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A tree fungus could provide green fuel that can be pumped directly into tanks, scientists say. The organism, found in the Patagonian rainforest, naturally produces a mixture of chemicals that is remarkably similar to diesel.

“This is the only organism that has ever been shown to produce such an important combination of fuel substances,” said Gary Strobel, a plant scientist from Montana State University who led the work. “We were totally surprised to learn that it was making a plethora of hydrocarbons.”

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Kazakhstan The Country

Kazakhstan, officially known as the Republic of Kazakhstan, could with some accuracy be described as “no mans land” since it actually lies between two worlds, straddling as it does both Central Asia and Europe. It could also be described as a form of no-mans land in another sense, since a large part of its historic population has been nomadic, and rural, and up to very recently the majority of the countries urban population have been migrants who have arrived from “elsewhere”.

Ranked as the ninth largest country in the world by size, it is also the world’s largest landlocked country, with a territory of some 2,727,300 km² (which is greater than the whole of Western Europe). It is bordered by Russia, Kyrgyzstan, Turkmenistan, Uzbekistan and China. On the other hand, and despite its enormous size, Kazakhstan has a comparatively small population. No one actually has an exact idea of the actual size of the Kazakhstan population (not to mention the thorny issue of just how many foreign migrants live and work there), but the US Census Bureau International Database list the current population of Kazakhstan as 16.763 million, while sources drawing their data from the United Nations (like the IMF which I have relied on for the chart below) give a 2008 estimate of 15.135 million. In any event the current population level, after falling in the early 1990s as ethnic Russians left, has now stabilised, and is virtually stationary. This virtually stagnant population constitutes, as we will see, a significant problem for a country with such a massive resource base, and such enormous economic and development potential as Kazakhstan would seem to have.

Record Oil Revenue Boom

Kazakhstan is the biggest energy producer in Central Asia and the country’s $100 billion economy has in fact grown at an average of 10 percent a year rate since 2000 (see chart below), in particular as the price of oil has surged. This rapid GDP growth produced a rapid increase in per capita income as well as national creditworthiness, and these in turn sparked in their wake a substantial construction boom. Indeed it has precisely been the bursting of this boom in the autumn of 2007 - on the back of the seize-up in global wholesale money markets which followed August’s financial turmoil in the USA - which lies at the heart of Kazakhstan’s current growth slowdown. Kazakhstan’s economy expanded at a ‘mere’ 5.3 percent rate in the first quarter of 2008, half the pace achieved in the same period a year earlier, following a dramatic curtailment in bank lending, and if Kazakhstan is still able, despite all the problems we will see below, to maintain some sort of growth momentum at this point it is undoubtedly the result of the oil and other commodity resources which the country has at its disposal, and indeed as part of its initial response to the present crisis the country increased crude production by an annual 6.3 percent in the first four months of the year, according to official government data.

Now one of the most curious details about the present slowdown in Kazakhstan, has been the fact that at the very same time as the economy started to lose velocity the central bank found itself busy struggling to curb an inflation rate which was steadily shooting onwards and upwards towards the outer stratosphere, as revenue from record oil prices pushed up domestic demand, and the resulting construction and consumption boom drove up wages far beyond normal “productivity-gain” rates of increase (remember, there are not THAT many people in the country, and much of the population is rural and unskilled in relation to the needs of a modern technological and services economy). In fact inflation hit year-on-year rates of increase approaching 20% in the autumn of last year (see chart below), although it had dropped by to an annual 18.2% by September.

So, as well as containing the property bust, the Kazakh authorities have also had to conduct an inflation fight (more details below). So far from lowering rates like the US Federal Reserve has been able to do, Karakhstan’s central bank was forced to raise the key interest rate to 11 percent in December 2007, at a time when annual inflation was riding at almost 19 percent, the highest for the country in over eight years. The refinancing rate was then maintained at the 11% level until it was finally lowered to 10.5% at the last central bank meeting in July.

Not Just Energy - Vast Resource Potential

The fact that Kazakhstan’s industrial output growth has lost a lot of momentum in 2008 as the slowdown in the building industry provoked a slump in cement and other materials production should not take our minds too far away from the fact that the underlying potential in Kazakhstan is enormous. In fact while industrial output growth was reduced to an annual 3.8 percent growth rate in the January-June period, it was at least still growing.

The low point seems to have been hit back in January, when cement production which, not surprisingly, was among the hardest hit sectors, was down 26 percent year on year, the sharpest January fall in five years, as growth in the construction industry stalled, brought to a halt by the fact that the Kazakh banks, who had been struggling to borrow from abroad following the collapse of the U.S. subprime mortgage market, virtually stopped lending to homebuyers and builders.

Copper and rolled-iron output also declined an annual 13 percent in January while output from oil refineries and manufacturing industry decreased an annual 2.9 percent as the problems rolled in. Thus there is evidence of a very sharp shock initially hitting the local economy. On the other hand, since the country is resource rich and the given that first half of 2008 saw a very significant global commodities boom, there were other economic sectors to fall back on, and mining production was up 6 percent from a year earlier in the first quarter, bolstered by an increase in natural gas and coal output, which climbed 15 percent and 11 percent respectively. At the same time crude oil production went up by an annual 5.4 percent.

Apart from oil and gas Kazakhstan has a huge array of potential resource reserves just waiting to be tapped. Among these there is copper. London-listed Kazakhmys accounts for the bulk of Kazakh copper output - and this was down 17.5 percent year-on-year in January-April. Industrial output in Karaganda region, home to Kazakhmys and Arcelor Mittal mines and smelters, declined 5.5 percent year-on-year in January-April.

Kazakhmys reported that their first-quarter output fell 9.9 percent on “severe winter weather” and repairs at its Balkhash smelter. Production of finished copper plates, or cathodes, from the company’s ore fell to 75,500 metric tons, from 83,800 tons a year earlier. These drops in output are, of course not entirely associated with the credit crunch, but they do give an idea of the challenging and volatile environment in which the mining and extraction industries work in Kazakhstan. Realistically speaking it seems quite likely that output in these sectors will return to more normal levels during the second-half of 2008, having alreadt rebounding significantly from the low point reached in the first-quarter.

On the other hand industrial output in capital Astana and commercial hub Almaty, where most construction activities are based, was down 13.2 percent and 8.6 percent, respectively, in January-April, and this activity may well take much longer to recover.

Kazakhstan has also had to cut its 2008 oil production forecast to 67.6 million tonnes (1.35 million barrels per day) from a previous estimate of 70 million tonnes citing maintenance works and transport bottlenecks. The country is able to produce a lot of oil, but it does have a large problem getting that oil to the places where people want it. Three major pipeline routes - the Atyrau-Samara and Caspian Pipeline Consortium (CPC) links to Russia, and the Atasu-Alashankou pipeline to China - carry Kazakh crude off towards its end destinations, but none of these are proving sufficient to the demands on them.

“It is impossible to transport crude out of Kazakhstan without some difficulties,” Senior Associate Klara Nurgaziyeva from law firm Dewey & LeBoeuf told an oil and gas conference last week in the Kazakh financial capital Almaty.

This means output is likely to remain roughly stationary since the country produced 67.5 million metric tons of oil and gas condensate in 2007. Kazakhstan has 3.3 percent of the world’s proven oil reserves and 1.7 percent of its gas, according to BP’s Statistical Review of World Energy.

