Streetwise Professor

I’m back!  And glad to be here.  Italy was great, but it nothing beats the US in my book.  Going away for awhile helps make that very clear.

And now, back to our regularly scheduled blogging . . .  

Earlier in the year I argued (mainly with BFC) that Russia was a high beta economy, meaning that the fluctuations in Russian economic performance, and the performance of its financial markets, would be more extreme than those in the rest of the world. This original diagnosis was predicated on Russia’s extreme dependence on hydrocarbon exports, and the dependence of hydrocarbon prices on worldwide economic conditions.   One corollary of this is that Russia’s economic fate is tied to that of the broader world economy: As goes the world economy, goes the price of oil, goes Russia.

Recent news provides some confirmation of this analysis, but also suggests quite strongly that other aspects of Russia’s economic fate are unique to it—and that those don’t, don’t bode well for Russia’s near and medium term future.   (It’s long term future is pretty bleak, given its demographic difficulties.)   That said, Russia is not hopeless; its prospects depend on foreign investors failing to learn their lessons about the dangers of putting capital in Putinist Russia, and past experience suggests that these investors are capable of just that.  

The confirmation of the high beta hypothesis: the fact that Russian stock prices fell far more than world prices during the height of the crisis 4Q 2008; the recent boom in Russian stock prices, up around 140 percent off their lows, coincident with a strong but substantially smaller (around 33 percent) increase in stock prices in the US and Europe, and the rally in oil—up around 120 percent off its lows; the more recent drop in Russian equities—around 20 percent—coincident with a 5 percent or so drop in developed market prices, and a 10 percent or so drop in emerging markets, and a modest drop in oil prices; and increased pessimism about the prospects for recovery in Russia, coincident with a diminution of hopes for an imminent, and robust, world economic recovery.  

Virtually all of the economic news emanating from Russia is quite bleak.    To wit:

A stunning drop in investment spending:  

Russia’s biggest contraction in capital investment since December 1998 shows that the government’s stimulus package is “not working,” Alfa Bank said.

Last month’s 23.1 percent annual drop means “the fiscal stimulus funds are not finding their way into the real economy,” Natalia Orlova, Moscow-based chief economist at Alfa, Russia’s largest privately owned bank, wrote in a note e-mailed today.

“The general conclusion is that the state’s fiscal policy is focused on the social sphere rather than investment and that the Finance Ministry is trying to offset the decline in budget revenues with lower spending,” Orlova wrote.

The economy of the world’s biggest energy producer shrank an annual 9.8 percent in the first quarter, the most in 15 years, and may contract 8 percent this year, the government estimates. The stimulus package earmarks 2.51 billion rubles ($80 million) to battle the slump, including funding designated for the auto industry, agriculture and construction.

The budget deficit widening to 511 billion rubles through the end of May was the result of increasing transfers to regional budgets, rather than funneling money to the economy, the report said.

The source of the widening budget deficit—transfers to regional budgets—is of particular interest.   It suggests that the center feels compelled to prop up the regional governments, likely out of fear of social discontent and popular unrest.  

EDM provides further detail on the desperate straits of the regional governments, and the central government’s pulling out all the stops to keep them afloat while demanding that they in turn support employment in their regions:

Kudrin’s main headache, however, is the need to bail out an increasing number of regions that face insolvency while the income from the state budget has fallen by more than one third (Vedomosti, June 19). Putin is inspecting the regions demanding from the governors not to close the plants that cannot find any demand for their products and to pay salaries to idle workers, but that requires more transfer of funds from the federal coffers – a policy that goes directly against Kudrin’s course on reducing inflation (Kommersant, June 19).

Moreover, the decline in investment reflects a very bearish view on the economic future.   Given that Russia’s recent investment levels are quite modest compared to other emerging markets, and to the past example of the Asian Tigers, this drop in investment bodes ill for future growth.

A widespread recognition that government policy is ineffectual at best, and more likely extremely counterproductive:

Russia’s “anti-crisis” program, signed by Prime Minister Vladimir Putin on June 19, probably won’t return the country to sustained growth before 2012 and risks increasing state intervention, Capital Economics said.

“At its core there remains a fixation with micro-managing the economy, characterized by a plethora of targets, an over- reliance on state intervention and a hint of economic nationalism,” Capital’s London-based emerging-Europe economist analyst Neil Shearing wrote in a note e-mailed late yesterday.

The economy of the world’s biggest oil producer shrank an annual 9.8 percent in the first quarter, the most in 15 years, and may contract 8 percent this year, the government estimates. The stimulus package earmarks 2.51 billion rubles ($80 billion to battle the slump, including funding designated for the auto industry, agriculture and construction.

The government’s intent to “pick winners” among industries and check the growth of food prices may distort market and curb the supply of products, the Shearing said.

Carmakers are set to receive 90 billion rubles, farmers 63.1 billion rubles for agriculture and construction companies 247.2 billion rubles, according to calculations by Trust Investment Bank.

The total amount in the final draft is less than the 2.98 trillion rubles pledged by the government earlier after it reduced support for the banking industry by 500 billion rubles.  

Declining retail sales:

Russia’s economy is shrinking more than expected, sending “damaging waves” throughout the former Soviet Union, the World Bank said.

Collapsing industrial production, rising unemployment and capital flight will reduce Russia’s gross domestic product by 7.5 percent this year and restrain “intraregional trade flows and transfers,” the World Bank said in a report posted on its Web site today.

. . . .

Retail sales fell the most in almost a decade in May, sliding an annual 5.6 percent, the fourth consecutive decline and the biggest since September 1999. The average monthly wage decreased an annual 3.3 percent in May, while real disposable incomes dropped 1.3 percent.

And perhaps most ominously, the prospect that rising energy prices—themselves dependent on the extremely uncertain prospects for a global recovery, and the policy of the Fed—will not be Russia’s (or should I say Putin’s?) salvation when (or should I say if?) they come to stay:

Russia’s economic slump may deepen in the second quarter to an annual contraction of 10.9 percent because rising oil prices won’t spur growth without a recovery in lending, according to Goldman Sachs Group Inc.

“Russia’s deep output decline, in our view, is less the direct impact of lower commodity prices and more the effect of the sudden stop in capital inflows that the country suffered beginning in the third quarter of 2008,” Rory MacFarquhar, Moscow-based economist at Goldman, said in a report today.

The world’s biggest energy supplier is falling into its first recession in a decade after the global decline sapped demand for commodities while capital flows to riskier markets dried up. A stimulus package has failed to spur lending even as the central bank cut interest rates three times since April.

Capital investment in May fell an annual 23.1 percent, the biggest drop since December 1998, as industrial output declined a record 17.1 percent last month. Russian retail sales slid an annual 5.6 percent in May, the fourth consecutive decline and the biggest since September 1999.

. . . .

Lending to households and companies declined in the fourth quarter of last year by the equivalent of 5 percent of gross domestic product and fell 6 percent of GDP during the first three months of 2009 from a year earlier, according to Goldman.

Urals crude oil, Russia’s chief export earner, traded at more than $71 a barrel this month after falling to a low of $32.34 in December. The higher oil prices won’t spur growth because the profits are largely collected by the government in taxes, MacFarquhar wrote.

In previous years, the non-financial sector expanded borrowing by over 20 percent of GDP annually and Russia’s external debt grew by 30 percent every year, the report said.

The rise in oil prices will result in a stronger ruble and increase nominal GDP, leading to a budget shortfall of 6.2 percent this year, compared with an official forecast for a deficit of more than 10 percent, according to Goldman.

The collapse in capital inflows is another manifestation of the widespread pessimism about Russian economic prospects, and parallels the decline in investment.   The disparity between the dizzying growth rate in household and business lending in recent years, and the decline in 4Q 2008-1Q 2009 is particularly illuminating.

