Monday, October 17, 2011

A framework for assessing a eurozone rescue

As we approach the October 23 eurozone summit, there will lots of news, leaks and trial balloons. To cut through the noise, here is a framework for assessing the credibility of any rescue plan. In the long term, either:
  • Greece and the rest of southern Europe will have to become more competitive. The obvious answer is currency devaluation. This means leaving the eurozone, either as a bloc to form a southern and softer euro, or individually (which could mean leaving the EU altogether).
  • The eurozone forms a transfer union, with the North supporting the South through a series of transfer payments channeled through Brussels. This will mean that member states will give up some degree of fiscal control and sovereignty.
According to Jeremy Warner of the Telegraph, Jean-Claude Trichet pointed out that the eurozone is actually in pretty good shape on the whole:
As Mr Trichet pointed out at the AFME dinner, if the eurozone were a single country, it would actually look like a model economy, with a small current account surplus, a primary budget deficit of less than half that of the UK and the US, subdued household debt, low inflation and a little growth.
The reality is the eurozone isn't a single country. It doesn't have a fiscal union. Wishing that it did doesn't make the current problem go away. Warner went on to ask the bigger question raised by a Greek rescue:
Such bailouts risk an Alice through the Looking Glass world where sovereigns are borrowing money to prop up banks that only need propping up because the sovereign has borrowed too much money. There's a self-defeating circularity about it which raises the obvious question of "who bails out the bailer-outer".
All these issues don't have to get resolved at the October 23 summit, nor do I expect that they will be. More immediately, the EU member countries will seek to kick the can down the road in order to settle these two choices that I raised. To rescue Greece and stop the contagion from spreading, you need to active particpation of three players:
  1. The EU needs to formulate a credible plan.
  2. The ECB needs to become more pragmatic and embark on quantitative and qualitative easing.
  3. The Greek Street has to agree to any austerity plan.
The immediate question then becomes, "Can all these elements cooperate in a credible way to avert a meltdown?"

The EU plan is coming together
In late August, I characterized the European players as looking like a circular firing squad, with no plan and no one in charge. Today, the Germans and French have taken control and they to be forming some semblance of a plan. In the wake of this weekend's G20 meeting of finance ministers, Bloomberg reported the outline of the Franco-German plan and the sense of urgency of the participants:
Europe’s strategy currently includes writing down Greek bonds by as much as 50 percent, establishing a backstop for banks and magnifying the strength of the newly-enhanced European Financial Stability Facility, people familiar with the matter said yesterday. Optimism the two-year crisis may soon be tamed spurred stocks higher this week and pushed the euro to its biggest gain against the dollar in more than two years.

