Opinion

Felix Salmon

International labor mobility datapoint of the day

Felix Salmon
Sep 2, 2011 13:50 UTC

One of the main reasons for the euro experiment failing is the obvious fact that the eurozone doesn’t have a common language. An optimal currency area needs labor mobility — areas without jobs need to provide workers for the areas with demand for them. But it’s hard to get a good job in Germany if you don’t speak German. And so something quite astonishing is going on:

In 2006, only 156 Angolan visas were issued to southbound Portuguese, but in 2010, the figure was 23,787.

To put that number in perspective, total emigration from Portugal — to all the countries in the rest of the world combined — ranged between 12,000 and 17,000 a year in the 1980s. Portugal is a very small country, and it hasn’t seen this level of emigration since the 1960s.

One reason: for skilled workers, a job in Angola pays a lot more than a similar job in Portugal: for a civil engineer, we’re talking four times as much, according to one Portuguese entrepreneur in Luanda. And there’s similar demand for skilled workers in fast-growing Brazil, too.

From a global perspective, this is good news. Developing countries like Angola and Brazil get to leverage western European education, while underemployed Portuguese find good jobs abroad. It’s an example of the cross-border labor market actually working.

From a European perspective, on the other hand, there’s a lot to worry about here — the PIGS aren’t going to recover if they lose the highly productive workers they spent so much to educate. But they can hardly wall those workers in and prevent them from moving to greener pastures. The only solution is domestic job creation. And that’s hard to do when you’re on an austerity regime.

COMMENT

plus Chinese is so easy to learn and has no cultural or political baggage

Posted by johnhhaskell | Report as abusive

Greece datapoints of the day

Felix Salmon
Aug 30, 2011 21:04 UTC

Nikos Tsafos has a fantastic post at his Greek Default Watch blog entitled “Ten Surprising Facts about the Greek Economy”. I normally hate listicles, but this one’s very good. For instance: it’s bad enough that Greek GDP won’t go back to its 2008 peak for the best part of a decade. But it’s worse that the two big drivers of Greece’s economy — tourism and shipping — are down 28% and 27% respectively in real terms since 2000.

Other parts of the list are equally surprising. Did you know that Greece’s 2011 budget deficit is just 40% of the size of its official tax arrears? Or that Greece has only really gone on a massive borrowing binge twice? Once between 1980 and 1993, and then again between 2007 and today. I, for one, didn’t know that Greece has the lowest level of private-sector debt in the eurozone — only about 150% of GDP, compared to well over twice that in Portugal.

One endgame for Greece is a managed departure from both the euro and the EU, with the ECB coming up with a mechanism for protecting depositors in Greek banks — George Soros, for one, says that “the Greek problem has been sufficiently mishandled by the European authorities that this may well be the best solution”. But that day is still a long way off. There’s no appetite in the EU generally for such a move, and even less in Greece. After all, the costs associated with ejection would be enormous — on the EU side for the bank deposit guarantees, and on the Greek side from the loss of all the benefits that come with EU membership. Meanwhile, the benefits on both sides are more amorphous and unpredictable. Argentina suddenly started growing after it devalued; Greece might not.

For the time being, then, the best we — and Greece — can hope for is more plans along the lines of “maybe if we tie two rocks together, they’ll float”. That, and continued austerity and stagnation. Joining the euro was, in hindsight, a really bad idea for Greece. But it’s one which is very unlikely to be reversed any time soon.

COMMENT

I would edit above sentence to say “Argentina, Indonesia, Malaysia, Thailand, Russia, Brazil, Mexico, the United States, the United Kingdom, Germany, Finland, Sweden, Norway, China and Italy suddenly started growing after they devalued, Greece might not.”

Further reading of Wikipedia would probably allow me to double the length of the list but those are just the ones I could think of off the top of my head.

Posted by johnhhaskell | Report as abusive

Lagarde leads from the front on Europe

Felix Salmon
Aug 30, 2011 01:21 UTC

Going into the Jackson Hole conference, everybody was breathlessly awaiting Friday’s speech from Ben Bernanke, which turned out to be incredibly boring. The most important speech of the meeting, by far, came on Saturday, and came from the new head of the IMF, Christine Lagarde. In decidedly undiplomatic prose she came right out and said what needed to be done:

Two years ago, it became clear that resolving the crisis would require two key rebalancing acts—a domestic demand switch from the public to the private sector, and a global demand switch from external deficit to external surplus counties… the actual progress on rebalancing has been timid at best, while the downside risks to the global economy are increasing…

I would like to delve deeper into the different problems of Europe and the United States.

