The Greek finance minister European tour of charm has some reasonable ideas in terms of financial engineering. Unfortunately, adjustment is about operational restructuring and only when this has been agreed should the financial engineering solution be designed. I will explain why through two stories.
First the micro story: imagine that Greece is a large corporation running three different businesses. The first business has a good customer basis (e.g. healthcare) but low profits because of over manning. The second has a very long payback period (e.g. infrastructure) and will only turn a profit after a decade. The third is a loss making business (e.g. corporate welfare) with a bleak outlook in terms of future returns. Overall, the company is heavily indebted and runs at a small profit or loss.
Let us consider three restructuring options: a) close down business 3, sell business 2 and use proceeds to refinance business 1; b) refinance existing debt, declare a wage cut for all businesses, stop any further investments in business 2 and reorganize business 3; and c) draw some idealistic reorganization plans and try to convince the creditors that it can only repay them by investing more in the three businesses.
Restructuring plan a) is what a private sector company might do. It would not be the most efficient, because it would not solve the over manning and would jeopardise its service quality and client base. It would continue a lousy business but generating enough cash to keep the creditors happy.
Plan b) is what one may call a restructuring a la Troika. It would ease the financial pressure in the short term but would not improve any of the businesses. Business 3 would still run at a loss and businesses 2 and 1 would deteriorate in both quality and customer base.
Plan c) we may call it a wishful thinking Syriza plan. If “romantic” creditors bought it, they would only throw good money after bad money. The promised growth, even if it happens, will not be enough or sustainable and will only last as long credit keeps flowing in.
Now for the macro story. Of course, if restructuring was done along private sector lines (option 1) the company will not need to worry much about what would happen to businesses 3 and 2, since business 1 was small in relation to the rest of the economy. However, this a fundamental difference in relation to Greece. The country as a whole could not ignore the macro consequences of plan 1, because aggregate demand would reduce significantly causing economic decline instead of growth with a consequent rise in unemployment. So, what could the central bank and budgetary authorities do to minimize such effects?
If they had their own currency (which Greece no longer has), they could devalue it to ensure that real (not nominal) wages would decline making the country as a whole more competitive and hope that the unemployed would quickly get a new job in the export oriented industries. This could be supplemented by printing money, retraining and many other supply side measures. Whether this was enough is not relevant because Greece wants to remain in the Euro and the ECB cannot manage the Euro to meet the needs of Greece. Moreover, Greece is indeed the heavily indebted company and would need extra credit to finance such measures, credit that she no longer may create and has difficulty to obtain in the financial markets.
As expected, see my 2011 post, plan b) has already failed with dramatic declines in GDP and employment. Plan c) could ease the current social disaster in the short run but would make the current imbalances much worse, by compounding over manning across all businesses, perpetuating loss making businesses and government mismanagement.
So, which macro policies can be implemented to emulate a better private sector restructuring plan compatible with economic growth? Basically by providing extra funding and refinancing based on strict conditionality to impose a modified private restructuring plan.
These modifications should involve a mandatory reduction of over manning in the surviving businesses 1 and 2. All redundant workers should be paid a temporary unemployment benefit plus grants to promote labour mobility and the creation of self-employment businesses. The business sector 2 should be capitalized and progressively privatized to maintain a minimum level of investment on a selective basis (only for projects with a short payback period or export orientation). Internal devaluation should be achieved by longer working hours paid in non-negotiable long term government bonds. The fiscal and welfare systems should be entirely revamped and simplified to eradicate tax evasion, free riding and corruption.
As long as conditionality forces the Greeks to use their well-known creativity in the right direction, instead of accounting and fiscal tricks, they will come up with many other ideas and we do not need to enter into further details here.
What Greece, Europe and its creditors cannot afford is to let the Greeks deviate from following a private sector type of restructuring. Without such conditionality, any moratoria, debt swaps, special funds and other types of financial engineering are a waste of money.
Otherwise, everyone risks being caught into a loose-loose dispute between Syriza’s loony left agenda and the Troika’s austerity fairy tale that self-flagellation creates by itself an invigorated economy.
