Streetwise Professor

July 31, 2009

Stuff and Nonsense

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Financial crisis,Politics — The Professor @ 3:32 pm

Following the CFTC hearings on position limits in energy reminds me of Through the Looking Glass:

‘Let the jury consider their verdict,’ the King said, for about the twentieth time that day.

‘No, no!’ said the Queen. ‘Sentence first – verdict afterwards.’

‘Stuff and nonsense!’ said Alice loudly. ‘The idea of having the sentence first!’

‘Hold your tongue!’ said the Queen, turning purple.

‘I won’t!’ said Alice.

‘Off with her head!’ the Queen shouted at the top of her voice. Nobody moved.

Chairman Gensler is an odd casting choice for the Red Queen, but he clearly has his heart in the part, given his opening remarks at the hearing:

But Gensler, the former Goldman Sachs’ executive who almost didn’t get the chairman’s nomination this year because of his past role in shielding over-the-counter derivatives from regulation, adopted a tough tone throughout the hearing.

“No longer must we debate the issue of whether or not to set position limits,” he said.

Then what are the hearings about?

And there’s this:  ”There seemed, at least, that the commission is hearing support. I think it’s more a question of how, than whether.”

And his understudy, Bart Chilton, is clearly ready for the part:  ”Whatever manner the agency proceeds, ‘going slow’ is not an option.”

Given that position limits are a mantra of the Senators to whom Gensler genuflected to get the job, it’s not really a surprise that they are now deemed inevitable.

Position limits in general are dubious at best.  There is little in the way of viable theories, and even less in the way of persuasive empirical evidence, that speculators distort prices in general, or cause prices to be excessively volatile.  There is no plausible theory or evidence that speculators caused energy prices to be artificially high in 2008.  As a consequence, position limits will almost certainly not reduce volatility for energy products, or reduce the frequency of price spikes.

After all, we’ve had considerable experience with position limits in agricultural commodities.  Note that the CFTC is essentially proposing to extend to energy and other commodities “in finite supply” (again, and examples of other types of commodities are . . . ) the same type of regime that has been in place for ags for years.  Yet, despite these limits, there has been substantial volatility in ag prices–including last year.  Moreover, there have been large spikes and crashes in ag prices despite the existence of a position limit regime there.  This should not be a surprise, as the theory of storable commodity pricing predicts that such price behavior is characteristic of efficiently functioning, competitive markets undistorted by speculation.

This perhaps explains the monomaniacal focus on index investors.  Via hedging exemptions, these types of firms have been able to amass positions in individual commodities (as parts of larger portfolios) in excess of the position limits.  Since position limits are in place in ag commodities, the fanatical opponents of speculation (fanatical in the Churchillian sense of “can’t change their minds and won’t change the subject”) need to focus on participants not subject to the limits.  Never mind that extant empirical evidence provides no support for the hypothesis that index investors are moving prices.  Or that the “theory” that these funds contribute to “demand” are completely bogus.  (It would be interesting for someone to see whether price correlations across components of major commodity indices have increased in recent years; if index investors are the dog and prices are the tail, since index investors act in a mechanical fashion across markets, they should induce very similar price movements across markets.)

Position limits have been around since the Grain Futures Act was supplanted by the Commodity Exchange Act in 1936.  I’m sure you’ve noticed what a dramatic effect they had on volatility–even before the rise of index investors.

So, we’re about to go for yet another run on the hamster wheel.

It is interesting to me to note that something that is almost impossible to be distorted by speculation–shipping rates–experienced almost the same spike and plunge as energy over the 2007-2009 period.  Shipping rates aren’t assets; they are the rental rate on assets.  Even if you have a speculative bubble in the prices of ships (i.e., a lot of ships are built on spec in anticipation of higher rates in the future), this should result in a fall in shipping rates; the entry of large numbers of ships should depress charter rates.  You can’t store the ability of a ship to make a voyage today for use in the future; you either use the space today, or you don’t.  You can’t buy up today’s space in anticipation of a higher rate in the future.  So, when you have price spikes in a non-storable like shipping space, you can’t attribute that to a speculative asset bubble, cuz it ain’t an asset.

What’s more, shipping rates are driven by global industrial activity.  The eerie similarity of the trajectory of oil prices and shipping rates (as measured by the Baltic Freight Index, for instance) therefore strongly suggests that underlying fundamentals, namely strong world industrial demand, drove both oil prices and shipping prices over the period of the energy price spike.  Indeed, I have some preliminary econometric evidence (more to come later) that shows that the Baltic Freight Index is strongly correlated with, and in fact leads, the price of oil.  (Lutz Killian has similar evidence, up through 2007: mine goes through April, 2009).

And then there’s  the issue of the details of implementation.  Given the complexity of the markets, the greater variety of products and instruments, and the greater variety of market users and strategies, designing a coherent position limit regime will be nigh on to impossible.

One disturbing matter relates to the aboveforementioned index investors, and financial market participants in commodities more generally.  Gensler stated:  ”While I believe that we should maintain exemptions for bona fide hedgers, I am concerned that granting exemptions for financial risk management can defeat the effectiveness of position limits.”

