Wishful Thinking – Part 2

It Always Ends in the Same Way …

Like many economically weaker EU members, Greece fudged the numbers to meet the qualifications for Euro-zone entry.

Membership of the Euro-zone reduced the ability of Greece to manage its economy. It lost the ability to use its currency, via devaluations, to improve competitiveness and stimulate exports. It also lost the ability to set interest rates. It also cannot print its own currency to fund sovereign borrowing. Greece also has low levels of domestic saving and is reliant on international capital flows.

The current episode exposed an underlying weak and unbalanced economy with few sustainable competitive advantages. It has also exposed poor political leadership and inadequate financial controls. The same could be said of a number of other countries.

No one, including the IMF, seriously believes that the austerity program announced by Greece will work. Argentina had debt to GDP of around 60% and a budget deficit of 6%. Adjustments necessary to halve both failed. After a long drawn out struggle between 1999 and 2001, Argentina was forced to reschedule its debt and have still not quite made their way back to normality. Many of the vulnerable countries in Europe are in a much worse position than Argentina in 1999.

Rapid economic growth or high inflation would improve Greece’s prospects for survival. Neither is a realistic option. The Euro-zone could continue to finance Greece, which would require extension of the current package, which is initially for 3 years.

Greece may not be able to avoid a debt restructuring. For the countries like, Ireland, Spain, Portugal as well the others, the savage austerity measures required are unlikely to be palatable and probably won’t work in any case. All roads may lead eventually to debt restructuring.

The best course of action for Greece would be to “temporarily” (that is, for the next several hundred years) opt out of the Euro and unilaterally re-denominate its debt into the “new” Drachma. Through the currency devaluation, this would effectively reduce debt and restore competitiveness.

In any debt rescheduling, lenders would take significant write downs, reducing Greece’s debt burden, giving it a chance to emerge as a sustainable economy. Previous sovereign defaults suggest that the losses to investors may be as high as 70-80% of the face value. The rating agencies have suggested a loss around 50%. This would equate to a total loss of around $130 billion to $200 billion, making this the single largest sovereign default in history.

The real agenda of the bailout is to avoid foreign lenders taking large losses. The investors were imprudent in their willingness to lend excessively to countries like Greece assuming EU “implicit” support and are now seeking others to bail out them out of their folly. As Herbert Spencer, the English philosopher, observed: “the ultimate result of shielding men from the effects of folly is to fill the world with fools.”

As at June 2009, Greece owed US$276 billion to international banks, of which around US$254 billion was owed to European banks with French, Swiss and German banks having significant exposures. Bank for International Settlement data indicates that German and French banks’ exposure to Greece is about $50 billion and $75 billion respectively.

In aggregate, the exposure of Germany and France to troubled European countries is around $1 trillion. According to the Bank for International Settlements, as at the end of 2009, French banks and German banks have lent $493 billion and $465 billion respectively to Spain, Greece, Portugal and Ireland.

The real purpose of the bailout is to prepare for a possible series of sovereign debt restructurings in Europe. In an ideal world, banks and investors raise capital and write down their exposure to the troubled debtors over time allowing the restructuring to be relatively smooth, avoiding disruption to financial markets. The strategy is the same that financial institutions have adopted to manage other distressed assets, such as commercial real estate and private equity loans. It is not certain that this is achievable.

Dysfunctional functionalism …

Contagion is already a reality. Highly indebted sovereign borrowers with immediate financing needs are facing higher costs and lower availability of funds. Scrutiny of their public finances is forcing them to adopt austerity programs to remain credible borrowers with access to markets

The risk of losses from a Greek or other sovereign defaults has affected financial institutions. Mirroring events at the start of the GFC, the close linkages between Euro-zone banks through cross border loans and investment to each other remain a serious potential problem. The connections and trading in instruments on the credit risk of banks and sovereigns (such as CDS contracts) may prove a major channel for financial contagion. A single sovereign default may affect banks, which in turn will affect other banks, resulting in renewed problems for the global financial system.

The stress is most evident in inter-bank funding rates that have risen sharply to their highest levels in a year. While they are below the extraordinary levels following the problems of Lehman Brothers and AIG, forward funding rates and instruments used to transfer liquidity between currencies (such as basis swaps) anticipate further increases. Some of the change is technical and driven by a shortage of dollars, due to investors repatriating funds. Central banks have reinstated currency swap deals to make it easier for banks to borrow dollars.

