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Saturday, February 25, 2012

Staring Into The Ukrainian Economic And Political Abyss

It's been a long time now since Paul Krugman spoke of the Ukraine economy epitomising the arrival of what he then termed the "second great depression", and its been an even longer long time since we lay awake at night dreaming about the coming conquests of the Orange Revolution. It's also been a good time since I looked at and wrote about the country, so now may be as good moment  as any to do so.

"Ukraine’s efforts to seek cheaper natural gas from Russia rather than comply with the terms of a bailout have alarmed investors, propelling the former Soviet republic’s credit risk above Argentina’s for the first time in two years. The government is shunning the International Monetary Fund as it struggles to agree on discounted fuel imports from Russia, with whom clashes halted European gas transit twice since 2006. That’s fanned concern over its ability to meet $11.9 billion in debt costs this year, with default risk rising more than any country Bloomberg tracks except Greece in the last six months."

Ukraine is once more getting into a mess. Part of the problem is political, part of it is economic, and part is a combination of the two. On top of which Ukraine has one of the most severe demographic problems in the CEE, which is itself a region of severe demographic problems. So what we have are a cluster of problems just waiting for the perfect storm to gather.

As is well known, Ukraine was one of the worst affected countries following the onset of the global financial crisis. Industrial output slid - great depression style - by more than 30% in a matter of months (the chart Krugman used was of course mine), largely due to a massive overdependence on steel, the price of and demand  for which had fallen off a cliff.

The onset of the crisis also brought to light the way the country had been living on an unsustainable credit boom fueled by short term forex borrowing in the years prior to its arrival, and as the fund flows which had been financing this rapidly reversed Ukraine was sent running into the arms of the IMF, and rapidly accepted a  $16.5 billion standy  loan in November 2008.

As the IMF put it in their programme documentation:
Ukraine’s current account and growth performance relied strongly on favorable terms of trade. From 2003 to mid-2008, the price for steel, which  accounted for 40 percent of Ukraine’s export and 15 percent of GDP at the time of the crisis,  had increased fourfold and prices for gas imports were still far below world market prices,  providing little incentive to improve Ukraine’s dismal inefficiency in energy use.  Nevertheless, by 2007 the current account had already deteriorated strongly as imports had  surged on the back of a credit and real estate boom and an overheating economy. Private  sector balance sheet imbalances widened sharply with foreign currency loans accounting for  nearly 60 percent of total loans, often extended to borrowers without foreign exchange income, and bank funding increasingly relying on short-term borrowing from abroad.

A Love Hate Relationship With The IMF?

Well, for those familiar with the region there is nothing particularly strange about the imbalances and the credit bust. But as the Fund itself makes clear in its ex-post evaluation of the first crisis programme, relations between the multilateral institution and the Ukraine administration have been far from easy over the years:

Ukraine has had long but complicated program relations with the Fund. From 1994  to 2005, the Fund supported Ukraine through six arrangements. Completion of reviews  tended to be difficult, as only 13 of the envisaged 24 reviews were completed, of which  10 with delay or involving waivers. The Ex Post Assessment of Longer-Term Program  Engagement in 2005 (IMF Country Report No. 05/415) found that “Fund-supported  programs had a mixed record in achieving their objectives. While the programs were quite  effective in supporting macroeconomic stability, they did not succeed in accelerating the  buildup of more market-friendly institutions.”
Unfortunately things did not go that much better this time, and the initial programme was terminated after the second review and a disbursment of $10.4 billion:
"Program implementation was difficult against the backdrop of sharp political divisions. Only two of the envisaged eight reviews were completed, with the first review already delayed by three months due to failure to reach understanding on fiscal and bankingrelated policies in the midst of political wrangling between the president and the prime minister.....After the second review was completed on time in June 2009—reflecting some progress with the bank resolution strategy, announcement of future plans to increase gas prices, the adoption of a restructuring strategy for Naftogaz, and a slowdown in foreign exchange interventions—the Fund remained closely engaged with the authorities. But the program went off track as ownership vanished and fiscal policy diverged further from the program".
In fact here we see three of the key Ukraine issues all lined up together - energy prices and the fiscal deficit, problems in the banking system and constant foreign exchange interventions to maintain a currency peg with the US dollar, a peg which encourages unnecessary forex borrowing while fueling inflation at continually high levels.

