The 2-year Transition to Brexit

On 23 June, the people of the United Kingdom (UK) voted to leave the European Union (EU).  The UK and the EU will have two years to negotiate the terms of the separation. (The 2-year period will start when the UK officially informs the EU of its intention to leave; this may be sometime in September) During this period, the British will already feel some negative effects of Brexit (British Exit from the EU).
During the 2-year negotiating period, the UK will remain a full member of the EU, with all the privileges and responsibilities this entails.

The coming two years will not be uneventful, however.

Devaluation. In response to the Brexit vote, the British Pound fell from a rate of 1.50 to the dollar, to a low of 1.33 on 24 June. It may still go down a bit farther. Devaluation is supposed to decrease imports (as they become more expensive) and increase exports (as they become cheaper); but this effect takes 9 months to happen. Inflation is sticky upwards (i.e. prices tend to rise fast but fall very slowly if at all), so devaluation would mean that inflation will increase as a result of devaluation.

Immigration. The Brexit vote will probably have the effect of increasing, rather than decreasing immigration – at least during the 2-year period. EU nationals seeking to work and live in the UK may rush in before the UK actually leaves the EU. British pensioners would delay deciding whether to move to Spain and elsewhere in the EU until the rules for this (e.g. for health care insurance, residency permits, etc.) are clear.

Short Term Grants Only.  EU funding for research, study, small business support, urban renewal , and other projects will need to finish before the cut-off date. As a result, fewer and fewer projects will be supported as the deadline comes closer.

Freeze on Foreign Investments. While the new agreement between the UK and EU is being negotiated, foreign companies would be extremely hesitant to invest in the UK. Foreign Direct Investment will dry up.

Transfer of Operations. Businesses will start the process of transferring some of their operations to EU countries as early as during the negotiation period. For those whose EU headquarters are in London, these offices will be downsized into UK offices. For foreign companies which had set up manufacturing plants in the UK to access the EU market, they will simply set up new plants elsewhere in the EU and downsize their UK operations gradually.

Separation. Scotland will most probably hold a referendum on leaving the UK, so that it can remain in the EU. During the Brexit vote, 62% of Scots voted to Remain, and Remain won in all of its counties. The Scots are mad at England for dragging them out of the EU.
Northern Ireland, which also voted for Remain,  is considering the option of leaving the UK and joining the Republic of Ireland. This will be more difficult for them than for Scotland because the Ulster Unionists are vehemently against leaving the UK. However, if Northern Ireland is allowed to hold a referendum on whether it wants to leave the UK, a majority will vote to do so.
If Scotland (and maybe Northern Ireland) leave the UK, this will have negative economic and political effects on the rest of the UK.

Economic Uncertainty. Nobody knows what kind of deal the UK will finally forge with the EU, or what kinds of political changes will take place. This means that the British economy will be saddled by uncertainty for the next two years at least. This is bad  for the economy. Credit rating agencies have lowered the UK’s rating; making it more expensive for the UK government to borrow money.

And finally, there is Regrexit – Regret at the British Exit from the EU. The online petition calling for a second referendum will not get more than a debate in Parliament; it will not delay or overturn the referendum results.
The growing movement against Brexit will  influence the negotiations between the UK and the EU, by pushing to keep the UK inside the Single Market (including immigration of EU nationals). There could be quite heated public debate on this during the negotiations.

All the above are a list of bad things that will happen before the UK leaves the EU. When the UK finally leaves the EU,  things will get even worse.

Oil Price may drop to $10/barrel

Last year, I posted a blog Oil Price will settle at around $35 predicting that oil will stabilize (on the medium term) at $35/barrel. On 14 December, the price of Brent oil was below $38/barrel. So, will the oil price finally settle at $35/barrel? Yes, but not right away. The nature of markets is that they tend to overshoot equilibrium points. Thus, the price will probably overshoot downwards; resulting in short-term prices well below equilibrium.

The limits of this is determined by cost. The average cost of producing oil is $35/barrel – with $25 as the price of development, and $10 the price of extraction.  The costs differ, based on the particular method of producing oil. Land-based shallow wells cost less than $25/barrel to develop; and also less than $10/barrel to pump. Deep-sea wells cost $50 or more to develop, and $10/barrel to pump. Oil from tar sands cost very little to develop, but $50/barrel or more to extract.