Kazakhstan also has around 15 percent of world’s uranium, most of which is processed at the Ulba Metallurgical Plant in Oskemen, a formerly secret city south of Siberia known in Russian as Ust Kamenogorsk. Management at the Ulba plant are currently planning to invest $850 million, 6.5 times the plant’s projected annual cash flow - and offering to trade domestic mineral rights to joint-venture partners in China, Japan and Russia in return for the technology they need in a bid to make Kazakhstan the world’s biggest supplier of atomic fuel for civilian nuclear reactors. If successful, Kazatomprom would consolidate the market for its 983 million pounds of recoverable uranium deposits, second in importance only to Australia’s, and become less reliant on the raw ore’s spot-market price by supplying higher-value products needed to fuel the next generation of reactors.

However one more time let us not forget the natural environment in which all this is situated, since Kazatomprom’s East Mynkuduk mines, which are 1,180 kilometers (733 miles) west of Almaty, lie beneath a semi-desert, where camels idly graze is surface temperatures which range from minus 30 degrees Celsius (minus 22 Fahrenheit) in winter to 60 degrees Celsius (140 degrees Fahrenheit) in summer. Kazakhstan is currently uranium ore’s third-largest producer, behind Canada and Australia, both of which it plans to surpass by 2010.

On top of oil and uranium Kazakhstan also has 38 percent of the global supply of chromites, used to produce corrosion-resistant steel; 22 percent of all lead; and 16 percent of known silver reserves, according to Renaissance Capital, a Moscow-based investment bank. And on top of all that there is its bauxite, copper, iron and gold. Indeed, while it is not entirely true that Kazakhstan is home to 95% of the elements in the periodic table, the statement isn’t that much of an exaggeration.

But what is obvious if we look at the large swings in output which followed the financial shock of last autumn is that the institutional environment is all important. A simple gung-ho “you’ve got the reources, we’ve got the money” investment plan won’t work without both serious structural reform and systematic inward migration, as we have been seeing. Kazakhstan looks in many ways like the United States did in the middle of the nineteenth century, with lots of spare land and huge resources to be developed, but where the “carrying capacity” of the country in a modern globalised economic environment far exceeds the resources of the native and nomadic peoples who constitute the historic population. Above all Kazakhstan needs the skilled labour force to leverage these resources and it needs to management and infrastructural support to make things work.

In a smoke-filled bar in the Kazakh financial capital Almaty, the laughter of Scottish ex-pats is loud and boisterous. More than three thousand miles (5,491 km) separate the Scottish Highlands and the Central Asian steppe, but a mutual interest in oil and gas has created a surprising alliance. Residents estimate that around 400 Scots live in ex-Soviet Kazakhstan, a resource-rich country roughly the size of western Europe.

Most come from Aberdeen, Britain’s northeastern oil hub, and they bring with them their technical expertise.”We’re going to try attract Kazakhs to Aberdeen over the next few years and look at initiatives, and create further investment in Scotland from Kazakhstan,” Lord Provost Peter Stephen of the Aberdeen City Council told an energy conference last week in Almaty. He said over 100 companies from in and around Aberdeen are active in Kazakhstan, and the Scottish oil town even has a Kazakh consulate to serve the hundreds of Kazakhs who go to Scotland to train up for the oil business. The Kazakh-British technical university, set up by a group of Scottish universities seven years ago, occupies a grandiose columned building in the centre of leafy Almaty, which housed parliament before the capital was moved to Astana.

Despite these evident problems there was, however, no shortage of “ready, willing and able” funding available during the boom, and foreign investment flooded the country after the discovery of the Kashagan oil field in 2000. At the time of discovery it was the largest new field unearthed in 30 years, containing 13 billion barrels of recoverable crude, according to Rome-based Eni, Italy’s largest oil company, which is currently contracted to develop the Kashagan field along with Exxon Mobil and Royal Dutch Shell .

However, the local authorities have not been totally irresponsible with the new found wealth from the commodities boom, and buoyed by the surging prices, Kazakhstan’s National Oil Fund has been busily soaking up the government’s share of the new petroleum revenue. As of November 2007, it had amassed $20.1 billion, according to central bank data.

Kazakhstan is also the world’s fifth-largest wheat exporter, and even though on April 15 the government placed a temporary ban on wheat exports in an attempt to control inflation, it made it clear that it would once more allow unlimited grain exports after the ban expired in September (a promise which was subsequently kept).

Apart from manpower all these resources also need, as I have been saying, infrastructure, and Kazakhstan is keeping itself busy building roads as well as pipelines. The Kazakh government is currently out looking for investors to build or maintain 1,000 kilometers (620 miles) of roads at a projected cost of 541 billion tenge ($4.5 billion), and doing it in the extremely practical way of accepting financed construction in exchange for operating concessions. One of the planned roads will connect the capital Astana with the regional mining center Karaganda to the southeast, while two more will run from the financial capital Almaty to Kapchagai Lake and Khorgos on the Chinese border. The government also plans to build a ring road around Almaty. The state may build a fifth road from Astana to the Borovoye forest in the north and again seems likely to seek an investor to maintain the road in exchange for operation concessions.

The government also plans to upgrade 2,552 kilometers of roads at a cost of 900 billion tenge to create a highway that would allow freight from Chinese manufacturers to be delivered directly to European markets. The first phase of the upgrade will cost 789.3 billion tenge and is scheduled for completion by 2013. A second phase will be finished in 2016. Kazakhstan has announced it already has agreed finance of 472 billion tenge ($3.93 billion) from banks to start the works.

The Financial Sector

Banks dominate the financial system in Kazakhstan, accounting for 80 percent of total assets. They are mostly locally and privately owned, although foreign participation has increased recently. The system is highly concentrated, with the largest five banks accounting for 78 percent of market share. Banks are very reliant on external financing, with external liabilities making up about 45 percent of the aggregate balance sheet. Easy access to external funding fueled very rapid domestic credit growth, which expanded at an annual average rate of 70 percent from end-2004 to August 2007, bringing bank credit to around 75 percent of GDP by end-2007. Lending was mainly to the household, trade, and construction sectors (the oil sector is not reliant on domestic banks for its financing).

But then, just as the good times were really letting themselves roll, and as does tend to happen with all fairy-tale, too-good-to-be-true-type, stories reality pocked its ugly nose yet one more time into other people’s business, and all that lending came to a “sudden stop”, almost as quickly as it had started, and confidence in Kazakhstan’s banks suddenly plumetted, as investors got nervous that something similar to what had been going on in the US sub-prime case might have been happening.

Or perhaps it was just the speed with which the debt had risen, the speculative nature of a lot of the activity that followed from it, and the front loading of much of the debt towards short term maturities that frightened people. Anyway the consequence was that household deposits contracted sharply during the August–October period while nonresidents sold about $4 billion worth of tenge assets — mostly held in central bank notes — putting in the process significant downward pressure on the value of the tenge.

Credit Downgrades

However, at the heart of the present economc slowdown in Kasakhstan, and just behind the sudden drop in confidence about Kazakhstan’s ability to meet its obligations, we should not be surprised to find the construction slump which the imposition of last autumn’s credit crunch last gave rise to. Concern about the rate of Kazakhstan’s domestic credit expansion does, in fact, go all the way back to an IMF report of October 2006 which argued that the rapid pace of “credit growth and external borrowing in Kazakhstan was making lenders more vulnerable to external shocks such as a reduction in the availability of financing”.

As is so often the case, such early warnings were not heeded, indeed quite the contrary, and when the credit crunch finally did arrive the consequences were always going to be pretty severe. Basically the European wholesale money markets, which had during the boom times been looking so favourably on each and every project which the wonders of the mind made it possible to dream up in Kazakhstan suddenly slammed their doors closed, and a number of local banks, who were in the uncomfortable situation of struggling night and day to try to borrow from overseas financial institutions (just like the Hungarian and Ukrainian banks in the last two weeks), had little alternative but to effectively cease lending to homebuyers and builders in September 2007.

