Streetwise Professor

August 30, 2011

Old Commie Habits Die Hard

Filed under: Commodities,Economics,Politics,Regulation,Russia — The Professor @ 7:08 pm

A couple of wonderful stories today about contractual fidelity, Chinese style.

First, in 2008, when dry bulk shipping prices skyrocketed, Chinese national champion shipping company Cosco chartered large numbers of ships under long term deals at sky-high prices.  Today, prices are far lower, and Cosco has reneged on numerous contracts–thereby setting up ugly legal battles.  Fortunately, the shipowners believe they have a very strong case, and are threatening to take Cosco to court.  Cosco is counting that the prospect of the loss of future business will lead the shipowners to swallow their pride and cut the charter rates.  But who wants to do business with someone who views a forward contract as a free option?

At the same time, there is a risk that Cosco’s reputation, built up over 40 years, could suffer serious damage. Shipowners are unlikely to feel the same eagerness in future to let Cosco charter their ships to Australia.

Funny thing, reputation.  40 years to make.  40 seconds to break.

And here’s a doozy.  Back in 2009 I predicted that no sooner would the Russia-China oil pipeline get built, than there would be a contractual battle.

Sho’ nuff.

According to the 2009 Russian-Chinese intergovernmental agreement, oil deliveries to China through the Eastern Siberia-Pacific Ocean pipeline are made under contracts among Russian oil company Rosneft, Russian state-owned pipeline monopoly Transneft, and the China National Petroleum Corporation (CNPC) for 15 million tons a year over two decades. In exchange for guarantees of long-term oil deliveries China provided Transneft and Rosneft with loans of $10 billion and $15 billion respectively.

But at the beginning of 2011 the CNPC started underpaying for Russian oil, as China demanded a revision of the price formula. It currently includes the price of transporting oil along ESPO’s entire route to the port terminal in Kozmino. But as the branch to China begins at the point of Skovorodino, 1,271 miles from Kozmino, China is insisting that the pricing formula must be revised and that the cost of transportation from Skovorodino to Kozmino must be subtracted from it, with Beijing originally estimating the difference at $12 a barrel, underpaying accordingly.

Accordingly, China’s debt as calculated by Moscow is now approximately $85 million. In a telling comment on the validity of both Russia and China’s court systems, Rosneft and Transneft have begun consulting with lawyers about the possibility of initiating a lawsuit against the CNPC at the London Court of Arbitration. Earlier this month Transneft sniffed that if the case goes to court, it is prepared to return to China the $10 billion received in 2009 and to stop transporting Russian oil to China, unilaterally abrogating the 20-year contract.

Switching gears, China is upping the stakes to begin discussions at the governmental level to resolve the impasse. Chinese negotiators have invited Russian Energy Minister Sergei Shmatko to participate in the next round of talks, which is to take place in Beijing starting at the end of August, when it was originally assumed that only Rosneft and Transneft representatives would be participating in the discussions.

Konstantin Simonov, general director of the National Energy Security Foundation, is convinced that China is indulging in a bit of good old fashioned “provokatsiia,” to use a Soviet word, telling reporters, “The statement by the Chinese customs is of a provocative nature: The Chinese are endeavoring to show that Russia is not fulfilling its contract obligations and is casting doubt on the development of energy relations with China as a whole.”

Two-sided opportunism, writ large.

The original pricing in the deal was very opaque (and still is), but given Russia’s palpable desperation in early-2009, my surmise was–and is–that the pricing terms were very generous to the Chinese.  I figured that Russia would try to find any pretext to break the deal, so this doesn’t surprise me: “Earlier this month Transneft sniffed that if the case goes to court, it is prepared to return to China the $10 billion received in 2009 and to stop transporting Russian oil to China, unilaterally abrogating the 20-year contract.” But the Chinese are feeling their oats too, and no doubt they are trying to squeeze even more out of a specific asset.

Thus, given the two parties involved, no doubt each is attempting to hold-up the other.  So the Arbitrage Court should have loads of fun dealing with this one. Is “a pox on both” an allowable verdict in an arbitration?

Keep these kinds of things in mind whenever anybody talks about “capitalist” China.  Only fools would have any such illusions about Russia, and it is just as foolish to harbor such thoughts about China.  It is capitalist/rule of law when capitalism suits it, and statist/above the law when it doesn’t.  The country still has many miles to go before it is a truly reliable and law-based trading and contracting party.  When the stakes are big enough–as is apparently the case with Cosco and the ESPO pipeline–it will treat contracts like toilet paper.  (Which they need in a lot of places in China.)

In other words: seller (and investor) beware.

