A Warning

In Basel, Switzerland. there is an international institution, founded in 1930 with a mandate to administer the reparations imposed on a defeated Germany by the Treaty of Versailles. Since then, the Bank for International Settlements (BIS) has evolved dramatically, from being nearly dissolved after WWII (technically, it was) on (strong) allegations that it facilitated looting of occupied countries, and Jews, by the Germans, to the point today where it is the central bank to sixty of the world's central banks - a sort of clearing-house for their views - answerable to no single national government.   

Yesterday, in its 83rd Annual Report, the Bank issued a warning which, unlike some past annual analyses (the Canadian, and then chief economist at the BIS, William White, famously suggested just before the financial crisis of 2008 that excessive credit growth was creating bubbles that would inevitably burst), should not be seen as a lonely voice. The Bank's essential theme this year is that, while countries' monetary policy stimulus has so far prevented an economic collapse equivalent to what occurred in the 1930's, there is a clear limit to what such policy can achieve. Central banks have bought time for governments. But it is those elected governments that now must put public finances back on a sustainable path, not just by short-term austerity, but, more importantly, by addressing long-delayed structural reforms in, for example, their labor and agricultural markets, by exerting control over health and pension expenditures, by deregulating small business, and re-vamping tax codes - all with a goal of re-igniting productivity and thus potential output. Indeed, the Bank noted, loose monetary policy is becoming counter-productive. It's allowing governments off the fiscal hook - through very low costs of financing deficits - and the longer it is in place, the harder it is to draw it back. (A case in point - Chairman Bernanke's mere signal last week that the Fed's current program of quantitative easing could slow later this year has contributed - along with China's clampdown on credit - to a world-wide sell-off of equities and a jump in long-term bond yields.)

Structural reform of developed economies is a long-term project, politically difficult, that cannot be expected to reap quick dividends. But it can lead to dramatic change - witness, for example, the recent German experience, known as "Agenda 2010", begun in 2003, when Chancellor Schroder introduced a set of sweeping regulatory, tax and labor reforms that over the past decade have restored the German economy's competitiveness, and its manufacturing and export prowess. Japanese Prime Minister Abe is now attempting a similar restoration (the subject of tomorrow's blog). Yesterday's sermon from Basel is a timely inspiration for Mr. Abe, and his counterparts in many other developed countries.

That Red Line

President Obama is talking today and tomorrow with leaders of the G8 group of countries, meeting in Northern Ireland. No doubt Syria in particular will be on his mind. 

Now that he is finally convinced that chemical weapons have been used against Syrians by the Assad regime (which for months Obama defined as a "red line"), and given his announcement late last week that America is prepared to do more, giving "military aid" to the Syrian rebels for the first time in the 27-month civil war, President Obama is likely to be especially interested in learning the nature of, and the extent to which, British Prime Minister Cameron and French President Hollande, both of whom have previously expressed strong desire to provide more help to the rebels, would like to be involved. He is also consulting with Vladimir Putin. Russia, which has a strategic interest in maintaining its only Mediterranean port - which is in Syria - has been supplying arms to the Syrian army through much of the conflict, and just last week Putin sharply criticized Obama's plan to ship weapons to rebel forces.

Already there are hints about how the Western leaders want to proceed. Prime Minister Cameron, who met Putin privately in London on Sunday, the day before the G8 summit began, issued a blunt assessment today. It seems the private Sunday meeting  didn't go all that well. Cameron noted that Russia must push the various Syrian factions to the negotiating table, not support a government that slaughters its citizens. Said Cameron: "The Syrian people must have a government that represents them, rather than a government that's trying to butcher them. We shouldn't accept that the only alternative to Assad is terrorism and violence. We should be on the side of Syrians who want a democratic and peaceful future for their country and one without the man who is currently using chemical weapons against them".

Whether Russia will support Cameron's call for peace talks will become evident this week. Such a u-turn is very unlikely. Indeed, there was an ominous sign over the weekend that further escalation of the Syrian conflict is the more probable development. Iran, Russia's proxy in the Middle East which all along has supported the Assad regime, announced that it will send 4,000 Iranian troops to Syria to fight with the Syrian army, joining Hizbullah forces (the Lebanese Shia party-cum-militia), likewise supported by Iran, already in the country. The Syrian, Sunni rebel forces may thus well need much more than just American/British/French-supplied light arms and CIA training on how to use them.

