Saturday, 21 January 2012

Merkozy v Cameronti

 Prime Minister Monti’s visit to the UK was a breath of fresh air. Gone were the winkles to pretty girls and glances to female backsides, in were clear speeches in excellent “international” English, delivered to a selected audience at the London School of Economics as well as investment bankers gathered in the London Stock Exchange. Mr Monti was on a roadshow to explain its economic reforms to the investors that would pay Italy’s bills in the coming years  and affirm his country’s commitment to stick to these plans. He spent time with Prime Minister Cameron discussing not only a backstop to the financial blows that Italy will face after the forthcoming Greek default, but also EU-wide growth measures dear to both UK and Italy, particularly full liberalisation of services. Then, Professore Monti rushed back to Rome where he will play host to both Ms Merkel and Mr Sarkozy. The contrast between the sober ex – EU Commissioner for competition, now a respected although unelected technocratic prime-minister and the vivacious Mr Berlusconi, the longest – serving Head of government in post war Italy, could not be starker.
Clearly, it’s not just appearance. In addition to heavy austerity measures that add up to well over 3% of his country’s GDP, Mr Monti launched a direct attack on tax evasion, labour market inefficiencies and mini-monopolies of various professional categories. His recent measures are aimed at liberalising parts of Italy’s ossified economy, particularly in the services market. Italy also implemented a rare pension reform which, hard to find elsewhere, creates a legal link between the retirement age and life expectancy.
Professore Monti looked very much like that species of Italian aboard that I came to observe in my life as an investment banker and were so different from what one could see in the ruling classes in the country’s recent history. Smart, sophisticated, very, very well educated (with a wonderful blend of classic education, Dante & all, plus excellent economic or technical literacy), professional and very good at their job. Many left Italy because their dream job, with commensurate pay, was in the City, or because they were not “raccomandati”, i.e. did not have an uncle in a senior position in one of Italy’s banks or companies. The “brain drain” from Italy is unique in the Western world and resembles that of an emerging economy. To my knowledge, most investment banks of any significance had at least some senior executives of Italian origin running their London headquarters. The contrast between these “emigranti” and Italy’s ruling class became even more perplexing during the absurd Berlusconi years, a heated topic of conversation at many dinners or cocktail parties in London.
British people generally like Italy and Italians. Although direct military conflict is not absent from the common history, there was never a real or perceived contest for some kind of regional supremacy. Italy was never a threat, as Germany and France were, just this wonderful place where classic education, great artists and wonderful food comes from. You can’t get mad on these guys!
Italy’s long absence from the European game-making machine was baffling. A founding member of the enlarged Europe (think Treaty of Rome), one of the four largest countries and economies of the continent, together with the UK, Germany and France, Italy was always supposed to be at the forefront of decision making. Always conscious of their role and very attentive to what they call a “bella figura” (make a good impression), Italians tried to reaffirm their importance by comparing themselves with the other three. A big deal was made over 25 years ago with the “sorpasso”¸ when a growing industrialised economy and favourable exchange rates powered the Italian GDP above UK’s. This was long forgotten post the 90s when, tributary to a poisoned political system and deep social and economic maladies, Italy practically became Europe’s problem child.  Over the last 15 years Italy had the fourth lowest average annual GDP growth in the world; in five of the last ten years, the economy was in recession. Had this been happening in a poor country with a weaker social fabric there would have been no other outcome than massive social unrest, violence, crisis.
