Wednesday, March 24, 2010

More on Euroland crisis

I have blogged earlier about how Greece has become the symbol of what ails the 16 nation European Monetary Union (EMU).

The experiences of many of the periphery economies of Euroland have mirrored the real estate bubble and post-bubble banking crisis that characterized US and UK. However, unlike both these countries (and others facing similar problems), who undertook unconventional monetary policy actions to loosen monetary policy and unprecedented fiscal stimulus spending to boost aggregate demand, recession fighting policies in the Euroland countries has been on a divergent trend.

As a consequence of the original sin with the rigid conditions imposed under the Growth and Stability Pact and the absence of any political union, these economies start with the considerable disadvantage of fighting the deep recession and financial crisis without the freedom to make the full use of the conventional fiscal or monetary policy tools. Adding to their discomfiture is the reluctance of stronger economies of Germany and France to assist them with any form of bailouts.

In fact, far from supporting them with liquidity injections, Germany has reiterated its traditional preference for fiscal austerity measures and have backtracked from any support for Greece. These calls for fiscal contraction during such a deep recession and financial market crisis threatens to tip Greece into a deflationary spiral and raise unemployment to politically unacceptable levels.

Simon Johnson and Peter Boone point to an IMF assessment that by the end of 2011 Greece’s public debt will be around 150% of its GDP, of which about 80% is foreign-owned. The major share of the foreign holdings are by investors from Germany and France, who flocked into the debt offerings of countries like Greece, Spain and Portugal in the later half of the last decade.

While other countries have in history managed their economies with much higher debt-to-GDP ratios, Greece suffers from a major credibility problem and economic weakness in addition to the lack of conventional macroeconomic stabilization tools. Paul Krugman points to a recent working paper examining public debt and banking crisis by Carmen Reinhart, and argues that some developed countries have managed their economies with relatively less disruption even when they had public debts in excess of 250% because they had stronger economies. He argues that "it’s not so much that bad things happen to growth when debt is high, it’s that bad things happen to debt when growth is low".

Given its precarious public finances (fiscal deficit of 12.7% of GDP) and stuttering economy, it is inevitable that Greece will need to repeatedly reschedule repayment of debt coming due for the immediate and foreseeable future (nearly half of Greek debt will roll over within three years). However, this would require offering attractive interest rates to get investors to buy Greek bonds. The spreads on Greek debt have widened since the crisis erupted.



Boone and Johnson estimate that for every 1 percentage point rise in interest rates, Greece will need to send an additional 1.2% of GDP abroad to its foreign bondholders. At a realistic interest rate of 10%, Greece would need to send at total of 12% of GDP abroad per year, once it rolls over the existing stock of debt to these new rates. As both they and Paul Krugman writes, this is simply unsustainable for Greece.

Therefore, even with the stringent austerity programs, it becomes almost a fait accompli that Greece can avoid a sovereign default - with its disastrous consequences for European (and global) financial markets (remember the massive share of European investors in Greek bonds) - only with massive capital infusions from the major European powers. Boone and Johnson estimates this capital requirement to be around 180 billion euros for the next few years. They advocate granting of long-term, subsidized loans that ultimately would cover a large part of the liabilities coming due in the next 3-5 years as the only solution to retrenching Greece's debt at an affordable level. And, even on such generous terms, Greece would probably need a daunting 10%-of-GDP fiscal adjustment just to return to a more stable debt path.

WSJ has a good article on how Ireland, another country which experienced the excesses of the property bubble and slipped into massive debt and public deficit (fiscal deficit of 12% last year), has been taking some steps towards recovery. The Irish GDP declined 7.3% in the third quarter of 2009 compared with the third quarter of 2008; exports were down 9% year on year in December 2009; and house prices havce fallen by more than 50% since 2008 and continues to fall.

The Irish government announced and implemented a massive fiscal austerity program which cut down on government expenditures, including social security spending and wage cuts (public sector salaries cut by 20% since 2008), that have been received positively by the financial markets, as reflected in the narrowing spreads on Irish debt. However, the spending freezes have adversely affected consumption, which forms nearly half the GDP, and is contributing towards keeping the economy weak.

Being in the Euroland means that Ireland cannot rely on the conventional tools - cutting interest rates and devalusing currency - to stimulate its economy. The only way for export dependent Ireland to retain its competitiveness is to cut wages, which had risen sharply during the real-estate and economic boom of the last decade. This will only add to the pressures on economic growth.

As Peter Boone and Simon Johnson point out in another article, Ireland's fall from grace from being the poster child of liberalization in Europe offers important lessons. With its massive investments in education (especially higher education), aggressive courting of investments in knowledge-based industries, ultra-low corporate tax rates (at 12.5%, the marginal corporate tax rates are amongst the lowest in the world), and fiscal prudence (the public debt to GDP ratio of 25% was one of the lowest among developed economies), Ireland was amongst the fastest growing economies in the Western Hemisphere.

