Category Archives: Euro area

18/2/15: IMF Package for Ukraine: Some Pesky Macros

Ukraine package of funding from the IMF and other lenders remains still largely unspecified, but it is worth recapping what we do know and what we don't.

Total package is USD40 billion. Of which, USD17.5 billion will come from the IMF and USD22.5 billion will come from the EU. The US seemed to have avoided being drawn into the financial singularity they helped (directly or not) to create.

We have no idea as to the distribution of the USD22.5 billion across the individual EU states, but it is pretty safe to assume that countries like Greece won't be too keen contributing. Cyprus probably as well. Ireland, Portugal, Spain, Italy - all struggling with debts of their own also need this new 'commitment' like a hole in the head. Belgium might cheerfully pony up (with distinctly Belgian cheer that is genuinely overwhelming to those in Belgium). But what about the countries like the Baltics and those of the Southern EU? Does Bulgaria have spare hundreds of million floating around? Hungary clearly can't expect much of good will from Kiev, given its tango with Moscow, so it is not exactly likely to cheer on the funding plans… Who will? Austria and Germany and France, though France is never too keen on parting with cash, unless it gets more cash in return through some other doors. In Poland, farmers are protesting about EUR100 million that the country lent to Ukraine. Wait till they get the bill for their share of the USD22.5 billion coming due.

Recall that in April 2014, IMF has already provided USD17 billion to Ukraine and has paid up USD4.5 billion to-date. In addition, Ukraine received USD2 billion in credit guarantees (not even funds) from the US, EUR1.8 billion in funding from the EU and another EUR1.6 billion in pre-April loans from the same source. Germany sent bilateral EUR500 million and Poland sent EUR100 million, with Japan lending USD300 million.

Here's a kicker. With all this 'help' Ukrainian debt/GDP ratio is racing beyond sustainability bounds. Under pre-February 'deal' scenario, IMF expected Ukrainian debt to peak at USD109 billion in 2017. Now, with the new 'deal' we are looking at debt (assuming no write down in a major restructuring) reaching for USD149 billion through 2018 and continuing to head North from there.

An added problem is the exchange rate which determines both the debt/GDP ratio and the debt burden.

Charts below show the absolute level of external debt (in current USD billions) and the debt/GDP ratios under the new 'deal' as opposed to previous programme. The second chart also shows the effects of further devaluation in Hryvna against the USD on debt/GDP ratios. It is worth noting that the IMF current assumption on Hryvna/USD is for 2014 rate of 11.30 and for 2015 of 12.91. Both are utterly unrealistic, given where Hryvna is trading now - at close to 26 to USD. (Note, just for comparative purposes, if Ruble were to hit the rates of decline that Hryvna has experienced between January 2014 and now, it would be trading at RUB/USD87, not RUB/USD61.20. Yet, all of us heard in the mainstream media about Ruble crisis, but there is virtually no reporting of the Hryvna crisis).

Now, keep in mind the latest macro figures from Ukraine are horrific.

Q3 2014 final GDP print came in at a y/y drop of 5.3%, accelerating final GDP decline of 5.1% in Q2 2014. Now, we know that things went even worse in Q4 2014, with some analysts (e.g. Danske) forecasting a decline in GDP of 14% y/y in Q4 2014. 2015 is expected to be a 'walk in the park' compared to that with FY projected GDP drop of around 8.5% for a third straight year!

Country Forex ratings are down at CCC- with negative outlook (S&P). These are a couple of months old. Still, no one in the rantings agencies is rushing to deal with any new data to revise these. Russia, for comparison, is rated BB+ with negative outlook and has been hammered by downgrades by the agencies seemingly racing to join that coveted 'Get Vlad!' club. Is kicking the Russian economy just a plat du jour when the agencies are trying to prove objectivity in analysis after all those ABS/MBS misfires of the last 15 years?

Also, note, the above debt figures, bad as they might be, are assuming that Ukraine's USD3 billion debt to Russia is repaid when it matures in September 2015. So far, Russia showed no indication it is willing to restructure this debt. But this debt alone is now (coupon attached) ca 50% of the entire Forex reserves held by Ukraine that amount to USD6.5 billion. Which means it will possibly have to be extended - raising the above debt profiles even higher. Or IMF dosh will have to go to pay it down. Assuming there is IMF dosh… September is a far, far away.