However, Italy is a wealthy country with estimated per capita wealth of over €450,000, although not uniformly spread. Moreover, the combination of exceptional family ties and cohesion (“ la famiglia” is still the bedrock of Italian society) and a high informal economy helped cushion the economic hardship. The effect was, unpredictably maybe, some kind of general anaesthetic at the level of common people, who were not as dissatisfied with the country’s leadership and economy as one might have expected, did not think anything was wrong and were convinced, well into the largest economic crisis in recent history that “la crisi” won’t make it to the country’s shores.
The country’s economic decline was mirrored in its diminished political stance within EU. The Franco – German engine, rather informal at the beginning, took over and became indeed the driving force in the EU. UK was always a bit of an outsider, the eccentric crazy aunt that steps on everybody’s feet and tells things as they are, but Italy became increasingly irrelevant. Mr Berlusconi’s antics only accelerated this process, nobody really wanted him around. So we, Europeans or not, all grew accustomed to this Franco – German engine, so much so that we’ve invented a new word for it, Merkozy.
Could things be changing now? France and Germany are likely to remain the driving force within EU in the near term. However, Ms Merkel does not seem to be able to understand what Germany can do to help Europe beyond austerity and more austerity, in spite of appeals to understand that it is in her “enlightened interest” to put German and ECB balance sheet to work. Mr Sarkozy’s increasingly erratic drive and economic problems (see the diminishing credit rating) make him look more and more vulnerable in an election year. It is not at all impossible that he will be kicked out of the race in the first round and France’s next president would be the non – Le Pen candidate that makes it in the second round, probably Mr Hollande.
The EU fiscal summit at the end of last year where the UK showed some English bulldog spirit, according to an exuberating Tory backbencher, and played a different tune to the rest of EU has less real impact than many commentators make it to be. A fiscal union cum Schuldenbremse (debt break – see my posting earlier this month) is by no means agreed, the plan is exceptionally complex and needs ratification from 26 multicoloured Parliaments. It is under heavy criticism from many individual countries for going too far and from the ECB (the plan’s real supervisor) for not being aggressive enough. While the current draft plan, drawn after heavy criticism from ECB on the negotiators’ first attempt, seem to include “a centralised correction mechanism that can be triggered automatically in case of significant deviation from the agreed 0.5% of GDP agreed structural budget deficit” (according to Bloomberg) it won’t be easy to enact all those heavy, detailed provisions in national law of so many countries. Ms Merkel and Mr Sarkozy seem also to be at odds on what can really be achieved with such a plan, which is anyway a long term structure that does nothing to fight the financial crisis in the short term.
In this context, one can only rejoice at the common elements of Italy and UK’s stances. UK’s major interest in the EU is full liberalisation of services, and they are pushing this relentlessly. Mr Monti’s interests and instincts are aligned, at least on these issues. If there is ever to be a major counterbalance to the Franco – German alliance, the UK – Italy duo is the real heavyweight.
Clearly, EU’s short term priorities (including UK’s and Italy’s) are survival and a coherent response to the financial crisis. After the very likely Greek default, Italy will be the next in the line of fire, so defensive mechanisms via the IMF (to which UK would need to contribute to), ECB or German – backed Eurobonds, are now essential. Mr Monti’s political career may be very short, particularly if he is exceedingly successful at delivering the economic performance all Italians hope for, hence incentivising his political class to get rid of him and reap the benefits. Italy has never been at the forefront of economic liberalism and the current stance owes much more to Il Professore’s instincts than to the mood of the left-leaning Italian public. Long – term redistribution of power in the EU is not a priority now, but it should be on the drawing boards. There is a long, long way to a meaningful UK – Italy alternative European engine, but this would indeed be something that would change history and may bring a new political term, Cameronti.