European officials “will have left Paris under no misunderstanding that there is a huge amount of pressure on them to deliver a solution,” U.K. Chancellor of the Exchequer George Osborne told reporters. Next weekend “is the moment people are expecting something quite impressive.”
There will be the inevitable sniping from the sidelines about any plan. What I am watching for is the validity of any criticism. For example:
  • The banks have come out against recapitalization. Is this grandstanding? They have threatened to get to the targeted capital ratios by shrinking their balance sheet, i.e. calling in loans, which would cause a credit crunch and cause Europe to nosedive into a severe downturn, rather than raise new capital by diluting their shareholder base. Deutsche Bank has also attacked the recapitalization plan in a similar way, yet at the same time they are said to be weighing a rights issue.
  • Will the bank recapitalization plan focus on the right ratios? This column from Jonathan Weil says it all. "Regulatory capital should not be confused with the actual amount of capital banks have in real life", he wrote, because "the French-Belgian lender Dexia SA reported having a 12.1 percent core Tier 1 capital ratio as of Dec. 31, the date the banking authority used for its latest stress tests." Oops.
  • Will the EFSF or any other bailout mechanism have enough to "shock and awe" the markets? In an interview last Friday, Bank of Canada governor Mark Carney stated that the current EFSF size of €440 billion was insufficient and went on to say, "You need to overwhelm the markets. You need to put on the table more than is necessary."  He added that the effective capacity needed to be at least €1 trillion (and he may be conservative with the €1 trillion figure because he was speaking on the record). This is an unusually frank level of public criticism from a G-7 central banker that has to be taken seriously. We have also heard similar criticism that the EFSF is too small from others, such as Tim Geithner. There are several proposals on the table to extend or lever up the EFSF. We'll have to see how credible or effective those are. The ECB has come out against the EFSF. There are, however, other proposals such as to turn it into an AIG-like *shudder* bond insurer. This brings me to my next point...
  • What is an EFSF guarantee worth? This was the question asked by FT Alphaville: "What would the state of the EU be if Italy had to default? Can you count on the EFSF guarantee in such a case?" Also see why the EFSF is not the holy grail for similar arguments. These objections raise a very valid point of the creditworthiness of the EFSF. For traders, though, it is less relevant as any rescue deal that doesn't immediately fall apart and kicks the can down the road would result in a rally of risky assets - and that's all they care about. For investors, it is an important consideration. These issues tend not to matter to the market until they matter.
  • What is the actual reduction in Greek debt vs. the level of debt haircut? This was another important point posed by UBS (vis FT Alphaville). Assuming that the IMF and ECB do not tender their Greek debt to a "voluntary" exchange offer, what level of haircut does the private bondholder have to take in order to achieve a X% reduction in Greek debt [emphasis added]:
[A] 50% haircut effectively equates to a 22% reduction in existing debt once the [Greek] banks have been recapitalised. This is far from enough. Or, to put it another way, to achieve an actual 50% reduction in the debt, Greece would need to implement a 100% haircut, i.e. repudiate its debt totally....

What the UBS economists have done is assume that both the ECB’s holdings of bonds and the official eurozone and IMF loans will avoid being written down. This will put all the load on the private holders despite the eurozone loans supposedly ranking equal with them. (Ask the Finnish government how likely that equal ranking will be…)"
This is a more important point for traders as the level of net reduction in Greek debt will be relevant to the Greek government and Greek Street. Insufficient debt reduction will have the potential to unravel the deal.

Will the ECB go nuclear with QE?
Can you imagine the Lehman aftermath without the cooperation of the Federal Reserve? The government unveils TARP, TALF and an alphabet soup of programs to rescue the American financial system. The Fed then proceeds to obstruct the rescue by refusing to engage in quantitative easing. Their efforts to supply liquditiy to the market is limited to collateralization by Treasury issued securities (and not mortgage backed and other "toxic" paper)? What would have done to credit spreads? What would that have done to inter-bank lending and counterparty risk? Might that cause a bank run like this?

Or like this?

Unlike the Federal Reserve, which has a dual mandate of fighting inflation and to maintain economic growth, the European Central Bank only has the single mandate of fighting inflation. That's why they have so far refused to engage in QE. Were the ECB to tender their Greek debt to the current voluntary 21% haircut offer, it would render them insolvent. There are two solutions, both of which are unpalatable. They can either go to member states for more capital, or they can engage in quantitative easing.

In my opinion, for any rescue deal to be credible, the ECB needs to cooperate with an EU plan. They have to be prepared to go nuclear and announce that they will print whatever it takes in order to reflate the PIIGS and that amount may have to be in the €1-3 trillion range. Moreover, they may have to hold their noses and accept toxic sludge as collateral in order to reliquify the system, just as the Fed did during the 2008-9 episode, and ride roughshod over any objections over the practice of "qualitative easing".

Such a volte-face may not be in the DNA of the Vichy European Central Bank. Consider these stories of how much of an obstacle that the ECB could be. They has come out strongly against sovereign default (FT Alphaville: You shall not default, the ECB commands it):
Against this background, the ECB has strongly advised against all concepts that are not purely voluntary or that have elements of compulsion, and has called for the avoidance of any credit events and selective default or default.
They argued that:
PSI [Private Sector Involvement] could also damage the reputation of the single currency internationally, possibly adding to volatility in foreign exchange markets. In particular, public and private international investors may be cautious about investing large portions of their wealth in assets denominated in a currency of sovereigns that may not fully honour their obligations and may be willing ex ante to rely on PSI in some circumstances.
FT Alphaville pointed out the unintended consequences of this piece of dogma [emphasis added]:
Frankly though, we’re amazed if the ECB thinks it has the suasion power to tell sovereign debtors what to do. And by linking the euro explicitly to a no-default rule, we would argue that they only make it more likely that sovereigns will leave the euro altogether in order to default
Here is another hint that the ECB may not be totally cooperative. Incoming ECB chief and current Bank of Italy head Mario Draghi, has admonished his own government for fiscal profligacy:
"We must act fast. The sorts of interest rate rises seen over the last three months, if protracted, could lead to an uncontrollable spiral," said Mario Draghi, who takes over as head of the European Central Bank next month.

