November 1, 2011

The Greek Prime Minister wants to hold a referendum on the new bailout deal to be signed with the Europeans. It appears that this was an unexpected move which has caused anger throughout the Eurozone (also here). The details are not yet available, but it seems that Greece will negotiate the rescue plan first, and then will put the proposal to a vote. The Greek people will decide if they agree or not.

To be honest, I thought that this was the best piece of news (for Greece) to come out recently. Negotiations thus far were a two-party game, which has now been forcibly turned into a three-part asymmetric game:

  1. The Greek Government who are on one side of the negotiating table,
  2. The EU, ECB, bankers, IMF, etc. who are on the other side of the negotiating table, and
  3. The Greek people who are voting on the outcome when negotiations are complete.

Now one has to only think: whose negotiating power increased immensely and whose negotiating power took a dive, when the third party entered the game. Yes, it is the Greek government who now drive the process.

Also, it is worth remembering that what Eurocrats fear most is democracy. The history of referenda on EU policies is not stellar, and I suspect that they really don’t want to lose this one. It will not surprise me if Greeks get away with an 80% uniform haircut including the ECB, and bank recapitalisation for free.

Unlike what Greek commentators keep repeating, Greeks have the option to say No: a standard EU policy is to keep having referenda until a Yes vote is won, giving more and more sweeteners in the process.

PS: All is not clear sailing though. A requirement is that the Greek government will maintain its slim majority until January, which is not certain. Another Greek MP resigned today, most probably because of the referendum proposal itself. The opposition leader does not want to hold a trump in his hands, and promises to stop the referendum at all costs.

The chance of Greece descending into a chaotic horde of witch hunters has gone up by another notch.

adverse efsf

October 24, 2011

There is a widespread view that the EU will attempt to lever up the EFSF capital to achieve an insurance capacity of EUR2-3tr, by turning it into the equity tranche of a sovereign CDO. Others put forward a TARP-like structure which will buy back bad sovereign debt.

A Special Purpose Vehicle (SPV) will be the financial entity that will implement this endeavour, where whatever is left of the initial EUR440bn EFSF money will serve as the capital. This is certaily a big number, which is bound to catch the headlines and trigger a stock market rally. But is there any meat on this bone?

How do you value that crap?

Although yet unknown, the bond buy-back structure will be probably similar to the TARP model which was implemented in the US to help banks offload their ‘misunderstood’ assets. The idea behind TARP was that the market for CDOs and other morgage backed instruments just dissappeared overnight. For that reason, if banks were to sell these assets they would receive very little, even though foreclosures at the time were not justifying such a severe price cut.

In order to implement the TARP, a price discovery mechanism was needed to gauge what a fair value would have been. An ‘inverse auction’ was put into place, where the holders of the assets posted the prices at which they were prepared to sell, and the lowest prices were filled first until capacity was reached. Therefore selling institutions had an incentive to post a low price to get rid of their assets, and losses were written down. To fill in the holes these sales punched in their capital, banks issued preferred shares that were bought by the same programme. A total of USD700bn were earmarked for this programme, of which about two-thirds were actually used.

How would that work in the context of the EFSF? Here Greek, Portugese and Irish bonds appear to be eligible at the moment, while Spanish and Italian bonds could become eligible in the future (if eligibility is defined as being bailed out). Banks that hold periphery bonds will post a selling price, and the cheapest ones would be filled first. One does not know yet the exact mechanics, but it is safe to assume that Greek bonds will be the first ones to go. Obviously, the current market price serves as a lower bound, but if enough banks try to get rid of the bonds, then the price might not be too far away.

The main driver behind the TARP was that households were not defaulting on their mortgages at a rate that would justify the market prices, and that if these ‘misunderstood’ securities were kept for a while then the market would resume and reasonable price levels would be restored. The current situation is markedly different: the problems facing Greece (and other periphery countries) are not due to the lack of liquidity but lack of solvency. The low price of Greek debt is not unreasonable if one considers the fundamentls, and is in fact supported by the implicit or expected haircuts described in the various PSIs. If these PSIs were gone, the price of Greek debt would be arguable even lower. Pumping liquidity in the secondary market would do little good to the banks involved, and no good to the Greek state.