A Pale Imitation

Filed under: Energy,Politics,Russia — The Professor @ 6:47 pm

Today’s big news was the announcement of a exploration joint venture between ExxonMobil and Rosneft.  This is widely being portrayed as a substitute for the abortive BP-Rosneft deal, but there are crucial differences.

First off, though let me say that it is unfortunate that western majors deal with unreliable Russian partners, and in so doing finance the kleptocracy that is Putin’s Russia.  In a better world, a modern version of medieval guilds consisting of major energy companies would boycott Russia in the aftermath of expropriations and other hijinks until Russia put safeguards in place that would reduce the hazards of doing business there.  In an even better world, companies would not be tempted to fund corruptocracies, individually or collectively.  But in this fallen world, achieving such cooperation is virtually impossible, so it is inevitable that companies will take the political and legal risk in order to get access to the physical resources.

That said, in my view ExxonMobil is less likely to get strongarmed than BP.  ExxonMobil has much more heft, much more pull, and is far less desperate.

Due to those features–notably the lack of desperation on XOM’s part–the deal is also structured in a way that gives much less to Rosneft. Recall that Sechin crowed about how the BP-Rosneft deal involved a share swap that gave Rosneft a large piece of BP stock, and board representation.  That was the crown jewel for him: the proof that Rosneft had arrived as a major player.  No such share swap here.  On this basis alone, this is a pale imitation of the BP deal.

Some are drawing an analogy between the share swap in the BP deal, and the agreement with Exxon in which Rosneft gets an equity participation in developments in the Gulf of Mexico and Texas tight oil.  Not even close.  Indeed, I think this misinterprets the purpose of this aspect of the deal.

I view this part as a hostage exchange.  If Rosneft/Russia screw around with XOM in the Arctic and western Siberia, they have assets at risk in GOM and Texas (and perhaps elsewhere).  Hostage exchange is a well-known way of supporting transactions that are difficult to enforce through formal legal channels.

Moreover, this should be viewed as Exxon putting its toe in the water.  The dollar number in the deal–$3.2 billion over several years, a sum that presumably includes a previous XOM-Rosneft agreement for development of Black Sea prospects–is not chump change, but it is small relative to XOM’s approximately $30 billion/year capex.

Over the years we’ve seen many Russian energy deals announced with great fanfare.  The follow through is usually far less impressive.  Shtokman comes to mind.  (How’s that working out for you, Total?)  Russia, thy reputation precedes thee.  I am sure that XOM will tread very carefully, and protect itself every step of the way.  The hostages will likely come in very handy.   But regardless, I would wager that this is the high point of the deal, and that this is another deal that will fade away.

August 28, 2011

A Tale of Two Contracts

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 2:27 pm

One of the leading crude oil futures contracts–CME Group’s WTI–has been the subject of a drumbeat of criticism for months due to the divergence of WTI prices in Cushing from prices at the Gulf, and from the price of the other main oil benchmark–Brent.  But whereas WTI’s problem is one of logistics that is in the process of being addressed, Brent’s issues are more fundamental ones related to adequate supply, and less amenable to correction.

Indeed, WTI’s “problem” is actually the kind an exchange would like to have.  The divergence between WTI prices in the Midcontinent and waterborne crude prices reflects a surge of production in Canada and North Dakota.  Pipelines are currently lacking to ship this crude to the Gulf of Mexico, and Midcon refineries are running close to full capacity, meaning that the additional supply is backing up in Cushing and depressing prices.

But the yawning gap between the Cushing price at prices at the Gulf is sending a signal that more transportation capacity is needed, and the market is responding with alacrity.  If only the regulators were similarly speedy.

Three companies are at various stages of planning new capacity to ship oil from the Midcontinent to the Gulf.  A fourth is looking to redirect flows from Cushing to Houston.  The addition to capacity would total 1.4 mm bbl/day if all were completed.  Since that’s more capacity than is needed, not all the projects will go to completion.  But regardless, over the medium term it is likely that new pipelines will break the bottleneck and crush the differentials between WTI and LLS, MARS, and Brent.

The main obstacles that the WTI contracts face are enviros and Coasean challenges.  Environmentalists have been trying to put every regulatory roadblock possible in the way of one of the pipeline projects–TransCanada’s Keystone XL. This would bring oil produced from oilsands from Alberta through Oklahoma and on to Texas.  The project cleared one roadblock last week, when the State Department (which has to approve due to the international nature of the pipeline) released an eight volume (!) study finding that the pipeline poses no significant environmental impacts.  The pipeline’s opponents are vowing to redouble their efforts, and the issue is now wrapped up in presidential election year politics.

