CEEMEA Waiting for the Rubel to Drop March 31, 2011 By Jacob R.

Nell | Moscow & Alina Slyusarchuk | London

Chronic external imbalance... The problem in Belarus is one of external balance, exacerbated by a loosening of economic policy. A sustainable solution to the underlying problem of external imbalance either requires a significant devaluation of the rubel or the Baltic solution of internal devaluation' to drive down wages and restore competiveness, in our view. Belarus had a very wide 2010 current account deficit of 16% of GDP, driven up in recent years by a cumulative 10% of GDP as Russia raised subsidised prices of oil and gas towards international levels. The current account gap was not financed by 2010 inflows of 13% of GDP on the capital account (a mix of FDI, a sovereign US$1 billion Eurobond, portfolio investment, bank loans, trade credits) plus IMF loans. ...accompanied by a loose fiscal policy: Despite this external imbalance, last year, in advance of the December 19 elections, the authorities loosened fiscal policy, including increasing some public sector wages by 50%, and credit growth, supported by loose monetary policy and government lending, rose to 38%. This increased domestic demand and imports, and exacerbated the external imbalance. At the same time, the National Bank essentially held the currency (the rubel) flat. By the end of 2010, international reserves had fallen to under two months of imports, and in 2011 they continue to deplete at a rate of US$600 million per month. The authorities also took to borrowing foreign exchange from domestic banks to bolster their reserves. A move to the edge of the existing band of 8% around the current central rate of 1,100 will not be enough to restore the external balance, we think. The January 2009 devaluation of ~20% - when Belarus devalued at the same time and to the same extent as the Russian ruble - has been largely eroded by domestic inflation running at 10% per annum versus US and EU inflation at under 2%. A move to the edge of the existing band of 8% around the current central rate of 1,100 to the basket (which is one-third RUB, one-third USD, one-third EUR) will not be enough to restore the external balance, we think. As the IMF put it, in uncharacteristically blunt language in its recent March 9 Article IV report, "the staff have a strong preference for using devaluation to reduce the current account quickly", and they estimate that a 12-16% devaluation combined with a 3.5% of GDP fiscal tightening should be sufficient to close the US$4.6 billion financing gap. Can Belarus borrow to cover the financing gap? The IMF estimates the financing gap to cover the current account deficit at US$4.6 billion, or 8.4% of 2010 GDP. There is a theoretical chance that Belarus could borrow this amount and muddle through, we think. Some help may come from Russia: In January, Belarus joined the new Russia-Kazakhstan-Belarus customs union, which allows Belarus to buy oil at the subsidised Russian domestic price, and in effect reduces the oil import bill by about 2% of GDP. On top of this, Belarus is currently seeking a loan from Russia or from the US$10 billion AntiCrisis Fund of The Eurasian Economic Community, which was established in 2009. According to Russian Finance Minister Kudrin during a visit to Minsk on March 15, the Belarus authorities have requested US$3 billion in loans to support their reserves. Belarus could sell the remaining 50% of the gas transport company (BeltransGaz), which it sold 50% to Gazprom for US$2.5 billion in 2007, and a stake in its industrial gem, Belaruskali, the potash company which the Belarusian authorities value at US$25-30 billion. However, we think that borrowing in the hope of muddling through is not credible: Belarus' level of debt is not yet at a critically high level on the standard metrics, since external government debt is only 22% of GDP and total external debt is an apparently manageable 52% of GDP. However, borrowing to muddle through is a high-risk strategy, we think. The global rise in energy prices will still affect Belarus negatively, as an energy importer, in our

strategy, we think. The global rise in energy prices will still affect Belarus negatively, as an energy importer, in our view. The Russian loan may not appear - Russia at one point proposed to provide Iceland a loan in 2008 during the crisis, but it did not materialise - and even if it did, it may have significant strings attached. Fundamentally, however, even if Belarus raises the financing to cover the gap in 2011, it will remain on an unsustainable policy path unless it tackles the underlying external imbalance, we believe. In this case, without credible supporting policies, additional financing is likely to be rapidly used as rubel holders rush to convert them to dollars and euros before any realignment of the currency. The holders of US$12 billion in Belarus debt (22% of 2010 GDP - the second highest in the region after Hungary) may be unwilling to roll it over. On balance, we think that international markets are likely to be closed to Belarus for new lending until it has a comprehensive programme