Running such consistently high inflation simply leads to rigid monetary policy, high interest rates, and inadvertently enhances the attractiveness of foreign exchange borrowing (which is the ultimate undoing of these pegged economies) since interest rates are much lower elsewhere, the currency is fixed (so where's the risk) and wages keep going up and up along with the inflation. You seem to be getting better off than your peers in the country you peg to, but in fact you are simply sliding steadily towards the precipice. In many ways things on the Euro Areas Southern fringe are only different in terms of degree. I can still remember Spain's now ex-Prime Minister José Luis Rodriguez Zapatero telling his compatriots that they were steadily moving towards the top of the EU per capita wealth league, overtaking Italy, and then France, just before the bubble burst, and the house valuations which lay behind those impressive appearances started tumbling.

Frustrated and fed-up, the IMF cannot simply ignore the country. Ukraine is simply too large and too strategically situated to be allowed to go awol. So when the new Ukraine government requested a further standy arrangement in the early summer of 2010 there was little alternative but to agree (shades of Greece and the EU) and make an additional $15.1 available to the country, bringing the outstanding borrowing to $25.5 billion. And here comes the rub: according to the IMF, Ukraine is due to repay $2.4 billion this year; $3.5 billion in 2013 and $1.3 billion in 2014. This is quite an onerous schedule for a country which is now  struggling to finance itself in the financial markets. Many of the current IMF programmes in Europe have the look of succes, until the time comes to pay back.

Predictably the second programme didn't proceed any more smmothly than the first one, and the first review was only approved after a lengthy tussle about pensions, with the Ukrainian government eventually ceding to pressure and in July 2011 passing a pension reform wherby the female retirement age was raised from 55 to 60, and the duration of pension contributions needed for entitlement increased by 10 years.We will return briefly to this topic, but it is instructive to note that while most economic analyses of the current crisis (everywhere, not just Ukraine) fail to mention the underlying demographic issues, the problem of how to pay for pensions keeps cropping up time and time again. The need for the reform was obvious, with a rapidly ageing population the country, despite being poor, had one of the most generous systems on the planet. In 2010, the last year before the reform, Ukraine spent 18% of its GDP on pensions and had a pension fund deficit of UAH 34.4 billion or 3.2% of GDP.

Despite this relations between the fund and the Ukraine administration failed to improve substantially (they have now been bitten too often) and at the end of August 201 an IMF staff team was sent to Kiev to carry out the second review of the new programme. The review was never formally completed, and the IMF announced on November 4 that negiotiations had been broken off.

It's All About Gas

Gas prices are an issue everywhere, and especially in election years, but in Ukraine, due to the geopolitical situation, they take on a special significance. Negotiations between Ukraine and Russia over the supply and payment of gas and terms of transit for Russian  gas to Europe have been a recurrent theme since the end of  the Soviet Union. During 2011, as gas prices rose by an annual 60%,  Ukraine repeatedly sought to renegotiate the 10-year contract signed in January  2009. The Ukraine administration considers the gas price  formula unfair and the gas price – currently US$416/mcm in  1Q12 – too high. The two sides have now been working for some months in an attempt to reach an agreement, but it is still not clear one will be reached.

Gas is a core issue for both the Ukraine and the IMF due to its impact on both the current account deficit and on the level of domestic consumption. It is evident that Ukraine growth is now slowing and coming under threat from rising energy prices. Morgan Stanley estimate that the country had a nonenergy current account surplus of 8.2% of GDP in 2011, but since it ran an energy deficit of 14.1% of GDP, the outcome was a  current account deficit of 5.5% of GDP.

