Wishful Thinking – Part 1

A year of wishful thinking …

The period from March 2009 was the year of wishful thinking. Central banks cut interest rates and governments opened their cheque books providing a flood of cheap money that gave the illusion of recovery and a normal functioning economy. By pouring a lot of water into a bucket with a large hole, the world sustained the impression that the receptacle was almost full. As Norman Cousins, an American political journalist, noted: “Hope is independent of the apparatus of logic.

Cognitive dissonance ensured that excessive debt levels and the unsustainable nature of debt fuelled growth was ignored. Governments merely transferred the debt from private sector balances sheets onto public balance sheets. The Global Financial Crisis (“GFC”) has morphed into a Global Sovereign Crisis (“GSC”) as sovereign governments now face difficulty in raising money. Stock markets and asset prices have tumbled. Credit markets are exhibiting an anxiety not seen since late 2008/ early 2009. The year of wishful thinking has run its course.

Cradle of debt…

If sub-prime was the Patient Zero of the GFC, then Greece, the cradle of Western civilisation, was the equivalent of the GSC. As historian Arnold Toynbee observed: “An autopsy of history would show that all great nations commit suicide.

Greece’s significance is not its economic size (around 0.5% of global Gross Domestic Product (“GDP”)) but its significant debts. Greece currently has around Euro 270 billion (113% of GDP), projected to rise by 2014 to around Euro 340 billion (150% of GDP)). In addition, Greece’s budget deficit was around 12-13%, at least that was the best guess. Profligate public spending, a large public sector, generous welfare systems particularly for public servants, low productivity, an inadequate tax base, rampant corruption and successive poor governments were responsible for the parlous state of public finances.

Several events focused attention on the problems. Greece needed to borrow around Euro 50 billion in 2010 to refinance maturing debt and fund its budget deficit. There were damaging disclosures that Greece, like many other European countries, had used derivatives to manipulate its debt figures. Greece bungled attempts to mask its increasing difficulties in refinancing maturing debt, including statements about a large purchase by China of its debt which was denied by the supposed buyer.

The revelations focused attention on underlying problems setting off alarm bells. Smelling blood in the water, markets began shorting Greece, pushing up the cost of Greek debt, both in the physical and derivative (credit default swaps (“CDS”) or credit insurance) markets. The Greek stock market fell sharply by around 30%. Gradually, the ability of the country, as well as Greek banks and companies, to raise money ground to a halt.

Greece was also the “canary in the coal mine“, highlighting similar problems in the PIGS (Portugal, Ireland, Greece and Spain) as well as some Eastern European countries. These countries alone have around Euro 2 trillion of debt outstanding. Larger countries – the FIBS (France, Italy, Britain and the ‘States) – also have similar problems.

The problem is the large amount of public debt, unsustainable budget deficits and (in most cases) unfavourable current account deficits (both in absolute terms and relative to GDP). The deterioration in public finances was structural (pre-existing the GFC) and also the result of initiatives to cushion the economies from the worst effects of the GFC. This does not take into account the long term massive problems of aging populations and unfunded social welfare schemes (pensions and health systems).

Greece’s problem highlighted that such debt may be unsustainable and investors may not continue to finance it, certainly not at current rates and perhaps not at all. It was a problem that had been there all along.

Going Nuclear …

Will Durant, an American historian, advised that: “One of the lessons of history is that nothing is often a good thing to do and always a clever thing to say.” Initially, European politicians and bureaucrats, who suffer from delusions of adequacy, did nothing, but wouldn’t shut up about it. The oft repeated battle cry was “no default, no bail-out, no exit“. Germany remained especially hostile to any financial “bailout“. Repeated invocations of the no “bailout” clause underlying the Euro-zone drew attention to the risks of Greece’s debt.

The major problem was “contagion” – the consequences if Greece was to unable to raise money from commercial sources. Much of Greece’s debt is owed to investors outside the country, mainly banks and investors in other European countries. If Greece defaulted on this debt, then the resulting losses would have serious consequences for the affected banks and banking systems.

Countries, such as Portugal, Spain and Ireland, with similar economic problems would inevitably be scrutinised and targeted. If a sovereign experienced funding problems, then banks and other borrowers in that country would also be affected. For example, Greek banks were increasingly unable to fund themselves in international markets, relying on the Greek and European Central Bank (“ECB”). The Euro had become increasingly volatile and had started to fall in value. There were concerns that the financial problems would affect the real economy – growth, jobs, investment etc. What happened in Athens was unlikely to stay in Greece.

