Crisis Talk - The World Bank Group

Local Bond Markets: From Strength to Strength

Most emerging markets are having a better crisis than their G7 counterparts. One sign of robustness in emerging markets is the growing importance of their local bond markets. A new paper from Vox by Ismali Dalla and Heiko Hesse (of the IMF) takes a look at how local-currency bond markets are becoming a viable funding alternative for many emerging market issuers.

Not surprisingly, many of the countries that have succeeded in weathering the worst of the crisis (China, India, Brazil, Poland) also have substantial local bond markets:

 

Weekend Reading

Real Time Economics interviews: Hernando de Soto talks about the effects of the crisis on the world's poorest, while our Chief Economist Justin Lin discusses China, the IMF, and stimulus packages.

Paul Kedrosky praises venture capitalists.

One quarter of US jobs are offshorable. It might not matter.

Unemployment is high on Europe's frontiers.

In other unemployment news, Ryan Avent thinks that the stimulus is needed to fight joblessness. Tyler Cowen doesn't.

The US trade gap narrowed last month. It is down almost 50 percent from a year ago. Could it have anything to do with the dollar?

Larry Summers dismisses the idea of a low-growth America.

Our East Asia blog looks at 60 years of China's development, and asks, "Are China's banks having a good crisis?"

Washington Update

Although much of the Washington-based development community is headed to Istanbul, there is quite a bit of news coming from headquarters.

First, IFC is teaming up with several private sector banks to launch a vehicle to purchase distressed assets in emerging markets. IFC will commit $1.5bn to the fund and is hoping to raise an additional $4bn from the private sector. A particular emphasis will be on Eastern Europe, which was home to 40 percent of pre-crisis foreign capital flows. Further details of the project will be announced in Istanbul. In the meantime, the FT reports:

The idea is to mimic the functions of a "bad bank" at an international level through a number of platforms rather than a single global investment vehicle.

As part of the initiative...the IFC is teaming up with HSBC to purchase and restructure distressed assets, in what it hopes will eventually be  $900m scheme.

IFC's chief executive, Lars Thunnel, is known for having managed Sweden's "bad bank" during its banking crisis in the early 1990s.

Crisis Roundup: Trade and Finance Edition

Chinese car sales are up 35 percent this year.

A look at tariffs over the past eight years. In 2008, they were significantly below the eight-year average.

The Baltic Dry Index is down, i.e. shipping costs have plummeted. Does this mean less trade, and lower growth? Or just increased capacity?

Global capital markets are entering a new era, with a greater role for emerging markets. The McKinsey Global Institute explains why.

Should the ratings agencies be downgraded?

Tensions are high at the G20 over how to reform the IMF. Simon Johnson's solution? Move it to Europe.

The World Bank is boosting its support to Eastern Europe and Central Asia. This past week Hungary, Ukraine and Latvia received a combined $2bn in assistance.

In other World Bank news, Robert Zoellick will be leading a discussion on the financial crisis next Monday (the 28th) from 1100-1230 EST. Crisis Talk will be Tweeting the event live.

Doing Business 2010: Reforming through Difficult Times

The World Bank Group has released its annual Doing Business Report, which provides quantitative measures of regulations of the life cycle of a small or medium-size enterprise. Regulations related to registering property, employing workers, dealing with construction permits, and paying taxes are measured. Getting electricity and worker protection were added to this year's metrics.

In spite (or because) of the crisis, governments worked hard at improving the business climates within their borders:

In 2008/09 more governments implemented regulatory reforms aimed at making it easier to do business than in any year since 2004, when Doing Business started to track reforms through its indicators. Doing Business recorded 287 such reforms in 131 economies between June 2008 and May 2009, 20% more than in the year before.

Reformers focused on making it easier to start and operate a business, strengthening property rights and improving the efficiency of commercial dispute resolution and bankruptcy procedures.

The US Dollar: The worst choice (except for every other option)

Barry Eichengreen has written a piece in this month's Foreign Affairs outlining the difficulties of replacing the dollar with an alternative reserve currency (subscription required).

Professor Eichengreen sets the stage with the usual talking points over the dollar's weaknesses:

• Confidence in the US-championed global financial system is waning
• The US government will continue to issue staggering amounts of debt
• In order for central banks to acquire dollars, the US must run a current-account deficit, which aggravates global imbalances and puts further downward pressure on the dollar
• The political logic for supporting the dollar has weakened, as the US is no longer seen as the military protector of Europe and Asia

In spite of this cocktail of structural weaknesses, there is an "inconvenient truth" to the dollar: its global importance hasn't changed as a result of the crisis. Based on the Federal Reserve's holdings of US Treasuries on behalf of its foreign counterparts, "foreign authorities have continued to accumulate dollars, and even accelerated their purchases in the first half of the 2009."

What gives? Why stick to a currency that is so clearly flawed? Why buy into a system that many respected economists warn is destined to fail?

Europe's Recovery: Half full or half empty?

A few weeks ago I pondered if Europe was the biggest loser in the crisis. In light of today's upbeat economic news coming out of France and Germany, was I being too harsh? 

Alas, Europe is not a homogeneous body, and this certainly holds true for its economies. The eurozone's northern members are doing better than those on the Med. Growth within the Europe is uneven and often unrelated. For example, Germany seems to be growing in spite of Europe, tying its export-led fortunes to the winds of Asia.

Furthermore, while good news tends to stay within national borders, bad news can spill over. Stronger exports in Germany cannot fix Spain's unemployment woes, and effective consumer stimulus efforts in France will not cure Ireland's Celtic Tiger hangover. Yet, a currency peg collapse in the Baltics, or a Hungarian debt crisis, can spread damage to Scandinavian and Austrian banks, and beyond. 

