Infrastructure, Politics and Energy Markets

The Obama administration's approval for the construction of the $5.4 million TransCanada Corp. XL pipeline, an extension that would deliver more Alberta crude oil to refineries on the U.S. Gulf Coast, has once again been delayed, as it has several times over the past six years. The State Department said last week it would push forward a decision, until next year at the earliest, an obvious stalling tactic that perhaps has just a bit to do with the upcoming mid-term Congressional elections this November.

In the short term, this is yet another blow to TransCanada Corporation. It's a boost to environmentalists, who, in their belief that oil sands development in Alberta must be stopped, seem quite willing to ignore the geopolitical advantage of enhancing North American energy production, thereby reducing dependence on supply from Mid-East countries. TransCanada's stock sold off, by nearly 4%, immediately after the announcement of this latest delay, but investors are hardly fleeing, perhaps recognizing that the XL investment, while significant, accounts for just a seventh of the $38 billion TransCanada plans to spend on capital projects over the remaining half of this decade.

The argument that halting construction of the XL extension would somehow stop, or at least restrain, both the development of the Canadian oil sands and the ongoing integration of North American energy markets is, simply, laughable. Even the State Department saw this when it released its final environmental assessment report earlier this year. TransCanada Corp., and other Canadian energy companies, are already producing and transporting ever-increasing quantities of Canadian natural gas and heavy crude oil into America via an existing maze of pipelines and rail lines throughout the continent, including those in Mexico. Recent trade data tell a genuinely dramatic, transformational story now well underway: Canada’s exports of crude oil and products hit a record 3.4 million barrels a day in the first quarter of this year – even as surging U.S. domestic oil production reached its highest level in 25 years. Further, while U.S. oil production has jumped almost 50 per cent since the middle of 2011, Canada’s shipments into the U.S. have risen by more than 30 per cent. And here's the offsetting, geopolitical kicker: the Organization of Petroleum Exporting Countries (OPEC) is losing its once-powerful grip on the U.S. energy market, and on American diplomacy -  in the past six years, OPEC’s exports to the United States have declined by nearly 50 per cent. In short, OPEC is being left behind as Canada, and American shale oil, fill the gap.

So, the Obama administration can go on indulging itself, fecklessly throwing around the political football called the XL extension, as much as it feels it must. Let the politics and pandering play out, however blatantly and unproductively. TransCanada Corp. will nonetheless thrive over the next many years, with or without the XL extension. And as long as fundamental energy market forces continue to exert their influence, the foreign policy of the next administration in Washington will be far less constrained by excessive reliance on OPEC oil, and by the concomitant excessive sensitivity to the political vagaries of that region.

Getting Ahead of Themselves

Investors' unrelenting quest for return, wherever in the world they can find it, has led some away from the US debt markets, where yields on even longer maturities have once again fallen well below 3%, and where the prevailing strong sentiment is that any further significant rise in bond prices is unlikely.

In recent months, they have turned their attention to the European continent. A sense that the worst of the sovereign debt crisis is over, and that even the weakest of the euro economies - along the fringe of the Mediterranean - are stabilizing, underlies a return of capital into these governments' debt markets. There is no clearer example of this trend than Greece, the country that at the depth of the debt crisis was forced to give up even trying to issue new bonds after their prices fell so far that yields exceeded 40%. On April 10 this year, Greece returned from its bond exile and sold 3 billion euros of 5-year notes to yield 4.95%, an offering that was some seven times oversubscribed, and whose yield has subsequently dropped even lower, to 4.75%, as demand has further boosted the notes' price. The Bloomberg Bond Indexes show that Greek bonds provided the highest returns year-to-date among more than 30 sovereign debt markets. And other periphery euro countries are experiencing similar demand for their debt. Thus, Portuguese 10-year securities were sold this week (for the first time since 2011) at an average yield of 3.575%, compared with a peak of 18.3% at the beginning of 2012; the government is planning on regaining full market access by next month, when its euro rescue program from the EU and the IMF ends. Spanish and Italian yields have likewise dropped to 8-year lows.

But there is a real question regarding the sustainability of this debt rally. Investors who are bidding up European bond prices seem to be focusing on the improvement in euro-government annual budget deficits. These have indeed fallen substantially. Data released today by Eurostat, the region's statistical agency, show that for the euro area as a whole, the government budget deficit to GDP ratio fell to 3.0% in 2013 from 3.7% in 2012. Of course there is considerable fragmentation between countries, with annual deficits in the periphery countries still well above 3%, although even here, the trend in most cases is sharply down from earlier years. But other figures from Eurostat also released today suggest that Europe's debt crisis is far from over. Overall outstanding debt levels continue to rise, from extraordinarily high levels. Thus, the total debt to GDP ratio in the 18-member euro area increased from 90.7% at the end of 2012 to 92.6% at the end of 2013. And the picture for the periphery countries is even more stark: Greece's debt ratio was 175.1% in 2013, compared to 157% in 2012; Ireland's debt ratio jumped from 117.4% to 123.7% over the same period. Even the debt burden of some of the region's larger economies (except Germany) is growing: the level in France grew from 90.6% in 2012 to 93.5% in 2013.