So, “financial risk management”–by which I presume Gensler means investors that use commodity derivatives to improve the risk-return performance of their portfolios–are not bona fide hedgers apparently.

This reflects a widespread mindset, redolent of what Thomas Sowell calls the “physical fallacy” that physical commodity derivatives are properly for physical market players, and that others should not participate.  That is, commodity markets and financial markets should be separate.  To put it more pungently, those holding this mindset endeavor to make the commodity derivatives markets a kind of ghetto, limited to a certain group of players.

This makes no sense from the perspective of financial theory.  Integration of disparate markets with disparate risks improves the sharing of those risks, leading to a more efficient allocation and pricing of those risks.  Segregated markets–ghettoized markets–don’t permit the full scope of risk sharing, and lead people to bear more risks than is necessary.

In earlier posts I have explained why some commodity market participants may prefer that these markets be ghettoes, rather than having them integrated in the broader financial markets.  This can explain the support for position limits from some quarters of the commodity community.  No doubt these are some of the sources of support Gensler has been hearing from.

Thus, the whole position limit hysteria–which is a particular symptom of the broader underlying disturbance of speculator hysteria–is, as Alice said, stuff and nonsense.*

And for saying that, I may anticipate the sentence: “Off with his head!”

*”Stuff ‘n’ Nonsense” is also the title of an excellent Supersuckers rocker.

Like a Tarantula Behind Glass

Filed under: Politics,Russia — The Professor @ 2:08 pm

Russian Foreign Minister Sergei Lavrov is undertaking another charm offensive (another irony alert), this one directed at Ukraine (you’re surprised, I’m sure):

Foreign Minister Sergei Lavrov on Thursday criticized a Ukrainian decision to expel two diplomats, saying Kiev had not presented any evidence that they were acting in violation of their diplomatic status.

Ukraine ordered Vladimir Lysenko, an adviser at the Russian Embassy, and Alexander Grachev, consul general in Odessa, to leave for “undiplomatic activity,” RIA-Novosti reported.

Yuriy Kostenko, Kiev’s acting foreign minister, said Thursday that his ministry was analyzing Russia’s decision Wednesday to oust two Ukrainian officials but that he was standing by the decision to expel Lysenko and Grachev.

He said the diplomats were “interfering in the country’s internal affairs.”

“The Ukrainian authorities didn’t give us a single example of spying,” Lavrov said, the news agency reported.

The Russian officials were told to leave after weapons movements by the country’s Black Sea Fleet that Ukraine said were not permitted. 

I don’t have anything to say about this specific dispute, but reading the article brought to mind a story told to me by one of the attendees at my Foreign Service/Civil Service talk.  He said that one of his colleagues, who works in intelligence (and has a Russian name, interestingly), told him that “Lavrov is a fascinating person.  Fascinating in the same way that a tarantula behind glass is fascinating.”

I think PETA should investigate this defamation of tarantulas.  After all, they are harmless to humans.

In all seriousness, though, whenever I read Lavrov’s name again, the image of a tarantula will immediately come to mind.

I think you’ve won a new nickname, Sergei!

Let Me Count the Ways

Filed under: Economics,Energy,Financial crisis,Politics,Russia,Uncategorized — The Professor @ 2:01 pm

In the early-1990s Exxon entered into a deal with the Russian government to develop the Sakhalin I project.  As part of the deal, Exxon received an exemption from Gazprom’s legal monopoly on exports of gas from Russia.  Now, in a shocking development (irony alert), it seems that the exemption is under threat:

The government will step up pressure on U.S. major Exxon Mobil to sell cheap gas from Sakhalin, analysts said Thursday, a day before construction begins on a new gas link to the Pacific.Prime Minister Vladimir Putin will travel to the far eastern city of Khabarovsk on Friday to inaugurate the start of the pipeline to the Pacific port of Vladivostok, which will ultimately liquefy gas from Sakhalin Island for export to Asia.

“I think Exxon Mobil knows that they will twist their arm. It is pure pressure,” said Mikhail Krutikhin, an analyst with RusEnergy.

. . . .

Valery Nesterov, analyst at Troika Dialog, said that despite a growing belief among investors that the government’s grip over resources is easing after deals with Total and Shell in recent months, foreign firms will often remain under pressure.

“Exxon does not have a free choice. Past experience shows that if [Moscow] has a strong desire, the foreign partner has to agree,” he said.

The Khabarovsk-Vladivostok pipeline will run 1,460 kilometers, and Nesterov estimates its cost at $2.9 billion to $4.4 billion.

Sakhalin is already connected to Khabarovsk with a gas link, which is supplying local consumers.

Krutikhin said that even if Exxon is forced to sell all its gas from Sakhalin-1 to Gazprom, volumes will not exceed 7 billion to 8 billion cubic meters per year, while Gazprom is eyeing a peak capacity of up to 47 bcm a year.

“So to fill the pipeline, you need to discover new fields or build a pipeline from Yakutia,” he said.

