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Nowhere to Run, Nowhere to Hide! -- Satyajit Das

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  • Nowhere to Run, Nowhere to Hide! -- Satyajit Das

    The recent drop in the dollar against the euro is a head fake. I expect it will rise yet again, until the dollar gets it's come-uppance...

    Nowhere to Run, Nowhere to Hide!
    • by Satyajit Das
    • July 08, 2010
    A year of wishful thinking…
    The twelve months starting March 2009 was the year of wishful thinking. Central banks cut interest rates and governments opened their check books providing a flood of cheap money that gave the illusion of recovery and a normal functioning economy. Pouring a lot of water into a bucket with a large hole created the impression that the receptacle was almost full. As Norman Cousins, an American political journalist, noted: "Hope is independent of the apparatus of logic."
    Governments merely transferred the debt from private sector balance sheets onto public balance sheets. The Global Financial Crisis ("GFC") has morphed into a Global Sovereign Crisis ("GSC") as sovereign governments now face difficulty in raising money.

    Stock markets and asset prices have tumbled. Money markets are exhibiting an anxiety not seen since late 2008/ early 2009. The year of wishful thinking has run its course.

    Cradle of debt…
    If subprime was the Patient Zero of the GFC, then Greece, the cradle of Western civilization, was the equivalent of the GSC. As historian Arnold Toynbee observed: "An autopsy of history would show that all great nations commit suicide."
    Greece's significance is not its economic size (around 0.5% of global Gross Domestic Product ("GDP")) but its significant debts. Profligate public spending, a large public sector, generous welfare systems particularly for public servants, low productivity, an inadequate tax base, rampant corruption and successive poor governments created the parlous state of public finances.

    Several events focused attention on the problems. Greece needed to borrow around €50 billion to refinance maturing debt and fund its budget deficit. There were damaging disclosures that Greece, like many other European countries, had used derivatives to manipulate its debt figures. The revelations focused attention on underlying problems and set off alarm bells. Smelling blood in the water, markets pushed up the cost of Greek debt. Gradually, the ability of the country, as well as Greek banks and companies, to raise money ground to a halt.

    Greece was the "canary in the coal mine," highlighting similar problems in the PIGS (Portugal, Ireland, Greece and Spain) as well as some Eastern European countries. These countries alone have around €2 trillion of debt outstanding. Larger countries—the FIBS (France, Italy, Britain and the ‘States')—also have similar problems of large public debt, unsustainable budget deficits and (in most cases) unfavorable current account deficits (both in absolute terms and relative to GDP).

    Going nuclear…
    Will Durant, an American historian, advised that: "One of the lessons of history is that nothing is often a good thing to do and always a clever thing to say." Initially, European politicians and bureaucrats, who suffer from delusions of adequacy, did nothing, but wouldn't shut up about it. The oft repeated battle cry was "no default, no bail-out, no exit," Germany remained especially hostile to any financial "bailout."
    The major problem was "contagion"—the consequences if Greece was to unable to raise money from commercial sources. Much of Greece's debt is owed to banks and investors in other European countries. If Greece defaulted, the resulting losses would have serious consequences for the affected banks and banking systems. Countries, such as Portugal, Spain and Ireland, with similar economic problems would inevitably be scrutinized and targeted.

    By February 2010, the need for coordinated action by the euro-zone countries and the European Union (EU) was evident. While pledging eternal support, the EU waited for Greece to agree to an austerity program to remedy its finances. The cause of European unity was not served by attacks by George Papandreou, the Greek Prime Minister, that the EU was creating a "psychology of looming collapse" and making Greece "a laboratory animal in the battle between Europe and the markets."

    In April 2010, as the market for Greek debt worsened (the additional interest rate that Greece had to pay reached 8.00% over that paid by Germany), after considerable prevarication, the EU proposed a highly conditional €30 billion rescue package. The haiku-writing president of the European Council, Belgian Herman Van Rompuy, hoped “it will reassure all the holders of Greek bonds that the euro-zone will never let Greece fail … If there were any danger, the other members of the euro-zone would intervene.”

    Markets considered the proposal inadequate and unlikely to avoid a Greek default. Increasingly desperate as circumstances began to rapidly spiral out of control, the EU increased the package in early May 2010 to €110 billion, including a €30 billion contribution from the International Monetary Fund (IMF) who would supervise the package and the implementation of the economic "cure."

    About a week later, continued market skepticism and increasing pressure on Portugal, Spain and Ireland forced the EU to "go nuclear." After months of slow and tortured discussions, the EU acted with surprising speed announcing a "stabilization fund" to the value of €750 billion to support euro-zone countries, including an IMF contribution of (up to) €250 billion. The actions were designed to salvage the EU, the euro and over-indebted euro-zone participants by stopping contagion and further spread of the crisis.