Investment is not robust anywhere, but the Russian fall is precipitous and nearly unique: notably the BIC countries have not experienced the collapse observed in Russia.   (Although lumping these countries together has never made much sense given their great differences on virtually every economically and politically relevant dimension—and including the Russian “R” to make BIC into BRIC was especially non-sensical).   This is the factor that seems on the one hand to confirm the high beta hypothesis, but which instead more likely reflects something distinctive to Russia other than its dependence on raw material exports.   Instead, it plausibly reflects the fundamental defects of the country’s natural state political and economic system.  

This is a natural implication of Putinism, as Shearing puts it: “At its core there remains a fixation with micro-managing the economy, characterized by a plethora of targets, an over- reliance on state intervention and a hint of economic nationalism.”   Add to this the Telenor fiasco, coming as it did on the top of numerous expropriations of investors both foreign and domestic; the ongoing farce of the Khodorkovsky trial, with its chilling implications for any Russian who falls afoul of the system, and its demonstration of the complete absence of an independent legal system and protection of individual rights; the trial of a different sort of being a foreign investor in Russia (cf. Ikea’s decision to suspend expansion in the country in large part due to the abuses it has suffered at the hands of Russian officialdom, petty and elevated); the WTO decision; the rows with everyone from Belarus to the US over food imports; the lack of credible commitment by the government to protect property or to adhere to contracts; the political risks epitomized by the Georgian War and its lawless, rogue aftermath (with the recent veto of the UN mission in South Ossetia and Abkhazia just the most recent example); and on and on.   Given this litany, it is no surprise that foreign investment has deserted Russia, and is unlikely to come back any time soon.

Here’s a way of summarizing this: high raw material prices are a necessary, but not sufficient condition, for Russian economic growth.   Booming resource prices in the earlier years of this decade created the possibility that Russia could be a lucrative investment market—if those investments were secure from predation.     And that proved to be a big if.   The capital outflows started before the world economic crisis—with the Georgian War, in fact, which put an exclamation point on the political risks in Russia.   The crisis, and the resulting collapse in materials prices, accelerated that decline.   The question is whether a reversal of the decline will lure foreign investors back.

There is room for doubt because there is no doubt that the government’s behavior both during the boom and the collapse made it abundantly clear that a fool is soon separated from his money in Russia—and that anyone who invests in Russia is very likely a fool.   If the high beta nature of the Russian economy doesn’t get you, the government is likely to.   Even companies and countries that assiduously courted the Putinite elite—BP and Norway come to mind—found themselves the victims of a predatory system.   (Is it a coincidence that Victor Fridman is deeply involved in both situations a coincidence?   Methinks not.)

Once burned, twice shy?   One would think so, and in the event, Russia’s future prospects would certainly be quite bleak.   For world economic prospects remain troubled, with pronouncements of the “green shoots” (gag) of an economic spring appearing decidedly premature, and Russia ill positioned to benefit from any world rebound due to its sinister reputation as a very dangerous place to invest.   For a country that experienced growth largely due to foreign investment attracted in large part by a boom in commodity prices, this is a very dangerous position to occupy.

But not all is lost for Putinism.   World economic recovery; a wildly expansive and inflationary US monetary policy; and the slashing of investment programs in oil and metals during the crisis; could lay the groundwork for another spike in commodity prices.   And past experience suggests that investors sometimes have short memories, and tend to let their wishes override the lessons of experience, and an understanding of the nature of Putinism.   Another commodity boom may induce foreign investors to throw caution—and common sense—to the wind, and invest in Russia again.  

So, in a nutshell, the positive case for Russian economic prospects: (a) another spike in commodity prices, and (b) foreign investors continuing to play Charlie Brown to Putin’s Lucy (tempting them with the financial football).   I put the probability of (a) in the 30-40 percent range in the 2010-2011 period, especially given the difficulties that the Fed will face when attempting to extricate itself from the extraordinary measures it has taken in recent years, difficulties exacerbated by the fiscal pressures emanating from Obamaism.   I put the probability of (b) somewhat lower than that—but not at zero, which is where it should be.   So, Russia should have no economic future due to the deformities of its politico-economic system, but it just might in spite of itself due to the prospects for policy errors in the US (and the West more generally), and (most importantly) to the cognitive and mnemonic deficiencies of Western investors.

John Dizard wrote an interesting piece on mandatory CDS clearing in the FT:

There’s a new series of disaster scenarios being talked out, most publicly in Congressional hearings on financial system reform. The two parties, buyside and sellside, are assembling their coalitions.

As is usually the case, the sellside, which is to say the big New York dealers, have so far been fastest off the mark. However, too many people on the buyside are watching this time to allow the sellside an easy win judged by friendly officials.

The CDS dealers now have their ICE Trust clearing platform up and running, have somewhat rationalised the documentation and terms, and have substantially reduced the volume of outstanding CDS contracts. They call the ICE Trust a “central clearinghouse”, by the way, which I would not. A real clearinghouse, of the sort that is used by commodities futures exchanges, is heavily, independently, capitalised, and can call on the resources of its clearing members to meet any shortfalls in capital caused by a failure. It also has clear margining requirements that are substantial in relation to the risks, which must be satisfied daily with cash on pain of liquidation.

The ICE Trust platform, in contrast, is a limited liability company. So no mandatory capital calls. The margining is modest in relation to value of the positions, and is more flexible and forgiving than that on public exchanges. The ICE Trust is a thinly capitalised bank, owned by other banks, and deals only through banks. Even well capitalised non-banks have to go through the likes of Tarp recipients. The security of the CDS clearing is based on trust and the taxpayers who underwrite the security of the banking system.

I share Dizard’s concerns about the capitalization of ICE Trust, although I believe he is wrong about “no mandatory capital calls.”  Chuck Vice, President of ICE, told me that ICETrust members can be required to contribute an amount equal to their original contribution to the guaranty fund in the event of a default that exhausts that fund.  The problem is, even with that feature, the clearinghouse may be less than adequately capitalized.  Moreover, I don’t think that the issue is that ICE margining is more modest and relaxed than at other clearinghouses.  My concern is that ICE doesn’t have the information to set the margins as effectively as bilateral OTC market dealers.  

Dizard also notes something that I mentioned some months back: the reluctance of some Chicago clearing member firms to embrace CDS clearing:

The Chicago traders, who had resented the New York dealers’ monopoly on CDS clearing, gradually realised that clearing CDS on single names (companies or countries) was a poisoned chalice. A Lehman or AIG-like failure could decapitalise all their other markets.

The FT has more information on exchange jitters on an OTC clearing mandate:

The word “standardised” sounds innocuous enough. But its use in a US policy document on the future of over-the-counter derivatives has set alarm bells ringing at derivatives exchanges.

Tim Geithner, US Treasury secretary, has said that to contain systemic risks he wants US laws to be changed to require clearing of “all standardised OTC derivatives through regulated central counterparties [CCPs]”.

This marks a sweeping change to the way OTC derivatives are handled, implying a shift away from the dealers at banks who brokered such contracts to the formal exchanges that have long jealously eyed the huge OTC markets.

But what does “standardised” mean? How much of the OTC markets can and should be shifted on-exchange, whether cleared or – as Mr Geithner also wants – traded?

Nobody has a clear answer, since OTC derivatives come in many shapes and sizes, ranging from straightforward interest rate swaps to more tailored products such as “average price options” used by grain processors to hedge against movements in crop prices.

Exchanges, many of which own their own clearing houses, might be expected wholeheartedly to welcome the Geithner proposals. But they are warning against a strict definition of “standardisation”.

Craig Donohue, chief executive of CME Group, the largest US futures exchange, which owns a clearing house, says: “Standardised is not the right way to do it.”