Bloomberg adds some details:

OAO Gazprom, Russia’s state-owned natural-gas exporter, started building a pipeline in the Pacific Ocean that may damage  Exxon Mobil Corp.‘s plans to export the fuel to China.

Workers welded the first joint on the initial 1,350 kilometers (840 miles) of the pipeline at a ceremony attended by Prime Minister  Vladimir Putin and Gazprom Deputy Chief Executive Officer  Alexander Ananenkov. The pipeline will link Sakhalin Island with the mainland city of Vladivostok.

“The development of gas transportation infrastructure in the east will let us diversify our exports,” Putin said today at the event in Khabarovsk, which is on the pipeline’s route. “But I would like to stress that the domestic market will be a priority for the Far East and eastern Siberia.”

I repeat: “The domestic market will be a priority for the Far East and eastern Siberia.”  To translate: If XOM has a deal that allows them to export the gas, well, that’s just its tough luck.

So how will Putin bludgeon ExxonMobil into moving the gas to the domestic market–and likely at controlled domestic prices–rather than to a more lucrative export market?

With apologies to Elizabeth Barrett Browning: “How can I screw thee?  Let me count the ways.”

There’s environmental laws (Sakhalin II); licensing (BP, various mining firms, and perhaps now MOL); taxes (Yukos, and myriad others); blowing stuff up (Turkmenistan); legal harassment of employees, including accusations of espionage (TNK-BP); legal fraud and theft (Heritage Capital); abusive lawsuits in pocket courts (Telenor).  I could go on, but you get the picture.  If they want it, they will take it.  The only question is what they’ll pull out their bag of tricks.

So why does anyone invest there, let alone go back after getting bashed around before (Shell, most notably).  When I gave a talk to some Foreign Service and Civil Service officers with energy-related responsibilities who visited Houston earlier this week, the analogy that came to mind was battered spouse syndrome.  Hopefully Exxon will fight this hard, and won’t succumb to the same syndrome.

As I said in an earlier post, I expect that this will all be a prelim to big confrontations between China and Russia on energy.  Note that the China angle plays into the Sakhalin I issue.  Moreover, China is becoming increasingly aggressive, and successful, in areas that Russia considers its fiefdoms, notably Central Asia (especially Turkmenistan) and now Moldova, of all places.  And finally, the big one: the Rosneft/Tatneft-China oil pipeline/loan deal.  That one will turn very interesting once the pipeline is done, especially if oil prices are well above those at the time of the signing of the deal.  And absent another world economic catastrophe, that’s almost a given.

h/t R

July 28, 2009

Medieval Fairs, Russian Style

Filed under: Economics,Financial crisis,Politics,Russia — The Professor @ 9:10 pm

The events surrounding the closing of the vast Cherkizovsky Market are fascinating.  They present an intriguing illustration of the natural state in action, and the consequent intersection between the personal and the political.  The New York Times has a story on the closing of the market that is worth reading.  This paragraph was particularly illuminating:

Government agencies quickly took up the theme of the market’s seedy side — which was hard to deny. The powerful director of the Investigative Committee of the Prosecutor’s office, Aleksander Bastrykin, called the market a “hell-hole” that had become a “a state within a state” on the edge of Moscow. “It has its own police, its own customs service, its own courts, its own prosecutor and stand-alone infrastructure, including brothels,” he said.

State-within-a-state.  Bug or feature?  ”Hell hole” or (relative) paradise?

Well, it appears that the traders thought it pointless to rely on the officially constituted authorities for protection, or contract enforcement.  So they created their own system of third party enforcement, much as did the operators of fairs in Medieval Europe.  That is, the market not only served as a convenient way place for people to congregate to buy and sell, it also facilitated the creation of an institutional infrastructure to support trade–an infrastructure sadly lacking in Russia.  No doubt this is one reason that it presented a daunting competitive challenge to more conventional Russian retailers and wholesalers; the traders’ costs were lower because they had a functioning system of third party enforcement conspicuously lacking in the formal economy.

Thus, the market in a way was a living reproach to Russia’s institutional backwardness.  Perhaps that is another reason it was the focus of such intense official antipathy and hostility.

There are some other jewels in the article.  Here’s one:

Before the market was finally closed late last month, the authorities said that one in every 40 traders had an infectious disease like tuberculosis or syphilis.

The authorities’ concern for public health is touching, and distinctly out of character.  How come it seems that public health is trotted out as a justification for state action primarily when that action serves to protect some economic interest (e.g., the periodic rows over food safety with Poland, the US, and Belarus; the swine flu silliness; and now, the Market)?  I am quite curious to know how the rate of infectious disease in the Market differs from the rate in Russia at large, and how many communities in Russia have similar rates of incidence.  I am also curious to know the source of the 1 in 40 figure.

From a purely scholarly perspective, it is very sad that the Cherkizovsky Market has closed.  It would have provided a fascinating case study for institutional economists (and sociologists).  A living laboratory to study the spontaneous evolution of self-enforcing rules and norms.  I hope that before it closed, some enterprising Russian (or Central Asian, or Chinese) scholar had had the opportunity to study the market, its traders, the institutions that had developed, and the process of that evolution.  Alas, that opportunity is now gone, another casualty of Putinism and the natural state.

