The Power and the Money

Argentina tries to stem the panic

Leticia Abad and Noel Maurer here again, reporting on some news that while not unexpected, has arrived unexpectedly prematurely. 

Imagine you are a banker in the mid-19^th century. All of a sudden, you observe more and more people demanding that your banknotes be converted to hard currency. After a couple of days, this is getting serious and you see your reserves plummeting: this is a bank run!

If the bank were in a weak position to start with, then this bank run could have been warranted. The banker will stop paying when she runs out of reserves. But sometimes bank runs are just panic for panic’s sake. Then, as a banker you could refuse to convert these notes to restore sanity, to calm people down.

Now, replace “ban”k with Argentina. The bank run is a peso run. Welcome to President’s Macri’s life.

Since the last post, our dear country has not managed to hold a steady course. The Central Bank keeps on hemorrhaging dollars and technically the country has defaulted, well, selectively, according to rating agencies.

Right now, the federal government is facing substantial payments on its dollar-denominated debt over the next few months. (See the below chart.) That means that the federal government will need to dive into the market to get dollars make the payments. (The Argentine federal government, not surprisingly, collects tax money in pesos.) That will lead to one of two things: (1) A further fall in the value of the peso against the dollar, which would be very bad; or (2) A big drain on the Central Bank reserves as the bank provides the government with the dollars it needs, which would also be very bad, since those reserves are falling fast. 

So what to do? 

Well, ask creditors to let you postpone the payments.

On August 28th, to hold on to its foreign currency reserves, the government tried short-term debt management. It unilaterally extended the payment of short-term bonds on August 28th. That lasted a day. Then the government came up with a plan for further extending repayment — or as they call it a“reprofiling.”  (Check #reperfilar for the corresponding memes).

My favorite: Reprofiling is the new “we need to talk.”

The renegotiation applies only to firms; individual creditors will receive payments as expected. This move should free up around $13.4 billions of reserves.

In other words, let’s kick the can down the road!

This strategy to ease the peso run failed quickly. The dollars kept on leaving the Central Bank’s vault.

To quell the panic, the Macri administration’s second move was the national equivalent of having the banks close their doors to depositors during a run. Capital controls ensued, first for foreign banks to repatriate profits. Then yesterday (on Sunday!) the government issued an emergency decree establishing good ol’ capital controls. All firms now require authorization to operate in foreign currency. Individuals have a cap of $10,000 per month on how much money they can change. Today will be the opposite of a banking holiday, withthe Central Bank extended banking hours until 5 pm (normally banks close at 3 pm).

President Macri decided that it’s better to adjust now when he has lots of reserves than adjust later. Will that stop the panic and make Argentine and foreign investors calm down?

It is clear that this is a last resort, as President Macri denounced capital controls during his presidential campaign. Since the primaries, he is facing an uphill battle to, at best, make it to a second election round. Hence, he is trapped between being a president and a candidate. From the quasi-populist policies announced two days after the elections to the imposition of capital controls binding for firms, he is trying to stabilize the country in hopes of attracting more votes. At the very least, he is trying to avoid to leave De-la-Rua-style — i.e., in a helicopter — before the end of his term.

All this, of course, has implications for the election and what the next president will do. Wait for the next post!

Guest post: Gone with the PASO

Leticia Arroyo Abad here, our woman in the Southern Cone.

Argentines have been battling a recession, several mini-crises, and high inflation for a while now. The result was a resounding defeat for the incumbent administration in the recent primary elections.

The primary is called the PASO, for “Primarias Abiertas Simultáneas y Obligatorias.” In English, that’s the obligatory and open simultaneous primaries. Which means exactly what is says. All parties hold presidential primaries on the same day (simultaneous), in which any voter can pick any candidate for the nomination of any party (open), and in which all Argentine citizens are required to vote (obligatory).

Admittedly, the fine is only 50 pesos, which was about US$1.25 before the election, but we Argentines are public-spirited. Or possibly just angry at our politicians. Either way, turnout hit 75%. 

To the shock of precisely no one who was paying attention, unless you include all the people who are paid big money to pay attention, the defeat for the ruling party triggered a massive response in the markets. The following day, “Black Monday”, the peso plummeted to from 45 to 63 pesos per dollar before recovering to around 54. The MerVal index and government bonds suffered massive losses. And things would have been worse had the central bank not intervened promiscuously to prop up the peso. Here are central bank reserves over the past two months:

(Extra credit if you can spot the IMF loan poor President Macri accepted as the markets battered Argentina in mid-July.)

The panic also hit the banking sector. With the plunge of government bonds, a group of foreign banks demanded a buyback from Treasury (as part of an earlier repurchase agreement to boost reserves) that further depleted our national reserves. But hey, what was lost in reserves was more than won in public debt reduction. That is good news, right?

President Macri was not, shall we say, gracious in defeat. With evident anger (or bronca as we say it here), he blamed the electoral results on all Argentines. In a strange technical sense that is true, as in voters do indeed determine election outcomes, but it seemed like he was blaming the crash on the voters ... and that is not generally a good way to win votes. He did apologize for his unfortunate reaction later on.

Trying to get a the solid win over the opposition will be hard, maybe impossible at this point. Nevertheless, Macri is giving it a try. On Tuesday, the President announced a new economic plan. It includes slashing the value added tax on the consumer basket, increasing university grants for students, cutting taxes for small firms, and freezing gas prices, among other things.

The problem is that this administration doesn’t want to be populist. (Or maybe it doesn’t know how?) So the whole package just falls short. And the Argentine people know populism very well; a collection of short-term half-measures is unlikely to fool anyone. Moreover, the government is trying to please God and the devil at the same time. A spending spree, however temporary, will not meet IMF targets. 

Now, as of this past weekend, we have a brand new minister of finance, as the previous one was not happy with the new “populist” detour. Hernán Lacunza believes that the number one priority is to stabilize the peso using the Central Bank’s reserves as “that is what they are for.” 

One week after the shock, Argentina has a new minister of finance, a somewhat stabilized peso, looming IMF targets to meet, and half-baked populist policies to implement. This should keep the President busy but it is highly uncertain that it may buy him another term.

So what will the opposition bring? Well, we can talk about that in another post.

Observatorio argentino 42: nobody is suggesting another default

I am in Argentina, my favorite country among all countries. Some of you may know that Argentina is in the middle of a presidential election campaign.

Background: The two main tickets are Macri-Pichetto and Fernández-Fernández. Mauricio Macri is the current president. He dumped his previous running mate in favor of a moderate Peronist, in order to (he hopes) siphon off some Peronista votes. Alberto Fernández was the chief of staff under the Peronist presidencies of Néstor Kirchner and Cristina Fernández de Kirchner (CFK). Everyone expected CFK to run for president, but she pulled a fast one and decided to run as Vice-President with Alberto (no relation) fronting the ticket. 

The controversy: Alberto Fernández declared that he was going to finance higher pensions by halting interest payments on “Leliq” bonds issued by the central bank. A firestorm ensued ... although not in the financial markets. They did not care. But the big agribusiness head convened at the La Rural exhibition to denounce default. Pichetto announced that it would cause a currency crisis. Everybody went running for cover.

Except ... well. Here is the thing. Leliqs are seven-day bonds issued by the central bank. Fernández proposed to stop paying interest on new ones. After all, they turn over every week. He did not propose defaulting on outstanding debt.

Now, all is not well with Fernández policy. After all, it is not clear how having the central bank stop interest payments on short-term notes is going to free up money for the federal government. In addition, the central bank conducts much of its monetary policy via the issuance of Leliqs, which it uses to mop up excess liquidity. That will not really work if they pay no interest. So the idea is kinda silly.

But nobody is proposing another default.

Yet.

Why not just let the Argentine peso fall?

I wrote this almost a week ago, but forgot to hit “post.” With today’s further fall in the peso to 25 per dollar, it sadly remains relevant. So ...

Why is Argentina going to the IMF at all? Why not just let the peso fall?

Answer: currency mismatch. Argentina seems to be shot through with foreign borrowings. Some of these borrowings are hard to understand.

Other foreign borrowings are not as hard to understand. Consider the gross data on Argentine financing through international capital markets. When President Macri took office, the country regained access to foreign lending. It then proceeded to take full advantage of that new access to raise needed capital. Together the federal government, provinces, and the state-owned oil company (YPF) have borrowed about $48 billion (gross) under the Macri administration through the end of 2017. (There are credible reports that these figures may be understated by a factor of two.)

Now, I’m not saying that borrowing caused the run on the peso. Nor am I saying that it’s a huge amount for a ~$545 billion economy. But it would be rough if the capital suddenly stopped flowing, which is what would happen if the authorities just threw up their hands and let the peso plummet. Budget deficits would still need to be plugged and expiring debts would still need to be rolled over, only at much greater cost in peso terms. 

But wait it gets worse! Argentina’s financial system is heavily dollarized. That means people and businesses denominate their debts in dollars, not pesos. Why they do this is not clear: there are plenty of other countries with as checkered a monetary history, yet debts and contracts are made in the local currency. Nonetheless, many Argentine businesses write their debt contracts in dollars, even though most of them make sales in pesos. 

How serious is this problem? Well, I once again turn to the Argentine central bank. In 2016, 39% of manufacturing industry debts were in dollars, along with 37% of farm debts and 32% of service businesses. Only commerce (17%) and construction (12%) had less dollar debt … but even those numbers are pretty high. Twelve percent of construction business liabilities, the nontradable par excellence, are in foreign currencies?

Should the peso crash, those debts would become overwhelming. In fact, according to the Institute for International Finance, the situation has become a lot worse in the last two years: they report that a whopping 64% of Argentina’s combined government and corporate debt is denominated in dollars. Imagine if the value of 64% of your debts doubled over the course of a few days.

It follows that Argentine banks are exposed to depreciation. As of September 2017, 9% of bank loans were denominated in dollars, against 15% of their liabilities. The weight of those liabilities could soar if the peso crashed. Moreover, considering as most of those loans are probably to Argentine entities who earn in pesos, those dollars loans would start looking shakier as well.

In short, jacking up interest rates and going to the IMF is bad. But letting the peso just fall as far and as fast as the market will take it is also bad. It might even be worse. In other words, cry for Macri, Argentina: it is a terrible and unavoidable choice. 

Colombian peso update, part 2

In 2015, I predicted that Colombia would not chop three zeros off the peso until the May 2018 presidential election. The last time around, Congress balked at the cost of replacing the bills. In 2016, though, the Colombian central bank issued new bills that replaced the three zeros with the word “mil.” On February 5th, the head of the central bank, Juan José Echavarría, pronounced himself in favor of redenominating the currency since the new bill design would make it cheap: just let new bills without the word “mil” circulate alongside old bills that have it. 

Congress took up the discussion on February 8th. 

So why bother? Well, first, redenomination is now free. (Although the private sector will have to pay some cost for new software.) That is a big reduction from the $123 million it would have cost to recall and reprint or remint everything. Second, the finance minister, Mauricio Cárdenas, wants Colombia to have a currency close in value to the prestigious hard monies in the world. This is supposed to have good psychological effects; hey, we have a serious currency now! Finally, getting rid of some zeros just makes things easier. No need to write down long strings of numbers or talk about “millones de millones.” 

Of course, introducing the new redenominated bills piecemeal takes away the benefit of forcing people to turn in unregistered stashes of cash. It isn’t that doing so would uncover nefarious doings and bring crimelords to justice; they use dollars. Rather, forcing people to exchange old bills for new would provide useful data as to the size of the underground economy.

But that looks to be off the table. What is left amounts to prestige. 

Nothing wrong with prestige! I would vote to redenominate were I a Colombian congressperson. But still bet Congress does nothing unless the new president takes the up mantle of giving Colombia a currency that can beat anyone else in Latin America. Absent that, why burn the political capital? 

¿Qué sigue en la madre patria?

The Catalan election descended into utterly predictable chaos. The secessionists won, on poor turnout. But the Spanish national police idiotically decided to wade in wearing full stormtrooper gear, and now nobody knows what will happen. The Catalan premier, Carles Puigdemont, has been coy about whether he will issue a unilateral declaration of independence (UDI, to use the abbreviation first used in 1965). 

So what will happen? Last night, in a bit of insomnia, I jotted down a game tree to help me think this through. I present it below. You can click to enlarge it. I have colored the boxes with the flag of the party making the decision to make things clear. (I am sorely tempted to write, “time for some game theory.”)

Right now the Catalans are deciding whether to declare independence. Their other option is to begin negotiations with Madrid on the precondition that secession will not be on the table. If they take that option, we can breathe a sign of relief: what follows will be contentious but not catastrophic.

But what if they declare independence? The ball goes into Madrid’s court. The Spanish government will have three options. The first would be to agree to negotiations. With a UDI in the background, that seems unlikely ... but if they agreed would could again breathe a sign of relief. 

The other options, however, are more likely. One is to do nothing, the bottom tree on the chart above. The other is to invoke Article 155 of the Constitution and suspend the Catalan government. What if Spain does nothing? Literally, just lets Catalonia go ahead and declare independence but takes absolutely no positive steps to remove Spanish authority. Well, that would give the Catalan authorities two choices:

1. Do nothing as well. That would leave Catalunya in a sort of limbo, with an autonomous  community exercising nothing more than its constitutional authority as part of Spain while claiming to be independent. Weirder things have happened. Life would go on, taxes would be collected, services would be delivered. Eventually they would talk.
2. Organize a parallel state. That would mean having Catalan bodies and bureaucrats take over functions currently carried out by the central government. Eventually, of course, there would be a conflict: a firm would refuse to pay Spanish taxes, two police forces would quarrel, a court order would be ignored, something. 

