15/2/15: European Federalism: Principles for Designing New Federal Institutions

This week, I was honoured to have been invited to participate in a discussion panel of the Future of Europe at the Trinity Economic Forum 2015.

Here are my extended speaking notes on the subject of European Federalism and the challenges of building future European institutions.


The Global Financial Crisis, the Great Recession and the Euro Area Debt Crisis exposed structural weaknesses in the political, economic and social institutional designs of the European Union. As the result of these weaknesses, today, we are increasingly faced with a Union of the few (the ever-shrinking in numbers European ‘core’), with the membership of the many (the growing ‘periphery’ excluded from the decision-making within the EU, and the stand-alone Eastern Europe, largely left to its own devices and pursuing own objectives that increasingly represent a confluence of geopolitical aspirations and the interests relating to achieving capital and economic convergence with the core).

As the result of continued build up in the relating economic and social imbalances, the deepening twin challenges of restoring both the viability and the cohesion within the Union present an existential threat to the EU. But beyond the fear of political and social disruption, the same challenges represent an opportunity to renew institutions of participatory democracy and cooperative governance that can harnesses the power of social, political, economic and cultural  heterogeneity of the Member States to deliver a renewed EU.


Currently, the European nations and their voters are being presented with two alternatives for addressing structural weaknesses of the EU, exposed by the crises. On the one hand, European Intergationism offers an ever accelerating and deepening concentration of decision making within the EU in the hands of technocratic institutions of the European Commission, the European Council, the Eurogroup and the ECB. On the other hand, Euroscepticism calls for a radical devolution of power and greater autonomy in favour of the member states, opposing any idea of federalisation of the EU or within the EU.


This is a false dichotomy, based on the ossified political ideologies no longer sufficient in the modern world of rapid change, amplified risks and social and economic disruptions. In my view, gradualism, coupled with institutional design from below, from the level of European demos, are the twin approaches that can deliver effective evolutionary process for building future European institutions.


A combination of internal and external challenges and on-going changes that acts to force a disruption to the status quo ideologies, politics and institutions of Europe is substantial. These include:
• On-going technological revolution that started with rapid computerisation and automatisation of economies in the 1980s and to-date has witnessed the EU member states falling far behind the productivity growth curve that has propelled North American and Middle Income economies growth during the 1990s and 2000s. The same technological revolution drives both, radical changes in the traditional models of enterprise development and the labour-capital relations which the European economies and European institutions are not equipped to address.
• Global economy shift away from traditional North-South globalisation axis of development toward much greater and growing regionalisation of trade, investment, savings and human capital flows, and, thus, greater regionalisation of growth drivers. These changes increase marginalisation of the ‘platform’ or ‘gateway’ models for trade and investment, as well as for human capital on-shoring on which many European economies rely today.
• Amplification and acceleration of shocks and traditional business cycles, including the ever-rising complexity of risk propagation and contagion channels across financial markets, real economy and public finances.
• Demographic challenges represented by ageing populations, declining labour force and rising unfunded liabilities. These challenges not only threaten the traditional social democratic model of income and services provision to the older populations, but also the supply of investment (in physical and human capital) and other drivers of future growth in the aggregate demand. They also weaken European economies and societies to innovate and adopt innovation.
• Decline and fracturing of the traditional body of politics and ideologies in the post-crisis environment – a challenge compounded by the changing nature of public discourse (social and alternative media), as well as by the rising power of direct democracy. One, immediate, manifestation of this is the decline of the traditional European Centre in politics and the rise of the more extremist parties and groups. But beyond that, there is also a far more threatening trend of reducing political participation and undermining democratic mandates of the Governments increasingly elected on the basis of shrinking and more concentrated segments of the demos.

To survive and succeed in this new and constantly changing environment, the EU needs to develop institutional structures that combine the benefits of both, traditional systems of governance (based on technocratic capabilities), and direct and open democracy structures (based on public discourse, sourcing of ideas and participation), while minimise their respective costs and risks.


Consider the economic and monetary policy institutions as a laboratory for testing this process of institutional transformation.

Eight years into the crises, it is now an accepted wisdom that the European leaders have failed to see even the basic risks arising from the rules-based compulsory monetary integration. The crises have highlighted deep divisions within the European Monetary Union (EMU) on matters as diverse as inflationary preferences, demographics-anchored economic expectations, legal systems regulating the financial markets, and fiscal transfers.

These differences underlie the reality that common currency cannot be successfully deployed across a vastly heterogeneous base of economies, demographics and institutions without, ex ante, federalising the political and fiscal systems. Nor can the lack of supportive political and institutional systems be remedied by the purely managerialist solutions.

In fact, it remains an open question whether federalisation itself is a sufficient or even feasible condition for addressing these challenges. The crises exposed the fallacy of European integrationism – a doctrine that closer and closer harmonisation of institutions between the member states should be the desired objective of the Union. Shocks impacting the euro area since 2008 have been asymmetric in nature, geographic distribution and magnitude, as well as heterogeneous across the economic sub-systems. This is true today, eight years into the crises, and it was true at the points of the individual crises impact. While German economy runs extremely low levels of unemployment, Italian unemployment is hitting historical highs and the French and Spanish unemployment figures remain stubbornly close to their crisis peak. Meanwhile, all four economies see government bonds yields at or near historical lows. While all four economies differ in terms of their external balances, all four share in terms of stagnant domestic demand and the resulting risks of deflation. Meanwhile, stagnation in the real economies is now contrasted by an asset bubble in the public debt markets, just as Europe’s capacity to use fiscal policy to stimulate short term growth is being exhausted by already high public debt levels. And it is being reinforced by another asset bubble emerging in risk-based equity markets, just as Europe’s real investment remains stagnant.

In this environment, no singular monetary policy can even in theory match the economic objectives of the EMU members. The integrationist’s solution to this problem is to enhance fiscal coordination and use debt federalisation and fiscal spending to compensate for the side-effects of monetary failures. Alas, that too is an impossible balancing act. Based on the IMF estimates, Euro Area’s General government gross debt stood at almost 97 percent of GDP at the end of 2014. With Euro Area Government revenues amounting to nearly 48 percent of GDP, and public spending running at close to 51 percent of GDP, there is simply no room for a ‘federalised’ Europe to pump more debt into the Member States’ economies.