Obviously the blame here can be shared out around a number of parties. Domestic authorities who did little to restrain the property and lending boom, and the international investor community who, it seemed, only needed to hear the long list of Kazakhstan’s undoubted natural resources to drool and march up to put their money on the table without any kind of serious due reflection as to the serious infrastructural and instititional problems the country was almost bound to have.

And when the stop came, it came abruptly. Kazakhstan bank sales of Eurobonds and syndicated loans, which had totaled $8.63 billion during the first eight months of 2007, suddenly plummeted to an estimated $300 million in the three months from October to December. Hence my references throughout this post to Kazakhstan’s “sudden stop”.

And the list of those who had previously been busying themselves arranging the deals for Kazakhstan’s banks looks just like a who’s who of international finance: New York-based Citigroup Inc., the largest U.S. bank by assets, edged out Amsterdam-based ING Groep NV (you know, the ones who have just been bailed out by the Dutch government), as the top underwriter. New York-based JPMorgan Chase & Co., the third-largest U.S. bank; Frankfurt-based Deutsche Bank AG, Germany’s largest lender; and Zurich-based Credit Suisse Group, Switzerland’s second-biggest, were all at the front of the queue.

Kazakhstan banks also attracted international equity investors. In November 2006, JSC Kazkommertsbank, Kazakhstan’s biggest bank by assets, sold $846 million of global depositary receipts in London. JSC Halyk Savings Bank, majority owned by President Nazarbayev’s daughter Dinara and her husband, followed in December with a $748 million sale. JSC Alliance Bank, the country’s largest consumer lender, sold $704 million of global depositary receipts in July 2007. All three are based in Almaty, the country’s financial center.

The outside money helped the country’s banks grow their assets 10-fold between 2002 and 2007, to $94.7 billion as of Nov. 1 2007. It also left the banks vulnerable when investors began retrenching.

From August through October 2007, $6.8 billion in foreign currency flowed out of the country - 28 percent of the central bank’s total reserves. With the country’s banks largely shut off from international borrowing, the ratings agencies started to get nervous. Standard and Poor’s started the ball rolling by lowering Kazakhstan’ foreign currency rating in October. By November the cracks were becoming visible, with the construction industry slowing rapidly.

The evolving situation lead to an ongoing series of “reappraisals” of Kazakh bank creditworthiness on the part of the ratings agencies, with Standard and Poor’s following its initial October downgrade of the country’s foreign currency-denominated debt rating (by one level to BBB-) by a revision on the outlook on Kazakh banks to negative in December. Fitch Ratings also changed its outlook on Kazakhstan’s long-term issuer default ratings to negative in December, and even the Kazahstan sovereign rating outlook was revised to negative by S&P in late April 2008.

Moody’s Investors Service joined the act, and reduced the credit ratings of six Kazakh banks, including TuranAlem, in November because of concerns they wouldn’t be able to refinance about $40 billion of international debt. Kazkommertsbank and Bank TuranAlem were cut to Ba1, one step below investment grade. Halyk was lowered to Baa3, the lowest investment grade, while TemirBank dropped to Ba2 from Ba1.

In an attempt to stop the haemorrage the government stepped in and provided lenders with almost $11 billion of emergency cash, reducing in the process central bank reserves by almost a quarter. The government also moved to place new limits on local banks’ foreign debt (according to the new regulation they will now be able to accumulate only up to a maximum of four times their capital base - beginning July 1, 2009). This move is expected to cut dependence on borrowing from abroad, although as a result commercial lending growth may slow to 13 percent this year according to central bank estimates, possibly reaching as much as 8.22 trillion tenge ($68.4 billion), compared with 7.26 trillion tenge in 2007. However - in a “worst-case-scenario” - the central bank warned that banks may post a 9.5 percent drop in commercial lending in the country this year, should access to foreign capital markets not be made available again.

At the same time the Kazakhstan government indicated during the summer that it was prepared to lend $4 billion to banks to ensure liquidity. The banks also were expected to get “about 300 billion tenge ($2.48 billion) of free money” due to a decision to reduce the size of bank reserve holdings with the central bank. The government has also said it will continue to purchase shares of Kazakh companies listed on foreign exchanges until they reach pre-August 2007 levels. Looking at the MCSI Kazakhstan core index, it would seem to me that they still have some distance to travel if this objective is to be achieved.

Kazakhstan banks’ foreign liabilities rose 490 percent in dollar terms between 2004 and the start of 2008 - to $13.5 billion - as they used their investment-grade ratings to borrow abroad and lend to consumers and real-estate developers, according to CreditSights. This debt has now become impossibly difficult to refinance because of investor wariness about all but the highest-rated debt. Kazakhstan’s central bank holds about $20 billion of reserves and the country’s oil fund has about $15 billion, so if push comes to shove they should be able to ensure Kazakh banks have sufficient funds to meet their obligations.

By June, credit-default swaps on Kazkommertsbank had surged to 694 basis points from an earlier 225 basis points, according to CMA DataVision. CDS contracts, which are used to speculate on a company or country’s ability to repay debt, increase when perceptions of credit quality worsen. But this was very small beer, and the position has recently deteriorated quite alarmingly, with the cost of protecting bonds issued by BTA Bank, Kazakhstan’s biggest lender, have more than doubled in the past month to 3,685 basis points (or 36.85%), while credit-default swaps on AO Kazkommertsbank cost 2,800 basis points (or 28%), according to prices at the time of writing from CMA Datavision.

All kinds of assets and revenue flows have been used as collateral in a desparate attempt to secure refinance for the debt, and one of the most innovative examples of this is the package that Bank TuranAlem JSC, Kazakhstan’s second-largest lender, put together last October - via ABM Amro and Standard Chartered - to sell $750 million of bonds in a DPR (diversified payment rights) securitisation scheme backed by foreign currency remittances from migrants. The deal is the largest bond sale of its kind ever by a Kazakh bank. The bonds were sold in four portions. Three were guaranteed by bond insurers and carried top ratings from Moody’s Investors Service and Standard & Poor’s. The other bond, which isn’t guaranteed, is rated Baa3 by Moody’s, the lowest level of investment grade, and an equivalent BBB- by S&P.

Construction Slump

After several years of rapid rises, Kazakhstan property prices are now declining, most notably in Almaty where the prices of existing homes are reportedly down (on IMF estimates) by anything up to 40 percent from their peak. This decline has partly corrected previous overvaluation, although the price adjustment may have further to go, particularly if credit availability and household incomes continue to weaken.

As well as the banks, Kazakh homebuyers also found themselves suddenly left out in the cold by the global credit shortage. In Almaty, the Kazakhstan’s biggest city, about 30 people were to be seen on March 18 in protest at the hole in the ground which was to be found where their new apartments were supposed to have been. Work stopped on the project after builder AO Corporation Kuat declared it was unable to get further funding.

About 29,000 people had prepaid for apartments which were uncompleted when the September squeeze arrived, and credit for Kazakh builders suddenly dried up. More than 140 housing projects were halted in Almaty alone, forcing the government to say it was going to provide $4 billion of emergency funding to get contractors working again. Kazakh construction companies had sold 280 billion tenge ($2.32 billion) of unfinished apartments by September, including 170 billion tenge financed by mortgages, according to government statistics.

Homebuyers have been receiving some help from the government, which in March 13 agreed to provide $500 million to help banks finance loans to builders in Almaty, although many are vociferous in saying that the money has not been arriving to them as promised. The governments announced $4 billion emergency investment program also includes funds to purchase 6,000 uncompleted apartments in Astana, the capital.