President Obama's prolonged shunning of American intervention in Syria would appear to be over. But what, and how much, to do next certainly continues to be debated intensely in Washington, with the legacy of Iraq still very much on the minds of many. All options are fraught with risk, in a context where a full-scale Sunni/Shia, Persian/Arab conflict involving many Middle East governments, including Israel, may now be developing in Syria. With 93,000 documented deaths(according to UN statistics) since the war began, at least 1.5 million Syrians having fled, with the country overrun by warring factions, and towns, cities and infrastructure in ruins, it is fair to ask if America and its allies have waited too long.

An Upgrade, Federally; A Further Shock, Municipally

America's credit rating received a boost today. Standard & Poor's (S&P) revised its credit outlook on U.S. sovereign debt to stable from negative, though it left the actual rating at AA-plus. (In August 2011, the credit-rating agency had lowered the rating from the highest AAA, to AA-plus, the second highest, and reiterated its negative outlook.)  The two other major agencies, Moody's and Fitch, have all along left their ratings at AAA, but also assigned, and still maintain, a negative outlook.

In a world awash with unprecedented annual government budget deficits, and levels of sovereign debt accumulated over decades that in some cases exceed the total value of a country's gross domestic product (Japan's public debt, for example, is equivalent to 250% of its GDP), this credit upgrade is a bit of good news. It reflects a rapidly shrinking U.S. federal budget deficit, from those in each of the past four years that exceeded $1 trillion, to the most recent estimate (from the bi-partisan Congressional Budget Office) of $642 billion in the fiscal year ended September 30, 2013 (see the accompanying chart). Measured as a per cent of GDP, the deficit improvement is considerable, dropping from 10% in 2009, the deepest point of the recession, to the 4% now projected for this fiscal year. The ongoing budget battles since 2011, between Republicans and Democrats in the Congress, have led to several piece-meal deals that managed to reduce the budget deficit through higher taxes and spending cuts. And, at least as importantly, America's economy is growing again, albeit slowly, a potent force as it increases the tax base and hence tax revenues.  

But this good news is of a very short-term nature. There is concern that the improving deficit picture, happening now and forecast by the Congressional Budget Office (CBO) to continue over the next 2-3 years, has virtually stopped bi-partisan talks to reach a 10-year fiscal "grand bargain" under which long-term entitlement spending (Social Security, Medicare and Medicaid) would be set onto a sustainable path. This is why the CBO projections indicate a resumption of increasing deficits beginning as early as 2016. Total federal debt would thus likely remain above 70% of GDP at least over the next decade, compared with an average of 39% over the past 40 years. "Such high and rising debt later in the coming decade would have serious negative consequences", the CBO said. U.S. financial markets apparently agree, barely budging today on the news of the S&P outlook upgrade.

There is additional news of a credit nature, coming this week, pertaining to municipal debt. Detroit's Emergency Financial Manager, Kevyn Orr, is expected to provide an update of the city's financial position, and leaked reports suggest that he will ask bond-holders and pension recipients to accept pennies on the dollar as the only way to avoid a formal declaration of municipal bankruptcy. Orr’s initial report last month found that Detroit’s cash-flow crisis makes it “insolvent” and unable to borrow more money to offset debts being made worse by skipping millions in payments for retiree pensions and health care. Protests are expected in Detroit.

Evolving, in Singapore

Yesterday's blog, updating political and economic developments in Egypt, struck the theme that that country's Arab Spring, supposedly a period of transition from many decades of dictatorship, has so far been about social disruption, political muddling and a sinking economy.  Meaningful transition, with the emergence of private sector investment, innovation, productivity growth, and employment opportunities for the young, has yet to start. With more time, perhaps this process will be ignited.

There are, of course, economies that have transformed themselves in the past century, sometimes relentlessly, and so successfully, that they have arrived at an inflection point, where what has worked needs significant tweaking. China, and the countries of South-East Asia, are the obvious examples, where decades of economic growth have lifted hundreds of millions out of extreme poverty. Arguably one of the most dramatic transitions has occurred in Singapore, the city-state of 5.3 million people that a hundred years ago was a regional port, but otherwise little more than swampland and rain forest inhabited by opium gangs, prostitutes, fishermen, and an English elite. Today, after decades of a one-party, one-family political dynasty that conducted itself as though it were a corporation (Singapore is by no means a liberal democracy, and the press and internet are tightly regulated), Singapore's per capita income is some $60,000, ranking it as the third-richest economy in the world (after Qatar and Luxembourg). In the World Bank's "Doing Business" report for 2013, Singapore once again tops the world rankings, on the basis of such things as overall ease, the cost and time involved in starting a business, and the strength of legal institutions. Visiting the city leaves one with an impression of gleaming, premium hotels and shopping facilities, ultra-clean and very orderly streets, and elaborately-conceived gardens, parks and island resorts. A sense of energy, entrepreneurship and innovation pervades.

