Monday, January 25, 2010

Debt and Debtors: Why Greece Matters for Governments and Investors, Part II

Say not unto thy neighbour, Go, and come again, and to morrow I will give; when thou hast it by thee.
Proverbs, 3:29

Into 2009, governments around the world went into serious deficit mode as taxes fell but spending rose. They also bailed out many banks and took on their debt load. The US's bailout of AIG has cost $180bn so far, and the total bailout cost in Britain is a stunning $1,380bn. In late 2009 and continuing to today, sovereign (government) bond markets are showing some strange signs.

Some facts doesn't make sense. Japan’s public debt has already risen above 200% of GDP, but the government can borrow for 10 years at 1.4%. In contrast, Australia’s government debt is much lower at about 25% of GDP, but it pays over 5.5%. Other rich countries with varying debt ratios all pay roughly 3.5-4%. Everyone is watching the sickest governments, which include Japan ("a bug in search of a windshield") and the PIIGS (Portugal, Ireland, Italy, Greece, and Spain). Greece is especially important.

To avoid scaring bond buyers (who buy the government bonds to finance deficits), governments need credible 5-year plans to bring deficits down.
They must convince markets of their discipline to get their fiscal houses in order. Germany has done this with a Constitutional amendment forcing a balanced budget by 2015; the US and UK have done nothing. Read about the German's prudent Constitutional Deficit Rule here: IMF on German CD Rule.

Members of the EU normally must abide by a clause of the Maastricht treaty where deficits remain under 3% of GDP. All the EU governments have collectively ignored this, but some have put measures into place to get back there (Germany, the Netherlands), whereas others have 6-8% deficits that may go on for a long time. This is bad for bonds. Across the eurozone, where countries lack control over their money supply, the risk of default is more real. That is one of the reasons why the Markit SovX index, a basket of sovereign CDS on Europe’s top 15 nations, at 71.5 basis points (bps), is now 14% more expensive than the the index for the region’s top 125 investment-grade companies. To wit: an index of government bonds costs more to insure than an index of corporate bonds - bond investors prefer the full faith and credit of companies over countries! This is shocking - Western governments are supposed to be safer and more stable than companies headquartered inside them, because theoretically they can tax the companies and the populace to pay their debts.

Greece seems to be the worst offender of the PIIGS. Its total debt is estimated as high as 875% of GDP, compared to rich world normal of 500-600% (this includes all on and off balance sheet debt and an estimate of social spending commitments, according to McKinsey). Greece's outstanding government debt alone is between 120-130% of GDP. The Greek deficits were worse than what the previous Conservative government published of 6%. The Conservatives under Kostas Karamanlis basically lied through the national statistics department. The new, Socialist government under George Papandreou came in on October 2009 and published the correct number of 12% (recently revised up to 13%).

To put Greece into perspective: The cost to insure bonds from Greece defaulting has risen 140bp since September, to 263bp. This is six times more than leading companies such as Unilever, BP and Deutsche Post. Before the financial crisis, the cost to insure sovereigns was lower than corporates. In August 2007, Greek CDS traded at 11bp, while Unilever, BP and Deutsche Post all traded around 20bp. I state the point again: markets trust some large multinationals more than they trust the sovereign government and people of Greece!

To get deficits down, the Greek Socialist government that campaigned on and promised more social spending and "cohesion" will have to cut public sector pay, reduce union wages, and generally force people's incomes down so labor costs in Greece come down. As the table title "Unit labour costs" below shows, Greek citizens got too many raises from 2000 to 2008 compared to Germany, so now their pay is bloated - just as the entire EU got bloated because the euro appreciated and made exporting tougher. Good luck to Mr. Papendreou, as any action he takes will lead to a recession and protests (it seems only a matter of degree - his choice is between a depression or a severe recession).

Labor is Expensive and Inflexible while Monetary Policy is Tight: A Deadly Combination

Greece has a few, difficult options (and traditional inflation isn't one of them):

1) Belt-tightening: The current government estimates it can bring deficits down from 13% to 3% by 2012. Even Germany, with its more modest 6-7% deficit, isn't that foolishly optimistic in projections. More importantly, no cuts have been enacted yet. As the Americans say, "Big hat, no cattle."

2) Default on debt:
This is what the Eurozone bond spreads are trying to settle on so far, with investors comparing the ultra-safe German bunds (equivalent to US Treasuries for Europe) to the PIIGs spreads over Bunds. While no one has a clue about the right price, to me a 2-3% spread on an irresponsible country doesn't seem attractive - rather, it seems pathetic. Also, default doesn't have to be outright debt repudiation. It can mean some type of moratorium on interest payments, and the restructuring of loan terms. (Even the US did it in 1934, when FDR abrogated the gold clause in government and private contracts and in 1971, when Richard Nixon abandoned the gold standard altogether). Default can also occur via inflation, currency debasement ("I loved the smell of a debased currency in the morning"), the imposition of capital controls, and special taxes that hinder or disrupt private contracts. Seen this way, a few countries in eastern and western Europe may already be technically at risk of default.

Spreads on Greece Bonds are Higher than Other PIIGS

3) Leave the Euro, return to the drachma, and force debtholders to accept a weaker currency when their bonds mature: Greece's Prime Minister and Finance Minister say it's committed to belt-tightening and keeping the euro, and won't leave. Which brings me to my "Financial Market Denial Rule": Anytime a CEO or government-head formally denies something in a press conference, the odds of it being true are higher than what the consensus previously expected.

As Greece denies it will leave the EU, its odds of doing so rise. Previously, I put the odds of that event at 5%, but now I bump it up to 25%.

As examples of this in the sovereign case, consider Russia denying it would default on bonds in 1998, Thailand claiming it wouldn't run out of foreign exchange reserves and devalue in 1997, or the UK denying it would take the pound of the ERM in 1992.