Prices for residential property soared 30.2 percent in 2007, reaching a record average mid-year high of 161,300 tenge ($1,338) per square meter, up from 123,900 tenge in 2006, according to the Astana-based state statistics agency. In the financial capital, Almaty, the average price was 345,200 tenge.

The drop in prices from these peaks and the sudden drying up of credit has caused numerous problems for would.be buyers, and Bank TuranAlem, Kazakhstan’s second-biggest bank by assets, received $81.2 million last December from the state emergency investment program simply to finance the completion of unfinished construction projects.

The most recent government bailout of the construction sector was announced during the summer - just two weeks before the celebrations of Nazarbayev’s 68th birthday and the 10th anniversary of the founding of the new capital Astana on July 6 - following the announcement by a group representing people who had purchased apartments in the unfinished buildings that they were planning a protest march to be held in Astana bang in the middle of the official festivities.

The Industry and Trade Ministry have said that there were 939 residential buildings, with 45,130 apartments pre-paid by homebuyers, under construction as of last January. Minister Edil Mamytbekov said in July that the cases of 4,558 homebuyers in 18 buildings “remain problematic” because of conduct for which the builders in question had been “charged with crimes.” The Kazakh Prosecutor General’s Office said 123 construction companies that received 104 billion tenge ($865 million) in pre-payments from homebuyers were behind schedule or haven’t even begun work on new apartment buildings.

Assets of “careless construction companies,” including buildings and vehicles, have been seized to compensate lost investments of homebuyers and the government, according to the Prosecutor General’s Office. Criminal investigations have been opened into eight companies. A total of 285 companies are building 407 residential projects in Kazakhstan and have received 231 billion tenge in pre-payments from more than 50,000 individuals and companies, prosecutors said. Of 200 “problem” projects delayed by at least six months, 110 are located in the capital Astana and 42 in Almaty.

The July rumpus was provoked by the fact that at the start of the summer the Kazakh government had spent only 51 billion tenge to complete stalled residential projects, a fraction of the bailouts promised by Prime Minister Karim Masimov in the autumn of 2007, according to data made public by the Ministry of Industry and Trade on June 23. The government had said on Nov. 14 2007 that it would spend $1 billion by the end of 2007 and another $3 billion in 2008 to “provide economic stability and growth” by supporting the real estate market and small and medium-sized businesses. Following publication of this data, and some international press coverage, Masimov said that his original emergency investment program was in the process of being expanded, and his government announced plans to spend 17.2 billion tenge to complete residential projects in Astana.

President Nursultan Nazarbayev instructed the state to step in and finish projects, “which have no source of financing,” to “help to reduce social tension,” according to Edil Mamytbekov, a deputy minister of industry and trade, on June 20. President Nursultan Nazarbayev also said it was necessary to take “tough measures against careless builders”. As a result the Almaty mayors office announced on July 26 that another 46.4 billion tenge had been allocated to support residential projects in Almaty. The state had already invested 22.4 billion tenge and was going to spend the remaining 24 billion tenge by year’s end, according to the announcement.

In April, however, the government had announced that the state development holding Kazyna would distribute 59 billion tenge to commercial banks during 2007 to finish 131 buildings in Almaty. Sergei Kuyanov, spokesman for Almaty Mayor Akhmetzhan Yesimov, declined to comment on the discrepancy between the numbers when question by journalists in July.

Whatever the complications of the present situation and the ins-and-outs of putting the construction and banking problems straight, we should not lose sight of the fact that Kazakhstan has, large financial resources which will surely help it weather the current situation. Official foreign currency assets totaled $46 billion in early June, comprising NBK reserves of $21 billion and oil fund (NFRK) assets of $25 billion. Commercial banks also have foreign assets of which about $3.5 billion are thought to be liquid. Total foreign assets broadly match foreign liabilities when the intracompany debt of the oil sector is excluded, while liquid foreign currency assets comfortably cover potential short-term foreign currency drains.

Favourable Demographics But Migrants Needed, And With Them Modern Citizenship Rights

The chart you will find below is known as a “heat chart”. It depicts the ongoing changes in Kazakhstan’s age structure. Each dot represents the number of people in any given age group at any given point in time. A dark red dot represents the largest concentration of people, by age, in a particular year while deep blue dots show the lowest concentrations. A single dark red dot is the equivalent of almost 406,000 people while each deep blue dot represents nearly 23,000 people.

In the upper left-hand corner of the chart the bright reds and yellow areas depicts the population boom that started in the mid 1970s and lasted until the late 1990s. The remnants of that boom extend downward from left to right across the chart. The band also narrows as this population segment ages. This is simply a reflection of the reduction in the total numbers in the population bulge cohorts as out-migration has taken its toll.

Many ethnic Germans and Russians, for example, left Kazakhstan during the years following the end of the Cold War. In the lower left-hand side of the chart there is a preponderance of dark blue dots, indicating a relatively small number of people over the age of 60 years. Over time these dark blue dots are replaced by light blues and greens, a pattern reflecting a gradual but steady increase in the number of elderly people.

Kazakhstan’s population has fluctuated notably over time, rising during the 1980s and then declining during the 1990s (mainly due to outward migration). A low point occurred in 2001 but population has been rising since, with the upward trend expected to continue through 2020 when total population is projected to reach an all-time high of 16.7 million – reflecting a natural increase of 1.8 million between 1980 and 2020 - before the long run impact of below replacement fertility locks-in, and the population starts to decline.

The number of potential workers (those between 15 and 64 years of age) will gradually “peak” - after having increased by a total of 1.9 million between 1980 and 2020 , while the number of those over 60 will nearly double, growing by more than 1 million in absolute terms.

The Kazazh government, being aware of the country’s enormous resource wealth and the need for a labour force large enough to exploit it, is taking a different view on this situation from its CEE peers, and is actively promoting the idea that the country’s population should rise to around 20 million by 2015. Clearly given the fact that Kazakh fertility (1.89 tfr 2007) is already below replacement, and heading downwards, this target is only achievable via significant inward migration. However, while much of Kazakhstan’s large surface area is desolate and uninhabitable, the densly populated urban areas currently lack the physical and social infrastructure necessary to accommodate any such lincrease in numbers. So to hit its “optimum” level of economic and social development the country needs both a positive migration policy and substantial infrastructural development in order to be able to adequately accommodate the new population.

Migration is nothing new for Kazakhstan, since its “no mans land” type location has meant that it has long been a transit point on the migration route of people back-and-forth between Asia and Europe. Kazakhsytans importance was only enhanced by the fact that historically it was used by Moscow as destination point to which colonists, dissidents, and other minority groups could be sent. Such groups included Volga Germans, Poles, Ukrainians, Crimean Tartars and Kalmyks.

Soviet-era policies were also designed to encourage the movement of ethnic Russians to the periphery of the then Soviet Union. As a result, by 1980 Russians had the largest nationality (exceeding even the Kazakh population) , and constituted slightly over two-fifths of the total.

After the fall of the Soviet Union, Kazakhstan’s German population emigrated en masse, lured by better economic prospects, ethnic ties to their original homeland and Berlin’s generous programmes for resettlement. More than a quarter of Kazakhstan’s ethnic Russian population returned to Russia during the 1990s, and the departure of such a large number of Russians had a particularly dramatic impact owing to their concentration in key urban areas (particularly in the then capital Almaty) and in specific occupations. In Almaty and a few other cities, Russians significantly outnumbered ethnic Kazakhs; they had their own cultural life, spoke their language freely and never even stopped to learn the local language. They also enjoyed a privileged occupational status, accounting for a disproportionate number of managers, scientists, professors, engineering-technical specialists, and other high-wage, high prestige professions. Filling the gaps created in Kazakhstans human capital resource base by the subsequent exodus of this population now constitutes one of the most important development challenges facing the country.

