In a recent piece, we suggested that the Italian government should implement a program of “rigor without austerity”, to promote fiscal consolidation and growth in economic activity. If such a program were implemented, fiscal consolidation measures would have a reduced impact on households’ disposable income, therefore reducing their recessionary (almost “depressionary”) impact. The two pillars of such a program should be (a) a reduction in the debt-to-GDP ratio and (via that) in the deficit-to-GDP ratio (i.e., the opposite of the current recipe) and (b) an increase in households’ and corporates’ disposable income.

Regarding the first pillar, the overarching aim would be to reduce the country’s gigantic public debt without impoverishing a large part of the population with excessive austerity measures. The latter were forced on Italy at the low points of the crisis in November 2011 and July 2012, when investors wanted the government to prove that it was able to generate the cash flows that would validate their investments in Italy’s sovereign debt (via expenditure reductions or tax increases, no matter how socially painful). At that point, the government had to adhere to the promise it made at the June 2011 Cannes EU/G20 meeting that it would achieve a nominal fiscal balance in 2013 (i.e., one year earlier than initially established). But insisting on deficit reduction for a country that has not exhibited meaningful fiscal slippages since the 1990s was a political-economy mistake, and dramatically backfired at the election. The road followed is not reducing the deficit to reduce the debt, but vice-versa. The second pillar aims at stimulating internal demand (household consumption and corporate investment), which is the real drag on economic activity from the demand side.

This program has been exposed in a detailed article published in the latest issue of LIMES, the Italian Journal of Geopolitics (in Italian only).

The key ingredients of the programs are the following:

First Pillar: Reducing the debt-to-GDP ratio and, via that, the deficit-to-GDP ratio

Growth-Enhancing Measures

Medium-to-Long-Term Measures

1) Continue the liberalization campaign started by Bersani in 2008 and reprised by Monti in 2012. This reduces the mark up (thus making Italy more competitive internationally) and increases household disposable income (thus positively impacting consumption).

2) Complete labor-market reform (re-introduce flexibility of hiring and firing). As a result, the number of employees in the least competitive sectors will probably fall, thus reducing ULCs. For this reason, this measure must be accompanied by a minimum guaranteed salary or citizenship income. The estimated cost is €20 billion, but €15 billion is already in place. Salary or income should be linked to professional qualification programs conducted by regions, which receive EU funds for that purpose.

3) Promote SME consolidation and incentivize R&D investment. This aims at promoting the innovation of product and processes, this increasing labor productivity.

4) Shift public expenditure from consumption to capital expenses, with public investments that should not be counted toward the calculation of the Maastricht-consistent fiscal deficit (ongoing discussion at EU level on the so-called “golden rule”). Public infrastructure should only be built if, at the same time, the environment is safeguarded. Safeguard historical and environmental heritage to promote price-insensitive tourism and exports.

Shock Therapy

5) Promote the inversion of brain drain (possible but difficult without a credible government); some projects are already in place (controesodo); others should be implemented (e.g., “productivity islands”). This is to enhance productivity (thus reducing ULCs) and shrink the growth differential with other countries (value added abroad starts being added domestically).

6) Large scale clean-up in public-auctioning procedures (infested by corruption) and zero tolerance (actual, perceivable and publicized internationally) on organized crime. This is to make Italy a safer place to invest, and to invert the FDI flows.

Debt-Reduction Measures

7) Privatize local providers of services after clean-up and consolidation. This is to cut the link between corruption and “bad politics” at the local and national levels.

8 ) Privatize local real estate via long-term leases rather than outright sales.

Second Pillar—Increase the Disposable Income of Corporations and Households

9) Reduction in the first two rates of personal income tax.

10) Re-modulation of the property income tax, to exempt the first property.

11) Unblock (at least a large part of) the €100+ billion credit that private nonfinancial corporates have versus public administration (some action has already been taken). For example, issue public bills to be sold to the personal owners of the companies.

12) Reduction in payroll taxes (cuneo fiscale); e.g., by increasing tax deduction for employers on IRAP.