to restore the external balance in place: In fact, we think that Belarus is likely to need an IMF programme before it will be able to borrow new funds from the markets, and the IMF will require "a credible commitment to strong stability-oriented policies and an ambitious structural reform agenda" (Public Information Notice, March 9, 2011) before any future financial arrangement is agreed. What next? To get policy back on a sustainable path, we believe that the Belarusian authorities will need to reduce domestic demand. Recent measures to freeze wages and pensions in 2011 after the stellar rises in 2010, to raise some tariffs and to increase the refinancing rate by 1.5% are welcome, we think. Recent foreign exchange market measures from the government only cause confusion, in our view: The authorities have announced some foreign exchange market measures, but these exacerbate or confuse the situation. The March 23 lifting of the requirement for 30-day notice to change foreign exchange from April 1 could well increase demand for foreign exchange, in the absence of credible policies. Even worse, the March 29 announcement that commercial banks can trade foreign exchange at up to a 10% deviation from the central rate introduces multiple exchange rates, but does not affect the fundamental issue, which is the ability to buy foreign exchange freely from the central bank. We see an enhanced short-term risk of additional restrictive measures, such as enhanced requirements on exports to sell all their foreign exchange to the national bank at the official rate, as the authorities seek to maintain reserves and the exchange rate. We expect a widening of the bands around the current central rubel-basket rate by 15-20%: We see no appetite in Belarus for a Baltic-style internal devaluation. There is no clear reason for it, such as the prospect of euro membership if Belarus avoids devaluation, and it would involve painful wage and pension cuts and a rise in unemployment, which the electorate has not been prepared for. Consequently, we see a comprehensive package, including a widening of the bands around the current central rubel-basket rate by at least 12-16%, as called for by the IMF, as required to restore competitiveness and the external balance.

Euroland A Response That Provides No Answer March 31, 2011 By Arnaud Mars | London

Response to the crisis does not mean resolution of the crisis. Over the past two weeks, euro area governments have announced a series of measures that form, in their own words, a comprehensive response' to the sovereign debt crisis. A response does not, however, necessarily constitute a resolution. A resolution of the crisis, in our view, would mean returning to a situation where government funding is ensured on affordable terms and on a lasting basis. In other words, this requires both restoring the solvency of sovereigns and securing their continuous access to credit. We have several times highlighted the importance of assessing the response of European governments to the crisis through this dual filter of solvency and liquidity (see Europe Economics: A Small Positive Step, but Still No Step-Change,

Small Positive Step, but Still No Step-Change, March 14, 2011). Liquidity: a necessary not sufficient condition to avoid default. Elga Bartsch, our chief European economist, has made the point that while access to liquidity is a necessary condition for a government to avoid default in the near term, it is not a sufficient condition to avoid it in the medium term. Liquidity support, in the absence of a restoration of solvency, does not eliminate the risk of default. It merely postpones it. The question becomes: until when? What liquidity support does is to give governments control over timing. The expansion of the lending capacity of Europe's financial assistance scheme (EFSF) and of its successor (ESM) ought to provide European governments with more control over the timing of a hypothetical restructuring of the debt of its weakest members, and allow postponing such an outcome for a very long time. Paradoxically, however, the conditions that have been spelt out for liquidity support achieve, in our view, exactly the opposite. If strictly adhered to, they will make sovereign debt restructuring much less hypothetical and might also bring its timing forward. At first glance, the decisions taken by European governments seem positive. They have agreed to raise the effective lending capacity of their current emergency financing scheme (EFSF) to its initially intended size of 440 billion, up from approximately 260 billion. They have also agreed to endow its successor, the European Stability Mechanism (ESM), with an effective lending capacity of 500 billion. The details of how exactly this lending capacity will be delivered in practice is admittedly unclear (this is to be resolved by end-June 2011) but that uncertainty is, in our view, of secondary importance, for two reasons: first, because where there is a will there is a way, and we take the commitment of European governments at face value; second, because we do not expect that the EFSF and ESM will actually