Meanwhile, you never hear much about Ukrainian external debt redemptions (aside from Government ones), while Russian debt redemptions (backed by ca USD370 billion worth of reserves) are at the forefront of the 'default' rumour mill. Ukrainian official forex reserves shrunk by roughly 62% in 14 months from January 2014. Russian ones are down 28.3% over the same period. But, you read of a reserves crisis in Russia, whilst you never hear much about the reserves crisis in Ukraine.

Inflation is now hitting 28.5% in January - double the Russian rate. And that is before full increases in energy prices are factored in per IMF 'reforms'. Ukraine, so far has gone through roughly 1/5 to 1/4 of these in 2014. More to come.

The point of the above comparatives between Russian and Ukrainian economies is not to argue that Russia is in an easy spot (it is not - there are structural and crisis-linked problems all over the shop), nor to argue that Ukrainian situation is somehow altering the geopolitical crisis developments in favour of Russia (it does not: Ukraine needs peace and respect for its territorial integrity and democracy, with or without economic reforms). The point is that the situation in the Ukrainian economy is so grave, that lending Kiev money cannot be an answer to the problems of stabilising the economy and getting economic recovery on a sustainable footing.

With all of this, the IMF 'plan' begs two questions:

  1. Least important: Where's the European money coming from?
  2. More important: Why would anyone lend funds to a country with fundamentals that make Greece look like Norway?
  3. Most important: How on earth can this be a sustainable package for the country that really needs at least 50% of the total funding in the form of grants, not loans? That needs real investment, not debt? That needs serious reconstruction and such deep reforms, it should reasonably be given a decade to put them in place, not 4 years that IMF is prepared to hold off on repayment of debts owed to it under the new programme?

Note: here is the debt/GDP chart adjusting for the latest current and forward (12 months) exchange rates under the same scenarios as above, as opposed to the IMF dreamt up 2014 and 2015 estimates from back October 2014:

Do note in the above - declines in debt/GDP ratio in 2016-2018 are simply a technical carry over from the IMF assumptions on growth and exchange rates. Not a 'hard' forecast.

18/2/15: Inflation Expectations and Consumers’ Readiness to Spend

In an earlier post I provided a rough snapshot of the evolving relationship between inflation and consumer demand. But here is a fresh academic paper covering the same subject:

Bachmann, Rüdiger, Tim O. Berg, and Eric R. Sims. 2015. "Inflation Expectations and Readiness to Spend: Cross-Sectional Evidence." American Economic Journal: Economic Policy, 7(1): 1-35. (h/t to @CHCEmsden for this link)

From the abstract: the authors examined "the relationship between expected inflation and spending attitudes using the microdata from the Michigan Survey of Consumers. The impact of higher inflation expectations on the reported readiness to spend on durables is generally small, outside the zero lower bound, often statistically insignificant, and inside of it typically significantly negative. In our baseline specification, a one percentage point increase in expected inflation during the recent zero lower bound period reduces households' probability of having a positive attitude towards spending by about 0.5 percentage points."

In other words, when interest rates are not close to zero, consumers expecting higher inflation do lead to a weak, statistically frequently zero, uplift in readiness to increase durable consumption (type of consumption that is more sensitive to price variation, and thus should see a significant positive increase in consumption when consumers anticipate higher inflation).

But when interest rates are at their zero 'bound', consumers expecting higher inflation in the future tend to actually cut their readiness to spend on durables. Not increase it! And this negative effect of future inflation on spending plans is "significantly negative".

Now, give it a thought: the ECB is saying they need to lift inflation to close to 2% from current near zero (stripping out energy and food). Based on the US data estimates, this should depress "households' probability of having a positive attitude towards spending" by some 1 percentage point or so. In simple terms, there appears to be absolutely no logic to the ECB concerns with deflation from consumer demand perspective.

Update: a delightful take on deflation from Colm O'Regan: And a brilliant vignette on prices, markets, consumers and ... thought for deflation too: by @CHCEmsden h/t above.

18/2/15: Deflation and Consumer Demand: Euro Area Evidence

The key premise behind the risk of deflation is the argument that faced with a prospect of declining prices, consumers will withhold current consumption in favour of the future consumption and producers will delay current investment in favour of lower cost future investment.