The related recapitalisation would be welcome though. Banks gain some immunity against sovereign default if the bonds are off their balance sheets. This also takes the burden to recapitalise the banking sector off the sovereign, but causes a moral hazard issue which invalidates the whole idea.

Survival of the fastest

As it stands the EUR440bn are not sufficient to provide a decent backstop. Already nearly half of the money has been spent, but let’s say that there is another EUR250bn left in the fund, and the liabilities of the larger periphery countries easily exceed that. An argument is to use the magic of leverage to turn these EUR250bn into EUR2tr or even more. I think that this argument is flawed, if one considers the incentives of the countries involved.

The size of the Greek default is constantly being debated in the financial press over the lat few weeks. The initial PSI of 21% has grown into a PSI+ of 50-60%, with some commentators advocating levels of 90-100%. There is a valid argument that the costs of recapitalising the Greek banking sector do not go away. Every Euro that a Greek bank loses through a haircut is a Euro that Greece has to borrow in order to recapitalise the bank. This means that the true impact of a 50% haircut might be actually less than the 21% that was originally proposed.

In the TARP world the default of a household was disconnected from the profit or loss that the MBS realised. But in the EFSF case this does not hold: if Portugal defaults then the Portugese state will need funds to recapitalise Portugese banks; if the EUR250bn have run dry because Greece and Ireland have already tapped the fund, then Portugal will be left exposed. It matters little that EUR2tr were insured, if the equity tranche is wiped out. The incentive for Portugal is to default before everyone else, just to make sure that her banks take advantage of the EFSF rescue funds.

The size of the default is now subject to adverse selection too. If Portugal need not worry about the impact of a default on her own banking system, then she might opt for a much larger haircut. As her banks are recapitalised externally, why not give them a helping hand?

Obviously moral hazard becomes an even more important issue for Spain and Italy, where the money involved would be stretched in the better of scenarios. If they want to have any chance of protecting their financial system, then they have to rush to the EFSF gates early in the day.

What this leverage will create, as the crisis deteriorates, is the equivalent of a good old bank run. A leveraged institution might not have enough capital, and everyone eligible rushes to get the most out of it. It also resembles the good old CDO: if CDOs underestimated tail dependence and systemic correlations, European politicians are making sure that a cluster of sovereign defaults will happen in the EU sooner rather than later.

As if there is not enough contagion as it is…

modesty please

October 11, 2011

Everyone has a solution to offer these days. A few days ago I stumbled upon Mr Yiannis Varoufakis, a Greek academic who promises aν elixir of health for the frail and failing Europe which he calls the ‘modest proposal’. It appears that Mr Varoufakis has a not-that-modest PR machine, spreading the word that the man is speaking but nobody is listening. As his name started popping up here and there, I decided to take a closer look to what he proposes (other versions can be found here, co-authored with S. Holland, a UK Labour MP of the 80s).

After reading through the document I emerged with the following bullet points:

  1. We should shuffle debt all over the place and change its name. Then it is not called debt anymore. And if we hide much of this debt in one place, then the markets might not notice that it’s missing.
  2. If we give large quantities of cash to hugely indebted nations at very low rates, then these nations can get by.
  3. Various transnational European institutions have been created over the years to serve specific goals. We should retrospectively redefine what these goals are, in order for them to pump money around freely.

Democracy deficit

Overall, as a holder of a mauve passport, I found the theme that permeates the document very disturbing. In the opening paragraph the authors rightly claim that ‘[the future] of European democracy is endangered’, but I found the proposal offensive to my sense of what democracy is.

The people of Europe have been growing increasingly uneasy towards European bureaucrats, long before the crisis took hold of the headlines. Mr Varoufakis’ proposal illustrates the paternalistic attitude of the Europhile, who believes that treaties have been the outcome of a lesser process that can be bypassed by the bevevolent bureaucrat.

A monetary union was established and not a fiscal one; this was not an oversight, but a conscious decision of the engaging parties. Even at inception, the architects acknowledged that further policy instruments -that is fiscal tools- were politically impossible. As Romano Prodi wrote in the FT in December 2001

I am sure the euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.

Is this the crisis that the European elite was waiting for?