The present situation of every producer pumping as much oil as they can would mean that the price would continue to drop below $35 (at least in the short term). Since production from existing wells continue to be profitable (i.e. the price of the oil is higher than the marginal cost of production); owners of those wells will continue pumping oil. They will do so until the price reaches $10/barrel,  the point where it will be more profitable to stop producing (for a large number of wells).
This means that, in the short term, the oil price could reach as low as $10/barrel.

This is only for the short term, however. After a while of oil at extremely low prices, when little or no new wells are drilled; the total oil produced will decrease because the depletion of existing wells is not compensated by production from new wells. The lower production will drive prices up, until it reaches the point where it would again be profitable to drill new wells.
Thus, the price will gradually rise, until it finally would stabilize at about $35/barrel.

In the long term (more than 5 years), the average cost of production would inevitably increase, as cheaper sources of oil get depleted. Thus, more and more, deep-sea wells and tar sands will take on a bigger proportion of the total oil produced. This will raise the average cost of production, meaning that the equilibrium point will rise.

In short, here are the projections for the oil price:
– short term (6 months to a year): as low as $10/barrel
– medium term (2 to 5 years): stable around $35/barrel
– long term (more than 5 yearsr): price will rise gradually, reflecting rising average production costs.

Myths About the Greek Crisis

In the days before the 13 July deadline for Greece’s bailout there were a lot of analyses by economists, politicians, etc especially from mostly from non-Euro-zone sources; and many were distinctly biased against the EU and the Euro. Because these analyses have not been sufficiently rebutted (in the English language world), many people continue to believe in them. Here, I will try to respond to the many myths these ‘experts’ had been spreading about the Greek crisis..

Bailout Benefitted Mostly European Banks
The 2012 bailout forced private holders of Greek debt to accept an average writedown of 52%, a long grace period and low interest rates. The banks could not be literally be forced because this would technically result in a default; so governments ‘persuaded’ them to do so. Part of this persuasion tactic was that the governments took over the bank loans.
Banks did not benefit from the transaction. Even if we consider the higher interest rates they charged before the bailout (around 6%), the 52% writedown more than negated any profit they made. Banks and governments throughout Europe had to shoulder the burden of the bailout. Especially heavily hit were Cyprus’ banks, which held a lot of Greek debt. The government bailed out the banks, but this meant that Cyprus itself had to be bailed out.

Austerity is needed so that Greece can Repay its Debts
Most of Greece’s debt is to other EU governments. This debt has a 1.8% interest with a 10-year grace period (meaning that no payments of interest or on the principal will take place in the first 10 years, i.e. till 2022). It would thus be some time before Greece would need to start repaying most of its loans.
What Greece needs to do in the meantime is to institute reforms to its financial system, upgrade its judicial system, and other reforms that would result in a healthy, modern economy and a balanced budget.

Grexit will Lead to the Collapse of the Euro
Greek Prime Minister Tsipras’ negotiating strategy from January up to 13 July was based on the premise that other Euro countries were so scared of a Grexit (a Greek Exit from the Euro) that they will give in to Greece’s demands (which were, in essence to get money but to do only minimal reform) at the last minute. So the Greeks dragged the negotiations to drive things to the climax where Europe was supposed to give in.
Tsipras was wrong. During the 13 July negotiations, a number of countries were offering a Grexit scenario to it. It was clear that not only were Euro countries not afraid of a Grexit; many were openly advocating for it, saying that it would be the preferred outcome.

The situation in 2015 is vastly different from that in 2012. In 2012, many Euro countries were in trouble: Ireland, Spain and Portugal needed bailouts, Italy suffered from very high bond rates. The ECB and the European Commission had to step in with extraordinary measures to prop up their economies. The Eurozone banking system was highly exposed to Greek debt. Many banks were not sufficiently capitalized. There was a real danger to the Eurozone’s stability if Greece left the Euro at that point. This was the reason why the Eurogroup decided not only to bailout Greece, but also to significantly cut its private debt (they forced private banks to write down their loans ‘voluntarily’).