The Coasean challenge is that reversal of the Seaway pipeline currently flowing from the Gulf to the Midcontinent would cost one of the owners–ConocoPhillips–money by raising input costs for its Midcontinent refineries.  Even though there are more than enough gains on the table to compensate CP for any losses arising from a rise in the price of Midcon crude, so far no one has been able to craft a deal whereby the winners (primarily Canadian and US producers) can make it worth CP’s while to agree to the reversal.

But these problems are all surmountable.  WTI’s problems arise from the consequences of too much supply at the delivery point, which is a good problem for a contract to have.  The price signals are leading to the kind of response that will eliminate the supply overhang, leaving the WTI contract with prices that are highly interconnected with those of seaborne crude, and with enough deliverable supply to mitigate the potential for squeezes and other technical disruptions.

Brent’s problems are more fundamental, because they arise from declining supply.  Even as paper volumes continue to rise, physical volumes available for delivery are falling inexorably.  The Brent complex had faced this problem before, and confronted it by adding Forties, Oseberg, and Ekofisk to the eligible stream.  But BFOE production has declined from 1.6 mm bbl/d in 2006 to barely more than half that today.  And the decline continues apace.  This makes the contract vulnerable to squeezes of a kind that were chronic in the 1990s and early 2000s, and which spurred Platts to add the three other grades to the benchmark.

There are, moreover, few additional North Sea oil stream that can be added to the benchmark this time.  So over the medium term Platts is considering adding other low sulphur crudes produced outside the North Sea to the contract.

The Brent problem is analogous to that faced by the Chicago Board of Trade grain and soybean contracts in the early-1990s.  Volumes of corn, wheat, and soybeans shipped into Chicago and Toledo–the delivery points–were falling, though not due to declining production, but due to changing trade patterns.  Deliverable supplies in Chicago and Toledo were not reliably sufficient to ensure the pricing integrity of the contract.  The Ferruzzi soybean squeeze in July, 1989 brought matters to a head and forced a reluctant CBT to act.

The CBT’s initial response was to tinker with the contract, adding St. Louis as a delivery point at a modest premium to Chicago.  Within a few short years, however, all delivery warehouses in Chicago proper had closed, and the exchange had to adopt a substantially different delivery mechanism (which I helped design–more on this below).

One approach available to Platts would be to create what I called an “economic par” contract in a report (subsequently a book–such a deal!) on the CBT contracts that I wrote in the aftermath of the Ferruzzi episode.  In an economic par contract, differentials for delivery of different grades (or at different locations) are set approximately equal to the cash market differentials.  For instance, if Brent was made the par grade, and another type of crude that typically sells for a $2 discount to Brent were made eligible for delivery against the contract, the deliverer would receive $2 less for delivering that grade than delivering Brent.

The advantages of this type of system are (a) it allows a dramatic expansion of deliverable supply, thereby easing technical/squeeze pressures on the contract, and (b) it can improve hedging effectiveness/reduce basis risk.  In essence (as pointed out in the book), options pricing theory implies that with economic par terms the futures price becomes like a weighted average of the prices of the deliverable grades.  This reduces the idiosyncratic component of futures price fluctuations, making the contract a better hedge for a variety of users.  (Cash settlement based on a variety of crude streams would produce a similar outcome.)  In the present instance, an economic par contract would be a poorer hedge for Brent cargoes, but a better hedge for other kinds of oil (e.g., Urals).

Since cash market differentials can vary over time, it is advisable to adjust the contract premia and discounts periodically.  (The failure to do so with Treasury Bond futures in the 1990s caused some problems with the contract that were eventually fixed by the change from an 8 percent par coupon to a 6 percent.)  Such changes can actually make the contract a better hedge by keeping the weights in the average more stable over time, thereby reducing the likelihood that the idiosyncratic risk of a particular deliverable grade exerts disproportionate influence on contract pricing.

Accomplishing such a substantial remake of a contract is, however, a difficult thing.  Contract changes have different effects on different players, and each will try to lobby for changes that suit its interests.  The case of Chicago grains is illustrative.  As the decline in Chicago and Toledo continued apace, and the tinkering that followed the Ferruzzi squeeze proved inadequate, the CBT formed a committee to come up with a new contract design.  The committee had representatives from virtually every affected party.  Since the interests of these parties were so divergent, the process became rancorous and political, and the committee could not come to agreement on the kinds of changes that would have been necessary to fix the problem.  Eventually, in late-1996 the CFTC said enough, and ordered the exchange to change the contract stat.

