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Eric Janszen Interviews Alex Jurshevski – Part I: Crisis of consensus
As, pent in an aquarium, the troutlet
Swims round and round his tank to find an outlet,
Pressing his nose against the glass that holds him,
Nor ever sees the prison that enfolds him;
So the poor debtor, seeing naught around him,
Yet feels the narrow limits that impound him,
Grieves at his debt and studies to evade it,
And finds at last he might as well have paid it.
- Barlow S. Vode
We’ve spent years talking to academic or industry economists who’ve given us a good understanding of the myriad ways governments drag economies into a state of over-indebtedness and how, theoretically, they might get out of it. It’s far easier to pontificate and speculate about debt and money goings on in Greece, Iceland and ex-Soviet countries, and speculate about euro zone countries leaving the euro than it is to work through a debt crisis with the relevant parties, with representatives of government and of international financial institutions (IFI) such as the IMF, within the operational constraints of the real world. Swims round and round his tank to find an outlet,
Pressing his nose against the glass that holds him,
Nor ever sees the prison that enfolds him;
So the poor debtor, seeing naught around him,
Yet feels the narrow limits that impound him,
Grieves at his debt and studies to evade it,
And finds at last he might as well have paid it.
- Barlow S. Vode
After all of the newspaper editorials are written someone still has to sit down with private and public lenders and borrowers to work out a deal and execute on it, even as the accusations fly in the press and angry citizens take to the streets. Such a person has the experience to offer informed opinions on risks, options, and outcomes for the sovereign debt crisis that has followed, with gruesome predictability, the global financial crisis before it. That’s where our guest, Founder and Managing Partner of Recovery Partners, Alex Jurshevski comes in.
Alex Jurshevski has more than 20 years of experience in investment management, M&A and advisory work. His firm offers Principal Investment and Risk Advisory Services in the area of distressed assets and turnaround management. During his career, Mr. Jurshevski has been involved in over US$40 billion of financial restructurings and over US$20 billion of primary transactions. He has been a managing director of the Bankers Trust and has also worked with the Investment Banking Division at Nomura. He was on the European Management Committee at NIplc and was also the Chair of the Emerging Markets Trading Committee, head of portfolio management operations for the New Zealand government in the New Zealand Debt Management Office (NZDMO), and a member of the Advisory Panel on Government Debt Management and the World Bank's Government Borrowers Forum.
EJ: Alex, we very much appreciate having the opportunity to talk to you today.
AJ: It’s a pleasure to be here.
EJ: You've had a long career in the financial industry. Give us the full rundown on your background.
AJ: Well, my background is actually as a professional economist, monetary economics and econometrics. I did my graduate work at McMaster and my undergrad at McGill up here in Canada following which I joined the Bank of Montreal as a financial economist. Apart from watching the Bank of Canada and the Fed this also involved bankruptcy research, assessment of fiscal policy and also projecting what we call up here the “all-bank balance sheet” which was part of the planning processes for the various production areas in the bank. So I cut my teeth early on by understanding financial flows and policymaking in the Canadian economy and the US economy.
EJ: That was in the early 1980s?
AJ: Yes. That set the base for moving over to the trading side in the mid 1980’s with the Bank of Montreal. Within a couple of years I was running all of the short-dated businesses in the trading room. I had about ten people working for me dealing FRAs, Futures, Over-the-Counter Options, Caps, Floors, Collars, that sort of thing. A few years after that, subsequent to the 1987 crash, my boss and I were looped into the Brady Commission, an investigation into the causes of the crash. We provided the submission on behalf of the Canadian banks through the Canadian Bankers Association to the Brady Commission in response to their questionnaire and survey. So I got into sort of larger scale financial issues at around that time.
Then I moved over to CIBC where I was running a multi-currency derivatives book, long-dated fixed interest swaps and cross currency structures primarily. They sent me to Tokyo to run Capital markets and so with that background I was recruited by the government of New Zealand in the early 1990s to clean up the debt problem in New Zealand. They had a portfolio that was completely miss-specified. They had under-developed capital markets. It was a complicated collection of problems but the main one being that they had too much debt. They were in a very slow growth type of mode because they were coming out of the end of a long period of austerity following the currency crises in the mid 1980s. And also the composition of the debt was inappropriate for their risk-appetite. It had a very small concentration of domestic debt and a very large concentration of foreign currency debt that was denominated in a number of different currencies. Long story short, it took about three to four years to clean that mess up.
Following that I went to London and worked in private equity for about seven years and that got me into a number of different economies in central and eastern Europe, on top of the developed economies in Europe and North America, where we were doing acquisitions of financial services companies, pubs, manufacturers and other private-equity situations.