The danger here is that with massive and still growing debt levels, but with suddenly renewed access to the debt markets, governments especially in the periphery euro countries will have much less incentive to continue with fiscal policy discipline - always politically unpopular - and instead fund any shortfalls through more borrowing. They may even feel less compelled to initiate the long-term reforms of their labor markets and tax regimes so essential to the resumption of productivity and overall economic growth. In this case, it's easy to envisage another decade in Europe of sluggish growth at best - with little or no improvement in double-digit unemployment rates - and of debt levels which at some point once again become unsustainable.

No Intifada This Time

Just as diplomacy at the highest level - between Presidents Obama and Putin, and between Secretary of State John Kerry and his Russian counterpart, Sergey Lavrov - has so far failed to defuse the crisis in Ukraine, so it is also failing in yet another quest to bring the Israelis and Palestinians into a formal peace settlement.

Secretary Kerry announced late last summer that his aim was an Israeli/Palestinian "final status agreement" within nine months, that is, the end of this month. A two-state solution would be the outcome. It is clear now, despite nearly frenetic effort, that this was indeed a grand ambition. Mr. Kerry himself now admits that reaching even a "framework agreement", requiring several more months, will be difficult. At this point, any agreement risks ending up being so vague as to be meaningless - at best, broad principles may be endorsed by both sides, but negotiations are suggesting that an agreement would have to include language allowing either party to express "reservations".

That a meaningful settlement is proving so intractable should come as no surprise, given not just the long history of enmity between the two sides, but also the massive gap between the Israeli and Palestinian political economies. On the one hand, Israel is a thriving democracy, with a GDP per capita, at $37,000, some 12 times that of its largest Arab neighbor, Egypt, and far higher than most of the other Arab states and even most EU countries'. Its economy is growing above 3% annually, unemployment is below 6%, inflation is under 2%, its current account balance of payments is strongly positive, and its currency is appreciating against the US dollar. Notwithstanding the ongoing concern with Iran's nuclear program, Israel militarily feels reasonably secure, with only a remote prospect of a third Palestinian intifada (uprising) equivalent to that between 2000 and 2005. Prime Minister Netanyahu is virtually unchallenged politically (even though a majority of Knesset members in his ruling coalition and most government ministers are against or lukewarm towards the two-state solution, outwardly endorsed by Mr. Netanyahu). From this position of strength, he has felt comfortable moving beyond his predecessors in setting Israel's demands: for example, he does not agree that Jerusalem should be shared between the two states, he is allowing the resumption of aggressive expansion of Jewish settlements in the West Bank, and he is asking that prior to formal negotiations the Palestinians state their willingness to not only recognize Israel (as the Palestinian Liberation Organization - PLO - did back in 1988), but to define it as a specifically Jewish state.

The Palestinians, on the other hand, negotiate from a much weaker starting point. Their economy can be described in one phrase - on the verge of collapse. And they are politically divided, with PLO leader Mr. Abbas regarded by his own people as a weak and even illegitimate leader of the parts of the West Bank that Israel allows him to govern. At 79, he is being challenged by a much younger Muhammad Dahlan who has courted and received the support of some Gulf states. And Mr. Abbas has no authority at all in the Gaza Strip, where the Islamists of Hamas rule and regularly denounce the PLO. And even if there were one strong Palestinian voice, it would hardly be ready to accept Mr. Netanyahu's additional demands, given the concessions already granted by the Palestinians over the years regarding especially  the 1967 border, and agreeing to talk without a settlement freeze.

Secretary Kerry and President Obama are clearly still pushing for a two-state solution, and even seem to be blaming Israel for the fizzling of the current talks. But with Israel strong, and the Palestinian movement weak and divided, and with scant support from its Arab brethren, it is difficult to imagine how American pressure can push both sides to a "final status agreement".

A Victory for Democracy

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Afgans went to the polls yesterday to elect a new President. Vote-counting is underway; it may be days before the result is clear, and it is widely thought a further run-off election on May 28 will be required, given the splitting of the vote among the eight contenders. But any one of the three front-runner candidates - Abdullah Abdullah, a former foreign minister who nearly won the last election in 2009, Ashraf Ghani Ahmadzai, an academic, a former finance minister and World Bank official, and Zalmai  Rassoul, also a former foreign minister - will be better than the mercurial Hamid Karzai, Afghanistan's outgoing President. More on this in a moment.