Since 2008, money markets have operated on the basis that large banks are “too big to fail“, due to support from the relevant sovereign. The problems of sovereigns themselves have heightened concern about the credit risk of banks. Banks fearful of the quality of borrowing banks may limit lending.

Banks, especially those in Europe, are paying higher interest costs and may face difficulties in raising funds. The ECB recently warned of the problems faced by European banks in financing their operations and refinancing maturing debt. Markets are stockpiling liquidity, as evident by surplus balances at the ECB and other central banks, fearing a sequel to the deep freeze in financial markets in 2008.

Activity in bond markets and new equity raisings has slowed sharply, albeit from very high recent levels. If these markets do not resume activity shortly, then further problems can be anticipated.

In the real economy, forced or voluntary retrenchment of government spending is restricting demand restraining economic growth. Lack of demand in Europe affects the exporting economies of Japan, China and East and South Asia.

Currency volatility, dominated by the appreciation of the dollar, is creating problem. It is driven by a flight to quality, away from Euros and Yen to dollars. It is also driven by a forced de-risking as traders unwind the carry trade (long risk/ short dollars). The Australian dollar, which has been masquerading as a respectable currency, reverted to the Peso of the South Pacific, falling an astonishing 12+ % in a few days. Concerns about commodity prices and Chinese growth accelerated the fall.

Dollar strength belies the economic fundamentals and will slow the ability of the U.S. to use exports as a growth engine. U.S. multi-national earnings have been adversely affected by the current shift. Continued dollar strength will ultimately affect U.S. growth and the adjustment of the current account deficit.

The weakness of the Euro and resultant appreciation of the Renminbi by 14+% also reduces Chinese exporter’s earnings and competitiveness. China is now even more reluctant to take steps to allow the Renminbi to appreciate.

The sovereign debt problems are creating serious dislocations and perverse outcomes. Paralleling the events after the Asian monetary crisis in 1997/1998, the flight to dollars has pushed down interest rates on U.S. government debt. Paradoxically, lower interest rates reduce pressure for deficit reduction by lowering the cost of servicing public debt. Low interest rates perversely encourage greater borrowing by an already deeply indebted borrower. Combined with the stronger dollar, it encourages spending. It also defers hard decisions addressing the U.S. budget deficit and structural problems.

The weak Euro will further increase Germany’s current account surplus, already forecast by the OECD to increase to increase to 7.2% of GDP in 2011 (from 5% in 2009) before the fall in the currency.

The European sovereign debt crisis has once again exposed the problem of unaddressed global imbalances. The weakness of Europe and currency volatility means that it is harder to deal with now than before.

Fading Hopes ….

A combination of self-reinforcing events is driving a pernicious reversal of the dynamics of 2008-09. Then, coordinated government action on a grand scale stopped the global financial crisis from turning into a depression. Government and central bank strategy was a bet on growth and inflation, as the most painless means of adjusting the overly leveraged and deeply indebted global economy. In the words of François Duc de La Rochefoucauld: “Hope, deceitful as it is, serves at least to lead us to the end of our lives by an agreeable route.

Now, governments have become the problem, perhaps calling time on the wishful thinking of markets.

The most important consequence of Greece and European sovereign debt problems will be to force governments everywhere to stabilise and reverse the deterioration in public finances, by a combination of new taxes and cutting expenditures. Many indebted economies, including Britain and Italy, have implement austerity measures. The sharp reduction of government spending coincides with the end of the effects of stimulus packages and is likely to slow economic growth.

Country specific factors – attempts by China to rein in excessive lending growth and property price rises; higher interest rates in Australian and India, driven by perceived inflation in local economies – may also undermine growth. Government demand for funds and deteriorating conditions in the financial system will reduce the availability of funds and increase cost, further restricting growth.

The ability to use inflation to reflate asset prices is increasingly difficult. Inflation needs convergence of several conditions – loose money supply, active lending by banks to increase the velocity of the money and an imbalance between supply and demand. Growth in money supply by itself may not be sufficient to create inflation. In Japan, years of loose monetary policy and quantitative easing have not prevented significant deflation over the last two decades.

Problems within the financial system have slowed the velocity of money. Capacity utilisation is generally low and over capacity exists in many industries. In the short term, high levels of inflation appear unlikely. Higher energy and food prices have prevented outright deflation in recent times. But with price rises, other than food or energy, low, the risk of deflation is present.

The GSC has profoundly shifted economic dynamics. Refusing to acknowledge the real problems, major economies have over the last decades transferred debt from companies to consumers and finally onto public balance sheets. A huge amount of assets and risk now is held by central banks and governments, which are not designed for such long-term ownership. There are now no more balance sheets that can be leveraged to support the current levels of debt.

