Archive for the 'foreign exchange' Category

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’.

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.