Following that experience I founded Recovery Partners around 2000 in London, England after the tech wreck. Recovery Partners was initially established as a turnaround practice where we would go into distressed businesses, look to see what the problems were, whether it’s a financing issue, an operational issue, a personnel type issue requiring an interim management stopgap--what have you. We’d supply appropriate advisory to those companies to try to get them back on their feet again—get them refinanced and off to the races.
Around about 2002 my old employer CIBC called and hired Recovery Partners to help manage their Basel II compliance program. And we took over half of the compliance activity for CIBC, working inside CIBC, helping them build credit-risk models, operational-risk models and bringing them generally into compliance with the requirements of Basel II. In that process I moved back to Canada from London along with my family and the bulk of the Recovery Partners business over here. Following the CIBC contract we repositioned the business slightly. While we are continuing to offer turnaround and restructuring advisory services and we have also tacked on an ability to invest in distressed loans that banks or near-banks were looking to divest from their portfolios because of the increased capital or just simple distress, or because they weren’t equipped or prepared to deal with a specific non-performing loan situation.
EJ: How many countries have you advised over the past few years?
AJ: We’ve been doing that business for about three-and-a-half years now on top of the advisory business and Recovery Partners has worked I guess in five or six different economies. Most recently we were in Iceland speaking to the government about the need for a comprehensive debt management strategy and offering advice on their relationship with the IMF going forward. Earlier we were on a retainer from one of the main IFIs to clean up a big debt problem in Tajikistan. We’ve done acquisitions in the US and Canada. So it’s been a variety of engagements.
EJ: Has the Global Financial Crisis (GFC) been as good for your business as one might expect?
AJ: The GFC has brought with it expectations of a huge flood of business but we have not seen that as yet up here in Canada. The amount of distress we’re seeing up here in Canada is actually less than it was two years ago before the crash. That said, there’s quite a bit of activity in Europe and there’s a growing sovereign debt problem worldwide. If we look from east to west I don’t think there are too many economies that are not affected by pressures on credit ratings and country finances. I guess the two islands of prosperity in this whole thing are Australia and Canada. But generally speaking, we have a world that is sinking deeper in debt. There are more problems and we think that the bulk of the opportunities we have been expecting to emerge for the last four or five years ago still lie ahead of us.
EJ: Great, then with your credentials firmly established, we have many questions. Let’s start with the sovereign debt crisis in Europe. The popular press here characterizes it as like a government debt version of the US sub-prime lending crisis, prone to contagion. Is that an accurate analogy?
AJ: Well, yes and no. I think what we saw as a response to the GFC was obviously a resort to what is now widely known as quantitative easing (QE) which, when I was in college studying economics was called “printing money.” There are second-order effects of Fed-mandated quantitative easing that are underappreciated. In the initial stages of the crisis governments were expected to widen their fiscal deficits, add more stimulus to the economy on the fiscal side and aggressively expand monetary policy—move to an expansionary policy—to support activity and to prevent a worse crash from occurring. As a stopgap, that policy did succeed in forestalling a much worse crash but what we are now seeing in a number of the weaker economies, especially, whose finances were not as strong going into the crash as other economies, are second order effects that include unsustainably large structural government deficits that need to be addressed. Those government deficits in turn are feeding back into expectations for some of those economies that there may be a real probability of sovereign default.
EJ: Who is on the top of your list?
AJ: That depends. Iceland, for example, is a special case. They would have crashed whether Lehman’s had gone down or we had a GFC or not because they were out of control for a whole different set of reasons. If we concentrate on Europe, the economies that seem to be in trouble are those that have taken on too much debt, that have not managed it appropriately and don’t have the social contract to be able to address it in a short enough period of time. Fiscal imbalances loom large, and I would include, obviously, among the cast of characters the PIIGS: Portugal, Ireland, Italy, Greece, Spain. Those guys are definitely out of control but there is a whole other cast of characters behind the curtain that have been having the same sets of troubles.
They would include many of the Eastern European countries—Latvia in the Baltics, the Ukraine, Hungary. These folks are all having the same sets of fiscal issues. You’ve got the huge fiscal imbalance in Britain as well, which is a very important European economy. The deficit this year is expected to come in somewhere around 12% of GDP. That’s unsustainability large. Britain already has a fairly high debt-to-GDP ratio and similarly even the mainstream economies like Germany and France that appear to be in better shape also have very significant financial requirements in terms of their funding gap.