    Nicolas Sarkozy, the French president, turned the euro-zone's sovereign-debt crisis into a personal triumph. The proposal, he let it be known, was 95% French. Le Figaro led the cheerleaders reporting Sarkozy's comment that "in Greece they call me ‘the savior'."

    Struggling for a telling phrase, journalists spoke of financial "shock and awe." A single word—panic—better summed up the actions. Initially, stock markets rose sharply, especially shares of banks that would benefit from the rescue. The interest rates on Greek, Irish, Italian, Portuguese and Spanish bonds fell sharply. As the announcement over the weekend caught traders unawares, the rally was driven largely by covering of short positions.

    "Shock and awe" quickly proved more shocking and less awe inspiring than the EU had hoped. Wiser commentators mused that if €750 billion wasn't going to do the trick, then what was?

    Brussels, we are not receiving you…
    Details of the "plan" remain sketchy. The entire package conveys the impression that the EU and European Central Bank (ECB) are hopeful that the announcement will suffice to bring stability to markets and the facilities won't ever have to be used. A problem of too much debt was being solved with even more debt. Deeply troubled members of the euro-zone were trying to bail out each other. Given that all have significant levels of existing debt, the ability to borrow additional amounts and finance the bailout remains uncertain.

    The reality is that Germany, with its large pool of domestic savings, must be the cornerstone of the rescue effort. Predictably, German credit risk margins have increased while the peripheral countries credit margins have fallen. The effect of the stabilization fund is that stronger countries' balance sheets are being contaminated by the bailout. Like sharing dirty needles, this has drastically increased the risk of infection.

    Trader Karl Dunninger, writing at, captured the madness: "The most amusing part of this is that nations seriously in debt and without a pot to piss in will be ‘contributing' some of the money to fund the debt. Spain, for instance, has pledged to do so. Where is Spain going to get the money? Will they sell bonds at 8% to fund a loan at 5%? That's a very nice idea.... let's see, we lose 3% on those deals. That ought to help Spain's fiscal situation, don't you think?"

    Solvency not liquidity, stupid…
    At best, the plan provides temporary liquidity to cover immediate financing needs, repaying maturing debt and financing deficit. In a striking parallel to the early stages of the GFC, the reality that it is a "solvency" problem not a "liquidity" problem remains unacknowledged.

    Most of the countries in the firing line have unsustainable levels of debt. For example, beyond 2010, Greece needs to refinance borrowings of around 7%-12% of its GDP (around €16 billion to €28 billion) each year till 2014. There are significant maturing borrowings in 2011 and 2012. In addition, Greece is currently running a budget deficit (currently over 12% but projected to decrease) that must be financed. As noted above, Greece's total borrowing, currently around €270 billion (113% of GDP), is forecast to increase to around €340 billion (over 150% of GDP) by 2014.
    The IMF's publicly available economic analysis assumes Greece is able to refinance long-term debt by early 2012 and short term debt even earlier. Given that Greece is expected to have a total debt burden of around 150% of GDP and total interest payment of 7.5% of GDP, the ability to raise funds and the assumed 5% cost of refinancing may be optimistic.

    The IMF plan calls for a program of fiscal austerity and major structural reform. This would entail a sharp reduction in the budget deficit to less than 3% of GDP and public debt under 60% of GDP. It is unlikely that Greece, despite heroic speeches from politicians, will be able to meet these targets.

    Temporary emergency funding will not solve fundamental problems of excessive debt and a weak economy. Government expenditure will need to be slashed and taxes raised to reduce its debt. But the government is too large a part of the economy and the suggested austerity measures will most likely cause a severe recession. In turn, this will drain tax revenues and increase expenditures, making it difficult to reduce the budget deficit and funding needs.

    The level of indebtedness may already be too high. Kenneth Rogoff and Carmen Reinhart in their survey of financial crises This Time It's Different argue that sovereign debt above 60-90% of GDP restrains growth. Greece's interest payments now total around 5% of GDP and are scheduled to rise to over 8%. Rising interest costs will only worsen this problem. The cure may not be feasible or will not help make it easier to meet future debt obligations. Ireland has already implemented austerity measures. The government debt as a percentage of GDP has increased to 64% from 44%. The budget deficit as a percentage of GDP has doubled to 14% from 7%. The nominal GDP of the country has fallen by 18%.

    The plan may also make further liquidity problems inevitable. Instead of allowing Greece to raise funds normally, the bailout package is helping investors reduce exposure via repayment of maturing debt and the sale of illiquid longer-term securities. The package also risks forcing other vulnerable countries to rely on the stabilization fund. As Woody Allen once observed, "More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly."