I’ll start with Europe…

Banks need urgent recapitalization. They must be strong enough to withstand the risks of sovereigns and weak growth. This is key to cutting the chains of contagion. If it is not addressed, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalization—seeking private resources first, but using public funds if necessary. One option would be to mobilize EFSF or other European-wide funding to recapitalize banks directly, which would avoid placing even greater burdens on vulnerable sovereigns…

The United States needs to move on two specific fronts.

First—the nexus of fiscal consolidation and growth. At first blush, these challenges seem contradictory. But they are actually mutually reinforcing. Credible decisions on future consolidation—involving both revenue and expenditure—create space for policies that support growth and jobs today. At the same time, growth is necessary for fiscal credibility—after all, who will believe that commitments to cut spending can survive a lengthy stagnation with prolonged high unemployment and social dissatisfaction?

Second—halting the downward spiral of foreclosures, falling house prices and deteriorating household spending. This could involve more aggressive principal reduction programs for homeowners, stronger intervention by the government housing finance agencies, or steps to help homeowners take advantage of the low interest rate environment.

The diagnosis of what needs to be done in the U.S. is spot-on. Revenues have to be raised — in the future, not yet. Mortgage principal needs to be reduced. And the government needs to help the private sector translate low interest rates into growth, because right now it’s looking like a deer in the headlights and refusing to take advantage of them.

But it’s Lagarde’s diagnosis of her native Europe which is proving highly controversial. Anonymous “officials”, quoted in the FT, rapidly said that she had it all wrong:

Officials said Ms Lagarde’s comments missed the point of banks’ current difficulties. “The key issue is funding,” said one experienced central banker. “Banks in some countries have had trouble securing liquidity in recent weeks and that pressure is going to mount. To talk about capital is a confused message.

This is simply delusional: anybody who knows anything about banking knows that the distinction between a liquidity problem and a solvency problem is not nearly as clear-cut as this makes out. Indeed, if there weren’t any worries about European banks’ solvency, then they wouldn’t have any kind of liquidity problems. If a bank has “trouble securing liquidity,” any responsible regulator must take that as a message that the markets are worried about that bank’s solvency — especially if the problems are happening, as these ones are, in a broader global context where liquidity remains abundant.

And if the markets are worried about a bank’s solvency, then that bank’s solvency is what must be addressed — perception is reality in such matters.

Elsewhere in the FT, other anonymous officials said that the European stress tests were already doing what Lagarde was calling for. This despite the fact that only nine European banks failed those stress tests. Where Lagarde sees a huge systemic problem, European officials, it seems, still thinks it can patch things up by triaging the worst banks and applying band-aids.

All of which, in and of itself, makes Lagarde’s concluding words ring rather hollow:

We have reached a point where actions by all countries, doing what they can, will add up to much more than actions by a few.

There is a clear implication: we must act now, act boldly, and act together.

Obviously, that’s not going to happen. It’s not going to happen in Europe, where officials immediately rejected her proposals. And it’s certainly not going to happen in the US, where she’s significantly to the left of the Obama administration and where her policies could never, ever pass either the House or the Senate.

This is depressing — but the FT does manage to find a sliver of a silver lining: Lagarde, they write, “has said publicly what most policymakers have avoided addressing since the crisis began”. Maybe she’s just leading from the front, here: even if policymakers don’t embrace her position immediately, they might come round to her way of thinking as the world’s developed economies continue to stagnate and financial markets continue to fret over a possible sovereign crisis. If such a crisis starts looking imminent, then at least Lagarde has already laid out a plan for how the banks — a crucial vector of contagion — might be turned instead into a kind of firebreak.

Certainly one can’t ever imagine Lagarde’s predecessor, Dominique Strauss-Kahn, giving a speech like this. He was the consummate behind-the-scenes diplomat; he wasn’t given to big set-piece public speeches. Lagarde, in that sense, is a breath of fresh air at the IMF, and quite un-French in how she’s operating. I do suspect, though, that it’s going to take little a while before Europe’s leaders to come around to her point of view.

COMMENT

She is approx 90% right, however, she must resort to a sledgehammer next time she addresses the ‘experts’ … hope is not a strategy amigo. Lets not morph the EU in to Japan 2.0

Posted by FunnyYuan | Report as abusive

Chart of the day, Swiss franc edition

Felix Salmon
Aug 22, 2011 05:07 UTC

EURCHF-vol-surface-082211.png

This chart comes from Eric Burroughs, who calls it “one of the best gauges for showing the extreme nervousness over what the endgame really is in Europe”. But I’m assuming here that you’re not the kind of person who looks at FX volatility surfaces on an everyday basis, so it might be worth a little bit of explanation.