Thursday, 19 January 2012

Natural gas, markets, politics and other bores

After the WWII,  US made a major commitment to natural gas as a source of energy. From a very small and local business (i.e. no long-distance pipe network), natural gas became a major energy source covering 25% of the US energy demand by the beginning of the 1970’ies. By that time, gas companies built an intricate network of pipes connecting high demand urban sprawls to remote gas fields. This economic and engineering development had not been matched by a similarly progressive policy, and the gas prices stayed highly regulated. As always, this means low prices to keep voters happy, but set arbitrarily and in a complex way. Politicians have generally shied away from the difficult task of convincing their voters to trade today’s low prices for a much larger but less clear multi-generational benefit. Economics suggests this is a disastrous choice that it discourages long-term investment, ultimately leading to supply constraints. As bad things come, such a bottleneck came in the exceptionally cold winter of ’76-77 and brought large scale industrial shut downs, closing of schools and major disruptions to other public services . Even the politicians found such a disaster hard to ignore and started the exceptionally difficult process of liberalising the prices, a process finalised with the Natural Gas Policy Act of 1978. Deregularisation brought predictability to a large and growing market, which in turn attracted the large, long-term investments required; gas supply never became a problem in the US, while overall reserves were fairly continuously augmented by new discoveries. Prices dropped and kept voters and businessmen alike content – there was even talk of a gas bubble at some point. The so-called bubble (oversupply) was, as it is in most cases, linked at least partially to the half-measures produced by the US legislators. Price deregulation did not mean full market liberalisation; politicians decided to ban the use of natural gas in the production of electricity as this was too valuable to just be burned away, so a growing economy resorted mainly to coal to satisfy its power needs, leaving natural gas mainly for domestic and industrial consumption. One can speculate on the long-term impact on the environment.
When this ban was removed in the 90ies to help sustain the booming economy of the Clinton era, gas prices increased rapidly but were soon tamed by alternative supplies, principally LNG, which Japan had been using for years to power its manufacturing-focus boom.  By 2000, the US energy market had two large alternative and complementary supply sources for the natural gas – multiple North American fields (plus the required pipelines) and multisource LNG supplies (Middle East, Trinidad). Shale gas becomes now the third, owing to very large, economically viable fields in North America. This is what energy security and a stable and predictable market really rely on – diversified supply sources.
As many other governments do, the Romanian one decided to ignore the lessons learned from past experiences of other countries and went on to make the same mistakes, mostly from incompetence and a natural desire to avoid political heat. Lucky to have domestic reserves of natural gas, the government decided to keep a tight grip on the prices for the domestically produced gas as well as on the other aspect of the markets – regulation, control, ownership of the national gas company (Romgaz), etc. Predictably, this determined a certain level of underinvestment resulting in decreasing natural gas reserves . As the domestic production is insufficient, there is a certain dependence of a single source of gas imports, Russia, for which Romania pays a high market price. In this case, what “market” really means is the result of some form of negotiation with the Gazprom mammoth, with no realistic alternative in short and medium term. Gas storage alternatives(large empty holes in the ground where gas can be pumped in during the summer and used to smooth the supply/ demand balance during the winter) have been feasible from an economic and technical standpoint, but these initiatives have suffered enormous delays.
However, some things have changed. The privatisation of Petrom, Romania’s national integrated oil company in 2004 brought both investments and a more business-like approach. Petrom is now Romania’s premier natural gas producer having taken over Romgaz years ago. Some liberalisation of the natural gas prices is being pursued, half-heartedly and only due to the pressure of the EU. Regulation has been maintained complex, with all sorts of rules on what kind of gas (imported or local production) various domestic and industrial consumers can use and when. Such a complicated and regulated market is, as almost everywhere, the perfect recipe for inefficiency, market disturbance, fraud.  In the meantime, the blanket subsidy of low prices continues to benefit everybody, the poor as well as the wealthy and inefficient – particularly some gas-intensive industries. When the next step of liberalisation comes through, a hard political act that most politicians will try to exploit one way or another particularly in an election year, the correct economic measure (liberalise the prices and direct financial help to some categories of poor private consumers) will be swamped by a torrent of populism and incriminations. Some say that this has already started and refer to recent events, particularly a large scale prosecution of some 40+ people connected to the market (executive management and Board members of Romgaz, officials from the relevant Ministry, the owner of Romania’s largest industrial consumer of natural gas, etc.).
In a nice symmetry to the American story above, the Romanian government took a keen interest in Petrom’s plans to bypass the over-regulation of the gas market by building its own gas-fired power plant, as the electricity market is indeed liberalised. Romania’s most modern power plant, the only facility of this sort built in the country in 40 or so years, was finalised last year. However, the government decided that Petrom’s own natural gas is far too valuable to be just burned and decided that the power plant can only burn a combination of domestic and imported gas. Petrom needs to buy the imported gas (expensive) while gas from its own domestic production (cheap) will still go to the over-regulated market. This issue may not be finally settled, but it is another example of market manipulation that goes against economic efficiency.
One can only hope that years from now all this would look as childish as the American experience of 30 years ago, and Romania will have a stable, secure and  well supplied market from domestic natural gas (Romgaz, Petrom and international companies), imported (Russia and Caucaz), LNG (Qatar)and off-shore shale gas.