The Projectionist

Filed under: Economics,Financial crisis,Politics,Russia — The Professor @ 8:49 pm

Joe Biden has attracted a lot of attention with his prediction that Russia’s “withered” economy would give us a decisive advantage in our relationship with it.  I think Biden is wrong, because he has committed the cardinal sin of projecting our logic on the Russians.  Big mistake.

I take the opposite view.  I think that for a variety of reasons, Russia will become even more aggressive and difficult to deal with.

Reason one: “Withering” is relative.  Yes, the Russian economy has taken a body blow, but compared to some neighbors, notably Ukraine and Lithuania and the other Baltic states, it is doing well.  Throughout the CIS states and Eastern Europe, many countries and companies are doing very badly, and are in serious financial straits.  The Russians still have money in the bank, and resources to deal with.  Although those have diminished, they are still enough to exert pressure on, and find bargains in, countries whose economies have been even more devastated.

In other words, the Russians realistically view power as relative, and in crucial areas the crisis has actually increased their relative strength.

Indeed, although one would have hardly considered it possible, even Germany is being more solicitous in its dealings with Russia, as this depressing article by Vladimir Socor demonstrates:

Russian President Dmitry Medvedev and German Chancellor Angela Merkel headed large governmental delegations for bilateral talks on July 16 in Munich. The process, known as Russo-German inter-governmental consultations, involves informal semi-annual summits at which leading business representatives join the cabinet ministers on either side. The Munich meeting reviewed ongoing cooperation projects and considered new ones.

Access to the Russian market is seen as critical to Germany’s export-oriented economy at any time. As an export nation, Germany’s reliance on the Russian market has developed in parallel with its overdependence on Russian energy supplies. The Russian market’s perceived importance increases during the ongoing recession, as global markets shrink and Russia has also significantly reduced its imports of German goods. In these circumstances, the German government agreed at this meeting on some measures to subsidize Russian imports of German goods.

. . . .

The inter-governmental meeting also considered an ambitious program for manufacture and delivery of Siemens trains and locomotives to the Russian Railroads state company. In parallel, Siemens is negotiating to establish a joint venture with Russia’s Rosatom for building nuclear power plants and electricity transmission systems. In March of this year, Siemens withdrew from its joint venture with the French nuclear power plant manufacturer Areva and proceeded to sign an agreement of intent with Rosatom instead. This move hurt the overall Franco-German partnership in Europe while highlighting the structural trend toward Russo-German cooperation. According to Russian Energy Minister Sergei Shmatko, the contract with Siemens is expected to be signed before the end of this year and will greatly improve Rosatom’s international competitiveness through technology transfers from Siemens (Die Presse, July 23).

The German government is tentatively looking at Gazprom to rescue the ailing German shipyards Wadan, in the Baltic ports of Wismar and Rostock. Under proposals under discussion, a Gazprom subsidiary would place orders for liquefied natural gas (LNG) tankers to be manufactured at those German shipyards. If implemented, this move would facilitate Gazprom’s entry into German and European LNG markets, with a corresponding increase in German dependence on Russian gas. The German government apparently feels that it must consider the proposal in this election-recession year, when job-saving is a top priority.

Reflecting that same short-term German priority, the Munich meeting discussed a Russian rescue of Opel, the German subsidiary of General Motors.

I think I need an aspirin.

Seriously, though, even though by every measure the German economy dominates the Russian, and even though the badly shaken German economy has still outperformed Russia’s, the dispiriting litany in Socor’s article (and I left some stuff out!) shows that even Merkel (no Schroeder she) is bending over backwards to supplicate Russia.  Look at all the things that Germany is doing to advance “withered” Russia’s interests, especially in energy, and then ask yourself “what the hell is Biden talking about?”

What’s the difference?  Well, a major factor is that the relative lack of organized political opposition within autocratic Russia, the state’s ability to crack down on the opposition that does appear, and the asymmetric vulnerability of the leadership in democratic Germany (especially with an election coming up).  The German government is anxious to appease important domestic constituencies, especially major corporations that do business in Russia, and those that work for these corporations.  This gives the Russians a lot of leverage, which they have used to the hilt.

Reason two: Aggressiveness abroad and obnoxious nationalism is one of the ways to distract Russian public opinion, weakened and apathetic as it is.

Reason three: Russia is obsessed with status, reputation, image.  The myth of Russia on its knees humbled before the West is ubiquitous, and powerful.  The Russian leadership is more than willing to do things that are objectively counterproductive economically and geopolitically just to avoid the appearance of subservience to the West.  (In fairness, Biden admitted that Russia’s prickly pride might make it more aggressive in the short run before it was forced to bend to objective economic realities.  The short run could be long indeed given the raging complexes that drive Russian relations with the West.)

Reason four: The very desperation of the situation tends to shorten time horizons, and make the elite willing to take huge risks.  Faced with ruin, gamblers will often double down.  What’s there to lose?  This would suggest that Russian behavior is more likely to moderate if their economic circumstances moderate.  Biden’s argument leads to the opposite conclusion.