Worse, looking at the net Government debt across the Euro Area, one quickly arrives at the conclusion that harmonising fiscal policies cannot be and should not be an objective even within a fully federalised EU. In 2014, net Government debt in the Euro Area ranged from -47.6 percent of GDP in the case of Finland to +168.8 percent of GDP in the case of Greece. And in terms of external balances, Euro Area remains fragmented across three dimensions, the fragmentation that persisted from the 1980s on through today. While ‘core’ Euro Area economies (Austria, Belgium, Finland, Germany, Luxembourg and the Netherlands) average current account surplus for 1980-2014 runs at 3.25 percent of GDP, delivering a cumulated average surplus of 91.3 percent of GDP over the period, the ‘peripheral’ Euro Area states (Cyprus, France, Greece, Ireland, Italy, Malta, Portugal and Spain) experienced average current account deficits of 3.2 percent of GDP and have cumulative average current account deficit of 102.2 percent of GDP over the same period. The third dimension to this fragmentation is the presence of the deficit-generating Eastern European Accession States (Estonia, Latvia, Slovak Republic and Slovenia). In simple terms, net borrowers remain net borrowers, net lenders remain net lenders and this situation remains ‘sticky’ over the last 35 years.

Federalised Europe may be a necessary condition for addressing these imbalances, but it is hardly sufficient, as increasing degree of policies and institutions harmonisation has not delivered any real convergence to-date. Clear example of this failure is the creation of the Euro itself. Since the formation of the common currency, none of the Euro Area ‘peripheral’ states have managed to shift from the regime of running perpetual current account deficits to a regime of generating surpluses.


European leaders’ diagnosis of the problems compounds them. Instead of treating the actual malaise (the attempt to view harmonised policies across the heterogenous economic, political and social systems as efficient solutions to the problems of combining under singular institutional umbrellas vastly heterogeneous and even divergent national systems), the EU is attempting to treat its symptoms (the lack of credit transmission from one economy to another, or the mismatch in debt financing costs across the economies, or deflationary pressures, or fiscal divergences and imbalances, and so on).

Having confused causes and effects, the EU is naturally confusing poison for cure.

Continued enhanced harmonisation of the European institutions, absent ex ante deep reforms of these institutions, risks weakening Europe’s ability to respond to the future crises by increasing systems’ rigidity in the face of the future shocks, and, thus, systems’ fragility. The Banking Union, the Genuine Monetary Union, fiscal harmonisation (the Fiscal Compact) and the Political Union – all are replicating the very same error of centralising command, control and supervision over diverse national systems in the hands of technocrats. This implies further weakening of democratic buy-in for future crisis-related policies, amplified memory of the lack of such buy-in from previous crises policies and, subsequently, reduction in the political spectrum that remains un-tainted by the previous participation in shaping unpopular policies. But beyond these already powerful forces, the increased harmonisation approach to dealing with institutional weaknesses fails at an even more basic or fundamental level: all top-driven harmonisation and consolidation efforts at reforming our institutions either de facto or de jure (and in majority of the cases – both) assume perfect foresight of the future crises and perfect wisdom of the one-solution-fits-all answers to such crises.

The main lesson of the Euro area crises should be that artificially centralised systems, such as the EMU, create own risks that compound external shocks, while adding complexity to the shocks- and risks-transmission mechanisms. When such systems are imposed onto structurally heterogeneous political and economic institutions, even smaller shocks (e.g. to the euro ‘periphery’) become systemic.


Instead of rigid umbrella institutions that standardise responses to shocks, Europe needs to develop more agile, adaptable and de-centralised institutions that encourage policy experimentation and learning, while setting robust downside controls and collective insurance. In financial markets, these twin approaches are known as diversification principle for portfolio allocation and stop-loss rule, respectively.

To achieve this, the EU needs to evolve a federalist superstructure that simultaneously draws on a direct democracy mandate, maximises cooperative policy formation and deployment, and is based on bottom-up approach to policy innovation.

By definition, such a structure cannot supersede the Member States’ except in the core competencies that reflect cross-shared values of all members of the Union. These competencies have been well-defined in the European polity and electorates as securing free trade, free mobility of capital and labour, and common markets. These, then, should once again become the sole competencies of the Federal EU.

The Federal system should be bi-cameral, with directly elected Parliament and nationally-elected, member states’ representative, upper chamber. Its executive should be headed by the directly elected President, and funded by a designated federal tax. The best basis for such a tax can be each member state GDP per capita, with the common tax rate controlled by the upper chamber of the legislature.

The model for balancing the referenda-based direct democracy, the national and Federal legislative and executive mechanisms across the EU can be Switzerland.

On the EMU side, Europe needs to create a functional and well-defined mechanism for member states to exit the EMU without jeopardising their membership in the EU itself. The EU will also need to abandon the requirement for its members states to progress toward membership of the EMU. This does not mean that Europe will move to pre-EMU fragmentation of its currencies. Instead, in many EU states, Euro can coexist – in circulation and deposits – with domestic tender. But it does mean that some of the states will be free to pursue their own monetary and exchange rate policies. These states should be facilitated in transitioning to a new currency set up. Such transition should allow parallel circulation of the Euro and domestic currencies for a period of time, with strict control from the ECB in terms of monetising Euro denominated liabilities.


There are many other reforms that will be required, beyond the main principles outlined above. But the core principles remains:
1. European federalism can only evolve on the basis of drawing strength from the diversity and pluralism that define Europe, not by undermining or displacing it.
2. European federalism cannot be imposed from above nor can be spread via technocratic reforms across an ever-widening space of competencies. Instead, it must build on the foundations of participatory democracy and pluralist approach to policy debate and formation.
3. Gradualism, beginning with a handful of core competencies areas of common agreements, should take precedence in building up federal European systems and institutions.

5/2/15: Gazprom's Nord and South Streams: Lessons Learned, Strategy Changed

An interesting paper from Oxford Institute for Energy Studies, titled "Does the cancellation of South Stream signal a fundamental reorientation of Russian gas export policy?" (January 2015: http://www.oxfordenergy.org/wpcms/wp-content/uploads/2015/01/Does-cancellation-of-South-Stream-signal-a-fundamental-reorientation-of-Russian-gas-export-policy-GPC-5.pdf).