The document proposes to create a mechanism that might adhere to the letter of the treaties but not their spirit, and thus create something that looks like a de facto fiscal union. There might not be direct fiscal transfers, because European institutions that are funded by the member states will act as intemediaries and become fiscal stabilisers for weaker nations. Or because, as the proposal advocates, the European Central Bank (ECB) will issue Eurobonds that will finance weaker states but will be guaranteed by the stronger ones. These transfers might not be direct, but they are trensfers nonetheless; and transfers go against the spirit of the treaties as they stand.

It comes to no surprise that the authors need legalistic tricks to avoid new treaties: they must acknowledge that if the people of Germany, Austria or Finland were offered their menu, they would certainly say no. They bluntly point out that the ECB is permitted to buy tranches of debt rather than bonds, because ‘[when the treaty was signed] no one had considered that there could be the need for one’ (perhaps nobody knew what a tranche was at the time). The authors acknowledge that the treaties of Maastricht and Lisbon demand that ‘each member-state [is] wholly liable for its debts’, but they attempt to find a way to bypass this obvious spirit of the treaty.

The proposal might envisage a more federalistic Europe, even something in the lines of the United States of Europe. I share the same views. But what they propose is openly against the spirit of Europe as it is now, and nearly certainly against the will of the people as it is currently expressed. Their proposal is, to my eyes, grossly undemocratic and a recipe for alienating further the citizens of Europe.

Debt is not debt

According to the proposal the ECB takes over part of each country’s debt, with face value equal to 60% of its GDP. Each country pays a standard rate to the ECB, and services its debt normally. The ECB will finance the purchase of this tranche by issuing bonds. The authors claim that this does not constitute a fiscal transfer; they go even further and claim that it pretty much does not even constitute debt as far as Maastricht is concerned. These are very dubious claims.

To me this sounds similar to one of the haircut arrangements that the IIF proposed, which are under revision at the moment. Essentially a portion of the principal of each bond is guaranteed by the ECB. If the country is Maastricht compliant and her debt is less than 60% of the GDP, then 100% of the principal is guaranteed. If the debt is 120% of the GDP, then 50% of the principal is guaranteed.

What will be the interest that countries will have to pay to the ECB? If the rate is higher than the one that they can achieve on their own, then there is an implicit transfer of the opportunity costs. The authors might prefer to call it something else, but it is what it is. If countries can opt out, then the tranche structure will not be viable since it will be predominately toxic.

This rate will depend, in turn, on what will happen in the event of default. Will the ECB be forced to print Euros to accommodate for the losses? Or will the ECB shareholders raise capital and pay the creditors? How will this affect the current mandate of the ECB to focus on inflation? The proposal does not spell out the details, but this is where the devil lies hidden.

Why debt is no longer debt is something I cannot comprehend. Aren’t the sovereigns liable to anyone for this face value? If they are, then in my book this is debt. And, risking a guess, this will be the view of the average European.

Access to cheap money was one of the drivers that propelled the debt of countries like Greece; the modest proposal seems to offer much more of the same as the remedy, but with someone else footing the bill. Belief in securitization increased the systemic impact of the initial shock; the modest proposal advocates the ECB becoming the AIG of the Eurozone.

Institution upgrades

The modest proposal also upgrades European institutions like the European Investment Bank and the European Investment Fund (EIB&F). At the moment entersises, especially small and medium ones, have trouble getting access to finance, and these institutions should be taking over banks as vendors of capital.

At the moment both institutions have a completely different mandate, with EIB&F engaging into small or medium scale project that support accesion countries, promote environmental communities, or guarantee equity for SMEs. Importantly, there is a typical 50-50 split of the costs between EIB&F and the host country.

The proposal wants to scale up these institutions and rewrite their mandate. It assumes that because they managed niche projects, they have the financing capacity and the knowhow to operate as an investment bank for the Eurozone. As Europeans get dissillusioned with the Euro project, the authors want an even more centralised distributor of funds with unelected officials determining the financing across the board.

More fundamantally, these institutions are not Eurozone owned. Countries like the UK or Sweden have a large share in both of them. The modest proposal is implicitly asking for non-Eurozone countries to guarantee ‘surplus recycling’. Forgive me, but I will not be putting any money on that happening.

Not modest at all

The modest proposal is not modest as all. In its heart lie proposals that point towards a federal Europe. Unfortunately, this path has not been been ratified by the members, and there is no appetite for further integration amongst the citizens.