So, I disagree with Biden’s diagnosis.  I think that we are in for a protracted period of testy relations with Russia, and that economic hardship will actually exacerbate these problems rather than ameliorate them.

That said, the Russian reaction to Biden’s interview has had immense entertainment value.

And Biden has it all over Hillary, who (like Obama) is apparently a firm believer in the Self Esteem Theory of Diplomacy.  Just tell them that we want them to be big and strong, and a great power, and express admiration for their contribution to history (and boy, do you have to leave a lot of stuff out to do that!) and they’ll be biddable.  Sheesh.  As if.

Maybe the NoKos are onto something in their evaluation of Hillary.  It is especially painful to watch such transparent diplomatic clumsiness.  Also, the discordant notes struck by Biden on the one hand, and Hillary and Obama on the other, hardly present an image of a well-oiled team executing a thoughtful and coherent Russia policy.

Regardless of whether the Biden view or the Obama-Hillary approach prevails, I think that our policy vis-a-vis Russia is in for some very rough sledding.

Konstantin Sonin Whiffs

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 7:22 pm

Konstantin Sonin is an excellent economist at the New Economics School in Moscow.  (Obama spoke there during his visit to Moscow.  My friend Sergei Guriev is Rector of the school.)  Konstantin and Sergei wrote an excellent paper using media freedom as a measure of property rights.

Unfortunately, Konstantin’s article in today’s Moscow Times lays a couple of eggs.  First, he argues that (a) production sharing agreements (“PSAs”) in energy markets are a means of protecting investors against political/expropriation, and (b) Russia has no need for PSAs because it presents no such risks:

An economist would normally criticize Deputy Prime Minister Igor Sechin. He rarely says anything meaningful in terms of economics. But twice in the past two weeks, it was necessary to come to Sechin’s defense. First, he was right in saying that Russia does not need a production sharing agreement, or PSA. Second, claims that Russia’s agreement to provide China with oil is unprofitable for Russia might really turn out to be groundless. But the lack of understanding on the subject and the controversy surrounding it attests to the lack of transparency in the agreement. This is an unacceptable situation, particularly when it involves such an important strategic interest.

Russia currently has three PSAs that are intended to protect foreign investors from political risks. Such agreements were specially created to allow major international corporations to sign long-term contracts with unpredictable, authoritarian regimes. In many countries, these PSAs have proven at least partially successful at protecting foreign investors from changes in leadership. But there is a certain stigma attached to them since they are only needed in unstable countries. In stable states with a safe investment climate, foreign investors do not require special protection because all investors are protected equally.

Although Russia does not need insure foreigners against risks connected with its own behavior, it might need to insure itself against the risks involved in deals with other countries.

First, PSAs are not in the first, second, third . . . instance a means of protecting investors against political risk.  Instead, they are a mechanism for sharing development cost risks.  Or, better put, they essentially put the development cost risk on the resource owner: the resource owner gets paid after the E&P company recoups its costs.  Second, even if they were intended to protect investors against political risk, how can Konstantin state seriously, in the aftermath of all that’s transpired in Russia (and the oil sector in particular) in recent years, that Russia poses no political or expropriation risks?  The risks there are huge.  Indeed, they are so large that I look in amazement when companies like Shell act like victims of the battered spouse syndrome and return to their abuser.  Third, if PSAs are intended to protect investors against expropriation and political risk, they do a lousy job of it.  Just ask Shell: it had a PSA for the Sakhalin II project, and a fat lot of good that did.  Indeed, PSAs have been used by the Russians to justify expropriation.

Konstantin’s second error in his defense of Sechin relates to the murky China-Russia oil deal consummated earlier in the year.  He argues that the deal was good for Russia, even though it was at below market prices, because it locked in prices, and therefore provided insurance (a hedge) against price fluctuations:

Although Russia does not need insure foreigners against risks connected with its own behavior, it might need to insure itself against the risks involved in deals with other countries.

Thus, there might be good reason to consider Russia’s agreement to sell oil to China at $55 to $60 per barrel as some form of insurance, considering that the deal only becomes profitable at a price of $80 per barrel. The idea of any insurance policy is that it chews up a certain percent of the profit when everything is going well but saves the insured party from major losses if things go badly.

Now here, Konstantin is somewhat unclear on what he intends by the word “insurance” and the phrase “things go badly.”  If by “insurance” he means price insurance, and “things go[ing] badly” he means a price collapse, the deal still is priced extremely unfavorably for Russia.  The price involved was well below the forward curve for oil for the foreseeable future, and the forward curve gives the price a seller can lock in.

As I noted in earlier posts on the subject, the seemingly unfavorable pricing makes sense, because it reflects a big credit spread.  That is, at the time the deal was done, Russia’s credit was in the dumper, and since the stated interest rate on the loan used to finance the pipeline was at a premium to LIBOR well under the premium on Russian debt prevailing in the market at the time, the Chinese were only willing to make the loan if there was an offsetting benefit–a below market price of oil.  That is, although Sechin touted the low interest rate in the deal, this was in effect a “teaser” rate–the oil price discount represented a hidden interest charge.

