Posts Tagged ‘Euro’


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…

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’.

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.

it’s in your hands

April 9, 2010

You can do your bit to help this decent, hardworking but misunderstood nation by donating at least £5 here. No amount is too small, every penny is important. You showed your charity to the people of Haiti, now the proud Greek civil servant is asking for a helping hand.

Before you leave remember to browse through the comments left by distinguished donors like Angela Merkel, Jean-Claude Trichet, Gordon Brown and many others.

always in your debt

December 24, 2009

This is how the Greek debt looks like for the next thirty years. EUR349bn is due, of which EUR95bn (or 27%) is interest and the remaining EUR254bn is the face value.

Distribution of the Greek national debt. Principal and interest in million euros. Source: Bloomberg, Dec09

Greece would typically issue 5- and 10-year bonds. As an example, the notional due in 2012 (approx EUR30bn) would consist of 5-year bonds issued in 2007 and 10-year bonds issued in 2002 (perhaps EUR15bn each). There are also some smaller notional from longer issues, but the bulk of the debt expires before 2019 (the weighted maturity is actually 2017 or thereabouts). This means that in 2010 the government can issue bonds that expire in 2015 and 2020, say EUR15bn each. Then, the notional for 2015 will increase to something around EUR28bn, and a new notional of EUR15bn will be added for 2020. There is a suspiciously large peak in 2019, but I did not have time to investigate its origin. I will collect some more information on each issue and come back with the breakdown.

The bonds Greece issues have typically fixed coupons, that is to say they pay fixed interest. Only a very small number of the issues in the chart pay floating or variable coupons, meaning that the whole current debate on interest rates is irrelevant to Greece’s current exposure. But they will affect the forthcoming issues, as investors will demand higher coupon rates in order to lend to the Greeks. Also, given that Greece might need to borrow money just to pay off the interest of previously issues bonds, there will be a refinancing cost as new coupons will be added. The new orange bars will be a bit larger than they would have been if debt was issued three months ago, and since Greece borrows at fixed rates they will remain higher for the duration of the debt.

Interest rates are close to historic lows, so even with this extra premium the actual amount will not be that different from what it was before: the new orange bars will not be a lot bigger than the existing ones in the chart. It is more of an opportunity missed: other EU countries will take advantage of the low rates to either improve their balance sheets or spend their way out of recession, Greece can do neither. The recession will bite harder, as there will be insufficient fiscal stimulus given the higher cost of money. Moreover, Greece is missing all infrastructure improvements that take place elsewhere in the name of fiscal stimulus. And when interest rates finally pick up, Greece will find herself in the back seat: she did not invest when money was cheap, but still has the same debt burden as if she did.

So who are the immoral bankers that pile up Greek debt, taking advantage of the high spreads that has driven the whole country in despair? Hugh Edwards brings forward some analysis by Goldman Sachs on Greek banks making extensive use of the ECB liquidity facility (which allows institutions to draw funds from the ECB using rated bonds or ABS structures as collateral). This facility was put in place in order to provide liquidity to the holders of highly rated but ‘misunderstood’ securities, and certainly not to provide cheap funding for speculative activities. For some reason Greek banks are always there asking for more, even though they do not appear to be liquidity drained under any measure. In fact, it appears that Greek banks have overdone that to the point where the Central Bank of Greece had to tell them off (presumably under instructions from a pissed off ECB). What do Greek banks do with all that money?

[…] the current spreads on Greek government bonds […] offer Greek banks an exceptional arbitrage opportunity, since by taking advantage of the uniform ECB liquidity rate Greek banks can buy higher Greek government bonds with a much higher yield than the government bonds which their French or German counterparts buy. Regardless of the risk implied through by the Greek CDS spread, Greek government bonds carry a zero risk weighting when calculating riskweighted assets for capital purposes. So for Greek banks this arbitrage carries no capital impact whatsoever. That is to say the Greek banks have been doing very nicely indeed out of the Greek sovereign embarassment, than you very much. Hence it is not difficult to understand the ECB’s growing sense of outrage with the situation.

This means that essentially ECB money is given to Greek banks at very low interest rates, under a scheme designed to help banks that are genuinely in distress. Greek banks use these funds to buy Greek government bonds, which offer a substantially higher rate of return. As far as ECB rules are concerned, these are risk free bonds and Greek banks are not penalized for holding vast amounts of them. The end result is that Greece ends up paying through the nose for funding that comes from the ECB printers via a Greek bank, and Greek banks make huge profits for just taking advantage of a loophole in the rules. One might say that Greek banks are taking on sovereign risk (at the end of the day there is a non-zero probability that Greece will default), but the fates of the Greek state and large Greek banks are so highly intelinked, that a Greek default will wipe them out anyway.

Surely, Greek banks must feel embarassed of employing a regulatory arbitrage scheme that many in Europe see as immoral, especially when the purpetrators are state-owned institutions. Enter Apostolos Tamvakakis, the newly appointed (by the newly elected government) CEO of the National Bank of Greece, the country’s biggest banking institution. Even befor Moody’s decided to let Greece go with a slap on the wrist, he made the bank’s intentions clear:

A downgrade by Moody’s would not affect our decision to fund the Greek state

Enough said.

something’s got to give

December 18, 2009

For all terms and purposes Greece is a country under a fixed rate regime. Yes, it is part of the Euro which is a freely floating currency, but in reality (i) Greece’s state or actions do not affect the Euro rate, apart from creating worries that other more systemically important countries might find themselves in choppy waters, and (ii) the largest part of Greece’s trade is with Eurozone partners, and this takes place on a fixed trivial Euro-to-Euro basis (55% of imports and 65% of exports are with EU partners, of which the bulk is with Eurozone members).

This implicit peg has served well as an anchor for inflation, but might not be optimal in the current circumstances. If one were to give an IMF-style advice to Greece, then one would probably recommend a currency devaluation or resetting the peg (as this IMF surveillance document points out, where advice is given this is towards more flexibility). It would not inflate the debt away, as this is denominated in Euro, but it will (i) improve the balance of payments in the short run, (ii) inflate away wages that are currently sticky, and (iii) reduce the size of the housing bubble which is also sticky due to the unwillingness of sellers to accept reductions. Perhaps this would have been already optimal in a beggar-thy-neighbor fashion, as recession hit the country.

Paul Krugman suggests, in the case of Spain, that the only option is for nominal wages to drop. This is the route that Ireland has taken, but Greece seems to be unwilling to follow due to pre-election commitments. Does that mean that for Greece the only remaining alternatives are (i) exit the Eurozone, get back to the old Drachma and devalue, or (ii) wait for the IMF to enter the frame and force the wage cuts that the government will not?

just form an orderly queue

December 17, 2009

Perhaps unsurprisingly, creditors start lining up. You can’t blame them for getting worried… Greece was one of those countries that announced that the whole population would be vaccinated against swine flu, rather than the more cost saving selective vaccination followed by others. This will certainly add fuel to the fire, as it will raise concerns that the true amount of Greek deficit is not yet well defined.

Dec. 17 (Bloomberg) — European health-care companies told the European Commission that Greece’s public-health system owes them almost 7 billion euros ($10 billion) for medicines and other items, the Financial Times reported. The companies’ trade body has filed a formal complaint with the commission, saying the Greek government is in breach of an EU directive on timely payment of bills, the newspaper said. Yiannis Chryssopathis, the legal counsel of Greece’s
pharmaceutical trade group, said drug and device suppliers were owed 6.5 billion euros by last summer, the FT said. The Greek health ministry has made no regular payments since 2005, when a settlement was reached on outstanding bills from previous years, the newspaper added.