Realizing that the traditional committee method that gave everybody a voice would not meet the demands of an impatient CFTC, the exchange created a small task force (0f which I was an outside member) of more independent participants, and which pointedly excluded the big incumbent players (mainly Cargill, Continental, ADM, and The Andersons).  This Grain Delivery Task Force came up with a radical new design (based on delivery via shipping receipts into barges on the Illinois River) in less than 6 months.  The new design was approved by the membership and the CFTC over the following months.

Suffice it to say that the kind of consultative process that Platts envisions in revising the Brent contract will almost certainly bog down in the kind of rent seeking self-interested behavior that stymied fundamental changes in the CBT grain contracts.  (In one of the early go ’rounds on this, in 199o–which spawned my report/book–one of the members of the committee set up to revise the contract was so outraged by my recommendations for bigger changes that we almost came to blows.  The representatives from ADM and Cargill took him outside to cool down.  I had similar experience, though more civil, during discussions of revising the canola contract in Winnipeg a few years later.  Considering that the Brent market is so much bigger and the dollars at play in 2011 are so much bigger than two decades ago, the potential for pyrotechnics is all the greater now. )

Which means that those who are crowing about Brent today, and heaping scorn on WTI, will be begging for WTI’s problems in a few years.  For by then, WTI’s issues will be fixed, and it will be sitting astride a robust flow of oil tightly interconnected with the nexus of world oil trading.  But the Brent contract will be an inverted paper pyramid, resting on a thinner and thinner point of crude production.  There will be gains from trade–large ones–from redesigning the contract, but the difficulties of negotiating an agreement among numerous big players will prove nigh on to impossible to surmount.  Moreover, there will be no single regulator in a single jurisdiction that can bang heads together (for yes, that is needed sometimes) and cajole the parties toward agreement.

So Brent boosters, enjoy your laugh while it lasts.  It won’t last long, and remember, he who laughs last laughs best.

August 26, 2011

Gazprom To It’s Customers: You Screwed Up. You Bought From Us.

Filed under: Commodities,Economics,Energy,Russia — The Professor @ 8:01 pm

Gazprom’s customers are continuing their fight against its pricing practices.  Apparently never having heard of Marshall Field (“the customer is always right”), Gazprom is blaming the buyers for their stupidity and mistakes:

OAO Gazprom said it isn’t responsible for its customers’ “strategic mistakes,” signaling Russia’s gas-export monopoly may not compromise in a pricing dispute with European utilities.

“In 2010, strategic mistakes were made in assessing the market outlook, with hopes for very cheap gas and further collapse of spot prices,” Sergei Komlev, head of pricing and contract formation at Gazprom’s export division, said in an interview at his Moscow office. Buyers are seeking “one-off help, given the difficult situation they found themselves” in.

. . . .

“Some of our partners expected they’d be able to sell gas to their clients cheaply by mixing Russian and spot gas, which turned out to be wrong,” Komlev said. “The first thing our clients have to do is admit the mistake they have made during the sales campaign of 2010. The general market obsession with low spot prices has proved to be a wrong strategy.”

This is so much gibberish.  Gazprom’s customers’ problem is that its prices are linked to oil prices (gasoil and fuel oil prices, actually, on a lagged basis), and oil prices have diverged from world gas prices.  Yes, perhaps the increase in spot prices has hit European customers, but these prices are still well below the oil-based Gazprom price.  For instance, the gas price at the TTF hub in the Netherlands is about $350/mcm, and has hovered around that level since December of last year (The price quoted in Bloomberg is per MWh, which can be converted to a price per MCM).  In contrast, the German Border Price for Russian gas is about $450 (it was $400+ last month).

Gazprom’s sweetheart spokesman Komlev (check out the video–and note the liar’s look down and to the left when answering the question about whether Russian gas prices are too high) has this to say:

“A deep connection between oil and gas prices has remained and even grown stronger.”

The gap between spot and contract prices isn’t as “gigantic” as it was in the past two years and will narrow closer to winter because of seasonal demand, Komlev said.

The only thing deep is the manure Komlev is spreading.  Well, that and his homey from ING Financial:

“The problem with the spot market is that it is not liquid enough and spot prices are highly volatile,” Igor Kurinnyy, an oil and gas analyst at ING Financial Markets in London, said by e-mail. “The oil link in Gazprom’s price formulas will stay in place for the time being.”

Insofar as a “deep connection” is concerned, the data clearly say otherwise.  Gas and oil prices have diverged.  And if there’s such a deep connection, then it should be a matter of indifference to Gazprom as to whether it prices off of oil or off of spot prices.

I guess not.