He and others are concerned that lawmakers in the US Congress may come up with a strict definition that would force a shift of OTC contracts into clearing houses that are ill-equipped for the task.

They warn that such a move could expose clearing houses to unnecessary risks that could even damage the financial system at a time when regulators are looking at ways to protect it against future crises.

Kim Taylor, president of CME clearing, says: “There is a danger in having regulatory mandates that are too broad, that would require clearing of products that clearing houses don’t feel comfortable risk managing.”

Declan Ward, executive director at NYSE Liffe in charge of clearing, says the danger is that certain OTC products with unique specifications negotiated to deal with particular risks are relatively illiquid. Coupled with lack of transparency in pricing “you are adding risk to a CCP”.

These are important points.  “Standardization” is not the only issue.  Certainly, more complex, non-standardized derivatives are problematic to clear.  Illiquidity and lack of reliable pricing information for seldom-traded instruments–standardized or not–can also raise major problems for clearing, as Declan Ward and Kim Taylor suggest: and as I’ve written in my academic work going back to 1997.  

CME’s Craig Donohue favors letting the market sort out what is, and what’s not, appropriate for clearing:

Mr Donohue says: “I worry that those kinds of definitions wouldn’t have all that much durability given the level of innovation.” Like other exchange heads, he argues that the market must have a role in deciding which OTC products should be cleared. A recent jump in the number of OTC energy derivatives being cleared through the CME’s Clearport clearer has been driven purely by market demand, he points out.

MarketWatch provides additional evidence of skepticism, including from a regulator (Britain’s FSA) and the DTCC:

Broad proposals for tighter regulation of the over-the-counter derivatives market have already been put forward in the U.S. and Europe authorities are widely expected to follow suit.

Alexander Justham, director of markets at Britain’s Financial Services Authority, said the derivatives market has grown without transparency.

The natural response is the “vanilla-ization” of contracts, by standardizing the terms so they can be traded on an exchange or cleared through a so-called central counterparty (CCP), which acts as an intermediary and absorbs the loss if one party defaults, Justham said.

“But not everything can be put on an exchange and not everything can be cleared,” he cautioned at a recent Mondo Visione conference in London.

Other commentators agreed, saying clearing houses would struggle to handle some of the more complex derivatives.

“The danger is that too much reliance will be placed on CCP clearing,” said Diana Chan, CEO of clearing house EuroCCP, which is a unit of the U.S.-based Depository Trust & Clearing Corp.

In order to be suitable for clearing, a derivative contract must be relatively easy to price, so the CCP can collect the right amount of margin, and trading must be sufficiently liquid for positions to be closed quickly, Chan said.

AIG’s downfall

Credit-default swaps have been at the center of the argument over derivatives because of their role in the near collapse of American International Group Inc.

CDS are similar to an insurance contract and pay out if a company defaults on its debts.

But volumes soared in the lead up to the credit crisis, and the opaque nature of the market meant it was almost impossible to track where the exposure to these derivatives lay.

Justham said a straight-forward CDS on, say, supermarket chain Tesco, might be suitable for trading on an exchange. But more complex contracts, such as bespoke agreements linked to several different credit events, wouldn’t work.

Even liquid contracts such as simple credit-default swap can pose problems, because when the underlying debt gets close to default, that liquidity can dry up very quickly, said Roger Liddell, CEO of LCH.Clearnet, a clearer mostly held by its users.

Glad to have company, folks.

Mandatory clearing, and the associated greater rigidity in margining, could also dramatically reduce the utility of the derivatives markets as hedging vehicles.  Rigid, daily mark-to-market payable in cash, subjects hedgers to cash flow risks.  Even if a derivatives position and an underlying position have mark-to-market values that are almost perfectly correlated, cash margining with daily mark-to-market generates cash flow changes on the derivatives hedge position that may not be matched by offsetting cash flows on the position being hedged.  This mismatch can greatly reduce the utility of hedging, and lead firms to do less of it–and hence result in them bearing more price risk.  That’s a highly undesirable outcome, and a cost that advocates of mandatory clearing do not address.  OTC markets permit more flexibility in managing these cash flow considerations, which is one reason why hedgers often prefer OTC markets to cleared exchange markets.

(As an aside, it’s also one reason why the LME fought introducing clearing even in the aftermath of the tin crisis, and even when forced to do so, implemented a clearing system that permitted more flexibility and use of credit.  This was intended specifically to meet the needs of metal hedgers, who would often have a gain on a hedged metal position, but since this gain did not generate a cash inflow, would be required to stump up additional cash to pay the MTM loss on the hedge under standard futures margining practice.)  

In sum, there are a lot of reasons to have a variety of methods for trading derivatives, and for allocating the default/performance risks associated with them.  These go a long way to explaining just why such a variety of methods exist, side-by-side.  As I’ve said before, the advocates of a mandate have not even attempted to provide a credible explanation as to why market participants would avail themselves of a variety of different mechanisms, if one is decidedly superior.  In contrast, there are numerous, well-articulated (if I do say so myself;-) arguments as to why they do so, and why it is best to let them do so.  As the foregoing articles suggest, moreover, numerous market participants–including those, such as exchanges and the DTCC, who might otherwise seem to have an interest in supporting a mandate because it would send business their way–also recognize that these considerations are quite important.  One hopes that they are sufficiently persuasive to convince Congressmen, regulators, and our Secretary of the Treasury, all enamored with clearing, that it is not a good idea to try to pound a square peg into a round hole.

A few scattered comments on Russia.

First item: John Wallis spoke at the Manufacturing Markets Workshop this morning, and I had a chance to speak with him a bit after his session.  In his talk he had mentioned the role of innovation in undermining natural states, and sustaining open order ones.  This brought to mind a dilemma that the Russian elite is clearly dealing with.  Medvedev in particular and those associated with him have lamented the rent-based nature of the Russian economy, and have expressed a desire to encourage innovation.  But they want to do it in a way that maintains the natural state.  Rather than encouraging the development of an uncontrolled, open access, Schumpeterian creative destruction technology sector, the Russian elite–even those who recognize that a rentier state is a dead end–want to foster innovation in state firms.  

State firms present less of a challenge to the existing order.  There is no chance of a massively successful entrepreneur upsetting the political equilibrium, creating an alternative center of power.  No high-tech Khodorkovsky, in other words.  

I predict that this system will half succeed.  It will succeed in sharply reducing the risk of the rise of challengers to the existing political order.  It will fail miserably in fostering innovation.  Bureaucratic state firms are death to innovation.   Innovation thrives because the very people that the elite fear–the risk taking, the entrepreneurial, the unconventional–have free rein.  But that can’t be allowed because it threatens the existing order.  Medvedev and others want their cake, and eat it too, but they can’t.  They can’t have a vibrant innovation culture without challenging the political status quo.  As Wallis said in his talk, political dynamism and economic dynamism are highly complementary.  In the end, Russia is likely to choose political stability, which per this argument requires foregoing economic dynamism.  

Second item: Missile defense.  The New York Times has an interesting article on the negative Russia response to a clever US initiative to position some missile defense assets in Russia.  According to the article, the Russian response is a categorical нет as long as there are also missile defense facilities in the Czech Republic and Poland.  Very revealing.  

The article says:

For Russia, any reconfiguration that preserves sites in Poland and the Czech Republic “is just window dressing,” said Dmitri V. Trenin, a political analyst.

“I’m not sure everyone in the U.S. understands how much is at stake as far as the Russians are concerned,” said Mr. Trenin, director of the Carnegie Moscow Center. “The issue for the Russians is, what are the U.S.’s long-term intentions vis-à-vis Russia? And they are looking at missile defense for the answer to that question.”

An unwillingness to scrap the Eastern European facilities would be seen by hawks in Moscow as evidence that “the hidden agenda is to contain and destroy Russia,” he said.