As one can see, a policy of aggressive tax cuts can only be funded by a new round of privatizations or a very aggressive campaign of cuts to so-called unproductive expenditure (i.e., public expenditure wasted due to corruption and rent-seeking), as well as a strenuous fight against tax evasion. This is not on the agenda at the moment, and the government’s heterogeneity does not bode well for Letta’s ability to obtain those in the future. The prime minister has also said that he wants the EU’s excessive deficit procedure against Italy to be closed, and expects this to happen in June; if this does happen, Italy would regain the fiscal room to allow some investment to jump-start economic growth.

The reduction in the tax burden is a pre-requisite for Berlusconi’s participation in the government and a necessity for increasing households’ and companies’ disposable income, but covering these tax cuts appears to be virtually impossible. Therefore, we regard near-term fiscal slippage as almost inevitable, but not necessarily bad. In the context of Spain having secured two more years to meet its fiscal targets and France continuing to delay its fiscal consolidation, Italy will try to find European support to temporarily deviate from the 3% nominal deficit-to-GDP target ratio, and will probably find some.

The ECB opened up two more doors today, though it hasn’t walked through them: first on securitization of SME loans into ABS, and second, to lower their deposit rate to negative levels, which the OECD also recommended over four months ago. Specifically, Draghi said the ECB is technically ready for, and “has an open mind on a negative deposit rate”, adding that while such a move would have unintended consequences they would cope with those negative effects. This doesn’t mean that they will be able to mitigate or avoid that collateral damage, though they might try. These might include the destruction of money market funds, dangerous financial engineering, distortions in certain markets, and increasing the interdependence between banks and sovereign risks. But they’d accept them as a necessary evil. Further disinflation and disappointing economic data will probably trigger such experimentation, rather than risk certain failure in meeting their inflation mandate by keeping real rates too high.

It is interesting to note how the ECB’s thinking on negative deposit rates has evolved:
Back in July 2012, tired out from LTROs and the rate cut implemented in that month, they weren’t even thinking about doing anything non-standard… less than a month later came the “whatever it takes” ad hoc that led to the OMT, but Draghi and the ECB were not even thinking about going into the unknown territory of negative nominal interest rates. Indeed, cutting the depo rate to zero proved extremely powerful, for a time.

Excerpts from that press conference:

Question: Is the Governing Council concerned about the impact of negative carry via negative yields for bonds and such, especially for non-banks? And does the Governing Council not think that a negative deposit rate could be risky and, if so, does that mean that the Governing Council rules out negative rates?

Draghi: We have not discussed this and, as usual, we will not commit to any further measures.

Question: My first question probably paraphrases what my colleague has just asked. In principle, would you consider operating under negative deposit rates?

And my second question is this: you have repeatedly stated that credit has mainly been driven by demand in recent months. Does that mean that the ECB is operating close to, or under, a liquidity trap?

Draghi: No, we do not think we are in that situation. And, frankly, on the other part of your question and your colleague’s question, I would say that, at this point in time, we are not really elaborating on various non-standard situations in which we may find ourselves. So, at this point in time we are not actually thinking about that.

Question: Is there any concern on the Governing Council that the ECB is now running low on policy options and that, if there is not an improvement as expected or hoped, there will be a need to turn to some more unconventional measures?

Draghi: No, there is no such feeling that we are running low on policy options. We still have all our artillery ready to contain inflationary risk in order to pursue the objective of price stability. Let me say one thing: when I say pursue the objective of price stability, I mean on both sides or in both directions.

In November 2012, Draghi was asked:

Q: …Governing Council member Ewald Nowotny said that, for him, a negative deposit rate, should you decide to cut interest rates, doesn’t appear to be a realistic prospect to him. Is that an assessment that is shared in the Governing Council?

Draghi: We did not discuss matters related to your second question.I want to elaborate on further non-standard measures at this point in time.

Then, at the end of last year, there suddenly was more discussion, and some readiness and preparation!  In December-2012’s press conference, Draghi replied to a question as follows:

“On the issue of negative interest rates on the deposit facility, there is nothing new to report. As Mr Praet recently has said we are operationally ready, but the discussions in this respect did not go into any depth. We briefly touched upon the complexities that such measure would involve and on possible unintended consequences. But we did not elaborate on this any further.”