In order to facilitate the rapid population growth the government understands that the country needs, they have, as I say, set targets to increase the population from 15 million in 2005 to 20 million in 2015, including introducing programs for the return migration of 4.5 million ethnic Kazakhs - so called “oralmans” - from neighbouring countries in Central Asia, Turkey, Mongolia, and China. Although 374,000 oralmans have returned to Kazakhstan in recent years, this is not proving to be a hugely successful programme and the bulk of Kazakhstan’s current population growth is rather the result of illegal migration from other neighbouring countries in Central Asia.

At the present time the majority of migrant workers coming to Kazakhstan are Uzbeks and Kyrgyz nationals, although the number of Tajik migrants currently working in Kazakhstan is small in comparison compared with the size of their presence in Russia. Since the mid-1990s, Tajiks have been fleeing their country in significant numbers and the have mainly entered Kazakhstan either as refugees or externally displaced persons.

Tajik migrant workers in Kazakhstan are engaged mainly in seasonal agricultural employment. Many of them often work irregularly. According to some sources around 12,000 Tajik citizens were residing illegally in Almaty in 2006. Many Tajiks are working as traders in markets, selling agricultural products.

Large numbers of migrants from the other Central Asian countries are drawn to Kazakhstan quite simply because it is easier to move there than it is to move to Russia; xenophobia is much less rife; and the rhythm of economic development makes it very attractive in salary terms. According to official estimates, about 500,000 migrants from other Central Asian Republics work in Kazakhstan. At the CIS summit in October 2007, the Kazakh government distinguished itself by promoting a resolution which involved a series of legal and social protection measures for migrants.

According to a recent study by Marlène Laruelle of the Central-Asia Caucasus institute, more than half of Kazakhstan’s Central Asian migrants are comprised of Uzbeks, while around 200,000 are Kyrgyz and around 50,000 Tajiks. The majority of migrants are concentrated in four regions: Almaty, Astana, Atyrau and southern Kazakhstan. In the first two regions, migrants are chiefly employed in the construction industry, while in Atyrau, several tens of thousands of workers (according to some sources, at least 30,000 Uzbeks) work in the oil industry. In southern Kazakhstan, predominantly Uzbek migrants are employed in the agriculture, especially in cotton fields. In Kazakhstan, a kilogram of cotton pays US$0.40 compared with only US$0.05 in Uzbekistan. As for the Kyrgyz, a large number of them work on tobacco plantations.

According to Laruelle, nearly a third of the migrants work in the construction industry, another third in convenience services (the food service industry, small business, home repairs services), and the other third in agriculture. The highest salaries are in the construction sector (about US$200 per month), whereas those in agriculture earn a lot less (about US$80 per month). Although the overwhelming majority of migrants are male, there are now an increasing number of female migrants: in 2002, women made up only 15 percent of Uzbek migrants to Kazakhstan, but by 2004 they were nearly a quarter. Kazakhstan has had labour shortages in sectors largely staffed by women, such as agriculture, the tertiary sector of the food service industry, and domestic services.

Central Asian migrations to Kazakhstan can be divided into three categories: daily, temporary, and permanent. The first takes place notably in the border regions of southern Kazakhstan, where an increasing number of Uzbeks commute to work on the Kazakh side of the border during the day, and return home at evening. Regular border closures and administrative complications at customs often trigger tensions among villagers who have become economically dependent on being able to cross the border.

The border post at Zhybek Zholy, for instance, is crossed by more than 4,000 Uzbek migrants every day. But for the majority of migrants, leaving for Kazakhstan is temporary. The length of stays thus vary largely depending on available opportunities: mostly they last between two and eight months, with construction work being seasonal, mainly in spring and summer, and while work tends to be concentrated in the autumn. Many hope to return to their own countries after accumulating sufficient capital to construct a house or start up a small business. However, there are a growing number of migrants who decide to stay on a permanent basis. Between 1999 and 2004, more than 130,000 Uzbeks, drawn by higher living standards (an average Uzbek salary is around US$40 dollars, compared to 250 in Kazakhstan), moved to Kazakhstan permanently.

The Kazakh authorities are fully aware of the size of the migratory phenomenon and do nothing to actively resist these flows. Indeed the government has stated on multiple occasions that its citizens are not in competition for the work done by migrants because the latter fill a specific social niche, as they tend to take the poor paying jobs normally refused by Kazakhstani citizens. The authorities nevertheless are seeking to reduce illegal immigration and to encourage legal migration.

Thus, in 2006, the Minister of the Interior finally legalized 164,000 migrants from other CIS countries, despite having initially announced that the number would be only 100,000. Out of these, nearly 120,000 were from Uzbekistan, 23,000 from Kyrgyzstan, 10,000 from Russia and nearly 5,000 from Tajikistan. Astana’s open policy on migration has also led to the naturalization of many migrants: in 2005, more than 20,000 persons were granted Kazakhstani citizenship, three-quarters of these from Uzbekistan, 10 percent from Kyrgyzstan, and 5 percent from Tajikistan.

Although migratory relations between Kazakhstan and Kyrgyzstan are good, managing migratory flows between Kazakhstan and Uzbekistan has proved more difficult. Tashkent refuses to acknowledge the scale of the phenomenon. The Uzbek state has a monopoly on the legal dispatching of workers abroad, meaning each migrant is obliged to obtain official authorization from the Uzbek Agency of Work Migration. Since 2006-2007, the Uzbek government has also sought to hive off some of the financial flows of its “Gastarbeiters”. According to a government resolution “On registration of citizens seeking employment abroad”, Uzbek labor migrants have to come back to Uzbekistan, go through registration and pay customs dues before returning to work abroad. As a result, the majority of Uzbeks leave without legal permission and thereafter are unable to seek protection from their home state. This situation promotes human trafficking and the organization of mafia networks by recruiters who go from door to door asking for volunteers to work in Kazakhstan.

Working conditions for Central Asian migrants in Kazakhstan are still relatively poor, a fact which is not that surprising given the kind of work they do. And legislation dealing with all this immigration continues to be largely inadequte, being light on penalties for those employers who abuse the system while failing to guarantee minimum social rights for newly arrived migrants.

Main Risk Factors

Returning now to the economic front, and to Karim Masimov’s assurance, the principal short-term risks to Kazakhstan’s slow landing would seem to be threefold: (i) a prolonged period of tight conditions in global financial markets; (ii) a substantial drop in oil prices and other commodity prices, and/or; (iii) a major domestic event that triggered a loss of confidence in the banks. All or any of these could easily cause a process which was now largely under control to become much less so.

Looking forward, growth is expected to remain relatively subdued. Assuming limited bank access to external financing and only modest deposit growth, credit within the economy is likely to decline in real terms. Nonoil GDP growth is forecast by the IMF to slow to 4.7 percent this year, from 9.2 percent in 2007, with spillovers from the oil sector partly mitigating the impact of the credit crunch. Oil output should support somewhat stronger overall growth of close to 5 percent in 2008. A strengthening in growth to 6.25 percent is projected next year assuming global financial conditions improve and pressures on bank balance sheets are reduced. The current account is even projected to move into surplus in 2008, following the large deficit last year, due to higher oil and commodity prices and much slower import growth. With banks repaying debt, the external debt/GDP ratio is projected to fall sharply this year, and appears to be on a sustainable path under a range of scenarios, while the overall government budget surplus is projected to increase to 6.75 percent of GDP in 2008 due to strong oil revenue growth.
Exchange rate stability is a central policy objective of the NBK. At present, exchange rate stability is viewed as essential for maintaining depositor confidence, limiting the risks from the large foreign currency exposure of the corporate sector, and helping reduce inflation. The central bank noted that downward pressures on the exchange rate had abated since the turn of the year, and its foreign currency reserves have been rising, in part due to the decision to delay the automatic conversion of oil fund revenues into foreign currency assets. The country’s official foreign assets (NBK reserves and NFRK assets) are now well above the level reached prior to the onset of market volatility in August 2007. Intervention in the foreign exchange market has been substantially scaled back (as a share of total transactions) in recent months, although the NBK stands ready to intervene in the market if downward pressures on the exchange rate re-emerge. The authorities continue to view the exchange rate regime as a “managed float with no predetermined path for the exchange rate.”