The chart is showing how expensive it is to buy options on the EUR/CHF exchange rate — that is, the number of Swiss francs per euro. When the Swiss franc strengthens, as it has been doing of late, the exchange rate goes down. The current exchange rate can be seen in the middle the “Delta” axis, where it says “ATM” — that stands for “at the money”. So everything to the left of that line — the PUT contracts — shows the price of a bet that the Swiss franc is going to strengthen. And everything to the right of the line — the CALL contracts — shows the price of a bet that the Swiss franc is going to weaken.

Now the Swiss franc has appreciated a lot against the euro of late — you could get more than 1.5 Swiss francs to the euro this time two years ago, while a couple of weeks ago the exchange rate dropped to as low as 1.03, and it’s still at 1.12 right now. To put it another way, a 100 Swiss franc meal in Zurich would have cost you €65 two years ago, €76 one year ago, and €89 today. At this point, the Swiss franc is so strong that the Swiss National Bank is doing everything in its power to try to weaken it. So the time to bet on a strengthening Swiss franc was clearly in the past.

But just look at the chart — it’s much higher on the left-hand side, the PUT side, than it is on the right-hand side. That’s known as “skew”, and it means that the market is decidedly bearish on EUR/CHF. If you want to bet that the exchange rate is going to go back up, that will cost you quite a lot of money. But if you want to bet that the exchange rate is going to continue to decline, that’s going to cost you an absolute fortune.

And in fact the market seems to think that even if the Swiss National Bank manages to weaken the Swiss franc in the short term, over the long term its efforts won’t count for much. The lowest parts of the chart — the cheapest bets of all — are the ones saying that the Swiss franc is going to weaken over the long term of 18 months to 2 years. Meanwhile, the highest parts of the chart — the most expensive bets you can make — are the ones saying that the Swiss franc is going to strengthen a lot over the long term of 18 months to 2 years.

Some of this activity is hedging, of course, rather than speculation. Let’s say you’re one of those corporate chieftains attending Davos in January as a Strategic Partner. That’ll cost you 590,000 Swiss francs. In 2011, that was €457,000. But as of right now your Davos membership fee has already risen to €523,000; you might well want to lock it in right there before it goes any higher. (If you’re unfortunate enough to be paying in dollars, it’s even worse.)

But the main message of the chart is that people are almost irrationally worried right now. The Swiss franc is a classic flight-to-safety play, a bit like gold or Treasury bills. That’s why it has appreciated so much of late. But the markets are saying that its recent appreciation might only be the beginning, and that the Swiss franc might well end up being worth more than the euro pretty soon. Here’s how Burroughs puts it:

When the skew starts to normalize, then the market may be convinced that Europe is getting a handle on this crisis. We are far from that point.

I’ll trust Eric to keep an eye on this chart — I wouldn’t know where to start even trying to build such a thing. But it seems clear to me that he’s right: we’re going to wait a long time before this chart stops sloping down and to the right. Which is another way of saying that we’re going to continue to have a crisis in Europe for the foreseeable future.

COMMENT

Interesting to note that while the Swiss Franc is high against the Euro, the Euro is still at the upper levels of historical values against the US Dollar. You need $1.44 to buy €1.00 today, but back in the days of the post launch “market test” of the Euro’s strength IIRC one Euro could only buy $0.87.

In global terms, aren’t they the only ones that really matter since they are the two world currencies fighting it out to be the World’s main Reserve Currency?

Posted by FifthDecade | Report as abusive

How austerity blooms on Keynes’s grave

Felix Salmon
Aug 19, 2011 15:37 UTC

James Macdonald has an extremely valuable way of putting things into stark focus:

The markets have highlighted a fundamental shortcoming in Keynes’s ideas: He assumed that governments would always be able to borrow. If they cannot, then Keynesian economics is dead in the water.

The thesis of Macdonald’s essay is simple and scary — and, I think, correct.

We have been living through, and are now probably witnessing the end of, an era with no historical parallels: what might be described as the “great debt experiment.”

In many ways this is a good thing. We’ve relied far too much, in the developed world, on debt-fueled growth — and that kind of growth rapidly becomes unsustainable in a world where the amount of growth that can be squeezed out of every marginal dollar of debt has been falling steadily for decades.