That would throw the ball back to Madrid. Assuming that voluntarily acquiescing to Catalan independence would not be an option, the Spanish government would have two choices:

1. Crack down with the full authority of the state. We got a taste of that yesterday.
2. Uncooperative withdrawal. Pull out without recognizing Catalan independence. 

Here is where backward induction is helpful. In both cases, the Catalans would have to deicde: give in to Spanish pressure or hold their ground. Problem is, by this point backing down would be political suicide. People would be angry. But resisting a crackdown means civil war. Not necessarily a repeat of 1936-39, but sustained political violence. 

And resisting an uncooperative withdrawal means complete economic collapse. First, the banks would fail as their headquarters pulled back operations; without ECB support euros would become scarce. Second, all contracts would be tied up in legal knots, dropping a paralyzing web of uncertainty. Third, all transfer payments from Madrid would stop; Catalunya would have to replace them ... only Catalunya would not have euros. So it would introduce a proto-currency, which would plummet in value, fueling a wave of defaults ... and so on, until you have something that looks like Greece, at best.

Except, well, backing down by the point would end the career of any politician who tried it, Thus, the big X’s through that option.

The lower tree does not look good. What about the upper one, where PM Rajoy invokes Article 155?

Well, that would give the Catalans a choice: acquiesce and fight it out inside the institutions of the Spanish State or organize mass civil disobedience. The first gets us into a nicely talking world. The second put Madrid in the position of deciding whether to negotiate in the face of mass resistance or resist Catalan demands. If they resist we are ... back on that lower game tree. (The upper and lower tree are the same after that point.)

The implication is that this is a no-win situation for the Catalans. Resistance ends in civil war or economic collapse. (Ironically, the European Union makes it easier to impose that economic collapse: the ECB cannot support Catalan banks if Catalunya is no longer a member.) The smartest thing is to do nothing. If there must be a UDI, then nobody should do anything. Nobody speak, nobody get choked!

Meaning that nobody should do anything, even if the other side does something. Nothing is the  best option. Do nothing at all. Nada. Nothing. 

I am hopeful that in this case that strategy will in fact dominate. But, well, game theory does not really a good record in these sorts of situations. If it did, the morons in Madrid would have never gotten us to this point. (In fact, I suspect that the Catalan nationalists are surprised at their own catastrophic success.) But here we are, so we can only hope that the politicos backwards induct correctly.

Unless ... gulp ... unless the game tree missed something, some option or payoff that makes the bad state good for someone. In which case we are jodi ... thoughts?

For a small fee in America: Hurricane Maria and Puerto Rico’s debt burden

Hurricane Maria has devastated Puerto Rico. The worst part is the power system: as of right now, all generation assets are offline. All of them. The Puerto Rico Electric Power Authority (PREPA) says it is going to resume normal functioning on Monday, but nobody knows what that means. The (outdated and expensive) power plants appear to have survived the storm, but the main transmission cables are out. (You can get DOE updates here.) That is why power barges, while useful, won’t solve the problem until the transmission network is back up: the distribution network cannot move the power to the load centers. Besides which, there are not a lot of power barges sitting around ready to go.

Unless the Trump administration allocates an entirely-unexpected sum of money, Puerto Rico is going to need to borrow massive amounts for reconstruction. (In a past America, the GOP might think $10 billion in emergency aid enough to cement Republican control over the island for a generation. We no longer live in that America.) 

The hurricane is going to permanently damage Puerto Rico’s ability to repay. Work by Leah Boustan (Princeton), Matthew Kahn (USC), Paul Rhode (Michigan) and Maria Lucia Yangua (UCLA), using a century of data, shows that natural disasters increase out-migration and permanently raise poverty rates. The latter, of course, is because wealthier people are more likely to move out. Puerto Rico, according to their estimates, will lose around 4 percentage points more of its population over the next decade than it would have otherwise; roughly 140,000 people and the associated economic activity.

That said, the hurricane is also likely to reduce Puerto Rico’s current debt burden. Title III of the Oversight Act (aka “PROMESA”) created a bankruptcy-like procedure for Puerto Rico. Under that procedure, judges and the Oversight Board have a lot of leeway. They will take into account that the island now needs more money and has less ability to repay.

What really needs to happen now is a fast resolution so that Puerto Rico can go back to the capital markets. Investors have short memories; the island will be able to borrow the $10 billion it needs for full recovery. But the existing debt needs to be written down. My worry is not that the debt won’t be written down enough, it is that it won’t be written down fast enough to speed hurricane recovery. 

The hurricane has made it a little bit more likely that the courts will quickly write down debts. PREPA bond prices here; graphed below. They are falling. Puerto Rican general obligation bonds, which are much less likely to be restructured, are not falling; think of them as a control. 

Privatizing PREPA could speed recovery by opening access to the capital markets. But there are two problems. First, in order to unlock the full value from a sale ($3½ billion is credible), you need to restructure the debts first. Second, in order to insure that the new enterprise gets the system in shape fast, you need enforceable performance targets. Many governments have screwed up power privatizations on both counts, so color me skeptical, although in this case the hurricane has likely left no alternative save more time with the lights out. 

In short, the debt burden is going to slow Puerto Rico’s recovery from the hurricane and slow it a lot. But at the same time, the hurricane is also going to speed resolution of Puerto Rico’s debt crisis. Note that these things are not contradictory; better for everyone had the hurricane never happened. For a small fee, indeed.

Observatorio Argentino 34: What is the opposite of blue?

The “blue market” was the name for the Argentine black market for dollars under President Cristina Fernández. It was called that because the blue marketeers used a blue marker to test whether U.S. $100-bills were counterfeit. On December 15, 2016, President Macri abolished exchange controls, letting the official rate crash, and supposedly ending the blue market.

Only, to my surprise, it turns out that there is still a blue market! The “official” rate right now is 15.6 pesos, while the blue rate is 16.0. That is not a big gap, but why is there a blue market at all? Who is changing money in this blue market?

Nobody seems to know. But the best guess is tax avoidance: people paying extra to avoid having to declare their dollars. I can understand that, but why then isn’t there a blue market in Mexico or Chile? Any explanations?

No, actually Trump really did drive down the Mexican peso!

Kevin Drum announces with much certainty that Donald Trump has nothing to do with the peso’s fall! Is he right?

No. He’s not.

It is true that the Mexican peso weakened in November 2014, when oil prices dropped from around $80 to $66 and analysts concluded that prices were heading further down. It is also true that the peso kept weakening for much of the remainder of 2015, for reasons which are unlikely to have anything to do with Donald Trump, even if the above graph might have you think otherwise.

But after that? Let’s start by eyeballing it. First you have the weakness in January and February, when Trump polls well and then, on February 1st, starts winning. After that the markets breathe a sigh of relief as Trump starts to attract opposition … until the day Trump cleans up in Pennsylvania (and DE, RI, CT, and MD) and makes it clear that neither Cruz nor Kasich can stop him. After that, some stability … until Election Day, 2016.

Sure, you can draw a nice line through the trend and say, “Nope, Trump had nothing to do with it.” But that makes the ups-and-downs look might coincidental. 

But it gets worse for Drum’s argument. The peso moved on individual debate performances. It jumped right to the minute when the election result became clear. It tracked events with entirely understandable precision. And academics took notice: for fancy econometrics making the point, see here and here.

Finally, theory. For Drum to be right, he needs some sort of causal theory, something that would predict a long slow decline with the rest being random noise. (Highly coincidental noise, but still noise.) In other words, he needs a hypothesis. Oil prices won’t do it; they were priced in early. There might be another just-so story out there. I’d be curious to hear him propose it. But it seems silly to look for one, when there is an obvious explanation that fits the data staring us all in the face.

Border adjustment, the Mexican peso, and Hoyt Bleakley

It now looks like the administration won’t (for now) be using its Economic Powers Act authority to impose a tariff on Mexican goods. Instead, he is going to ask Congress to create a border adjustment tax, which would stop American companies from deducting imports from their taxable income. At the same time, it would leave their exports untaxed. (Full explainer from Forbes, here.) 

So what would that do to the auto industry? Well, let us proceed in two stages.

1. What is the immediate impact on an American auto producer? Well, the border adjustment tax is less harmful than a tariff. The auto companies would not be able to deduct the cost of goods coming in from Mexican affiliates and suppliers, but they also would not be taxed on the cost of goods going out to Mexican affiliates and suppliers. But they would still have an incentive to source more inputs at home.
2. Except that the peso would fall (or the dollar would rise, same thing) in response to the tax. A 20% depreciation in the peso puts the auto company back where it started. 

But would Mexico allow the peso to fall that much? In the past, the Mexican central bank has acted terrified that depreciation would hammer Mexican corporations that had borrowed in dollars. That is a reasonable fear ... in theory.

In practice, it might not be. My friend and colleague, Hoyt Bleakley (with Kevin Cowan) looked at 450 non-financial firms in five Latin American countries. 

We consistently find that, contrary to the predicted sign of the net-worth effect, firms holding more dollar debt invest more than their counterparts in the aftermath of a depreciation. We show that this result is due to firms “matching” the currency denomination of their liabilities with the exchange rate sensitivity of their profits. Because of this matching, in equilibrium, the negative balance sheet effects of a depreciation on firms holding additional dollar debt were more than offset by the larger competitiveness gains of these firms.

In other words, depreciation might not be that harmful.

The other reason the central bank might not want to let the peso fall is fear of inflation. But that depends a lot on the reputation of the central bank and the structure of wage bargaining. Banxico is very credible and Mexico has weak unions, so while a fall in the peso will lead to a one-time increase in costs, it seems likely that Mexican workers would just have to suck up the fall in their living standards. It is hard to see how they could demand the kind of compensating wage increases that you would need to set off an inflationary spiral.

So yes, the peso could fall.

In short, the Trump tax would likely make Mexicans poorer with no compensating gains for American workers. But also no losses for fans of big American cars like the amazing Dodge Challenger, like my son. In other words, a gratuitous punch in the nose of those perfidious foreigners! And you can pretend that the tax flows are coming from those foreigners, when they are really coming from American consumers. 

Yeah, I can see why this might actually happen. 

Radicalism is mainstream

Yesterday, there was a speech. Seven quotes:

1. “Many citizens in advanced economies are facing heightened uncertainty, lamenting a loss of control and losing trust in the system. To them, measures of aggregate progress bear little relation to their own experience.”
2. “When the financial crisis hit, the world’s largest banks were shown to be operating in a ‘heads-I-win-tails you-lose’ bubble; widespread rigging of some core markets was exposed; and masters of the universe became minions. Few in positions of responsibility took theirs.”

3. “High income inequalities are dwarfed by staggering wealth inequalities.”

4. “Trade and technology do not raise all boats.”

5. “Higher uncertainty has contributed to what psychologists call an affect heuristic amongst households, businesses and investors. Put simply, long after the original trigger becomes remote, perceptions endure, affecting risk perceptions and economic behaviour. Just like those who lived through the Great Depression, people appear more cautious about the future and more reluctant to take irreversible decisions. That means less willingness to put capital to work and, ultimately, lower growth. These dynamics are clearly visible in financial markets.”

6. “There appears to be little evidence that stimulative monetary policy makes groups worse off.”

7. “For free trade to benefit all requires some redistribution.”

I put quote #5 in italics, because it is extraordinary: a claim that markets don’t work. Quote #6 also deserves scrutiny: it is a claim that some inflation is good. And #7 speaks for itself.

The author? Well, he heads the Bank of England.

To be honest, I have posted this for a specific audience. It is one that takes as an axiom that Ricardian rents should not be reduced or redistributed. But when the head of the Bank of England starts to doubt that markets work or that finance adds value, it is time to start rethinking basic assumptions. 

Establishing the rule of law is not easy

The rule of law is something that is very hard to define. We know when it is not there at all: chaos and warlords. We also know when it barely exists: bribery and impunity. But it is very possible for a state to operate without outright bribery and impunity and yet still lack the benefits of the rule of law. 

Consider the recent Casas Geo bankruptcy in Mexico. (Hat tip: Xóchitl Herrera.) Casas Geo started by building small modern houses for poor Mexican families. The houses would be built in long rows, sharing foundations, with modern utilities already hooked up. A small four-bedroom house went for around $46,000. Reforms that made mortgage credit widely available fueled the company’s growth.

 

In February 2013, however, the new administration announced a change in housing policy: federal subsidies would be redirected from suburban expansion to more center-city housing. The reason was that Mexican suburbs had outrun their cities’ transportation nets, leaving increasing amounts of vacant housing around the outskirts and burdening poor households with crushing commutes. The problem was that the housing companies had accumulated a lot of land outside existing built-up areas. Geo was particularly hard hit. In April, the company announced a 38% decline in quarterly sales. (Page 2.) By May, the company had begun to default on some of its bonds. To be fair, housing construction had been in trouble before then and the reform was sorely needed. But it sent Geo over the edge into bankruptcy. Geo sought protection under the 2013 amendments to Mexico’s 2000 Bankruptcy Protection Act. 

The Mexican congress modeled the Bankruptcy Protection Act on American bankruptcy law. (A comparison can be found here.) As in the United States, federal courts run bankruptcy proceedings. Creditors cannot make an end-run around the bankruptcy proceeding by appealing to state or lower federal courts. 