The NFRK continues to be managed prudently, and the government does not
expect to draw on the Fund beyond the amount of the guaranteed annual transfer to the
budget. The assets of NFRK consist of a stabilization portfolio of about $5 billion (invested in short-term debt securities) and an investment portfolio (invested in longer-term debt and equity securities). While the NFRK fulfils both a stabilization and savings role, at present the government has no intention to use the Fund’s assets to help cushion the downturn. Indeed, the government spent only 86 percent of the guaranteed transfer from the NFRK last year, and expects the mandated transfer to be adequate to meet spending needs this year.

The exchange rate regime in Kazakhstan has been reclassified from a managed
float to a conventional peg under the IMF’s de facto classification system. This is due to the very limited movement of the tenge against the U.S. dollar since last October. At present, the IMF take the view that there is no clear evidence of either over or undervaluation of Kazakhstan’s real exchange rate when compared to its estimated equilibrium level.

Kazakhstan fiscal position is very strong. It has a large budget surplus and low public debt. And external debt has been reduced from 92.8% of GDP in 2007 to an estimated 67.9% in 2008, with the IMF forecasting a further reduction to 59.6% in 2009. The IMF said the following in their most recent concluding Mission statement in September:

The strong budget position in Kazakhstan has provided scope for the government to use fiscal policy to support the economy as growth has slowed. We believe that the increase in spending in the recent supplementary budget is appropriate, and that the automatic fiscal stabilizers should be allowed to work, with any revenue shortfalls due to a weakening economy being accommodated in the near future rather than offset with expenditure cuts to meet budget targets. Going forward, the government’s recently announced three-year budget plan maps out a transparent path for fiscal policy over the medium-term. We believe, however, that it is important that the government not commit to further large increases in public sector wages and pensions in future years given uncertainties about budget revenues—particularly from the oil sector—and the stage of the macroeconomic cycle in two or three years time.

The Kazakh government is to buy as much as $5 billion of distressed assets from banks in the next two years and will seek to spur growth by spending up to $10 billion from the National Oil Fund on agriculture and development projects. The government is also going to release 52 billion tenge ($430 million) for a bank-rescue fund.

However, not everything is going to be plain sailing. Oil has now tumbled to as little as $72 a barrel, down is down $75 — or 51 percent — since catapulting to a record high of $147.27 on July 11.

Commodity prices continued their downward march last week, with the Reuters/Jeffries CRB Index of 19 raw materials from coffee to silver, dropping 3.6 per cent amid concerns that the global economy was heading into recession. The abrupt falls in commodities - the RJ-CRB index hit its lowest level in four years - even engulfed gold , which closede last Friday at a one-month low of $775 a troy ounce,

And property prices continue to fall, which prices in the Kazakhstan’s largest city Almaty are now down at 15 percent from a year ago (according to the national statistics agency) and more like 40% according to sources cited by the IMF. Net income at Kazakhstan’s 36 banks fell 47 percent the first eight months of this year as lenders put aside more money to cover bad loans. So there should be no doubt that conditions in Kazakhstan at this point are “tight”.

However, in contrast with Iceland, Kazakhstan has $49.5 billion of reserves to weather its crisis in the short term. That includes $27.6 billion in the National Oil Fund created eight years ago to guard against a drop in oil prices. The existence of this fund means that the Kazakh government could repay all $13.7 billion of foreign debt due in the second half this year, including $9.3 billion owed by banks. The reserves would also cover the $16.9 billion of debt maturing next year, including $6.9 billion owned by banks, according to a recent report by Goldman Sachs, which cites National Bank of Kazakhstan data.

We should also stop for a moment and think about the implications of assuming that oil and other commodity prices will not rebound as we move through 2009. The implication here would be that global demand would have dropped and stayed down. If we go for that scenario, this would seem to imply a generalised recession in the developed economies of almost unprecedented depth (at least in post WWII terms). While not doubting that some individual countries (Spain, for example) may be in for a very rough ride indeed, I am not convinced that conditions will universally deteriorate to this extent. We will have a recession in 2009, but hope fully it will not be so deep as to send Kazakhstan off into Iceland-type bankruptcy.

Let me put this another way, if the recession is so deep that Kazakhstan goes off into receivership, then I dread to think what the situation will look like almost universally across the CEE.

So then, to return to my original question which was posed at the start of this post: should we simply believe Karim Masimov when he tells that Kazakhstan won’t be needing that IMF help? Well no we shouldn’t, since among other things he would be saying that, wouldn’t he - and if you don’t believe me just look what the rest of East European walking wounded are saying as they amble in.

But we don’t have to take Masimov’s word for it in this case, since there are other, more objective evaluations of the situation available. So why don’t we close by taking a look at what the IMF themselves have been saying, in this case in their September 28 Mission Concluding Report. At this point in time their assessment and judgement is good enough for me, especially since I think the principal arguments they advance make a lot of sense.

Kazakhstan has large financial resources to help it weather the current situation, and medium-term economic prospects remain favorable. Official foreign currency assets, comprising central bank (NBK) reserves and oil fund (NFRK) assets, reached $48 billion at end-September, well above the mid-2007 level. The current account balance has strengthened significantly this year, and oil production is set to increase substantially in the years ahead.

As at the time of the Article IV consultation discussions in April, we believe that in the short-term policies should remain focused on managing risks to the outlook and setting the stage for the resumption of strong and sustained growth. Since our last visit, the authorities have continued to skillfully handle the difficulties the economy has faced, and we welcome the policy steps that are being taken in the monetary, fiscal, and supervisory areas to strengthen the resilience of the Kazakhstani economy. Nevertheless, considerable challenges remain, and these have been heightened by the renewed bout of global financial market volatility.

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- - UniCredit is one of Europe’s top 10 banks by market value, with a capitalisation of about $39 billion. It is second to Intesa Sanpaolo SpA among Italian banks.

– In a U-turn on Oct. 5 it announced plans to boost capital by 6.6 billion euros. It will ask investors for 3 billion euros in a capital increase and offer shares rather than a cash payout on 2008 results, putting 3.6 billion euros instead in its own coffers.

– UniCredit on the same day boosted its target for Core Tier I to 6.7 percent at the end of 2008 based on Basel II requirements from its previous aim of 6.2 percent. The figure was 5.7 percent at the end of June.

– It also slashed earnings per share forecasts for this year to 39 euro cents from around 52 euro cents previously.

– It is the Italian bank with the most foreign exposure. UniCredit gets about half its revenue from outside Italy and its conservative lending market.

– UniCredit, whose units include Germany’s HVB, is among market leaders in Germany and Austria.

– UniCredit’s share price has dropped about 62 percent since the start of the year, pushing it second to Intesa Sanpaolo among Italian banks. The DJ Stoxx European banks index has lost about 52 percent.