But deleveraging,which is great from a systemic-stability perspective, has another name in the short term: austerity. And that’s something we’re only starting to get used to, and which is going to get much more painful, especially in Europe, before this cycle has played itself out.

Greece was the first Eurozone country to find itself locked out of public markets; it won’t be the last. And even now, Greece can still borrow: the ECB and Eurozone have enough faith in Keynesian principles that, for the time being, they’re willing to step in as the lender of last resort to troubled sovereigns. But Greece is small enough to save in that matter; Italy, not so much. If the public markets shut out Italy, or if the Eurozone lacks the political will to continue throwing good money after bad, then we’ll immediately enter the most severe crisis of our lifetimes.

Here’s a couple of charts from Spiegel’s excellent slideshow on the subject to put Europe’s sovereign debts in perspective; the second one should be titled “debt”, not “deficit”. But the first one is the scarier one: it just shows the debt coming due by end-2013 in the five crisis countries. We have a serious liquidity issue here, never mind the questions of solvency raised in the second chart.

image-248828-galleryV9-sbqi.jpg

image-249015-galleryV9-jbbr.jpg

The Maastricht limit, of course, is the maximum debt that Eurozone countries are allowed to have. So much for that idea. And debt in general, as we saw in 2008-9, is a treacherous and precarious beast — you never want to push it to its limits. The market will roll over a country’s debts happily and indefinitely — until it won’t. Some countries, like Japan, are relatively safe in that regard: “the market”, there, is domestic savers in a country with a high domestic savings rate. But when a country is reliant on foreign investors to buy its debt, and can’t easily fund itself domestically, it’s playing an extremely dangerous game.

Is that the case in the US? Happily, no — as you might suspect, given the 10-year Treasury yielding 2%. But you’d probably be surprised how much of America’s $14 trillion debt is money we’ve lent to ourselves in one form or another.

image-248948-galleryV9-bidc.jpg

So the US, by rights, should be the last country onto the austerity train. We’re the happy recipient of the global flight-to-quality trade, we fund in our own currency, and we fund largely domestically. (Yes, the “public debts” includes a lot of foreign investors, and even some foreign sovereigns, but all that money being taken out of our paychecks in the form of social security contributions and the like goes a surprisingly long way — it’s forced lending to the US government, and it’s not going away.) There are serious questions about some countries’ ability to be able to continue to tap the capital markets; there are no questions at all about others. The US is, happily, in the latter category: if the Treasury ever stops borrowing, that will be thanks to Congressional edict, rather than due to any reluctance on the part of the markets to roll over debt.

That said, the US is running into enormous political problems just trying to make up with sovereign borrowing what the economy has lost in private-sector borrowing over the course of the recession. If it can’t rise to the Keynesian challenge domestically, there’s absolutely no way it will let itself be dragged into becoming a lender of last resort globally.

Which means that we’re in the final innings of the Keynesian game. If you look at the history of sovereign debt, we started with countries borrowing large sums of money from rich private-sector individuals like the Rothschilds. When those sums weren’t enough, the era of big publicly-owned banks began, and borrowing capacity rose sharply. Then we moved into domestic capital markets, and eventually international capital markets. Each move increased the amount of money available for lending to sovereigns. Finally, when sovereigns get tapped out, they can try to appeal to super-sovereigns: the ECB, the EFSF, the IMF and the like. But those funds are limited, and don’t last long. Hence the move to austerity — the only other option. Or, of course, there’s always inflation — the other way that the ECB can bail out overindebted sovereigns. But that doesn’t seem likely any time soon.

Update: Matt at Obsolete Dogma has a really smart response.

COMMENT

theinfamoush6, imagine if Al Gore had been elected. Then he would have got the blame for the crash after the dot com bubble, for not doing anything about 9/11, corporate scandals like Enron and WorldCom and probably destroyed his and Clinton’s reputation. Instead he is a multimillionaire Nobel Prize winner private jetting around the world telling people to lower their carbon footprint. Will bet he thanks all the major deities at night.

Posted by Danny_Black | Report as abusive

The CDS market and Greece’s default

Felix Salmon
Jul 22, 2011 13:46 UTC

ISDA has made the right decision: the Greek bond default does not and should not count as a “credit event” for the purposes of whether Greek credit default swaps will get triggered.