Showing posts with label debt crisis. Show all posts
Showing posts with label debt crisis. Show all posts
Wednesday, 4 February 2015
Thursday, 10 November 2011
How the ECB Can Prevent the Suicide of the Euro Zone
First, three facts:
1) For a currency that is in risk of imploding, the Euro has done better than the Dollar:
2) At the end of 2010 the total foreign net debt (private and public) of Italy was $0.5 trillion (26% of GDP) while that of the US was $2.47 trillion (17% of GDP); the current account deficit of the two countries was identical (3.24% of GDP); and the total central government debt was 109% of GDP in Italy and 61.3% in the US.
3) Yet the markets are pricing their sovereign debt in a way quite unrelated to these fundamentals (yesterday the 10-year Yield for Italy reached 7.48% while in the US it was at 2.01%):
This is clearly a speculative attack against the Euro itself.
Yet, the ECB seems hand-tied to do anything to repel such attack. By hiding behind its statutory limitations in lending to sovereigns; waiting for successive failed schemes of Merkel-Sarkozy to deal with the sovereign debt problems of Greece, Ireland and Portugal; and sticking to self-defeating half-hearted bond buying in the market, the ECB risks letting the downfall of the Euro occur before its own eyes.
This does not need to be so. By itself, the ECB can kill this speculative attack. First, it needs to point out to the European Union governments that if they persist in a simultaneous suicidal pursuit of restrictive budgetary policies it will need to offset them by pursuing an aggressive expansionary monetary policy. Second, it needs to send a strong message to the markets that, if necessary, it is ready to act as lender of last resort for the Governments under attack.
Here is a suggestion of how it can be done. The ECB should replace its bond-buying in the secondary market (which is fueling the speculation) by a new bank lending facility that in practice would work as back to back loan to the governments. There are various ways to structure such facility within the current lending practices of the ECB; and, as long as the loans would not feed back into the market, they would work.
1) For a currency that is in risk of imploding, the Euro has done better than the Dollar:
2) At the end of 2010 the total foreign net debt (private and public) of Italy was $0.5 trillion (26% of GDP) while that of the US was $2.47 trillion (17% of GDP); the current account deficit of the two countries was identical (3.24% of GDP); and the total central government debt was 109% of GDP in Italy and 61.3% in the US.
3) Yet the markets are pricing their sovereign debt in a way quite unrelated to these fundamentals (yesterday the 10-year Yield for Italy reached 7.48% while in the US it was at 2.01%):
This is clearly a speculative attack against the Euro itself.
Yet, the ECB seems hand-tied to do anything to repel such attack. By hiding behind its statutory limitations in lending to sovereigns; waiting for successive failed schemes of Merkel-Sarkozy to deal with the sovereign debt problems of Greece, Ireland and Portugal; and sticking to self-defeating half-hearted bond buying in the market, the ECB risks letting the downfall of the Euro occur before its own eyes.
This does not need to be so. By itself, the ECB can kill this speculative attack. First, it needs to point out to the European Union governments that if they persist in a simultaneous suicidal pursuit of restrictive budgetary policies it will need to offset them by pursuing an aggressive expansionary monetary policy. Second, it needs to send a strong message to the markets that, if necessary, it is ready to act as lender of last resort for the Governments under attack.
Here is a suggestion of how it can be done. The ECB should replace its bond-buying in the secondary market (which is fueling the speculation) by a new bank lending facility that in practice would work as back to back loan to the governments. There are various ways to structure such facility within the current lending practices of the ECB; and, as long as the loans would not feed back into the market, they would work.
Monday, 29 August 2011
We can’t all deleverage at the same time
We can’t all deleverage at the same time. That would be equivalent to everyone moving to the same spot in a sinking ship. It would capsize immediately. To see why, imagine this nightmare scenario: everywhere and everybody – banks, firms, governments and families – think that they are overleveraged (i.e. is excessively in debt) and decide to reduce debt (deleverage) simultaneously. Regardless of whether they are right or wrong about their excessive level of debt (in a previous post we explain why this is difficult to define); the simultaneous deleveraging could start the following fatal spiral.