Given the realities of the proposed installation, such attitudes are best explained as paranoid, and immune to reasoned argument and diplomacy.  

Item three:  Russian GDP declined at a 9.8 percent annualized rate in the first quarter:

Russia’s economy contracted the most in 15 years in the first quarter after industrial production plunged and the government’s 3 trillion rubles ($97 billion) in stimulus spending failed to boost companies and banks.

. . . .

The world’s biggest energy supplier is falling into its first recession in a decade after the global slowdown sapped demand for its commodities and companies struggled to find funds. The government’s stimulus package has failed to spur bank lending, even as the central bank cut its main interest rates three times since April.

“Aggressive cuts in official interest rates over the past six months have not fed through to lower borrowing costs,”  Neil Shearing, a London-based analyst at Capital Economics, wrote in a report last week. “A sustained recovery is unlikely much before the second half of next year.”

Manufacturing fell 23.5 percent in the first quarter, compared with a revised 6.6 percent expansion in the same period last year. GDP may slump as much as 8 percent in 2009, Economy Minister  Elvira Nabiullina  said last month, after growth of 5.6 percent in 2008 and 8.1 percent the year before

. . . .

The  deficit, Russia’s first in a decade, may reach 10 percent of GDP this year, according to the Finance Ministry. The Reserve Fund may be exhausted by the end of next year, Finance Minster  Alexei Kudrin  said.

The 10 percent budget deficit projection is 25 percent more than the 8 percent projection that Kudrin had said was the maximum possible allowable.  

Rising oil prices will help the budgetary situation, but not the overall economy:

The recovery in oil prices is unlikely to bolster Russia’s economic performance,  Rory MacFarquhar, a Moscow-based economist at Goldman Sachs Group Inc., said in a report last week.

“We have long argued that oil prices do not have a direct impact on activity, since they are almost entirely taxed away by the state,” he wrote. “In the past, high oil prices were accompanied by strong credit inflows, which do have a stimulative impact. But we do not expect a rebound in credit under current circumstances, given the damage already suffered by both domestic and foreign lenders.”

Goldman predicts a contraction of 7.5 percent in GDP this year, while theInternational Monetary Fund  on June 1 said it expected the economy to shrink 6.5 percent.  Alfa Bank, Russia’s largest privately owned bank, expects the economy to contract 5.7 percent.

That is, the continuing weak worldwide economic situation, with weak investment, weak banks, and weak finance, translates into poor prospects for Russia in 2009 and 2010, higher oil prices or no.  Although some in Russia (particularly in the Putin and Sechin circles) apparently believe that the rebound in oil prices alleviates the need for any structural changes in the economy, this may well be a false hope.  And, as noted in item 1, Russia’s way of groping towards structural change is likely to be unsuccessful in any event.  

This is particularly true in light of:

Item four: Vimplecom and Telenor. Russian bailiffs are edging towards selling off Telenor’s shares in the company pursuant to a Russian kangaroo court verdict in a suit filed by Alfa Group stalking horse Farimex:

Russian bailiffs said they are ready to sell shares in OAO VimpelCom held by Norway’s  Telenor ASA  that were frozen by a court in March.

All documents needed to proceed with the sale of 15.34 million  VimpelCom  shares have been completed and the stock will be offered on the open market “in the near future,” Russia’s Federal Bailiff’s Service said in a  statement  on its Web site today. Bailiffs seized Telenor’s shares in VimpelCom, Russia’s second-largest mobile-phone company, representing a 29.9 percent stake, after the levying of a $1.7 billion fine.

Farimex Products Inc., the Russian owner of a 0.002 percent VimpelCom stake, brought a case against Telenor in Siberia that found the Norwegian company liable for damages for delaying VimpelCom’s expansion in Ukraine, leading to the fine. Telenor says Farimex is a front for billionaire  Mikhail Fridman‘s Alfa Group, which owns 44 percent of VimpelCom. Altimo, Alfa’s telecommunications unit, has denied any link to Farimex.

If Telenor’s shares in VimpelCom are sold, “we are likely to see an escalating political conflict,” said  Konstantin Chernyshev, an analyst at Uralsib Financial Corp. in Moscow. “Telenor is a state-owned company and it’s unlikely it’s going to give up without fighting in the courts.”

As noted above, foreign investment has largely deserted Russia, contributing to its economic implosion (which is stark compared to its supposed BRIC peers).  Things like this are hardly the way to encourage its return, which will make its recovery all the more difficult.  This is also an illustration of the highly personalized nature of justice in Russia, where a favored oligarch gets preferential treatment in the legal system.  

Lastly, just a quick remark on Putin’s performance in monotown Pikalevo:

Mr Putin, who is a master at dispensing ritual humiliation, likened Oleg Deripaska to a cockroach and forced him to accompany him on a tour of Pikalevo, a factory town that has witnessed the most serious social unrest Russia has seen since the start of the global economic crisis.

Last week Pikalevo’s residents vented their anger over job losses and unpaid wages at one of the oligarch’s local factories by blocking a major road and causing a 250-mile traffic jam. The unprecedented protest reportedly worried the Kremlin, which has long been afraid that Russia’s imploding economy could cause serious political unrest.

Anxious to ensure that the Pikalevo problem remained an isolated one, Mr Putin sought to cast himself as the town’s saviour – and Mr Deripaska as its villain.

The prime minister rounded on the hapless tycoon as they toured a cement plant.

“Why has your factory been so neglected?” he demanded, as Mr Deripaska hung his head in apparent shame. “They’ve turned it into a rubbish dump.Why was everyone running around like cockroaches before my arrival? Why was no one capable of taking decisions?”

He then ordered the tycoon to pay all outstanding wages – £830,000 – before the day was out. Mr Deripaska was Russia’s richest man until last year. He has suffered a dramatic reversal of fortune as mounting debt has seen his assets shrink from £17 billion to about £2 billion today.

This is a perfect illustration of the a-institutional, personalized style of the Russian polity.  As Wallis emphasized in his talk, personalization, and the absence of impersonal institutions, are the hallmark of the natural state.  Wallis says that natural states are good things–compared to the alternative of a Hobbesian war of all against all.  And perhaps such a conflict is the only realistic alternative to the existing system; it is quite plausible that an open order with impersonal rules is not a realistic alternative for Russia anytime soon.  But all of these seemingly unrelated items make it very clear that the natural state is deeply embedded in Russia, and that the price to be paid in terms of lack of economic dynamism is likely to be high indeed.

I was somewhat surprised to see both CME and ICE come out in opposition to mandatory OTC derivatives clearing:

Top managers from two major financial exchange groups on Monday warned the U.S. government not to go too far in forcing central clearing of over-the-counter derivatives, a troubled, multi-trillion-dollar market whose future is central to both companies.

Terrence Duffy, executive chairman of CME Group Inc <CME.O>, said in prepared remarks to be delivered on Tuesday to a congressional panel that government-mandated clearing of all over-the-counter derivatives could drive business overseas.

. . . .

ICE’s Sprecher said in prepared remarks that forcing illiquid, unstandardized derivatives contracts into a clearinghouse could actually increase market risk.

“While ICE certainly supports clearing as much standardized product as possible, there will always be products which are either non-standard, not sufficiently liquid, or that do not have enough interest in them for clearing to be practical, economic or necessary,” he said.

“While the illiquid and unstandardized contracts should not be forced to be cleared, firms dealing in these derivatives should report them to regulators, so regulators have a clear and total view of the markets.”

Jeff Sprecher has it exactly right.  You can get the transparency without going to the full risk sharing inherent in clearing.  What’s more, mandatory clearing can actually increase risks.  