But in 2015, the Eurozone is much more able to absorb any problems a Grexit could cause. Tthe crisis in all other Eurozone countries is over. Former problematic countries e.g. Ireland and Spain have high growth rates. They, and Portugal, have exited their bailout program. Even Cyprus (which needed a bailout in 2012 because it suffered a lot from the 2012 Greek bailout package) had lifted its capital controls. Banks all over the EU had been significantly strengthened, and Eurozone-wide financial decision making had been streamlined, including giving the ECB more powers. European leaders were quite confident that a Grexit would hardly affect the Eurozone as a whole.
European leaders did not want a Grexit not because they feared a contagion of the crisis, but because of possible negative political consequences, and because the Greek people would suffer a lot from an economic collapse.

Austerity will only make the problem worse
There are two things wrong with this myth. First, is the use of the term ‘austerity’; and second, on the nature of the problem that is supposed to get worse.
The Germans are supposedly pushing the Greeks to make budget cuts out of some ideological logic. But the Eurogroup (not only the Germans) did not call for many cuts in the Greek budget. In fact, the $100 million euro proposed cut to Greece’s bloated military budget is the only budget cut that was proposed by the Eurogroup. Greece is spending outrageous amounts on money on its military, even though the country is surrounded by allies, and is not threatened by anyone. Greece has, for example, more tanks than the UK; and the percentage of its GDP for defense is higher than that of Iraq. The Greek military budget is clearly one item that needed to be cut.
Europe didn’t propose to raise Greece’s Value Added Tax (VAT) to 23%; VAT was already at that level. What was actually proposed was to classify hotels from the low VAT rate of 14% to the regular rate of 23%, which will align Greece with the rest of the Eurozone.  Hotels across the EU are charged the high VAT rate. The VAT basic rate of 23% is in the range of the Eurozone (where VAT varies from 21% to 25%).

Now to look at what the problem is. Americans think that the Greek problem is its negative GDP. They think that the solution of the problem is economic stimulus. But Greece’s problem is worse than that. Its government has been spending way beyond its means because of structural reasons including: generous social benefits (for some groups of people); a huge military budget, poor tax systems and tax compliance (e.g. there is no nation-wide land and property registry), a ponderous bureaucracy (up to 1 in 4 employees work for the government) and a balkanized labor force (with many groups of ‘protected’ workers and professions).
A glaring example of Greek overspending is its pension program. The country allowed government employees to retire as early as 52 years old (‘allowed’, because after 13 July the retirement age was raised to 67). Early retirement meant that the government had to pay pensions (which used to be quite generous) for longer than the rest of Europe (where the retirement age is 67 years).
Increasing growth will be like giving more booze to an alcoholic.What is needed is to address the biggest structural problems of the Greek economy. Greece has managed to ‘protect’ its severely handicapped economy through the years, and rebuff Europe’s attempts to reform it. So now, in order to get money to avoid an economic crisis, Greece needs to make a real start at reforming its economy.

Greece was already in a deep economic crisis before the first bailout in 2010. While the bailouts may not have resulted in Greece ending its crisis, it had saved Greece from economic collapse.

The Troika Blackmailed Greece
Tsipras accused the EU, the European Central Bank (ECB) and IMF (the so-called ‘Troika’) of blackmailing it by plunging Greece into a crisis during the final negotiations. Specifically, Tsipras accused the ECB of cutting off emergency financing (its Emergency Liquidity Assistance program), thereby forcing to Greece to close its banks and have capital controls.

The ECB was not blackmailing the Greeks. The uncertainty on Greece had resulted in massive withdrawals of money from the Greek banks in the weeks before 30 June. During that time, the ECB had provided 79 billion euros to Greek banks through an extraordinary channel called the Emergency Liquity Assistance program. The ECB had been technically violating its own rules in doing so, because it didn’t want to plunge Greece into crisis while negotiations were going on. After the Greek government broke off negotiations on 26 June, and defaulted on its IMF loan on 30 June, the ECB was forced by its rules to stop providing emergency credit.