To slow the rate at which this current account deficit is eroding reserves and undermining the stability of the currency, the Ukraine central bank has tightened monetary policy sharply, which in turn has contributed to the rapid deceleration in growth, which consensus forecasts put at  around 3.0% in 2012, but which may eventually turn out to be significantly lower. To put this slowdown in perspective, despite the fact that Ukraine's economy has been growing steadily since the 2009 annus horribilis, output levels are still below the pre crisis peak. As Capital Economics' Neil Shearing puts it:
"Ukraine grew by 5.2% last year, which, on the face of it at least, seems a decent outturn. But context is crucial. In 2009, output contracted by a whopping 15% – a recession from which the economy is still recovering. What’s more, the pace of recovery has actually been somewhat disappointing. Output is still well below its pre-crisis peak [see my chart below - EH] yet growth already appears to be slowing. In Q4 GDP expanded by 4.6% y/y, down from 6.6% y/y in Q3. At current rates of growth, it will take another two years for output to return to pre-crisis levels. But even this could be a tall order given how vulnerable the  economy is to a fresh escalation in Europe’s debt crisis".

In addition to the energy price constraint domestic consumption in Ukraine is still weighted down by the indedbtedness problems created by the earlier boom. Non-performing loans are still running at a very high level, although no one really seems to know quite how high, since there are major question marks hovering over the official figures. The IMF's permanent representative in Ukraine Max Alier estimated in the spring of 2011 the figure might be as high as 30% of total loans. And with every 1% drop in the value of the hryvnia the proportion rises, due to the extent of forex borrowing.

In addition, with many Ukraine banks being owned by parents in other EU countries, the credit crunch in the west is rapidly transmitted to the east. Corporate lending growth is slow, and the steady contraction of household borrowing is following a path which looks very similar to that seen in Southern Europe, or the Baltics.

Ukraine - like Hungary - badly needs an agreement with the IMF to facilitate the financing of debt which needs to be rolled-over this year. These rollovers will put significant strain on the system, Neil Shearing estimates something of the order of 34% of GDP.
"Meanwhile, Ukraine faces external debt servicing costs of $52.5bn (around 30% of GDP) this year. A large chunk of this debt is in the banking system, but roughly $5.4bn is owed by the government ($3.5bn of which is due to the IMF). Put together, we estimate that Ukraine’s external financing needs are close to $58bn this year – equivalent to 34% of GDP."

Obviously, with so much debt needing to be rolled over, the country is very exposed to any sudden reversal in risk sentiment, just as it was in 2008. It needs to be under the sheltering wing of the IMF, but this time round the dynamics are rather different. In particular, countries which once got a large net benefit from IMF lending are now facing the moment of truth - when they need to start paying back. Unfortunately, and for whatever reason, the programmes sponsored by the IMF - in Ukraine, in Latvia, in Hungary, in Romania, in Greece, in Ireland, in Portugal - are not yielding the benefits which were initially claimed for them by the advocates of the "structural reform path", in particular in the growth area.

In addition, years of fiscal austerity are now starting to take their toll on the populations concerned. Expectations are not being fulfilled, and a backlash is underway. Regular readers will be aware that my baseline case in Europe is that these misguided/insufficient programmes will steadily destabilise the political systems on Europe's periphery, leading to unstable and unpredictable outcomes. Not the kind of stuff would-be investors like.

Evidently it would be unfair to blame the Fund itself for the kind of problem which exists in Ukraine. Clearly it is a very complex and difficult-to-handle situation. But if you haven't gotten hold of the full extent of the problem in the first place, then it is hard to offer recipes which open a sustainable path forward. Read as much as I can, I still fail to be able to find any single mention of the isssue Ukraine's dire demographics presents for future growth prospects in the IMF literature.

The country's population is falling steadily, due to a long run excess of deaths over births and a steady outflow of working age population, leaving to seek a better life elsewhere. This is not only causing the population to shrink, it is also leading to a dramatic change in the age composition of the population, increasing the average age of the workforce, and lowering the number of those employed per person retired. This is the strategic importance of health and pension system reforms in a country like Ukraine.

Naturally structural reforms are important, but they need to be part of a mix of policies, and among these doing something to address the country's demographic death-spiral should be given a great deal more importance than it is presently - where in fact the issue is almost absent from economic debate.

At this point it is hard to say how the present stand off between the IMF and the adminstration will work out, but as in the Hungarian case I have the feeling that most mainstream bank analysts are underestimating the capacity of the political system to produce "bad outcomes".