have to disburse this full amount (more on this below). What this expanded lending capacity means is that the EFSF and later the ESM, in combination with the IMF (assuming an IMF contribution in line with current policy), could in principle refinance the entire marketable government debts of Greece, Ireland and Portugal combined, with some room to spare (especially as Greece currently benefits from loans outside the EFSF). So long as European governments are happy to keep financing their more fiscally challenged peers, therefore, the latter have no reason to default. The question, though, is whether European governments will want indeed to keep refinancing the debt of their peers to the full capacity of the EFSF. This takes us away from the question of liquidity and towards that of solvency. Liquidity can also support solvency, if provided on favourable terms. We made elsewhere the point that liquidity support could turn into marginal solvency support if granted on sufficiently favourable terms (see Sovereign Subjects: Sense and Sustainability, November 8, 2010). The reason for this is that the cost of funding of governments directly impacts what is best described as the fiscal hurdle, by which we mean the primary balance to be achieved year after year just to stabilise the debt. The primary balance is effectively a measure of fiscal pain, as it is the difference between what the government takes away from its constituents (in the form of taxes) and what it gives back to them (in the form of public services). The higher the cost of funding, the higher the likelihood that the fiscal hurdle exceeds the pain threshold of the body politic. With this in mind, it would seem that to maximise the probability that fiscal adjustment programmes are successful, it would be desirable to lower as much as possible the funding costs of governments. A lower funding cost does not eliminate the need for growth- and revenue-enhancing measures and/or expenditure cuts. It does, however, help at the margin, by a small amount initially (the share of the debt held by EFSF is small to start with) but by a much larger amount eventually. There lies the first of several inconsistencies in the architecture of the European Union's financial assistance schemes, which in our view undermine their effectiveness: EFSF/ESM/IMF loans are not on favourable terms. Neither the EFSF nor the ESM (nor for that matter the IMF) provides cheap financing. The EFSF currently provides loans at a rate equal to its cost of funding plus 247bp, irrespective of maturity. The ESM, according to the content of its term sheet, will provide loans at a rate equal to its funding costs plus 200bp, and another 100bp for loan amounts outstanding after three years. A six-year loan, for instance, would carry a rate equal to the cost of funding of ESM plus 250bp.

instance, would carry a rate equal to the cost of funding of ESM plus 250bp. Clearly, this surcharge on top of the funding costs of the financing schemes does not help solvency. For the sake of illustration, assuming that the EFSF then ESM end up refinancing the entire stock of Irish debt over time, this surcharge would require the Irish government to post every year a primary surplus higher by 3% of GDP to what it would have to achieve without the surcharge. This can easily be the difference between the plausible and the unachievable. Fiscal transfer from the weak to the strong? Pursuing this reasoning leads to bizarre conclusions: assuming that the assisted governments succeed in their adjustment programmes and repay the EFSF then ESM in full, then these schemes would end up making a (sizeable) profit. According to the ESM term sheet, the Board of Directors can then decide by a simple majority to distribute a dividend to its shareholders (the member states) based on their contribution to capital. What this means is that, if all assisted governments repay in full their liabilities to ESM, one may end up in the counterintuitive situation where there takes place a budgetary transfer from Greece, Ireland or Portugal to Germany, France, Finland, the Netherlands, Austria and other sovereign creditors. Lowering by 100bp the interest rate on assistance loans to Greece (from European governments, not the IMF) was positive, in our view, because it does contribute to improving solvency, as underlined by Elga Bartsch (see again Europe Economics: A Small Positive Step, but Still No Step-Change). In a similar way, a reduction by 100bp of EFSF loans to Ireland would make a small positive contribution to improving its hopes of restoring solvency. We understand that such a reduction of the rate is still on the negotiating table and would not encounter significant opposition, providing Ireland and its official lenders can find a common understanding on the orientation for its future (corporate) tax policy. This begs the question, why cut the rate by only 100bp and not the maximum extent possible, which would mean lending to Ireland at the EFSF funding cost? Moral hazard? What moral hazard? The main argument, to our understanding, is the moral hazard associated with providing countries