It was Greece’s decision to break off talks and to let the IMF payment lapse that eventually forced them to establish capital controls. The ECB’s moves were forced by its rules.

Germany and other Surplus Countries should Transfer Money to the Poorer Countries
This statement is made by American economists who know little about the EU. Transfers have been going on for decades through the EU’s structure funds, which are supposed to help the EU’s poorer countries improve their competitive position. Greece itself received around 100 billion euros through the years.

While the EU is already making massive transfers of money to the poorer countries, increased fiscal coordination would probably mean that the fund transfers will increase. But these transfers will only be politically acceptable if there would be much closer convergence of fiscal policies among Eurozone countries.

No Grexit, but a miserable summer for Greeks

On 5 July 2015, the Greek people voted NO to the 26 June proposal of the Eurogroup. Strictly speaking, the proposals were no longer on the table by that date, since the bailout program it was part of had expired on 30 June. I am sad that the Greeks voted NO – because they unwittingly rejected what was the best deal that their country could possibly get.

Greek Prime Minister Tsipras claims that the NO vote strengthens his hand in negotiations with the Eurogroup. This is not true. The other Euro countries understood the NO as a Greek demand for a fee pass – money without conditions – and they consider this unacceptable.

The EU does not create money to cover fiscal deficits. It is unlike the US which can print money to finance its deficit because the US dollar is the world’s reserve currency. Money for bailouts has to be sourced from national budgets. The Greek bailouts of 2010 and 2012 were shouldered by the 334 million citizens in all Eurozone countries (or 323 million if you exclude Greece). They paid for these bailouts through cuts in government services and increased taxes in the various Eurozone countries. In the Netherlands, for example, the VAT was raised from 19% to 21%, medical insurance expenses also rose.

Now, 3 years after the last bailout program started, the Greeks have voted NO to austerity in a referendum. This actually means that they want the rest of the Eurozone citizens to shoulder the cost, while they themselves will be exempted. This is what NO means; and this is why a bailout deal after the referendum will be opposed by the majority of citizens of Eurozone countries.
Citizens of Eurozone countries are perfectly willing to support Greece; but only if Greeks implement reforms that will put their national budget in order. For them solidarity means that  Eurozone citizens contribute their money to help Greece, and that the Greeks also do their part.

Reforms Required
Eurozone governments proposed a list of reforms for the Greeks to implement before they give it money. This is the only way that the 18 other countries with the Euro could accept any deal. What Greeks derisively call ‘austerity’ are simply minimal reforms that Euro citizens feel are needed to have a fair deal. Any deal without these measures would simply not be approved by 18 governments.
Any proposal that Greece makes should contain enough reform measures to be acceptable. A particularly important reform will be on pensions, specifically on raising the pension age to 67 years. Greeks in government service benefit from an early retirement scheme in which they can retire as early as the age of 52. Eurozone countries, which have a retirement age of 67, could not accept giving money to Greece so that it could retain its early retirement scheme.

There are other proposed reforms, e.g. a reduction in the military budget (Greece has a bloated military, with a budget comparable to that of Iraq, and more tanks than the UK). I think that there is flexibility in putting together an acceptable mix of these other reforms,

Grexit?
While the NO vote increased the chance of a Greek exit from the Eurozone (or ‘Grexit’), a Grexit is not yet inevitable. There is still a big possibility that a Grexit can be avoided.
Talks will take place between Greece and the other Eurozone countries, and I think there could be enough basis for an agreement on a bailout package. I believe that such a bailout package should include structural reforms, as well as some restructuring of Greek debt..