But two months ago, the ECB seemed to backtrack, having more reservations about the cons and uncertainty about the pros:

March press conference: …And my second question is whether the Governing Council has actually discussed a cut in the deposit rate, and what you think the biggest risks would be if you implemented a negative deposit rate?

 Draghi: … The answer to the second question is the following: we have looked at that and we do not commit to doing anything. The unintended consequences of a measure like that can be serious, as similar experiences in other monetary jurisdictions have shown. I think in the past I have described this as “unchartered (sic) waters”, which is all I can say on the matter.

Finally, last month’s presser was all about the Cyprus fiasco, and the negative interest rate did not come up in the Q&A.

One further unanswered question is if further repo and marginal lending rates will come first,  compressing the “corridor” between its three different rates (deposit, refi, lending) to Czech-type levels first (see below). That seems likely.

Of course SD is NOT against recovery, per se. He seems to be against recovery that comes with the hidden expense of large risks, (e.g. Listed here http://www.project-syndicate.org/commentary/the-risks-and-costs-of-quantitative-easing-by-nouriel-roubini by RGE Chairman Nouriel Roubini) or that results in one bubble being replaced by a bigger, more damaging one. These consequences (the foreseen ones of inflation, damaging liquidity, difficulty in exiting loose policy, and causing bubbles) are legitimate but not a present concern for Bernanke and a large majority of the FOMC. SD identifies the previous recession’s cause correctly as the gigantic credit bubble, for which in turn he ascribes some culpability to the Greenspan and Bernanke Fed for failing to normalize rates fast enough after the 2001 recession had turned to recovery.

PK is right that 7.9% unemployment and slow growth call for very expansionary monetary policy. But what if policy is even looser than it ought to be—is there any harm in that? In normal times, are there no penalties for when the Fed keeps rates very low, or when in the midst of a boom the Fed ignores the irrational exuberance? History shows that the cost of misguided monetary policy is high.

While I’m at it, another annoying thing that PK and some others tend to do, related to the above argument, is to compare the state of a given recovery to the pre-crisis high. PK did this with the Bush “jobless” recovery—doesn’t seem so bad now, does it?—and the present one in the US, and does it as a matter of course with Ireland, Latvia, Spain, Iceland, etc. But he really should know better. All of those pre-crisis points were the peaks of giant unsustainable bubbles. The bubble-level equity (Nasdaq 5000) and credit spreads (Bank of America and Ireland at a few bps over USTs) are equally meaningless now, except as a reminder of quite how irrational the exuberance can get. More prosaically, the IMF estimates the US had a “positive output gap” in 2000 and 2006 of 4.3% and 1.8% respectively, meaning output was way above potential. For the PIIGS, Latvia, and Iceland those overheating episodes are estimated at 3-9%, and manifested themselves in asset bubbles, grotesquely large current account deficits, and huge buildup of external debt to finance them.

Based on this the Greenspan criticism of SD looks on target: after preventing a major recession, the effort to reflate GDP was misguided. PK and SD seem to agree that dealing with our future obligations is a problem as well, though they might differ on how to measure it (SD probably would go with Kotlikoff’s number of $222 trillion or so = 148% debt/GDP on top of reported debt = US is bankrupt, and characterize it as fiscal child abuse, while PK would say seniors were promised and deserve every penny and that the $222 trillion should be divided not by 2012 GDP but by the sum of 2012-2055 GDP = $1 quadrillion = 22.2% of future GDP.) But while we shouldn’t aim to restore the economy to 2006-07 levels, the chart below shows that not advocating forceful fiscal and monetary measures to help the economy normalize now is foolish or cruel.

Figure 1: Current Account Deficit Comfortably Financed by FDI, for Now

Source: BCB, RGE

Portfolio flows in 2012 totaled $8.2 billion and averaged barely US$690 million per month, well shy of the $5 billion average during 2010 and the 2011 average of $3 billion. However, Brazil may need increased portfolio flows in the next few years to help finance its current account deficit, as external accounts are affected by the deceleration of the Chinese economy—the chief consequence of which will be lower demand for metals, such as iron ore—and increased imports as investment accelerates ahead of the World Cup and Olympics.