This is the right decision for two reasons. Firstly, the swap is voluntary. If you don’t want to suffer a haircut, or see your six-month maturity suddenly become a 30-year maturity, then all you have to do is nothing. If the CDS paid out, that would be tantamount to giving free money to anybody who wanted it: just buy short-dated Greek debt and also credit protection on that debt. The bonds will pay out in full, and the CDS would pay out as well.*

Secondly, this should be a large nail in the coffin of the CDS market generally. Credit default swaps were designed primarily for banks: it took many years before they became widely-traded speculative instruments in their own right. The idea behind them was that banks could keep loans on their balance sheets while at the same time hedging the risk that they would default. That was easier and cheaper than selling the loans outright, and also helped banks maintain good relations with their borrowers.

In the case of Greece, however, banks are going to take a 21% haircut on their loans to the country — and if they hedged themselves in the CDS market, too bad. Whatever they paid for their CDS protection — and if they bought it recently, it could be quite a lot of money — will not help them one bit. If buying CDS doesn’t help you in the event of a default, then there’s really no point in buying CDS.

So even though there isn’t going to be a formal credit event in Greece, have no doubt that this is a default — or, at least, that it will be a default if the banks are correct in anticipating a participation rate of 90%. But I have to say I’m surprised they’re so bullish, and I will be extremely impressed if Greece wakes up one morning to find that 90% of its private-sector debt has been tendered into the exchange.

For one thing, the exchange is structured in a pretty unsophisticated way. No matter whether you have a bond maturing tomorrow or a bond maturing in a decade, you’re swapping it into exactly the same 30-year instrument. Banks with short-dated Greek debt aren’t going to be happy about this, and will have a strong incentive to quietly sell that debt on the secondary market to someone willing to just hold it to maturity.

And more generally, it’s almost impossible to see why anybody who isn’t a bank would tender into this exchange. If you’re an individual holding Greek bonds, or a big bond investor like Pimco, the obvious thing to do is to hold on to your debt for the time being, since the exchange includes no carrots and no sticks. The only incentive for you to tender into the exchange is that the new bonds will be partially collateralized with zero-coupon 30-year bonds. Triple-A-rated 30-year bonds in euros currently yield 4%, which means that the collateral in the new Greek instruments will be worth less than 31 cents on the dollar. And so far, there’s been zero indication that holdouts will get anything less than all their money back, in full and on time; they might have a bit less liquidity, but bond investors are used to illiquid instruments.

Is it really the case that over 90% of Greek bonds are held by banks which will tender all of their Greek debt into the exchange? Maybe so; non-bank investors looking to go long Greek credit might well have found it easier and cheaper to do so by writing credit protection in the CDS market rather than buying cash bonds. In which case they’re smiling broadly today.

If that’s the case, then maybe this deal is one of those rare occasions where the CDS market was genuinely useful. Back in the 1980s, when sovereign debt was held overwhelmingly by banks, negotiations about restructuring that debt could be held with the London Club of bank creditors. Non-bank investors didn’t really matter. But then the loan market became a bond market, and investors in sovereign debt were mainly non-banks; no longer were negotiations even really possible.

Now, however, we seem to have come full circle: banks are able to put together bond-restructuring deals on their own, without worrying much about non-bank bond investors. And one reason would seem to be that the non-bank investors have largely moved from the bond market to the CDS market.

Is this scheme going to work? There’s a big collective-action problem at the banks, and an even bigger problem with the non-banks. So the 90% target is ambitious. But so far I haven’t seen much doubt. I will say this: if the 90% target is achieved, then the Institute for International Finance will deserve a lot of credit. I’m no fan of the organization — I’ve been very rude about it for many years. But if it manages to pull this off, it will finally and genuinely have justified its existence.

*Update: Kid Dynamite asks a good question in the comments: if the bonds paid out in full, wouldn’t the CDS auction clear at par, with the CDS paying out nothing? No. To a first approximation, the CDS auction clears at the price of the cheapest-to-deliver Greek bond, and Greek bonds are trading at a substantial discount. The cheapest-to-deliver bond will probably have a very long maturity, and if there was a credit event for CDS purposes, then holders of credit default swaps would get a nice check in the mail.

COMMENT

“banks are going to take a 21% haircut on their loans to the country — and if they hedged themselves in the CDS market, too bad”
CDS may (and shall) not be triggered, but I don’t think banks are writing down hedged bonds — unless they voluntarily participate of course.
Too early to say, though.

Posted by vastunghia | Report as abusive

Greece defaults

Felix Salmon
Jul 21, 2011 22:39 UTC

The latest Greek bailout is done — the official statement is here — and it involves Greece going into “selective default,” which is, yes, a kind of default.