Mr Draghi said austerity measures must be enacted "immediately" and warned that Italy's €54bn austerity package is "not enough"...
Mr Draghi hinted that ECB help is nearing its political limits, evoking Italy's "atavistic temptation" of waiting for an army to cross the Alps to sort out its problems. "It is not going to happen. All our citizens must be are aware of this. It would be a tragic illusion to think that the help will come from outside," he said.
Does this sound like someone who will embrace quantitative easing?

More surprising is the story that the ECB tells Belgium not to guarantee Dexia’s interbank deposits:

The European Central Bank advised Belgium not to backstop Dexia SA (DEXB)’s interbank deposits and to avoid providing guarantees on debt maturing within three months because it risks interfering with the central bank’s monetary policy.
The ECB also said the planned debt guarantees for Dexia may last as long as 20 years, which is inconsistent with European Union guidelines for national support measures to be temporary in nature, according to a statement published on the Frankfurt- based central bank’s website and dated Oct. 13.
James Saft points out that the ECB is a central bank like no other in that it isn't necessarily the lender of last resort (perhaps we need to rely on the SNB for that role because they vowed to prevent the CHFEUR exchange rate from rising) [emphasis added]:
While the ECB is a central bank in almost all respects, what it isn’t is a lender of last resort for individual euro zone nations, a role that is expressly ruled out by the European Treaty.
On the other hand, the latest G20 communique contained an odd statement which, if it applied to the ECB, suggests that they may be prepared to play ball [emphasis added]:
We remain committed to take all necessary actions to preserve the stability of banking systems and financial markets. We will ensure that banks are adequately capitalized and have sufficient access to funding to deal with current risks. Central banks have recently taken decisive actions to defend, and will continue to stand ready to provide liquidity to, banks as required. Monetary policies will maintain price stability and continue to support economic recovery.
What does the phrase, "maintain price stability and continue to support economic recovery", mean? The latter phrase has never been part of the ECB mandate?

Of course, this may just be a turf war. This analysis suggests that the ECB may just be using a crisis to maximize its powers:
It is important to remember that the ECB is not a normal independent central bank in the mold of the Bank of England, the Bank of Japan, or even the Federal Reserve. Normative academic studies of what outcomes monetary policymaking should target and how to achieve them rarely apply to the ECB. It has no single government counterpart within Europe and thus enjoys far more political independence than any other large central bank.

This unique independence derives from Article 282 of the EU Treaty [pdf], which states that the bank “shall be independent in the exercise of its powers and in the management of its finances. Union institutions, bodies, offices and agencies, and the governments of the Member States shall respect that independence.” In other words, the ECB has no political masters. Even if it did, the treaty would bar them from criticizing its decisions.
If the ECB's ultimate endgame is more power, might it be more cooperative when the chips are down and come to Europe's rescue at the last minute? Here is what the Bank wants:
The ECB’s overarching goal is for the euro area’s politicians to establish credible European institutions working alongside the bank. It seeks, for example, bulletproof fiscal constraints on euro area members (something more credible than the Stability Growth Pact, which was widely ignored). It also wants a common euro area crisis fund to relieve the bank of the primary bailout responsibility. In addition, the ECB wants individual member states to accelerate structural reforms in their national economies.
Such goals cannot be achieved within several weeks, which is the timeframe for rescuing the eurozone. If that is indeed the case, don't necessarily count on them to be a team player in any rescue deal.