Figure 2: Private-Sector Credit Deceleration Highly Correlated with Portfolio Flows (left axis: $, millions; right axis: y/y)

Source: BCB, RGE

Interestingly, there is a strong correlation between portfolio flows and private-sector credit growth in Brazil, which was particularly strong for the 2006-09 period, and somewhat weaker postcrisis. If we accept the premise that portfolio flows, to some extent, affect domestic credit, and embrace the idea that that credit is a key growth driver in Brazil (as we believe it is), it is unsurprising that 2012 saw dramatic drops in portfolio flows, private-sector lending and economic activity (bearing in mind, of course, the many other challenges faced by Brazil in 2012). Significantly, credit growth levels before the crisis were a cause for concern, arguing for a more stable equilibrium. The relationship between capital flows and the credit boom brought forward a set of vulnerabilities at the time, which seem to have been contained in the postcrisis years.

Still, credit growth is necessary for domestic expansion; hence, perhaps, a healthier Brazil requires higher portfolio flows to help drive credit growth aimed at infrastructure investment, as the current account widens due to higher imports of capital goods and lower export revenues. But such credit expansion needs to be better channeled toward productive investment rather than to continue feeding already over-leveraged household consumption. In fact, clear game rules, prudent macroeconomic management and proper incentives for private capital would generate the proper conditions for foreign capital to fund local investment projects directly through debt and equity channels. There is no doubt that the bulk of the financing for the current account deficit needs to come from FDI rather than portfolio flows. However, FDI has already broken records in Brazil and other Latin American countries and, as current account deficits widen, further financing may be required. In particular, a deceleration in China risks deterring FDI destined for sectors like commodities or other tradable goods, leading to greater concern about the future financing of current accounts. Could it be possible then that portfolio flows deliver a dual role of providing extra financing for the current account while feeding domestic credit? And, more importantly, can such credit be aimed at productive investment rather than short-term consumption?

Figure 1: Brazil Well Below Growth Potential, Well Above Inflation Target (%, y/y)

Source: RGE

In 2012, Mexico, Chile, Colombia and Peru boasted: Strong central bank credibility regarding their respective inflation-targeting mandates; clarity and overall predictability over the choice of reserve-accumulation programs and market intervention by central banks and finance ministries; an absence of punitive capital controls; fruitful debate about, or implementation of, macroeconomic reforms; demonstrable respect for private capital and its role in generating growth; a friendly environment for private investment; central banks independent enough to make decisions on technical grounds; and a coherent overall policy mix. The macroeconomic performance of these countries has reflected productive policy stances: Their currencies appreciated throughout 2012; reforms in various fields such as the labor market, fiscal policy, education and energy have been debated or implemented; inflation expectations remain anchored; fiscal accounting has been clear; business and consumer confidence remain high; domestic demand remains robust; and investment (or fixed capital formation) continues to grow.

Figure 2: BRL Management Suggests Clear Target (%, y/y; 30-day moving average)

Source: Bloomberg and RGE

Brazil, meanwhile, has grown increasingly interventionist. The authorities have resorted to a variety of hostile measures in an attempt to engineer a perfect economic state: Volatile and unpredictable capital controls have been implemented to control the value of BRL, price controls (as in the electricity sector) have been enacted to tame inflation pressures and conditionality regarding labor markets has been attached to stimulus in the industrial sector. This suboptimal policy mix has undermined the credibility of both the central bank and finance ministry: Inflation expectations remain unhinged, inflation dynamics have been detrimental to the economy, fiscal targets have been met only with arbitrary accounting exercises, official forecasts have been divorced from reality, and, more importantly, there is a lack of any sort of acknowledgement that the problems the country faces are endogenous.

This lack of policy-making credibility could translate into uncertainty about the future health of the economy, which would in turn discourage private investment, dragging down economic performance in a negative feedback loop. Exogenous factors can only go so far in explaining Brazil’s poor economic performance in 2012: Weak global dynamics and adverse weather conditions affected industrial production, exports and inflation, but regional peers did not exhibit Brazil’s weakness. Look at Chile and Peru, which also saw deterioration in their external accounts, or Colombia, which suffered a deceleration in industrial production, or Mexico, which has had to deal with elevated food prices stemming from exogenous shocks.