Only they did! A bunch of would-be homeowners whose made down payments but never received a house wanted cash instead of the promise of a future house. So they sued in a different federal court. And now the whole reorganization is at risk; Geo might be forced to liquidate, which would leave everyone worse off.

That is not supposed to happen; you are not supposed to be able to get around a bankruptcy court decision by filing in a non-bankruptcy court. But since it did happen, well, now it is not clear if Mexico even has a functioning bankruptcy law. 

This sort of thing is not as obvious as corruption or an executive branch that flaunts judicial decisions. But it is nonetheless pernicious. The rule of law looks similar everywhere, but every place that lacks it lacks it in its own way. 

Paul Ryan has a tough job with the Puerto Rico oversight bill

 To recap, the Puerto Rico Oversight Act as it currently stands will:

1. Give Puerto Rico a six-month stay on all debt payments;
2. Require the Governor to create 5-year fiscal plans and submit them to an appointed Oversight Board for approval;
3. Require the Legislature to submit all passed budgets to the Oversight Board for approval;
4. Allow the Board to unilaterally cut budgets if the Governor submits a budget that does not comply with the fiscal plan;
5. Allow the Board to negotiate with creditors to restructure debts (which usually means reducing them in net-present value terms);
6. Allow the Board to suspend certain federal labor regulations on the island, including the federal minimum wage;
7. Grant bankruptcy protection to Puerto Rico (without using the term) and give the Oversight Board the ability to intervene in litigation against the island.

Without (1) and (7) the island goes to pieces right quick. You can see a (rather misleading) summary of what Republican supporters say the bill will do here.

My worry about the Oversight Board is not that it will cut budgets more drastically than an elected Puerto Rican government. The examples of Portugal, Spain, and Greece are pretty clear: when they cannot borrow anymore, elected officials do a fine job of imposing austerity. Maybe too fine a job. Rather, I worry that they won’t negotiate as hard as the government would. On the other hand, as Felix Salmon points out, the Board will consist of seasoned professionals who may be able to drive a harder bargain than Puerto Rican officials. So it is a bit of a wash.

But ... weirdly ... Republicans kept trying to neuter the bill in committee! (The link takes you to a blow-by-blow of the action.)

Consider the McClintock amendment. (Rep. McClintock, R-California, has in fact offered several amendments.) It would clarify that the bill would not apply to Puerto Rico debt obligations that are supported by a pledge of “full faith, credit and taxing power,” meaning, like, all of them. It would also clarify that nothing in the bill would alter debt holder rights or guarantees under Puerto Rico’s constitution or other laws. Which would, in effect, nullify bankruptcy protection by insuring that creditors could sue under Article 6, Section 8, of the Puerto Rican constitution.

Pretty blatant. Rejected 12 to 27. 12 Republicans in support, 16 Democrats opposed, 11 Republicans opposed.

Which Republicans opposed the amendment? Well, there was the committee chair, Rob Bishop (R-Utah). Good for Rob! The other Republicans that opposed it consisted of a collection of retirees on their way out (so under no political pressure), Raúl Labrador (R-Idaho, but born in Puerto Rico), Amata Radewagen (R-American Samoa), and a handful of others.

For most of the markup the Chairperson Bishop has been able to beat back amendments with points of order, but the more senior Republicans (including McClintock, obviously) lined up behind these poison pill amendments. The final vote was 29 to 10 and basically split the Republicans.

You gotta wonder what it will look like on the floor. If Paul Ryan lets it move without the majority of the caucus behind it, then he will have earned my respect. Sure, I may be a little disgusted at his resorts to magic asterisks to justify his silly budgets, that cut social insurance not because we have to but because he wants to ... but hey, reasonable people can disagree. If he gets this bill through and refrains from helping the Drumpfster this year, well, then the man will deserve to be the GOP nominee in 2020. Honorable opposition indeed!

Good luck with that, Paul.

I hope Bernie Sanders is talking cheap about Puerto Rico

 Short version: PROMESA would grant bankruptcy protection to Puerto Rico. (Since I hate these cutesy names Congress loves, I will henceforth call it the Puerto Rico Oversight Act.) But the bill would also put P.R. under a fiscal receivership. An Oversight Board appointed by the President of the United States from lists submitted by Congressional leaders. The Board would essentially take control of the island’s budget process. In return, the Board would get the power to take Puerto Rico’s creditors to bankruptcy court, including the holders of general obligation debt. (That suspends a provision of the Puerto Rican constitution.) The board would also have the power to suspend federal minimum wage laws.

The Oversight Act is a less-than-great deal, but it is also less than it seems. First, without it Puerto Rico’s creditors will tie the place up in lawsuits. Nobody wants a board forcing budget cuts, but it’s better than a bunch of vulture funds making the decisions. Second, Puerto Rico will have to cut its budgets in any case: it can’t afford to borrow any more. The Board might make stupid decisions, but austerity is sadly already backed in the cake. Third, Puerto Rico will be able to restructure general obligation bonds. That is more than most plans involved; in fact, it gives Puerto Rico a power that most states lack. (Although to be honest, the law on that is less than clear. Start with the 11th Amendment and go from there.)

Senator Sanders opposes the bill, calling it colonialism. And he’s right! It is.

But what’s his legislative strategy to replace it and replace it quickly? Because the bill is way better than the status quo. 

I don’t think he has a plan. I think this is an easy way to score political points, same as Senator Rubio did back when he was running for President. If it’s cheap talk, then I’m okay. But if he’s really mobilizing Democratic opposition, then he’s doing immense damage to the people of Puerto Rico and giving lots of power to hedge funds and their lawyers, aka “Wall Street billionaires.” 

It would be ironic if actual livelihoods weren’t in the balance. 

I would like to believe that the Senator from Vermont does indeed have a secret plan to get a better bill through, but I don’t.

And now for something completely different

 Venezuela! An economy in such bad shape that the Economist is now comparing it to Zimbabwe circa 2001.

The immediate question is: will Venezuela default? Ricardo Hausmann says yes. The markets say maybe. And Francisco Rodríguez says no. 

Here is the logic behind a “no.” Venezuela has $52 billion of liquidatable external assets. It has internal assets that include 7,000 tons of gold deposits, worth about $274 billion. (Admittedly, that is gold under the ground.) Moreover, while Venezuela is importing a lot, the level of those imports is due to the country’s distorted exchange rate. 

Of course, the Bolivarian Republic would default if default were costless. But it’s not. First, the country has a lot of external assets that creditors could try to seize. Second, Venezuela would run the risk that the receipts from its oil exports could be attached. According to Rodríguez, Ecuadorean oil prices fell almost 20% against Brent when that country defaulted and did not rise again until the 2009 buy-backs. He estimates that something similar happening to Venezuela could cost the country $5.2 billion per year. Third, if the price of Venezuelan oil goes back to $42, the country will be fine, and that will happen within a year or so.

If oil prices stay low, Venezuela will need to finance $25.4 billion in 2016. If they rise, those needs will drop to $20.3 billion. Either way, they can be financed, as this table shows:

2016 oil price	$ 24.9	$ 41.3
External financing needs (bn)	$ 25.4	$ 20.3
Sources of financing:
Chinese fund renewal	$ 5.0	$ 5.0
Use of existing Chinese deposits	$ 2.5	$ 1.5
Mining concessions	$ 2.5	$ 2.0
Bond swap	$ 3.1	$ 3.1
Asset-backed loans	$ 5.0	$ 3.5
Sale of Petrocaribe trade credits	$ 2.0	$ 1.0
Net bond sales	$ 0.5	$ 1.2
Change in reserves	$ 4.8	$ 3.0

Not all of these would be easy. Mining concessions means mining concessions granted by a government with a long history of expropriation. Asset-backed loans means issuing loans against assets (like Citgo refineries and stations) that might be attached in event of default. And as for the cost of default, well, I do not think Francisco is correct when he argues that Ecuadorean oil prices took a hit when the country failed to pay.

I suspect that Venezuela will avoid default his year, because it can. But in the next two posts, I will explain why it won’t be easy to take loans out against Citgo and show that Ecuadorean oil prices suffered no hit when that country defaulted. In other words, Venezuela will put off default for another year, but the costs will be higher and the benefits rather lower than Francisco calculates.

Background on my disillusionment with Marco Rubio

 OK, now I am little more free to mention that I spent a chunk of the past year doing paid analysis on Puerto Rico.

During that time, Senator Rubio went from an extremely helpful proponent of extending U.S. public bankruptcy law to the island  to a complete opponent.

His opposition made no sense. The bill would not have protected the island government; only counties and public corporations. In other words, it would have given Puerto Rico the same treatment as any U.S. state. Considering as Senator Rubio supports making them a state, it is hard to see the rationale behind denying them the same protection now. Other than, well, the recent receipt of campaign contributions from creditors to the island government.

That point marked when I got off the Marco Rubio bandwagon. (Not that I was a supporter; I am a Democrat. But I thought he was a very reasonable conservative.) His October tax proposal pushed me further away. And now, it seems, that he advocates giving away the store to the financial industry. Click the link; it is very good. And it draws some comparisons with Jeb Bush from which  Rubio comes away looking pretty bad.

I am tempted to say, in fact, that with a GOP congress, Donald Trump might make a better president. 

OK, talk me out of that. 

The barber of Kiev

 UPDATE: What a difference a year makes! At 14%, yes, yes it does. I started my analysis in 2014, which if you think about it, makes no sense since it is already 2015. The following has been rewritten to take that basic error into account. It has a big impact, as you will see.

So I get asked a question about the recent debt relief granted the Ukrainian republic. Is it a lot? A little? Since I was just in California enjoying the weather (or not, it is beautiful back east right now) I will attach a photo to set the mood. I hope I look properly contemplative.

So after about an hour of contemplation, the short answer is ... it is a fairly good restructuring, but it is not great. Kudos to the Ukrainians! Although they need more.

The Ukrainian finance ministry says that the value of the debt will be cut by 20% with no prinicipal payments until 2019. The coupon on the new bonds is increased from 7.25% to 7.75%. There is no break in interest payments. 

The right way to calculate the full amount of the “haircut” taken to creditors is to compute the change in the net present value of the debt. That depends, of course, on how long payments are extended for and at what interest rate. Without that, we can’t calculate the correct value of debt relief.

I got a rough idea of the principal payment schedule from Barclay’s. (You can find the key data in graphical form here.) I then calculated the country’s total payments through 2027 under the old deal and the new deal, assuming average coupon payments of 7.25% under the old deal and 7.75% under the new one. Total mickey-mouse, but enough to get some idea of the payment stream under the two deals.

The upshot? Ukrainian sovereign debt is currently yielding around 11.4%. It was yielding around 14% before the deal. If you use 14% as a benchmark, then the new deal is the equivalent of a 33% 44% haircut. 

How much is that? Christoph Trebesch of the University of Munich has put together an amazing database of every sovereign debt restructuring since 1970. The average haircut is 38%. The median is 33%. In 2004, Serbia got 71%. Greece recently got (an insufficient) 65%. The Russians got 51% back in 2000. Mexico got 31% back in 1990, at the end of the Latin American debt crisis. 

In short, this is about average pretty good! Ukraine does not look to be coming out much ahead. 

The deal looks a little even better if we restrict ourselves to the 17 restructurings that involved $18 billion or more. The average haircut on those was 30% with a median of 25%. Ukraine comes out between Venezuela in 1990 and Argentina in 1993. Ukraine does better than all the Latin American restructurings that came out of the 1982 debt crisis. It is bested only by Russia in 2000, Greece in 2012, Argentina in 2005, and Iraq in 2006. (The latter is not really comparable, since it involved odious debt.) 

Unless I am using bum data (entirely possible!) the point is made: Bloomberg is probably wrong when it calls the restructuring a wash for creditors, but no extraordinary concessions have been made given the scale of Ukraine’s problems. This deal looks pretty good. 

I should add here that creditors will have the option to exchange their debt for receive GDP-linked warrants! (The link goes an earlier discussion of similar instruments on this blog.) The warrants, it seems, will be granted to all creditors in addition to the restructured notes. Or at least that is my current understanding! 

The warrants essentially give investors an equity stake in Ukrainian economic performance. On the surface, they look incredibly attractive. As long as Ukraine has a nominal GDP over $125.4 billion, investors will get 15% of all real economic growth between 3 and 4% and 40% of all growth above 4%.

But who would take that deal? First, the payments will not start until 2021. Second, the World Bank estimates that Ukraine’s nominal GDP this year will come to about $94 billion at current exchange rates. Who knows when (or if) its economy will get back above $125 billion? Ukraine may come to regret including the warrants, but I doubt it ... and they are a nice sweetener for the creditors. After all, who knows? Maybe Ukraine will boom beyond dreams of avarice in the 2020s.

In short, this deal looks about average for debt restructurings. this is a good deal, but considering the problems Ukraine is facing, it strikes me as small beans. 

Finally, for those who want it, here are my guesstimates of the annual payments in billions of USD that Ukraine faces under the two deals. If anyone can correct them, I would be delighted! 