    It always ends in the same way…
    No one, including the IMF, seriously believes the austerity program announced by Greece will work. Argentina had debt-to-GDP of around 60% and a budget deficit of 6%. Adjustments necessary to halve both failed. After a long drawn-out struggle between 1999 and 2001, Argentina was forced to reschedule its debt and has still not quite made its way back to normality. Many of the vulnerable countries in Europe are in a much worse position than Argentina in 1999.

    Rapid economic growth or high inflation would improve Greece's prospects for survival. Neither is a realistic option. The euro-zone could continue to finance Greece, which would require extension of the current package, which is initially for 3 years. Greece may not be able to avoid a debt restructuring. For Ireland, Spain and Portugal, as well as others, the savage austerity measures required are unlikely to be palatable and probably won't work in any case. All roads may lead eventually to debt restructuring.

    The best course of action for Greece would be to "temporarily" (that is, for the next several hundred years) opt out of the euro and unilaterally re-denominate its debt into the "new" drachma. Through the currency devaluation, this would effectively reduce debt and restore competitiveness. In any debt rescheduling, lenders would take significant write downs, reducing Greece's debt burden, giving it a chance to emerge as a sustainable economy.

    The real agenda of the bailout is to prevent foreign lenders taking large losses. The investors were imprudent in their willingness to lend excessively to countries like Greece, assuming EU "implicit" support, and are now seeking others to bail out them out of their folly. As Herbert Spencer, the English philosopher, observed: "the ultimate result of shielding men from the effects of folly is to fill the world with fools." As of June 2009, Greece owed US$276 billion to international banks, of which around US$254 billion was owed to European banks with French, Swiss and German banks having significant exposures. Bank for International Settlement data indicates that German and French banks' exposure to Greece is about $50 billion and $75 billion respectively. In aggregate, the exposure of Germany and France to troubled European countries is around $1 trillion. According to the Bank for International Settlements, as of the end of 2009, French banks and German banks had lent $493 billion and $465 billion respectively to Spain, Greece, Portugal and Ireland.
    The bailout's purpose is to prepare for a possible series of sovereign debt restructurings in Europe. In an ideal world, banks and investors raise capital and write down their exposure to the troubled debtors over time, avoiding disruption to financial markets.

    Dysfunctional functionalism…
    Contagion is already a reality. Highly indebted sovereign borrowers with immediate financing needs are facing higher costs and lower availability of funds. Scrutiny of their public finances is forcing them to adopt austerity programs to remain credible borrowers with access to markets. The risk of losses from a Greek or other sovereign defaults has affected financial institutions. Mirroring events at the start of the GFC, the close linkages between euro-zone banks through cross-border loans and investment to each other remain a serious potential problem. The stress is most evident in inter-bank funding rates, which have risen sharply to their highest levels in a year.

    Since 2008, money markets have operated on the basis that large banks are "too big to fail," due to support from the relevant sovereign. The problems of sovereigns themselves have heightened concern about the credit risk of banks. Banks fearful of the quality of borrowing banks may limit lending.

    Banks, especially those in Europe, are paying higher interest costs and may face difficulties in raising funds. The ECB recently warned of the problems faced by European banks in financing their operations and refinancing maturing debt. Markets are stockpiling liquidity, as evident by surplus balances at the ECB and other central banks, fearing a sequel to the deep freeze in financial markets in 2008. Activity in bond markets and new equity raisings has slowed sharply.
    In the real economy, forced or voluntary retrenchment of government spending is restricting demand and restraining economic growth. Lack of demand in Europe affects the exporting economies of Japan, China and East and South Asia.
    Dollar strength belies the economic fundamentals and will slow the ability of the U.S. to use exports as a growth engine. The weakness of the euro and resultant appreciation of the renminbi by over 14% also reduces Chinese exporters' earnings and competitiveness. China is now even more reluctant to take steps to allow the renminbi to appreciate.

    Sovereign debt problems are creating serious dislocations and perverse outcomes. Paralleling the events after the Asian monetary crisis in 1997/1998, the flight to dollars has pushed down interest rates on U.S. government debt. Paradoxically, lower interest rates reduce pressure for deficit reduction by lowering the cost of servicing public debt.

    Fading hopes…
    A combination of self-reinforcing events is driving a pernicious reversal of the dynamics of 2008-09. Then, co-ordinated government action on a grand scale stopped the global financial crisis from turning into a depression. Government and central bank strategy was a bet on growth and inflation as the most painless means of adjusting the overly leveraged and deeply indebted global economy. In the words of La Rochefoucauld: "Hope, deceitful as it is, serves at least to lead us to the end of our lives by an agreeable route." Now, governments have become the problem, perhaps calling time on the wishful thinking of markets.