I was invited to testify at these hearings, but had to decline due to my prior commitment to a conference.  Hopefully I’ll have the opportunity to do so at a later date, and give it to them with the bark off, for it is evident that there is much ignorance on these issues in both the press and Congress:

First, the press:

Many OTC derivatives flew off the rails in 2007 when the housing bubble burst and credit tightened, leaving banks, such as the now defunct Lehman Brothers, with huge losses. Credit default swaps played a major role in the troubles at American International Group <AIG.N> that led to its government bailout.

The connections in the sentence about Lehman Borthers are completely incoherent.  This is just stringing together a bunch of things that happened and asserting a causal connection.  Lehman had OTC derivatives.  There were housing and credit crises.  Lehman had huge losses.  The OTC derivatives of the kind at issue in clearing were not Lehman’s main problem.  How about some real reporting, and some real forensics, about the connection between OTC derivatives, including CDS and interest rate swaps, and what happened to Lehman.  What I’ve quoted above is far to common, and is just lazy repackaging of somebody else’s lazy BS.  And for the billionth time, AIG is the reddest of herrings in the OTC derivatives debate.  Give it a rest.  Please.  

Now, Congress:

As lawmakers and the Obama administration move to crack down on OTC derivatives, the House Capital Markets Subcommittee is set to hold a hearing to “advance the discussion in Congress on … meaningful regulation of this dark corner of the financial services industry,” said Representative Paul Kanjorski, Democratic subcommittee chairman, in a statement.

Can we please give the “dark corner” and “dark market” metaphors a rest too?  Yesterday, maybe?  And WTF does “meaningful” mean?  Bad regulation can be meaningful.  Just what is the appropriate regulation, and how do the proposed regulations–especially mandatory clearing–make the markets more efficient?    

Don’t wait up for an answer.  These people don’t even know to ask the questions.  We just get bromides about dark markets.  

I know who’s in the dark.  And it ain’t the markets.

In the aftermath of the financial crisis, CFTC head Gary Gensler believes that OTC derivatives markets need regulation in the worst way, and that he’s just the man to do it.  Gensler testified in front of Congress, and presented an outline of his ideas for regulation of the OTC markets.  It is now clear how Gensler was confirmed in his post, despite his involvement (salutary, in my view) in the (wrongly, in my view) widely excoriated Commodity Futures Modernization Act:  he agreed to push all the derivatives policy nostrums emanating from Capitol Hill.

There is enough here for several posts, and I’ll probably do just that, time and travel schedule permitting.  The Cliffs Note version is: I disagree with just about everything, and think that most of the arguments raised in the letter are wrong, when they’re not retarded.  (Can you say that anymore?)  Actually, that’s not quite right.  There are NO arguments in the letter to speak of.  Just a series of unfounded assertions on which Gensler erects a set of far-reaching policy proposals.  The Monty Python “Argument Sketch” goes to Washington.

Today I’ll focus on the issue that constitutes the most important part of Gensler’s letter: clearing.  It presents a cartoonish version of what clearing does, and grotesquely misstates the economic implications of clearing.  Gensler presents clearing as a panacea, a silver bullet, that will banish systemic risk.  Based on this distorted depiction of the costs (none) and benefits (incalculable) of clearing, Gensler recommends that virtually everything be cleared, and that non-cleared product be subjected to intense scrutiny.

Gee.  If it’s such a great idea, why didn’t anybody think of it before?  That’s the first clue–and it’s a big one–as to why Gensler’s advocacy (which, admittedly, just echoes Geithner’s and Congress’s) is almost certainly based on fantasy rather than fact.  

Gensler’s most grotesque distortion is to assert that bilateral markets are too interconnected, and that cleared markets would be less so:

One of the lessons that emerged from this recent crisis was that institutions were not  just “too big to fail,” but rather too interconnected as well.   By mandating the use of  central clearinghouses, institutions would become much less interconnected, mitigating  risk and increasing transparency.   Throughout this entire financial crisis, trades that  were carried out through regulated exchanges and clearinghouses continued to be  cleared and settled.  

Where do I start? First, clearinghouses CREATE interconnections, albeit different ones than in the OTC market; clearinghouses formalize a specific and extensive form of interconnection between systemically important market participants, and their customers. They are a means of SHARING default risks, and determining the allocation of losses from default. Sharing means a connection.  By definition.  The members of the clearinghouse share the risks of default. The clearinghouse members and their customers are therefore interconnected, and the failure of one has financial implications for the financial health of others. Moreover, the central clearing structure can actually lead to greater concentration of risk than occurs in the bilateral market, and result in less capital being available to absorb default losses.  That is, the particular interconnections in a cleared market can be more systemically threatening than those in a bilateral one.  It is false, misleading, and borders on the fraudulent for Gensler to claim that clearinghouses make markets “much less interconnected.” It is false, false, FALSE.  

Clearing changes the nature of the interconnection.  It is incumbent on advocates of the imposition of clearing to demonstrate that this change is an improvement.  Gensler doesn’t even begin to try to do so.  He just misleadingly asserts the issue out of existence.  Out of such sloppiness, bad policy is made.

The last sentence of the quoted paragraph is also misleading. First, other than the AIG trades (which I’ll get to in a minute), products OUTSIDE the regulated exchanges and clearinghouses also continued to be traded and settled. Lehman’s collapse did NOT lead to a cascade of failures, for instance. Second, the distribution of products traded on exchanges and in the OTC markets is not determined exogenously, so the comparison is not a fair one. Where things trade and the institutions of trading are endogenously determined by the actions of market participants. In my academic work, I argue that some products are suited for clearing, some not, and that trading patterns reasonably reflect those differences. Therefore, a comparison of the performance of cleared and non-cleared markets does hold everything equal. The stuff that is cleared is basically the easier stuff–hence you would expect fewer problems there.  

I’ve heard this argument about how well futures and options clearinghouses worked during the crisis several times now.  Every time I’ve heard it, those advancing it have failed to consider the possibility that this comparison is superficial and incomplete, and it ignores the fact that despite all of the hyperventilating, bilateral markets continued to work too.  

And for those with short memories, I suggest a look at the near death experience of the CBT and CME clearinghouses on 20 October, 1987, and the problems with COMEX clearing on Silver Tuesday in March 1981 (when the Hunts imploded) and during the mid-80s, to get a better understanding of the potential frailties of cleared markets, and how they can actually create systemic risks.  

I would also submit that many of Gensler’s proposals actually would lead to increased interconnectedness. For instance:

Central counterparties should also be required to have fair and open access criteria that allow any firm that meets objective, prudent standards to participate regardless of whether it is dealer or a trading firm. Additionally, central clearinghouses should implement rules that allow indirect participation in central clearing.

Extending the membership of clearinghouses by government fiat means that more firms are members of the clearinghouse–and hence interconnected to the failure of any other member. So much for reducing interconnection.

I would also note that Gensler completely overlooks that mandating open access to clearing will increase the heterogeneity of the membership of these organizations, which will have important implications for their governance. In my work on exchanges I note how heterogeneity greatly complicates governance, tends to impede decision making, leads to divisive political infighting, and on and on. (The paper I am presenting in Florence focuses on the effects of heterogeneity of the membership of financial cooperatives like exchanges and clearinghouses affects their governance.)  

Now, I have also shown in my academic work that membership limitations can also be used to turn the clearinghouse into a cartel. But nonetheless, it is very dangerous to blithely dictate the membership policies of such systemically important institutions without even the slightest consideration of how these diktats will influence governance–and how governance might affect policies relating to margining, capital, risk management, and systemic risk. Governance matters, and the heterogeneity of membership that Gensler’s recommendations would create would inevitably affect the politics of exchange governance, and the efficiency of clearinghouse operations.  Not that Gensler–or anybody else flogging this policy–even acknowledges the governance implications.