Banks reduced excessive leverage by not renewing their lending facilities to firms; these add misery to injury and reduce further their leverage by firing workers and trying to sell assets. Braced with lower tax revenues and higher calls for unemployment insurance, governments answer by reducing public debt through higher taxes and massive cuts in spending; which reduce the revenue streams of banks, firms and families. Families, affected by higher unemployment, loss of revenues and fearing the future, decide also to deleverage by saving more or defaulting on their loans and by massive cuts in spending. This would reduce further the revenues of banks, firms and governments. Thus, to pursue their debt reducing objectives all would initiate a new round of cuts. This would cause a downward spiral of spending cuts that would stop only after the economy was brought to a complete halt and widespread defaults.
Wait, there must exist some break point on this spiral. After all, debts are owed to someone and those receiving the debt repayments must use their surplus money. Yes, but what if, fearing that same spiral, they decide to hoard it by holding cash, exchanging it for some remote currency (e.g. the Swiss Franc) or buying some relic from the past (e.g. gold). The first, if not offset by the Central Bank, would cause a major liquidity crisis accelerating the depression. The other two may lead to absurd bubbles whose anticipated bust would hang on the heads of enterprising people. So, not much hope here.
What if there is somewhere an unleveraged entity willing to finance an orderly sequence of deleveraging through saving and inflation? To a large extent that was the situation at the end of World War II, when the US played that role. Can’t China and other emerging nations play that role now? Probably not, because they do not have the economic size needed to face a much bigger problem. Moreover, by accepting a rescue from a dictatorship, the Western democratic nations would risk losing their freedom.
Indeed, despite some double counting, the following table shows that the net international investment position of the Western countries is less than 3% of their GDP, largely because of the high level of savings in Japan. Yet, Japan has the largest government debt as a percentage of GDP (226%).
Unfortunately, a deleveraging spiral may start without all countries being overleveraged. A debt crisis in one sector (e.g. the Government) may easily infect the remaining or be started off by a generalized downgrade by the rating agencies. In fact, some fear that the leading Western nations (US, European Union and Japan) may be in the brink of getting into such a depression spiral started by deleveraging in the sovereign debt sector. So they desperately need to find an alternative solution.
First, they must plug once and for all the holes emerging in the weaker economies of the Euro Area. Second, they must mobilize the spending power of the few remaining sectors with borrowing capacity. Finally, and most importantly, they must acknowledge that at least one entity must be allowed to continue to increase its leverage while the others deleverage.
Here the obvious choice must be the Government (except in Japan), due to its policy powers, but mostly because it is the only one that can borrow with very long maturities.
Thus, although we live in a peacetime period, sovereign debt limits in the US and Europe can be increased to levels close to those observed at the end of wars. That is, countries with national debts around 60% of GDP could borrow close to a 100%, while those already above the 100% should be allowed to borrow up to 180% of GDP.
The process, relying on multilateral facilities, should be sequential with an agreed calendar and coordinated at the level of the G3 group of countries (not the G20, which should only have a consultative role).
Banks reduced excessive leverage by not renewing their lending facilities to firms; these add misery to injury and reduce further their leverage by firing workers and trying to sell assets. Braced with lower tax revenues and higher calls for unemployment insurance, governments answer by reducing public debt through higher taxes and massive cuts in spending; which reduce the revenue streams of banks, firms and families. Families, affected by higher unemployment, loss of revenues and fearing the future, decide also to deleverage by saving more or defaulting on their loans and by massive cuts in spending. This would reduce further the revenues of banks, firms and governments. Thus, to pursue their debt reducing objectives all would initiate a new round of cuts. This would cause a downward spiral of spending cuts that would stop only after the economy was brought to a complete halt and widespread defaults.
Wait, there must exist some break point on this spiral. After all, debts are owed to someone and those receiving the debt repayments must use their surplus money. Yes, but what if, fearing that same spiral, they decide to hoard it by holding cash, exchanging it for some remote currency (e.g. the Swiss Franc) or buying some relic from the past (e.g. gold). The first, if not offset by the Central Bank, would cause a major liquidity crisis accelerating the depression. The other two may lead to absurd bubbles whose anticipated bust would hang on the heads of enterprising people. So, not much hope here.