The sophistries that are employed to bypass the current state of Europe, as it is engraved in her treaties, are dangerous. The people of Europe are realising that the major deficit in Europe now is democracy, and are increasingly vocal against the paternalism that originates in Brussels. Personally, I might be a firm proponent of closer integration, but I have to accept that at the moment there are more issues that divide rather than unite us. And this proposal makes clear to me why this is the case.

Beyond that, I find the claims that the modest proposal entails no fiscal transfers or sovereign guarantees wrong. You can repackage debt exposure in as many layers of European institutions as you like, but ultimately the shareholders of these institutions are the European sovereigns. The described approach is conceptually not far from the repackaging of dodgy debt in credit securities, and we all now know that such risks just refuse to go away.

I am a commited Europhile myself, and I look upon the idea of the Kantian cosmopolitan, just like the next man. But I can still believe that this process must complete itself naturally and smoothly; shoving the federalistic medicine down people’s throat will only make them vomit.

if I stay it will be trouble

September 26, 2011

… but if I go it will be double

Chancellor Merkel made the point today that if Greece were to leave [the Eurozone], others would swiftly follow. This is at the core of the problem, and it seems to be overlooked by the hawkish commentators and politicians, who seem to be gaining traction in Greece. As Willem Buiter points out, there are genuine commentators who believe that such an exit will be positive not only for the remaining Eurozone members, but also for Greece herself.

The story is a simple implementation of a beggar-thy-neighbor policy: Greece leaves the Euro, returns to the new Drachma and pulls herself out of the mess with competitive devaluations. What these commentators seem to forget, is that this is a multi-round game. And in repeated games the tit for tat strategy is the winner.

A healthy restructuring of the Greek debt is all but a certainty, so let’s make the working assumption that greek debt is reduced to ‘sustainable levels’. The question is what to do the morning after; and there are three major alternatives:
(1) Stay in the Eurozone and the EU, or
(2) Return to Drachma and exit the EU, or
(3) Return to Drachma but stay in the EU.

Of these three options I believe that only (1) and (2) offer some sense of long-run equilibrium. The punters in Greece and abroad that offer (3) as a viable option overlook the retaliation potential from existing Eurozone members, which will eventually lead to a Euro break up. Here I try to take a look at the three options, and take them to their logical conclusions.

In (1) the internal devaluation continues, and Greece finds herself in a new equilibrium where every Greek is substantially poorer but more competitive (the unit labour costs has dropped to more sustainable levels). En route to this equilibrium, house prices have collapsed and unemployment is persistently high. There has been a massive delevariging exercise, and Greek banks are nationalised with their shareholders wiped out. Throughout this transition Greece finances her deficits through European funds. There is the risk that at some point Greeks declare that they have had enough, and decide to take a gamble with the other two options (2) and (3). This depends on the speed of convergence, and on whether a Greek politician is able to sell these options as viable. “Austerity fatigue” is clearly visible already in Greece, and “bailout fatigue” is visible amongst the creditor countries.

In (2) Greece tries to take advantage of lower exchange rates. She moves out of the EU, and returns to the Drachma. In order to protect against capital leaving en masse, capital controls have to be imposed. The new currency is automatically devalued, and Greece is outside international capital markets for a prolonged period. In order to finance her deficits, Greece has to rely on internal borrowing and extract substantial seignorage. Therefore one should expect inflation to be rampant, and real wages to decline rapidly.

Will the lower exchange rates give a boost to the economy? This depends on the response of the remaining EU countries. Most periphery and some non-periphery countries are direct competitors for Greek goods and services. Portugal, Spain. Italy and France spring to mind as countries that Greece has been competing against for the agricultural and tourist Euro. An exit of Greece from the EU and subsequent competitive devaluations will cause direct losses, and some of them will declare that either (i) tariffs and other restrictions are introduced on imports from Greece, (ii) their products are supported to remain competitive, or (iii) they will also exit the EU. If the common currency (and equlibrium) is to be maintained, then a combination of (i) and (ii) will be implemented; (iii) results into a Euro break up. Nevertheless, this second-round breakup in (iii) can be carried out by the remaining nations in an orderly fashion (without leaving the EU); therefore Greece is left substantially worse off, withought any currency advantage and without access to European markets.

