income of $84 billion in 2013, while Freddie's was $48.7 billion. Yet investors are not reaping any profits. And that’s because the government changed the rules.

During the 2008 bailout the government took preferred shares carrying a dividend of 10%, along with almost 80% of common stock. It also placed Fannie and Freddie in “conservatorship”, meaning the government had administrative powers for the foreseeable future. Nobody seemed to care too much at the time, but interest picked up once the entities started making money. In 2012 the government used its conservatorship powers to change the bailout terms to ensure that all profits from Fannie and Freddie went to the Treasury.

Fannie and Freddie have now paid back more in dividends than they received in the 2008 bailout. Understandably chagrined, investors have launched a myriad of lawsuits against the government alleging that the 2012 amendments constitute a taking of private property without any compensation. A recently revealed 2009 Treasury memo stated that the conservatorship of Fannie and Freddie “preserves the status and claims” of preferred and common shareholders. But illogically, the government doesn’t seem to think future earnings are a claim for shareholders.

Regardless of arguments about the efficiency of Fannie and Freddie (some laud their ability to facilitate 30-year mortgages, others denounce their facilitation of reckless greed), or that most shareholders are hedge funds, it cannot be overlooked that investors who backed the companies’ survival are now being punished. Private investment in government-backed initiatives cannot be discouraged. The government was not in a position to nationalize Fannie and Freddie, the $4.9 trillion obligations were understandably too large, so it had to rely on investors to keep the mortgage groups alive.

Profit-saga aside, there is still the issue of deciding what to do with Fannie and Freddie. The Obama administration has rightly voiced support for overhauling the entities and it is true that the historic structure can no longer work; in the boom times it was overly imbalanced in favor of private investors and now the roles are reversed. Several reform bills are sitting in Congress, with some calling for a complete dissolution of Fannie and Freddie. An alternative proposal was made by a group of hedge funds and private equity companies late last year in which the entities would be replaced with two private firms, backed with an initial capitalization of $50 billion. Yet neither proposal is expected to gain widespread approval.

In reality, the most efficient solution involves a scenario in which the balance of responsibility is shifted so that private investors carry the larger share of the burden. On Tuesday the Senate Banking Committee released a bipartisan plan to unwind the mortgage companies and create a new system in which the private sector would be required to take the first 10% of losses before any government guarantee would be triggered. This is a step in the right direction, allowing the government to take the position of secondary guarantor and spare itself from the role of loss-absorber to private sector bets.

Yet the proposal does not include any provision for investors to share in the companies’ profits. Investors did not back Fannie and Freddie for the good of the US mortgage system; they bought shares with future profits in mind. Even so, private investment is needed for such government-backed entities to function efficiently and should not be discouraged.

Monday 3 March 2014

Does The Keystone XL Pipeline Still Matter?

Last month it seemed the Keystone XL pipeline was nearing approval, but as with most things surrounding the project, things weren’t as they seemed. A US state department report reviewed the Alberta, Canada–Nebraska pipeline and indicated the project was unlikely to have a significant impact on climate change. This seemed like a significant positive step for pipeline, but within the details of report were critical comments from the Environmental Protection Agency.

Environmental concerns have been the most publicized aspects of the pipeline, with opponents arguing that the project could accelerate climate change by enabling increased production from the oil sands of Alberta, which creates 17% higher greenhouse gas emissions than the average crude used in the US. President Obama will make the final decision on the pipeline and given his campaign to battle climate change, it is difficult to imagine him defying the EPA and his core Democrat base, especially with Midterms later this year. Then again, labor unions will be angered if he blocks the pipeline and the thousands of potential jobs it could create. It is not surprising that he has taken so long to make a decision.

TransCanada first proposed the project seven years ago and a lot has changed since then. Back in 2007 there were still concerns that “peak oil” was imminent and demand for energy was booming in the pre-financial crisis environment. The pipeline was initially viewed by many as a much needed tool to bring down oil from Canada and ease supply concerns. But now the US is apparently nearing energy independence and the Keystone project is seen as an environmentally unsafe method of transferring oil to major refiners in the Texas Gulf (via Nebraska).

But oil companies have not been sitting idly during the prolonged approval process and have been working on other methods of getting the oil from Canada. The refiner Valero signed on to receive oil from the Keystone pipeline early in the project and has spent billions upgrading its equipment to handle the type of heavier crude produced in Canada. So to make good on their investment, the firm has invested in rail terminals at its refineries to help get the oil in. Last month Exxon Mobil announced the construction of a rail facility in Alberta that will be completed early next year.

Oil-by-rail has attracted scrutiny following a series of recent accidents, most notably a crash in Quebec last year that killed 47 people. This might bring additional regulation such as railcar modifications, but such developments will only result in a short-term slowdown in the rail expansion. Companies will continue to aggressively pursue this transportation method as long as the Keystone XL pipeline remains in limbo.

The economic impact of the pipeline has also generated much debate, but despite heated arguments from both sides its effect is unclear. TransCanada claims Keystone XL will support approximately 42,100 direct, indirect and induced jobs in the US and will and provide a substantial increase in tax revenues for local counties along the pipeline route, with 17 of 27 counties expected to see revenues increase by 10% or more. It added that the project will result in “spending $7 billion stimulating the local economy.”

These claims are countered by the Cornell Global Labor Institute which says the project budget that has a direct impact on US employment is between $3 and $4 billion. Moreover, any jobs created would be temporary and between 85-90% of the people hired to do the work would be non-local or from out of state. It also warned of the economic risks from possible pipeline spills, pollution and the rising costs of climate change. But there is no way of quantifying these risks.

Another argument revolves around the possible impact on oil prices. Intuition would say that the more oil that comes into the US, the cheaper prices will become. But the market isn’t so straightforward. Since 2011 refineries in the Midwest have benefitted from a glut of oil produced in the region and Canada which has been easily accessible thanks to an array of pipelines that were granted approval. This has seen US WTI crude oil trade up to $20 less than the global benchmark, Brent over the last year. The spread was about $8 last week.

However, if the Keystone XL pipeline enables the efficient transport of oil from Canada to the Gulf, then more refiners will be bidding for the oil. It is feared that increased competition for the Midwest oil glut will see an increase in prices.

Yet, just like predicting anything in financial markets, there is no certainty about future prices. Nobody knows where how much oil will cost next year but the logical policy is to create the most efficient oil transportation network so that supplies can be maximized, thus lessening the impact of a price shock brought about by unexpected events.

Efficiency involves the full development of the Keystone pipeline. Even if Obama rejects the proposal, companies will pursue other methods of transporting oil from Canada, and as has been evidenced, oil-by-rail is not a risk-free alternative. Rejecting Keystone XL won’t reduce the production of heavy oil in Alberta. That will only happen when better energy alternatives are promoted.