That is, the pricing of the deal doesn’t reflect insurance–it reflects Russia’s credit risk at the time the deal was done.

Russia’s credit has rebounded since the deal was inked.  Note Gazprom sold Eurobonds at a pretty good rate last week.  This raises a possibility that I raised in my original posts, and reiterated in a presentation on Russian energy strategy to a group of Foreign Service people (including some folks based in Moscow working on energy issues) today: namely, that Russia will try to find a way to back out of the deal, or force renegotiation, when the market turns.  Both the oil market and the credit market are much more favorable to Russia today than when the deal is done–which means the the deal done then is much LESS favorable to Russia today (and hence more favorable to China today) than when it was signed.  I see the potential for a dispute arising very soon.  That would be VERY interesting to watch.

Konstantin does make one very good point in his article:

Thus, criticism rained down on Sechin from all sides for having orchestrated an unprofitable agreement with China. But its profitability can only be gauged once all the terms of the agreement are finally made public.

That disclosure process should happen as soon as possible. The rules are very simple: If an economic agreement is signed in the best interests of the country, there is no reason to hide anything. If the agreement is sound, it will naturally withstand criticism from political opponents, analysts and the press. The fact that leaders are afraid to reveal the terms is probably a sign that the agreement has problems. If the agreement with China is flawless, why keep it secret?

Russia already has enough corruption without adding speculation about whether the agreement with China was on the up and up. If, however, anything underhanded is involved here and the agreement is not sound, Sechin’s contract with China might go down in history like the notorious privatization auctions of the early 1990s.

Hear, hear.  There is considerable room for skepticism about the benefits of the deal to Russia, because of the dishonest way that it was spun publicly; notably, Sechin’s crowing about the interest rate, and obfuscating about the oil price.  Both pieces of information are needed to determine the REAL interest rate in the loan, and therefore to determine whether it was on-market or not, and how far away it is from the current market (probably a lot, given the changes in the credit and oil markets).

Given that the deal’s economics probably look far worse for Russia today than they entered into the contract with China earlier this year, I wouldn’t hold my breath waiting for the Full Monty from Igor.  The most likely way that information will come out is that if the unfavorable economics are used to justify abrogating the transaction.  That is, the only way that the details of the transaction are likely to be made public is if Russia decides to claim that the Chinese screwed them as a justification for walking on the deal, or insisting on renegotiation.

Which just may happen.

Vladimir Darling

Filed under: Economics,Financial crisis,Politics,Russia — The Professor @ 4:50 pm

No, I haven’t succumbed to the Stockhome Syndrome and begun to love Vladimir Putin.  (And anyways, if that were the case, I would have written “Vladimir, Darling.”)  No, what I mean is that UK Chancellor of the Exchequer Alistair Darling is doing his best Putin imitation, and trying to browbeat banks into lending:

Ministers have warned Britain’s banks to increase the supply of affordable loans to businesses or face the threat of a competition probe if evidence of market failure emerges.

Alistair Darling, chancellor, has ordered ministers to hold a series of one-to-one meetings with bank chiefs through August to establish whether margins and fees have risen excessively on loans to small and medium-sized companies.

The bosses of seven big banks were yesterday told that ministers would leave “no stone unturned” and could present their research to the Office of Fair Trading if there was a suspicion that competition was not working effectively.

“It is very important that each and every bank knows that there is someone looking over their shoulder,” Mr Darling said after the Treasury meeting. “I want to make sure that we have a competitive banking system in this country.”

But Philip Hammond, shadow chief secretary, said Mr Darling was “asleep on the job and the public will take his synthetic anger with a pinch of salt”.

The chancellor’s aides said he did not yet have any evidence of anti-competitive behaviour. To encourage more competition, Mr Darling wants to cut the two years it takes to obtain a banking licence. Paul Myners, City minister, and Shriti Vadera, small business minister, have been charged with going through banks’ lending policies over the next few weeks.

The Treasury claims that in 2007, only 2 per cent of SMEs paid margins on their loans of more than 9 per cent; in 2009 that had risen to almost a third.

Just out of curiosity, what would “evidence of market failure” be, oh Olympian one? And, has there been a substantial decline in competition between 2007 and 2009 that could account for a widening of margins?  Or, is it more likely that the widening in margins reflects a decline in the credit quality of borrowers, and the fact that the banks are likely constrained in their ability to borrow due to their own straitened balance sheets?  And what does “affordable” mean?  Loans that businesses and individuals can afford to take–or ones that banks can afford to make?  Will pressure to lend lead to a decline in the quality of loans, thereby deepening the British banks’ already weak condition?  Is that a reasonable, not to say sane, policy objective of the Chancellor of the Exchequer?

So, the UK is hiding behind the fig leaf of “competition policy” to engage in the same type of pressure tactics that Putin is exerting on Russia’s banks.  Great example to follow there, Alistair.  It will almost certainly do nothing to actually help the British economy.  Instead, it is more likely to put British banks even deeper into a hole, thereby hamstringing growth going forward.