– First-half net profit was 2.9 billion euros on operating income of 14 billion euros. Deposits from customers and debt securities totalled 639.8 billion euros.

– The bank traces its origins back to 15th century Bologna. The current UniCredit resulted from the merger of nine of Italy’s biggest banks in 1998, as well as the purchase of HVB in 2005 and Italy’s Capitalia last year.

– The biggest shareholder is the Fondazione Cassa di Risparmio di Verona Vicenza Belluno e Ancona, at 5 percent.

– Libya now comes second with its combined 4.23 percent, followed by:

Fondazione Cassa di Risparmio di Torino with 3.83 percent

Carimonte Holding with 3.35 percent

Gruppo Allianz with 2.37 percent

Fondi Barclays Global Investors UK Holdings Ltd with 2.01 percent.

– UniCredit is the biggest shareholder in powerful investment bank Mediobanca SpA with an 8.7 percent stake.

Evidently, in this type of business, what you pay for is what you get:

Italian Prime Minister Silvio Berlusconi pledged $5 billion over 25 years to Libyan leader Muammar Qaddafi in compensation for the occupation of the country in the 30 years before World War II.

Italy will pay $200 million per year to Libya in the form of investments in infrastructure. The money will finance the construction of a coastline highway that runs about 1,600 kilometers (994 miles) between the Egyptian and Tunisian borders.

“It’s a full moral recognition of the damage done to Libya during Italy’s colonial period,” Berlusconi said after arriving at the airport in the Libyan city of Benghazi, where the two leaders met to sign the accord. “This will end 40 years of misunderstandings.”

And why, we may ask, does the Italian government find itself in need of recourse to what might be termed the Libyan Connection” in order to recapitalise its banks. Well, Global Insight in a very informative recent survey of EU government commitments to their banking sector perhaps offer us one part of the explanation, they simply don’t have any money available to spend themselves, and with debt at around 104% of GDP, people - apart from the kind Libyans that is - are going to become increasingly reluctant to lend it to them.

In a deviation from the measures seen in France and Germany, Italy has not created a fund for its rescue plan, with Finance Minister Giulio Tremonti stating that, “As of today, we estimate that it’s not necessary to have a predetermined figure.”……Italy is in stark contrast to other European nations by providing no firm capital commitments; however, the government’s reluctance to create a rescue fund could partly be a reflection of the restraints imposed by its substantial public debt, which stood at 104% of GDP in 2007.

So, as I said, with people more than likely about to become increasingly apprehensive about buying Italian government paper, then having rich and obliging friends like the Libyan government is going to be a real boon. Oh yes, and when I said “people”, I wasn’t, of course, including, at least for the moment, that other untiring friend and trusted workhorse the Italian government can still count on over at the ECB.

The Bank of Italy will also engage in a 40-billion-euro debt swap, taking on inferior bank debt for government bonds that can then be used to obtain financing from the ECB.

So don’t let yourself get behind the curve, and don’t miss out on the very latest talent-stalking trend towards ever more exotic varieties of global look-alike contests. Now which country was it where the banks were being busily underwritten by the Shanghai Pudong Development Bank, just let me go and check my records……?

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The current pressure on the euro is more the result of liquidity and solvency problems in the banking sector (and perceived institutional deficiencies when it comes to being able to address these) than it is a response to the growing weaknesses in the real economies eurozone real economies, which, as I have already recently argued here, probably mean that the zone as a whole has now entered the first recession in its short history.

When it comes to the liquidity and solvency issues, I do think we can already identify some clear trends, since we can see that in those European countries which had substantial housing booms - the UK, Ireland, Greece, Spain and Denmark - the bank exposure is to the drop in the value of the underlying assets (the houses, or the land, or the malls, or the office blocks) and to the defaults in payments (either by builders or by companies, or by homeowners) which have their origin in the impact of the mortgage seize-up on the real economy (rising unemployment, declining bonus payments, falling retail sales and industrial output, etc), whereas in non-housing boom countries (lead by Germany, Italy, Sweden and Austria) the exposure is to lending which was made to banks in the boom countries - first and foremost in the United States, but also in the UK and Ireland (see Germany’s Hypo and it’s Irish subsidiary Depfa) and, of course (and the largest slice of this is yet to come) in Eastern Europe (lead by banks in Sweden, Austria and Italy).

The other key thread is whether or not the institution in question lent against deposits, or depended on the wholesale money markets for funding. The banks - lead in this case by the Spanish armada - who were most dependent on external borrowing are now evidently those who have (or are about to have) the biggest problems as the worlds wholesale money markets remain firmly closed, with little possibility of them being permanently reopened until this crisis is over.

In theory, the 27-nation EU structure should offer a ready means of coordinating policy. But while the EU has unified laws on areas like trade and labour standards (and in the near future on immigration) more broad-reaching policy harmonisation (such as fiscal coordination) has long been resisted, and the recent sorry attempts to introduce a basic constitution provide clear evidence of the difficulties which lie ahead for any substantial moves in this direction. The EU has no institutional equivalent of the US Treasury, which is why all the initiatives which we have seen to date - for all the European “feel” about them - have been either ad hoc bi- or tri- lateral arrangements.

US National Bureau of Economic Research head Marty Feldstein has long been on record as pointing out that the greatest weakness in the eurosystem architecture from the start has been the absence of a common fiscal system, and the inability to correct the problems caused by deficits in one country by drawing on surpluses in another. When he first raised these issues Feldstein was undoubtedly thinking about the possibility of asymetric recessionary processes, and the need to coordinate fiscal stimulus - and I doubt was thinking about a problem of the severity of the one we now face - but in the longer run he has been proved right, this sort of problem was always going to arise at some point or another. As Jean Claude Trichet is now finding out, in macroeconomic management terms you simply cannot have your cake and eat it.

My basic point is a simple one: the European institutional structure with a centralized monetary policy but decentralized fiscal policies creates a very strong bias toward large chronic fiscal deficits and rising ratios of debt to GDP. An effective political agreement among the Eurozone countries is needed to prevent those deficits.

Without either discretionary monetary policy or an automatic cyclical adjustment of interest rates or of the exchange rate, a country can stimulate aggregate demand only by fiscal policy. While a fiscal policy can in principle take the form of a revenue neutral change in fiscal incentives – e.g., an investment tax credit offset by a temporary rise in the corporate income tax rate – the usual fiscal response to an economic downturn is a tax cut that increases the budget deficit. Moreover, deficitexpanding fiscal policy has greater potency with the interest rate and exchange rate essentially fixed than it would if the country had its own currency.

There is also a greater need in Europe than in the United States to use discretionary fiscal policy to respond to an economic downturn in a “local” area – i.e., in a European country or an American state. This reflects both fundamental labor market differences between Europe and the US and differences between the two fiscal systems. By fundamental labor market differences I mean the much greater geographic mobility and wage flexibility in the US than in Europe. A sharp decline in demand for the products of Massachusetts, my own state, some years ago led to a relative decline in the Massachusetts labor force (more out-migration and less in-migration) and to a decline in the relative wage of Massachusetts workers. The European labor force is much less mobile (because of differences in language and culture and a general reluctance to move even within countries) and wages are much less flexible.