Will the Greek Street cooperate?
As austerity starts to bite down hard, the Greek Street can rebel, either figuratively or literally. My base case is that Greece will go along with whatever package the Eurocrats fashion, as long as it doesn't include more fiscal pain. However, here is a report from Naked Capitalism of a report from Greece that highlights the risks involved:

Red = the IMF-EU program is not beneficiary for the country
Blue = it is beneficiary
The most important slide which shows the bankruptcy of the ruling system in Greece is the following. Please pay attention…

Red = do not trust
Blue= trust
Top bar (1st) = fellow citizens/people
2nd= social movements
5th=trade unions
8th=political parties
The Greek government is no doubt aware of the risks. The latest Reuters headlines Papandreou begs Greeks to help avert "catastrophe" as strike-hit Greece heads to standstill ahead of crucial vote are testaments of the power of the Greek Street. This is a huge wildcard to which I have no insights. This is the stuff of revolutions and civil turmoil. At the very least, Greece could pull an "Argentina", as explained by John Hempton of Bronte Capital:
When Argentina defaulted not only did the government default but they forced a private default. If you had a debt in US Dollars in Argentina prior to the default you were forced to pay it back in Peso. Indeed it was illegal to make payment in US dollars.

Likewise if you had a US dollar asset you got back Peso. A dollar deposit in Citigroup in Buenos Aires became a peso deposit. If you really wanted to keep your dollars you needed to make your Citigroup deposit in New York.
The forced private sector default was necessary for Argentina. The Argentine banks all had lots of US dollar funding. If you devalued without forcing their default then they would all have uncontrolled defaults (a true disaster) and the country would lose its institutions. Telefonica Argentina would have failed too - failing to replay USD debts.
The same applies in Greece. If the Greek Government were to devalue the new Drachma (to perhaps a third the value of the Euro) then the banks (which are loaded with Greek Sovereign paper) would default. Even Hellenic Telecom would default because they would be forced to repay their billions of Euro borrowings whilst collecting only Drachma phone bills.
At the extreme, Papandreou could be assassinated or the military could stage a coup d'etat. It was certainly within my lifetime that Greece was ruled by a military junta. (Maybe that's why they just bought 400 American tanks).

I might also add that another wildcard is the behavior of the other peripheral countries. John Mauldin visited Ireland and wrote that the Irish fully expects to be offered a debt reduction on terms similar to Greece [emphasis added]:
When you press politicians and establishment types (and I did) who are against unilaterally disavowing the debt, a strange thing happens. I kept asking, "But the voters seem to want to forego the debt. And the math suggests that Ireland can't pay back these foreign bankers without great sacrifices." At first, they would point out that Ireland is doing what needs to be done: cutting spending and payrolls. We are not Greece, they say; there is a need for "respectability." But when pressed, they would come around to admitting that, "Yes, Ireland will get a haircut." Everyone I met expected it to happen. The difference was the path to the haircut. But while the politics matter, the destination is the same.

Some favor doing it outright. Others truly believe they will be offered a haircut when Greece and Portugal get theirs. They fully expect it. In a meeting with an establishment-insider economist (off the record), who was at the table when the first deal was done, he said there was an implicit understanding with the IMF (and ECB) that whatever was offered to Greece, et al. would be available to Ireland. So Ireland went along with the bailout to keep from imploding the euro and averting a crisis that would have been biblical in proportions. The future of the euro is now not in their hands, because by taking on the debt they did not blow the euro up. Which could have happened, because European politicians were not ready for such a crisis.

So rather than having to kick the door open for a haircut, they expect the door to be opened for them by the IMF and the ECB. A far more respectable path for those who are very pro-Eurozone. But Irish leaders clearly get that voters expect that something will be done. They have time, as it will be another three-plus years before elections. By then, the crisis will have fully evolved and resolved itself, as far as the political public is concerned. And politicians will take the credit, as they always and everywhere do.