(I would further note that the possibility that the members of a clearinghouse can effectively use this institution to operate a cartel undermines arguments that anti-competitive motivations underly dealers’ refusals heretofore to clear many products. This provides further support for my argument that there are other costs associated with clearing, namely costs relating to asymmetric information, that outweigh the private benefits that clearing can provide the members of the clearinghouse.)

Gensler brings up AIG to justify his arguments. This, in my view, is the modern financial equivalent of arguendo ad Hitlerum: invoking AIG to justify any policy without a full and fair discussion of just how that proposed policy would have affected AIG’s behavior or the market, is irresponsible and usually reflects a lack of thought. It, like arguments ad Hitlerum, is an appeal to emotion rather than fact and analysis.

Sadly, Genlser’s invocation fits that characterization:

By novating contracts to a central clearinghouse coupled with effective risk management practices,  the failure of a single trader, like AIG, would no longer jeopardize all of the counterparties to its trades.

Wrong again, Mr. Gensler. This seems to suggest that a clearinghouse makes default risk Disappear!, like some amazing magician. No. It does not. It redistributes the risk. As I showed in It’s a Wonderful Life: AIG Edition, (a) it is highly unlikely the products AIG traded would have been cleared in any event, and (b) if they had, it is unlikely that clearing would have materially mitigated the implications of an AIG collapse, and indeed could have made it worse.  This is related to the interconnection point.  Once AIG blew up, the members of the clearinghouse would have been on the hook just as its bank counterparties were.  And guess what?  The members of the clearinghouse would likely have been the same bank counterparties.  

There is no acknowledgement in Gensler’s prepared testimony of even the possibility that clearing may be inappropriate for some products, and that requiring clearing of these products may result in greater costs than benefits.  Indeed, the fact that clearing has not succeeded for numerous products, and has not even been attempted for some, raises quite clearly (no pun intended) the possibility that the costs indeed exceed the benefits.

Think of it this way.  By recommending a mandate, Gensler (and others like Geithner who have taken similar positions) is asserting implicitly the existence of a market failure.  The key word is “asserting.”  He is not specifically identifying what that market failure is, and how his proposal corrects it.  Why, if clearing is so socially beneficial, has it not been adopted?  What market failures, what transactions costs, are preventing the adoption of this socially optimal arrangement?  If it is not possible to present a coherent, plausible, and evidence-backed case for the existence of such a market failure, the presumption should be that the market knows better than Mr. Gensler, and that market participants have adopted one set of institutional arrangements for some products and another set for other ones because costs and benefits differ across products and users.  Mr. Gensler apparently believes one size fits all.  The market has been acting as if it believes something very different.  Why is the market wrong?  It may be–but it is incumbent on Gensler and others to make the case.

This implicit assertion of market failure pervades the Gensler letter.  His recommendations to dictate how instruments are traded, with a decided preference for exchange trading, represent another example.  We see invocations of transparency and other Motherhood-and-Apple-Pie virtues to justify dictating market structure, with no serious discussion as to why market participants have apparently chosen suboptimal arrangements.  I will hopefully return to this part of the proposal soon.    

The Gensler testimony also suggests–though it is somewhat ambiguous on this score–that the government will establish margin requirements on all derivatives trades.  One could also read the letter to mean that it will require clearinghouses to set prudent margin requirements.  Either alternative is problematic to the extent that the government and the clearinghouse–but especially the former–are unlikely to have better information for setting these requirements for some products than some private market participants.  This is problematic–as is the possibility that a government regulator or a clearinghouse may be subject to political pressures that lead it to set margin requirements based on rent seeking considerations, rather than prudential ones.

I could go on, but it’s late.  Suffice it to say that Gensler is predicating a massive change in the regulation of financial markets based on a set of implicit assertions.  He is implicitly asserting the existence of a plethora of market failures.  Not one of which does he demonstrate by thorough argument or evidence, beyond the ritual incantation of the Ghost of AIG.  He does not even identify what the market failures are.  This is the stuff that public policy disasters are made of.   If there are market failures that need fixing, it should be straightforward to identify what they are, and to show how the proposed policy will improve the allocation of resources by reducing the severity of these market failures.  

But Gensler doesn’t even try to do that.  That shouldn’t be sufficient, but given that Gensler is primarily serving as Charlie McCarthy to Congress’s Edgar Bergen, sadly it will be more than enough.

Vlad Socor has two  pieces  on the South Stream pipeline project.  Here’s the nub of the analysis:

Despite facing gas production shortfalls (relative to internal and external supply commitments) post-2010, Russia is multiplying its supply offers to European consumer countries through South Stream and other pipeline projects. Gazprom signed bilateral agreements on building South Stream with state-controlled Italian, Bulgarian, Greek, and Serbian companies on May 15 in Sochi, with Prime Minister Vladimir Putin attending, and it is negotiating similar agreements with more countries (Interfax, May 15, 16; EDM, May 27).

As enticements, Moscow is declaring ever-larger design capacities for the putative South Stream pipeline system, rival to the European Union and the United States’ backed Nabucco and Southern Corridor projects. South Stream’s other goal is to threaten Ukraine with diverting gas transit volumes, from the Ukrainian transit system into the South Stream pipeline on the seabed of the Black Sea. The Kremlin will most likely roll back its South Stream project, if Moscow achieves its earlier goal of gaining control over the Ukrainian gas transit system.

Gazprom’s strategy reminds me of the movie The Producers; the company is promising the moon to everybody with little chance that it can deliver. The promised capacity is growing by leaps and bounds, from 30 bcm/year in 2008, to 47 bcm/year in February, to 60 bcm/year this month.    It is offering every country in the region a piece of South Stream, with new pipelines wending through southern and eastern Europe, and storage facilities here, there and everywhere.  But with nothing really to back it up.  There are no sources of gas committed to the project (unlike with Nord Stream, as dubious as those sources are).  Cost projections are ballooning along with capacity plans.  In the midst of an existential financial crisis, just where is Gazprom–which has seen its market cap plummet, its cash flows decline dramatically, and which has just slashed its dividend by 83 percent–going to get the $24 billion plus to pay for this project?  Not to mention the money required to develop the gas fields required to fill it and Nord Stream and meet anticipated growth in domestic demand.  

I’ve written before on the vaporware aspect of many Gazprom plans.  Just like software companies that announce brand new software initiatives (that never appear) in order to dissuade entry by competitors, Gazprom announces these grandiose expansion plans to deter entry, in this case, entry by Nabucco.  (Robert Amsterdam calls this “premature contractualization” but the idea is the same.)  The plans and capacities and the like are sort of Monopoly money that Gazprom throws around in an attempt to peel off enough countries to prevent Nabucco from getting the scale and traction it needs.  (Nabucco has its own problems, of course, not the least of which being where the gas for it is going to come from, and the indecisiveness of the Europeans.)  

The frantic increase in the amount of vapor being pumped out seems to suggest a certain amount of desperation on Gazprom’s part.  Nabucco has made some tentative strides of late, particularly getting Turkey more or less onside (even though it still hasn’t resolved the supply issue).  In response, Gazprom seems to be making more extravagant promises.

In other gas news which may be closely related to the South Stream saga, is this piece relating to a story I wrote a couple of posts about a few months back.  Turkmenistan is threatening to sue Russia over the gas pipeline explosion:

Turkmenistan threatened to take Russia to court over last month’s gas pipeline explosion, RIA news agency reported, escalating a dispute that has severed a vital energy link through Russia to Europe.

Turkmenistan blames Russia for blowing up the pipeline, which carries more than half of its most valuable export, by cutting the gas flows without enough warning.

“When you shut off the flows, you get what is called a vacuum-bomb effect,” Odek Odekov, head of Turkmen state geological institute Turkmengeologia, told reporters during an energy conference in Paris, RIA reported.

“The system has to be prepared for a shut-off three days in advance, and Russia did it in the course of one day,” he said.