Brazil’s underperformance in 2012, which strongly contrasts the performance of its inflation-targeting LatAm peers, is likely underpinned by poor policy making. This year, Brazil’s growth will likely outperform that of its LatAm peers, fueled by stimulus, base effects and short-term investment buffers, although it will remain below potential. As we have stressed, higher growth will be accompanied by higher inflation if underlying factors are not addressed. Brazil has huge growth opportunities, but downside risks swell when macroeconomic management shifts further toward interventionism.

Nowakowski: If a law is passed that contradicts existing law, but does not directly make a reference to the current law being amended, does the new law always supersede the old? Is there a legal name for this principle? For example, Congress passes a law that says, no meat may be eaten during Lent. Then a year later, they pass a law (not a constitutional amendment) stating “The right of the people to keep and eat bacon is hereby established and protected.” I would say that means you can eat bacon during Lent. If the chronology were reversed, then no bacon til Easter.

Mollow: The new law will trump the old one if that was clearly the legislative intent; the term “amend,” which you use, is correct. It is sometimes said that the old law or statute has been effectively repealed by the new law. In many situations, a court will find a way to infer an exception to or exemption from the old law, rather than strike it down entirely. The court can look quite carefully at the language of both statutes and sometimes at the legislative history, and can apply a number of canons of statutory interpretation to both laws. If the legislative intent is unclear, then things can get more confusing. In practice, the courts in these kinds of circumstances are really likely to base their determinations, with or without saying so, on public policy considerations, aka politics.

A well-known instance of your question arose after Congress enacted the National Labor Relations Act of 1935 and other labor laws. Courts had to decide whether the labor laws trumped the Sherman Antitrust Act of 1890, which generally prohibited contracts in restraint of trade. The antitrust law did not have an express exemption for labor organizations. But it seemed that Congress would not have enacted the labor laws in the absence of an intent for unions to be exempt from the Sherman Act’s prohibition, for such an exemption was necessary if unions were to engage in collective bargaining. So a real conflict existed there, and as a general matter the courts ended up finding implied exemptions to the antitrust laws. See, e.g., United Mine Workers v. Pennington 381 U.S. 657 (1965); Meat Cutters Local 189 v. Jewel Tea Co., 381 U.S. 676 (1965).

Nowakowski: What about the budget ceiling debate? Isn’t the ceiling the “old law”, while the budget, which tells the government what to spend and what revenues it can raise and how, is the “new law”, which arithmetically forces borrowing to be the difference, even if the budget doesn’t make that explicit?

Mollow: I don’t think so. Though as a practical matter the two laws may “arithmetically force” the borrowing, as a conceptual matter they do not, because cutting spending to bridge the chasm is logically possible, as is default. A law capping the debt ceiling and a later law mandating certain expenditures therefore do not seem to me to constitute a true—i.e., substantive—conflict between two federal laws. My sense is that Congress really has to explicitly raise the ceiling in order for the spending to be lawful. I don’t see a compelling argument that the new budget supersedes the debt ceiling, meaning that the latter has already been effectively repealed by Congress. One problem with an argument along those lines would be that if Congress had intended to repeal the “old law” it could have said so explicitly in the “new one”; a related problem is that extensions of the debt ceiling have occurred historically as independent legislative action. I think that it would be hard to argue persuasively that such actions were essentially superfluous, that Congress could have accomplished the same result by simply enacting spending legislation.

Nowakowski: Turning from federal law to constitutional issues: is section 4 of the 14th amendment relevant to this debate? Given the amount of interest and the size of the deficit, if the government can’t borrow more because it is at the legal limit, will it be forced to default, eventually?

Mollow: Regarding the Fourteenth Amendment, I don’t think so, though some commentators (e.g. Yale’s Balkin) have suggested that it could be relevant. The Fourteenth Amendment—ratified in 1868, shortly after the Civil War—provides: “The validity of the public debt of the United States. . . shall not be questioned.” So the argument has been raised that President Obama could spend by executive order on the basis of this language. This is a novel argument, as I understand it, and one that I do not expect to see taken very seriously; apparently the White House has made clear that it does not intend to invoke this expansive view of executive power under the 14th Amendment.