By February 2010, the need for coordinated action by the Euro-zone countries and the European Union (“EU”) was evident. While pledging eternal support, the EU postponed action, waiting for Greece to agree to an austerity program to remedy its finances. The cause of European unity was not served by attacks by George Papandreou, the Greek Prime Minister, that the EU was creating a “psychology of looming collapse” and making Greece “a laboratory animal in the battle between Europe and the markets“.

In April 2010, as the market for Greek debt worsened (the additional interest rate that Greece had to pay reached 8.00% p.a. over that paid by Germany), after considerable prevarication, the EU proposed a highly conditional Euro 30 billion rescue package. The Haiku writing, Belgian Herman Van Rompuy, President of the European Council, hoped “it will reassure all the holders of Greek bonds that the Euro-zone will never let Greece fail … If there were any danger, the other members of the Euro-zone would intervene.

Markets considered the proposal inadequate and unlikely to avoid a Greek default. Increasingly desperate as circumstances began to rapidly spiral out of control, the EU increased the package in early May 2010 to Euro 110 billion, including a Euro 30 billion contribution from the International Monetary Fund (“IMF”) who would supervise the package and the implementation of the economic “cure.”

About a week later, continued market scepticism and increasing pressure on Portugal, Spain and Ireland forced the EU to “go nuclear“. After months of slow and tortured discussions, the EU acted with surprising speed announcing a “stabilisation fund” to the value of Euro 750 billion to support Euro-zone countries, including an IMF contribution of (up to) Euro 250 billion. The actions were designed in no particular order to salvage the EU, the Euro and over indebted Euro-zone participants by stopping contagion and further spread of the crisis.

Struggling for a telling phrase, journalists spoke of financial “shock and awe“. A single word – panic – better summed up the actions. All constitutional doubts and concerns about the legality of any bailout were jettisoned. The new consensus was that the actions had always been possible under the “exceptional circumstances provision” (Article 122) to counter a systemic threat.

Nicolas Sarkozy, the French President, turned the Euro zone’s sovereign-debt crisis into a personal triumph. The proposal, he let it be known, was 95% French. Le Figaro led the cheerleaders reporting Sarkozy’s comment that “in Greece they call me ‘the saviour’.

Initially, stock markets rose sharply, especially shares of banks exposed to Greece who would benefit from the rescue. The interest rates on Greek, Irish, Italian, Portuguese and Spanish bonds fell sharply. As the announcement over the weekend caught traders unawares, the rally was driven largely by covering of short positions.

Shock and awe” quickly proved more shocking and less awe inspiring than the EU had hoped. Wiser commentators mused that if Euro 750 billion wasn’t going to do the trick, then what was?

We Have A Plan!

Details of the “plan” were sketchy. Greece will receive up to Euro 110 billion in emergency loans (Euro 80 billion from Euro-zone countries and Euro 30 billion from the IMF). The Euro 750 billion Euro-zone stabilisation fund (including the IMF contribution of Euro 250 billion) is the overarching facility of which the Greek deal is ex post part of. The facility would have an initial life of 3 years.

The Euro-zone stabilisation fund includes an extension of the Euro 50 billion balance of payments facility for non-EMU members to Euro-zone members and an increase in the size of Euro 60 billion for Euro-zone members, The facility requires compliance with IMF conditions. The facility was to be financed by the issuance of EU bonds backed by the Euro 141 billion EU budget. There is a new Euro 440 billion special purpose vehicle (“SPV”), guaranteed proportionally by participating Euro-zone member states. Once the initial Euro 60 billion is utilised, the SPV will provide additional required financing.

The entire package requires IMF participation, which limits the amount of any bailout package and also makes it conditional on meeting the Fund’s stringent economic prescriptions. It is unclear whether countries must exhaust commercial debt market sources prior to accessing the package. The aid requires “unanimous” agreement amongst the Euro-zone members.

All money will be provided at agreed rates – a margin of 3.00 % p.a. over benchmark rates and further 1.00 % p.a. for amounts outstanding for more than 3 years. In conformity with IMF charges, a one-off service fee of maximum 0.50 % will be charged to cover operational costs.

Germany’s support was also conditional on enacting changes in the EU framework to tighten control over future bailouts of this type. It is unclear whether this will be a feature of the emergency stabilisation fund though legislation providing for better control of member country public finances is being considered. Other European leaders have made clear that renegotiation of the Treaty of Lisbon is not currently contemplated.