As for liquidity, (a) liquidity is increasing, (b) liquidity would increase substantially if Russian gas were priced off of spot, and (c) there are numerous markets in the US where large quantities of contract gas are priced off of spot prices with modest levels of liquidity.

Gazprom’s testiness over its pricing mechanism reflects the fact that it is increasingly under siege, and not just from European utilities.   Gazprom has played divide-and-conquer for years.  It has repeatedly tried to scare the Europeans by threatening to sell gas to the Chinese.  But that’s no longer working.  The Chinese are bargaining hard, and have lined up large quantities of gas from Central Asia.  So in order to try to put pressure on the Chinese by convincing them that they’ll send gas elsewhere, the Russians are reaching out to one of the charter members of their Coalition of the Losers, North Korea (other members–Venezuela, Syria, Libya–whoops, scratch that one), with a truly risible proposal to build a pipeline through North Korea to sell gas to South Korea.  Like the South Koreans are going to put themselves at the mercy of Kim Jong Il and the nutocracy to the north.  And like the Chinese need the gas.  I’m sure they’re rolling on the floors in Beijing.

So it can’t play the Chinese against the Europeans.  It can’t play the Koreans against the Chinese. The threat from the spot market is growing with gas supplies around the world. So Gazprom is left to treat its European customers like Otter treated Flounder:

Time and the markets are not on its side. It can insult now, but more options are becoming available, which will put increasing pressure on the oil-linked pricing mechanism. Which means that the company will have to come up with somebody a helluva lot slicker than Komlev to make their case in the future–because it will have no case.

August 25, 2011

Heads Up!

Filed under: Russia — The Professor @ 9:16 am

Well, August is more than 3/4’s gone, and in Russia, no submarines have sunk, thousands of hectares of peat bogs and forests are not burning, and there hasn’t been an epidemic of drunks drowning trying to escape the heat, not to mention the absence of wars or coups.  But this is not to say that the country has escaped the late Summertime Blues altogether.

Indeed, this year, there is a unifying theme to Russian travails. They all involve aerospace. First, Russia’s answer to the F-22 Stealth Fighter, the T-50, had to abort a takeoff at the Moscow Air Show due to an engine failure. About the same time, communications were lost with an advanced, uhm, communications satellite that had just been launched. And finally (h/t R) a Russian Proton rocket ferrying supplies to the International Space Station decided it liked earth better, and did a Bat Turn, burying itself in a Siberian forest and endangering pine nut gatherers.

The best part of the story is this: Alexei Kuznetsov, head of the space agency’s press service, didn’t answer five calls to his cell phone.

Somehow, I figure if he had answered, the conversation would have gone something like this:

Still a week left in August. A lot can happen in a week. And this year, if you’re in Russia, I’d keep an eye pointed skyward. Especially if you’re looking for pine nuts.

August 24, 2011

Projection or Prescience?

Filed under: Economics,Financial Crisis II,Politics,Regulation,Russia — The Professor @ 1:12 pm

Vladimir Putin weighed in on the ouster of S&P’s CEO:

Russian Prime Minister Vladimir Putin on Wednesday appeared to link the resignation of Standard & Poor’s chief executive to the agency’s downgrade of the U.S.’s sovereign rating earlier this month.“We all know what goes on in the financial world. Here you have the S&P ratings agency lowering the U.S. sovereign debt rating. And now they fired the agency’s head, and started an investigation regarding the agency itself,” Mr. Putin told a meeting of Russian academics, Interfax news agency reported.

“There is much that’s unclear about the situation, many things which are, let’s say, superficial,” Mr. Putin said.

To quote Joe Biden (always dangerous, I know), Putin’s suspicions are completely understandable.  That would be the obvious inference regarding a similar situation in Russia.

The more interesting question is whether Putin is merely projecting/mirror-imaging, or is instead correct in his conclusions.

Developments in recent years, most notably from 2008 on, and especially post-January, 2009, increase the odds that Putin has in fact nailed it.  There has always been an element of gangsterism in American government (as in any government), but those tendencies have become more overt and numerous in recent years.  So, as a Bayesian, I would say that my estimate of the likelihood that Putin is right is far higher now, than it would have been several years ago.

There is an ironic sort of convergence in this story.  One of the reasons my interest in Russia was rekindled several years ago after decades of slumber is that it struck me as a classical liberal (libertarian, if you must) dystopian novel come to life.  It illustrated all of the dysfunctions that arise in the absence of a rule of law and particularly property rights, the atomization of civil society, the dominance of a government operating with few real institutional checks, and the intersection between private economic interests and said unchecked government.