Russia’s gas export monopoly Gazprom denies any wrongdoing and it has said it hopes to resolve the issue through talks. The company has avoided making detailed public statements on the matter.

Silence is probably advisable, under the circumstances.

As I originally opined, there is a strong case to be made that the cutoff of gas from Turkmenistan (which led to the explosion) was economically driven.  Russia had gotten what it asked for, but came to regret it.  In 2008 it agreed to buy all of Turkmenistan’s gas at what seemed to be a bargain price, but what which in the aftermath of the financial crisis turned out to be too much gas at too high a price:

Every month, Turkmenistan is therefore losing between $800 million and $1 billion per month in export revenues, said Mikhail Korchemkin, director of East European Gas Analysis. “Turkmenistan has every right to demand this money,” he said.

U.S. PUSHES FOR BYPASSING RUSSIA

Due a sharp drop in demand for gas in Europe, Russia no longer needs to buy Turkmen gas, because it can meet European demand more profitably by selling its own.

For the short term, therefore, analysts said the explosion played into Russia’s hands by halting imports from Turkmenistan.

Korchemkin estimated that Gazprom is getting an additional $330-450 million per month in net profits out of this situation, while the Russian budget is getting an extra $300-400 million in customs duties.

So there’s another  Producers parallel: when their scam failed, the hapless producers blew up the theater to avoid paying off their debts.  When its Turkmenistan scheme backfires, Gazprom blows up the pipeline to avoid paying off  its debts.  LOL.  

The cutoff of purchases from Turkmenistan helps Russia out of a short term difficulty, but creates serious longer term ones.  First, Turkmenistan has take-or-pay contracts with Russia.  Though Russia is likely to claim force majeure due to the pipeline explosion, if this matter gets to a reliable arbitrator, Gazprom may end up on the hook to pay for the gas it didn’t take.  

Second, it has made the wily Turkmen president  Kurbanguly Berdymukhamedov look for other options:

After the row with Russia, Berdymukhamedov has spoken out about the need to diversify gas exports.

Russia, keen to maintain control over the region’s gas flows, is plowing ahead with its own pipeline project in the region, South Stream

“But South Stream does not open any new markets for Turkmenistan, because Russia would remain its only consumer. Nabucco, however, opens up all of Europe,” Korchemkin said.

And Turkmen cooperation could be just what Nabucco needs to be viable.  And that, in turn, could well explain why The Producers at Gazprom have gone into high gear, promising more to every country in Eastern Europe than they can possible deliver.

This Reuters article provides confirmation that Russia’s opportunistic attempts to use OPEC to advance its own interests (opportunism analyzed in detail in several SWP points) have left the oil cartel spitting mad:

Russia is no longer a welcome guest of OPEC after boosting its production to levels far above those pumped by the group’s biggest exporter, Saudi Arabia, and snatching away market share.

After flirting with OPEC when a barrel of oil cost less than $40, Moscow has once more set its course on raising production to support an economy entering its first recession in a decade, leaving OPEC to shoulder the burden of record output cuts.

“OPEC members have cut almost 4 million barrels per day in order to subsidize the Russian oil industry and economy to the tune of about $150 million per day,” said Chris Weafer, chief strategist at UralSib investment bank.

“This is unlikely to sit well with OPEC member countries.”

. . . .  

Senior Russian government officials have attended the last few gatherings, while producers, including the largest independent oil firm LUKOIL (LKOH.MM), had signaled they might be willing to cut output.

Yet Russian oil production rose in April to 9.85 million bpd — 1.3 percent more than the 9.72 million bpd produced in February.

Saudi Arabia, the world’s top exporter, has been pumping less than 8.05 million bpd since February as it accounts for the bulk of OPEC’s cuts.

“Russia, rather than cutting exports, has now increased exports of oil products at a time when OPEC supplies are at their lowest in five years,” said Valery Nesterov, oil and gas analyst at Russian investment bank Troika Dialog.

While OPEC has cut output by about 5 million barrels per day since last July, Russia has increased the supply of oil and oil products by 6.4 percent, or 0.45 million bpd, Nesterov said.

“In other words, Russia has compensated for about 10 percent of the cuts made by OPEC.”

The Russian response?  A real howler:

Russian officials said they were not invited to this week’s OPEC meeting, but say their absence is not political.

“It has nothing to do with the rising oil prices. There are some organizational issues,” Anatoly Yankovsky, Russia’s deputy energy minister, told Reuters. Another ministry official said OPEC called Russia to its meetings as an observer during crises in global oil markets. “OPEC now considers that the situation is stable,” he said.

Yeah.  There are some organizational issues.  Like, the organization in question has had enough of Russia’s BS, and is not going to be played for chumps again by Igor Sechin.  

Now, I detest OPEC, and attempts to cut output collusively to prop up prices above the competitive level.  So, in that sense, it is a good thing that Russia cranked up output in response to OPEC cuts.  Though I know that Russia’s actions had nothing to do with any commitment to competition or any aversion to anti-competitive tactics.  

That said, I still find this dispute among thieves to be quite illuminating.  In particular, it casts a glaring light on the duplicity and opportunism that characterizes the actions of the siloviki that dominate the Russian energy business, and hence, by extension, the Russian government.  OPEC has found to its dismay (but to the joy of energy consumers) that Russian declarations of solidarity and cooperation are intended primarily to gull the credulous, and that such whispered sweet nothings are completely incredible.  Chumming for chumps.  This has implications that extend far beyond Russia’s dealings with OPEC.  In particular, it seriously undermines the case for a “realist” “reset” with Russia; what’s the point of negotiating grand bargains with such bald faced opportunists and liars?

I like Jeremy Grant of the FT, and his colleague Gillian Tett is a media darling right now, flogging her book on the financial crisis.  But in their article on the Geithner derivatives proposals (along with Aline van Duyn), they laid an egg.  They repeat the conventional wisdom on clearing, and the supposed benefits of forcing OTC trading onto exchanges.  Actually, it would be more accurate to say that they repeat the conventional ignorance on the subject.

They say that on exchanges “[t]rades are then ‘cleared’ on a central platform, which completes a deal even if one counterparty collapses.”  Similarly, they say that in OTC markets, “[t]hat means in many cases there is no centralised system to monitor prices or deals nor any third party to ensure a trade is completed if a counterparty fails.”  These quotes suggest that counterparty risk does not exist in a cleared market like it does in an OTC market.  This is wrong, because the clearinghouse can fail.  More to the point, given the size of the position of a defaulting party, clearing only affects the allocation of losses, not their total amount.  Now, this allocation can be superior, but not necessarily so.  But I grind my teeth at the suggestion that clearing magically makes default risk disappear.  

This also has implications for systemic risk.  In a cleared market, the default risks are borne in the first instance by clearinghouse members, who are typically systemically important banks.  Clearing can actually concentrate and increase the counterparty risks that these systemically important banks bear.  This point is seldom made, but it is important.  Grant, Tett and van Duyn overlook it altogether.  

Most egregiously, they say this:

The proposals Mr Geithner, Ms Schapiro and others have unveiled try to tackle these problems in four ways. First, they demand all “standardised” derivatives are  centrally cleared to remove counterparty risk, even if they are not traded on an exchange.  [Emphasis added.]

No. No. No. NO!  Clearing DOES NOT REMOVE COUNTERPARTY RISK.  The three FT reporters should be sentenced to write that sentence over and over again on a blackboard, Bart Simpson-like, until they get their minds right.  Moreover, to atone for this, the FT should be required to devote an entire front page consisting entirely of “CLEARING DOES NOT REMOVE COUNTERPARTY RISK” in headline-sized type.  

Again.  Clearing redistributes the losses arising from counterparty default.  It does not remove it, or make it magically disappear.  What’s more, it does so in a way that can reduce efficiency, and increase systemic risks.  