No equilibrium can be sustained in (3) as it will degenerate into scenario (2) if Greece proposes to exit the Eurozone but remain within the EU. There are legal reasons that postulate that if a member country wants to leave the monetary union, she will also have to leave the EU as well. Obviously these problems can be bypassed if the other EU members accept Greece to remain in the EU having left the Eurozone, for example by using the trick of exit and instantaneous re-entry. But such tricks require universal consensus, and I argue that this cannot happen. The competing nations will not agree to give Greece all the benefits of flexible exchange rates and free trade, while they are stuck with an overvalued (as far as they are concerned) Euro. If such a strategy becomes an option, then they too will opt for a new currency and Euro breaks up. Remember, when the Euro was introduced all these competing nations entered simultaneously, in order to maintain some element of status quo. For these reasons I think that option (3) is a non-starter, and should be put to bed.

If I had to choose from the above three options, then (1) looks like a no-brainer. I would not take a gamble and risk being excluded from a European trade zone, without any tangible benefits. The main risk in (1) is that the process can take too long, and Greeks might give up before the devaluation is complete. There could be variations that potentially speed up the adjustment process, for example introduce a quasi-currency that will be used in parallel to the Euro for internal purposes.

But the main problem as it stands is that Greeks, unlike the Irish, have not made the problem ‘their own’. They are still suspicious of a worldwide conspiracy, a ploy to deprive them of their assets. Many still believe that a painless way out exists, but they are not presented with it. And this is why I am worried that at some point a populist politician will raise option (2) and Greeks will say ‘why not try’.

rush for the exits

September 11, 2011

There is talk of capital leaving Greece at an unprecedented rate. Obviously this will be hard to investigate or quantify in real-time as events unfold, but here is a small piece of evidence from the property market.

Obviously for capital to leave, a decent quantity of capital must exist in the first place. I therefore focus on the Athenian seaside suburb of Voula, an affluent area popular with the Greek nouveau riche and ex-pats. I asked a top Greek real estate portal the following question: how many properties were added to the site in the last week with an asking price of EUR1m or more? The answer 127 properties.

How can we benchmark this number? Well, let’s take the London borough of Kensington and Chelsea, the most expensive borough of one of the most expensive cities in the world, popular with Hollywood stars, Russian oligarchs and Arab sheikhs. A similar query on a UK portal revealed that 103 properties were added to the site (with asking price of GBP1m or more, over the last seven days).

For completeness, Voula is three-quarters the size of Kensington and Chelsea in terms of area (8.7 versus 12.1 sq Km), but only one-sixth in terms of population (30,000 versus 180,000).

If that’s not a rush for the exits, I don’t know what is.

consequences of a euro break-up (ubs analysis)

September 6, 2011

UBS economists published today a research piece on a possible breakup of the Eurozone. They contrast feasible solutions like Greece leaving the currency union or Germany doing the same. They also explain why other alternatives (like expelling Greece) are not feasible.

They estimate that Greece leaving the Euro will incur a one-off cost of about EUR10,000 per person during the first year, and about EUR4,000 each year after that. There are obviously severe social costs that cannot be monetized. The one-off figure for the Germans (should they choose to leave instead) is somewhat lower at about EUR8,000.

Contrast that to the cost of bailing out Greece, Portugal and Ireland simultaneously, which is about EUR1,000 for each German taxpayer. It seems clear that the only viable solution at this stage is a default within the Eurozone, even though this could eventually take us to the same point in a few years’ time.

EUR60bn currency shield

September 6, 2011

The crisis in the Eurozone seems to be dragging on and on. The loosers have their heads on the chopping board, but are there any winners? On one hand the slump in Greece is perhaps going to continue for the foreseeable future, while Germany is posting record exports (in the second quarter of 2011) and is set to easily beat the staggering EUR1tr once more this year.

As the Independent shows, Germany’s main trading partners are in the Eurozone, therefore it would not make sense for Germany to initiate the breakup of the common currency. As one can easily see in the chart below, three-quarters of all German exports go to countries within the EU. The article goes even further, blaming Angela Merkel for not making clear to the German people what the benefits are. Could one make the case that this continuing fiasco is actually benefiting the German economy, and that Merkal’s objective should be to keep the circus going?