	New deal				Old deal
	Debt	Principal	Interest	Total	Debt	Principal	Interest	Total
2015	$ 14.4		$ 1.1	$ 1.1	$ 18.0	$ 1.5	$ 1.3	$ 2.8
2016	$ 14.4		$ 1.1	$ 1.1	$ 15.8	$ 2.3	$ 1.2	$ 3.5
2017	$ 14.4		$ 1.1	$ 1.1	$ 12.3	$ 3.5	$ 1.0	$ 4.5
2018	$ 14.4		$ 1.1	$ 1.1	$ 12.3	$ 0.0	$ 0.9	$ 0.9
2019	$ 12.8	$ 1.6	$ 1.1	$ 2.7	$ 12.3	$ 0.0	$ 0.9	$ 0.9
2020	$ 11.2	$ 1.6	$ 0.9	$ 2.5	$ 10.8	$ 1.5	$ 0.8	$ 2.3
2021	$ 9.6	$ 1.6	$ 0.8	$ 2.4	$ 9.3	$ 1.5	$ 0.7	$ 2.2
2022	$ 8.0	$ 1.6	$ 0.7	$ 2.3	$ 6.8	$ 2.5	$ 0.6	$ 3.1
2023	$ 6.4	$ 1.6	$ 0.6	$ 2.2	$ 5.8	$ 1.0	$ 0.5	$ 1.5
2024	$ 4.8	$ 1.6	$ 0.4	$ 2.0	$ 0.0	$ 5.8	$ 0.2	$ 6.0
2025	$ 3.2	$ 1.6	$ 0.3	$ 1.9
2026	$ 1.6	$ 1.6	$ 0.2	$ 1.8
2027	$ 0.0	$ 1.6	$ 0.1	$ 1.7

Wealth management for capos revisited: maybe there is no wealth

 The always-brilliant Alejandro Hope reads my mind! Go read his latest piece. Or, to prevent link rot:

El Chapo’s millions. Over at El Universal, a big piece on companies allegedly connected to fugitive kingpin Joaquín El Chapo Guzmán. Apparently, the US Treasury Department has identified 288 firms connected to the capo, out of which 95 are Mexican and may have even received government contracts. The surprise? How small and unimpressive some of these ventures are. Case in point (translation mine): “The day care center Niño Feliz was one of the first companies identified by OFAC (Office of Foreign Assets Control) as connected to the Sinaloa Cartel. The main reason was that María Teresa Zambada Niebla, daughter of drug kingpin Ismael “El Mayo” Zambada, was one of the firm’s founding partners … The day care center provides service for 209 children and charges 3042 pesos per month for each children. In total, the federal government pays the center almost 8 million pesos (500,000 USD) every year.” A day care center? Really? (The business “empire” also includes, allegedly, eight service stations and one moving company, among other equally exciting activities.)

No boom town. So if El Chapo is not using his wealth to create world-beating companies, where is he parking his money? Certainly not in his home town, Badiraguato. The legendary largesse of the capo is nowhere to be seen in the streets he roamed as a child. Mark Stevenson, from the Associated Press, reports: “The roads to La Tuna are still washed-out dirt tracks, and Badiraguato itself has none of the flashy accoutrements of money — luxury car dealerships, palatial mausoleums, acres of fancy, gated communities of new homes, or dozens of street money-changers offering cheap dollars — that are abundant in Culiacán, the state capital, 1½ hours away. The town’s big projects include a new balcony for the town hall that looks out over the sleepy square dominated by a 19th-century church, where residents seek shade from the punishing Sinaloa sun.”

So where’s the dough? What if most of the drug money was actually reinvested in the illegal economy. This is something I wrote some years back:

“Imagine you’re a drug dealer. Even if you’re Chapo Guzman, you cannot be considered a good credit risk: you might be killed or arrested tomorrow, and then who will pay the debt? You will not be able to obtain a revolving line of credit, and your suppliers will probably not give you marijuana or cocaine on credit. Nor can you leverage yourself using your employees’ salaries: it is not a good idea to stop attending to the payroll when your staff is armed to the teeth and knows too much. Factoring is not an option, for the obvious reason that there are no receipts. Furthermore, nobody is going to sell you an insurance policy to protect the product; therefore you have to have a financial reserve in case goods are seized, stolen or lost (planes fall and boats sink).

“The only real option is to finance your operations with the profits of previous deals. But you do have this; if the product meets a good fate, you will get back more (perhaps a hell of a lot more) of what you invested. Given that, where you would put your money: in bonds, on the stock market, into the production of serrano peppers, in real estate development, or in the smuggling of illegal drugs? Perhaps you would try to diversify a bit, but in all likelihood the most important part of your portfolio will be in the most profitable activity. And how will you preserve your working capital? Most likely, you will want to keep it in cold, hard cash, guarded by some unfriendly thugs: In addition to known risks, you do not want to worry about your bank account being frozen, do you?”

My (somewhat depressing) conclusion: “If the majority of the profits of crime are reinvested in crime, no amount of financial intelligence can help: the only way to seize the money is by physically finding it (as in the case of Zhenli Ye Gon).”

There is another implication to Hope’s idea. No enterprise can expand forever. At some point, you hit diminishing returns. But if narcos prefer to reinvest their profits in more narcotrafficking, then they will tend to expand their businesses well past that point. The enterprises will start to resemble ‘70s-era conglomerates or Japanese keiretsu: too big, basically unprofitable shambolic zombie organizations overextended in the product lines they do best and muscling into all sorts of markets where no rational profit-maximizer would go. In the end, there might not be any profits the way we think of them; everything would get reinvested for an overall return of zero, if properly accounted for ... hell, given the margins, returns could even be persistently negative.

Which does sort of resemble Mexican organized crime, no? One mystery has always been the scale of the violence. It just doesn’t seem profitable to spend that much trying to monopolize drug routes, not given the scale of the U.S. market and the porousness of the border. Live and let live. But if all you can do with the returns is plonk them back into the organization, then the creation of a giant metastasizing enforcement arm might be just the ticket. What the hell else are you going to do with the money? 

It would also explain the relentless push into new businesses. For crying out loud, the Knights Templar went after iron mines and took over avocado farms. The Zetas took to kidnapping impoverished Central Americans. To be honest, I suspect my family earns higher percentage returns on some Miami real estate that we own, or hell, our house here in D.C. (It’s a highly-leveraged investment.)

And low profitability (caused by overexpansion) might also explain cartel fragmentation. They start to lose money, can’t keep their enforcement arms happy (or pay enough bribes), spin apart.

In this view, Sicilianization happens when organized crime can reinvest its profits in things other than organized crime without getting caught. Like construction. Or waste management. Then violence declines and things become stable. But if that doesn’t happen — and the state can’t get its act together sufficiently to impose order — then you get cartels that resemble ... Beatrice.

At least until they spin apart. Like Beatrice. Only with more blood. The scary clown seems appropriate. 

And the implications of Hope’s insight seem worth exploring further. Some fascinating testable hypotheses may emerge. 

Wealth management for capos

 So, that tunnel appears to have been a pricey, gold-plated, Second-Avenue-Subway of escape tunnels. 

Which begs an interesting question. How did Shorty pay for it? He couldn’t just write a personal check, for obvious reasons. So what did he do? Note I am not asking how he launders the proceeds. I am asking how he keeps control of the money after he launders it.

We know how Michael Corleone did it. He stayed personally untouchable, so his legal control of the enterprises into which he channeled illicit gains was not questioned. He could (and did) write personal checks. If a fictional reference does not satisfy, then this was also the strategy employed by Al Capone and Meyer Lansky. My father briefly worked for the latter in the late 1940s, in a completely legal racket to extort the clients of high-class Miami prostitutes. Those two guys, they could (and did) write personal checks. The challenge was in laundering the money, not controlling it once cleaned.

Shorty, then, would have a few options.

1. False identities. This would be an entirely fake persona controlled only by El Chapo. Hard to maintain, relatively high risk of detection, but cheap and secure.
2. Trusted compatriots. Emma Coronel, for example, is not openly wanted. But she would not be a good choice, since she is linked to Shorty. (For those of you who do not recognize the name, she’s Shorty’s wife.) But there is little doubt that our man has other trusted people willing to act as his financial sock puppets. That said, loyalty can be bought; I have trouble believing that the Sinaloa Federation is run solely on the basis of trust. Too much risk of betrayal.
3. Interlocking monitors. Here you have multiple sockpuppets. Each one controls a chunk of your wealth, but each one is also monitored by potential assassins who are paid from a different source. This will involve high overhead costs, especially the smaller the chunks into which the overall kitty is divided. But it is likely the best way to go. Except it also opens up oversight problems: where do you keep the centralized double-entry accounts to monitor the operation? We know the Zetas did that (I have seen such accounts but have no permission to use them) and that such accounts were one of the ways in which the authorities finally brought down their leadership.

In addition, there is another dilemma: keep laundered wealth in cash or invest in other assets? One popular, hard-to-detect and easy-to-control asset would be loan-sharking. People will owe you money on pain of death and dismemberment; the killers and dismemberers will depend on the continuing health of your operation for their salaries. The problem here is twofold: you will need to invest in a very large portfolio of sharked loans if you want to put any sizeable sum into such schemes ... and the resulting wealth will not be particularly liquid. (I guess you could sell your debtors’ organs in extremis, but that would seem to incur heavy losses. Not a great solution to the liquidity problem.)

It is an interesting problem. At least from a distance.

Has the crackdown on money-laundering hit the average Mexican?

 In 2012, we reported about the scandal involving U.S. banks laundering narcotics money going back to Mexico. The scandal caused bankers to get scared. And so, they claim to be pulling back from their cross-border services, hurting everyday Mexicans. 

Hmm. The story at the link does show big U.S. banks pulling back, and goes deep into the hassles faced by Columbia professor when they found their accounts had to be shut down. But is it really affecting everyday people?

There do not seem to be any signs that people in the U.S. need to queue up in order to send money to Mexico. Absent a shortage of cross-border money-transfer services, then, one would expect restrictions on money transfers to show up in higher prices. Fortunately, the World Bank records the price of transferring money to Mexico. And they report (as a % of the sum transferred):

There is seasonality, which does make it seem that prices have recently ticked up ... but in context they have not. Moreover, the cost of moving money via non-banks has gone down monotonically, with only a recent bump. This is not surprising, since it would seem weird for a 2012 scandal to cause prices to rise in 2015.

An article from the New York Times says, “While immigrants say they have not noticed broad price increases from companies like Western Union, industry experts say higher costs are inevitable with fewer banks acting as middlemen for money transmitters.” Meaning that maybe costs will rise in the future, perhaps, but they have not yet.

So maybe the new regulations will impact everyday Mexicans. But not yet. And to be honest, probably not ever.

Be afraid! Be very afraid

 A long time ago, I worked on financial systems. And so, back in 1998, I was called to give some comments to a gathering in Mexico City’s historic district. (I still have the suit I wore, a very sturdy Christian Dior; it isn’t the one in the below photo from December 2014.) I kept my discussion short, since I was well-aware of my ignorance, having just lost a potential job at Columbia University due to overly sweeping claims of knowledge.* 

So, still chastised from the New York fiasco, I made only one claim to the gathered dignitaries from the Financial Ministry, the U.S. State Department, the IMF, and the big Mexican banks: shareholders must lose in a bailout. Give away money, write checks, defend depositors, make good guarantees on subordinated debt, throw bags of money at the banks’ creditors. But shareholders must be wiped out. 

And so, I am terrified to read today that a federal judge held that the U.S. government was too harsh when it bailed out AIG. The bailout, you see, wiped out the shareholders and ultimately made money for the Treasury while preventing a much worse financial collapse. But wiping out the shareholders, according to the judge, was too harsh. Better to have let the shareholders be ... uh ... wiped out with no public benefit.

Wait, what?

It gets even weirder than that. The AIG investors received nothing in damages ... the judge recognized that without the bailout they would have lost everything. But he still held that the government overstepped its bounds. I cannot parse the logic.

Which means one of two things the next time a financial crisis rolls around. One, no direct bailouts. Fun! Why have a second Great Recession when you can go full on to a second Great Depression? Two, bailouts (or bailouts in disguise) that enrich the already prosperous, who will face no consequences for their bad investments. Heck, let’s see just how unequal a modern automated economy can get! 

I don’t even have to mention the words “moral hazard” to make this look scary. But since I am on the topic: Moral hazard! Boo!

And so, I give you Judge Thomas Wheeler, a George W. Bush appointee still making the world a worse place. I guess it deserves some sort of prize.

I really need to respond to the comments in the Crazy Base World post, no?

If you impose capital controls, you need to take some risks

 Capital controls are state-imposed restrictions on moving money in or out of a country. If you have money inside a state with capital controls, then it is legally-difficult to lend that money to foreigners or use that money to buy foreign assets. In fact, to be binding, it even has to be difficult to use that money to freely import stuff. Otherwise you could move money out simply by buying something overseas on credit, importing it, and selling it to yourself at an inflated price.

Why might a government want to impose them?

1. Governments sometimes impose capital controls during economic crises. They might do this to stem a panic. Say that people have started dumping assets and taking the money out of the country. (If they are not doing that, then they are likely using the money to buy other assets, which is less of a problem.) The fire sale is driving down asset prices and pushing otherwise healthy companies towards insolvency. In that situation, capital controls basically stop the foreigners from being able to dump their assets. It’s a way of forcing everyone to calm down, the way a bank facing a run might stop withdrawals for a little while.  
2. Capital controls can also be used to give central banks the ability to fight a crisis without worrying about the exchange rate. They can prints lots of money and do other unorthodox things without the fear that people will start dumping the currency. In countries where lots of companies have foreign-denominated debt, that is a good thing.
3. Finally, governments can shift the pain of external adjustment by using controls. A collapse in the exchange rate has all sorts of distributional effects. If a government doesn’t like those effects, then it can use capital controls to shift them around. (Venezuela is doing this ... for so long that it long became massively counterproductive. But that is a different issue.) 