It is a very insightful and interesting paper worth a read. Here are some extensive quotes, occasionally with my own comment.


In 2006, Gazprom and the Italian company ENI, subsequently joined by the French EdF and German Wintershall, announced South Stream project – two gas "pipelines, each 930 km in length to be laid from Anapa on the Russian Black Sea coast to Varna in Bulgaria in water depths of up to 2,250 metres." Note the timeline: 2006. Following January 2009 Russia-Ukraine gas dispute/crisis, the project was doubled from 2 lines to 4 lines and capacity of 63 Bcm/year. First line was scheduled to come into production in Q4 2015, second line by the end of 2017 and all four lines by 2020. Note: doubling of the pipeline, in theory, allowed for a partial offset for gas flows currently transiting Ukraine. Permitting for growth in the Turkish market (supplied via link via Bulgaria) and for expected growth in demand for Russian gas across Europe, South Stream at full capacity could have reduced Russian gas transit via Ukraine by around 40-50%.

Per paper, "From 2008-10, Russia signed intergovernmental agreements with seven European countries… The total cost of South Stream …was estimated at around $40 billion in mid-2014, comprising: $17 billion for the Russian Southern corridor; $14 billion for the offshore section and $9.5 billion for the onshore European sections." In other words, Russia agreed modalities and permissions for construction with all EU member states involved. Some estimates put the cost at EUR50 billion (see here: http://www.eegas.com/S-Stream_cost_en.htm) once feed-in pipelines were to be included, of which EUR 40 billion was supposed to be Gazprom own share, large portion of which would have been unrecoverable (sunk) cost if South Stream were to proceed to on-shore landing at Varna.

In the end, Gazprom held 50% of South Stream shares (excluding feed-in pipes), Eni owned 20%, and Wintershall Holding and EDF had each 15% shares. These only broadly corresponded to the final cost breakdown as well, with the Russian side was required to supply in excess of USD20 billion worth of own funding to the project, raised predominantly via debt to be assumed by Gazprom. No participant to the project required any access to the pipeline for any other party or for project shareholders, other than Gazprom. The pipeline was conceived, planned and funded absent any other suppliers than Gazprom and no participant in the project objected to this.

So what happened from the date of enthusiastic European engagement with Gazprom till the day of its cancelation of the entire project in early December 2014?

Well, a lot. The key change was regulatory volatility induced by the EU. The Oxford paper is straight on that: "The regulatory environment worsened dramatically for Gazprom, following the introduction in 2011 of the EU’s Third Energy Package (TEP).The TEP mandated regulated third party access (TPA) to pipeline capacity …unless an exemption from these rules is granted by an [National Regulatory Authority] NRA and approved by the European Commission (EC). Thus the TEP created major problems for Russian gas exports to EU countries in terms of compliance with the changing regulatory environment both in respect of existing and new pipeline capacity."

Recount that: five years after the initiation of the project, EU unilaterally demolishes the regulatory basis for the project. This, in Brussels' view, is how one does business involving decades-long capital commitments. Proceeding with South Stream, therefore, post-2011 meant that Gazprom would sink tens of billion into infrastructure to supply own gas, based on several decades of expected revenues, and EU could hold a stick of barring Gazprom access to its own infrastructure, built on its own money, at a whim.

You think I am exaggerating? Oxford paper describes another case where Gazprom fell a victim of the EU regulatory caprices: the OPAL line. In the OPAL case, as Oxford study details, EU agreements were not worth the paper they are written on, and EU National Regulators have been found to hold no power to even exercise the power legally granted to them by the EU. All of this was already in play before the Ukrainian crisis.

Similar happened in the case of the South Stream pipeline. But as an even bigger farce. EU Commission argued that national-level agreements signed by Gazprom with member states violated TEP. Here's what Oxford paper says on that: "The TEP (in)compatibility argument, which was the main reason for the South Stream cancellation, is somewhat flawed as the TEP in its current form does not contain any rules for construction and utilisation of new pipeline capacity, but only rules for existing pipeline capacity."

Yep, Russians made a major mistake. "Given this regulatory void in respect of new capacity, which would not be filled until the second half of the 2010s, Gazprom and the Russian government should have recognised and acknowledged much earlier in the process that South Stream could not proceed on its original timetable." In other words, Moscow should have canned South Stream back in 2011-2012 and opted for the Turkey Stream instead (but see more on this latter bit below).

Only after all this TEP brandishing as a lethal sabre in front of Gazprom does the Ukrainian crisis enter the frame: "…following the Ukraine crisis and Crimean annexation, relations between the EU and Russia on all gas issues were “frozen”, creating great difficulty in even scheduling meetings between the two sides. …The inability of the parties to even negotiate, let alone reach a compromise, on regulatory issues ultimately led to the South Stream cancellation."

Was Ukrainian crisis a convenient excuse for the EU to bully Gazprom? Was, at the same time, arbitrariness of the EU regulatory process applied to Gazprom as the means for assuring that Russian gas deliveries to Europe remain subject to control by Ukraine? Is Gazprom transit being treated by the EU as a direct subsidy to Ukraine? I don't know nor do I want to speculate - the powder keg of Ukrainian conflict geopolitics makes any rational discussion impossible, given the proliferation of policy trolls and the vitriolic pseudo-intellectual debate being promoted by all sides to the conflict. But are these questions legitimate, given the timing and nature of events pre-dating Ukrainian conflict? Should they be asked?

There are many examples of absurdity of the EU position, were one to be tempted to explain it from the rational / logical point of view:

• One: EU aims to secure Russian gas deliveries without interruptions. Would this objective not be best served by cutting out middle men from the transaction and allowing delivery via more pipelines than less? In finance, South Stream completion would have been equivalent to portfolio diversification. 
• Two: What happens when the majority shareholder in Gazprom and the CEO of Gazprom simultaneously announce a strategy change? "On December 1, 2014, …president Putin and Gazprom CEO Alexey Miller announced that South Stream had been cancelled due to the combined failure of the Bulgarian government to provide assurances that the pipelines could be laid; and the European Commission to provide assurances that gas would be allowed to flow through them." What does the EU Commission do in response? It "notes" the “currently unofficial nature of this announcement”. Unofficial announcement? By the President of the country that owns Gazprom and Russian gas? By the CEO of the company itself? How more official can it get? Clarify what? Do the EU Commission boffins know the word "No"?

