Friday, April 30, 2010

Greek Debt Crisis: Moratorium Compromise? - Part II

Contd. from Part I

Are high debt ratios and public spending issues rare in S.Europe?

Such stories are not new in South Europe. Indeed it is typical of Southern European economies that are quite different from their Northern European cousins. Spain's woes are similar with a real estate bust, soaring public deficits and unemployment etc amongst a motley of reasons have caused S&P to issue a downgrade with a negative outlook.

Why are these rating downgrades being discussed in much detail?

Simple. Because of the impact it will have on Greece's banking sector and the ensuing ramifications for Greek economic stability that will serve as harbinger of what is in store for Portugal, and Spain. While media comparisons and dark mutterings about the debts of UK, Japan and US abound, the fears of a contagion are at best overblown. But the implications for Greece are serious because,

In international capital markets and specifically in money markets, bonds and in particular, government bonds tend to be used as a collateral to fund money market operations. For instance, if Greece cannot use bonds as collateral, then Greek banks lose upto EUR 17 bn in funds (Source: For example: The National Bank of Greece (NYSE: NBG) uses Greek Govt bonds for 45% of its ECB repos. Get the picture? it is worrisome if the domino indeed sets off as the solutions are unpalatable and in cases impossible to implement.

It is now generally agreed that even ECB's relaxed rules allowing BBB- debt as collateral might not be enough to save Greece. As Roubini noted, "This might be the tip of the iceberg as far as sovereign defaults go". He has a point, public finances have been massively re-leveraged since 2008 as fiscal stimulus, tax cuts and underwriting of private sector losses have pushed deficits sky high across the western world. This has two possible outcomes if not reversed a)High Inflation b) debt (and default)

Ofcourse, the 'doom' delphi is correct about the twin outcomes. However, as I said in Part I, this issue has to do more with the internal dynamics of the Eurozone rather than some worldwide phenomenon. UK, US are another story.

Is cutting public services or reducing spending by 9% as bandied around the solution?

Well, the argument that spending needs to be cut is correct. It is at best a partial remedy. As one Greek expat in the US noted in the NYTimes, cuts to spending need to be accompanied by basic changes to the structure of the Greek economy as I said earlier. Especially structural changes that boost the competitiveness of the Greek Economy are critical such as removing the stranglehold of family businesses and boosting entrepreneurship. Taxing rationally would do good as well. The current taxation regime is ridiculous as is enforcement.

Some solutions floating around and my views:

Allow Greece to exit the Euro: While not impossible, it will be a horrible process with bad consequences. Technically, Greece could withdraw from the EMU and as a result from the EU and issue the Drachma again. But with 300 bn in USD and EUR denominated debt, the ensuing pressure on the Drachma and rising interest rates would be too hard to manage. This would mean 'restructuring' or 'haircuts' with debt partially written down. this would cause even more problems with higher debt leading default in a somber progression

devaluation ----> debt ------> default

Verdict: Best not attempted

Haircuts: Another bad idea in this case. This could turn really bad not only for Greece but for the other 'PIGS' in the pen they might not want to hold any member's debt who is under threat of default. This could lead to capital flight with adverse economic consequences.

Verdict: a big no

Outright Default: This will make Greece a 'debt market pariah' for atleast half a decade or till the time their economy has been significantly restructured to prevent defaults in the future.

Another No

Moratorium with some restructuring: A five-year moratorium on Greek debt repayments would be one solution that can keep investors satisfied at a lower cost coupled with select restructuring. As a commentator said, this would amount to a "soft default" which would offer Greece the timeframe for fiscal consolidations. While it is a default of sorts, the US$ 159 bn aid package and time to accelerate fiscal consolidation and improve economic competitiveness gives everyone the best chance to ensure the mess never occurs again .

That would be crucial to ensure the Euro succeeds as an experiment....

Denmark is one such precedent that comes to my mind...

Is the Fed risking Inflation to continue to support the Recovery?

The Fed said in a recent meeting that, Inflation concerns were benign and that it would keep rates lower for an extended period. Jason Cummins of Brewan Howard Asset Management noted that 50% of the consumer Index was in deflation region. However, I find that a bit contradictory because 60% of the US CPI index has been rising in the last year while the 40% represented by rent/shelter had dragged it down (see the graph later in the post for CPI excl. rent component). Then I saw the US PPI data and that points to what I feel is an oncoming rising inflation cycle. I disagree with Cummins' conclusion while sharing his view on the Fed having real tough policy choices..anyway back to Inflation and the PPI....