What if there is somewhere an unleveraged entity willing to finance an orderly sequence of deleveraging through saving and inflation? To a large extent that was the situation at the end of World War II, when the US played that role. Can’t China and other emerging nations play that role now? Probably not, because they do not have the economic size needed to face a much bigger problem. Moreover, by accepting a rescue from a dictatorship, the Western democratic nations would risk losing their freedom.
Indeed, despite some double counting, the following table shows that the net international investment position of the Western countries is less than 3% of their GDP, largely because of the high level of savings in Japan. Yet, Japan has the largest government debt as a percentage of GDP (226%).
Unfortunately, a deleveraging spiral may start without all countries being overleveraged. A debt crisis in one sector (e.g. the Government) may easily infect the remaining or be started off by a generalized downgrade by the rating agencies. In fact, some fear that the leading Western nations (US, European Union and Japan) may be in the brink of getting into such a depression spiral started by deleveraging in the sovereign debt sector. So they desperately need to find an alternative solution.
First, they must plug once and for all the holes emerging in the weaker economies of the Euro Area. Second, they must mobilize the spending power of the few remaining sectors with borrowing capacity. Finally, and most importantly, they must acknowledge that at least one entity must be allowed to continue to increase its leverage while the others deleverage.
Here the obvious choice must be the Government (except in Japan), due to its policy powers, but mostly because it is the only one that can borrow with very long maturities.
Thus, although we live in a peacetime period, sovereign debt limits in the US and Europe can be increased to levels close to those observed at the end of wars. That is, countries with national debts around 60% of GDP could borrow close to a 100%, while those already above the 100% should be allowed to borrow up to 180% of GDP.
The process, relying on multilateral facilities, should be sequential with an agreed calendar and coordinated at the level of the G3 group of countries (not the G20, which should only have a consultative role).
Tuesday, 16 August 2011
The Euro Zone Bond Debate: Can we have a common treasury without a common budget?
The debate on whether an European Agency (some kind of Euro Area Treasury department) should replace the Euro Zone countries in financing a substantial share of each country’s public sector borrowing requirements (some suggest a minimum of 60%) has gained new momentum since leading German business groups called for the issuance of Euro Zone bonds in defiance of the official German position.
The centralization of the debt issuing function in the Euro Zone is seen by many (including George Soros) as a solution for the current sovereign debt crisis as well as a way out of the intrinsic weakness of a Monetary Union built without a corresponding budgetary policy. Indeed, the later is the only convincing reason to argue for joint Eurobond issues and the debate should focus on its pros and cons.
Indeed, the European Union has already a long history of joint debt issues. Through the European Investment Bank it finances a non-negligible share of infrastructure projects in Europe. Through the European Commission it has also made several issues to finance specific programs of industrial restructuring and balance of payments support, the most recent being the EFSF mechanism to support the adjustment programs in Greece, Ireland and Portugal. However these issues were for limited purposes and for limited amounts. The centralization of the public sector borrowing requirements is an entirely new game.
In principle, a central Treasury Department for the Euro Zone makes sense. Indeed, that is what happens within national governments where debt issuance by local, state or regional governments is often supplemented by grants, borrowing and guarantees provided by the Ministry of Finance or National Treasurer. However, the later are usually granted under nationally agreed budgetary policies and often require the setting of borrowing limits. These are often the source of frequent disputes between national and sub-national governments that occasionally end up in blackmail by separatist movements.
In a Union like the Euro Area, which is taking the first steps towards a future political unification, a simple setting of borrowing limits by a central Treasurer (no matter how well designed they are) is more prone to such separatist threats because there is no national solidarity. These separatist threats would be a permanent risk undermining the credit standing of the central Treasurer and would become a burden for the remaining members.
To some extent national solidarity can be substituted by common interest in joint spending. For this reason, tying a large share of joint debt issues to the financing of centralized spending in common policies needs to be considered as an essential part of a monetary union package.
Although the experience of common policies in the EU is nothing to write home about (e.g. agriculture) it does not mean that it cannot succeed in areas like transport infrastructure, security (defense and policing), research and population policies (health, education, migration, etc.).
The only certainty is that, like a stool, a solid monetary union also needs three legs – a monetary authority, a treasurer and a spending authority.