Meanwhile, Russia was left nursing serious losses and had to redeploy allocated funding to a different route.

Again, from Oxford paper: "While one strand of opinion was that the real reason for the cancellation was a recognition from the Russian side that, due to economic problems stemming from sanctions and a falling oil price, the project could no longer be afforded, this seems unlikely… By the time the project was cancelled, Gazprom had already spent $4.7 billion on the offshore and European sections, most of which would have been for the offshore pipe and the charter of the barge; and a similar amount on pipe and compressors for the Russian Southern Corridor. This represented approximately 40% of the $20 billion of capital investment required for the first two lines (approximately 30 Bcm/year of capacity). … once the pipe was on the seabed, then the Russian side would be completely dependent on Bulgarian and EU decisions to monetise its considerable investment. Hence ...the timing of the decision was crucial." In other words, the costs were about to become 'sunken' or, rather, full hostage to the EU meddling with the project, and by extension, to the Ukrainian geopolitics of the EU.

Turkey Stream announcement allows Gazprom to recover much of the capital already allocated. And, according to the Oxford paper, Turkey Stream replacement for South Stream makes business sense. For all parties concerned, not just Gazprom. "The cancellation of South Stream and adoption of new pipelines arriving in a non-EU member state remove a major problem in EU-Russia gas relations..."

However, the sticky point is, you guessed it - Ukraine. "…as a result of the events of 2014, the EU political agenda expanded to include maintaining a gas transit role for Ukraine, and this is also important for maintaining reverse flows to Ukraine…" In other words, forget the Energy Security blabber and the rest of the EU agendas. The core objective is to retain Gazprom capture by the Ukrainian transit system. Chain that bear!

Here is the take on the Russian-Ukrainian game of energy poker: "The Ukrainian government led by Arseny Yatseniuk has expressed a determination to phase out Russian gas imports (replacing them with LNG and pipeline gas from other sources), but a willingness to continue transit. On the Russian side, …Alexey Miller reiterated the claim that transit of Russian gas across Ukraine would be phased out, but a willingness to continue supplying the country. The positions of the two countries on supply and transit are fundamentally in conflict, and appear equally unrealistic."

The problem, folks, is that it is Russian gas, not Ukrainian. It's up to Russia to say who it sells it to and to agree terms on which it is sold. Not Ukraine's. Ukraine has a right, under existent contracts, to receive gas it pays for. And it has the right to negotiate its terms for receiving this gas. It also has a right to refuse buying Russian (or anyone else's) gas. But it has no right to demand Russian transit via its territory.

More crucially, however, is the overall change in Gazprom business strategy that underlies the Turkey Stream announcement and other developments in Russian-European gas markets.

Again, as Oxford paper states, "All of this is consistent with the announcement by Alexey Miller that the company is abandoning its long held strategy of direct sales to European end-users: “The principle of our strategy in relation to the European market is changing. The decision on stopping South Stream is the beginning of an end to our operation model of the market within which we oriented ourselves towards supplying [gas] to the end consumer… But you can’t win love by force. If the buyer doesn’t want the purchase to be delivered home, well then perhaps he needs to get dressed and go to the store, and if it happens in winter, get dressed warmer. Well he could also take some package… which can well be the Third Energy Package, but what counts most is that it should not be empty. In our case the store is certainly the delivery point on the Turkish-Greek border.”"

In other words, if a grocery store is not allowed to deliver directly to consumers' homes, consumers will have to go to the grocery store, where it is located.

Per Oxford analysis: "This firmly closes the door on any possibility of a `strategic partnership’ between Russia and Europe on gas, and places the trade at the level of a `commercial partnership’ i.e. if Russia has gas to sell and Europe wants to buy then trade will take place, but there will be no deeper economic or political commitment to facilitate trade." Question is, is Europe Europe ready to engage in commerce instead of political 'partnership' games that are designed to assure a 'revenue cut' for the Ukraine? Time will tell…

Is "an ironic result of the 2014 crisis - a much more logical commercial strategy for Russian gas exports?" ask the Oxford analysts. And their answer (and I agree with it) is 'Yes'. "US and EU sanctions, limiting the availability of finance for Russian energy companies and threatening the possibility of an embargo on LNG technology, have accelerated both a move into the Asian market by Russian companies and a shift away from Russian LNG to pipeline gas projects. ...Abandoning South Stream, which looked very complicated from a regulatory point of view, in favour of direct undersea pipelines to Turkey, prioritises Gazprom’s second biggest market, and its only European market with major expansion possibilities over the next decade. Refocussing on pipeline gas – where Gazprom has decades of experience, compared with LNG where it has very little - looks like an entirely sensible strategic move."

Do note the LNG threat. If Russia was allowed to develop LNG capabilities, it could have serviced some of the European markets (e.g. Italy) via LNG supplies. By threatening this capacity, the US and EU are de facto forcing Russia to push gas via pipelines. Coupled with the EU opposition to South Stream, it means that the US and EU were forcing Russia straight into the monopoly hands of Ukraine as transit route. Does this make any sense? No. Instead of diversifying supply routes, it retains them at the point of highly volatile geopolitics and domestic Ukrainian politics. Why, someone should ask, would EU want this outcome?

"…an irony of the post-Ukrainian crisis period may be that a combination of western sanctions, EU regulation and the breakdown in EU-Russia relations, may have pushed Russia and Gazprom into a much more logical commercial strategy for gas exports." And delivered to China long term strategic partnership-based access to gas and oil from Russia.  Congratulations, Brussels.

27/8/2014: Russian Economy Outlook

Russian Economy Outlook

Main macroeconomic points:

First, at the aggregate level: Russian GDP grew by 0.7% y/y in the first seven months of 2014. On preliminary basis, Rosstat’s estimate posted Q2 2014 growth of 0.8% y/y down from Q1 2014 growth of 0.9%. On seasonally-adjusted basis, Russian GDP is now estimated to be marginally lower in the first half of this year than at the end of 2013.

We do not yet have an official recession, but output in the five core sectors of the Russian economy : industry, agriculture, construction, retail sales and transport rose by only 0.3-0.4% y/y in Q1-Q2 2014.

