The known uknowns – speech at the European CFO summit
On 14 th October I will delived the guest of honor speech at the Europen CFO summit organized by ACCA in Warsaw, Please find the text of my speech below.
There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know. This Donald Rumsfeld quote applies very well to our present ability to forecast what will happen in the next few years in the global economy and in the Central and Eastern Europe. Back then, post September 11 crisis, the unknown-unknown was the smoking gun, a possible nuclear weapon facilities secretly operated by Saddam Hussein regime. Today, in the world still suffering from 2008-2009 credit derivatives crisis, we are yet to find out what is the smoking gun in the economic and financial dimension.
Let me begin my today’s economic story with known knowns. This is the easiest part. We know that the world has suffered the first global recession after the second world war, and the worst recession since the Great Depression. We know that the total financial market meltdown was avoided amid unprecedented action by governments and central banks. Total fiscal support including various new guarantee schemes exceeded 10 trillion US dollars, interest rates in many advanced countries hit rock bottom, and large central banks begun money printing exercise, loading their balance sheets with stuff that private investors declined to buy, often even at the firesale prices. This included mortgage backed securities and sovereign bonds of countries that enjoyed very narrow spread to German bunds just few years back.
Another known known is the fact that after music stopped and zombie-bankers refused to dance their zombie-dance, not only sovereigns in the developed world had to bail out the banks, but also they had to replace nose-diving private demand with the public spending. Cash for clunkers and other stimulus programs were engineered, leading to massive fiscal deficits. This was particularly pronounced in Anglo-Saxon countries, with deficits in the range of 10 to 15 percent of GDP in US and UK, and in excess of 30 percent of GDP in Ireland.
Finally the very important known known in that crisis came in a very bad moment for the public finances in developed world, exactly when the effects of aging were starting to affect the public finances. The costs of recession, the costs of bailout and the costs of aging together contributed, and will continue to contribute to the next big problem yet to be solved – the upcoming developed world debt crisis. The title of the most recent book by Jacques Attali, the first EBRD president, and very powerful thinker puts it very bluntly (my English translation from French)- “The West. Ten years before the total meltdown?”. According to 2009 study be EU Economic Policy Committee average public debt in the EU countries in 2060 will approach 500 percent of GDP if demographic trends, migration trends and economic policies remain unchanged.
Early signs of the upcoming debt crisis were seen few months ago, when sovereign credit of PIIGS countries came under pressure and the European Union had to come up with 750 bn euro rescue package and ECB was forced to sail on unchartered waters. As a former central banker I must confess, that I still find it hard to believe that ECB, with its tradition and reputation based on Bundesbank legacy, with single price stability mandate engaged in financial operations, that may have long lasting negative credibility consequences. The known known is that ECB continues to buy Greek and Irish government bonds, but the long-term consequences of this activity are among important known unknowns.
Turning to our region, Central and Easter Europe, or the EU10 as it is often referred to, it should be noted that after 3.6 percent GDP decline in 2009, these economies are expected to grow 3.7 percent in 2010, according to economic forecasts presented in October release of IMF World Economic Outlook. EU10 economies’ performance during the crisis was a function of the scale of excesses before the crisis. With the exception of Poland, all countries experienced contractions, some were very severe. Baltic states, which were heavily leveraged and did experience massive credit booms saw their GDP drop by 14 to 18 percent in 2009, with unemployment rates rising from 4-6 percent range in 2007 to some 20 percent in 2010. Other countries in the region, which had smaller credit booms, lower overall foreign imbalances and flexible currencies performed better. Poland was the only country to avoid recession, so it is worth outlining the known knowns that did contribute to this green island effect.
Poland was and still is a country with very low leverage, credit stood only at 50 percent of GDP, and banking sector credit to non-financial corporations was only marginally higher that the deposit base. Poland was relatively closed economy, with trade to GDP ratio twice smaller than in many smaller and more open economies in the region, such as Czech Republic or Hungary. Of course it is not conducive to growth in the long run, as more trade openness with right policies in place promotes growth, but it did help during the crisis. Another factor was luck. Previous government engineered massive tax reduction in 2007, which was designed as pro-cyclical stimulus in already fast growing economy, and created a risk of overheating. But the crisis came and risky pro-cyclical policy turned into anti-cyclical incomes supporting policy, which left extra income in consumers’ wallets to spend amounting to 3 percent of GDP. Finally it was also our entrepreneurial DNA. When Eurobarometer asked people what would they do with extra money, citizens in many EU countries opted for bigger house or extra holidays, while many Poles wanted to open new businesses.
One known known these days is also related to Polish anti-crisis economic policy. For quite some time government pretended that unlike in other countries pursuing pure Keynesian policies, Poland opted for a different policy – to save during the crisis. Government did perform few PR exercises pretending to save money – such as shifting road construction spending from budget to off-budget National Road Fund. But today it is well known known, that public sector spending went up in Poland by more than 6 percent in real terms in 2009, and Poland was in the camp of countries trying to avoid recession by large public spending programs. Similar to other countries in the region Poland used EU funds as the stimulus program, and some early research performed by the World Bank shows that it might have added some 0.3-0.4 percent of extra growth. Fiscal deficits widened massively in almost all EU10 countries, with the exception of Hungary, which saw its fiscal deficit fall from 5 percent to 4 percent, according to the World Bank quarterly review. Largest fiscal deteriorations took place in Latvia and Lithuania, with fiscal deficits swelling by almost 9 percent of GDP between 2007 and 2009. Then there is Slovenia, Romania, Poland and Czech Republic which saw their deficits widen by more than 5 percent of GDP. Of course the debt challenge in our part of Europe depends also on the overall level of public debt, which is very low – in the range of 15-35 percent in most countries. There are two exceptions, Poland with 2009 level of debt to GDP at 51 percent, and Hungary with public debt at 78 percent of GDP.