Kris James Mitchener and Kirsten Wandschneider have a good working paper on capital controls during the Great Depression. What did they find?

1. Controls worked on the most basic level, as in governments succeeded in making it hard to take money out of the country;
2. Controls abetted recovery from the Depression ... but no more so than in the countries that just let their currencies depreciate;
3. One of the reasons for (3) is that central banks seemed very reluctant to take advantage of the manuevering space that the controls provided. In short, they stuck with basically the same policies as the countries that let their currencies float, even though they no longer needed to. 

What are the implications for the current Russian predicament? I see two. If the crisis really is a panic-driven flight, then the controls may work well. The Russian government has been informally imposing such controls for several weeks, mostly by ordering state-owned businesses to refrain from taking money out of the country.  

On the other hand, if the crisis is more systemic, then the Russian government could use controls to keep the ruble from plunging further while it uses its foreign reserves to bail out various companies. That might be useful! It would keep import prices from spiking and keep various exporters solvent. But it is not clear that it would really produce less overall pain than just letting the ruble fall.

The problem does not seem to be driven by a short-term panic, so it seems that the Russia government has a difficult choice. But the lesson seems to be that capital controls do not do much good unless you have a plan for using the breathing room. Does anyone in Moscow?

Policy of attraction, part 3

 In comments, J.H. asks why the Phillipines didn’t adopt the U.S. dollar. After all, Hawaii and Puerto Rico did, as did Cuba, Panama, and the Dominican Republic. So why not the Philippines?

By the time the Philippine War ended in 1902, five different monies circulated in the Philippine Islands:

(1) Mexican silver pesos;
(2) Spanish silver pesos minted under the 1897 Royal Decree;
(3) Fractional currency;
(4) bank notes issued by the Banco Español Filipino; and
(5) U.S. dollars paid to American troops during the war.

The silver currencies traded at values that had little to do with their actual silver content; the Philippines were basically on a fiat money standard, with the difference that nobody was actually in charge of issuing it. Nobody liked that, so the U.S. had to decide between three different options. First, it could regularize the silver currency, basically continuing the existing system but under the control of a single mint. Second, it could introduce the U.S. dollar. (The U.S. was then on the gold standard. Dollar coins had a fixed gold value, and federally-regulated banks were required to back their note issues with gold or U.S. government bonds.) Third, it could introduce a separate Philippine gold-backed currency.

Why adopt the dollar? I give the floor to Representative Ebenezer Hill (R-Connecticut): “I want to say to every one of these representative from the Pacific coast that whenever they vote to put a new and strange system of coinage in the Philippine Islands is to build a fence between the trade of those islands and the trade of that coast.”¹ Since Republicans backed the permanent retention of the Philippines, such a position was not terribly surprising.

What might be much more surprising is that most of the support for adopting the dollar came from the Democrats, who were loudly and uniformly opposed to annexation. What explains that? Well, examine the following exchange:

William Jones (D-Virginia): I would like to ask the gentleman if he does not think by extending the coinage laws of the United States to the Philippine Islands and giving them our lawful money we could get out of there if we wanted to much more easily than if we gave them a distinctive currency which we would have to redeem and pay for?

Sereno Payne (R-New York): Oh, on the other hand, I think it would look as though we meant to stay there forever. [Laughter on the Republican side.]²

What was Jones getting at? How would installing the dollar in the Philippines make it easier to leave? Well, let’s go to Representative James Williams (D-Illinois):

A moment ago the gentleman from New York twitted those of us who want to get out of the Philippines with some sort of imagined inconsistency because we were supporting the substitute bill. ... I believe with all my heart that a greater mistake was never made than ever having landed a man to stay upon the Philippine shore after the Spanish fleet was destroyed. ... But I claim that when we leave we should leave behind American money as a stimulating agency for the expansion of American trade in the future. ... I say today that if you turn the Philippine Archipelago loose as an independent nation upon the Earth, it can not by any legislation float a token coin.³

In other words, the Democrats supported introducing the dollar because they believed that it would promote economic stability, thereby making it easier for the U.S. to get out forthwith. After all, Cuba had the dollar but the United States was smoothly on the way out. (The Democrats had no problem with Puerto Rico, although they were upset that the constitution was not extended to the island.) This position was honest: as I may talk about in a future post, the Democrats also strongly supported restrictions on American investment in the islands as long as they were under American sovereignty.

So why did Republicans prefer the option of a gold-backed Philippine currency?

The first problem is the Philippines were poor. One cent in 1901 was worth 27¢ in 2010 in the United States. In 1901, the price level in the Philippines was a lot lower than the price level in the U.S. (This is a general phenomenon: prices are lower in poor countries than in rich ones.) So one American penny bought at least the equivalent of fifty cents, whereas a Filipino centavo bought half as much. Losing the smaller denomination would have been a serious problem.

Of course, Philippine poverty wasn’t the only problem: Representative Hill proposed that the U.S. reintroduce the half-cent as an easy solution. The second fear was a bout of inflation. Puerto Rico had seen that during the changeover, as merchants attempted to charge as much in the new currency as they had in the old. (In theory, that shouldn’t happen. In practice, it did, and it forced an unpleasant political response.) William Howard Taft, the governor of the Philippines, was particularly worried; the last thing he wanted was popular discontent. Puerto Rico had handled the trouble, but Puerto Rico wasn’t coming out of a vicious guerrilla war.⁴

Finally, the Commission government convinced itself that a new peso could be introduced faster than the dollar. The Taft government (and potential American investors) were unhappy with the exchange rate fluctuations that afflicted the archipelago. It wanted a gold peso to stabilize the situation, and it wanted it quickly. If it could not get a gold peso, then it wanted the right to mint silver ones, but it wanted something.

The Democrats were a minority in Congress. They couldn’t pass a bill adopting the dollar in the House. In the Senate, Democrats were willing to fight for investment restrictions, but they were not going to do that over the currency. So bills passed both houses.

Except different bills passed each chamber. The House of Representatives voted 89-55 in favor a gold-backed Philippine peso, whereas the Senate accepted unanimously a proposal to coin silver. No compromise was forthcoming. As a result, the Philippine Organic Act of 1902 contained no monetary proposal, save an authorization to mint small change.

After another year of monetary chaos in the Philippines, the Philippine Commission went back to Congress. On January 22, 1903, the House of Representatives changed its position and voted 147-127 to introduce the dollar into the islands. The Senate then also changed its position, and voted on February 16th to create a gold peso. This time, however, compromise was forthcoming, in the sense that the House reversed itself. On February 24th, the lower house voted 139-104 to create a gold peso at a fixed rate of 2:1 with the dollar.

The introduction turned out to be messy and unsettled. It proved difficult to get the old silver pesos out of circulation; the exchange ratewith silver varied wildly; and managing the new currency proved more difficult than expected. It is far from clear that switching to a gold peso avoided many of the problems that switching to the dollar would have entailed. But there you have it.

In short, Taft and the GOP wanted to create a fixed exchange rate with the U.S. (believing that would promote trade and investment) but without the delay and dislocation that they believed would come from introducing the dollar. They then got all the delay and most of the dislocation anyway because Congress could not decide.

That said, it is also extremely unlikely that adopting the dollar would have made much difference. For it to have had a big effect before independence, you would have to be a very strong believer in the (excellent!) work of Andrew Rose on the effect of currency unions on trade to argue that having the dollar (as opposed to a fixed rate of 2:1 under American sovereignty) would increase trade by much. (In fact, Rose would expect it to make no difference; the fixed exchange rate between the U.S. and the P.I. was already a strong currency union.) There was a big financial crisis in 1919-22, in which the management of the fixed exchange rate was involved, but it is unclear at best whether the dollar would have really made any difference. The combination of postwar dislocations and mismanagement at the Philippine National Bank would have been a major problem either way; the dollar did not protect Cuba.

As for post-independence Philippines, well, after WW2 the U.S. spent a lot of effort to de-dollarize countries that used the currency. Considering how important capital controls were for postwar Philippine governments, it is hard to see why the Philippines would have been any different. Capital controls would have still been imposed and an American commission would have helped introduce a new currency, and the only difference is that the exchange rate would have fixed under the Bell Trade Act at 1:1 instead of 2:1. Perhaps the Philippines would have resisted de-dollarization (Panama did) but that seems very unlikely.

In short, the Philippine currency embroglio probably belongs in the list of Great Debates That Turned Out Not To Matter. But it get the world some coins that it otherwise would not have had, and now you know why.

A short primer on the Ethiopian banking system

 Because this is what I do.

Ethiopia’s banking system is weird. It’s like a throwback to an earlier Africa, the Africa of the 1970s or 1980s. Three reasons.

First, the system is dominated by two big state owned banks. One of them — the Commercial Bank of Ethiopia — accounts for almost 50% of all lending, by itself. Throw in the other one (the Development Bank of Ethiopia) and the majority of lending in the country is being done by state-owned banks. That was pretty common in Africa thirty years ago, when almost everyone had a big state-owned bank or two that dominated the sector. But in 2012, state-owned banks are an endangered species. About half of all African countries don’t even have them anymore. In those that do, the state-owned bank is usually small and specialized, focused on some neglected sector like agriculture.

There are a couple of reasons for this. One is that, historically, African state-owned banks generally didn’t work very well. Another is that the big multinational lenders — the World Bank and the IFC — dislike state-owned banks, and have encouraged African countries to break them up and privatize them, or at least shrink and marginalize them. (For the record, I think this was mostly a positive thing — but like a lot of World Bank/IFC policies, it’s been applied in a rather ideological and ham-handed way. A lot of bad, corrupt, ineffective old state banks needed to go, but a lot of babies got thrown out with that particular bathwater.)

Ethiopia, though. Ethiopia is run by a bunch of former revolutionaries who are very nationalistic and not inclined to trust or listen to the World Bank and its ilk. So they’re keeping their big state-owned banks. But at the same time, they’ve allowed — no, encouraged — the growth of a vibrant private banking sector. There are about fifteen private banks in Ethiopia today, and they account for about 40% of lending and about 60% of deposits. They’re a vital part of the economy already, and they’re growing by leaps and bounds. So the banking sector is a true public-private hybrid. In this, Ethiopia looks a bit like a less-developed version of Brazil, where public banks are common and the BNDES development bank plays a major economic role ... but keep reading.

The second odd thing about the sector is that it’s closed and protected: no foreign banks are allowed. Ethiopia has no Barclays, no Bank of Africa, no Citi or HSBC. That’s also weird and unusual, because in 2012 most African and Latin American countries have opened up their banking sectors to foreign competition. Among other things, you can’t join the World Trade Organization unless you agree to do this — and everyone wants to join the WTO. Out of 54 African countries, all but seven or eight are already WTO members. (The ones that aren’t in the WTO are either oil-rich — Libya, Sudan, Equatorial Guinea — or recluse states like Eritrea, or tiny places like the Comoros. Oh, and Somalia, which doesn’t have a functioning government.) So pretty much everywhere in Africa, from Botswana to Senegal, you’ll encounter a bunch of international banks. But not in Ethiopia.

The third weird thing: the Ethiopian Central Bank? The guys who regulate the banks, control the money supply, set interest rates and all that? The Central Bank is not independent. Doesn’t even pretend to be. It’s an arm of the executive branch. It’s there to do all the normal central bank stuff, but it’s also there to carry out government policy. (In this, Ethiopia is also quite different from Brazil. The Banco Central do Brasil has little statutory independence, but plenty of de facto autonomy.)

Here’s an astonishing example. Couple of years back, the Ethiopian government wanted to build a hydroelectric dam. Huge, huge thing. Going to light up half the country. Also going to displace tens of thousands of villagers and do untold ecological damage, including possibly wiping out Lake Turkana, but do you want electricity or not? — So they want to build a dam, but for various reasons nobody wants to lend them money to build it. (Ethiopia’s credit is not good: Dagong rates the government at CCC, and Moody’s and Standard & Poor’s don’t even bother.) Where to get the money, then?

Well, the government of Ethiopia simply followed the Willie Sutton principle. The Central Bank told the private banks that they needed to start buying dam bonds. Lots of them. In fact, the Central Bank announced that for every dollar lent by a private bank, they would have to buy twenty-seven cents worth of bonds. Since commercial loan rates in Ethiopia are around 12% to 15%, and dam bonds pay just 3%, the banks were not very happy about this. But they had no choice: if they didn’t comply, the Central Bank would shut them down. So they’ve been buying dam bonds — millions and millions of dollars of them. And now the government has money to build its dam.

So, a mixed public-private banking system that’s protected from international competition, run by a non-independent central bank with a history of brutal intervention. How’s that working out?

Surprisingly well. But this may need another post.

This would be a painful way to end European union

 Over the last two months, family business has kept me away from blogging. Before that, I was in the throes of finishing a first draft of a book manuscript. The family business is over and I’m now in the far more relaxed process of fixing the manuscript, so this time I think I think we’re really back!

In December of 2010, I made a bet with Doug Muir and Omar Serrano that the eurozone wouldn’t make it to March 25th, 2013. If any of the big eurozone economies leave the single currency, I win. The bet is structured so that I will lose even if Ireland, Portugal, and Greece all abandon the euro; it has to be Spain or Italy. The loser will either fly across the Atlantic to meet the winner, or pay for the winner to fly to meet them, and then buy them a steak dinner, with port and cigars.