This means that main drivers for growth so far have been:

- Services other than retail and logistics,

- Investment, and

- Government spending

Bad news is, the above are changing for the worse since the beginning of Q3. Car sales tell the story: down 23% y/y in July 2014. Economy has contracted in June (-0.1% y/y) and July (-0.2%) after growing 1.3% in May. GDP grew 1.6% y/y in July 2013, so the swing is now 1.8% down. Retail sales were up only 1.1% in July before the heavier segment of the sanctions hit, which was a positive surprise (expectation was for 0.9% growth) and this is an improvement on 0.7% growth in June. In comparison, retail sales grew 4.5% in July 2013. But investment fell 2% in July, erasing gains recorded in June and this compares to growth of 2.2% in July 2013.

IMF latest forecast is for 0.2% growth in the economy in 2014. Official Economy Ministry forecast is for annual growth of 0.6% although some recent statements from the Ministry officials voiced a higher figure of 1%. You might as well say it will be -0.2%. Any growth for Russia below 2% is poor showing and the real issue here is - what will happen in 2015-2016.

So far, the cost of the Ukrainian crisis is relatively indirect, not hugely significant but rapidly rising.

Russian foreign reserves are down by USD42 billion at the end of July 2014, but gold reserves are up USD3.5 billion over the same period. This rate of depletion is sustainable for now, but presents two problems forward:

1) Ruble valuations; and

2) Companies and banks supports over the duration of the sanctions

It is worth remembering that during the Crimean crisis in March this year, the CBR intervened aggressively in the FX markets, selling more than $22.3 billion of reserves in just one month. This was followed by sales of USD2.4 billion in April and a net purchase of USD1 billion in May. The result was moderation in devaluation of the ruble. [The currency lost roughly 13% of its value against the dollar since August 2013.] And devaluation is ongoing.

On the first point above, Central Bank of Russia continues to push toward a fully free-floating ruble - a long-term policy objective of the CBR that is [for now] firmly in sight.

The CBR further adjusted its ruble exchange rate steering mechanism [a range for the exchange rate relative to a dollar-euro currency basket] in mid-August:

* The fluctuation band limits have been widened from 2 to 9 rubles.

* The CBR also committed to not intervening in the markets as long as the steering rate stays within the steering range. This is a departure from the previous practice of supporting ruble even within the bands.

* Bands limits sensitivity to market rates changes was also made tighter, to allow for more flexible adjustments in the bands in response to smaller appreciation or depreciation pressures on the ruble.

Net effect of the three recent changes is that ruble is moving closer and closer toward full free float; and CBR pressures to defend ruble will decline further, leading to stabilisation in the rate of FX reserves depletion and freeing more resources to deal with other crises and risks, such as banks' funding etc.

The above will likely increase effectiveness of the interest rates-setting policy, allowing the CBR to ease on the rates increases necessary to sustain capital outflows and contain inflation.

Capital outflows remain a problem: Russia saw some USD74.6 billion worth of outflows in H1 2014 (USD48.8 billion in Q1 2014 and further USD25.8 billion in Q2 2014). I suspect we will see acceleration of these outflows in September, assuming no significant stabilisation in Ukraine and absent capital controls. It is worth noting that currency swaps were included in the above figures. If swaps and foreign-currency accounts were included, the net outflows would have been around USD42 billion in Q1, marking the highest quarterly outflow since the 2008, and USD12.3 billion in Q2. [http://online.wsj.com/articles/russia-sees-further-rise-in-capital-flight-1404918861]

To increase credibility of its commitment, the CBR did not intervene in the ruble markets since June this year.

On the second point, companies and banks in Russia are starting to feel the heat from the restrictions on their access to funding markets in the US and Europe.

Moscow gave approval to National Welfare Fund (USD86.5 billion SWF) to buy new preference shares worth some USD6.6 billion (RUB239 billion) in two major banks hit by the sanctions:

* VTB Bank - some USD5.9 billion (RUB214 billion)

* Rosselkhozbank - balance.

The real problem here is that demand for new funding is coming on foot of already contracting household investment and tightening credit conditions in the economy. VTB reported an 80% decline in profits to RB1.9 billion in 12 months through July 2014.

Another area is corporate funding, exemplified by Rosneft. Last week, Economic Development Minister Alexei Ulyukayev told the company that is will be provided with state support but at the levels "significantly less than asked for". Rosneft head Igor Sechin said earlier this month that the company will require RUB1.5 trillion (USD41.5 billion) from the state to help the company meet the repayment of debts of RUB440 billion (USD12 billion) by year-end and another RUB626 billion next year. The debt was raised to finance Rosneft's USD55 billion acquisition of Anglo-Russian oil firm TNK-BP. Rosneft has taken steps to mitigate refinancing risks by selling forward oil contract with China's CNPC back in June 2013. Rosneft and CNPC agreement will double oil exports to China to 600,000 barrels per day in a deal worth USD270 billion over 2018-2037. The contract includes partial pre-payments.

But just to make things more complicated, the company that is at the top of the US and EU sanctions list has just been given green light to bid for drilling in Norway's Arctic, despite the fact that Norway fully backed EU sanctions. Rosneft has also signed a long-term agreement on offshore drilling with the Norwegian company North Atlantic Drilling Ltd that involves long-term purchase out of six offshore rigs for offshore production, including for work in the Arctic. Also in August, Rosneft bought a stake in one of the world’s largest oilfield contractors – Swiss Weatherford.

Russian corporates need funds to roll over maturing debt coming due 2014-2015 and they are facing difficult funding conditions regardless of their corporate balance sheets health. Non-financial firms’ external debt totals USD432 billion, of which USD128 billion is due within 12 months and further USD47 billion due in the subsequent 12 months period.

And another problem looms on the horizon. In the short-term future, sanctioned Russian banks should be able to replace European funds with liquidity provided internally (CBR can deploy a range of options tested in EU and US during the GFC, such as ELA and LTROs) or in the Asian markets. In the medium-term, a switch to Asia-Pacific funding can take place.