Walking the (Crisis) Talk

By now it's no secret that Simeon Djankov, chief economist of the Financial and Private Sector Development Vice Presidency of the World Bank Group and regular contributor to Crisis Talk, has been appointed as Bulgaria's finance minister. (You can read about Simeon's appointment at Reuters, Forbes, and SETimes.) He will have his work cut out for him. The impact of the financial crisis on the real sector has meant that Bulgaria has seen declining budget revenues. Never one to rest on his laurels, Simeon has already set out an impressive goal for Bulgaria: adoption of the Euro by 2012 or 2013.

Update: In a more recent article in Forbes than the one I linked to above, Simeon explains the difficult task he faces:

'The situation we have inherited is much worse than what the previous government has said,' he said. 'It is necessary to fill a gap of 2.5 billion levs ($1.81 billion) so that we can achieve a balanced budget'.

Emerging Market Wrap Up

Today's FT has a comprehensive summary of the current state of emerging markets. Not surprisingly, China and India are the clear winners, while the picture in the rest of the world is more murky. Perceived government mismanagement has steered investors away from Argentina and Venezuela, while Central and Eastern European nations, particularly Russia, continue to suffer the most.

The article, "Developing nations shine amid the crisis gloom", is well worth the read, and has some excellent quotes from leading emerging market investors, like this one from Robert Buckland, global head of equity strategy at Citigroup:

The financial crisis has been the making of the emerging markets in that they are no longer some kind of super-cyclical play.  It is no longer the case that if you downgrade US GDP by 1 per cent, the emerging market GDP will be downgraded by 2 or 3 per cent.  The balance sheet management of the emerging markets has been better in this crisis than the developed world.

Decoupling, anyone?

Europe: The Biggest Loser?

The IMF just released a revised survey of its global economic outlook, which is generally less pessimistic than the one it originally released in April, particularly for GDP growth in 2010. There is one obvious exception amidst this "optimism": Europe.

Of all advanced economies, only Japan is expected to perform worse in 2009 (though the German economy, Europe's largest, should contract more). The Eurozone is the only entity forecasted to experience negative growth in 2010. The recovery in Central and Eastern Europe, when it arrives in 2010, is forecasted to be slower than in any other emerging market.

More on Russia's Recovery

Vladimir Putin has ordered Russia's top bankers to forgo any upcoming holidays and dedicate their summer time to making more loans. The Prime Minister has demanded an additional $16bn in fresh loans, arguing that increased lending is the only way to break the cycle of fear that has paralyzed the nation's banking system. According to Mr Putin:

The less lending goes on, the greater the risk is that loans won't be returned, because by ceasing to credit, you are strangling the real sector.

Russia's Economic Prognosis

Last week the World Bank released its Russian Economic Report, forecasting an annual GDP contraction of 7.9 percent and a 10 percent reduction in the ranks of the middle class. The report highlights a 59 percent drop in year-on-year capital flows for the first five months of 2009, contributing to a decline in all major sectors of the economy.

What will be the leading factors of a Russian turnaround? Goldman Sachs argues that the restoration of capital flows is more important to Russia's economic recovery than the return of higher oil prices. From Bloomberg:

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.

Public Finances in the EU

A new report by the European Commission has painted a bleak picture of what is to come. Deficits in nearly all EU countries. And that is coupled with GDP growth forecasts that are oddly lagging by 3-4 months. In other words, the picture will be bleaker.

France reported last week that the deficit is expected to be 7% of GDP. This report says 6.6%. Not too far off.

Reading the report, one thought comes to mind: European citizens may expect higher taxes soon.

Czech Exceptionalism

The Czechs have long sought to identify themselves more with the West than the East. It looks like the financial crisis has given a boost to their claims to be exceptional. A new note from J.P. Morgan (subscription required) on the EBRD meetings reports:

The CNB [Czech National Bank] is pleased that foreign investors and the media have started to differentiate between the specifics of the Czech economy and the rest of Central and Eastern Europe. The CNB emphasized that, unlike the rest of the region, the local banking sector is a creditor to foreign banks due to the surplus of deposits over loans. Household FX borrowing is non-existent.

It's interesting to note one of the reasons behind this Czech exceptionalism - they avoided the eastern European equivalent of subprime loans in the United States. No foreign-currency denominated mortgages for the Czechs, unlike their neighbours a little further east. Smart move.

Two Views on the Prospects for Recovery in Eastern Europe

The IMF's recent Regional Economic Outlook for Europe has a less than sanguine view of the prospects for recovery in eastern Europe. The report contains a graph (pictured below) that estimates the likelihood of various regions emerging from the crisis, based primarily on the extent of external debt and deficits. Europe is a pretty clear outlier:

Europe Divided

It looks like the IMF will have its work cut out for it in eastern Europe:

The European Central Bank has rejected pleas from central and eastern European states for it to use its firepower to boost euro liquidity in the region’s beleaguered banking system, Emerging Markets can reveal.

Non-eurozone central banks in eastern Europe had aggressively lobbied the ECB in recent months, to accept their local currency-denominated sovereign bonds as eligible securities in ECB refinancing operations with parent banks operating in the region.

But central banks in Poland, Hungary and the Czech Republic – the most vocal of lobbyists on this issue – yesterday received letters from ECB president Jean-Claude Trichet informing them he had rejected their calls, people familiar with the matter said.

Perhaps we should go back to capitalizing "eastern" in "Eastern Europe"? 

The IMF Blows One

Apparently, in the zeal to show just how bad the situation in eastern Europe is, the IMF exaggerated the external financing needs of a few countries "due to typographical errors." See a polite Reuters report on this story. Also see a less-polite Financial Times story.

After the numbers for some countries were challenged by central bankers, analysts and journalists, the IMF revised the data and began publishing new figures for the external debt/reserve ratios of some eastern European countries. The ratio for the Czech Republic was cut from 236 per cent to 89 per cent and Estonia’s was reduced to 132 per cent from 210 per cent. It is understood that the figure for Ukraine is also being cut to 116 per cent from 208 per cent, that Lithuania’s ratio of 425 per cent may also be recalculated and that others may follow.