Russia and Britain are not the only ones who are treading on very dangerous ground when it comes to banking policy.  China is concerned that the huge amount of credit it is pumping through its banks is feeding a real estate and stock bubble:

Chinese regulators on Monday ordered banks to ensure unprecedented volumes of new loans are channelled into the real economy and not diverted into equity or real estate markets where officials say fresh asset bubbles are forming.

The new policy requires banks to monitor how their loans are spent and comes amid warnings that banks ignored basic lending standards in the first half of this year as they rushed to extend Rmb7,370bn in new loans, more than twice the amount lent in the same period a year earlier.

Beijing’s concerns are echoed in other countries across the region, most notably South Korea, where the government says it is taking steps to cool a real estate bubble, and Vietnam, where the government has ordered state banks to cap new lending to head off inflation.

The situation in much of Asia is very different from most Western economies, where governments have flooded the financial system with liquidity to encourage unwilling banks to lend more.

. . . .

In statements published last week, Wu Xiaoling, who recently retired as deputy governor of the central bank, warned new lending this year would probably reach as high as Rmb12,000bn, a staggering increase of 40 per cent of the entire stock of outstanding loans in just one year.

She called this sort of growth excessive and said it would lead to bubbles in the property and stock markets.

The flood of new lending also has implications for the quality of bank loans and the country’s overall growth.

“China’s economic recovery is being constructed on the back of a savaged banking system,” said Derek Scissors, a research fellow at the Heritage Foundation in Washington. “Tens of billions – and perhaps hundreds of billions – of dollars of loans will not be repaid.”

He points out that in recent years total loan growth of around 15 per cent has supported gross domestic product growth of higher than 10 per cent but in the first half of this year total loan growth of around 33 per cent supported GDP expansion of only 7 per cent.

“China’s economic policies have shifted from being unsustainable over the very long term to being unsustainable for any more than one year,” Mr Scissors said.

New loans are 40 percent of outstanding loans!  (That is, the flow is 40 percent of the stock.)  That is un-freaking-believable.  And as the wonderfully-named Mr. Scissors said, is un-freaking-sustainable.

Just how does one ensure that loans don’t go into equity or real estate markets?  Lend a money to a company, and it is very difficult to keep it from going where it will.  Like industrial companies can’t buy real estate?  And what’s more, even if there is a way of walling off real estate and equities, why would one believe for a second that loans being made so indiscriminately to the “real economy” are really flowing to high value uses.  It seems like the Chinese banks are lending to anybody with a project and a pulse.  Not only does that raise the risk of a spike in bad loans, but relatedly, it will lead to mal-investment; a distortion in the pattern of investment as well as the level of investment.

In other words, China is setting up itself–and the world–for the mother of all Austrian-style crashes.  Austrian business cycle theory emphasizes how credit expansions lead to distortions in the pattern of investment that are corrected through sharp contractions.  The shovel-the-money-out-the-door theory of loan underwriting will almost certainly distort the allocation of capital, requiring a reckoning when the government cuts back on the stimulus, as it must, if not now, in the coming months.

The banking system in China already had a lot of bad loans.  Indeed, in 2007-2008 I had conjectured that if the world economy were to crash, it would be because of a banking problem in China.  Uhm, right diagnosis (banking crisis), wrong location.  Well, one out of two ain’t bad.  But even though I erred in identifying China as the world’s leading likely source of a systemic shock, that’s not to say that its financial foundation is strong.  Rapid growth in recent years has helped obscure the vulnerabilities in the banking system.  The policy of promiscuous lending will only exacerbate those vulnerabilities.  Thus, China has climbed on the tiger’s back through its aggressive stimulus; how can it climb off, knowing that doing so will increase its bad loan problem?  There’s no immediate answer to that question.

The Russia and Britain and China stories could be supplemented by stories about the way the US in particular has handled its banking problems.  None of these inspire confidence.  Indeed, to me it seems that all of these policies are setting the stage for bigger problems down the road.  The extremely short-run orientation of these policies, which have the whiff of panic about them, carry the very great risk of laying the foundations for future crises, and at the very least, impeding the process of recovery from the current one.

The first rule of holes is that when you’re in one, stop digging.  When it comes to banking problems, politicians around the world are ignoring that lesson, and are making the dirt fly as fast as they can.  And in so doing, they risk burying us all.

July 27, 2009

SWP in FTAlphaville

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis — The Professor @ 12:04 pm

I am a guest poster on today’s FTAlphaville.  The subject: clearing.  The post riffs off an article in the FT that notes the importance of price information for clearing to work efficiently.  The basic points are that price information is necessary but not sufficient for clearing to work; that clearinghouses are consumers of information, not just producers of it; and that the debate about standardization has focused on what is really a red herring–contractual standardization–and overlooked the difficulties of economic standardization.

Many thanks to Stacy-Marie Ishmael for providing this opportunity.