The centralization of the debt issuing function in the Euro Zone is seen by many (including George Soros) as a solution for the current sovereign debt crisis as well as a way out of the intrinsic weakness of a Monetary Union built without a corresponding budgetary policy. Indeed, the later is the only convincing reason to argue for joint Eurobond issues and the debate should focus on its pros and cons.
Indeed, the European Union has already a long history of joint debt issues. Through the European Investment Bank it finances a non-negligible share of infrastructure projects in Europe. Through the European Commission it has also made several issues to finance specific programs of industrial restructuring and balance of payments support, the most recent being the EFSF mechanism to support the adjustment programs in Greece, Ireland and Portugal. However these issues were for limited purposes and for limited amounts. The centralization of the public sector borrowing requirements is an entirely new game.
In principle, a central Treasury Department for the Euro Zone makes sense. Indeed, that is what happens within national governments where debt issuance by local, state or regional governments is often supplemented by grants, borrowing and guarantees provided by the Ministry of Finance or National Treasurer. However, the later are usually granted under nationally agreed budgetary policies and often require the setting of borrowing limits. These are often the source of frequent disputes between national and sub-national governments that occasionally end up in blackmail by separatist movements.
In a Union like the Euro Area, which is taking the first steps towards a future political unification, a simple setting of borrowing limits by a central Treasurer (no matter how well designed they are) is more prone to such separatist threats because there is no national solidarity. These separatist threats would be a permanent risk undermining the credit standing of the central Treasurer and would become a burden for the remaining members.
To some extent national solidarity can be substituted by common interest in joint spending. For this reason, tying a large share of joint debt issues to the financing of centralized spending in common policies needs to be considered as an essential part of a monetary union package.
Although the experience of common policies in the EU is nothing to write home about (e.g. agriculture) it does not mean that it cannot succeed in areas like transport infrastructure, security (defense and policing), research and population policies (health, education, migration, etc.).
The only certainty is that, like a stool, a solid monetary union also needs three legs – a monetary authority, a treasurer and a spending authority.
Friday, 22 July 2011
Bond swap plan is for Greece and Greece only, but it won’t be enough.
The FT just published a few details of the bond swap agreement in the new bailout for Greece. The swap agreement is only for Greece, and “All other euro countries solemnly reaffirm their inflexible determination to honour fully their own individual sovereign signature”.
The only interesting feature of the agreement is the voluntary exchange of bonds maturing before 2019 by 15 and 30 year bonds, paying 5.9 and 6.8%, as a compensation for the banks accepting a 21% “haircut” on the value of the existing bonds. IIF, the Banker’s designer of the plan, estimates a participation rate of 90%.
The Greek government will have to use the new funding to buy European AAA bonds to post as collateral for the new bonds. The cover ratio was not specified, but if it is close to one the “haircut” will be meaningless. Even at 50% and with a take up rate of 90% the effect of the effective haircut would be only “9.45%”.
As been amply demonstrated in last few years the Greek problem is not one of liquidity but of solvency. We and many other observers have estimated that to get out of insolvency Greece needs a debt pardon of about 50%.
All the other measures announced to support Greece are not enough to fill the gap between these 50% and the expected “haircut” of 9.45%. So, it is only a matter of time before Greece needs another bailout, probably as early as 2013.
The only interesting feature of the agreement is the voluntary exchange of bonds maturing before 2019 by 15 and 30 year bonds, paying 5.9 and 6.8%, as a compensation for the banks accepting a 21% “haircut” on the value of the existing bonds. IIF, the Banker’s designer of the plan, estimates a participation rate of 90%.
The Greek government will have to use the new funding to buy European AAA bonds to post as collateral for the new bonds. The cover ratio was not specified, but if it is close to one the “haircut” will be meaningless. Even at 50% and with a take up rate of 90% the effect of the effective haircut would be only “9.45%”.
As been amply demonstrated in last few years the Greek problem is not one of liquidity but of solvency. We and many other observers have estimated that to get out of insolvency Greece needs a debt pardon of about 50%.
All the other measures announced to support Greece are not enough to fill the gap between these 50% and the expected “haircut” of 9.45%. So, it is only a matter of time before Greece needs another bailout, probably as early as 2013.
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