Breakdown of German exports

In the same chart, one can also notice that this mix seems to be changing: as the crisis intensified in 2010 the share of German exports outside the Eurozone steadily rises and a spike is forming. Overall, there seems to be a relative shift of about 5%. Now one can argue that this is due to the falling demand within Europe, and this can be correct. But other things equal, such an export surge would cause the currency to appreciate, making exports more expensive abroad, negatively affecting demand, and finally bringing back the revenues (as a footnote, the caveat here is the Marshall-Lerner condition). Obviously this currency appreciation has not happened, as the future of the currency itself remains uncertain.

Which brings us to the question: has Germany benefited from the uncertainty surrounding the future of the Euro? and if yes, to what extend? This is not easy to answer, as we do not have access to an alternative universe where the Euro experiment never took place. Peter Brandt uses the Swiss Franc as a proxy of what a Deutschemark would look like, and we take this approach a step further.

Fortunately, European currencies have been moving in step with respect to USD for a while now. We take exchange rates of the old Deutschemark (DEM) and other non-Eurozone currencies from 1971-2000 (British GBP, Swiss CHF, Swedish SEK and Norwegian NOK). Out of these, a regression analysis (in logs) shows the the DEM can be approximated rather well by a mixture of CHF and GBP. We then apply this mixture and impute a fitted DEM exchange for the period after 2000. The results are shown below, with some emphasis on the recent period after the crisis begun.

German exchange rate

German exchange rate (detail)

The fitted DEM explains rather well the movements of the DEM pre-Euro, and of the Euro afterwards, up to the crisis. After that point the two series deviate substantially: the Euro appears weaker by about 10% during 2010, and has weaken even further to over 25% by mid-2011. A freely-floating DEM should have been 25% more expensive in terms of USD, and obviously for a net-exporter like Germany this can have very significant implications.

A back-of-the-envelope calculation goes as follows: Germany exported EUR990bn worth of goods in 2010, and is expected to reach EUR1,150bn in 2011 (EUR550bn was achieved in the first half). We can assume that 25% of these exports went out of the Eurozone, and therefore benefited from the weaker Euro. The size of the benefit depends on the so called ‘export elasticity’, which the EU estimates to be around 0.60 (this means that every 1% depreciation will cause a 0.60% rise in exports). Putting all these together we can estimate that in 2010 the benefit of the crisis for Germany was EUR15bn, which rose to about EUR45bn in 2011. In total, the benefit that the German economy extracted from the ongoing lack of direction amounts to EUR60bn, and keeps rising fast. Perhaps the Greeks should factor this out in their negotiations with the EU, as they are the ones providing this EUR60bn currency shield.

This German advantage cannot continue in perpetuity, and the currency wars are on. Today the Swiss central bank (SNB) have decided to weaken the Swiss franc by pledging to buy foreign currencies at ‘unlimited quantities’. It is perhaps a matter of time for the rest of the advanced economies to step in and restore a more level playing field.

fair markets

August 24, 2011

Some are still talking about it:

ATHENS (AFP) – Greece will hasten its efforts in the next four months to check a runaway public deficit that threatens recovery goals agreed with its creditors, the finance minister said on Tuesday.

Some have actually done it:

Ireland’s trade surplus hit a record in June, rising by 8 per cent to €4.08 billion, new data from the Central Statistics Office said.

And the results are here for everyone to see…

Greek 2Y bond index

Greek 2Y bond index

Irish 2Y bond index

Irish 2Y bond index

Who said that markets are unfair?

argentine illusions

August 24, 2011

The Greek stock market (the Athens Stock Exchange, or Ase) has now reached a 15-year low at 900 points, as the country marches towards formal default. For some time now, a number of commentators, politicians and various forum dwellers have started making comparisons with late 2001 Argentina. The general line is that the Buenos Aires (Merval) index was 200 points when the country defaulted, and reached 500 points within three months. This offered the patient (or intrepid) investor a 150% return before you could say ‘I-am-broke’.

This is an argument to support one of the following: either “if you happen to be in the stock market, and feel possibly creamed at the moment, don’t panic and make the mistake to sell”, or “if you are not holding stock this is the best time to get a bit adventourous and go long; after all, how much lower can the stocks go from here?”.

Both messages, if taken at face value, would contribute to slowing down the rapid market decline. I can see that trying to prop up a collapsing stock market or forecasting happy days in the near future serves the punters’ own agendas, but they are misleading the public.

