The United States of Europe

While national parliaments in Europe are voting for the new Greek bailout, here’s an excellent counterfactual showing where Europe could be now if it had a real union:


That’s the summary of the choices that Europe made (and continues making) since at least 2000. If the year of 2009 explains itself with toxic assets and international shocks, the second dip is a European invention. It started with politicians denying the intention to bailout the indebted EU members. This ambiguity provoked the sovereign debt crisis in 2011-2012. The debt crisis, in turn, increased the cost of borrowing for the European countries that had to counteract high unemployment. Unable to do so, the periphery retained its 20-plus percent unemployment and the loss of output that followed.

To that the European Union responded in slow motion. The European Financial Stability Facility — the major vehicle of intra-EU bailouts created in 2010 — had been expanding constantly in response to the deteriorating situation in indebted economies. But actions took place only after the bad things had happened.

Now take the United States, which settled its major debt issues via the TARP in 2008-2009. More importantly, it was the federal government that paid $700 bn for this program. The American states didn’t waste time figuring out which state government was unacceptably immoral and, therefore, should have been reformed. In a hypothetical scenario, they could. The poorest American states have only a half of output per capita produced by the richest states. Also, the recovery was uneven:


Secondly, the US had the Fed that provided liquidity regardless of the bank’s state of origin. Meanwhile, as the first figure reminds, the ECB-led eurozone performed worse than the EU on average (and much worse compared to the nine EU countries that retained their national currencies).

This problem is much bigger than the Greek case alone. With Greece, European politicians ignore the most respected macroeconomic experts making reasonable arguments. But these politicians are not supposed to listen to the reason, if by reason we understand the wellbeing of an average European. Merkel and Schauble are accountable to the German voter, not to the Greeks. And the German voter is fine with paying nothing to Greece. He can continue enjoying low unemployment at home — even if this became possible thanks to the euro weakened by the indebted EU members.


Paul Krugman shows the divergence between Sweden and Finland. Finland is a eurozone member lagging behind Sweden, with an overall picture similar to the first figure here.

Debt and Currencies: The Soviet Connections

To have a currency crisis Russia suffered this week, a country needs two things: a local currency tied to a volatile international commodity and some external debt.

In oil exporting countries, the local currency is tied to your-know-what. As for the second condition, oil exporters are not supposed to borrow abroad when oil makes new highs. However, when the central bank let the local currency get stronger as export bucks flow in, borrowing abroad becomes attractive.

This opportunity is exposed when the PPP conversion factor to market exchange rate (PPP/EX) ratio is growing. And the ratio had been growing in oil exporting countries, though most of them escaped the temptation to borrow abroad:

World Bank
World Bank

(Russia and many others are missing in the World Bank’s data on debt. Among the remaining countries, red stands for energy producers. Negative changes in debt are due to countries (sometimes) repaying their external debts in 2001–2011. The worldwide average of external debt to GNI halved during this decade.)

And absolute values:

World Bank
World Bank, 2001–2011

The debt is an important addition to yesterday’s currency overview. A currency may diverge from its “value,” but it’s external debt what creates risk. The Russian debt to GDP ratio stood still around 35% for years, but this level became a problem when the private sector had lost access to western credits. Kazakhstan isn’t under sanctions, but its 80% debt together with dependence on oil put the country in a similar position. Also, some other former Soviet republics, like Tajikistan, depend on dollar-denominated remittances from Russia—it’s their “oil” risks.

A Brief History of Russian Debt

Paul Krugman draws attention to the role of exchange rates in the Russian debt. I’d add a few notes on this in addition to yesterday’s overview.

External Debt Was Cheap

For two reasons:

  1. QEs and zero interest rates made the dollar and the euro very attractive currencies for borrowing.
  2. The ruble appreciated in nominal terms, while its PPP conversion factor (how much rubles you need to buy the stuff worth $1 in the US) grew steadily (Paul Krugman’s point). Here’s the movement between 2000 and 2008:
WDI 2013
WDI 2013

The ruble becomes de-facto weaker (red line), but the exchange rate (green line) moves in the opposite direction. Russian businesses thought that borrowing abroad at low interest rates was a great idea. A corporation borrows a dollar at 1% per year, exchanges it for rubles in 2004, holds rubles for one year while the exchange rate going down, and returns the principal and the interest to the lender in 2005. Okay, corporations did something else to this money and paid a higher interest, but ruble-denominated debt was still more expensive.

The Russian Private Sector Accumulated $650 bn. of External Debts

About 90% of Russia’s external debt is corporate, though the state owns many of these borrowers:

World Bank's Russia Report, 2014
World Bank’s Russian Report, 2014

It Was Time to Pay the Debts

Russian corporations had to pay about $100 bn. of debts by the second half of 2014, when the States and EU lifted the sanctions:

World Bank’s Russian Report, 2014

Meanwhile, the oil prices fell to $60 and the currency inflow halted. This led to the shortage of dollars in Russia, so several big borrowers could break the thin market when they started lurking for dollars inside Russia:


The Central Bank of Russia held about $500 bn. in reserves but it didn’t support the ruble much over the year:

The Economist
The Economist

It didn’t matter than Russia had a current account surplus of about 5% of GDP throughout the 2000s. These $700–900 bn. were export revenues. Exporters converted them into rubles to pay taxes, wages, and other expenses. So, $500 bn. ended in the central bank.

External Debt Became Expensive

The corporate borrowers panicked in December 2014. The Central Bank didn’t offer enough dollars when the market was running out of them. The exchange rate hiked on December 16. This 10% daily hike meant really large annual returns (try to calculate 1.1^365). The dollar became an attractive investment. Not only corporate borrowers, but the entire population wanted dollars for now. Companies and families bought dollars with their savings or newly borrowed rubles.

People also reasonably expected import to become more expensive and started shopping before retailers adjusted their prices for the new exchange rates. It ended with a daily inflation peak because retailers did react to the new demand.

After the government intervention, the ruble stabilized around 60 RUR/USD. But $720 bn. of external debt remained. Corporations now have to pay about 100% of real interest, adjusted for the exchange rate shift. Though many of them are exporters and sell for dollars, Russian banks naturally earn their revenues mostly in rubles, which makes it difficult to pay forex debts. (Banks can buy the dollars back after the hike, but the financial sector has many other problems now.)

Finally, Weather Forecast

Asian countries had a pretty severe recession after the 1997 currency devaluation:


As Paul Krugman noted, broken balance sheets created troubles for these countries. When you borrow the currency that is different from the currency of your operations, well, you must hedge. Did Russian corporations know the Asian lesson and hedge? We’ll see, soon.

Picking the winners is still up to the government. The Central Bank has plenty of options here. It can use the remaining reserves to bring exchange rates down. It can keep the interest rate high (but not for long because businesses need credit). Or it can pick winners one-by-one.

More notes on the consequences are coming.