These were known knowns regarding current economic landscape. Let’s turn to known unknowns. Most of them are global in nature and apply to many emerging countries around the globe. Few years ago there was one specific factor that applied to EU10 countries and did not apply elsewhere. An IMF study few years back showed, that controlling for various macroeconomic variables sovereign credit spread in EU10 countries was lower than justified by fundamentals, by some 50-100 bps. It was explained by the euro convergence. This theme is gone by now, as some market participants question the future of the euro, and some EMU member states pay much higher sovereign spreads than non-EMU EU members in their local currencies.
So the known unknowns are of a global nature. Let’s discuss some of them, and let’s begin by quoting one London-based bank:
“The spectacular growth of emerging markets in recent years has attracted significant attention from investors worldwide. But the ability of many EM countries [… ] to weather remarkably well the most severe financial crisis in seventy years changes dramatically, in our view, the nature of this asset class. In particular, the passing of such a demanding test suggests that as the developed economies recover from the financial crisis – which could take years – the relative ex-ante Sharpe ratios of a subset of EM assets should be more attractive than anytime in the recent past”.
This is a representative view now shared by many financial institutions around the globe. With large developed economies facing massive public debt problems, investors turn their attention to countries which will not have such problem, will continue to grow at solid pace and their assets (mostly local currency bonds) are expected to deliver solid risk-adjusted returns. Indeed, we see emerging markets stock markets heading north, we see record high inflows into local bond markets, including massive short-term capital inflows to China. These inflows are driven to a large extent by emerging markets currency appreciation story. With large central banks printing money as fast as printing press allows, this extra liquidity finds its way via various channels into stock and bond markets in developing countries putting pressure on local currencies. The big known unknown is how it will end? This short-term capital inflows are not welcome: several countries intervened on currency markets (including Poland, which intervened for the first time in twelve years in April 2010), some countries resort to taxes or capital flow controls, for example Brazil imposed and then raised capital tax on local bonds purchases by foreign investors. Recent annual IMF-WB meetings in Washington ended with no conclusions. Currency wars – as some analysts put it – seem to continue and enter a new, more dramatic stage, with Federal Reserve contemplating to run printing press even faster possibly as early as in November this year. We know that trade protectionism in 1930s turned depression into Great Depression. It remains to be seen whether loose monetary policies in large developed economies designed to prevent recession and deflation in these countries translate into global financial turbulence, when overvalued bond and equity markets collapse one day, the day when printing press stops.
Another known unknown is a method which will be used to handle swelling public debt in large developed economies. So far Greece, Ireland and possibly Spain and Portugal was saved by huge bailout and ECB direct bond purchases. But one day ECB will have to stop, which will put to a severe test market confidence in sustainability of economic policies in these countries. Recall, that aging costs have not been dealt with in most EU countries, with the sole exception of Poland, which will see the cost of aging in relation to GDP fall over time thank to pension reform which massively reduced future pensions, with replacement rates expected to drop from 56 percent to 30 percent. Are other nations ready for such reforms? And if they wish to keep high replacement rates, are they ready to accept increase in pension age to 67 years for both men and women. Recent events in France and Spain suggest that we are far from this reform acceptance point.
So the big known unknown is what will happen when reforms fail. Will governments in the eurozone and in the US resort to high inflation to reduce the real value of the public debt? It is openly contemplated in the US, with target inflation rate suggested at 4 to 6 percent. Foreign creditors holding large US dollar denominated assets may feel nervous reading these suggestions postulated in Financial Times by top US economists, including High level IMF officials. Or maybe some sovereigns that hold high investment grade today will fail to meet their debt obligations in the future? The book of 800 years of financial folly by C.Reinhart and K.Rogoff shows that very few countries in the world have track recon of avoiding bankruptcy. Will default lead to another wave of market panic and possibly global recession? How will EU10 countries perform in inflation and in developed country default scenario? These are important known unknowns.
And finally we have arrived at unknown unknowns. The smoking gun. Something that may or may not surface, but anticipation that it may become reality one day, even if it is a distant possibility, may affect the economic and financial landscape in a major way. By definition we do not know what type of risk or opportunity may arise. On the one hand we can enjoy benefits of massive technological advances, that one day will take care of a global warming threat. On the other hand the world has never had to deal with more than seven billion people, as it will this decade. It can bring war about resources – from oil to water – and can also lead to major viral diseases outbreaks. Keep in mind that China National Petroleum Corporation at the end of 2008 run worldwide 75 projects, and each of them was targeted to gain access to raw materials, especially oil and gas. And China has several such state owned companies operating on a global scale.
I was supposed to offer you my forecast for the CEE region. Instead I presented the list on factors that cannot be predicted with reasonable accuracy, and some cannot be predicted at all. I did it in purpose. I believe that after twenty years of Great Moderation, we entered a very different economic era, the Age of Turbulence, as Alan Greenspan put it. In the Age of Turbulence, forecasts based on models fed by last two decades of data will give terribly wrong predictions. I expect that this decade will bring challenges of magnitude compared only to wars. I am not sure whether nations in countries expecting these problems are ready to face these challenges. This is the biggest known uknown, as I see it.
Thank you for your attention.