The macabre "culebron" associated with the apparent medical condition of the country's former Prime Minister - in prison for having signed the last gas deal - only adds to  the sense of surreal drama associated with the country's potential default.

Ukraine’s ex-premier Yulia Tymoshenko is ill and in constant pain, Canadian doctors who examined her in prison said, adding that authorities denied her key blood and toxicology tests. A team of Western doctors went last week to the prison where Ms Tymoshenko is held to examine the opposition leader amid complaints about her treatment and health.The three Canadian and two German medics included a cardiologist and a nervous system expert, the former Soviet republic’s penitentiary system said in a statement.“

After meeting and examining Ms Tymoshenko, it was the Canadian opinion that she required confidential blood and toxicology testing,” doctor Peter Kujtan said in a letter to Ukraine’s ambassador in Ottawa, Troy Lulashnyk.The medical team had been invited by Ukraine to carry out the examination and even brought along diagnostic equipment which could produce on-the-spot test results, Dr Kujtan said.“But Ukrainian authorities refused to allow its use, stating that we would be breaking several laws of the land and could face prosecution,” he said. 
Now here's the "official version" via interfax:
Ukraine's jailed former Prime Minister Yulia Tymoshenko needs no surgery, the State Penitentiary Service cited a seven-member medical panel as saying on Friday after Tymoshenko had extra checkups on Thursday.The findings of an X-ray test confirmed the previous diagnosis and meant there was no need to revise "the recommendations for her preliminary treatment, while changes that have been detected do not warrant surgical treatment," a statement from the Penitentiary Service cited the seven doctors as saying in their assessment. Tymoshenko, who had herself requested the additional checkups, was examined at a clinic in Kharkiv, the city where her prison is situated. She had an X-ray test, a computed tomography scan and a magnetic resonance imaging scan. However, she again refused to have a blood test, the Penitentiary Service said, adding that foreign doctors would need the results of a blood test for the final diagnosis and treatment recommendations.
Naturally this sort of thing is not new in the country, and anyone with an interest in reading about a similarly surreal situation some years ago might like to read my "Will The Real Ukraine Central Bank Please Stand Up! " post.

And if you have the kind of sense of humour I have about technical issues, you might appreciate this short list of concerns about the way the bank problem resolution issue was handled by the central bank, as voiced by the IMF in their ex-post  first standby agreement review:
a) Liquidity provided to insolvent banks: As it was difficult to distinguish between solvent and nonviable banks, liquidity support was likely extended to the latter. Moreover, the maturities of NBU loans, which originally ranged from 14 to 365 days, were later converted up to seven years providing de facto solvency support.

b) Relaxation of collateral requirements: Banks’ own shares were accepted as eligible collateral despite the significant risk for the NBU.

c) Mandatory purchases of bank recapitalization bonds: The NBU was required to purchase at face value recapitalization bonds issued by the government, a practice that the Fund staff advised against.
The first point is an important one in any traditional approach to bank resolution, distinguishing between the rescuable and the un-rescuable,  but, of course, none other institution than the ECB itself has now crossed the line, and with the 3 year LTROs (which will, naturally, be extended) the central bank is offering, as the IMF suggest in the Ukraine case, solvency support to a number of otherwise insolvent banks. On the collateral side, the ECB isn't accepting bank shares as collateral, yet, although it is accepting nearly everything else, and this idea of the central bank buying recapitalization bonds, wasn't it first tried and tested in Ireland, and hasn't it be applied to some extent in Greece? Nuff said, I think.

What Can't Go On Forever Will Only Go On As Long As It Can

So where do we go from here? The IMF have dug their heels in about gas, but this is only a symptom of a much deeper sense of frustration. The fund has been financing the Ukraine deficit and cheap gas, but will the money disbursed ever get returned, or will the can be continually kicked down the road. It is worth remembering that the initial financing of 11 billion SDRs was equivalent to 802% of the country's quota, a very large quantity in terms of the standards of 2008. As the fund puts it in the review:
"No major shift in policy making  occurred and political economy considerations continue to drive policy making in Ukraine.  Efforts to tackle the underlying structural and institutional weaknesses stalled. Bank  resolution remained incomplete, the exchange rate regime returned to pre-crisis practices, the  energy sector remained largely unreformed with quasi-fiscal deficits widening, and legal and governance reform fell short of objectives".
Put crudely, the fund was being used to finance cheap energy to win votes for populist governments. The frustration to be seen in the above summary suggests to me at least that coming to a new agreement won't be as easy as many think. Especially with a number of other countries looking on. It all used to be called moral hazard I think.