And yes, under the hypothetical circumstances you specify default would be conceptually possible, as would slashing popular government programs. Neither of these arithmetical solutions would be politically plausible, though. I therefore really expect to see the Republicans cave (it may be that many of them are grandstanding to demonstrate to constituencies that their interests are being represented to the extent possible) and simply increase the ceiling. If the political conflict proves to be especially intractable, it is possible that there will be a brief selective default limited basically to entitlements (i.e., not bonds), and that the unpleasantness this entails will then force a deal, as a crisis or the appearance of one can sometimes be necessary to clarify the real political interests and their relative strengths. Default beyond this limited kind does not strike me as a realistic possibility as it would not serve the interests of any major political constituency and has not been foreseen by the bond markets.

David Mollow practices law in New York and Massachusetts. He received a J.D. from Columbia Law School in 1999 and a B.A. in history from Tufts University in 1994.

David Nowakowski is RGE’s senior director of research.

Regarding the ongoing U.S. fiscal cliff negotiations (but recorded before Congress reached the mini-deal), Das expected that a bargain would be reached, but permitted the “meaningful tail risk that that deal is not reached” by February—a risk that is still significant, as the sequester and debt-ceiling loom in the next calendar month. While turmoil in the U.S. would naturally have flow-on effects for the rest of the world, Das did not expect any surprises on the fiscal front in India, saying, “The government has sent the signal that it will roughly keep the budget where it is, so effectively tighten as the economy slows further,” and explaining that while some fiscal slippage is inevitable, too much amid global instability could see “meaningful” consequences in the markets, “because of the portfolio financing hot money flows that are holding up the rupee, the equities [market] and, increasingly, the bond market.”

Lastly, he touched on geopolitical risk and glanced ahead at Indian monetary policy, determining that Middle East risk will remain elevated, presenting an upside risk to inflationary pressure via the imported price of oil, which could require a tighter monetary policy. He concludes that the RBI will cut rates by 50 basis points in Q1 CY2013 and by 25 bps every quarter in 2013.

View the full video here.

I would estimate that Global Financial Wealth rose by $17,500,000,000,000 to $162 trillion (I ignore bank assets and real estate and use IMF data; BCG also hasgood studies on the topic). That seems like a lot, but it is only $23,200 per capita after the year’s $2,500 gain if it were equally divided, which it ain’t (more specifically, BCG calculates that 12.6 million “millionaire households” control 40% of the total but comprise just 1% of their sample population). Anyway here are the numbers:

Fixed Income:

Global Sovereign:            13.4%

Global Corporate*           11.2%

Global High-yield              19.6%

US Munis                              6.8%

US Treasuries**                 2.0%

EM Currencies                     7.5%

EM Loc FI (GBI-EM)         19.9%

EM Ext Debt (EMBIG)     18.5%

EM Corporates                  15.2%

Equities:

Global                                   16.5%

EM                                         18.6%

S&P 500                                16.0%

Commodities:

CRB Index                           -3.4%

Gold                                        7.1%

*  This doesn’t mean spreads widened; sovereigns did well thanks to currency effects (different weights from Corporates) and PIIGS’ high yields. Corporate spreads rallied all year long, coming in from 260 to 148 at year end, a major rally.

** These are market weighted, so most of the index is short-maturity, very low yielding stuff. The 10-year did somewhat better, returning ~5%.

A tough growth environment: Growth has slowed sharply across Emerging Europe, as highlighted in our recent outlook, and several export oriented countries slipped back into fiscal austerity, weak EZ demand and a persistent credit crunch chilled domestic demand. More domestically driven economies also slowed including Russia, Turkey and Poland. 2013 will be a bit better across the board, particularly if herculanean efforts of global central banks give local authorities more policy space. The region still underperforms other EM regions, as local fiscal austerity and credit sluggishness accentuate weak demand from the EZ.

Balance sheet repair continues: Regional economies are still rebuilding balance sheets from the boom years, to differing degrees. Generally balance sheets are more encumbered, particularly public sector ones, posing chronic if not necessarily acute challenges.