The IMF said on Wednesday it would verify its numbers and publish correct figures on its website as soon as they were available. “We regret any confusion that may have arisen as a result of our publication of erroneous figures.”

Bosnia: The Latest IMF Client

Bosnia just announced a $1.6 billion package from the Fund. Who is next?

Buiter on Emerging Markets

Willem Buiter is among the foremost European monetary economists who is providing commentary on the unfolding crisis. (Charles Goodhart and Martin Hellwig round up the top-3). Here is what Buiter wrote recently on his blog:

The prospects of the emerging markets depend:

• First, on their dependence on external demand
• Second, on their dependence on external finance and,
• Third, on the scope for expansionary domestic demand management and the ability of the authorities to use it intelligently and flexibly.

Where Economic Freedom is Still in Fashion

In the East and South. With the advent of the economic crisis, Western pundits have immediately jumped on the "capitalism is dead" story. Things French are in fashion - and not only French kissing.
 
Yet in Eastern Europe, where I have travelled extensively over the past few months, the opposite is true. Policymakers are even more determined to divest the state from the remaining state-owned enterprises, the remaining subsidies to inefficient sectors. No one is talking about the death of capitalism, and certainly no one is talking about state ownership of banks. According to Arvind Subramanian, the same sentiment is prevalent in India and China.
 
Why is that? First, because only a decade ago Eastern Europe underwent a big "adjustment," and in many countries this was blamed on the corruption and incapacity of state-owned institutions. This changed society in two ways: the average citizen considers herself a freemarketeer in economics issues, and a new class of politicians came about, espousing free markets. 

Effective Insolvency Regimes: Q&A with Mahesh Uttamchandani

Editor’s Note: Recently, I sat down to have a chat with Mahesh Uttamchandani, Senior Counsel for Insolvency & Creditors' Rights at the World Bank and head of the World Bank's Global Insolvency & Creditors' Rights Initiative. An expert on insolvency regimes, Mr. Uttamchandani kindly answered my questions about the role that effective insolvency regimes can play in helping emerging markets cope with the impact of the financial crisis. (A PDF of this interview is also available.)

Q:

One of the issues that has been raised in the context of the crisis are the estimates for corporate debt in emerging markets – somewhere between $1.25 and $2 trillion is coming due in 2009. Do you see a wave of corporate bankruptcies in 2009? And if so, how prepared are emerging markets to deal with this?

A:

If you look first at the U.S. as an example, going from 2007 to 2008, you see a 2.5 times increase in the number of corporate bankruptcies, which is significant. But what is staggering – if you look at only non-financial firms – you see a 1,000 percent increase in the value of assets that have gone into bankruptcy. What we thought was a financial crisis is now a real-economy crisis, certainly in the United States. That’s got to migrate, and it has certainly migrated to the developing world. So, the implication is you’ll see rising unemployment and a significant drop in productivity as this hits the real sector.

In a lot of countries, particularly in Eastern Europe, the banks couldn’t raise money in the local market sufficiently, so they went to the foreign market and raised foreign currency and passed this foreign exchange risk on to their borrowers. So now you have borrowers who have seen a significant drop in the value of their local currency, which raises their indebtedness overnight. So I think that’s exactly what we’re expecting.

Belt Tightening in Eastern Europe

Hungary just adopted measures to reduce government spending and increase taxes. The new measures cut 1.3 billion forint ($5.7 billion) off the budget and increased the VAT from 20 to 25 percent. In addition, the payroll tax on gross wages is reduced by 5%, and pensions and public sector salaries are frozen.
 
"The goal is to save jobs, and protect families and small businesses from the crisis," said the prime minister in announcing the measures.
 
Soon, every East European country will need such measures. Those who are able to cut expenditures may be able to keep their budgets from accumulating big deficits. Otherwise the last decade of growth and increased prosperity will soon be forgotten.

Russian Leaders Join the Global Assets Disclosure Movement

On Monday, Russian President Dmitry Medvedev and Prime Minister Vladimir Putin published their assets and income declarations for 2008. The move was followed by the the Cabinet ministers on Tuesday. Among other officials, the Speaker of the Upper House of the Parliament, Sergey Mironov, published his declaration on April 1.

In a TV interview aired on March 24, Mr. Medvedev made disclosure a moral value. When disclosing, "every person will have to make the decision to honestly show his income and assets or to hide them”, he stated. Using his own example, the president intends to solve the debate on whether the declarations should be published. A debate, which has not been solved legislatively - Russian disclosure laws, including the big anti-corruption package of December 2008, are ambiguous about publication of declarations.

A Brave IMF

In a supposedly-leaked report, the IMF has said the best strategy for Eastern Europe in fighting the current crisis is to adopt the euro fast (see the FT article). This is an obvious point and one that some Baltic countries and Bulgaria have made for months. To the consternation of the European Central Bank (ECB), which takes the view that proper procedure should be followed and conversion to the euro shouldn't be rushed. It could in fact be delayed.
 
This is a case of bravery on the side of the IMF - and a second big hit for the institution in a week (also see this). And a case of constipated thinking on the part of ECB. The cost of early euro entry is surely a lot smaller for Europe than the eventual cost of bailouts and macro instability that is otherwise likely in Eastern Europe. So why does the ECB push this line (for now)?

Trouble Brewing in the Balkans

In just a single week, Serbia got a $4.1 billion emergency loan from the IMF (see coverage from the BBC), and Romania got a $27 billion loan (see more coverage from the the BBC) from the IMF, the EU, the World Bank and EBRD.
 
Who is next? Turkey? Bulgaria? Croatia? FYR Macedonia?

Russian Stimulus Spending Debate: Opportunities for Greater Transparency

This last January the Russian Parliament adopted in a breakthrough vote the Law on Access to Government Information, which has been pending ever since… 1997! The context for this measure is a heated debate on the usage of stimulus money. If you Google “anti-crisis money” in Russian, you'll see what I'm talking about: all top results are about ensuring the transparency of spending.