A crucial function of a dystopian novel, of course, is to point out through extension and exaggeration what will happen if existing repressive tendencies and features in society grow.  If the leading figure in a real world dystopia has, in fact, correctly diagnosed the reason why Deven Sharma was ousted from S&P, it would indicate that the US is itself slouching towards dystopia.

I have little respect for the rating agencies, and recognize that they are in many respects government creations and benefit from various government protections and mandates.  That said, N wrongs don’t make a right.  Better to eliminate privileges as a matter of principle, than to strongarm a company for having the temerity to question Leviathan’s solvency.

So I hope Putin is merely projecting, but I would also lay non-trivial odds on his prescience, at least in this matter.

That’s Crazy Talk

Filed under: Economics,Financial Crisis II,Politics,Regulation — The Professor @ 12:42 pm

There are rumors flying around–all adamantly denied–that JP Morgan Chase will acquire tottering Bank of America.  In my opinion, that’s crazy talk.  It’s crazy because JPM has to be smarter than to buy a toxic loan dumping ground and lawsuit magnet.  (There’s a joke going around: “Will the last person to sue Bank of America turn out the lights?”)

The only way it would not be crazy in the sense of it might actually happen is that another shotgun marriage is being arranged, with Uncle Sam at the trigger.  I can see that.  This is a tried and true regulatory game.  It happened in 2008: Bear (with JPM), Merrill (BAC), Lehman (with Barclays, ultimately aborted).  It happened during the S&L Crisis.  Regulators like this because offering financial support to dodgy banks through the front door is politically radioactive, and that’s especially true now.   Mashing together a (relatively) healthy bank and a very unhealthy one kicks the problem into the future, and miracles–including resurrection–can happen in the future, dontcha know.  Moreover, regulators can reduce the risk of leaving fingerprints if they do it this way.  If it turns out bad, it looks like the dealmakers made the mistake (witness BAC’s Ken Lewis).

But it would still be crazy in the sense of economic irrationality.  The first order problem that needs to be addressed right now is rightsizing banks, not creating fewer, bigger ones.   Moreover, the analogy that I made with respect to Europe–amputation vs. gangrene–works here too.  Grafting the definitely gangrenous Bank of America on top of the still healthy (in comparison to its peers around the world) JP Morgan would extend the rot far more directly than would be possible along the normal inter-bank connections.  It would be better to ringfence, isolate, quarantine Bank of America and deal with the problem straight up (like the Swedes did in the early-90s, or the Resolution Trust Corporation did with S&Ls in the same time frame).  But that would be politically parlous, which means that the sensible thing might not happen.

I believe–and hope–that this rumor is only that, the product of heated imaginations dealing with possible resolutions of BAC.  If it isn’t, if there is there there, be afraid.  Be very afraid.  Because it will mean that things are very bad indeed, and that the political and regulatory will does not exist to deal with the problem in a rational, hardheaded way.

He Would Say That

Filed under: Economics,Financial crisis,Politics,Russia — The Professor @ 10:02 am

I’ve followed the Bank of Moscow story with one eye.  Howard Roark asked me to blog about it, and I’ve been looking for an angle, but the facts are so obscure, and the sources of information so suspect, that’s hard to get a grip on things.

Speaking of suspect sources, the fugitive ex-CEO of BOM, Andrei Borodin, claims that the seizure and bailout were unnecessary, and by implication, political:

Andrei Borodin, who fled Russia in March and is wanted by authorities there over a loan Bank of Moscow made under his leadership, said the bank “never needed state help.”

“The problems there are of an artificial nature,” he said.

In early July, Russian regulators unveiled a $14 billion rescue package for Bank of Moscow after saying they discovered a huge hole in the bank’s balance sheet.

. . . .

His comments add to the controversy surrounding the bailout, which was so large it raised investor concerns about the soundness of the Russian banking system and the credibility of the central bank, the country’s main banking regulator.

Bank of Moscow was a key pillar of the regime of Yuri Luzhkov, the long-serving mayor of Moscow who was fired by President Dmitry Medvedev last fall. Part-owned by the Moscow government, the bank was a key lender to big real-estate developers such as Inteko, a company owned by Yelena Baturina, Mr. Luzhkov’s wife. The ousting of Mr. Luzhkov has set off a struggle for control of some of Moscow’s choicest municipal assets—Bank of Moscow among them.

Mr. Borodin, an ally of the former mayor, is wanted by Russian authorities over a $415 million loan that Bank of Moscow made in 2009 to Premier Estate, a company that state investigators say is linked to Ms. Baturina. The investigators claim most of the money ended up in her personal account. Mr. Borodin and Ms. Baturina have denied any wrongdoing. Ms. Baturina hasn’t been charged with any crime. Russian police put Mr. Borodin on an international wanted list two months after he fled the country.