I can’t remember a major financial story which has been covered so inadequately by the financial press. All the incomprehensible eurospeak seems to have worked, along with the fact that the deal was announced in Brussels, where the general level of journalistic financial literacy is substantially lower than it is in London or New York or Frankfurt. On top of that, statements are coming from so many different directions — Eurocrats, heads of state, the Institute of International Finance, Greek officials, Portuguese and Irish officials, you name it — that it’s extremely hard to put it all together into one coherent whole.

Oh, and to complicate things even further, most of the day’s discussion was based on various widely-disseminated draft documents which differed substantially from the final statement.

This is a bail-in as well as a bail-out: while Greece is getting the €109 billion it needs to cover its fiscal deficit, both the official sector and the private sector are going to take losses on their loans to the country.

As such, it sets at least two hugely important precedents. Firstly, eurozone countries will be allowed to default on their debt. Secondly, a whole new financing architecture is being built for Greece; French president Nicolas Sarkozy called it “the beginnings of a European Monetary Fund.”

The nature of massive precedent-setting international financing deals is that they never happen only once. There’s lots of talk today that this deal is for Greece and for Greece only, but some of the more explicit language to that effect was excised from the final statement. On thing is for sure: these tools will be used again, in future. They will be used again in Greece, since this deal is not enough on its own to bring Greece into solvency; and they will be used in other countries on Europe’s periphery too, with Portugal and/or Ireland probably coming next.

As far as the public sector is concerned, the European Union will do four main things. First, it will extend the maturities on Greece’s debt from the current 7.5 years to somewhere between 15 years and 30 years: the loans that the EU is currently giving Greece aren’t designed to be repaid, in some instances, until 2041.

Second, the interest rate on those loans will be extremely low — essentially, Greece is getting those EU funds at cost, currently about 3.5%. The EU is also extending these ultra-low financing rates to Portugal and Ireland, so as not to implicitly punish countries which don’t default.

Third, the EU will put together its own stimulus plan for Greece. The phrase “Marshall Plan” was taken out of the final statement, but there’s still talk of “mobilizing EU funds” and building “a comprehensive strategy for growth and investment.” This is vague, of course, but it does at least constitute an attempt to help Greece through a period of very painful austerity.

Fourth, the Maastricht treaty will get resuscitated, with all eurozone countries except Greece, Ireland and Portugal committing to bring their deficit down to less than 3% of GDP by 2013. Paul Krugman is screaming about this, but this was a central part of the eurozone project from the get-go, and clearly the eurozone needs some kind of fiscal straitjacket for its constituent members to prevent the rest of them from running up enormous deficits and then getting bailed out by Germany.

Finally, the EU will provide “credit enhancement” for Greece’s private-sector bonds. This is a central part of the default plan, and it looks a lot like the Brady plan of the late 1980s. The official statement from the IIF, which is representing private-sector creditors in this matter, is a little vague, but essentially if you’re a holder of Greek bonds right now, you have three choices.

  1. You can do nothing, and hope that Greece pays you in full and on time.
  2. You can extend your maturities out to 30 years, and accept a modest coupon of 4.5%; in return, your principal will be guaranteed with an embedded zero-coupon bond from an impeccable triple-A-rated EU institution, probably the EFSF.
  3. You can extend your maturities out to 30 years, take a 20% haircut, and get a higher coupon of 6.42%; again, the principal is guaranteed with zero-coupon collateral.
  4. You can extend your maturities out to 15 years, take a 20% haircut, get a coupon of 5.9%, and have only a partial principal guarantee through funds held in an escrow account.

The first option is by far the most interesting. No one has come out and said that Greece is going to default on bondholders who don’t exchange their bonds; instead, there’s just a lot of arm-twisting of big banks to do all this “voluntarily.” But that won’t stop the credit rating agencies giving Greece’s bonds a default rating — this is a coercive deal, which clearly reduces the value of banks’ Greek debt. (After all, just look at those haircuts.)

Is it possible for other bondholders — those who haven’t had their arms twisted — to free-ride on the back of this deal and continue to get paid in full? I suspect that it probably is. Which is one reason why this Greek restructuring won’t be the last.

Overall, this looks like a deal which can quite easily be scaled up and used as a framework for future default/restructurings. I don’t know if that’s the intent. But there’s nothing here to reassure holders of Portuguese and Irish bonds — or even Spanish and Italian bonds, for that matter — that they’re home safe. Greece will be the first EU country to default on its debt. But I doubt it’ll be the last.

COMMENT

If Greece defaults, it won’t be the first government to renege on its financial obligations, but its failure would set a new record, both for scale and complexity.