Under the arrangements, the ECB will provide additional support. Euro-zone bonds can be used as collateral for ECB funding. Originally the ECB only accepted bonds rated A or better, which was relaxed temporarily until the end of 210 to cover bonds rated BBB or better at the start of the GFC. The ECB has now relaxed its rules completely and will accept bonds as eligible collateral irrespective of rating.

The ECB will also buy Euro-zone sovereign bonds in the secondary market. By early June 2010, the ECB had purchased around Euro 40 billion of bonds, mainly of the “porcine” variety. In addition, the ECB has been funding Euro-zone banks, such as Irish, Greek and Spanish banks. Other major central banks have re-opened emergency currency swap lines to the ECB and individual European central banks to provide support, such as dollar funding.

The entire package conveys the impression that the EU and ECB are hopeful that the announcement will suffice to bring stability to markets and the facilities won’t ever have to be used.

Brussels, we are not receiving you….

A problem of too much debt was being solved with even more debt. Deeply troubled members of the Euro-zone were trying to bail out each other. Given that all have significant levels of existing debt, the ability to borrow additional amounts and finance the bailout remains uncertain.

The need for governments to raise the required amount risks “crowding out” other borrowers as well as increasing the cost of funding. In order to avoid the risk of inflation, the ECB proposes to sterilise payments by issuing bonds to soak up the additional liquidity created. The entire plan resembles a money shuffling exercise between European sovereigns.

The use of the SPV structure echoes the ill-fated Collateralised Debt Obligations (“CDOs”) and Structured Investment Vehicles (“SIV”) that proved problematic at the start of the GFC.

On 7 June 2010, the EU announced that the SPV will be backed by individual guarantees provided by all 16 members of the Euro-zone. The guarantees are individual rather than joint and several. This means that there is real doubt as to whether some of the weaker countries are in a position to actually support or fund their share of the facility. There is a surplus “cushion” arrangements to ensure against the failure of any of the guarantors to supply their share of funds. The adequacy of this arrangement is questionable.

The structure obscures, perhaps deliberately, the real underlying risk of the borrower. The risk assumed by an investor is difficult to establish because of the conjoint liability and unspecified support arrangements. In the final analysis, this structure may be self defeating and unworkable.

The reality is that Germany, with its large pool of domestic savings, must be the corner stone of the rescue effort. The effect of the stabilisation fund is that stronger countries balance sheets are being contaminated by the bailout. Like sharing dirty needles, the risk of infection for all has drastically increased.

The IMF contribution to the Euro-zone rescue package also needs to be obtained from its members, many of whom would, in turn, have to borrow the money. The IMF’s 186 members have pre-assigned ‘quotas’ that equate to its maximum financial commitment. The quota is denominated in SDRs (Special Drawing Rights), an international reserve asset based on a basket comprised of the British pounds, the Euro, Japanese Yen and the U.S. dollar. The U.S., the largest member, has a quota of SDR37.1 billion (US$54.7 billion). Australia has a quota of SDR3.2 billion (US$4.7 billion).

The IMF finances any contribution from it quotas (25% of which is paid up), proceeds of sales of its gold holdings or borrowing from its members. The IMF’s ability to finance its activities is directly dependent on the member’s capacity and willingness to fund its activities.

Upon announcement of the US$700 billion TARP “bailout” package, Republican Senator Jim Bunning quipped: “When I picked up my newspaper yesterday… I thought I woke up in France. But no, it turned out it was socialism here in the United States…” Senator Bunning and his fellow Americans were perhaps equally bemused to find that they were now a part of the rescue plan for Greece and Europe.

Karl Dunninger, a trader, writing at www.seekingalpha.com captured the madness: “The most-amusing part of this is that nations seriously in debt and without a pot to piss in will be “contributing” some of the money to fund the debt. Spain, for instance, has pledged to do so. Where is Spain going to get the money from? Will they sell bonds at 8% to fund a loan at 5%? That’s a very nice idea…. let’s see, we lose 3% on those deals. That ought to help Spain’s fiscal situation, don’t you think?