The big question, of course, is how a government could leave the eurozone. Now, Nick Rowe has proposed a way. “Eurozone governments and banks that cannot pay their obligations in euros may end up paying their obligations in a scrip that is not pegged to the euro. A scrip issued by each national government that is worth whatever people think it is worth. And if people start using that scrip as a medium of exchange, and medium of account, it becomes a new money. Sure, Greek supermarkets might prefer payment in euros, but if their customers can only pay in New Drachmas, then it’s either accept New Drachmas or let the vegetables rot on the shelves. And the supermarkets’ suppliers might prefer payment in euros, but it’s either accept New Drachmas or let the vegetables rot in the fields. And the workers picking the vegetables might prefer payment in euros, but it’s either accept New Drachmas or nothing.”

Sounds almost painless! Matt Yglesias implied so. But it wouldn’t be! It would be a mess and cause the economy to cycle the drain until the government defaulted on its debts anyway. Moreover, it would not cause the scrip to drive euros out of circulation.

Consider, for a moment, what Spanish obligations consist of. In part, they are debt payments. Spain’s debts, however, are denominated in euros and will remain denominated in euros no matter how many nuevas pesetas are printed unless the Spanish government withdraws altogether from the European Union. Rather, the obligations which the Spanish government can insist on paying in nuevas pesetas are the obligations that it owes to its own citizenry: salaries, pensions, unemployment benefits, etcetera. The nueva peseta would trade at a discount against the euro, of course, but that is the idea.

Except ... the incomes of Spaniards would drop in terms of euros. They would be increasingly earning in discounted nuevas pesetas. The problem, of course, is that they would then be paying less taxes in terms of euros. But the Spanish government owes debts denominated in euros! The debt burden would rise. The more the debt burden rises, the more the government needs euros to pay it. The government would, of course, trade nuevas pesetas for those euros. That would increase the discount on nuevas pesetas, further driving up the size of the debt burden, further increasing the discount on nuevas pesetas. (While this is going on, the interest rate on Spain’s euro debt would skyrocket, of course, unless it is by then owed to the European Union rather than private investors. In that case, however, it is very unlikely that Spain would be going around issuing scrip to pay salaries.) At the end of the story Spain’s income in euros falls enough to force the government to default on its euro debts, but only after setting off an inflationary spiral.

There’s a second problem. Rowe wrote, “Greek supermarkets might prefer payment in euros, but if their customers can only pay in New Drachmas, then it’s either accept New Drachmas or let the vegetables rot on the shelves.” That, however, isn’t correct. Government employees might be paid in new drachma, or nuevas pesetas, but they can exchange those pesetas for euros. The supermarket cannot be required to accept those pesetas unless Spain leaves the eurozone. If the owner insists on being paid in euros, then the customers will swap their pesetas for euros in the market and he or she will be paid in euros. This is a process that has occurred in many high-inflation countries, where people abandoned the local currency for the dollar ... and in most of those countries, the dollar was not legal tender! In short, the logic breaks down at that point: it is not clear why the pesetas would replace the euro as a medium of exchange ... except, of course, to make tax payments.

Of course, it isn’t clear that Spanish government employees (or pensioners, or students, or the unemployed) would want to receive devalued nuevas pesetas in lieu of euros. They would, quite rationally, perceive it as a pay cut. Anyone who owed money would be doubly hit: their debts would still denominated in euros.

Finally, such an action would be perceived (correctly) as a prelude to formally leaving the eurozone, precipitating the mother of all capital flight. Without leaving the eurozone (in fact the country would have to leave the European Union altogether) the government would have no way of combating that flight.

In short, introducing scrip would be a terrible way to exit the eurozone. It would run a high risk of triggering a depression, and it would certainly worsen the country’s debt burden. Professor Rowe is, I think, incorrect. History bears this out: the issuance of patacones (or créditos) in Argentina around 2000 did not result in the creation of a new Argentine currency or stave off default. Rather, they contributed to the depression, and quickly inflated away.

There are many ways in which the eurozone could fail. The issuance of a parallel currency for any length of time strikes me as one of the worse ones. Is there a hole in my logic?

This is (not) how European union ends: options

 Ireland is in trouble. Kevin O’Rourke has written an despairing piece on the country’s woes that is, I think, well worth reading. There is a good analysis of the situation up on Crooked Timber; the comments are well-worth reading. There seems to be some question about the extent of German banks’ exposure to Irish debts, private and sovereign. That matters: the less exposed the foreign banks, the easier a solution. (And yes, that is back-asswards from what you would think.) Tyler Cowen thinks the situation is doomed; he even thinks that a unified banking market (which would have helped a lot) is probably now off the table.

Interestingly, the bars in Southie are not full of discussions about the recent Irish loss of sovereignty, as opposed to an older one.  

 

Yesterday’s Financial Times had a nice recap of the E.U.’s options on page 2. Here they are:

1. Step up ECB bond purchases: this seems to have happened, according to today’s front page. They have succeeded in driving down the interest rate on Portuguese debt by 50 basis points, to 5.82%, and on Irish debt by 25 points, to 8.30%. What I doubt is that the ECB will do enough of this to actually produce any inflation, which would, if there was enough of it, solve the problem. Internal devaluation made easier in the periphery, deleveraging made easier everywhere. But German public opinion hates the idea, so what can you do?
2. Increase the size of the E.U. rescue fund: The fund is not big enough to allow Greece, Ireland, Portugal, and Spain to all simultaneously refinance their sovereign debt, let alone adding Belgium and Italy. (Estimates are that it is short €140 billion.) But Germany is opposed to expanding it, so that’s that. Plus, an expansion could trigger a crisis, by indicating that officials think a Spanish crisis is imminent. In other words, it should’ve been two or three as big to start with.
3. Issue eurobonds: Here the idea is that the E.U. countries would issue collective bonds for which they would all be responsible in some fashion. Basically a bailout in any other name. But as the FT author writes, “They would be seen as an unacceptable large step towards ...”
4. Greater fiscal union: Fiscal union is not going to happen. Even if it did, there would still be the problem of uncompetitiveness in places like Portugal and Spain ... although those could be worked out the hard way if the countries didn’t have to worry about sovereign defaults and the subsequent banking collapses that they could cause.
5. Nothing: “If none of the above works, talk could grow about the eurozone breaking up. But no eurozone policymaker seriously believes an exit by a country such as Greece would make its predicament any easier. ... Even if Germans became fed up with their neighbors, a return to the D-mark would also be economically catastorphic: the currency would soar, pricing its exporters out of business.”

Now, the part about Greece is not quite right. In the short-run, exit would be a disaster. But it would lead to an export boom down the line, and if the banking system had already collapsed then the costs would be relatively low. That however, is really a fairly weak nothing-left-to-lose argument: if we ever reach the point where leaving the eurozone is costless for a country, then that country has already been plunged into something as severe as the Great Depression. The real money line is the one about Germany, as discussed in the previous post: a wave of eurozone exits would devastate the German economy.

I had an idea for another option, but it slipped my mind. Anyone know what it might have been?

This is how European union ends: badly

 In my previous post, I wrote, “The problem seems to be the German government’s unwillingness to explain that Germans benefit more than anyone from the eurozone. Break it up, and German banks go kaplooie, German exports become uncompetitive, German wages become unsustainable, and the German people get blamed.”

 

One reasonable objection might be that Germany depends relatively little on the rest of the eurozone for its export revenue. (See the above chart for German exports in billions of current dollars.) In 2009, the eurozone took only 41% of all German exports. Moreover, much of the eurozone is likely to survive any crisis. The six countries whose new currencies are likely to collapse in the event of a breakup (Belgium, Greece, Ireland, Italy, Portugal and Spain) took only 17% of German exports. Those statistics certainly make it seem that Berlin could afford to let the European Union go hang.

Except ... well ... Germany depends a lot on exports. Exports to the Notorious Six may come to only 17% of German exports, but Germany exported 38% of its GDP in 2009. Exports to the Notorious Six, therefore, came to 6.6% of German GDP. In addition, imports from the Notorious Six came to 5.0% of German GDP. Imagine, then, a devaluation that caused German exports to those countries to drop by a third, while imports from them rose equivalently. The total negative shock to Germany’s economy would come to 3.9% of GDP. That is, I think, quite large. Depending upon the multiplier, the shock could be even larger.

Add to that the negative effect from the collapse of all those German banks that invested in the Notorious Six (plus the huge rise in uncertainty that any European collapse will entail) and the negative effect is likely to be much much larger than 4.9%. Six percent? Eight percent? Your guess is as good (and likely better) than mine. But the numbers look to be at Great Depression levels, unless the German government proceeded to throw its current rulebook out the window and deficit spend as if there was no tomorrow. (1931 all over again!)

Will German voters prefer to pay that price rather then pay to resolve the credit crises currently besetting (or threatening to beset) the Notorious Six? I do not know. I increasingly suspect that they would. Buckle up; we seem to be in for a rocky ride.

Dubai in debt

 On November 25, 2009, Dubai World announced that it intended “to ask all providers of financing to Dubai World and Nakheel to ‘standstill’ and extend maturities until at least 30 May 2010.”  The problem was Nakheel, the real estate arm that had (among other things) created the artificial Palm and World islands. Nakheel had $4.05 billion in debt coming due on December 14, and it couldn’t finance it. Stands to reason that Nakheel was overleveraged, right?

Well, not really. According to Nakheel’s June 2009 filing, it possessed $20.0 billion in liabilities against $40.0 billion in assets, which isn’t bad at all. Of those assets, $30.7 billion were “properties under construction.” Since Nakheel acquired land for free from the Emirate’s government, those costs were actual construction costs, and didn’t reflect overheated land values. Sounds good, very responsible. They could sell the properties for a full third less than they cost to construct and still be solvent.

The problem was cash flow. Sometimes nobody wants to buy gold-plated bidets at any price, whether at cost or ⅔ of cost or whatever. On a gross profit of $175 million for the first half of 2009, Nakheel took impairment costs of $3.3 billion. Now, that might be theoretical — but cash flow from operations was negative $948 million in the same filing.  That is not good when you’ve got a lot of debt coming due and a world financial system in the midst of freezing up. In normal times, Nakheel might have been able to brazen through, even with the 50% decline in Dubai property prices between September 2008 and September 2009. This was not a normal time.

 
The IMF put together a handy time series on the cost of insuring debt from the government of Dubai and Nakheel. There are two interesting things and a mistake in the time series. First, it looks like the markets didn’t pay any attention to Moody’s. Second, they paid a lot of attention to Sheikh Mohammed bin Rashid Al Maktoum. (Strangely, the first turned out to be right and the second wrong.) Third, the $10 billion support package wasn’t really a support package from Abu Dhabi. Rather, the Emirate of Dubai sold $10 billion in bonds to the central bank of the UAE and used the revenues to backstop its public entity debt. The actual bailout didn’t come until December 14, when Abu Dhabi stepped in to lend Dubai World $10 billion to pay its sukkuk.

 

So where to from here? Well, there is a lot of debt coming due over the next few years. In millions of U.S. dollars: 

	Dubai Holding	Dubai World	ICD
2010-Q1	$ 600	$ 1,199	$ 3,250
2010-Q2	$ 2,933	$ 3,140	$ 294
2010-Q3	$ 0	$ 0	$ 0
2010-Q4	$ 295	$ 140	$ 920
2011-H1	$ 0	$ 4,455	$ 1,544
2011-H2	$ 3,161	$ 2,192	$ 6,044
2012-H1	$ 500	$ 0	$ 3,702
2012-H2	$ 330	$ 4,592	$ 2,191
2013-H1	$ 260	$ 1,000	$ 1,222
2013-H2	$ 246	$ 550	$ 2,640
2014-H1	$ 1,511	$ 0	$ 154
2014-H2	$ 632	$ 350	$ 1,957
Beyond 2014	$ 4,621	$ 4,534	$ 4,357

The Emirate of Dubai certainly can’t pay it. The government is in already in deficit. It will need to raise taxes to maintain basic services and pay the interest on the $18.7 billion that it currently owes — yes, the UAE central bank wanted interest, and lots of it. Raising taxes even further to support the development companies seems, well, not that likely.

 

Dubai could default, but that would pose a bigger problem. First, as readers of this blog certainly know by now, sovereign immunity basically doesn’t exist in the United States or European Union. Creditors could go after any and all Dubai-owned assets used for “commercial purposes.” Dubai has already started “ringfencing” its bad debts, for example by listing DP World on the London Stock Exchange as a separate entity, or transferring Nakheel’s overseas property holdings to Istithmar World. Those strategies, however, depend on laws in the U.S. and E.U., and so they have limits. (Judge Griesa would have a field day.) Second, Dubai depends on debt. An Argentine-style strategy would wreck Dubai’s entire development model.

	Disclosed debt	Other liabilities	Total  liabilities
Dubai World	$ 26,219	$ 7,866	$ 34,085
Dubai Holding	$ 15,090	$ 4,527	$ 19,617
ICD	$ 28,275	$ 5,655	$ 33,930
Dubai government	$ 18,700	$ 0	$ 18,700
Other Entities	$ 1,885	$ 0	$ 1,885
Total	$ 90,169	$ 18,048	$ 108,217
Total (ex-government)	$ 71,469	$ 18,048	$ 89,517

It’s a problem. But it isn’t necessarily a killer. First, Abu Dhabi knows that world markets will be rocked if Dubai entities start defaulting. Since Abu Dhabi has invested billions and billions in those very markets, it has an interest in making sure that Dubai debts are restructured in an orderly fashion.  In fact, the Abu Dhabi government has stated that it will continue to “support Dubai in its efforts to achieve a viable position.” Second, of the $22 billion in Dubai debt that the IMF estimates has been affected by the standstill, $12 billion consists of syndicated loans and $7.5 billion of individual loans, with only $2.5 billion in bond issues. The prevalence of bank debt makes restructuring easier, since Dubai can assemble and talk to a small group of creditors. Finally, Dubai may have overbuilt, but there is still a reason for there to be a city there: it probably isn’t going to go the way of Detroit. With debt-to-asset ratios around 50% (pre-crash) the city-state’s public development entities will probably be able to find some combination of debt restructuring and price cuts that keeps them solvent.