At the moment, the dubious honour of biggest deadbeat goes to Argentina, which failed to make good on its government debts in December 2001, to the tune of about $100 billion US.
but yes its quite important that What Will Be Outcome Of Greece Debt Crisis. http://www.abnglobalonline.com/what-will -be-outcome-of-greece-debt-crisis/

Posted by CienMichel | Report as abusive

Felix Salmon smackdown watch

Felix Salmon
Jul 20, 2011 05:48 UTC

Apologies to everybody here who would normally warrant a whole blog post of their own, but I’m way behind when it comes to catching up on the Felix Salmon smackdowns and so I’m going to clear them all out in one fell swoop, starting with:

Yves Smith, who hates my post on triple-A debt so much that she accuses me of “spending too much time with lobbyists from ISDA and SIFMA”. Her main beef is with my contention that an excess of overcaution was responsible for the enormous demand for triple-A debt. That can’t be true, she says:

If there was “overcaution” you would have seen a wide spread between AAA bonds and lesser-rated bonds.

The first thing to remember here is that there were so many triple-A bonds at the height of the bubble that all the other bonds in the world combined were in the minority. The supply of triple-A debt expanded to meet the demand for it; lesser-rated debt had its own supply-and-demand dynamics and spreads became tight as the Great Moderation thesis took hold.

On top of that, the bond bubble generally was indicative of overcaution: if cautious people buy triple-A-rated debt rather than other debt, they also buy bonds rather than stocks. An overcautious world has too many bonds relative to stocks and too many triple-A bonds relative to other bonds. That’s exactly what we saw.

Yves has her own explanations of the rise in triple-A-rated debt. One is the rise in the derivatives market, which meant a similar rise in the demand for triple-A-rated collateral; the other is regulatory arbitrage, in that under Basel II, banks could hold triple-A debt on their books with zero capital requirements.

Both of these explanations are entirely true, but they’re not really dispositive of my thesis; in fact, both are symptoms of the very overcaution I’m talking about. Collateral is designed to protect you in the event that your counterparty makes bad bets and can’t pay; by asking for triple-A-rated collateral, Wall Street essentially outsourced its diligence to the ratings agencies while being able to say that it had extremely high standards. And the Basel II rules, too, gave triple-A-rated debt a zero risk weighting because they wanted to encourage banks to stay cautious when it came to the quality of their assets.

Next up comes Richard Smith, also at Naked Capitalism, with a very long post taking issue with my very short dismissal of the idea of coin seignorage as a tool to get around the debt-ceiling problem. I should probably explain my position in slightly more detail: yes, there is an argument to be made that coin seignorage is legal and that it could be done without Congressional approval if the coins were made of platinum or maybe palladium. But just because something can be done doesn’t mean it should be done. We shouldn’t rule via loophole, and more importantly, we shouldn’t take monetary policy out of the hands of the Fed and put it into the hands of Treasury. Sometimes, in a crisis, loopholes are the only way to get things done. But we’re not in a real crisis right now — insofar as we’re in a crisis at all, we’re in an utterly fake one. So let’s deal with the root of the problem, which is Congress, rather than trying to ignore it with the use of dangerous loopholes.

Then there’s Brad DeLong, who isn’t impressed with my take on Larry Summers:

Let us parse this:

  1. Summers says that peripheral countries that cannot access the private market cannot repay their debts if the strong countries of Europe charge them high premium interest rates.
  2. Summers says that peripheral countries that cannot access the private market can repay their debts if the strong countries of Europe charge them the interest rates at which the strong countries can borrow.

Both of these statements by Summers seem to me to be true. It is often the case that debt loads that are unsustainable at high interest rates are very sustainable indeed at low interest rates.

But to take a very salient and obvious example, the debt load of Greece is clearly not sustainable, even if it were brought down to German-government interest rates.

Brad also has a clever way in which the ECB can take $10 billion of French and German money and turn it magically into $471 billion of liquidity which could be provided to Italy. But bringing the ECB into this doesn’t help matters: yes, of course the ECB can lend $471 billion to Italy and it could probably do so even without a French and German guarantee. But it won’t, because (a) doing so would be politically impossible and (b) doing so would violate Article 123 of the Lisbon Treaty, which bans monetary financing.

Finally, there’s John Hempton, with his novel thesis that “the last ethical newspaper company is News Corp”, on the grounds that it’s the one company where the proprietor doesn’t ask for journalists’ sources. I’ll leave the rebuttal of this one as an exercise for the reader, I think; I’ll simply note that Rupert Murdoch is perfectly happy dictating his newspaper’s front pages, sometimes with highly embarrassing consequences. Does that sound like a company where the proprietor is assiduously disinterested in his newspapers’ content to you?