Most importantly, the new Russian law, which will enter into force on January 1 of next year, reversed the principle of access to public information in the country. From now on, government information is presumed to be open. It is no longer the citizen who has to convince the official why s/he needs the information. It is the official who has justify why (if so) the information is not granted.

Being very high-tech minded, the authors of the law placed the responsibilities on the government agencies to proactively publish on the Internet their legislative acts and information on their structure, budgetary spending and activities. To ensure broader access, public Internet spots will be created in government premises and public libraries. Government websites will have email channels for submitting queries. Furthermore, for the first time ever, the law opens the door for citizens to attend meetings of government collegial bodies.

Access to public information is a crucial transparency area. Although critics say that the law may have weaknesses, Russia is definitely progressing in turning the financial crisis into an opportunity for greater transparency.

Turkey's Stimulus

The Turkish government announced a comprehensive economic stimulus package on March 13, 2009. The package of economic measures amounts to 5.5 billion Turkish liras ($3.2 billion). New regulations will lower the private consumption tax rates (OTV) on the automotive sector and remove the OTV completely on home appliances, while the value added tax (VAT) on apartments over 150 square meters (1,614 square feet) in size will be lowered from 18 to 8 percent. The package also foresees measures to boost exports by allocating an additional 500 million liras ($296 million) to Eximbank, a state-owned bank geared to supporting exporters.

The new tax regulations seek to stimulate domestic demand in Turkey’s leading industries. Industry Minister Zafer Caglayan explained the details of the reduction of the OTV on motor vehicles and said that it might be implemented as early as March 17. For automobiles with engines of up to 1,600 cubic centimeters, OTV will be reduced from 37 percent to 18 percent, and for vehicles with engines of between 1,600 and 2,000 cubic centimeters, it will be reduced from 60 percent to 40 percent.

Representatives from other sectors also pointed out that given the three-month time limit on the tax cuts, the package would fall short of expectations and fail to stimulate the economy in the long run. Representatives of the housing sector noted that since only 5 percent of Turkey’s total real estate consisted of homes of more than 150 square meters, reducing the VAT on property was not likely to have a major effect. The VAT on houses with fewer than 150 square meters is already 1 percent.

Czech Stimulus Package

On February 16, 2009 Czech Finance Minister Miroslav Kalousek announced a stimulus plan worth 73 billion crowns (US$3.3 billion). The stimulus plan allocates 40 billion crowns (US$1.8 billion) in tax cuts, which is equivalent to 1.9 percent of the Czech Republic’s gross domestic product. "The main tasks we have set in an effort to eliminate impacts from an economic crisis include maintaining employment, and keeping public finances stable," Topolanek said.

The pro-export plan aims to preserve some 50,000 to 70,000 low-income jobs through welfare insurance cuts and stays away from directly handing out money to citizens. "We do not want to give people who lose jobs welfare pittance. The goal is to protect their jobs," Topolanek said. The measures include a corporate tax cut (already effective since January), more money for road construction and business loan guarantees. The government aims to encourage investment by relieving small firms and entrepreneurs of advance tax payments this year. Another measure is a value-added tax write-off for the purchase of new cars.

The government also expects to sell excess carbon-emission credits worth 10 billion koruny and spend the earnings on energy efficiency projects, such as heat-proofing public buildings and households, which should employ 12,000 people, Environment Minister Martin Bursik said.

The stimulus plan is based on the assumption that the economy will shrink by 1 percent or more this year, a darker scenario than the central bank's 0.3 percent recession forecast and the finance ministry's 1.4 percent growth outlook.

How Fast Do Currency Boards Adjust?

Editor's Note: Georgi Angelov is a senior macroeconomics researcher at the Open Society Institute in Sofia, Bulgaria.

It is an old debate. Some believe that currency boards – because of their fixed exchange rate – bring about adjustment of external imbalances very slowly. Currency boards cannot and do not depreciate the currency, and that is perceived as a problem.

Is this true? We can check fresh data. Because of the financial crisis in the post-Lehman world, East European countries cannot attract as much capital inflow as before – so their current account deficits should decrease quickly.

In the case of Bulgaria, the trade deficit started decreasing rapidly after October. Within three months the deficit decreased by two thirds. The decrease of the trade deficit year on year is 45% in January 2009 – and the current account deficit is also down by 45% year on year in January. Quite a substantial adjustment within just a few months. With this speed, the big current account deficit will be history very soon.

Has the Crisis Affected You? How?

The main Bulgarian weekly Kapital is running an open forum (in Bulgarian) on these questions. I read the answers to-date and found some expected and some unexpected things. Expected: one in five people complained about job losses or increased job insecurity; the construction sector is down significantly; planned vacations are scrapped; new cars are not purchased.

On the positive side: rents went up (says one rentier), as few people can afford mortgages; several small businesses said their larger rivals are in such trouble that there is more opportunity for them; stopped watching TV (as the news is so gloomy); less social divide - the nouveau rich are only nouveau now; more time to read; take more interest in the rest of the world. My personal favorite: find economics more interesting.

Assessing the Trade Finance Situation

It is difficult to find reliable information on how severe the trade finance problem really is. There are a lot of numbers circulating, all of questionable quality. Take, for example, the figure on the importance of trade credit. Recent news reports state that 90 percent of the US$14 trillion in world trade is financed by trade credit (see, for example, the International Herald Tribune, Forbes, and the WTO). But, where does this “90 percent” come from? I traced the number from various WTO documents, and it appears to come from a 1998 paper by Malcolm Stephens at the IMF. However, the statement in the paper is quite different: “90 percent of world trade is conducted on the basis of cash or short-term credit” [p.5, emphasis is mine]. 

An additional reason the number is suspect is because of the growing share of trade between a parent firm and its affiliate. This so-called intrafirm trade is unlikely to use external financing. The OECD reports that approximately one-third of trade for the US and Japan (countries for which data are available) is intrafirm. More than two-thirds of Austria’s imports from Eastern Europe are intrafirm. This makes the 90 percent even harder to swallow.