. . . .

hen last month, VTB and Russian regulators said they had uncovered $12.6 billion in suspicious loans at the bank—more than half its total loan book.Officials said a large portion of the bad loans were made to companies linked to Mr. Borodin and other members of the bank’s former management.

Mr. Borodin insisted that the loans were fully collateralized and of high quality.

A spokeswoman for Mr. Borodin, Claire Davidson, said the bank’s former president had never been presented with a list of the alleged related-party loans and so couldn’t respond directly to the allegations.

She said a team of five officials from the Russian central bank had been monitoring operations at Bank of Moscow since 2008, and “if they knew there were problems at the bank, why didn’t they tell anyone?”

The bailout of the bank consisted of $10.2 billion in low-interest loans from state regulators and $3.4 billion in capital from VTB. Analysts were shocked by the size of the rescue package, which was equivalent to nearly 1% of Russia’s gross domestic product.

Earlier this month, Gennady Melikyan, head of banking oversight at the Russian central bank, resigned. The central bank declined to comment and Mr. Melikyan couldn’t be reached.

So, there are two theories on offer, neither of which gives one the warm and fuzzies about the Russian financial system, and the Russian politico-economic complex.

Theory One: BOM was a piggy bank for the politically powerful Mayor of Moscow and his billionaire wife.  They used the bank to tunnel funds to their pet projects–and their own pockets.  When the mayor was pushed off his political perch, the new powers that be discovered gaping holes in the balance sheet, necessitating a bailout.

Theory Two: BOM was actually healthy, and its loans were good even though a good chunk of them were made to the politically powerful.  Indeed, in Russia, what better security for a loan than a крыша from the local political Godfather?  Said Godfather was pushed out as a result of typical bulldogs-under-the-carpet infighting in Russia, and the scandal over the state of BOM and the bailout were all just part of the powerplay intended to discredit Luzhkov and Baturina, and to create leverage that could be used to force them to disgorge some of their billions.  Or all of them.

Corollary to Theory Two: The seizure/bailout is actually part of a scheme by the new powers in Moscow to direct state funds to them.

Given that no one involved here has any credibility, and indeed, are all up to their necks in corrupt and shady dealings, it’s hard to choose between these alternatives.  But it’s really not that important.  It just demonstrates the density of the nexus between politics and finance in Russia.  Finance is politics and politics is finance.  Following Lenin’s advice, the powers that be have seized and exploit the Commanding Heights.

Sadly, the nexus between politics and finance is very dense outside of Russia too, and becoming more so all the time.  Right now the shakiest bank in the US is Bank of America: its CDS has been gapping, its stock plummeting, and all sorts of rumors are swirling around it.  Former Treasury Secretary Paulson admitted that he basically forced BAC to buy Merrill Lynch.  BAC’s biggest problems stem from its acquisition of Countrywide, and there are suspicions that regulators at least cajoled BAC to buy Countrywide in January 2008.  Regulators were certainly happy when BAC bought the mortgage lender.

Big banking has always been politicized to some degree (because, like Willie Sutton said, that’s where the money is), but this tendency has accelerated in recent years.  But given the path-dependence of the situation, it’s hard to see how that will reverse any time soon.  Indeed, the dynamic seems to be pushing towards more politicization.  Which is hardly a good thing.

August 23, 2011

EOD a la Russe

Filed under: Military,Russia — The Professor @ 6:17 pm

Another ammunition dump exploded in Russia today.  (h/t Charles.)  Third time this summer.  I’m still betting that these are cover-ups of corrupt sales of arms and ammunition.  As for the six dead and twelve injured you know the old saying: to make an omelette, you need to break some eggs.  Russian soldiers have always been disposable (as Figes’s new book on the Crimean War makes plain).

Manifest Absurdity

Filed under: Economics,Politics,Russia — The Professor @ 3:25 pm

Presidential statements about economics and social science–regardless of the country the president leads–are usually cringe-worthy.  But even against such competition, this disquisition on alcohol and alcoholism by Russia’s president Dmitri Medvedev stands out:

Russia’s winemaking industry should be developed to help tackle widespread alcohol abuse, President Dmitry Medvedev said on Monday.

“Winemaking is one of the branches that should be developed and contribute to the eradication of alcoholism. Countries where this branch is strong, have no problems with alcohol abuse,” the president said at a meeting with the governor of Russia’s southern Krasnodar Territory, Alexander Tkachev.

I mean, what obstacles could there be to such plans?  Other than culture and climate, I mean.