But… the proverbial but… the Asian markets will come with a price tag: higher funding costs, lower coverage ratios and pressure from the US. To continue trading deeper into Asian markets, Russia will need to control for US pressures on China, Indonesia and Singapore. It can be done, but it will be tricky and costly.  Issuance in Asian markets is already constrained. Take the issue of Dim Sum (renminbi denominated, Hong Kong-issued bonds). Just over a year ago, JSC VTB Bank, Russian Agricultural Bank OAO and Russian Standard Bank ZA raised USD482 million in Dim Sum paper. This outstrips USD477 million issued by Chinese companies. However, overall volumes of Dim Sum bonds are shallow, markets are not highly liquid and even with this, yields on Russian corporate bonds denominated in renminbi are now rising, driven by two factors: credit slowdown in China and Western sanctions.

For example, yield on VTB’s 4.5% October 2015 renminbi bonds rose from 4% to around 6% in less than two weeks following July 17 shooting down of MH17 Malaysian flight in Eastern Ukraine. Russian Agricultural Bank’s 3.6% February 2016 Dim Sum bonds yields shot up from 4.7% on July 16th to over 6.5% within a week. The yield on Gazprombank’s 4.25% January 2017 Dim Sum bonds rose from 5% on July 16, to 6.5% at the end of the month. [http://www.ifrasia.com/asian-markets-no-quick-fix-for-russia/21158400.article]

Meanwhile, domestic economy capacity to sustain higher retail rates to fund margins is questionable. Russian banking sector’s total external debt is USD214 billion. Of this, USD107 billion is due within 12 months, USD22 billion more is due in the following 12 months.

So do the math: 300bps hikes in average funding cost will take out USD16.2 billion out of the economy in the next 24 months. Give it 500bps and Russian economy has to fund USD27 billion of additional costs.

In the longer term, things might get easier, but it will take a while for renminbi markets to build up and it will take improvements in Chinese credit supply to support more issuance by Russian banks and corporates. On a positive side here, at a BRICS summit in Brazil in July, Russia and China  agreed to set up a bank-clearing system to increase payments settlements in renminbi and rubles. The two countries aim to increase their bilateral trade from USD90 billion in 2013 to USD200 billion by 2020.

Meanwhile dollar funding for Russian banks is running at 16-months high. 5-year cross swaps on RUB / USD pair are hitting negative 120 bps, signaling that forex traders are paying a premium to swap rubbles for dollars. The swaps rose sharply by roughly 20% in a month of August. But Russian swaps are in the negative territory while other emerging markets swaps are all over the shop, so the pricing is not solely down to the sanctions.

On the positive side, deposits funding is easing: Ruble Overnight Index Average rate, or Ruonia, was down to around 8.1% last week, just above the CBR reference rate of 8.0%. July 28 marked Ruonia peak of 8.96%.

There is room for CBR to engage in more aggressive repo operations, as cash supply conduit for banks, as repos fell to USD71 billion (RUB2.58 trillion) at the end of August, compared to the year high of RUB2.96 trillion back in July.

Back to the macroeconomic performance.

Russian external balance is improving, driven primarily by declining imports. Nothing new here - it has been thus in every slowdown/recession.

In H1 2014, value of Russian goods imports fell to USD153 billion, a decline of about 5% y/y. Imports contracted broadly across almost all categories of goods, down to sluggish demand, ruble weakness and tighter credit markets, but not to sanctions. Imports from non-CIS were down less than imports from CIS.

Goods exports rose by just over 1% y/y to $256 billion. Sources of increases - exports of petroleum products such as gasoline. This was offset by drop in crude oil exports.

The EU accounted for half of Russian goods trade, APEC countries about a quarter and the CIS countries 13%. The biggest drop in Russian trade volume was registered with the CIS countries.

But Government finances are showing strain.

Urals oil price has been gradually slipping under USD100 per barrel (p.b.). Mid-August it fell to USD98 p.b. - the lowest level since May 2013 and over the last 12 months, the price is down around 11-12%, most of which came about since January 2014 (-8-8.5%). Part of this is seasonal. But part is structural: a 25% rise in Libyan output is here to stay, most likely. On the other side, Iraq uncertainty is likely to remain in play.

Crucial point, however, is Urals trending below USD114 p.b. which is the assumed annual average for the Russian Federal Budget and balanced budget is deliverable at around USD110 p.b., assuming no significant ruble devaluation ahead. The fiscal position is not a short-term problem right now, especially considering the CBR is moving to allowing free float of the ruble and considering interventions in FX markets have declined dramatically. In other words, more devaluations are coming. But scope for devaluation-induced rebalancing of the budget will be more limited in the Winter-Spring period, since devaluation implies higher cost of imported food, consumer goods and capital goods, compounding unpopular pains of Russian counter-sanctions.

To counter potential risks of Urals falling below target, Russian oil majors have been scaling back their expectations for longer-term prices. For example, in May this year, Gazprom announced that it is basing its 2014 business outlook on an average Urals price of USD111.5 p.b., but its longer term projects are proceeding on the assumed price of USD95 p.b. [Note: during the GFC, Urals price dropped from USD147 p.b. to USD40 p.b. in June-December 2009].

Fiscal exposure is large: in 2013, oil, gas and related earnings amounted to 52% of Federal revenues (in direct and indirect revenues), in 2014, the proportion is likely to be around 45-46%.

As mentioned above, devaluations offer restricted scope for dealing with budget imbalances. Primary due to their inflationary effects. And inflation is rising, not falling. Latest data points to inflation running at 7.5% and rising, despite normal seasonal pattern that implies decline in inflation during summer months. In my view, this is the beginning of the sanctions-induced inflation, with overall effect on price likely to be around 1.2-1.5% uplift in inflation in 2014. It is worth noting that groceries and food account for 37% of Russian official 'consumer basket' - a high proportion due to relatively low cost of housing. All of this is clearly despite the CBR hiking rates by 250bps over the year to 8%. As a reminder, CBR target inflation for 2014 was 5% and this is likely to be revised up.

Problem with Russian sanctions is that imports substitution is

1) Difficult and

2) Costly.

From the cost basis point of view, logistics networks and supply contracts need switching, which takes time even if there is supply in the market available for shipment. Often, there is none and this is especially true for the current pre-harvest period in the Northern Hemisphere. In the Southern Hemisphere, supply can be built into new crops plans. Which goes to the difficulty of securing substitute supply from abroad. The scale is large - sanctions are impacting directly some USD9 billion worth of imports, though Agriculture Ministry is now estimating the end loss of some USD5 billion in EU food exports to Russia.