Only industrial users in Ukraine currently pay the full cost of gas. Residential users pay something like 30% of the cost of the gas they consume. This subsidy is a key cause of the loss suffered by the state-owned oil and gas company, Naftogaz, which was UAH 21 billion orUS$2.6 billion, equivalent to 1.6% of GDP in 2011. A planned 50% hike in gas tariffs in April 2011 was negotiated down to 30% hike in two tranches in return for unspecific "offsetting measures" to keep the wider fiscal deficit at 3.5% of GDP. However, eventually, the tariffs were not hiked at all in 2011, widening the actual deficit to 4.3% of GDP. The result of all this is that the IMF have their foot firmly put down, and it will be hard to get it lifted again.

So one possibility is that the Ukraine government, seeing their approval ratings dropping, will consider the political costs of household gas tariff hikes to be too high, and not seriously pursue a renewed IMF deal, hoping that the cut in the current account deficit due to the lower gas import price plus any other investment commitments or payments which would arise from of a Russian gas deal will be enough to reduce pressure on reserves to a sustainable level. The Bank has spent nearly $7bn – or 20% – of its reserves since last August, and with reserves now approaching $30 billion this strategy is clearly becoming unsutanable.

There is, of course, another possibility, and that is that there is no Russia deal and no IMF deal. This could occur  if the government baulks at both of the possibilities on the table: either selling a stake in the gas transit corridor to the Russians or raising household gas tariffs. Under this scenario the Ukraine government could follow in the footsteps of Hungary's Prime Minister Viktor Orban which involves seeming to cooperate (in this case with both parties) but doing nothing, and in the meantime hope to muddle through - at least in this case till the elections in October. However, against the backdrop of falling reserves, a rising current account deficit and external funding markets which are closed to Ukraine, a sharp devaluation could become virtually unavoidable if there is neither a gas deal and nor a resumption of the IMF programme.

Following the decision of the ECB to introduce 3 year LTROs and the agreement on the terms of a second Greek bailout global risk sentiment has improved significantly in recent weeks, but it would be foolhardy to imagine that this situation will become permanent. Too many risk elements are still in play, and there are still far too many loose cannon floating around on the EU upper deck for vigilance to relax. But that is exactly what may happen, in which case, if disaster does strike in Ukraine, it will surely be disaster.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Thursday, February 23, 2012

2012 - The Year We All Learn To Live Dangerously

"Nihil sapientiae odiosius acumine nimio" (Nothing is more hateful to wisdom than excessive cleverness)
Petrarch, "De Remediis utriusque Fortunae"

Like Leo Messi charging his way through a packed Real Madrid defence, twisting now this way, now that, never stopping without being stopped, so did the Spanish sovereign debt surge forward, breaking directly into the red zone near the penalty box, provoking confusion and consternation amongst horrified EU officials and regulators forced to look on as it blindly sought to touch down somewhere well beyond the authorised 100% finishing line.
Spain's deficit has been much in the news in recent days. Both the target for this year and actual details of last year's outcome have been the source of much comment, scrutiny, and consternation, but the deficit itself will not form the primary subject matter of this post. What we will be concerned with here is debt, sovereign debt, and the current trajectory of the Spanish variant. In a recent article in the Financial Times Victor Mallet draws attention to the situation and shows how an excessive emphasis on deficits may sometimes mislead people into missing the bigger picture, since at the end of the day deficits are only interesting as they add to debt, and in the long run what matters - as we have seen in the Greek case - is whether or not the debt itself is sustainable.