whose solvency is doubtful what is effectively an AAA cost of funding. Namely, the incentive to put public finances in order and abide by fiscal commitments is weaker if cheap loans are available to offending governments. This is an old debate, for which there exist at least two counter-arguments: the first is the political and social cost of entering into an externally imposed structural adjustment programme, which more than compensates for the attractiveness of a low cost of funding. Neither Greece, nor Ireland, nor now Portugal went willingly to seek assistance. In each case, it was a last resort to which they submitted reluctantly (or will likely submit reluctantly, in our view, in the case of Portugal) after having lost market access. The second counter-argument is that moral hazard is relevant ex ante, and dealt with by creating disincentives for a government to let itself be drawn into a position of difficulty. It does not work ex post. So while a penalty charge on ESM loans might encourage governments that have not lost market access to front-load fiscal adjustment, it does little to help those countries that are already in trouble to restore solvency. The comprehensive response' of European governments aims at averting the next fiscal crisis, not so much at resolving the current one. Why protection against credit risk is not a convincing justification for a rate surcharge. A second argument in favour of a surcharge on loan rates is that it provides protection against (credit) risk, as indeed implied by the wording of the ESM term sheet. Again, there exist at least two counter-arguments: the first is that the best protection against credit risk, for EFSF as for ESM, is that the fiscal adjustment succeeds. If sovereign default is deemed detrimental to the financial (and economic) stability of the zone - which we believe indeed to be the case in a context where the banking system remains insufficiently capitalised to weather such an event smoothly - then the aim of supporting governments ought to be damage limitation, not profit maximisation. Imposing a penalty charge does not appear consistent with an objective of damage limitation. Preferred creditor status offers stronger protection. Even if the previous counter-argument is discounted, lending governments still benefit from another layer of protection in the form of the seniority of their claims relative to those of other creditors. While the EFSF does not in principle benefit from preferred creditor status (a situation that may change), the ESM will do so. The term sheet of the ESM indicates indeed, consistently with the policy stated by euro area finance ministers at end-October 2010, that:

area finance ministers at end-October 2010, that: Heads of State or Government have stated that the ESM will enjoy preferred creditor status in a similar fashion to the IMF, while accepting preferred creditor status of IMF over ESM. Preferred creditor status acts in a way very similar to collateralisation of exposure in providing to the lender protection against credit risk. Judging by the experience of the IMF, this protection is effective and loans that benefit from it are eventually repaid in almost all circumstances, including those of countries in much worse situations than those of Greece, Ireland or Portugal. Inconsistencies do not stop there. There is therefore, in our view, an inconsistency between the fact that the ESM is intended to charge borrowers a substantial surcharge over its funding costs as "an adequate mark up for risks" and its preferred creditor status. There is actually an even more bizarre inconsistency between the pricing of the different loans to distressed governments and their degree of seniority. If the rate of EFSF loans to Ireland is lowered by 100bp as still seems likely, this would imply that EFSF loans would be granted at a rate lower than ESM loans in the future, despite the fact that the preferred creditor status of ESM would make EFSF, in principle, junior to ESM. Meanwhile, the super senior status of the IMF is not reflected by, as one would expect, even lower rates on its own loans. These inconsistencies suggest to us three things: 1. The grand bargain is a compromise rather than a consensus. The agreement on the ESM and other measures adopted by the European Council on March 24 represents less a consensual master plan for resolving the crisis than an internally inconsistent compromise between diverging and at times irreconcilable positions; 2. Final decisions may not be that final. Because it contains inconsistencies, this agreement is not necessarily final. As has happened at the end of 2010, evidence of the unintended consequences of policy decisions may well lead European governments to reconsider and amend their positions. It is however possible, even likely, that there is no longer appetite to re-open debates that have been officially closed. This is not good news; 3. Sovereign default is becoming less taboo. The emphasis of at least a number of governments appears to have shifted away from preventing a sovereign debt restructuring to managing its implications. Restructuring