California didn’t go away after 1873, Panama remained a great place for a canal after 1888, and Miami remains a very nice city in 2010, for some values of “nice” anyway. The go-go days may be gone, but I suspect that a major trading center will remain.

 

Then again, that trading center may be rather smaller than the current one. This will, finally, bring us to Mr. Cotter’s question in the next GCC post.  Until then, any questions, criticisms, requests, or ideas?

Iceland, European empire, deposit insurance, and terrorism ... really

 Why is the Icelandic taxpayer on the hook, asks Jonathan? The short answer is: blame Europe!

 
Everyone knows about the European Union, the big confederation (with some federal characteristics) of countries sitting there on the Old Continent. Fewer people know about the European Economic Area. The EEA is basically an agreement under which Iceland, Norway, and ... er ... Liechtenstein get access to the European market in return for adopting some E.U. laws and regulations. (Switzerland has basically replicated the same arrangements without formally signing on to the EEA.)  The EEA required its members to adopt European law on deposit insurance in return for granting EEA banks the right to branch into the E.U. As a result, Iceland adopted a deposit-insurance scheme in 1999.

Click the link on the Icelandic scheme. (Or keep reading.) Scroll down to Chapter 5, Article 10. It reads: “This amount shall be linked to the EUR exchange rate of 5 January 1999.”  The reason is quite simple: the E.U. law required countries to create schemes that insured deposit accounts with a value of at least €20,000. Ergo, the Icelandic scheme guaranteed €20,887. Now, the scheme was financed by a 1% levy on bank deposits and was rather vague about what would happen if it could not meet its obligations. Was the government then responsible? Were savers then on their own? What?

The 300,000 British depositors who fell in love with the 6% rates that Landsbanki offered through its “Icesave” accounts did not seem troubled by these distinctions. They deposited £5 billion. In an Icelandic bank. A bank they had never heard of before 2006 based on a tiny island of 300,000 people. Any resemblance to Barbados is entirely coincidental. Barbadian banks do not do this sort of thing. This may be because Barbadian bankers have banked for some time, while the Icelandics were pretty green.

 
Maybe the Britons thought that Iceland was in the Caribbean? More likely they were taken in by a message that Britain’s financial regulators allowed to stand on its website:  “You can also rest assured that with Icesave you are offered the same level of financial protection as every bank in the U.K.” 

Well, when Iceland finally went kablooie, worried Britons began a run on Landsbanki, which led to a rather remarkable conversation between Iceland’s finance minister, Árni Mathiesen, and Chancellor Alistair Darling of the United Kingdom:

Darling: “Do I understand that you guarantee the deposits of Icelandic depositors?”

Mathiesen: “Yes, we guarantee the deposits in the banks and branches here in Iceland.”

Darling: “But not the branches outside Iceland?”

Mathiesen: “No, not outside of what was already in the letter that we sent.”

Darling: “But is that not in breach of the EEA treaty?”

Mathiesen: “No, we don’t think so ... Since we can’t cure the domestic situation, we can’t really do anything about things that are abroad.” 

Darling:  “See, I need to know this in terms of what I tell people. It’s quite possible that there is not enough money in [Iceland’s depositor guarantee] fund. Is that right?”

Mathiesen:  “Yes, that is quite possible.”

Darling:  “You have to understand that the reputation of your country is going to be terrible. It really is a very, very difficult situation where people thought they were covered and then they discover the insurance fund hasn’t got any money in it.”

After hanging up the phone, Darling did something even more remarkable: declare Iceland a terrorist state. It was the easiest way to freeze Landsbanki assets inside the U.K. (Sadly, most of Landsbanki’s assets were not in the U.K.) He then guaranteed that British depositors would be repaid in full. Good politics, of course, and probably needed to prevent crippling bank runs in Britain, where a lot of foreign banks operate.

At that point, Darling went back to Iceland — which desperately needed financial support from other Nordic countries to prevent runs there and obtain IMF money — and convined them to pass a bill that would pay Britain back for the money it spent supporting the deposits of its citizens who had placed their money in the banks of a terrorist state. Icelandic voters, for some reason, were miffed by that ... and the result was the referendum.

 

 
What happens now is anyone’s guess, although I am fairly confident that my most excellent proposal will not be adopted. Answer your question, LT?

Dubai, Incorporated

 State capitalism is an interesting term. What does it mean? Some definitions, like Rothbard’s, include everything outside perfect laissez-faire. Most Marxist definitions include everything other than complete Soviet-style central planning. Finally, others effectively define it as a synonym for crony capitalism or resource nationalism. None of these definitions strike me as particularly useful.

But state capitalism exists. When I parse the Potter Stewart definition inside my head, I wind up with a a system in which profit-maximizing state-owned companies operate in ostensibly competitive markets. I say “ostensibly,” because both profit-maximization and competition exist mostly in the eye of the beholder.

 

The Emirate of Dubai is the epitomy of state capitalism. The state’s investments run through three holding companies: Dubai Holding, Dubai World, and the Investment Corporation of Dubai (ICD).  Sheikh Maktoum directly owns Dubai Holding, while the latter two are formally owned by the government of Dubai … of whom Sheikh Maktoum is the absolute ruler. All three holding companies have real estate arms charged with developing land granted to them by the emirate. ICD’s Emaar Properties developed the Burj Khalifa, while Nakheel created the offshore Palm and World developments on reclaimed land.

Dubai built its airport in 1960 — over the objections of the emirate’s British advisors — and then borrowed against oil revenues to expand it to handle jumbo jets in 1968. The airport (separately from the airline) directly generates a lot of ancilliary economic activity: landing fees, retail sales, warehousing, maintenance, etcetera. The airport generates even more indirectly … not least the tourist industry. Things like the Burj Khalifa might seem like wasteful ego-driven expenditures. And they are. But they’re also the sort of over-the-top more-Vegas-than-Vegas kind of thing that draws in the tourists, along with the indoor ski slopes and the “seven-star” hotel. Visitor expenditures made up another 8% of GDP.

 
In 1985, Dubai established Emirates Airlines. At the time most air travel between the Gulf and other points was handled by Gulf Air. Mohammed Al-Maktoum worked secretly with Maurice Flanagan, a former British Airways executive who had run the Dubai National Air Travel Agency, to launch the airline with $10 million in seed capital. The Sheikh supplemented that with subsidies Flanagan estimated at $90 million, including two barely-used Boeing 727s, help with aircraft purchases, a training building, and $64.7 million in other off-the-books investments. As you all probably know, the investment paid off: by 2007, Emirates flew 119 aircraft to 101 destinations in 61 countries, earning a profit of $1.4 billion.  Think about that number for a second.  In 2007, the profits from that one enterprise alone contributed 2% of Dubai’s GDP. And 2% is a minimum estimate: Emirates’ total turnover came to $9.6 billion … 15% of GDP. (Obviously, not all of that number accrued to Dubai — but even a quarter would put the airline’s direct contribution at 4%.)

And then there are the free zones. I’ve already mentioned Jebel Ali, but there’s also the Dubai International Financial Center (DIFC). The DIFC has a special legal regime modeled on the United Kingdom, allows for 100% foreign ownership, and guarantees no taxes on profits or income for fifty years. (Inasmuch as that guarantee means anything in an absolute dictatorship.) Then there’s Dubai Media City, which offers a similar deal to firms in media and marketing services, printing and publishing, music, film, internet-related activities, video games, leisure and entertainment, broadcasting and information agencies. Running free zones has become an export industry. The Orangeburg Industrial and Logistics Park in Santee, South Carolina, won’t be able to offer the same range of tax breaks as the Dubai zones, but it will offer whatever the State of South Carolina can provide over two square miles. Ditto, Economic Zones World is neck deep in the Indian government’s attempt to emulate China’s “special economic zones” and has sunk a lot of capital into trying to turn Djibouti into a second Dubai.

So what’s the catch? Simple. The Emirate leveraged the oil money into the financial center, the port, the free zones, and the tourists in part by real estate profits ... but mostly by actual leverage. As the cost of running the government inescapably grew, taxes + profits generated from real estate provided the necessary income. Unfortunately, once the rate of growth in the value of real estate slowed — reversed, actually — the system became unsustainable.

That said, Dubai Incorporated has one advantage over other places that have tried similar development models (everywhere from Singapore to, well, the State of California), which is that it can treat most of its labor force the same way that a real company would. That, however, brings us to Barry Cotter’s question (and eventually Randy’s) and another post.

Questions, comments, requests? I am going to make a strong effort to get around to them.

I have your Chinese consumer price inflation right here

  I figured out a back way to get in to the account, but it took too much work to post regularly.  I’m here in the UAE on business, and have an impossible amount of other stuff to complete, so adding on hassles with proxy servers and the like was a large disincentive.  The government appears to have let up on Typepad — meaning that they’ve likely identified and blocked the offending sites — so I’m back on board.

Which is why my first post, of course, will be about China.  Why isn’t there more inflation in China?  We looked at that on December 28th.  On January 6th, Brad Delong wrote: 

Every month the People’s Bank of China pays 200 billion renminbi to China's exporters to buy up the dollar-denominated assets they have accumulated and so prevent those assets from generating upward pressure on the value of the renminbi. It gets those 200 billion renminbi by borrowing them from the good burghers of Shanghai. By now the central bank owes the good burghers of Shanghai some 16 trillion renminbi. To them, this wealth is nearly as good as cash. It has been piling up for years — and because it is nearly as good as cash, the good burghers of Shanghai should be spending it.

Here is a picture of the assets held by the People’s Bank of China (PBOC).  It shows fairly awesome growth, driven entirely by foreign asset accumulation.

 

They should be spending it. But the goods that are the counterparts of this financial wealth have been shipped via container to Long Beach. So demand in China should be massively outrunning supply, and China should be seeing strong and rising inflation.

Professor DeLong then links to James Hamilton, who suggests that the reason is that monetary growth in China leads to asset price inflation rather than goods-and-services price inflation.  He concludes:

The fact that our standard models do not appear — so far — to apply to Chinese inflation is yet another disturbing feature of today's world economy.

I’m not so sure that is correct.  Below the fold is a graphical representation of the liability side of PBOC balance sheet:

Trills, warrants and kickers

  This post is not about organized crime. This post is about a proposal from Robert Shiller and Mark Kamstra featured in today’s New York Times. (Sanchez got the first down! At the opposing 46.)  The idea is for the government to issue bonds whose payout is linked to GDP. (Sanchez sacked!  Commentator yells, “Are they trying to kill Sanchez?”) In the case of Shillers proposed “trills,” the payout would be directly linked:  each one would yield one-trillionth of quarterly GDP every three months.

It’s a fine idea, although I suspect that the benefits would be, well, limited. They protect against inflation, but so do inflation-linked bonds, and investors would presumably demand some sort of equity-ish premium. That said, they’d offer an easy way to diversify ... you get to buy a security linked to the income of every single income-earning entity in the country! On the other hand, the income stream won’t come directly from those entities, but via the tax revenue that they generate for the federal government. 

(Holy s--t! Did that just happen? Challenge. Why yes, it did. Two-point conversion, 18-15.)

But that is not what this post is about. This post is just to point out that Argentina issued something not unlike the trill back in 2004. The “GDP kicker,” pronounced “keek-air,” aka a warrant, offered creditors payments equal to one-twentieth of the dollar value of all GDP growth above a threshold of 4.2% per year. Bosnia, Bulgaria, Costa Rica, and Singapore have issued similar securities. None of them are as simple as the trill, of course, but still. When have you heard of Argentina being a financial pioneer, in a good way?  (Field goal! 21-15.)

Of course, there are some people who think that Argentina gave away the store with the kicker. And they may be right! Which is what worries me about the trill. It might turn out to be a rather expensive way to finance the borrowing needs of the government ... and that, ultimately, is what I tend to think government debt is for. Although Alexander Hamilton would not agree.

The great recession

  This weekend, my wife and I made our way up to Fort Lauderdale Executive Airport to grab a helicopter ride above ground zero for the real estate collapse.  It isn't just in marginal neighborhoods, as some observers have suggested.  Spot the foreclosure in this photograph.

In fact, if you look closely, you can spot a second distressed property in the picture. 

Nor is it only individual single-family houses.  South Florida is dotted with what Mexicans used to call “obras negras”:  stopped construction projects left to rot.  And in the South Florida humidity, they will rot:  unsealed foundations will flood and unprotected fixtures will erode.  They are calling them “ghost towers” down here. 

It was a Sunday, but note the lack of construction machinery around the site.

In fact, readers of this blog have already had contact with what became a pair of ghost towers.  Last year, we spotted my brother working on a high-rise located on the border of the Everglades, far out on the urban edge, near nothing but a ginormous shopping mall.  Now it is an infamously distressed complex in which, as far as the local papers can figure, no one lives.