This "Singapore model" is well-known.  But the interesting story today is about the adjustments to the model that are now required, and that are being conceived and implemented with typical vigor by Singapore's policy-makers and business leaders. As a deliberately open economy, with few natural resources of its own, and thus dependent on financial services, and on the process of importing raw materials and transforming them into finished-goods exports, the global recession of the past several years has slowed Singapore's growth dramatically - GDP barely expanded in 2012 and in the first quarter of this year, and is not expected to increase much more than 1-3% for all of 2013. (Growth in Singapore averaged in the high-single digits over the past several decades.) But with huge trade, current account and budget surpluses, and international reserves, Singapore is comfortably positioned to foster the next phase of its expansion thrust - research and cutting-edge science and technology development. At the center of this strategy is the massively-funded Research, Innovation and Enterprise Council, headed by Prime Minister Lee Hsien Loong himself, and charged with the responsibility of seeking investment in Singapore from the world's multinational corporations, especially the knowledge-based ones. Success so far is impressive. Thus, for example, drug giant Roche is researching cancer and infectious disease treatments in Singapore, China's Baidu is developing language-processing technologies focusing on South-East Asia languages, France's Danone is creating new child nutrition products, America's Procter & Gamble is developing new health-care products for Asians, and Denmark's Vestas Wind Systems is establishing a technology research facility. Smaller multinationals, such as Canada's Sustainalytics, which focuses on environmental, social and governance services for private corporate clients, have also opened Singapore offices.

Singapore's model-tweaking can be summed up in a single phrase - moving up the value chain. As this process unfolds, the country will continue to exploit its existing comparative advantages, for example, in providing off-shore financial services especially to the rapidly growing segment of wealthy Asians. Taken together, these strategies are the very definition of constructive transition. 

Re-Shuffling and Muddling, in Cairo

Fundamental transition, politically and economically, is a long process that is often choppy, at best. Describing Egypt's Arab Spring - that is, its transition since the overthrow of Hosni Mubarak in 2011 - requires some adjective other than "choppy". Indeed, it's fair to question whether constructive transition of any sort is occurring.

Egypt has been negotiating, on and off, with the International Monetary Fund (IMF) to obtain a $4.8 billion loan (in IMF parlance, known as a Stand-By Arrangement) for close to two years, with an agreement in principle reached in November 2012. But over the past several months, President Morsi's government has stumbled repeatedly in trying to convince the IMF that it can and will introduce the austerity measures needed to control the country's massive and growing budget deficit, now estimated at over 11% of GDP in the current fiscal year.

Yesterday, in yet another hopeful declaration from the government, Egypt's Prime Minister, Hesham Qandil, said that Egypt and the International Monetary Fund (IMF) "agree" on the measures needed to address the fiscal gap (including raising taxes and cutting fuel and food subsidies), adding that "there are no differences between the two sides on the procedures to be adopted, but rather on the timing of their application". This is a spin if ever there was one. Egypt's government is nearly dysfunctional, sorely lacking in economic expertise, especially following yet another re-shuffle of the cabinet at the beginning of May. Egypt's new Finance Minister, for example, is a university academic who has spent most of his career studying questions of Islamic finance, with virtually no international market experience. In all, nine key ministers were replaced, thereby actually increasing the influence of the Muslim Brotherhood at a time when a large and vocal portion of Egyptian society is striving for more secular representation. Moreover, two of the ousted ministers had played central roles in the IMF negotiations, adding to the confusion already created late in April when the lead Egyptian negotiator, the first deputy finance minister, resigned, apparently also under pressure from the Muslim Brotherhood.

Egypt's foreign exchange reserves are critically low, sufficient to cover not even 3 months' imports, and its currency continues to drop against those of its trading partners, notably the US dollar. The country's ability to buy wheat, for example, of which it is the world's biggest importer, or fuel, is compromised. The IMF's Stand-By facility is clearly urgently needed. But President Morsi's government's ability to convince the IMF that it really intends to implement difficult economic reforms is doubtful. The country is likely to struggle on for the rest of the year without the loan, or at least until the parliamentary elections in the fall, somehow coping with a summer of worsening fuel and food shortages, power cuts, a dearth of foreign investment and tourism - and domestic unrest.