Example: US PPI went up unexpectedly in March, rising 0.7% against forecast 0.4% and February’s -0.6%. This translates to over 6% on an annual basis in March 2010. With core CPI rising by nearly 1% YoY, with much of the increase in prices is related to rebound in commodity prices (viz. food and energy), there is a risk that this temporary inflationary surge translates into a more generalized pick up in inflation and inflation expectations. This could have the impact of rising wage and salary costs even as unemployment remains extremely high. Thus the risks for US inflation remain to the upside. (part of this is from marketwatch)

This is where Jim Bianco's take on Inflation becomes very interesting. As mentioned earlier, Bianco correctly says that the 60% basket of the CPI comprising food, gas, utilities etc.. have been on the uptick since the last 3 quarters as commodity prices have rebound.

Whats the bad news?

Well, the other 40% namely rent/shelter was kept low through Government tax credits for housing causing rental demand to slow down. With this measure expiring today, the demand for rentals will move upward. Thus the 2.3% figure quoted by Bernanke is at best incorrect. The US CPI should move into the 3% territory around end June 2010 as the effect of the tax credit begins to die out.

This only leads to one conclusion...

The Fed is risking higher inflation to sustain growth (The Fed or any central bank has one basic question in front of it always: do i foster growth ot stabilize prices?). The Fed is soon going to face the fact that the above objectives will go in the opposite direction shortly. The policy dilemma seems to go the way of low rates atleast till December 2010.

In my opinion, We might see a hike in the fed funds rate in Jan or Feb 2011. But if you see my tail-piece below, you may realize why the Fed is in a tight spot..

My conclusion is also connected to three other elephants in the room: soaring deficits, looming bond bubble and potential damper of Fed action on equity markets. Each deserve a separate post.

Tail Piece:
(Policy is also complicated due to the amount of long-term mortgages held by the Fed. A rate hike might end up undoing the Fed's efforts to help banks...we will see that in another post)

Greek Debt Crisis: Moratorium Compromise? - Part I

Well you may seen CNBC blaring the news that the spreads between 10 Year Greek Bonds and German Bunds narrowed to 775 basis points from 800 two days back while two year Greek bond yields are at over 13.5% (Bloomberg, Apr.29). Europe is in jitters as Portugal, Spain and even the UK (yes the UK, the pound got walloped in the past few days...). Germany has been locked in an intense debate over bailing out Greece while a EUR 120 bn package is being readied to ensure Greece can stay in the debt markets.

So what is happening? Greece is in the throes of a 'default' while Portugal and Spain are finding themselves in hot water and its temperature is rising. Right, Greece first, because what happens in Greece will determine what will happen in Portugal and Spain. This is despite rising fears that a 'debt domino' has already been set off . I disagree on the 'contagion' brouhahaha... despite the IMF's views and S&P's (dubious and discredited in my opinion) chain of ratings downgrades in S.Europe.

I think that, far from being a contagion, it is merely a short period of intense turbulence where Northern Europe led by Germany is essentially saying to the PIGS and especially Greece, that membership of the Euro zone comes with responsibilities.

What Chancellor Merkel is saying is that "Greece, we are going to make an example of you and give you enough of a fright to get the other guys on the line".

Now a little background before we discuss specifics of the Greek crisis,

20 Fiscal Regimes under one Monetary Union: The structural anamoly in the Eurozone permitting 20 odd Fiscal regimes under a single Monetary Union has played a significant role in this mini-crisis. The traditionally weaker and fiscally imprudent Southern European Economies have borrowed as if they possessed Germany's credit rating and borrowed recklessly. The Euro merely provided a convenient front acting as a smoke screen w.r.t debt. This gave a misrepresentation of Eurozone capital markets being homogeneous (not unnoticed, but things happen anyway). As I will mention shortly, the scale of borrowing got hidden from Eurozone firewalls and tragedy has now struck Greece. (Portugal is scampering to enact measures to save itself from further damage...)

A brief background of Greece's woes: For the uninitiated, Greece has traditionally suffered from poor public finances owing to weak spending controls and widespread tax evasions aided by high wages in the bloated public sector. In addition, control of the Greek economy by traditional family businesses have stifled innovation. Further, Greek's populism has ensured labour is amongst the most expensive in Europe affecting pensions, health spending too. Previously Greece could rely on the Drachma to manage debt related issues. However, accession to the Euro has meant that, while poor public policies continued, Greece's predecessor govt to the current socialist regime indulged in skullduggery courtesy (Guess Who?) Goldman Sachs to hide the size of it's ballooning deficits to around Eurozone mandate of 3% of GDP.

(Courtesy: Daniel.S.Mitchell, Cato Institute, December 2009)

However, Greece's debt stands at over 300 bn US$ now and deficit has reached close to 14% of Greek GDP while Debt/GDP ratio is over 113%.

To be contd. in Part II