Do keep the smackdowns coming. They’re the true essence of blogging.

COMMENT

Yeah I guess I am not clever enough to work out how cash goes down in value. Have you considered a job in financial journalism?

Posted by Danny_Black | Report as abusive

Larry Summers’s inadequate plan for Europe

Felix Salmon
Jul 18, 2011 16:59 UTC

Larry Summers reckons that “with last week’s tumult in Italian markets, the European financial crisis has entered a new and far more dangerous phase”; he’s right about that. But his prescriptions for what must be done, laid out in the second half of his column, are a mess. For one thing, they’re impossible to implement from a political perspective. For another, they contradict Summers’s own diagnosis of what the problem is, as laid out in the first half of his column. And in any case they’re a textbook case of too little, too late: even if implemented they wouldn’t actually fix the problem.

Summers is quite right, in the first half of the column, to write this:

The approach of lending more and more from the official sector to countries that cannot access the market at premium rates of interest is unsustainable. The debts incurred will in large part never be repaid, even as their size discourages private capital flows and indeed any growth-creating initiative.

It’s hard to see how he can square that with his prescription in the second half of the column:

First, for program countries. Interest rates on official sector debt will be reduced to a European borrowing rate defined as the rate at which common European entities backed with joint and several liability by all the countries of Europe can borrow. A default to the official sector will not be tolerated so there is no reason to charge a risk premium, since charging a risk premium needlessly puts the success of the whole enterprise at risk.

Somehow, Summers has magically gone from “the debts incurred will in large part never be repaid” to “default to the official sector will not be tolerated so there is no reason to charge a risk premium,” without ever explaining how he got there from here.

It seems, here, that Summers has gone effortlessly from “you can’t just extend and pretend that there won’t be any default to the official sector” to “let’s extend and simply declare that there won’t be any default to the official sector.”

It’s precisely this kind of thinking that the tumult in Italian markets makes untenable. As the chart in Summers’s column makes clear, Italy has $471 billion of government debt maturing in less than one year. If the private-market window for Italian debt closes as it has done for Greece and Portugal, then the official sector would be on the hook to lend Italy that entire sum itself. And there’s simply no way that Europe can find that kind of money, especially not if it’s lending it out at close to risk-free rates.

And then it gets worse:

Third, there must be a clear and unambiguous commitment that whatever else happens, the failure of major financial institutions in any country will not be permitted. The most serious financial breakdowns—in Indonesia in 1997, Russia in 1998, and the USA in 2008–come when authorities allow there to be doubt about the basic functioning of the financial system. This responsibility should rest with the European Central Bank with the requisite political support and cover provided.

The implication here — although Summers doesn’t quite spell it out — is that the debt of a country’s banks can and should be safer than the debt of the sovereign. That’s something which has never worked in the past, and it’s very hard to see how it could possibly work in the future. After all, if you look at the assets of any given country’s banks, sovereign debt in one form or another constitutes a huge proportion of that number. And look what Summers wants to do to that debt:

Creditors gain nothing from breakdown. They have signalled that they will support an approach based on a menu of options. Some will want to sell out of their exposures at prices marginally above their current market value. Others who still regard sovereign European debts as worth par should be provided with appropriate reduced interest rate, longer maturity options. Debt repurchases are a possibility if the private sector accepts sufficiently large present value debt reductions. The key standard by which any approach should be judged is the genuine sustainability of program country debt repayments on realistic assumptions.

If the present value of the banks’ debt plunges, then the banks become insolvent and fail. If that will not be permitted, then the present value can’t go down very much. In which case you’re unlikely to get to the “genuine sustainability” that Summers wants.

In general, if you have a private-sector debt restructuring where reprofiling is an option — where principal value is untouched and maturities just get termed out with lower coupons — then that’s not going to make enough of a difference to the stock of sovereign debt to make the difference between unsustainable and sustainable. On the other hand, if you take a serious hatchet to the stock of sovereign debt, then there’s no way that any country’s domestic banks could avoid failure.

Summers says of his plan that “much of this will seem unrealistic given the terms of Europe’s debate.” But frankly most of it seems unrealistic just on its own terms — it doesn’t bring countries back onto a sound fiscal footing, and it punts the questions of how much they can be lent by the official sector, and how much the ECB would have to spend to bail out their banks. Summers is quite right that the European debt situation is dangerous. But he doesn’t have much of a plan to deal with it.

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