Since many middle class Greek families are “entrapped” in the falling market, pundits aligning with the ruling Pasok party are quick to claim that there is hope for a quick rebound. Supporters of the opposition, after placing the blame on the current governments amateur approach to the problem, want to put themselves in a position to reap any potential future benefits. A significant number of (probably badly burnt) investors roam unregulated investment fora spreading the same lines, presumably believing that they are looking after their own interests.

But notwithstanding ones intentions, they are blatantly wrong. Greece might be similar to Argentina, but only to the extent that they both found themselves committed to an exchange rate peg that they find hard to support. Pundits are confusing real and nominal returns, or returns denominated in hard or soft currencies. And while small investors might argue that they were ignorant, politicians and commentators should know better.

Merval, Merval$ and the Ase

Merval (in ARS), Merval$ (in USD) and Ase (in EUR) indexes

In the chart above I put forward the Merval index from 2000 to 2005 (in blue). I rebase the index to 100 in November 2001, which is when the final leg of the crisis begun to unfold. This makes it easier to assess the performance as we approach or move away from the crisis. Merval is denominated in Argentinian Pesos (ARS), the local currency. I also chart the Merval$ (in red), which is the same index denominated in USD and rebased at the same point. Before the end of 2001 there a one-to-one fixed exchange rate between the ARS and the USD; for that reason the two charts overlap in the former part of the chart. This peg broke in November 2001, and the ARS rapidly lost three quarters of its value in the next few months; therefore, following the default, the Merval index produced divergent nominal returns for investors in ARS or USD.

It is true that the Merval rebounded in nominal terms, and more than doubled after the country defaulted and the peg to the USD was broken. But investors received cashflows in a worthless currency that was had lost 75% of its purchasing power; the 150% increase is irrelevant. Denominated in USD, the Merval index has a different story to tell: even after Argentina formally defaulted, the market carried on sliding at the same pace, and bottomed out after it had lost another 50% within the next six months. It then took a further year to return to the level it was when the currency peg was broken.

But how does that relate to Greece? I also collected nearly two years’ worth of the Ase index, and rebased them to the same point (as if we are sitting in November 2001) to make some comparisons. For a start, the decline in the two markets looks surprisingly similar, given that they are ten years apart: both have lost two-thirds of their value over the same length of time. For all practical purposes Greece is essentially pegged to the Euro, in the same way Argentina was up to the breaking point. The decision to be made (by Merkozy perhaps?) is whether this peg is to be maintained.

The Argentinian experience suggests a path for both eventualities: Staying within the Eurozone implies that the Ase investor is still a Euro investor, and the USD-based index indicates a further drop by 50% before recovery begins. This means that one should brace themselves for a ride down to 500 points. Leaving Euro for a New Drachma (or some dual currency setup) can cause the index to rebound, if it is denominated in this new heavily devaluated currency. Then the gains are illusional, as the ARS-based index gains were.

Obviously things are much more complex in practice, and the path of Argentina is not going to be followed exactly by every country that defaults. One should hope so, given that Argentina experienced a 10% contraction during 2002 (the year after default was declared), inflation which topped at more than 10% per month, and more than 50% of the population below the poverty line. Argentina only recently re-entered the capital markets; the abundance of agricultural commodities she produces and rising commodity prices kept her at a surplus through the years following default. This was a relief that Greece does not seem to possess. But it gives an indication of where things can go from here, and a message to the punters to keep their mouth shut.

memory lane is a place greeks avoid

August 3, 2011

[…] in my first talk with him, referred to many government employees as “camp followers” and “coffeehouse politicians” and described the whole civil service as a kind of pension system for political hacks. These are harsh words, but are not unwarranted. The civil service is overexpanded, underpaid and demoralized. The low salaries have been augmented by a completely baffling system of extra allowances by which a few civil servants probably get as much as four times their base pay.

The result is complete disorganization. I have never seen an administrative structure which, for sheer incompetence and ineffectiveness, was so appaling. The civil service simply cannot be relied upon to carry out the simplest functions of government – the collection of taxes, the enforcement of economic regulations, the repair of roads. Thus the drastic reform of the civil service is an indispensable condition to getting anything else done in Greece. But the civil service is just the beginning. There is far more intricate and explosive question of the political leadership of the country.