in the euro area appears to have become more acceptable in some policy circles, despite its consequences, or more exactly providing its consequences can be managed. This last point is of considerable importance. Without unanimity, ESM financial assistance post-2013 cannot take place. Even with unanimity, assistance may be conditional on some form of private-sector involvement (from voluntary' maturity extension to haircuts on bonds, all of which cause damage to the property rights of creditors). While private sector involvement is expected, according to the term sheet of the ESM, on a case-by-case basis', it is a reasonable assumption that at least a number of governments expect or intend that it will take place in all plausible cases. At the very least, incorporating the penal rate charged by ESM in the intended assessment of debt sustainability of assisted governments makes it more likely that the assessment leads to the conclusion that governments are indeed insolvent and therefore to private sector involvement. In our view, this implicit shift of policy emphasis both increases the likelihood that sovereign defaults eventually take place in the euro area and brings forward their likely timing. The reasons are the following. Greece and Ireland are unlikely to come back to the market in 2012 as their assistance programmes envisage. The programmes foresee very small bond issuance for Ireland (respectively 1.1 billion in 2012 and 4.8 billion in 2013) but more substantial amounts in the case of Greece (26.7 billion in 2012 and 37.9 billion in 2013). Given the EU Council decisions discussed above, it seems unlikely to us that either government can actually sell bonds, at least not to private investors. In both cases, the fiscal situation is unlikely to look sufficiently better than it did when governments lost market access to warrant a complete change in investor confidence (debt ratios will still be rising). More importantly, we doubt that there will be much appetite from investors to purchase bonds that are

rising). More importantly, we doubt that there will be much appetite from investors to purchase bonds that are effectively now subordinated debt instruments, when they are being told explicitly that they may face maturity extensions or haircuts in the near term. Investors might prefer holding the subordinated debt of a solvent government than the senior debt of an insolvent one, but the penal rate of financial assistance schemes means that they are in fact being asked to hold the subordinated debt of possibly insolvent governments. This does not hold much appeal (on this point, see Sovereign Subjects: Curing Demotion Sickness, December 6, 2010). More official loans will be needed to fill the void. The implication, in our view, is that, if early debt restructuring is to be avoided, the financial assistance programmes of Greece and Ireland will need being expanded in 2012 to compensate for the inability of governments to raise funds in the market. We expect this to be the case. Doing so would result in the exposure of official lenders (European governments and the IMF) to Greece, Ireland and probably Portugal rising faster than initially envisaged. Core governments have the ability to keep on lending for as long as they want to their distressed peers. The question, though, is how long they will maintain the willingness to do so. There are, in our view, two ways to approach this question. The first is to look at it from the perspective of the direct financial protection of lending governments. Preferred creditor status, as discussed above, provides protection to official lenders, but only up to a point. If we assume that debt restructuring will take place (this strictly for the sake of the argument that follows), then preferred creditor status only provides protection if the exposure of governments is lower than the expected recovery rate on the whole debt. If exposure of super senior creditors exceeds this rate, they too must suffer a loss (which is of no comfort for private creditors, whose recovery rate at that point is zero). The implication is that if core European governments want to avoid any fiscal loss as a consequence of bailouts, they ought to force debt restructuring before their exposure reaches the expected recovery rate. At what point exactly this happens depends naturally on the expected haircut on the entire debt at the hypothetical point of default. This is admittedly entirely a matter of judgment. It would hinge on many moving parts such as the international economic environment at the point of restructuring, the level of prevailing interest rates, etc. Still, one can reasonably assume that if Greek or Irish sovereign debts were restructured, recovery rates could be very low. They would have indeed to be low enough to restore solvency decidedly. It would make little sense to restructure Greek or Irish public debt and still leave it above 100% of GDP. Bringing debt/GDP to 60% (considered a ceiling under the European Treaties) or even below would arguably make more sense. This would imply a recovery rate for Greece of between one-third and