Looking across the entire OECD this year you’re looking at a funding gap on the order of $12 to $13 trillion that needs to be funded and this is going to create pressures in financial markets—pressures we’re already feeling now in the sense that the markets have gotten very balky. There’s limited liquidity in a lot of the funding markets. Many deals are being pulled. Even up here in Canada we’re seeing a number of IPOs for good issuers being pulled because the investor base has simply retreated and is, I think, waiting for things to shake out. This is, in my opinion, one of the worst crises I have ever seen and it’s something I don’t believe is going to go away as a consequence of the “reflate-and-wait” strategy which is what I think the authorities were counting on when they implemented the QE to start off with.
EJ: Given that you’ve been at this since the early 1980s, that’s saying something. If reflate-and-wait isn’t going to fly, let’s talk about scenarios. The theory behind reflate-and-wait is that once a reflated economy becomes self-sustaining it grows itself out of debt. But public debt levels, at least in places like the UK and the US, were so high before the GFC and unemployment was so high after the crisis that the amount of stimulus required to get the economy moving again left these countries hopelessly indebted relative to income that can be generated to grow tax revenues enough to cover the debt. They are likely to find themselves needing to do a second round of stimulus but won’t have the credit to do it.
AJ: Well, exactly. Going back to first principles, there really is no evidence of a “Keynesian Multiplier.” I mean this idea that if the government steps in and fills an output gap it’s going to lead to additional activity down the road. There is absolutely no evidence of that historically to ever have worked so what you end up with is the government applying a short-term patch. In previous cycles there was enough underlying momentum in the economy to propel the economy forward to make it “look” like the government stimulus was actually having an effect, but in fact, if you filter out all of the extraneous influences, you typically find that government spending produces slightly less output proportionate to spending, or a lot less. In other words, there is a cost to the activity of reflation and the cost gets passed on to future generations.
EJ: What’s the probability of successful fiscal consolidation?
AJ: In the last 20 years I’m only aware of two countries that successfully consolidated their finances and worked themselves out of a debt hole without a default or a restructuring. Here I am talking about countries that lowered their Debt to GDP ratio by 10% or more – which is what is required now pretty much across the board. One of those countries is Canada, which embarked on a process of fiscal consolidation in the mid-1990s. That process was complete about seven or eight years later. Debt-to-GDP stabilized and moved down. The government moved into a primary surplus and things were fine. The other economy is New Zealand where you had, in response to the currency crisis of 1984, a very focused political platform amongst all the parties in New Zealand to concentrate on debt reduction and fiscal consolidation. Over a period of about ten or eleven years, between 1984 and 1995, they were eventually successful.
Best case scenario: New Zealand escapes a debt crisis during the great global expansion
The conditions for successful consolidation in places like Greece, Spain, the UK, the US simply don’t exist because you don’t have the political consensus that’s needed as a first order condition for one of these programs to ever take off successfully. In Greece, for example, you have a very large rentier class that has benefited the last couple of decades from government largesse. The fact that they have a debt problem is why there’s not going to be any political consensus to solve the debt problem—because you have a large part of the electorate that’s benefiting from the current set of arrangements. Therefore, voting in a government that is going to implement a serious program of austerity and get the fiscal house in order is a low probability event. The same is true in Spain and certainly true in the UK and, for that matter, in the US where by many calculations you have over a hundred million electors who are directly tied into federal and state government spending programs in one form or another, whether they’re employees of government, collecting unemployment insurance, welfare, social security, or food stamps. If you’ve got that many people on the gravy train” it’s hard to see how, through an election process, you’re going to get support for austerity where those people end up being the losers –especially when the historical evidence shows that the adjustment could take a decade or more.
The problem the world faces from a policy-making standpoint is that we are caught in this fiscal trap with no real politically feasible way of generating the consensus needed to implement policies that will get us out quickly enough to avoid a more serious crisis.
EJ: Let’s say for the sake or argument that the political will and consensus develops to, for example, get the US fiscal house in order. Wouldn’t that necessitate massive cuts in government spending, especially the military?
AJ: Huge. Huge. A lot of it depends on your starting point. Russia, for example, defaulted in 1998 with only about 50% debt-to-GDP ratio. Latvia defaulted I believe in 2008 with only around 30% debt-to-GDP. Those are manageable debt-to-GDP numbers as long as you know what you’re doing in terms of debt-management. They obviously did not. If, however, you’re starting point is where Greece is, at around 108% debt-to-GDP, or Iceland at around 104% debt-to-GDP, there the difficulty is quite simply the fact that once you’re up around those levels the interest bill as a portion of government spending starts to crowd out other expenditures—such as schooling, housing, welfare, and health. And so you end up with a situation where the government budget simply can’t bear up to the strain and the impetus really becomes one of “let’s default on this debt” or “let’s inflate the debt out of here” because mathematically, once you’re at 100% or more, you’re on a treadmill. If you don’t understand debt management and haven’t got a strong capability in that area and you are at those levels you are simply waiting for the axe to fall.