One could be excused for guessing that the above was taken from a recent report on the Greek sovereign crisis. Unfortunately, it was written in 1947 by the (former by that time) US Presidential Emissary to Greece. And it highlights the Greeks’ acute lack of memory, who strongly believe that their current plight can be traced to either the 80s or 90s, depending on which “camp” they follow. The grim reality is that the Greek psyche has been stubbornly refusing to modernize; the dreams, aspirations, motivations, hopes and fears of the modern Greek family are the same as they were when the Greek state was established in mid 1800s.

And the flirtation of the Greek state with bankruptcy, collapse and chaos is not new neither. This week hordes of taxi owners have been blocking airports, ports and major roads at will, as new legislation would open their profession to competition. Next week another group will take to the streets and make a complete mockery of the state. The head of the British Economic Mission in the 40s makes a point, which seems to be as valid today as it ever was:

When visitors on arriving in a new country [..] run into a sandstorm or a hurricane, they are always told how unusual the weather is. But the situation you are running into here in Athens – the monetary crisis, the possible civil service strike, the pending fall of the government is the normal [..] political climate of Greece. So far as I could see, the Greek government has no effective policy except to plead for foreign aid to keep itself in power [..] It intends, in my judgement, to use foreign aid as a way of perpetuating the privileges of a small banking and commercial clique which constitutes the invisible power in Greece. [Assurance of foreign aid] was not to stimulate the government to further efforts, but to give it the relaxed feeling that it was delivered from the necessity of having to do anything at all. So it declared a national holiday; there was dancing in the streets. And at the same time it shelved a plan for the immediate export of surplus olive oil – a plan which had stepped on the toes of some private traders

The collective amnesia of the Greeks is constantly kept in check by an army of incompetent journalists, commentators, politicians, academics and general “public” figures. A little bit before Greece had her Will E. Coyote moment, I found myself at a round-table event where some hotshot from the National Bank of Greece was speaking just before me. Rather than boring the audience with equations and figures, he went through the script: the “common journey of the NBG and the Greek nation”, the many ways “NBG supported the Greek state throughout the journey”, and how neither of them have anything to fear if they stick together. I am sure that the audience left the event relieved that this long-standing special relationship of mutual support has been there. The Emissary has a different opinion:

[..] behind the government is a small mercantile and banking cabal, headed by [Georgios] Pesmazoglu, governor of the National Bank of Greece and a shrewd and effective operator. This cabal is determined above all to protect its financial prerogatives, at whatever expense to the economic health of the country. Its members wish to retain a tax system rigged fantastically to their favor. They oppose exchange controls, because these might prevent them from salting away their profits in banks in Cairo or Argentina. They would never dream of investing these profits in their country’s recovery

The Pesmazoglus were a family of bankers from the Greek community of Egypt, which moved to Athens in the late 1800s. Since, they have produced generations of politicians, bankers and newspaper owners. Georgios was all three. The Pesmazoglus are now revered in Greece as national heros; the old Athens stock exchange is on Pesmazoglu street.

Greek shipping was born in the 40s, and the great Greek shipowners of the past are the stuff of legends. Everyone speaks of their business acumen, their ability to succeed where others have failed, their courage entering new markets and pushing frontiers, and ultimately their undying love for their country. The ones that spared some change to build an orphanage or a girls’ school have achieved sainthood to the eyes of the modern Greek.

The shipping interests are in a particularly scandalous position. Today the Greek merchant marine is enjoying a boom, and the shipowners are raking in the profits. But the bankrupt Greek government is benefiting almost not at all from this prosperity.[..] Greek shipowners are making most of their profits out of Liberty ships sold to them by the US Maritime Commission after the Greek government had guaranteed the mortgages. The yearly earnings of a Greek-owned Liberty ship will probably run between $200,000 and $250,000. Of this, only the ridiculously small amount of $8,000 goes to the government in taxes. Foreign experts have urged the government to raise the tax requirements to about $30,000. But the political strength of the shipowners has prevented any effective action.

The US Emissary finished his article on a positive note: although Greece has issues that need to be addressed, when you compare her to Turkey or the Communist Balkan states she is still a long way ahead. This was in the 1940s; now Turkey and the Balkan states are marching forward, while Greece is once again bracing herself for default. The collective amnesia will take care of the rest.