Another number that has been circulating in these articles is a $25 billion “liquidity gap” in financing by the private sector. This is the "market's estimate" - $25 billion is less than two-tenths of one percent of the value of trade, so it is quite small in the grand scheme of things. How can trade finance be a major issue in the stunning decline in trade (trade was down about 15 percent from the previous year in November and December, and available data for January looks worse) if the liquidity gap is just 0.16 percent?

In order to diagnose and improve the trade finance situation (if necessary), we must first measure it.  Given the market's failure at quantifying assets, liabilities, and risk, we cannot rely on its estimate of the trade finance gap without any supporting data. It is unfortunate that reliable data from banks working in trade finance have not been made available.

Will The West Bail Out the East (in Europe)?

Absolutely. No question. Over the weekend, the heads of European Union states met in Brussels to voice their unity against protectionism and to discuss a possible aid package for the badly-hit Eastern members. Neither goal was fully achieved. (Read the BBC article on the meeting.) 
 
On the aid package, there were vague statements of support but no specifics. This will undoubtedly come. Western European banks cannot afford to have a collapse in the East. Their exposures are too large. So lobbying will be intense. And in the grand scheme of European things, the aid package would not represent a large part of what has already become a year of dishing out money left and right. Might as well do it. It will be good for a united Europe, and it will be good for business too.
 
So the question is when, not if.

Tax Stimulus Gathers Speed

As the crisis deepens, more and more governments resort to tax stimulus. On February 25th, China announced cuts in value-added taxes for metals exporters. This is in addition to the $17.5 billion in corporate income tax cuts announced last November. A week earlier, the Czech government announced cuts in social contributions (which are similar to payroll taxes), worth $1.3 billion. The goal is to save 70,000 jobs. The same week, Australia unveiled $3 billion in income tax cuts.

In January and February alone, 22 countries announced various tax stimulus measures: ranging from cuts in social contributions (Germany, Denmark, Finland, Norway, Vietnam, Latvia), cuts in value-added taxes (Israel, Singapore), tax rebates on payroll taxes (the United States), income tax reductions (Korea, Japan, Brazil, Chile, Mexico, India, Indonesia), and lower taxes for small businesses (Canada, the United States, Germany, Italy, Thailand).

The stimulus varies in relative size from country to country. In Finland, for example, 40% of the 2 billion euro package is slated for cuts in social contributions. In the US, 37% of the $787 billion package is tax stimulus. In Japan, it is 21% ($111 billion of $516 billion). In Brazil, tax stimulus represents about 7% of the $283 billion.

Will the Currency Board Survive in Bulgaria?

Yes, we can. But since this is a lively topic in Bulgaria these days, it is useful to go through the reasons. A new Citibank report entitled CBA likely to ride out financial turmoil does just that.
 
Before going into the report, let me just say why the alternatives are bad. During crises, the common argument for devaluation is that your exports become more competitive. Italy has used devaluations successfully now and then, and more recently Russia, Belarus, Ukraine and Kazakhstan have all devalued their currencies. Other currencies like the Mexican peso, the Czech krony, the Polish zloty and the Korean won have depreciated by 30% or so too. It is not clear, however, that this has helped their exports. The December export numbers show a universal decline of 25-30%. The collapse in demand in many sectors is so great that depreciations are just not cutting it. In addition, for a country like Bulgaria where banks have borrowed in euros or dollars or Swiss francs and have given some credit in lev, a depreciation would be bad news. In sum, exiting the currency board arrangement won't pay off.

Revising the Balance of Consumption

Marinus Verhoeven, a lead economist in public sector governance at the World Bank, raised an interesting question to my earlier post, Living in a Madoff World:

I am not sure excess provides a good framework for thinking about the crisis...It may have had something to do with inadequate control of the money supply, misguided legislation, and an unequal distribution of wealth, but excess consumption--no, I don't think so...The second issue is more controversial...is there a moral dimension here?.

This got me thinking.  So, here's my response. I was using excess as metaphor for bubbles we have had in real estate, in consumer spending, in leveraging, and so on...and excess consumption too.
 
Like most economists, who first look for a phenomenon and then go find a theory to fit it, let me try the same here…
 
Over the last decade, many countries became frugal, some by their demographics such as Japan, others by choice like the middle income countries (MICs), which, afraid of exchange-rate volatility, ran precautionary current account surpluses and accumulated large stocks of foreign reserves. And yet others like China where a combination of demographics, exporting more and spending less, induced large savings.

A Second Chance for Abandoned Construction in Ukraine

Kyiv has a long history of abandoned construction, with some objects dating back as far as the beginning of 20th century. However, most of it has accumulated in the city (and throughout the country) within the two last decades. We can find at least several groups here:

1. Unfinished construction from perestroika times – mostly huge administrative buildings that were started in the eighties and abandoned just before or soon after the collapse of the Soviet Union, when public spending on construction was cut off;
2. Buildings that were started after 1995, with the rise of private building companies – mostly apartment blocks – and dropped at different stages of construction for several reasons. The builder may have gone bankrupt or due to frauds with funds collected from individual investors;
3. Construction frozen as a consequence of the current financial crisis and lack of liquidity. This last group includes both residential and commercial real estate.

Fortunately, the Ukrainian language has a word for this phenomenon: dovgobud. Some of these are lucky and eventually get finished; others are forgotten, and in some very rare cases ruined. Dovgobudy in the third category, however, may be getting a second chance. Overall, as for apartment blocks, around 75-80 percent of objects have been put on hold, and as for commercial real estate – it’s close to 30-40 percent. Just before the end of 2008 the Ukrainian Parliament adopted a special law aimed at mitigating the influence of the financial crisis on building construction. The Government will now allocate UAH 3 billion (roughly USD 375 million) to help finish the objects built by at least 70 percent in 2009. Those built by 50-70 percent will be covered by the program in 2010.