July 26, 2009

Blatant Theft vs. Discrete Theft

Filed under: Economics,Politics,Russia — The Professor @ 8:21 pm

The initial reporting on the  Russian Union of Industrialists and Entrepreneurs’ call to ban Skype and other VOIP services focused on the Union’s statement that these services were a threat to Russian security because they couldn’t be tapped.  More thorough follow-up reporting makes it clear, however, that this line was primarily intended to entice the government into protecting incumbent telecom operators from competition:

At a meeting of the lobby this week, telecom executives portrayed the most popular VoIP programs like Skype and Icq as encroaching foreign entities that the government must control.

“Without government restrictions, IP telephony causes certain concerns about security,” the lobby’s press release said. “Most of the service operators working in Russia, such as Skype and Icq, are foreign. It is therefore necessary to protect the native companies in this sector and so forth.”

. . . .

In a presentation posted on the lobby’s Web site, Vice President of TTK, a telecoms unit of state-owned Russian Railways, Vitaly Kotov, called on regulators to stop VoIP services from causing “a likely and uncontrolled fall in profits for the core telecom operators.”

Valery Ermakov, deputy head of Russia’s No.3 mobile phone firm MegaFon, drove the point home with a picture of two hands in handcuffs, the caption running, “protect investments and fight VoIP services.”

Delegates at the meeting also warned that it has been impossible for police to spy on VoIP conversations, Vedomosti business daily reported on Friday.

The lobby, called the Russian Union of Industrialists and Entrepreneurs, forecast that 40 percent of calls could be made through VoIP services by 2012.

As an alternative to Skype and its peers, the telecom executives proposed creating VoIP services inside their own firms, which would then make them safely available to the Russian public.

“MegaFon is interested in this market. We’re interested in providing analogous services. We don’t support limiting competition, but we want the market to be civilized,” Ermakov said.

TTK’s press service said on Friday that it will take until September for the relevant legal amendments to be drafted by the special committee, whose members include top telecoms executives and lawmakers from Putin’s United Russia party. [Emphasis added.]

Yes, Russia is renowned for its civilized markets.  What a hoot.

In some respects, though, there is something refreshing about the in-your-face honesty of these remarks.  In the US, companies seeking some special favor are more likely to use smarmy flacks and slick PR campaigns intended to gull people into believing that these favors are Good For America.  The ads that ADM runs during Sunday news gabfests are classics in the genre.  You wouldn’t know that ADM makes gobs of money off of you and me through ethanol subsidies, etc.

This contrast is probably a testament to the substantial difference in the impact of public opinion on public policy between Russia and the US.  For the most part, the government and the connected can ignore an atomized and apathetic Russian populace, and have relatively frank and open negotiations for quid and quo.   In the US, however, such deals–which occur, alas, all too frequently–must be negotiated more discretely, with opposition defused and support built through PR.

Health Care Nirvana

Filed under: Economics,Politics — The Professor @ 11:39 am

Paul Krugman proclaims that a free market is impossible in health care:

Um, economists have known for 45 years — ever since  Kenneth Arrow’s seminal paper — that the standard competitive market model just doesn’t work for health care: adverse selection and moral hazard are so central to the enterprise that nobody, nobody expects free-market principles to be enough. To act all wide-eyed and innocent about these problems at this late date is either remarkably ignorant or simply disingenuous.

A few brief comments in response to The Exalted One (in his own mind, anyways):

  1. Krugman falls victim to the Nirvana fallacy.  Any analysis of alternative institutions and organizations for delivering a particular good or service must be a comparative one.  It could be that, as Churchill said of democracy, that “the free market is the worst system of health care, except for all others that have been tried from time to time.”  You need to compare real world alternatives.  Just shouting “market failure” (i.e., moral hazard, adverse selection) does not end the argument.  It is only the beginning.  You need to evaluate alternatives–especially since moral hazard and adverse selection, if they exist, are endemic to the nature of the good or service, and hence are likely to affect alternative means of supplying health care.  These problems inhere in information asymmetries, and changing the system from “free market” to some alternative does not eliminate those information problems.  It just deals with them in different ways.  And those different ways can be inferior.  As Krugman well knows, since he has written about it in his books on trade, there can be government failures too.  An adult discussion of the issue should be about what set of institutions most effectively deals with the information problems inherent in health care.  A ritual invocation of market failure with no follow up on the susceptibility of alternative systems to failures that could be more severe is the sign of a lazy mind, or of a partisan hack wanting to circumvent debate.
  2. Health care economists are skeptical that adverse selection explains the problems in the health care market.  Krugman invokes Arrow, who wrote decades ago, and in a theoretical, general way.  Arrow’s work started an immense literature on insurance generally, and health insurance in particular.  And that literature does not strongly support the claim that the adverse selection model is the best explanation for the way the health care market has evolved, and the apparent dysfunctions therein.
  3. Relatedly, many of the dysfunctions in health care in the United States, and elsewhere, are arguably the result of specific policy interventions, including inter alia, the tax deductibility of insurance premia paid by employers, mandated coverage, licensing requirements, limits on entry into medicine, and tort rules.  I don’t want to sound like one of those “socialism hasn’t failed because it has never been tried” types, but it is fair to say that health care has been the subject of political manipulation and regulation, and to blame all of the things we don’t like about it on the market is a misleading and tendentious diagnosis.

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