Of course, the recession is also visible at ground level:

The end of the Chimerican balance of terror

  There is some evidence that the era of the “financial balance of terror” between the United States and the People’s Republic is coming to an end.  The financial balance of terror, also called “Chimerica” by Niall Ferguson, are names for the situation in which the U.S. depends on massive inflows of capital from China to keep interest rates low, and China depends on massive outflows of goods to the United States to keep its people employed.  China sells widgets to the U.S. and buys dollar-denominated debt, in the process keeping the price of the dollar high and U.S. interest rates low. 

The balance of terror recently made an appearance in a discussion thread on Charlie’s blog.  The idea was that Chinese holdings of U.S. debt limit American freedom of action ... although the Chinese, of course, would be damaged by an attempt to use their leverage. 

I contend that the balance of terror is rapidly coming to an end, to China’s relative disadvantage.  Emphasis on relative, of course, because everyone will ultimately benefit from getting out of this rather insane situation in which poor countries lend huge sums to rich ones.

Consider the recent indirect exchange between the President of the United States and the Chinese government.  China worried about the value of its Treasury holdings.  The President said, “Pshaw,” and went on to tell the G-20 that they could not expect the world of America as a consumer of last resort to return, and the Chinese president seemed to agree.  Meanwhile, the head of Chinese central bank emulated St. Augustine.  “America should buy less, and we should consume more, but not yet.” 

In other words, the Chinese are starting to flex their muscles just as they begin to atrophy.  More below the fold.

Borrower run

  We’re all familiar with the scene in It’s a Wonderful Life where the good people of Bedford Falls go running down to the bank in order to demand their money.  That’s the vision of a bank run most of us have in our heads.

Strangely enough, similar runs have occurred in both the U.S. and the U.K. over the past year.

More importantly, however, have been the 21st-century style runs on institutions that don’t call themselves “banks” but are in fact banks, inasmuch as they borrow short and lend long.  When those non-bank-banks suddenly find themselves unable to roll over their short-term debts, it is the functional equivalent of a bank run, even if the visuals are less dramatic. 

But according to some very smart people here at HBS, this financial crisis has seen something that I’d never heard of before:  the borrower run.

What in the world is going on out there?

  Warning:  This is a village idiot post.  I am utterly unqualified to be talking about business cycles. 

We all know that the U.S. economy is in a bad way.  The signs of mayhem are all around:  rising unemployment, falling sales, failing businesses.  This Thanksgiving my family besieged me with questions about why, and I gave the standard answer.  “All these credit institutions invested in this crazy sludge, which may have no value.  So they’re rebuilding their balance sheets in order to protect themselves, a fancy way of saying that they’re not lending.  No lending, and businesses go under when they can’t borrow to meet lumpy expenses.”

It sounded good, a short unified field theory of financial collapse.  It certainly convinced my relatives, all of whom run or work for small businesses in metro Miami.  But was it true?  I got on the internets and downloaded some data to check it.  What I found perplexed me. 

For those of you who don’t want to be bothered by the full chain of discovery, I’ll cut to the chase:  I was surprised to find little evidence of a credit crunch, even more surprised to be told that a bunch of economists at the St. Louis Fed had gotten there first … and then rather relieved (in a perverse way) to learn (courtesy of Dante Roscini) why there was in fact plenty of evidence that a lack of credit is in fact directly slapping around the real economy. 

Details below the fold.

Sovereign Wealth and the American Empire

I can’t complain about yesterday’s game.  Lots of fouls, but very entertaining, and the good guys won.  How often do I root for the Red over the Blue? 

That’s not what I’m here to discuss, however.  I’m here to discuss “sovereign wealth funds,” the consequences of which I think have been seriously misread by most observers.

The rise of “sovereign wealth funds” has scared a lot of people over the past few years, myself included.  At first glance, these things are scary.  SWFs don’t just represent ownership by foreigners of your nation’s assets, they represent ownership by foreign governments of your nation’s assets.  To paraphrase Joseph Stalin, sovereign wealth funds represent “socialism outside your country.”

Control of your domestic manufacturing firms and financial institutions by foreign socialists is not a comforting thought.  Those socialists might be, as socialists often are, motivated by things other than profits.  And that possibility opens the door to a wide range of potential abuses.

The flip side, however, is that the emergence of sovereign wealth funds provides the governments of the countries in which they invest a golden opportunity to protect their own overseas investors, insure access to overseas markets, and generally shape world economic policies. 

In other words, the rise of sovereign wealth funds controlled by Beijing, Abu Dhabi,  and Brasilia will, if handled correctly, reinforce Washington’s control over the world economy rather than weaken it.

“The logic of the capitalist system depends on shareholders causing companies to act so as to maximise the value of their shares. It is far from obvious that this will over time be the only motivation of governments as shareholders,” wrote Larry Summers in 2007.  What might those motivations be?

First, and most often cited, foreign governments might use control over domestic industries to transfer key technologies to foreign competitors.  Why is this danger any different when the owner is a foreign government rather than a foreign company?  Well, a foreign company is presumably limited in their ability to transfer key technologies to competitors by the need to preserve the value of its investment.  After all, if Nissan transfers technologies from Renault at Renault’s expense, then the value of Nissan’s investment in Renault will fall.  Nissan may nonetheless choose to share Renault’s technologies, but only inasmuch as such sharing increases the total profitability of both companies — what economists call Pareto optimality and businesspeople call synergy. 

That logic might not apply to a foreign government, which is presumably motivated by many things other than the profitability of its investment portfolio.  (In fact, for the sake of their citizens, one would hope that foreign governments are motivated by things other than the profitability of their investment portfolios!)  Such a government might willingly choose to reduce the value of the foreign companies under its control by transferring technologies to companies headquartered within its boundaries and controlled by its own citizens. 

In fact, foreign governments might go further than the simple transference of technology:  they might bias strategic decision-making in the companies under their control order to favor their own nation’s companies.  For example, a sovereign wealth fund might try to replace one CEO with another, influence plant location decisions, reject new product lines, demand increased dividend payouts, or engage in other sorts of subtle and not-so-subtle economic sabotage.  A concrete example proposed by the Economist was a situation in which “Venezuela bought Alcoa and set about closing its aluminium smelters in the United States in order to move production to Latin America.” 

Financial institutions provide particularly fertile places in which sovereign wealth funds could do mischief.  Such funds would not need to fully control such institutions in order to engage in “directed lending,” in which the institutions would direct capital towards favored companies.   In that way, a SWF could leverage its funds to use foreign capital to support domestic companies, although good financial market regulation would lessen this possibility. 

Finally, of course, SWFs could potentially leverage their ownership into political influence.  Kevin Hassett, a prominent conservative, suggested that “an enemy of the U.S. could, if it had sufficient control of our financial institutions, use that power to gain intelligence about the activities of private American citizens. It might even use its influence to attack the U.S. economy during a time of conflict. Imagine, to take it to the extreme, that the Chinese bought Citigroup, then shut it down during a conflict with Taiwan if the U.S. tried to interfere.”

It all sounds very frightening.  But it’s not … for the United States.  The rise of sovereign wealth funds should, in fact, be frightening for the countries that run them, not the countries that receive their capital.

Why?  Simply put, because Kevin Hassett’s reasoning applies even more so to the governments investing their hard-earned funds outside their borders.  Imagine, to take it to the extreme, that the Chinese bought Citigroup, and then the United States threatened to nationalize their investment during a conflict with Taiwan if the Chinese did not withdraw their forces. 

In fact, the U.S. regularly freezes (or threaten to freeze) the assets of countries with which it has conflicts.  The U.S. froze Japanese assets in the run-up to World War 2.  It froze Iranian assets in 1979.  And the U.S. isn’t alone in this.  At America’s request, the E.U. agreed on June 16th that it would freeze the European assets of Iran’s largest bank.

Of course, there is no reason to take it to the extreme.  The U.S. government could use the presence of foreign assets in the United States to increase the security of American investments overseas without taking any overt legislative or policy steps.  There already exists an international institution intended to secure foreign investments against expropriation.  Foreign-owned hostages located in U.S. territory strengthen that institution immensely, and give the U.S. government even more control over the terms under which capital crosses borders.   

The institution is called the International Center for the Settlement of Investment Disputes — ICSID, pronounced “Ick-sid,” like a Klingon warrior.  ICSID, a division of the World Bank (and thus part of the U.N. system), runs arbitration panels that decide investment disputes between nations that have signed a bilateral investment treaty.  The New York Convention obliges all signatories to “enforce” ICSID rulings against third countries, unless it violates their public policy.  That is to say, unlike the WTO, ICSID provides for collective enforcement of its rulings. 

So far, only four ICSID rulings have been violated  … but the system hasn’t been used much until recently.  Between 1965 and 2000, only 66 cases came before it.  Since then, however, 202 more cases have been brought, of which 128 are still pending.  Argentina, Bolivia, and Venezuela have all declared their intention to withdraw from the convention … and they have also all declared that they will ignore unfavorable ICSID rulings. 

But governments that own significant commercial assets in the United States ignore ICSID rulings at their own risk.  In fact, they ignore any agreements with the U.S. to protect U.S. investors or U.S. market access at their own risk.  Venezuela, for example, may have gone after Exxon, but its ownership of Citgo means that the Chávez is taking a huge (and probably stupid) risk if he defies whatever ICSID rules about his actions. 

In fact, U.S. companies can already sue foreign governments in American courts without going through ICSID.  The Foreign Sovereign Immunity Act of 1976 removed “sovereign immunity” from all government-owned property (or flows of funds) within the United States as long as they were for “commercial purposes.”  The holdings of sovereign wealth funds are, by definition, for commerical purposes.  In other words, the rise of sovereign wealth funds gives the U.S. even greater teeth with which to protect its own companies and businesspeople overseas, without needing to change the scope of international or American law. 

That said, the U.S. will almost certainly change its law to obviate the potential adverse effects of sovereign purchases of American assets.  The emergence of a code-of-conduct based on the codes under which American public pension funds operate is almost inevitable.  Even if Congress doesn’t impose such a code, SWFs will probably voluntarily adopt one in order to pass CFIUS review.  (CFIUS — pronounced “seefy-uhss,” like a Star Wars droid — is the Committee on Foreign Investment in the United States, a group of cabinet officials which reviews foreign investments and possesses the power to deny them on national security grounds.)  CFIUS has become much more active in recent years, and given the current political climate it’s unlikely to become less so.

In addition, most of the dangers from SWF investment could be obviated by one simple reform proposed by the New America Foundation:  limit (or prohibit) SWFs from exercising their voting rights when they purchase shares.  Such a reform would allow sovereign ownership without sovereign control.  There would be no more fear of technology transfer or strategic decision-making on behalf of foreign interests. 

The rise of sovereign wealth funds, if handled correctly, will strengthen America’s ability to shape the global investment environment and global economic policy.  Other countries are, in effect, voluntarily providing a hostage to the United States contingent on their agreement to follow the rules laid down by the United States and its allies.  All Washington needs to do is make a few small legal changes to protect its companies from possible strategic interference by their new owners, and the end-result will be all good for America, its companies, and its citizens.  American investments and contracts abroad will be effectively collaterized against bad behavior by host governments.  Other governments will have great incentives to abide by the prescripts Washington lays down.  Finally, in times of crisis, the power of American economic sanctions will be multiplied. 

Far from weakening the American hegemony, the rise of sovereign wealth funds greatly strengthens it.  I, for one, gladly welcome our new Chinese, Latin, and Arabian owners … because while they may have the ownership, our elected officials still have the control. 

American democracy, in the form of domestic control over foreign assets, is in the end not only more powerful than globalization, but essential to it. 

The Barber of Buenos Aires

On March 1st, 2005, President Nestor Kirchner effectively repudiated Argentina's obligations to those bondholders who refused its final offer to restructure its debts. 

Four years earlier, during the chaotic month of December 2001, Argentina defaulted on its dollar-debts. Over that evil month, the economy was reduced to barter, mobs sacked bank buildings, and the country went through five presidents in eleven days ... starting with the unlucky fellow in the blue shirt, Fernando de la Rúa. 

After President Néstor Kirchner took office in 2003, Argentina began negotiating over the debt in Dubai.  The Argentine side did everything possible to flummox its creditors, up to and including bringing very scantily clad female “assistants” to meetings with high-ranking American women.  The Argentine chief negotiator also played doornail dumb, honestly confusing the Americans and Italians across the table (unsurprisingly, the half-naked assistant ploy discomfitted the Americans rather more than the Italians) about whether he was uncannily brilliant or honestly didn't understand what a bond was.  (I've met the man, and I don't know either.) 

The Argentines put a truly fascinating offer on the table:  the creditors would forgive past-due interest would be forgiven, and the old bonds would be swapped for new ones worth 35 cents on the dollar.  In return, however, the new bonds would include a GDP “kicker.” The kicker — pronounced “keek-care” by everyone involved — promised the creditors additional payments equal to one-twentieth of the dollar value of all GDP growth above a initial threshold of 4.2% per year, which would eventually fall to one-twentieth of all growth over 3%. 

The creditors rejected the offer, preferring a “haircut” of 40% on the face value of the debt, no interest-forgiveness, and no kicker.  In response, Kirchner told them, and the IMF, and the U.S. Treasury, and eventually even President Fox of Mexico (don't ask), that the bondholders could take his haircut or drop dead.  On March 1st, 2005, the president finally told the holdouts to drop dead, and repudiated their bonds.

Below my friend Aldo contemplates the question: was that the right thing to do?

A year ago, I would have unhesitatingingly answered, “Yes.”  Now, I still think it was the right thing to do ... but I'm worried about what the Fernández Administration intends to do with its hard-won fiscal freedom.  More below the fold.