Nomura's geopolitical analyst Alastair Newton is highly concerned about Europe. Pay attention about what he says about the precarious position of Portugal [emphasis added]:
  • Greece: It will struggle to meet obligations for its bailout and could see its government collapse at any moment.
  • Portugal: Before presenting a draft budget to parliament on Monday, Portugal is expected to announce a new austerity package amidst rising civil discontent. Portugal is looking like the new Greece.
  • Spain: Despite the progress made by the outgoing Spanish government, Newton thinks the country's troubled banking system continues to face contagion from Portugal. Its November 20 general election, however, is likely to bring the Partido Popular party to power or a coalition which will push through more reforms.
  • Italy: It needs to win back market confidence as investors are panicked about contagion risk and the country's politics. The country failed to pass its 2010 budget and amidst his other scandals, prime minister Silvio Berluscnoi's leadership is in doubt.
  • France: Newton is concerned about the 2012 elections. Though incumbent President Nicolas Sarkozy is 5 percentage points ahead of his biggest threat Marine Le Pen, a run-off between Le Pen and a Socialist candidate (to be decided next week) would not settle well with markets.
The degree of proposed fiscal austerity will create enormous tensions within many European societies. Ambrose Evans-Pritchard compared Japan and Europe and noted that Europe is already suffering from youth unemployment levels that are off the charts and then rhetorically asks what will happen when further austerity measures are imposed:
Even today, the jobless rate for youth is near 10pc in Japan. It is already 46pc in Spain, 43pc in Greece, 32pc in Ireland, and 27pc in Italy. We will discover over time what yet more debt deleveraging will do to these societies.

He agreed with Alastair Newton that Portugal is in very precarious shape:
Portugal is in much the same trouble, despite the heroic austerity drive of premier Pedro Passos Coelho -- a latter day Marques de Pombal. The country’s total debt will top 360pc of GDP next year, and its current deficit is stuck near 10pc of GDP. This mix is worse than in Greece.
Rome erupted in riots on the weekend. Even in Germany, there are signs of civil unrest (see Left-wing terror group blow up railway line in EIGHTEENTH attack in three days). Once you open up the Pandora's Box of civil unrest, you can lose control and won't have any idea of where it leads.

Watching the signs 
As the week pass, my inner trader continues to watch the news headlines to see if the three main players can cooperate and form the platform for a rescue deal. Right now, the biggest question is whether the ECB will be a team player. Recall Jeffrey Grundlach's comment about cooperation and divisiveness (via Josh Brown):
On Bull Markets and Bear Markets: If you study history, you'll see that "bull markets are about cooperation, bear markets are about divisiveness." Jeffrey says the Euro common currency came about in 1999 at the very peak of global cooperation, the fact that asset prices peaked around then too is not a coincidence. Right now divisiveness is everywhere and a global bear market is underway.
My inner investor, on the other hand, is watching the bigger picture of whether Europe can move back into a sustainable path for growth, or will any solution just kick the can down the road once again without the real problems getting resolved.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.  


EP Chamberlin said...

Thanks for your assessment.
It helps to cut through the wailing and gnashing of teeth that arise whenever individuals/states/nations are told they cannot live on credit forever.

EP Chamberlin

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FGH said...

This is the most insightful presention of the EU wrestling match that I have read anywhere. Why should EU politions "do the right thing" with Geithner's IMF saying things like : "We have very, very substantial uncommitted (i.e. US taxpayer) resources" - to throw down the EU rathole. In the end Germany and France will protect their OWN banks and leave the rest to the mercy of the IMF, which of course will be a disaster of epic proportions and those new Greek tanks will get plenty of use.

Macro Rants said...

I think your initial assessment was good, though I think incomplete. The two choices are (1) PIGS become more competitive; or (2) EU becomes a giant transfer system.

You neglected to point out that choice #2 is essentially World War One reparations. Use whatever silly politically correct labeling you like, but be honest enough to call a spade a spade. Huge ongoing transfer payments do not make for a stable system.

Europe's true list of choices are:
1) PIGS become competitive
2) Continent wide warfare
3) The EU goes back to its more modest pre-1999 configuration

Tiho said...

Copper, Crude Oil or Emerging Market indices are not falling because of Greece, PIGS or EU debt problems.

These assets are falling because of Chinese economic deceleration. It seems everyone is focused on Europe. You should be looking East!