Sheesh.  Grant et al state: “A public debate about derivatives is long overdue.”  I agree.  It would be nice if that debate would be based on a thorough, fact-based, understanding of the actual tradeoffs involved in clearing and exchange trading.  Instead, this article just recycles the same old bromides.  

The article does the service of quoting this gem by new SEC head Mary Shapiro (which I had wanted to call attention to when I saw it last week, but got distracted):

As Mary Schapiro, chair of the Securities and Exchange Commission, says: “OTC derivatives, particularly credit derivatives . . . contributed to the financial mess we are cleaning up today.”

Just how did they contribute?  Yes, like the Treasury letter, you can point to the OTC posterchild, AIG, but that would be incredibly dishonest (as it was when Treasury did it).  It is dishonest because the type of contracts AIG traded would never be cleared, and never traded on exchanges, and hence would be/have been unaffected by the Treasury proposal.  But although credit derivatives have been accused over and over again of contributing to the financial crisis, the type of products that would be affected by the Treasury proposal are conspicuous by their absence from any honest accounting of culpability for the crisis.  

This only goes to show that Mary Shapiro’s replacing of the execrable Chris Cox has not increased the intelligence or market knowledge at the SEC.  And that is a very scary thought.

I was quoted in today’s WSJ:

Companies could try to skirt the regulations by creating new contracts that are similar but not identical to clearable trades.

“People will see where the lines are…[and] devise products that fall outside the scope of this particular regulation and that particular regulation,” said Craig Pirrong, a finance professor at the University of Houston.

The Treasury Department says that clearinghouses need to ensure that “customized OTC derivatives are not used solely as a means to avoid” clearing.

Regarding the sentence following my quote.  As I noted in my post on the proposed Treasury regulations, the clearinghouses are not in a good position to monitor the use of non-cleared products, due to their lack of information, and perhaps more importantly, their conflict of interest in seeing more business come their way.  Although the WSJ article accurately characterizes the Treasury’s position, so much the worse for Treasury.  It suggests a serious failure to think things through.

If they decide to prevent the use of customization to circumvent the clearing requirement, as it almost certainly must if the clearing mandate is to survive, Treasury and Congress will require a regulator to enforce the circumvention ban.  This would require an incredibly intrusive regulator, evaluating the design of every contract, and the intent behind it.  I can state almost categorically that no regulator has or will have the information, expertise, or ESP required to do this.  Moreover, this will just throw us back into the days of pre-CFMA requirement that all “futures” be traded on exchanges.  Not a good thing.  This created regulatory uncertainty, legal ambiguity, and served to protect the interests of exchanges.  One can only imagine the Talmudic inquiries that would be involved in determining whether a particular derivative is, or should be cleared, or was designed to escape a clearing mandate.

Regulators–or clearinghouses serving as their agents–should not be in the position of intervening so intrusively in the contracting decisions of derivatives markets participants.  Such intrusion will raise transactions costs, and interfere with the efficient allocation of risk in the marketplace.  What’s more, there is no reason to believe that this interference will reduce systemic risk.  Indeed, it could well increase systemic risk.

I’ve written about the hard-to-explain behavior of oil prices and stocks.  But oil isn’t the only commodity around, so I thought it would be worthwhile to look at some others to see whether their behavior may shed light on which version of the “green shoots” theory their behavior supports–the green shoots of a recovery in output, or the money-is-green version that the price rises are a harbinger of inflation.

The best data on prices and especially stocks for industrial commodities is available for non-ferrous metals.  Here are the comparisons (all data from the LME):

• Copper 3/2/09.  Cash: $3329, 3 Months: $3355, Stocks: 530,875 MT.
• Copper 5/13/09.  Cash: $4507, 3 Months: $4530, Stocks: 373,750 MT.
• Lead 3/2/09.  Cash: $1160, 3 Months: $1166, Stocks: 60,750 MT.
• Lead 5/13/09.  Cash: $1450, 3 Months: $1440, Stocks: 73,500 MT.  
• Nickel 3/2/09.  Cash: $9602, 3 Months: $9607, Stocks: 99,378 MT.
• Nickel 5/13/09.  Cash:  $12450, 3 Months: $12545,  Stocks: 111,648 MT.
• Primary Aluminum 3/2/09.  Cash: $1270, 3 Months: $1310, Stocks: 3,243,900 MT.
• Primary Aluminum 5/13/09.  Cash: $1428, 3 Months: $1521, Stocks 3,880,325 MT.
• Tin 3/2/09.  Cash: $11,047, 3 Months: $10702, Stocks: 9,140 MT.
• Tin 5/13/09.  Cash: $13,890, 3 Months: $13,615, Stocks: 13,405 MT.
• Zinc 3/2/09.  Cash: $1078, 3 Months: $1104, Stocks: 355,500 MT.
• Zinc 5/13/09.  Cash: $1430, 3 Months: $1475, Stocks: 322,025.

Note that the prices of each commodity have risen.  Depending on the metal, the rises have been between about 15 percent and 40 percent.  For some of the metals, spreads have narrowed.  For instance, the contango in copper has decreased, as has that of lead (which has gone from contango to backwardation).  For aluminum, however, the spread has widened, as it has for zinc (though not in percentage of the spot price).  

Interestingly, lead, nickel, tin, and especially aluminum stocks have increased; stocks for copper and zinc have decreased, especially the former.  Aluminum is of special interest, as this is a major industrial commodity, and is highly sensitive to industrial uses (e.g., in autos).  

Overall, the story is quite mixed.  Copper suggests bullish fundamentals: a sharp rise in price and a pretty steep fall in stocks.  But, overall, the stocks data give no evidence of a near term strengthening in demand that would explain the price rises across all metals.  Note the rise in aluminum price and the contemporaneous nearly 20 percent increase in stocks.  Hardly a signal of a rebound in industrial demand.

There are two interpretations consistent with the data: (1) spot demand remains low, but demand is expected to pick up in the future, and (2) real spot demand remains low, future real demand is expected to remain in the doldrums, but prices are being buoyed by expectations of a possible inflationary burst (i.e., the money is green version of green shoots).  

Even the copper data, and perhaps data from the oil market, are potentially consistent with (2).  It is widely reported that China is stockpiling copper and oil.  Indeed, some of the copper stocks decline may be a mirage as copper is merely being transferred from LME warehouses to Chinese strategic stockpiles that are invisible to the market, rather than being consumed.  This could reflect a Chinese substitution of dollars/dollar denominated assets into real assets such as copper (and perhaps oil) due to their fears about the US dollar and inflationary pressures in the US.  That would be consistent with the inflationary expectations story, and indeed, a channel by which these expectations influence current prices.

If I had to choose between (1) and (2)–between an anticipated increase in future real demand and an anticipated increase in nominal demand due to inflationary pressures–I guess I would choose (2).  Suffice it to say that although I’m not metaphysically certain as to which explanation is right, the data do not contradict the inflationary expectations story.  Moreover, the future demand/spot demand story is not that convincing.  Anticipation of future demand should lead to an increase in current demand, but that is not being reflected in stocks.  

With stocks largely signaling weak real demand (especially when one considers that the copper stock drawdown may not reflect an actual increase in copper consumption), but prices rising, there is a very good chance that metals prices are in fact a harbinger of inflation.  In his speech at the Atlanta Fed conference on Tuesday, John Taylor suggested that the Fed may not have much time before it has to decide whether to switch gears and fight inflation.  The metals data support that suggestion.  Indeed, if China’s actions in the copper market reflect a substitution of real stuff like the red metal for dollar denominated nominal claims, rather than a real need for the commodity, the time for choosing may be coming much more quickly than is conventionally believed.

Just sayin’.  Or, perhaps I should rephrase that: Just the metals market sayin’.  Listen up, Chairman Bernanke.