But it will take time to forge such an agreement.
First, the Greek rejection of the proposed reforms means that it will take time before they can backpedal and agee to most of them.
Second, a totally new agreement has to be made, and for a significantly bigger amount. This is because the previous bailout program had expired on 30 June. Extensive consultations (and parliamentary debates) would be needed before agreement on it could be made. Greeks underestimate this, thinking that all it takes for an agreement is for Merkel to say yes. But in reality, democratic consultations within 18 countries are needed, and Germany cannot dictate the result of these. (Merkel, in fact, seems to be one of the leaders who is most sympathetic to the Greeks.)
Third, the dire state of the Greek finances (e.g. the capital controls and shortages of cash) would need to be addressed by many stop-gap measures. Arranging these will take time, and this will delay the process of negotiating a bailout.
Fourth, Greece’s default on the IMF loan (on 30 June) and an impending default on an ECB loan (on 20 July) are factors that will complicate any negotiations. It would be extremely difficult to get both institutions to participate in a bailout agreement when the Greeks had defaulted on their loans.
Fifth, Syriza’s haphazard, amateurish approach to negotiations would introduce all kinds of delays in the process.
Sixth, after a bailout agreement would be reached, it would still need to be ratified by all 18 countries (with unanimity). This process will mean an additional week delay, or longer.

The Greeks’ decision to have a referendum instead of just negotiating on a deal before the 30 June deadline unnecessarily extended the time such negotiations would take. If instead of declaring the referendum it went on negotiating, the Greek government could have signed an agreement before 30 June, and there would be no bank crisis, or default on the IMF loan. By this time, the Greeks could be talking about debt relief etc with its Eurogroup partners.

At the same time,the ECB would need to take urgent measures would need to be taken to avoid an accidental Grexit (the ‘Grexident’). In order to do this, the ECB would need to be armed with political decisions from EU leaders, because it would require amending or stretching ECB rules.

The Greeks would need to wait a couple of months before a bailout agreement will be signed. There is a chance that banks will remain closed for weeks, with the economy remaining in deep freeze.
In the end, the NO vote would mean that the Greeks had to wait 2 or more months before a bailout agreement is implemented, with conditions similar to the ones they voted against..

Oil Price will settle at around $35/barrel

The price of Brent Crude has crossed $50/barrel, and it still has some way to fall. This is not a temporary short term drop in the price; it is the middle of a long-term price movement.There are huge reasons to think that the low price of oil is here to stay – at least for the next few years.

Analysts say that the Saudis are out to get the shale oil producers by keeping the oil price lower than their production costs. Sounds logical. But let’s take a look at the actual production prices.The production cost of oil shale is between $35 and $50/barrel – and this is the average production cost. But the bulk of the production cost is up front – when the well is being set up. The marginal production cost (i.e. the additional cost for prducing every additional barrel of oil) is lower – perhaps as low as $10/barrel. This means that shale oil wells that are already producing will continue producing as long as the oil price does not dip below $10/barrel. However, new wells will not be opened if the price of oil is less than $35/barrel (because investment decisions are made based on marginal production cost).

Offshore oil wells produce oil at $50/barrel. There are a lot of these wells in operation, e.g. in the Gulf south of the US. Their marginal cost of production is a mere $10/barrel, and will thus continue to produce inspite of the low price. However, it costs a lot to sink them ($40/barrel of the cost is from the exploration and development of wells). A price below $50/barrel will mean that new offshore wells will not be developed.

Oil from oil sands costs from $50 to $80/barrel to produce, and most of this is in everyday production cost. This means that this kind of oil will probably be frozen (figuratively and literally), if the price remains below $50/barrel. And there are other marginal producers, e.g. US small-scale drillers (e.g. producing less than 10 barrels/day) which may close down because production has stopped being profitable.

A price below $50/barrel means that offshore and shale oil will thus continue production in existing wells and even sink new wells. Specific economics will determine which wells will be sunk, and which will be deferred. As the price goes further below $50/barrel, fewer new wells will be started, and then not enough will go online to replace older wells that get depleted.

At the same time, oil continues to come from ‘traditional’ sources. Neither OPEC nor the other oil-producing countries are willing to reduce their production. Some are actually increasing production, e.g. Russia and Iraq; while some OPEC countries may also increase theirs e.g. Venezuela and Nigeria.

In the short term, the oil price will continue to drop because there is a lot more oil produced than is needed. The price will go even lower than $30/barrel. It will settle somewhere around $35/barrel.Below this point, it would not be profitable to open new shale oil wells.
In the next 3 to 5 years, the price will range between $30 and $40. After this, economic growth will push up the demand for oil to the point that the price will gradually rise again.