Domestic substitution is also problematic. Crops are already in place and cannot be altered until next year. Producing substitutes for partially imports-covered demand will require some investment and time to uplift production. Producing substitutes for goods more reliant on imports will require very substantial investments.

Just how substantial? Prime Minister Medvedev last week called for amendments to the state's development plans to increase self-sufficiency of Russian agriculture. Existent plan offers more than RUB1.5 trillion (USD42 billion) in state funds for farming supports over 2013-2020 horizon.

Agriculture Minister Nikolai Fyodorov said in late August that Russian agriculture will require

RUB137 billion (USD3.8 billion) more to meet demand for imports substitution. Overall, the sector needs some USD16.7 billion (RUB600 billion) in investment between 2014 and 2020 to fund expansion of output to achieve 90% self-sufficiency targets set by the Government from current 66% (excluding small farmers output) or 78% (including small farmers). And the time frame for getting there is around 5-7 years, not in the next 12 months. On positive side, over recent years small milk producers started receiving direct subsidies, boosting their milk output by 5% in 2013 alone.

Again, key stumbling block is that even with state subsidies, as the National Association of Milk Producers puts it: lending rates to the dairy sector in Russia are on average between 8 and 10 percent, against 2 to 4 percent rates in the EU and U.S. Logistics and transportation costs are also higher. This, alongside growing state arrears on subsidies, have led to production of raw milk in Russia falling by 6 to 8 percent y/y in 2013.

There is, however, some experience and a road map for hitting the long-term targets. Russian meat sector saw increased Government funding since 2006. Poultry production is up and is now delivering 90% of the domestic markets demand. Pork production is very close to self-sufficiency levels: over 70% of Russian pork demand is being delivered from larger domestic producers, and this is growing - expectation is that 2014 will see output rising by 200-250K tons. However, major bottleneck remains in beef production, which depends on imports for more than 50% of domestic consumption.

In summary:

Russian economy is showing signs of stress, both in structural terms and in terms of the fallout from the Ukraine crisis.

In structural terms, reforms of 2004-2007 period now appear to be firmly shelved and are unlikely to be revived until the sanctions are lifted and some sort of trade and investment normalization takes place. Structural weaknesses will, therefore, remain in place.

In dealing with the crisis fallout, even if Russia were to switch to self-sufficiency in food production and tech supplies for defense sector and oil & gas sector, as well as re-gear its corporate borrowings toward Asia-Pacific markets, the reduced efficiencies due to curtailed trade and specialisation are likely to weigh on the economy. There is absolutely no gain to be had from switching the economy toward an autarky.

Politics aside, it is imperative from economic point of view that Russia starts to make active steps to disentangle itself from Ukrainian crisis. Rebuilding trade and investment relations with the West and Ukraine – both very important objectives for the medium term for Russia – will take a long, long time. It’s best to hit the road sooner than later.

  

ECB's survey of banking conditions in the Eurozone: July 2009 data

This is part 1 of the lengthy exercise in analysing the ECB quarterly data on banking sector conditions in the Eurozone. I intend to regularly update the data set... Enjoy and do comment...

Overpaid Public Sector in Ireland

Here is a detailed analysis of the National Employment Survey 2007 from CSO, released earlier this month.

One overarching conclusion worth making is that the Public Sector in Ireland is grossly overpaid by all measurable standards before we factor in the value of their Rolls-Royce pensions.

Another one is that in Ireland, it does not really pay for a person to increase their education beyond the secondary level, as all and any increases in earnings will be swallowed by taxes – even before we factor Brian Lenihan’s disastrous two budgets.

Now, before I begin, some folks in economics suggest that the gap is not there, or at least that it is very small, because, as they claim, our Public Sector employs more professional grade workers... Yeah, I see. So if you chose to call your third-level educated workforce 'professionals' than you can pay them more than to their counterparts in the private sector. Common, folks, are we really saying that banks specialists are equivalent to nurses and second grade teachers? But both are professional grades.

Another argument I've heard is that there should be adjustment for tenure of education-related returns... I do make this adjustment below, and guess what - the premium is still there.

Third argument is that workers in the public sector in general have been longer on their jobs than in the private sector. Ok, this is seriously daft - if someone has worn out more pairs of trousers sitting in one chair does it make him or her a better specialist? Surely not. Aptitude and eagerness to excel do. But there is no need for this in the public sector, for Trade Unionism philosophy is to reward better chair-sitting more than better work practices. We know this to be the case with work practices in health and education. For economists out there - here is a chance to do a natural experiment. Look at Forfas, NESC and NCC - their economics staff is older than that in many private sector outfits. And they produce spectacularly bad research. Get my point? Or the CB?

Fourth, there are people out there who argue that higher pay is justified by greater complexity of work performed. Yes, indeed - filling paperwork and filing it from one end of the desk to another is certainly hard. Get real - Ireland is a small, geopolitically insignificant country on a margin of a largely internationally inert region. Does our Department of Foreign Affairs compare to the US State Department? Does our CB compare to the ECB? Does our CSO compare to the Eurostat? Does our department of Finance compare to the US Treasury? And yet - they are all paid more in Ireland than in these other countries.

Regressions, my eye. There is, somewhere behind this screen smoke of academic economics, an intuitive ability to comprehend simple facts without regressing them to death. I hope.

Let us start with the distribution of earnings by sector:Evidently, both Public Admin and Defence, and Education have much heavier segment of earnings falling at or above €30 per hour than in the overall economy. This, undoubtedly, is because our secondary and primary teachers and bureaucrats are so significantly more skilled and more productive than the rest of this economy.Now, the chart above shows mean earnings by sector. Guess who’s consistently above the economy total lines? Yeah, Electricity, Gas and Water Supply sector composed largely of Public Sector employees, Civil Service & Defence, Health and Education. Notice that the gap between part time (non-unionised) and full-time (unionised) labour pay in Education is beyond any comparison with other sectors. Is this a sign of the trade unions-led exploitation of part-time workers? Surely, was this the case in, say Financial Services, ICTU/SIPTU gang would have claimed this to be the case of part-time workers being underpaid.