EJ: What’s preventing the treadmill from running out of control?
AJ: Right now what’s preventing the treadmill from spinning out of control and throwing most of these countries onto the ground immediately is simply the fact that nominal interest rates are at, or close to, zero. Real interest rates are actually arguably in many economies below zero. If we were to have an interest rate shock most of these folks would end up going into the tank right away and therefore the probability of a fiscal consolidation plan succeeding –a fiscal consolidation plan would typically have a time frame of say five to ten years)—the probability is low of something like that succeeding in an environment where you are vulnerable to an interest rate shock. At the same time there’s incredible pressure on your finances because of a very large interest bill as a proportion of government expenditures. Under these circumstances, the probability of these fiscal consolidation plans succeeding today is very, very low in the context of the history.
Eric Janszen Interviews Alex Jurshevski – Part II: Watch the Red Zone ($ubscription)
EJ: Now that we’ve defined the crisis-prone environment, let’s talk about potential triggers for a sovereign debt crisis among the countries that you’ve mentioned. There was a very good paper written by Roubini back in 2003, that we went over in some detail on iTulip about a year ago [link], that identifies different thresholds that individually or in combination tend to trigger a sovereign debt crisis. One of those is when foreign currency reserves fall below a level that markets believe is sufficient o cover the interest payments on foreign debt owed in a foreign currency. Is that a likely trigger in any of the countries that you’re looking at?
AJ: Well I think that’s probably a likely trigger certainly in Iceland. Not so much in the euro zone, obviously, because they owe their debts in euros and the ECB can print euros to pay off the euro debts in these countries. But in a number of the Asian countries such as Kazakhstan one of the triggers might be exchange reserves. Another crisis trigger might be the reset profile of government debt—if they’ve got a lot of floating rate debt and rates rise and the market sees that they’re going to have to roll over and reset at higher rates. Anther scenario for countries that have large maturities coming up that need to be refinanced and the markets are unfavorable and possibly the refinancing might fail. That’s something that affected New Zealand just prior to my arrival there. There are a number of different triggers that individually or in combination can lead to default.
EJ: Others?
AJ: Another would be a monetary policy signal event, such as if the market sees, say, in Latvia, that the authorities are starting to expand the money supply very aggressively. Or in Spain or Croatia—these types of places that are also in the “red zone”. If they see rapid monetary expansion they may discount towards the future and say “Jesus, these guys are out of control. We want to pull out.” Then you end up with capital flight, collapse of the currency and—boom, you’ve got a crisis. It all has to do with capital flight, what the triggers are that will spook foreign or domestic investors to want to get out of government bonds, to want to get out of that currency and want to get into something safer. This is why the United States is in also a very vulnerable position, one that could under certain circumstances see things unravel much more quickly than anyone currently thinks possible.
Notes: Japan’s Public sector debt is very high. However, Japan has a high savings rate that makes it easier for the government to finance the debt: 90% of Japanese debt is owned by Japanese individuals and none is owned by foreigners. Nevertheless, the National Debt of Japan is a real burden for the economy. The US has a low savings rate and 25% of US debt is owned by foreigners. The National Debt numbers for the US also do not include off-balance sheet obligations. An important factor is not just cumulative national debt, but the annual budget deficit. This annual deficit determines the rate of deterioration in the public sector debt
EJ: We wrote a piece a couple of years ago on sudden stops as the process might apply to the U.S. Surveying various countries, such as Korea during the currency crisis, the sudden stop process depends on a complex mix of factors. For example, in the second crisis in Argentina in ten years in 2001, the debt and currency crisis was triggered by the US financial markets crisis; the US was its primary creditor standing behind the IMF and the US decided it wasn’t going to support Argentina any longer. The US had its own problems. Could the same principle possibly apply to the US and China? What if China were to run into serious economic trouble that made it difficult for them politically to continue to finance the US economy?AJ: Well, I think that’s sort of a medium-term problem. In the short run the US would simply resort to the printing press in order to get its bonds out the door, but certainly in the longer run, China is a very important source of funding for the US. If it were to run into such difficulty that it needed to resort to bond sales in order to maybe fund its own domestic spending programs, or maybe it wanted to sell some of its own US-dollar-denominated currency reserves in order to shift into another currency rapidly—I think that could cause enormous upheaval. But in the short run, because the US is the world’s reserve currency you’re cushioned from the effect that might have if you were, say, Russia, or if you were a Latvia or a Iceland where you owe debt in another country’s currency and you’re a much smaller economy and what happens outside means a lot more than what happens inside. more... ($ubscription)
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