two-thirds on the overall debt, a bit better for Ireland. These numbers are not out of line with past episodes of debt restructuring in emerging markets. We illustrate the share of official loans in the central government debt of Greece, Ireland and Portugal, assuming that, from now on, these loans are the only external source of finance available. What this shows is that, in the absence of market financing, the exposure of lending governments to their distressed peers would very quickly reach uncomfortable levels. Our conclusions at this stage are that: If governments continue to focus on a narrow definition of their financial interests (penal rates on EFSF/ESM loans and rejection of any fiscal transfer), the likelihood of policy-induced sovereign debt restructuring in peripheral European countries at or shortly after mid-2013 rises quickly. The later it takes place, the worse it becomes for private creditors, whose recovery rates would quickly fall to near zero levels. In any case, if restructuring is to take place, private creditors need being prepared for very low recovery rates. The obvious flaw in the analysis presented above is that EFSF loans, unlike IMF and in the future ESM loans, are in principle pari passu with bonds. So, early restructuring (before EFSF loans are refinanced by senior ESM loans)

principle pari passu with bonds. So, early restructuring (before EFSF loans are refinanced by senior ESM loans) could result in a direct cost for supporting governments. We do not think that this necessarily creates much of an incentive to postpone sovereign debt restructuring. Waiting until all EFSF loans are rolled into senior ESM loans would leave official lenders holding too much of the debt of assisted sovereigns for comfort. Rather, it creates a temptation - and a valid justification - to upgrade the seniority of EFSF by granting it de facto preferred creditor status (remember that preferred creditor status is a creature of policy, not contract, so can be changed at any time). A stronger incentive for postponing sovereign debt restructuring in the euro area results, however, from looking not merely at the direct impact on creditor governments, but at the indirect impact on their economies. As we have had the opportunity to explain elsewhere (see Europe Economics: Sovereign Debt Crisis - A Roadmap for Investors, February 7, 2011), the main concern with sovereign default is the hole it creates in the liability structure of banks and thereby on the availability of credit to the overall economy. From this perspective, sovereign debt restructuring remains undesirable until such point at which banks are sufficiently well prepared to be able to handle it. This is a strong argument for disallowing European sovereigns to default now. But if and when banks are sufficiently recapitalised, this argument becomes weaker. We note in this context that the EU Council is committed to the recapitalisation of banks in the aftermath of the forthcoming stress tests as well as to enhanced disclosure on the banks' sovereign debt holdings. It seems inconsistent to us to incorporate assumptions of losses on sovereign exposure (albeit only in trading books) in bank stress tests without eventually requiring banks to hold capital against their sovereign exposure. So, over time, the direction set by the Council is one where the banking system is gradually prepared to absorb the effects of a sovereign debt restructuring, which in turn makes this a more plausible outcome - eventually. A third argument against sovereign default is the fear of contagion towards other governments. While we deem this fear to be valid, the current decoupling between the performance of the bonds of the three distressed governments and that of other governments, most noticeably Spain, supports the views of those in policy-making circles who think that sovereign default in the periphery of Europe can remain idiosyncratic (views which we do not share). To some extent, a solid performance of the Spanish bond market increases the plausibility of eventual sovereign restructuring in Greece, Ireland and possibly even Portugal, because the main argument for sovereign support is, again, to prevent systemic instability. It is not to prevent default per se. The conclusions of the European Council of March 24-25 set a course that, if not altered, raises in our view the probability that sovereign debt restructuring does occur in the periphery of Europe, and might paradoxically bring this event forward. This is not a foregone conclusion. European governments may choose an entirely different course of action, either by amending the current agreement (in particular the crucial question of the rate on which we have insisted here again) or by abandoning their inter-governmental approach in favour of a more integrated approach, with enhanced federal control of banks and government finances (a course of action we discussed earlier - see again Sovereign Subjects: Curing Demotion Sickness, December 6, 2010 - and that has been advocated, e.g., by Lorenzo Bini Smaghi and George Soros). The odds, at this moment, do not look favourable.