    The most important consequence of Greece and European sovereign debt problems will be to force governments everywhere to stabilize and reverse the deterioration in public finances by a combination of new taxes and cutting expenditures. Many indebted economies, including Britain and Italy, have implemented austerity measures. The sharp reduction of government spending coincides with the end of the effects of stimulus packages and is likely to slow economic growth.

    Country-specific factors–attempts by China to rein in excessive lending and rising property prices, higher interest rates in Australia and India driven by perceived inflation in local economies–may also undermine growth. Government demand for funds and deteriorating conditions in the financial system will reduce the availability of funds and increase cost, further restricting growth.

    Refusing to acknowledge the real problems, major economies have transferred debt from companies to consumers and finally onto public balance sheets. A huge amount of assets and risk is held by central banks and governments, which are not designed for such long-term ownership. There are now no more balance sheets that can be leveraged to support the current levels of debt.

    Borrowing can only be repaid by the sale of assets, including those funded by the debt, or by redirecting income, perhaps generated by the asset purchased, towards repayments. Unfortunately, the level of income and cash flow is insufficient to cover interest costs or amortize the amount borrowed. The GSC focused attention on the excessive level of debt and how it was used.

    Based on per capita income of $30,000 (roughly 75% of Germany's), Greece gives the appearance of a developed economy. In fact, Greece's economy and its institutional infrastructure are weak. In the World Bank's Index for Doing Business, which measures the commercial environment, Greece ranks 109th—behind Lebanon, Egypt and Ethiopia and, among developed countries, next to last. Around 30% of the Greek economy is unreported and informal. Tax revenue losses may be around $30 billion per annum. Productivity and quality are low. Despite the size of the public sector, public services are inadequate. Corruption is endemic.

    While entry into the euro may have helped Greece ascend to major league status, it decreased international competitiveness as the country effectively priced itself out of the market for goods and services. Entry into the euro compounded existing weaknesses by providing access to low-cost funds. Greek bonds became eligible as collateral for ECB funding. Assumptions of "implicit" ECB and EU support (since proven correct) facilitated easy access to bank funding. A period of credit-driven expansion financed a construction boom and social policies, such as early retirement with large pension entitlement, often in excess of those available in more affluent countries.

    The reality is that much of the debt in Greece was not used to finance productive enterprises but fuelled consumption or was channeled into unproductive uses. There are no substantial assets or income from those investments that will help repay the debts. Many countries and businesses face identical problems and now must adjust to that painful reality.

    As Tyler Cowen, Professor of Economics at George Mason University, observed in his opinion piece "How Will Greece Get Off the Dole?" (New York Times, May 21, 2010), "…it's a moot point whether Greece is a poor country masquerading as a wealthy country or vice versa. … If the old illusion was that Greece was a wealthy country, the new illusion is that Greece will, in short order, become wealthy enough to pay back ever-growing sums of debt." The lack of viable policy options is increasingly evident in the panicked reactions of governments. In literature, they all quote Shakespeare in the end. When things go wrong in financial markets, it seems that everybody looking for a scapegoat blames speculators and short sellers.

    Nowhere to run to, nowhere to hide…
    The onset of the GSC marks a new dangerous phase of the credit crisis. At best a withdrawal of government support (through lower spending and higher taxes) will reduce global demand and usher in a potentially prolonged period of stagnation. At worst, increasing difficulty in sovereigns raising money and a clutch of sovereign debt rescheduling may result in a sharp deterioration in financial and economic conditions.

    Financial institutions will continue to build up capital and reduce balances sheets, anticipating further losses and write-offs over time, including potential losses on exposures to sovereign loans. Lending growth will continue to be low, reducing growth. Consumption and investment will be below potential.

    There is no political will to tackle deep-seated problems. The electorate is unwilling to accept the necessary adjustments and lower living standards. As the credit crisis enters its third year, the scale of sovereign debts means that governments now have limited room to counter any new economic downturn. The liquidity and government-spending-driven rally also caused "bubbles" in emerging markets. There is a risk that the GFC and GSC may morph into an EMC (Emerging Market Crisis).

    Until early 2010 markets were, as the song goes, “Dancing in the Street.” Increasingly, another standard also made famous by Martha and the Vandellas is relevant: "Nowhere to run to, baby/Nowhere to hide."

    © 2010 Satyajit Das All Rights reserved.
    Satyajit Das is the author of the Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010) due for release in the U.S.A. in late August 2010.