Adam Smith and Ricardo both noted that it would be possible, but inefficient to grow grapes for wine in England or Scotland.  For instance, in Wealth of Nations, Smith wrote:

By means of glasses, hotbeds, and hotwalls, very good grapes can be raised in Scotland, and very good wine too can be made of them at about thirty times the expence for which at least equally good can be brought from foreign countries.  Would it be a reasonable law to prohibit the importationof all foreign wines, merely to encourage the making of claret and burgundy in Scotland?  But if there would be a manifest absurdity in turning towards any employment, thirty times more of the capital and industry of the country, than would be necessary to purchase from foreign countries an equal quantity of the commodities wanted, there must be an absurdity, though not altogether so glaring, in turning towards any such employment a thirtieth, or even a three hundredth part more of either.  Whether the advangates which one country has over another, be natural or acquired, is in this respect of no consequence.  As long as one country has those advantages, and the other wants them, it will always be more advantageous for the latter, rather to buy of the former than to make.  [Book IV, Chapter 2.]

Since the climate of Russia is even less hospitable to viticulture than that of Scotland, just think of the multiple of capital required to grow wine grapes in Russia, than in France, or Chile, or Australia, or California . . . or Missouri or Texas, for that matter.

And how, pray tell, would Medvedev support the development of viticulture?  Let’s say he mandates the tried-and-true method of import protectionism, via quotas or tariffs.  Tariffs would have to be quite high, and even then, it may be the case that domestic demand for wine is insufficient to support more than a very small industry.

Tariffs or quotas would raise the price of wine relative to other spirits.  Which would encourage Russians to substitute towards these other products.  That is, attempting to encourage domestic wine production would discourage domestic wine consumption and encourage the consumption of other liquors.*

What other liquors?  Vodka, of course–not to mention the vile home brews that thrive in Russia (samagon).  And apparently now vodka is the Adult Beverage That Shall Not Be Named:

Medvedev said problems with alcohol abuse stem from “other drinks.”

So what Medvedev proposes is indeed manifestly absurd.  It would be absurd on crass protectionist grounds.  It is doubly or trebly absurd on the social policy grounds of attempting to induce substitution away from vodka and samagon towards wine.

No, a far more reasonable policy would be to permit unrestricted imports of wines.  From Georgia maybe.  (Ironic, isn’t it, that Russia banned importation of wines from Georgia–one of the most popular and economical sources of the stuff.)

But such a policy would be unlikely to change this map.  Medvedev’s Vinyard of Dreams–if we build it the culture will change–is beyond manifestly absurd.  It ignores the path dependence of culture, and presumes that habits are highly malleable.  That France, say, has both abundant wine production and a low rate of alcoholism, is a deep cultural fact determined over millenia–just as vodka consumption is a deep cultural fact that evolved centuries ago.  Even if global warming were to make Russia a viable wine producing region tomorrow, it is unlikely that this would result in a profound change in Russian consumption habits in Medvedev’s lifetime–a period over which a good chunk of the male Russian population and more than a few women will succumb to alcohol-related death.

And there are also data points that contradict Medvedev’s story that domestic production of wine would engender a deep cultural shift.  The Economist blog post that includes the map linked above notes that Moldova is the world’s leader in alcohol consumption, much of it home brew–and it is also the home of a vibrant domestic wine industry.  An industry which was, ironically, more vibrant before Russia banned imports of Moldovan wine.  So a domestic wine industry is not sufficient to produce consumption of alcohol in moderation.  And Moldova has far closer cultural affinity to Russia, than France or Italy: just ask any Slavophile.

Chronic abuse–and that term seems to mild by far–of The Adult Beverage That Shall Not Be Named is indeed a national tragedy in Russia.  One suspects that Russian leaders despair at the prospects of combating this scourge.  Medvedev’s pathetic proposal illustrates just how futile their past efforts have been.  (And when not futile, destructive: Gorbachev’s anti-vodka campaign put a huge whole in the USSR’s finances, and accelerated its collapse.)  It would be truly perverse–and peculiarly Russian–if Medvedev were to act on his crack-brained theory, protect the domestic wine industry, and encourage more consumption of that which he believes is wreaking havoc on his nation.

* The analysis of subsidies is more complicated.  Subsidizing wine production could reduce the price of wine relative to other spirits.  This would also have income effects, though, which are more difficult to trace through.  For instance, the taxes required to pay for the subsidy reduce incomes.  This could lead to reduced consumption of all kinds of spirits, but it could also lead to increases in the consumption of things like samagon (which are plausibly Giffen goods). And regardless, it would be more efficient to reduce relative prices by reducing restrictions on wine imports, than by subsidies of domestic production.

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