Increasing University Enrollment as Crisis Response

My friends in economics departments around the United States tell me that applications to PhD programs have trippled this year relative to last year. Some law schools have also reported a large increase in applications. This is because the unfolding crisis is putting lots of young people - particularly Wall Street types - out of jobs. What better time to get a graduate degree?

Even business schools report higher demand, even though one wonders what they really teach students there. Some "modesty" courses may be in order.

Increasing university enrollment is a good anti-cyclical device. In a country like the United States, this happens naturally as people with dimmed work prospects upgrade their skills. In smaller countries, this may be trickier as universities may be less prepared to meet increasing demand. Especially if they depend on government subsidies for financing a share of their operations. Hence, the need for a possible public policy.

Georgi Angelov, a senior economist at the Open Society Institute in Sofia, and I have just written a short paper on this topic, using data for Bulgaria as an example. The policy proposal is relevant for any country, however.

We develop a proposal for expanding university enrollment in Bulgaria by 30,000 students (or about 12% over 2008 enrollment). This is done by creating a student loan program guaranteed by the government. Student loans, offered competitively by commercial banks, would cover up to 50% of the cost of education. The remainder is covered by direct government subsidies (as is currently the case) and household income. The proposal is budget neutral – the government spends as much money on university education as in previous years.

Russia: Corruption Prevention during the Financial Crisis

Editor's Note: Larisa Smirnova is a consultant at the World Bank and is currently working with the Transparency indicator team. She previously worked with the United Nations High Commissioner for Refugees in Russia and Japan.

Experts at Troika Dialogue Group, a Russian investment company, estimate that the financial crisis may naturally decrease corruption in the country due to… lower oil prices! As the Russian economy is largely dependent on oil exports, lower oil prices means less money and therefore… less bribes?

Among fears that government anti-crisis money may become another easy prey for corruption, Russia adopted a new anti-corruption law in December 2008. After heated debates, financial disclosure requirements were extended to family members of government officials. However, the content of the declarations is confirmed to be not just publicly unavailable but constituting a "state secret".

The conclusions of a recent paper, Disclosure by Politicians, which compared financial disclosure procedures in 175 countries, suggest that Russia’s corruption prevention measures might not be the most effective ones. Analysis showed that family members’ disclosure does not correlate with lower perceived corruption. Publicity of disclosure, on the contrary, appears to be the crucial imperative for political accountability.

Creating Jobs for Ukraine’s Migrant Workers

It seems that Ukraine won’t be seeing a massive return of its migrant workers due to the economic downturn, as was predicted last fall. At least, not from EU member states. Officials from the state employment service say the migrants who have returned from abroad due to lay-offs are mostly construction workers that were employed in neighboring Russia. Overall, the migration experts estimate between 200,000 and 250,000 Ukrainian migrants returning home.

The data on Ukrainians working abroad are very ambiguous. According to the official statistics, slightly over 2 million Ukrainians are currently employed abroad, with around 48 percent in Russia and almost the same in EU countries, mainly Spain, Poland, Czech Republic, Italy and Portugal. Alternative estimates that include illegal migrants reach figures that are almost three times as high. There are also different assumptions as to amounts sent home by the migrants in remittances, ranging from Euro 2 to 8 billion annually.

In the mid-1990s it was common to hear politicians and social workers complaining about “brain drain” – the mass emigration of Ukrainian scholars, technicians, doctors and other highly qualified staff. The profile of Ukrainian migrant workers has changed significantly during this last decade. A few are leaving with the intention to settle for a lifetime, while most people seek to earn money and come back. Now it’s mainly construction and agricultural workers (mostly men) and also women employed in the area of household and nursery services. Ukrainians with advanced degrees and sufficient work experience are often ready to accept much lower-skilled jobs than they occupied at home. One example is a teacher of physics who is now working as a hotel maid in Italy.

Competitive Devaluations?

Kazakhstan’s central bank devalued the tenge by 18 percent yesterday. The central bank is letting the tenge weaken for the first time since it started managing the currency in 2007. Kazakshstan joins Russia, Ukraine, and Belarus in abandoning attempts to prop up exchange rates as currency reserves dwindle and economies stagger. A number of other resource-rich countries have also seen their currencies fall substantially against the dollar over the last few months, including Brazil, Mexico, and South Africa. 

Maintaining a currency’s value under pressure is costly. Kazakhstan spent $3.5 billion, or 16 percent, of its foreign-exchange reserves supporting the tenge. Russia spent between $7 and $8 billion in one day last month defending the already weakened ruble. And the longer the process lasts, the more money that goes down the drain. Argentina’s net reserves fell by $20 billion in 2001 before the currency board eventually collapsed the following year. 

Some countries attempt to maintain currencies because of a history of inflation. Sudden and large depreciations can be destabilizing, leading to inflation and higher interest rates. Depreciations also increase the cost of foreign currency debt. But depreciation is not necessarily bad for growth. Depreciation mimics an export subsidy and import tax, boosting exports and consumption of domestic goods. This can help countries to grow when domestic demand is weak or declining. 

But what happens if many currencies collapse simultaneously? This puts downward pressure on import prices, fueling deflation in foreign markets. Kindleberger has argued that such competitive devaluations are part of what led to the Great Depression. 
 
Volatile currency movements are already aggravating uncertainties in global financial markets. But at least so far, most of the these currency declines are understandable. Sharp declines in commodity prices have worsenened the terms of trade of the resource exporters at the same time as western capital has dried up. If depreciations spread to the large manufacturing countries then there could be real trouble.

The Ukrainian Tax Administration's Response to the Crisis

It is widely known in Ukraine that the performance of the State Tax Administration (STA) is assessed by the volume of collected tax revenues, which is tracked on a monthly and annual basis. It is these figures that matter, and not the level of taxpayer service or public opinion. A new year has just started and the STA is already asking the Government to reduce the targets on tax revenues for 2009, which are the same as last year for company profit tax and slightly higher for VAT.