Oh, and ditto for the median earnings as well:And just to highlight that exploitation question a bit more:Now, is there any correlation between our secondary and primary teachers being over-represented in the Dail and the pay outcome for the Education sector? I am not sure… may be that great state-owned think-tank of ours, ESRI/Forfas/NCC/NESC can ask this question? Neah, unlikely…

Well, above shows even more conclusively that our Public Sector employees are living good lives: males and female alike. Ditto in terms of median earnings:In fact, the frightening overpay – by age comparisons and gender comparisons – in the public sector relative to the private sector should warrant an introduction of a new statistical measure. As opposed to the ‘median’ earnings in the private sector, we should report the ‘comedian’ earnings in the public sector, so farcical are these differences. Oh, and notice how median earnings in the public sector rise before the retirement? Well, of course, this the ‘Golden Handshake’ bonus – when management gives workers and itself a final raise in late employment to lock in higher pensions. Regardless of their efforts, abilities, productivity etc. Just to be sure that the private sector taxpayers really pay for the Trade Unionist policies on public sector pensions through the nose.

So what about the total tenure on the job, you’ would ask? Ok, here it is:Same picture here too – overpaid public sector for any level of tenure. And ditto for the median earnings:
An interesting look at the labour force vintage:Notice that male/female differential? Pretty strong and it does not get much lower for higher education levels, which means that the previously mentioned wages gender gap evening out in higher education levels cannot be explained by greater labour force participation by women with higher education. The Public Sector overpay for education might be a real reason, then.

Oh, want to see the real reflection of unemployment risk in the private sector? Here it is:
Notice how years in employment I public sector exceed those in private sector? Oh yes, that’s because in public sector there is no unemployment, folks. It is also because some work practices in the public sector allow temporary exits from work without disrupting tenure (continued education and family care are two examples), while they do so in the private sector.

For the previous chart: we combine hourly earnings, plus bonuses and BIK. No evidence of public sector bonuses being any lower than private sector one. And of course our ESB-led energy sector is rolling in cash, because, as you would have expected, without them, the country would be plunged into a new ice age.




On to the ‘knowledge’ economy reality:
Since this is the gender gap, it captures in part the educational premia un-adjusted for tenure (with women having traditionally lower tenure than men across the labour force). In other words, it does reflect the mixed benefit of longer tenure at each educational level. Notice the decline in the Mean/Median premia with higher levels of education attained. So far, the chart really suggests that Post-Leaving Cert is associated with the highest gender gap. This is good news, as it suggests that the more educated the person is, the lower is the earnings gap. But what it also tell us is that at higher education levels, either women tenure is getting closer and closer to men, or we are not pricing fully the differences between men and women in terms of labour supply. Other explanations can contribute to this trend, including:

• It is possible that at higher levels of education productivity of workers increases in time into later years, when both men and women tend to supply very similar work hours (not the case per below);
• It is possible that a single large sector drives the right-tail differentials in wages down artificially (which is indeed is the case with the higher education attainment in Public Sector employment as we shall see).
  

Either way, this is a largely un-researched area…

Now, returns to education:
Self-explanatory, really... not much to add other than clearly, something is not working here in the land of our 'knowledge' economics. I'll tell you what:

• High returns to tenure - courtesy of the Trade Unions we have extremely high returns to tenure, so that the older workers receive the benefits of higher productivity brought on-board by the younger workers' educational attainment and aptitude;
• High taxes - upper marginal tax rate of more than 50% today is wiping out the benefits of additional education.

This is why, incidentally, I do not swallow this idea of a Swedish-styled 'knowledge'-intensive labour markets. Anyone with real knowledge would be better off working somewhere else, rather than Ireland.

Next, consider median hourly earnings by nationality. Clearly, Accession EU12 and Other nationalities stand out from the EU15 citizens in terms of achieving much lower wages for males (female wages are substantially lower for the Accession 12 nationals) and by an out-of-line gender wage gaps. Irish wages are the highest across all nationalities, which, given the fact that both the UK and EU15 migrants have higher educational attainment on average than their Irish counterparts also illustrates the fact that it is tenure that determines Irish wages, rather than other characteristics of the workers.
Chart above further breaks down the labour market returns by nationalities and sectors. Foreigners work longer hours and earn less in wages than the Irish workers in every sector. Exceptions are:

• Public Admin & Defence, where foreigners do earn less and work slightly lower hours, reflective of their predominantly part-time work basis and the cynical unions policies that protect Irish workers while allowing for no protection for many foreign ones;
• Ditto Education, where as we all know well, even at a third level, there are barriers to promotion and pay amongst foreign researchers and lecturers.
  

So now on to the returns to education again. The chart above shows education premium ratio to tenure premium for two upper categories of educational attainment. Of course, the CSO cannot be bothered to separate 3rd level degree holders with those who have higher educational attainment. But the picture is already relatively compelling.

Because of restricted hiring (the younger workers are first to be fired due to lower cost of doing so), promotion (tenure considerations in wage increases and promotion awards) and pay conditions (pay and benefits linked to tenure), life-time education premium is abysmally low (or even negative) for males in all age groups. This can be, possibly, interpreted as returns to on-the-job training, but the severity of tenure premium over education premium makes it doubtful that this is indeed a factor that fully accounts for such differentials.

Note an interesting feature that shows females as being significant gainers from education? Well, this is because, as I’ve shown earlier, the public sector employment premium is so vastly greater for females. In other words, the female return is severely skewed by the public sector employment conditions.
Ditto for tax-adjusted real returns net of costs of investing in education.

So few last slides then:
Back to the public/private sectors gap, take €30 per hour in earnings and look at the share of employees earning in excess of that by sector. Hmmm... this was before massive cuts in earnings in the Financial Intermediation and unadjusted for the risk of ending up without a job. Of course, note the Health sector, where lower paid (often) foreign workers are outweighing consultants and managers...

Next, comparatives for mean and median full-time earnings:
Here, let us benchmark against the Public Admin and Defence. Pretty good stuff for the bureaucrats, who earn third highest median wages in the sample for males and second highest for females and in the overall total count. Apparently, they are better than the bankers and finance professionals... if only someone can tell me in what.

And another look at the same thing, from a different angle:

Ok, enough - there are only so many ways one can look at the same data set, so here is the last one - a look at the education premium...
Obviously, once you have a luxury of tenure, go study... but before then?..