The problem, of course, with this theory is two-fold:

  1. It ignores the entirety of the evidence from the modern sectors (e.g. ICT services, ICT manufacturing and pharma) where deflation (falling prices of comparable services and goods, adjusted for quality and efficacy) has been ongoing for decades and the demand and investment grew, not fallen.
  2. It ignores the totality of fundamentals that drive both demand and prices, and in particular the role of the after-tax disposable incomes available to support consumption and investment.
But never mind, the Euro area, griped by the fears of deflation is itself proving the meme of the deflation = bad, inflation = good as consumers continue to buy, because of falling prices, not despite of them.

Here's a telling slide from BBVA assessment of the European situation:

Thus, we have a question: why, then, do European policymaker fear deflation? The answer is a simple one: deflation hurts tax intake. So the real concern here is not for the wellbeing of the economy or consumers or society at large, but for the fiscal position of already over-stretched (and in some cases insolvent) sovereigns. 

16/2/15: Euro v ‘Sustainable Growth’: Mythology of Brussels Economics

Euro existence has been invariably linked to the promise of a 'sustainable' prosperity. From days when it was just a dream of a handful of European integrationists through today.  Which means that we can have a simple and effective test for the raison d'être of common currency union: how did GDP per capita fare since the euro introduction.

So let's take a simple change in GDP per capita, expressed in constant prices (controlling, therefore, for inflation) across the advanced economies around the world. Chart below details annualised rates of growth achieved between the end of 1999 and the end of 2014.

Excluding the most recent addition to the euro area, let's consider the original EU12. Across all advanced economies (34 of them), average annualised rate of real GDP per capita growth was 1.57%. Across the euro area 12 it was 0.727% - less than 1/2 of the average. Average for non-euro area 12 states was 2.126% or almost 3 times the euro area 12 average.

All of this translates into a massive gap between the euro area 12 (euro 'growthology' states that supported from the start the idea of 'sustainable' growth based on the EMU) and the rest of the advanced economies. In cumulative terms - over 2000-2014, EA12 states clocked growth of 11.674% in terms of their real GDP per capita. Over the same period of time, ex-EA12 advanced economies managed to grow on average by 40.01%.

Oh dear... even if you are not Italy or Cyprus (the latter made utterly insolvent by the EU inept 'resolution' of the Greek crisis and then promptly accused of causing this disaster upon itself - just to ad an insult to an injury), even if you are the 'best in the class' Ireland... within the euro, you are screwed.

So the key question is: where is the evidence that having a common currency results in better economic outcomes? Key answer is: nowhere. 

22/1/2015: Don’t Put Too Much Dosh on ECB’s QE Dark Horse…

Today's ECB announcement of EUR60 billion per month from march 2015 through September 2016 QE aiming to take the ECB balance sheet up to EUR1.14-1.26 trillion (estimated, based on starting timing and treatment of 12% share of European institutions securities) has been dubbed a massive boost to the euro area, a watershed, a drastic measure and so on.

Official details are here:

In truth, it is neither.

Quantum of Asset Purchases and Types of Assets

  • Monthly EUR60 billion. This is lower (at current EUR valuations) than 'tapering' levels of Fed purchases (USD75 billion) and is lower than BofE interventions in 2009 which run at STG25 billion / month because EUR60bn ECB intervention is ca 7% of Euro area GDP, while BofE intervention was ca 20% of GDP.
  • Monthly purchases will combine public and private sector securities. Which means the QE is really an add-on to ABS. Purchases will start in the secondary markets and will cover investment grade securities issued by the euro area governments and agencies and European institutions in the secondary market. The key objective is to 'inject new liquidity' to improve liquidity supply. Problem is: with majority of Government bonds in negative yields territory already, where is the targeted shortage of liquidity in the system? I can't find one.
  • Limitation to investment grade cuts out Cyprus and Greece, but the ECB promised to include them into the programme under extended rules.
  • Government and euro area agencies securities will be purchased on the basis of risk-sharing. Quantum of purchases will be proportional to Eurosystem shares of each National Central Bank (NCB). 
  • For European institutions-issued securities,amounting to 12% of total purchases, 80% of purchased quantum to be held on NCB balance sheet, 20% on ECB balance sheet. The latter measure prompted some analysts to conclude that risks can be amplified for the already indebted sovereigns. But this is nonsensical for two reasons: 1) NCBs are part of the Eurosystem, and 2) NCBs will purchase liabilities of the state, so only risk attached to these liabilities is carried through. In simple terms, there cannot be any double liability, just in the same way as one cannot eat the same slice of cake twice. More fundamentally, liabilities of the NCBs do not have to match the NCBs assets, nor do they constitute a claim on NCBs assets. Here is an informative primer on the topic:
  • For National securities, there will be no risk sharing. So risk sharing only applies to Agencies-issued debt.
  • As a part of QE announcement, the ECB has also altered the set up of the TLTROs (there are six more tranches of these forthcoming). TLTROs will now be priced at MRO set at the time of each TLTRO tranche. This will lower the cost of future TLTRO tranches by some 10 bps. Net result - TLTROs are now marginally more attractive.
  • The ECB can cut short the asset purchasing programme if there is a signal of 'sustained improvement in inflation'.