Solvency Not Liquidity, Stupid…

At best, the plan provides temporary liquidity to cover immediate financing needs, repaying maturing debt and financing deficit. In a striking parallel to the early stages of the GFC, the reality that it is a “solvency” problem not a “liquidity” problem remains unacknowledged.Most of the countries in the firing line have unsustainable levels of debt. For example, beyond 2010, Greece needs to re-finance borrowings of around 7%-12% of its GDP (around Euro 16 billion to Euro 28 billion) each year till 2014. There are significant maturing borrowings in 2011 and 2012. In addition, Greece is currently running a budget deficit (currently over 12% but projected to decrease) that must be financed. As noted above, Greece’s total borrowing, currently around Euro 270 billion (113% of GDP), is forecast to increase to around Euro 340 billion (over 150% of GDP) by 2014.

The IMF’s publicly available economic analysis assumes that Greece is able to refinance long-term debt by early 2012 and short term debt even earlier. Given that Greece is expected to have a total debt burden of around 150% of GDP and total interest payment of 7.5% of GDP, the ability to raise funds and the assumed 5% cost of refinancing may be optimistic.

The IMF plan calls for a program of fiscal austerity and major structural reform. This would entail a sharp reduction in the budget deficit to less than 3% of GDP and public debt under 60% of GDP. It is unlikely that Greece, despite heroic speeches from politicians, will be able to meet these targets.

Temporary emergency funding will not solve fundamental problems of excessive debt and a weak economy. Government expenditure will need to be slashed and taxes raised to reduce its debt. But the government is too large a part of the economy and the suggested austerity measures will most likely cause a severe recession. In turn, this will drain tax revenues and increase expenditures making it difficult to reduce the budget deficit and funding needs.

The level of indebtedness may already be too high. Kenneth Rogoff and Carmen Reinhart in their survey of financial crises This Time It’s Different argue that sovereign debt above 60-90% of GDP restrains growth. Greece’s interest payment now total around 5% of GDP and are scheduled to rise over 8% by GDP. Rising interest costs will only worsen this problem.

High levels of sovereign debt are sustainable where three conditions are met. Firstly, the debt is denominated in its own currency. It is helpful if the currency is also a major reserve currency, an advantage enjoyed by the U.S. dollar. Secondly, there is a large domestic saving pool to finance the borrowing, such as exists in Japan. Finally, the country possesses a sound, sustainable industrial base and there is economic growth. Greece does not meet any of the above criteria.

The cure may not be feasible or will not help make it easier to meet future debt obligations. Ireland has already implemented austerity measures. The government debt as a percentage of GDP has increased to 64% from 44%. The budget deficit as a percentage of GDP has doubled to 14% from 7%. The nominal GDP of the country has fallen by 18%.

The plan may also make further liquidity problems inevitable. Instead of allowing Greece to raise funds normally, the bailout package is assisting investors to reduce exposure via repayment of maturing debt and the sale of illiquid longer-term securities.

The package also risks forcing other vulnerable countries to rely on the stabilisation fund. Investors are selling rather than purchasing Spanish, Portuguese and Irish debt to also lower exposure. The effect of the bailout package is that bondholders are subordinate to the IMF and the Euro-zone. This means that if the bailout fails, then the bond holders will be paid out after the IMF and the Euro-zone creating a disincentive for either holding existing debt or providing new debt.

This affects not only Greece but any country considered vulnerable and likely to access the bailout. Recent lack of support for Spanish debt issues may be evidence of the problem.

Sovereign debt problems have also affected the ability of European banks to raise money in wholesale markets.

The ECB is increasingly the lender of last resort to some European banks. Greek banks account for 6.6% of all ECB credit to financials whilst holding only 1.6% of all EU assets. Similarly, Irish banks account for 12% of all ECB funding while holding only 5.24% of European assets.

By early June 2010, unable to fund in international money markets, Spanish banks were being forced to borrow record amounts from the ECB. In May 2010, Spanish banks borrowed Euro 85.6 billion. This is double the amount borrowed in September 2008 before the collapse of Lehman Brothers. It is also 16.5% of all ECB funding and compares to the 11% shares of Euro-zone banking assets held by Spanish banks. ECB funding for Euro-zone banks is an indication of tensions in the banking system.

These problems will increase the cost of debt for all affected countries. The increasing cost of market debt makes the cost of the bailout funding more attractive encouraging resort to the facility. If this pattern continues, then other countries may be forced to access the package and the Euro 750 billion will quickly be insufficient to meet the total liquidity needs.

As Woody Allen once observed: “More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.

An earlier version appeared in www.eurointelligence.com and www.nakedcapitalism.com.