However, like the US, Ireland experienced a spectacular property bubble financed by cheap credit from its major banks. Its three main banks built up 2.5 times the country’s GDP in loans and investments by 2008. But when the crash came in the fall of 2008, property prices fell over 50% and people started defaulting on loans, the Irish government bailed them out. The government injected cash into these banks and purchased their worthless assets for government bonds. As Boone and Johnson write, "one way or another, the government will have converted the liabilities of private banks into debts of the sovereign (i.e., Irish taxpayers)... It could have avoided taking on private bank debts by forcing the creditors of these banks to share the burden". Thanks to this largesse, the public debt to GDP ratio of Ireland is estimated to cross 100% by end of 2011.

Peter Boone and Simon Johnson also argue that any sustainable solution to the debt crisis in the periphery countries will have to include some form of restructuring involving the creditors taking "haircuts" on their capital. In the event of such defaults, forced or otherwise, by these countries, those most affected would be creditors in Germany and France. It would be a just penalty for those reckless creditors who threw caution to the winds in lending to the "Banking Real Estate Complex" in Ireland and financing the Greek government's irrepsonsible spending on its bloated (and unionized) public sector over the last decade.

In light of the aforementioned experiences, a centralized fiscal and monetary stabilization authority may be a necessary pre-requisite for successful monetary union. I have already posted on the proposal gaining wide currency about a centralized European Monetary/Fiscal Council, which would help struggling members with their exchange rate crises, macroeconomic imbalances or debt problems. It will help such countries implement counter-cyclical fiscal and monetary policies to provide all the required traction to flagging economies during down-turns.

In a Vox article, Micheal Burda calls for the setting up of a European Monetary Fund (EMF), with the same type of prudent, independent governance as the European Central Bank as the logical next step along the path of political integration. See also Daniel Gros and Thomas Mayer making a more detailed presentation in Vox of their EMF proposal.

WSJ has an excellent interactive graphic, prepared by RBC Capital Markets, which offers an assessment of the relative strengths/weakness of many developed economies with respect to fiscal deficits, debt loans, growth rates and inflation. It then uses a 'sovereign risk' index to capture the riskiness of the country.

Update 1 (25/3/2010)
In an announcement that would be welcomed by banks and other lenders with exposure to Greece, the European Central Bank (ECB) will hold off tightening lending rules until 2011 and would also keep the credit ratings for the collateral that its accepts from banks, in return for short-term loans, at an exceptionally low level (it had been lowered as an extraordinary measure to help banks in the euro area weather the global credit crunch) for longer than planned.

This re-assurance comes in the aftermath of Germany's refusal to support any financial commitments to Greece, except as a "last resort", when the country can no longer borrow on financial markets.

Update 2 (30/3/2010)
Greece finally managed to raise $6.7 billion by issuing seven-year bonds priced to yield 6%. This rate is a princely 3.34 percentage points above what Germany, considered the European benchmark, pays to borrow at a similar maturity. It was also well above the rates paid by the governments of Portugal, Spain, Ireland and Italy, other countries where indebtedness has caused concern.

Last week, the European leaders had announced that, as the last resort, EMU member nations would offer Greece coordinated bilateral loans "as part of a package involving substantial International Monetary Fund financing", in exchange for which Greece offered a package of painful austerity measures this month for a population accustomed to more than a decade of rising wages.

Update 3 (7/4/2010)
With an additional 11.6 billion euros ($15.5 billion) of debt coming due before May, so as to cover its gaping deficit and refinance old debt, bond spreads on Greek debt has surged indicating low investor interest and risk aversion. It needs to raise more than $40 billion before the end of the year, so an additional 1 percent in interest would cost the Greek treasury an extra $400 million annually.

The yield on Greek debt climbed past 7% as investors sold Greek bonds. At the last Greek bond auction on March 29, when the country raised $6.7 billion, yields stood at 5.9%.

See also this superb interactive graphic of European debts and deficits as share of GDP.

Update 4 (16/4/2010)
Next on line to follow Greece looks to be Portugal. Sample this from Simon Johnson and Peter Boone

"Just to keep its debt stock constant and pay annual interest on debt at an optimistic 5 percent interest rate, the country would need to run a primary surplus of 5.4 percent of G.D.P. by 2012. With a planned primary deficit of 5.2 percent of G.D.P. this year (i.e., a budget surplus, excluding interest payments), it needs roughly 10 percent of G.D.P. in fiscal tightening.

It is nearly impossible to do this in a fixed exchange-rate regime — i.e., the euro zone — without vast unemployment. The government can expect several years of high unemployment and tough politics, even if it is to extract itself from this mess."

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