Impact Assessment:

The measures are sign of desperation and frustration on ECB behalf. And not with the persistence of deflationary risks.

Instead, QE announcement was accompanied by another round of 'fighting' rhetoric from Draghi, who clearly continues to push member states and the European Commission to aggressively pursue structural markets reforms.

Draghi downplayed expectations for QE by stressing that QE only provides conditions to support growth. In his own words: "Monetary policy can create basis for growth but it's up to governments and Commission to make sure growth actually takes place". In so far as absent growth there won't be inflation, we, therefore, have a perfect excuse ex ante for any QE failure.

The key, however, is that we are now into the unchartered territory of watching the emergence of the second round effects of QE announcement.

The reason for this is that the direct impact - lowering Government borrowing costs - is effectively useless - the euro area as a whole is already enjoying record low yields. Meanwhile, market expectations of inflationary pressure over the longer horizon (e.g. 5yr/5yr spreads) are starting to price higher inflation, albeit modestly so.

Mr Draghi's claim that the measure is aimed at supplying liquidity is a red herring - a token nod to the German hawks. In reality, most likely, the QE will not unleash a wave of new credit creation.

More likely, we shall see some easing of deflationary risks, with inflation picking up in the medium term on foot of both QE and oil prices reversion back toward fundamentals-justified levels. Euro devaluation will also help to cover up underlying structural drivers for deflationary risks.

The real causes of deflationary risks in the euro area is weak demand. The latter is driven by collapse in after-tax household incomes and savings, and by the ongoing deleveraging of the households and firms. None of these can be helped by the QE.

Meanwhile, the QE is likely to provide some easier conditions for issuance of new Government debt. Currently, just under 50% of the euro area economy is accounted for by the Government spending. Pumping more spending into this economy is unlikely to do much for future growth and is hardly going to trickle down to the ordinary households. Which means that the entire QE exercise is dubious in nature. It will, however, significantly pads the pockets of bonds dealers and stock markets, and banks that hold these securities.

One caveat few noticed is that the ABS segment of the QE programme now falls under the remit of the NCBs. Which means that national authorities can select assets for purchases from the private sector. How this mechanism can prevent selection biases to, say, potentially favour so-called National Champions (larger state-owned entities and private monopolies) or corrupt selection of politically-connected enterprises and other similar behaviour is anyone's guess.

The circus surrounding the ECB announcement was (and remains) quite bizarre. The ECB announced effectively new (as in unknown to us before) measures to the quantum of roughly EUR114-260 billion, since it already previously set a target of ca EUR1 trillion balance sheet expansion.

Even more bizarrely, we know many details of the QE mechanism, but we have no idea as to the split between the sovereign bonds purchases and private asset purchases. We have no defined limit to the balancesheet expansion and we do not have a defined process for ending the programme (sudden stop or tapering).


As I tweeted today, a viable alternative to the largely dubious QE would have been supporting household incomes and companies investment. This can be done more effectively via targeted and structured tax policies that are medium-term revenue neutral. One example, coincidentally, provided today in FT by Martin Feldstein:

In the medium term, the key should be using monetary policy and fiscal policy to deleverage the economies: households, companies and governments. This is not being helped by the QE. Here is an interesting recent paper on the subject:

In the long run, the key is finding real new catalysts for growth in the euro area that can compensate for the structural and demographic declines the EMU economies are suffering from. This too is not being helped by the QE.

Update 1: Here is the proportion by which ECB will allocate purchasing allowances for each NCB:

Update 2: And here is yet another reason why ECB's QE might not be the 'big bazooka' that will end markets fragmentation (aka increase credit supply to the real economy) - read bottom tweet first:

Courtesy of @Lee_Adler