Prefunding debt burdens: Most regional players have been capitalizing on cheap financing costs to prefund liabilities – expect more of them to try to lock in capital and corporates and banks to follow. The move to localize liabilities is a positive step, reducing FX debt burden and the vulnerability to FX swings. However, the region is still highly reliant on external finance, particularly shorter-term portfolio capital, which leaves it vulnerable to a change in risk appetite. Attracting FDI will be trickier.

IMF on backburner?: Stronger risk appetite may encourage regional economies to play hardball with the IMF or defer a return to talks (most notably in Hungary, despite continued market unfriendly reforms). Romania, benefiting from its new USL-led coalition should be able to come to terms with the IMF, when its loan expires next year. perhaps with a precautionary line.

• Ukraine has less room for maneuver – steel demand will be scarce, despite China’s temporary bounce, its financing position precarious and the government unwilling to recognize the costs of its unfriendly investment environment.

Assessing the EZ future: As EZ (and EU) leaders continue to move forward with deeper integration, expect more public chatter on accession to the monetary union. Polish authorities have already stepped up rhetoric in recent weeks, exposing some differences within the government and between the government and population. We expect no large members to accede in the near or medium-term, but we’ll be watching for regional players moves to stay at the table in EZ discussions while maintaining the benefits from independent monetary policy.

A better harvest (hopefully): The region was hit by extreme hot weather and weak harvest in 2012, drawing down its agricultural reserves and hitting economic output in Romania, Hungary and Ukraine among others. 2013 should be a better year, but some of the weak harvests may be structural and new irrigation, agricultural practices and land reform (especially in CIS) could be needed to persistently raise yields.

Cheaper gas (for some): Although CEE (and especially south Eastern Europe) still lacks the flexibility of power sources in Western Europe, Eastern Europe is finally starting to benefit from the effects of the spot market in reducing gas prices. Poland recently won a reduction in gas prices from Gazprom after suffering some of Europe’s highest gas prices. Local shale gas production should be a slow-going trend given geological and political backlogs (we see the progress as particularly challenging in Ukraine given recent stall in energy and economic policy, including failure to strike an MOU with Exxon).

Sluggish privatization prospects: Despite a stronger debt environment, privatization may remain a hard sell as growth and domestic liquidity remains weak. We don’t see Russia in particular being willing to give up authority over key companies.  We’re watching also Poland’s plans to lever up some of its state-owned assets to avoid breaching public debt requirements.

Continued deleveraging of Banks and households in EE and slower leveraging in CIS/Turkey: The ECB measures don’t end deleveraging, just soften them. A new Vienna initiative should limit any sharp withdrawals, but financiers will be making decisions accordingly on countries which have more space to grow leverage (Turkey among others).

Chinese role: Chinese capital is coming to the region, mostly to resource rich countries. Aside from Russia and Kazakhstan, Chinese capital is still relatively limited, but likely to grow in coming years. Regional producers may find themselves struggling to avoid the dumping from oversupply and Chinese investment, coming with its implementing, workers may create political issues. We don’t see Chinese funds as being sufficient to offset other bilateral and multilateral support (EIB, EBRD, IMF etc).

Some latent risks:
Political strains: There are risks of coalition splintering in a few countries (Czech Republic, Baltics) as well  as loss of support in Russia.  Sluggish economic growth and labor market slack could amplify political pressures in a push for market share.

Stagnation in structural reforms: 2012 brought long-awaited improvements in business environment – regional economies were some of the biggest improvers in 2012’s WB doing business (Poland etc) but business environment remains constrained – in a slower growing world capitalizing on trade links and corridors and fostering innovation will be key to attracting FDI needed to fuel investment in the absence of meaningful domestic savings.

Persistent corruption problems in South Eastern Europe , and CIS which limit absorption of structural funds (for EU members), government funds and also private capital.

Still high levels of unemployment – high single digits in most countries which raise political risks, and accentuate other strains on domestic demand. These developments could increase attractiveness of nationalist parties.

Risks of trade protectionism, particularly in CIS: So far the Russian led customs union has had only modest restrictive effects on trade by increasing tariffs to those outside the zone.