Borrowing can only be repaid by the sale of assets, including those funded by the debt, or by redirecting income, perhaps generated by the asset purchased, towards repayments. Unfortunately, in many cases, the current value of the asset will not cover the outstanding debt. The level of income and cash flow generated is insufficient to cover interest costs or amortise the amount borrowed. The GSC focused attention on the excessive level of debt and how it was used.

Based on per capital income of $30,000 (roughly 75% of Germany), Greece gives the appearance of a developed economy. In fact, Greece’s economy and its institutional infrastructure are weak. In the World Bank’s Index for Doing Business that measures the commercial environment, Greece ranks 109th behind Lebanon, Egypt and Ethiopia and, amongst developed countries, in the same index, second last. Around 30% of the Greek economy is unreported and informal. Tax revenue losses may be around $30 billion per annum. Productivity and quality are low. Despite the size of the public sector, public services are inadequate. Corruption is endemic.

While entry into the Euro may have assisted Greece’s ascension into major league status, the Euro decreased international competitiveness as the country effectively priced itself out of the market for goods and services. Entry into the Euro compounded existing weaknesses by providing access to low cost funds. Greek bonds became eligible as collateral for ECB funding. Assumptions of “implicit” ECB and EU support (since proven correct) facilitated easy access to bank funding. A period of credit driven expansion financed a construction boom and social policies, such as early retirement with large pension entitlement, often in excess of those available in more affluent countries.

The reality is that much of the debt in Greece was not used to finance productive enterprises but fuelled consumption or was channelled into unproductive uses. There are no substantial assets or income from those investments that will help repay the debts. Many countries and businesses face identical problems and now must face and adjust to that painful reality.

As Tyler Cowen, Professor of Economics at George Mason University, observed in a 21 May 2010 opinion piece entitled “How Will Greece Get Off the Dole?” in the New York Times: “…it’s a moot point whether Greece is a poor country masquerading as a wealthy country or vice versa. … If the old illusion was that Greece was a wealthy country, the new illusion is that Greece will, in short order, become wealthy enough to pay back ever-growing sums of debt.

The lack of viable policy options is increasingly evident in the panicked reactions of governments. One manifestation has been re-regulation of financial markets and institutions. While increased financial oversight is inevitable, the specific regulations and timing need to be considered carefully. Actions that could curtail credit availability abruptly and excessively risk making serious problems worse. Increased capital, reduced leverage and more strict controls over liquidity and derivatives are necessary but need to be implemented in a way so as to not exacerbate existing problems.

Germany’s decision to ban naked short selling was poorly conceived and a politically driven initiative. As other nations are unlikely to follow, the proposal may be practically ineffective. Blaming “wolf packs” (wolves are actually seriously endangered in Europe and are protected) misses the point that the short sellers are merely pointing out the blindingly obvious – some sovereign states are effectively bankrupt and not in a position to pay back the debt.

In literature, they all quote Shakespeare in the end. When things go wrong in financial markets, it seems that everybody looking for a scapegoat blames speculators and short sellers.

Nowhere to run to, Nowhere to Hide….

The onset of the GSC marks a new dangerous phase of the credit crisis. At best a withdrawal of government support (through lower spending and higher taxes) will reduce global demand and usher in a potentially prolonged period of stagnation. At worst, increasing difficulty in sovereigns raising money and a clutch of sovereign debt rescheduling may result in a sharp deterioration in financial and economic conditions. Recent difficulties by Germany to issue debt highlight the risks.

Financial institutions will continue to build up capital and reduce balances sheets, anticipating further losses and write-offs over time, including potential losses on exposures to sovereign loans. Lending growth will continue to be low reducing growth. Consumption and investment will be below potential.

There is no political will to tackle deep-seated problems. The electorate is unwilling to accept the adjustments and lower living standards that will be necessary. As the credit crisis enters a third year, the scale of sovereign debts means that governments now have limited room to counter any new economic downturn, any new problems or crisis.

The liquidity and government spending driven rally also caused “bubbles” in emerging markets. There is a risk that the GFC and GSC may morph into an EMC (Emerging Market Crisis).

Until early 2010, markets were Dancing in the Streets. Increasingly, another Holland-Dozier-Holland standard also made famous by Martha and the Vandellas is relevant: “Nowhere to run to, baby/ Nowhere to hide.”

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