The remarkable story is that the election occurred at all. In the week leading up to Saturday's vote, escalating,Taliban-inspired violence in Kabul and throughout the country necessitated the deployment of thousands of Afghan security forces at strategic buildings and mosque squares; hundreds of new checkpoints were set up, and thousands of vehicles were searched. Twenty-two tons of explosives and six landmines were seized in Takhar province before they could be used for bomb attacks at polling stations. Nonetheless, suicide bombers struck relentlessly, and many civilians were killed. Even the final candidates' debates scheduled to be televised last week had to be cancelled. Yet, in such an environment, voter enthusiasm could not be diminished - reports emerged of Afghans spending hours, even days, lining up to register to vote, triggering a last-minute rush for voter cards by citizens, many of whom had never voted in previous elections. Voter turnout hit a record, even though several polling centers could not open because of gunfire and rocket attacks. Stations ran out of ballots, and most were forced to remain open an extra hour. An estimated 7 million Afghans - men in traditional tunics and loose trousers and, notably for Afghanistan, some 2 million women, many clad in burqas - showed up, stood in segregated lines, often in the rain, and voted. The turnout ratio, at nearly 60 per cent of eligible voters, exceeded that of the last presidential election in America. Mindful of the widespread fraud during Karzai's re-election in 2009, electoral officials insist the extra measures they've taken this time - bar codes on the ballot boxes, for example - will prevent vote-rigging.

President Karzai is leaving office - he is constitutionally barred from running for a third term - at a time when America is withdrawing its combat troops, and when the Taliban still command support and sympathy from an estimated third of the population (mostly Pashtuns and others living in rural areas). He has refused to sign a security agreement with the United States which would maintain a US troop presence after 2014 - apparently to mitigate his image as an American puppet. Yet the country remains, at the very least, fragile. A new President will step into an economic and political environment of endemic poverty and official corruption - Transparency International ranks Afghanistan with Somalia and North Korea as the three most corrupt countries in the world - which Karzai has been impotent to change. It is reasonable, therefore, to ask whether the new President - even if more competent and honest - can contain a Pakistani-supported Taliban, with or without American assistance, and spark an era of economic development so crucial to the employment of the Taliban's biggest source of recruits - disaffected youth.

Afghanistan's election demonstrates a yearning for, even a faith in, representative government, moreover under extraordinarily difficult circumstances. This is a victory. The challenge for the new President will be to ensure that this outpouring by voters will be more than just a flare of hope, such that it develops into a functioning, sustainable movement that establishes individual rights and democratic institutions, and a President who respects both.

G-SIBs

Readers of this blog will be well aware of the role played by the International Monetary Fund (IMF) in assisting countries facing balance of payments and fiscal crises. Active since its creation in 1944, it has been particularly involved in the wake of the financial turmoil that followed the collapse of Lehman Brothers in September 2008, providing loans to near-bankrupt countries (both emerging and developed), conditioned on the implementation of economic plans that focus on reductions in public sector deficits, and on structural reform, usually with the goal of reducing labor market rigidities and enhancing tax collection methods. Most notable of these have been the programs advanced in Greece, Portugal, Ireland and Cyprus, in partnership with the European Commission and European Central Bank (the so-called "Troika"), but assistance has also been advanced recently to Pakistan, and offered to Egypt where the disbursement of funds is still waiting on a government willing to, and capable of, implementing the Fund's conditions. And just yesterday, speaking in Washington, Managing Director Christine Lagarde indicated that the Fund has $18 billion ready, and is leading a $27-billion global bailout for cash-strapped Ukraine, an example, as Ms. Lagarde noted, of "international (read "western") co-operation in action".

In addition to this role of global firefighter and lender, however, the Fund is a think-tank powerhouse, packed with economists regularly issuing scholarly papers on a range of economic issues. One of these, reported on by the Fund frequently in recent years and again just this month, has been the issue of "too-important-to-fail" (TITF) banks, alternatively referred to as "globally-systemically-important-banks" (G-SIBs). These are the institutions whose scale, complexity, and interconnectedness have made them difficult to manage and supervise, especially since the onset of the financial crisis in 2007, but too significant to world financial stability to permit their failure. Required fiscal expenditures to finance distressed SIBs have been substantial, but immediately forthcoming, leaving little doubt about governments' willingness to bail them out.

But as the IMF authors point out, such developments have, indeed, reinforced incentives for these banks to become even larger - and more complex - with the result that in many countries, the banking sector has become more concentrated. This is illustrated in the schematic below:

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It is true, the authors note, that these banks have been repairing their balance sheets, and policymakers have introduced broad-ranging financial reforms (such as the Dodd-Frank Wall Street Reform and Consumer Protection  Act in America). Nonetheless, the IMF concludes that "the expected probability that SIBs will be bailed out remains high in all regions". Or as Mark Carney, Governor of the Bank of England and Chairman of the BIS Financial Stability Board, said in October 2013, "the expectation that systemically important institutions can privatize gains and socialize losses encourages excessive private sector risk-taking and can be ruinous for public finances...Firms and markets are beginning to adjust to authorities' determination to end too-big-to-fail. However, the problem is not yet solved".

So, seven years into the worst financial crisis since the Great Depression of the 1930's, we are still dealing with the TITF quandary - impossible to ignore and difficult to resolve.