The STA argues that the targets are unrealistic considering the general decline in production and trade, the reduction of exports, etc. The signal is clear – we should prepare for hard times and the STA doesn’t want to be a poor performer, with a culture that demands the set targets should be exceeded, a heritage coming from the Soviet past.

This last decade tax revenues have been growing from year to year, based on a natural tendency of inflation and GDP growth. 

Banking and the State

Ample empirical evidence shows that the state is often a poor banker, both in normal times and crises. This is particularly true in less developed countries. Yet, state ownership is mostly prevalent in those countries. This evidence can be easily forgotten as the crisis unfolds.

Financial crises tend to increase state involvement

The severity of the current financial crisis has raised doubts about market effectiveness. As Mr. Greenspan recently pointed out: “Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity are in a state of shocked disbelief.” States have intervened in unprecedented ways to address fears of insolvency, aimed at safeguarding stability and restarting lending. Direct interventions ranged from massive capital injections (e.g., in UK and US) to bank nationalizations (e.g., Fortis, Glitnir, B&B). Indeed, bank nationalizations are a common intervention tool: they occurred in 57 percent of recent financial crises and future state involvement can be persistent. For example, during the East Asia crisis, assets of Indonesian state banks jumped from 40 to 60 percent of total bank assets. Korea and Thailand experienced similar increases. In these countries, state involvement was still at elevated levels years after the crisis.

Dire Straits

Hopping into a taxi at Sofia airport, it is as if I go back to the mid-1980s: the radio is playing Pink Floyd's The Wall. I have long noticed a strange regularity about taxis in Bulgaria: they always play 1980s music: Pink Floyd, Scorpions, Queen, Dire Straits. During our latest trip last summer, my wife (an American) noticed this too. So it's not my imagination. I also see this pattern in other countries in Eastern Europe - for example, the Czech Republic, Poland, FYR Macedonia.
 
This is the music I grew up on, so I like it. But I struggle for an explanation. Surely there is some decent music that has come since. And one could go back to the Beatles, the Doors, etc. I can come up with two explanations: either the radio is controlled by people of my generation, who do it for fun; or there is a general sense of nostalgia towards the high years of socialism (before it started crumbling). For the mid-1980s was a fun time, at least in Bulgaria. Full employment, an overall sense of security, good education.
 
I was hoping that for the sake of the region, I would be increasingly limited to listening to The Wall at home. But the unfolding economic crisis may increase nostalgia for the "good old times" and it may be all Dire Straits in the next few months/years.
 
The signs are around. I spoke to a software producer who said that demand for his company's products is down 15% relative to January 2008, and that payments on finished work are down 60%. That is, clients are trying to stretch payments so accounts receivables are accumulating. Some of these presumably will not be paid as clients go out of business. And this is in a sector which is supposed to be among the most crisis-resistant. Imagine what is happening in construction.
 
Fortunately, the music of that age offers some good anti-crisis advice. See, for example, the refrain in Money for Nothing (Dire Straits, 1984):

We gotta install microwave ovens
Custom kitchen deliveries
We gotta move these refrigerators
We gotta move these colour tvs, lord

In other words, increase household consumption. The lyrics stop short of recommending tax vs fiscal stimulus. Unless they are really deep and the title "Money for Nothing" suggests fiscal expansion will be wasted.

When Will Stocks Rebound in Eastern Europe?

Editor's Note: The following is a joint contribution from Simeon Djankov and Facundo Martin. You can also download a PDF of When Will Stocks Rebound in Eastern Europe?

Eastern European stock markets had a traumatic 2008. In several countries, including Bulgaria, Lithuania, Romania and Ukraine, the market indices dropped 75%. In all other countries but Slovakia, stocks lost about half their value.

Will 2009 be different? Do investors have something to look forward to?

Stock market returns depend primarily on the underlying company profits. In emerging markets, these depend on the global economic outlook, as a large share of production goes to foreign buyers. So to know when stocks will rebound, you need to know two things: when the economic downturn will end (both at home and in major export markets), and whether stock prices turn up before or after economic activity picks up.

We study the latest economic forecast by the World Bank to answer the first question. We look at historical data in emerging markets and two developed economies (the United States and the United Kingdom) to answer the second question. In particular, we investigate the relationship between changes in industrial production and changes in stock market indices during previous downturns in six emerging markets (Indonesia, 1997-98; Korea, 1997-98, Thailand, 1997-99; Malaysia, 1997-98; Russia, 1998-99, and Argentina, 2001-02); and the United States (1980-81, 1982-83, 1990-91, and 2001-02) and the United Kingdom (1990-92 and 2001-03).

Tomorrow's Trade

Editor's Note: Caroline Freund is a Senior Economist in the Research Department of the World Bank and runs a research project on the effects of the economic crisis on trade.

Tension is developing between trade and employment policies in some countries. The need to reduce costs and improve profits has pushed many companies to restructure production globally, with the result of increased foreign outsourcing. For example, Dell, the world's number two PC maker, recently announced plans to shift manufacturing from Ireland to Poland to cut costs. The monthly minimum wage is over $2,000 in Ireland, compared to $406 in Poland.

Other firms that are reportedly planning to expand outsourcing in emerging markets include: the major entertainment company Warner Brothers, Ireland's Wedgewood, and Japan's Renesas. Financial companies - which already account for about 25 percent of revenues of the large Indian service offshoring companies Infosys and Wipro - are also expected to increase outsourcing to cut costs. This fragmentation of production will help firms improve productivity, while softening the blow of the financial crisis on low and middle income countries, which gain both jobs and technology. The allocation of resources around the world will be improved, leading to gains from trade.

However, government policies are countering this force. The incoming U.S. administration has signaled an end to tax breaks for companies that outsource abroad and promised tax credits to companies that maintain or increase U.S. workers relative to those abroad. In France, state aid will not be offered to
auto companies that plan to shift jobs to lower wage countries. Lou Dobbs, among others, is calling for similar restrictions on a U.S. auto package.