The contrast between the centralized fiscal system in the United States and the decentralized fiscal system in Europe is also very important in this context. A decline of economic activity in a single US state automatically causes a substantial decline in the flow of taxes to Washington from residents and businesses in that state and an increase in transfer payments from Washington. The magnitude is roughly equal to 40 percent of the local decline in GDP. This net fiscal swing constitutes a significant external fiscal stimulus to the local economy. In contrast, with the decentralized European fiscal system, a fall of GDP in any country causes a contraction in tax revenue in that country but very little net transfer from outside. In short, the combination of a centralized monetary policy and a decentralized fiscal structure in Europe increases the need for and the effectiveness of countercyclical fiscal policy.
Marty Feldstein, The Euro And The Stability Pact

The issue really is that any economy is a single organic whole, and that monetary and fiscal policy really form part of one integral continuum. Basically both are concerned with demand management, monetary policy via the indirect route of trying to influence peoples saving and borrowing behaviour, and fiscal policy via the direct route of either injecting or withdrawing demand from an economy. Trying to manage one without having control over the other simply ends up in incoherence at the end of the day, and it is just this policy incoherence that we are in danger of seeing now as the financial crisis (and the political credibility one which is liable to follow in its wake if people aren’t careful) takes hold. Basically economies like Spain and Ireland, where the real economies are now almost in free fall (Spain’s industrial output fell at the fastest rate of any among the 26 key global economies tracked on the JPMorgan global purchasing managers index in September) need a substantial injection of funds via the fiscal conduit to enable their governments to inject liquidity and demand into their systems without those governments seeing their accumulated debt to GDP ratio’s rising at rates which will set of alarm signals over at the credit ratings agencies. And they need this funding now, since - and without wanting to sound too dramatic - the situation is deteriorating rapidly, and by the day.

Unicredit Sinks Like A Stone

The shares of Italy’s second largest bank, UniCredit SpA, fell as much as 16 percent at one point in Milan trading this morning, hitting 2.59 euros and taking the shares back into the region of the 11-year low of 2.55 euros registered on Sept. 30. The drop follows a capital boost of 6.6 billion euros decided on at an emergency board meeting held yesterday afternoon, where among the exceptional measures decided on to raise the cash was the idea of paying this years dividends to shareholders by giving them more company shares.

The “shares for dividends decision” forms part of a battery of measures which includes significant cost cuts and asset sales in order to try to guarantee that the core Tier I capital ratio, a measure of the banks’ financial strength, rises to 6.7 percent by the end of the year, from 5.7 percent now. A core Tier I of 6 percent or higher is generally considered an adequate minimum for banks, while anything below it starts to raise eyebrows.

During a chaotic day trading in Unicredit shares was suspended several times following the initial dramatic fall, and they were finally down on the day by 5.5 percent, closing at 2.914 euros. Indeed the problems being experienced at Unicredit lead the whole Italian banking sector down, and with it Italy’s S&P/MIB Index, which declined the most in more than seven years this morning, losing 1,435, or 5.5 percent, to 24,476.

But what if this had been a bank with a name of a large European country, or an acronym that refers to a large European city, banks that are simultaneously too big to fail and too big to save? I shudder to think what would happen when Silvio Berlusconi, Angela Merkel, Lech Kaczynski and the next Austrian leader have to meet to discuss the future of a large cross-border European bank.
Wolfgang Munchau, The Financial Times, Monday 6 October 2008

UniCredit SpA, is, as I say, Italy’s second biggest bank and it is also owner of Germany’s HVB Group. The current crisis started last week when shares fell more than 24 percent in three days as it became increasingly clear that the bank was going to need to raise money to strengthen its finances. One of the issues arising was whether or not UniCredit would be asked to help in the bailout of Germany’s Hypo Real Estate Holding, a development which could have negative consequences for Unicredit’s capital position. Hypo Real Estate was in fact spun off from the Unicredit owned HVB Group in 2003.

But Unicredit is also exposed due to the extent of its lending in Eastern Europe - which is estimated to amount to one quarter of the banks total lending operations. Unicredit is deeply involved right across Eastern Europe via its ownership ofthe HVB group, as well as via it’s ownership of Bank Austria Creditanstalt. Among other issues Unicredit is evidently exposed in the Baltics, given the fact that as of September 1, 2007 ASUniCredit Bank Estonian took over the business of HVB Bank Tallinn. But the extent of Unicredit East European lending is much more extensive than this, and with property markets in one EU10 country after another now likely to “correct” the problem is about to become considerably larger than simply the German Hypo Real Estate one. Unicredit made direct acquisitions in 2007 in Kazakhstan and Ukraine, while extending its position in the Russian banking sector. The first of these counries had a financial “sudden stop” in September 2007, while the latter two are in the process of a major domestic credit “unravelling.

Fitch Ratings last Thursday downgraded the Outlook on UniCredit to Negative from Positive. At the same time Fitch changed the Outlook on Unicredit’s main subsidiaries - Germany-based Bayerische Hypo- und Vereinsbank AG (HVB) and Austria-based Bank Austria Creditanstalt AG - to Negative from Positive. Fitch stressed as reasons for the downgrade the poor macroeconomic outlook in Italy and Germany and in particular the less benign outlook for some central and eastern European markets. Fitch also regards UC’s current capitalisation (end-H108 Basel 1 core Tier 1 ratio of 5.55%) as tight in relation to its risks especially given thatconditions in the wholesale funding market remain “extremely challenging”.

So the question is going to be, is Unicredit too big to fail, or too big to save?

Government Guarantees For Deposits

One popular way of handling the present wave of pressure hitting the banks has been to give guarantees to depositors. The Irish were the first to do this, and they have been subsequently followed by The Greeks, the Danes, the Swedes and now the Germans. Up to this point the Italian and Spanish authorities have been notably silent on the matter, and the reason why is not hard to imagine.

Basically Ireland may have quite large problems, but it can, being a small country, “piggy back” from the United Kingdom, by attracting deposits from their larger neighbour. An analysis carried out at Credit Suisse has shown how movements of cash by relatively few depositors may have a bigger effect in countries which a significant proportion of deposits is concentrated among relatively small percentage of the customer base, as is the case in the U.K. (for example) where 4 percent of the banks’ customers hold 45 percent of the deposit base.

But where can the Spanish banks look for this kind of support? It is their very size and the size of the problem they have that makes for the difficulty. The vaguely-insinuated plan which was “nearly - but never actually - proposed” at last Saturday’s Paris meeting was for a fund of 300 billion euros. But Germany’s Die Welt reported over the weekend that Hypo Real Estate alone will need 20 billion euros by the end of next week and 50 billion euros by the end of the year, to be followed by as much as 100 billion euros by the end of 2009. And this is just one relatively minor “quasi bank”.

Spain’s needs are likely to be much larger - I personally have estimated a sum of between 300 and 500 billion euros for Spain alone, between the need to roll-over toxic financial instruments and non-performing loans from builders and other corporates. And what about Unicredit? We have no real idea at this point how much funding Unicredit may need.

And so we need to go back to Marty Feldstein, and to think about the budget deficits issue. In general European governments have little room for large scale fiscal support either on the annual deficit side, or on the debt to GDP ratio one. Given the ageing-related commitments (pensions, health costs) which are looming (in particular after 2012) for some key European governments (especially Germany and Italy) it is reasonably clear that - following the deficits which were all too often being run during the “good years” - there is now not much headroom to play around with, and remember all this government support for banks that is bbeing freely undertaken has to be funded somehow - either out of revenue, or by raising debt. In particular, if certain of the EU national governments move back on the commitment to balance the budgets by 2011 then we will only start to shift from banking instition downgrades to sovereign rating ones. This is why I titled this post the way I did. If either Italian government finances, or the Spanish banking system, are simply allowed to unwind for lack of visible support, then the integrity of the Eurozone itself which most definitely be put at risk. And events could happen very rapidly indeed if either important systemic banks or a large sovereign government suddenly go into financial meltdown. So the visible lack of any coherent startegy or plan could not be reasonably considered one of those cases where some people somewhere busy fiddling with their thumbs while Rome and Madrid were burning, now could it?

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