Wednesday, 11 January 2012

European fiscal stability pact. How credible or good is the Schuldenbremse?

The favourite catch-phrases of political and financial commentators nowadays seem to be gravitating around the tabloid-friendly idea that Germany may have lost the war but finally, after 70-odd years, just won the peace. Disappointingly, there is no talk of eurozone’s citizens goose-stepping dressed-up in lederhosen. The Europeans will first have to demonstrate their credentials and cast in law, constitution or stone, the cornerstone of the Teutonic austerity that is the Schuldenbremse. This “debt-break” for us, the non-German speakers, is meant to inject a bit of responsibility into the dealings of profligate European governments that like to spend the next generation’s money on this year’s Christmas party.
All in all, not such a bad thing. Many West-European governments  worked hard to implement the left half of the communist ideal, i.e. to everyone according to their needs, not worrying too much about the bill that comes, as we know, exactly when economies start sliding down on the choppy economic cycle of the day. The deal is in fact a limitation of the deficit the government can run (which in the case of Germany is to be eliminated by 2016 at the federal level) and  seeks to limit eurozone’s members to a structural deficit of 0.5% of GDP. This will be achieved, i.a. by fining governments whose budget deficit exceeds 3%.
Poorer countries such as Poland, have already implemented hard debt limits, as have other non-Europeans such as Georgia. The poles have a 60% cap on public debt in their constitution, but this is a limit that they have not reached in the recent history, so not something where they had to get after years of hard-fought surpluses, but rather something not to get too close too. Italy’s debt to GDP is at over 120%, France’s sails towards the 90% mark that will surely mean a debt downgrade and  Germany is just under 83%. The crisis has pushed down some of the current account balances of the PIIGS countries, but in relative terms this is just cosmetic. The Dutch and the Germans will still be more productive and will still run surpluses that seem to match the deficits of their southern partners in the eurozone, irrespective of what Merkozy, Barroso and van Rompuy say.
The practicalities of implementing a debt limit are huge and will clearly test the political will of most European countries. It is not at all clear that economies poisoned for decades by sclerotic labour markets and unsustainable fiscal indiscipline can implement such a task without a major impact on the standard of living of their citizens, particularly when strangled in a monetary union where traditional quick-fixes such as devaluation are not possible. Italy is probably the first example on everybody’s lips, but Spain, Portugal, Greece, all countries with poor labour markets and productivity well below the European average, are in the same situation. These are countries with chronic budget deficits, old-fashioned labour relations and a propensity to protect vested interest of various interest groups, be they lawyers, notaries, pharmacist or taxi drivers.
Germany’s unit labour costs have barely notched-up around 5% since 2000. Over the same period, France’s jumped well over 20%, while Portugal, Spain and Greece are all happily hovering around the 30% mark; all are expected to notch down a bit over the next two years, according to OECD. Italy alone, happily to indulge in the bunga-bunga Berlusconian style of running the economy, has increased its unit labour costs by over 35% and may fare even worse over  the next two years in spite of the honest efforts of Professore Monti. In the Italian case, such an abysmal performance has been achieved over a period when the average GDP growth was the world’s smallest, bar basket cases such as Haiti, Zimbabwe and Somalia. This is the key factor behind the eurozones imbalances and, given it’s huge, visible and immediate impact of any correcting measure, it is something difficult to correct.
Germany will be able to set an example of sombre management of their deficit by flagging the self-imposed limit and push their economic model as they are indeed the European paymasters. In the meantime, the other eurozone member will be too busy to notice that last year’s generous deficit calculation gives Germany a wonderful base-effect breather, which will be reflected in the state employees 2012 bonuses. In the meantime, all those “lazy” Europeans will get back to work (whoever has it) and more and more austerity. The danger is that, while sipping on their espressos halfway through the day, they will start thinking whether to repay or not that loan they took from Deutsche Bank to pay for the shiny new BMW.