Even without restrictions, industrial subsidies are a threat to trade. They are contagious, and could result in a subsidy war that would leave everyone worse off. (See, for example, a recent article from Jagdish Bhagwati in the Financial Times on this type of scenario.) In addition, they pull resources away from more productive uses. It's not just the industrial countries at fault. Recent trade policy reversals in the developing and emerging markets are also of concern. At least 15 (including Brazil, China, India and Russia) have plans to expand protection in some sectors.

Yes, creating jobs and maintaining income during the downturn is crucial. But this is a global recession. World leaders should choose policies that stimulate domestic demand, without inflicting pain on others.

Sustainable Solutions to the Crises in Ukraine

Ukraine has suffered through so many crises lately – political, financial, gas. Where should we be on the lookout for the next one, and how can we work to mitigate it? The financial crisis provides a window of opportunity to consider new possibilities. What kind of solutions will not only get us out of this mess but will prove sustainable well into the future?

One prime candidate for a solution is the energy sector. Simply put, municipal heating in Ukraine is a centralized system that relies on natural gas, whereby hot water is transported long distances through pipelines to apartment blocks. This is a system that is highly costly for many reasons – expensive fuel, huge losses of heat, centralized control, etc.

Although the common thinking is that reforming the existing system is a challenging task for the state in the near or distant future, some forward-looking businessmen have seen it differently. They set up autonomous heating systems for newly built cottages and apartment blocks. Those with the longest-term thinking have already devised ways to offer alternative energy, mainly windmills and solar panels, on the assumption that sooner or later clients won’t be willing to remain dependent on ever-more-expensive natural gas.

Latvia Cuts the Income Tax by 2 Percentage Points

In yesterday's post, we presented a new paper arguing the merits of tax reform as part of the crisis response. An interesting (and sobering) document to read in this regard in Latvia's stand-by agreement with the IMF. Among other crisis measures, Latvia will reduce the personal income tax by 2 percentage points, from 25 to 23% (this is described on page 67).
 
The rationale is to leave more money in the hands of consumers, who will be weathering various hits, including a 25% cut in public wages.
 
As we argued in Tax Stimulus as Crisis Response, a temporary tax cut is a faster and less-prone-to-corruption measure to stave off the crisis than most fiscal expansion projects. The Latvians get this.

Tax Stimulus as Crisis Response

A new paper from Simeon Djankov, a regular contributor to Crisis Talk, and Georgi Angelov, a Senior Economist at the Open Society Institute, argues for the merits of tax incentives in dealing with the crisis. From the abstract: 

Many countries are contemplating stimulus packages as a response to the deepening economic crisis. This paper discusses the benefits of tax reform as a crisis-response measure. It provides a calculation of the benefits of such reform, taking as an example the reduction of payroll taxes in Bulgaria. We also estimate the costs in terms of foregone revenue. We find that a reform to reduce the payroll tax by 7.5 percentage points, from 31.3% to 23.8%, would result in 130,000 jobs being created or saved, and a 0.5% increase in annual GDP growth. Taking the static and dynamic effects of such reform into account, the cost would amount to 0.63% of GDP. The reform has three additional benefits. First, it is not subject to corruption: the government is not in a position to distribute largesse as under a fiscal expansion program. Second, it works as a direct stimulus - every business and worker in the formal economy gets the benefit. Third, tax reform is quick to implement and can have immediate effects.

>> Download Tax Stimulus as Crisis Response

Is Deposit Insurance Really the Solution to Depositors’ Worries?

Deposit insurance is an attractive tool for politicians, especially in crises such as this one. Announcing (unlimited) coverage of deposits in the banking system can prevent depositors from bank runs. And as long as the authorities do not have to make good on their promise, it is also a cheap tool. By now, however, most economists are well aware of the moral hazard effects of generous deposit insurance, a product of reduced market discipline. The result? Aggressive and imprudent risk taking. But considering recent events in Russia, one should be careful about believing blindly in the confidence-creating effect of deposit insurance either.

Some months ago, a small Russian bank called Capital Credit simply refused routine withdrawals by their customers, thus clearly signaling its illiquidity (which normally comes after insolvency!). But the Central Bank of Russia (which is also responsible for bank supervision) did not take any action for several weeks despite heavy protests by depositors. Only when depositors threatened to demonstrate in front of the Central Bank did bank supervisors finally withdrew Capital Credit’s license, thus allowing depositors to start the process of recovering at least part of their savings from the deposit insurance.

The result: despite an explicit deposit insurance scheme and despite the government’s assurance that all deposits would be secure, a loss of trust and confidence in the banking system occurred. As long as bank supervisors are not strong enough to intervene into failing banks, deposit insurance schemes cannot help conserve or restore confidence in the banking system.

Tax Cuts vs. Government Spending

Simeon Djankov argues for the merits of tax cuts over increased government spending as a form of fiscal stimulus, particularly in some eastern European countries. (The two policies are of course not mutually exclusive, but with limited fiscal space one may be preferred more than the other.) A new paper from NBER on What Are the Effects of Fiscal Policy Shocks? offers additional support for this line of thinking. According to the abstract:

We propose and apply a new approach for analyzing the effects of fiscal policy using vector autoregressions. Specifically, we use sign restrictions to identify a government revenue shock as well as a government spending shock, while controlling for a generic business cycle shock and a monetary policy shock. We explicitly allow for the possibility of announcement effects, i.e., that a current fiscal policy shock changes fiscal policy variables in the future, but not at present. We construct the impulse responses to three linear combinations of these fiscal shocks, corresponding to the three scenarios of deficit-spending, deficit-financed tax cuts and a balanced budget spending expansion. We apply the method to US quarterly data from 1955-2000. We find that deficit-financed tax cuts work best among these three scenarios to improve GDP, with a maximal present value multiplier of five dollars of total additional GDP per each dollar of the total cut in government revenue five years after the shock.

(Hat tip: Tyler Cowen)