The consequences would likely be high. A Greek central banker, George Provopoulos, recently wrote an FT op-ed to his own country counseling against it, and he listed these consequences of Greece leaving the EU:
●Any devaluation of the new currency would increase the cost of imports, raising inflation.
●Monetary policy would lack the credibility established by the European Central Bank. As a result, inflation expectations would rise.
●Expectations of further devaluations would arise, increasing both currency-risk and country-risk premiums.
●The above factors would push up nominal interest rates, leading to higher costs of servicing the public debt and undermining fiscal adjustment, thereby taking resources away from other, productive areas.
●The costs of converting currencies with the remaining members of the eurozone would be re-introduced, inhibiting trade and investment.
●The exchange-rate uncertainty with the euro area would increase the costs of conducting business, further deterring trade and investment.
●Existing euro-denominated debt would become foreign-currency debt. Any devaluation of the new domestic currency against the euro would increase the debt burden.
●Greece would no longer benefit from the economies of scale, including the enlargement of the foreign exchange market, which decreases the volatility of prices in that market, derived from sharing the euro.

So it's clearly the last and worst option for Greece is to leave the EMU - it's akin to Iceland telling the UK goverment and banks to "go f- themselves" in not bailing out British depositors who put money with Icelandic banks.

Even more interesting, the European Central Bank (ECB) recently released a paper about the legality of Greece leaving the EU. See the abstract below.

by Phoebus Athanassiou, ECB

This paper examines the issues of secession and expulsion from the European Union (EU) and Economic and Monetary Union (EMU). It concludes that negotiated
withdrawal from the EU would not be legally impossible even prior to the ratification of the Lisbon Treaty, and that unilateral withdrawal would undoubtedly be legally controversial; that, while permissible, a recently enacted exit clause is, prima facie, not in harmony with the rationale of the European unification project and is otherwise problematic, mainly from a legal perspective; that a Member State’s exit from EMU, without a parallel withdrawal from the EU, would be legally inconceivable; and that, while perhaps feasible through indirect means, a Member State’s expulsion from the EU or EMU, would be legally next to impossible. This paper concludes with a reminder that while, institutionally, a Member State’s membership of the euro area would not survive the discontinuation of its membership of the EU, the same need not be true of the former Member State’s use of the euro.

The carefully worded (and confusing) abstract suggests that a country can't pull out of the EU and EMU. Yet the guts of the paper says that the new Lisbon treaty (enacted in late 2009) actually makes it quite easy for Greece to leave the EU. The newspapers have misread this paper as meaning that pulling out is legally tough or impossible.

One can interpret the paper as the Germans, through the ECB in Frankfurt, telling the Greeks that they're OK with the Greeks leaving. The paper also points out that it's nearly impossible to expel a member nation (would take a unanimous vote from all, including the expelled country). So the Germans can't force the Greeks to leave, but they can strongly hint: "Get your house in order, or else get out (no bailout)." And that's just what the German Finance minister did lats monh when he told the Boersenzeitung newspaper that governments allowing their budgets to slide deep into deficit, like Greece, face “severe consequences" and that Greece mustn’t serve as an example that “one can somehow muddle through."

Government (and societal) deleveraging will be difficult over the next few years. Many governments will be tempted to default, and George Magnus of UBS gives five reasons why:
First, sovereign debt service costs are set to soar, overshadowing those for programmes, such as environmental protection and some social services, and, unlike past successful fiscal adjustments, no country can lower interest rates as a palliative. Perversely, the contrary may be the case.
Second, OECD governments have experienced a threefold increase in their structural deficits, about a quarter of which is attributable to the drop in tax revenues, some of which may be permanent, for example, where they are related to financial services and housing.
Third, a weak economic growth environment augurs poorly for effective fiscal adjustment, as will be evident as the bungee jump nature of economic recovery becomes clearer.
Fourth, the financial crisis and the recession are the immediate cyclical reasons for the disarray in public finance, but these pale next to the structural costs of age-related public spending, which are starting to rise relentlessly.
Fifth, high levels of capital mobility complicate debt management. Credit rating agencies have been quick to downgrade and opine about several sovereigns. The significance of their actions lies in the fact that most central banks, and some sovereign wealth funds, cannot hold securities rated below AA. Most ‘long-only’ asset managers have such restrictions too.

So what can governments have to do to get out of the mess? Mr. Magnus states the hard choices eloquently:

Governments have to commit to credible details for fiscal stabilisation, and to structural reforms that address demographic issues, and the need for new growth drivers. The war on waste, raid on the rich, and other slogans will no longer do. They should raise the pensionable age, tackle public sector pension arrangements, and blaze a trail towards higher labour force participation and phased retirement patterns. They should end post-1945 middle class, homeowner, and corporate tax privileges, to finance jobs- and growth-oriented programmes that support the green economy, infrastructure, innovation, and education. Effective political leadership and imagination are essential if default risks are to remain at arm’s length. Otherwise, a spike in bond yields somewhere is all but assured and it may be impossible to prevent both contagion, and in the end, recourse to capital controls.

1 comment:

  1. Rather bleak situation in any case for Greece;all the countries under EMU will suffer,starting with the weakest links and expecting a following domino effect;European assymetric economies offers no resilience to the new currency,it works artificially well in boom times but prove to be a want-to-be giant with an "Achile's heel" in rough times. The Euro is overvalued at best at the present time, at worst it can be in peopardy of existence down the line if some countries are forced to go back to thier former currency to solve their specific economic problems.
    Germany, which is the big debtor of the group, stretched his capacity with East-Germany and is still chewing the big bite; it is not ready and willing to take another bite yet and moreover not for less organic countries to his.
    Political rhetoric from France won't convince anybody but themselves.