Now Victor quotes me on two counts: the real size of Spain's debt, and the effectiveness of Spain's institutions.
“Spanish sovereign debt is already over 80 per cent of GDP,” said Edward Hugh, a Barcelona-based economist. “I think it’s getting nearer 90 per cent"......Mr Hugh also said the situation in Spain could not be compared to the confusion in the public accounts of Greece because much of the Spanish data are public and made available by the Bank of Spain, or can be deduced from official sources. But he added that the centre-right government’s transparency risked curbing Spain’s room for manoeuvre should the crisis deepen further.
Well, while it's the first claim that is controversial and in need of justification (and believe me Victor Mallet demanded to see the justification for the numbers before putting up the quote) let's start with the second one first as it forms an important part of the background. I think it is very important to understand that Spain is not Greece, in the important sense that the people in change do in fact normally know what is going on. They have auditors and inspectors whose job it is to know, and they do do their job. So the Bank of Spain know virtually everything there is to know about each and every one of Spains many banks and savings banks, about the state of their balance sheets, about the level of bad loans, etc etc. Naturally, knowing what they do, what they tell you is another matter.

Similarly in the case of the public administration, auditors and controllers are in place to constantly measure and follow the exectution of the annual budget at all levels, but again what they know is often one thing, and what they actually say publically is another. When Spain's bank regulators become worried about specific cases they try their best to put on a brave face and maintain confidence while looking for solutions somewhere behind the curtain. Similarly with the public administration, although in this latter case there may well be political reasons for allowing an overspend to continue, or even for encouraging it.

Let me take another example, from an area outside the financial system and beyond the realm of public finance: migration statistics.  Between 2000 and 2008 around 6 million irregular migrants arrived in Spain attracted by the prospects of work in the then (house) booming economy.

We know with some degree of accuracy the number of such migrants present (although not authorised to be) in Spain due to the existence of a system known as the "Padron Municipal" (or Municipal Register) which is managed via an electronic database. So we know how many migrants register, but how do we know that the migrants always register? Well this is the part which is "typically Spanish", since a far from innocent circularity has been created - all those present in Spain are entitled to free health treatment in the public health service, but in order to have a health card you need to register with the Padron Municipal. In addition, registration adds to the possibilities of being able to regularise your situation later, so the first thing virtually every migrant does is go to register. You see, that way the central adminstration has all the data to hand.

Well, you may say, that is fine, but how do we know the register doesn't overstate the number of migrants? In fact, at one point it did, since migrants were only obliged to confirm their continuing presence every two years. That was when the focus was on measuring who was coming in, but since the economic crash and the massive surge in unemployment, for a variety of reasons the emphasis has moved towards measuring who is still here. So the interval for address confirmations and things like that has changed, and most of those who don't have residence rights are now required to confirm their presence every few months, which means that Spain has some of the most accurate data on migrant flows to be found within the confines of the EU (and possibly anywhere).

Now, you might say, why be so meticulous in collecting all this information, why not follow the UK example, and require all those who lack authorisation to be in the country to leave? Well, this is Spain and not the UK (or Greece) and this is the point of the present rigmarole I am explaining, to give an idea of how things work in Spain, not to offer an analysis of the migration policy. Understanding that you can accurately measure something that officially doesn't exist is the key to understanding how the financial and public administration systems work, and unless you "get" this part, you will be lead astray by almost everything else.

The Omnipresence of "Dinero B"

Now, on the public accounts issue itself , I actually started digging into all this in the summer of 2010, and indeed posted an interim "report" at the time. So it is something of a mystery to me why all the hedge funds, journalists and bank analysts have taken so long in waking up to the existence of  "Spain's regional and local debt problem", especially since all the information on the topic is freely available on the Bank of Spain website. It seems to me that people see what they want to see at any given point in time, and this is the point of the Petrarch quote which starts this post. It comes from an Edgar Allen Poe short story, the purloined letter, and to cut a long issue short, a letter goes missing which no one can find, and the reason they cannot find it is precisely because it is lying there, right before them, on the living room mantelpiece.

"Nothing" remember, "is more hateful to wisdom (astucia) than true cleverness", which means if you try to go rummaging round round Spain for Goldman-Sachs-style interest-rate-swaps you will almost certainly leave empty handed. Handiwork here is all much simpler, and more artesanal than that, and therein lies the beauty and the sophistocation of the thing.

Hence, if you are someone who is really interested in trying to answer the question about just how high the present level of Spanish sovereign debt actually is (officially it was to have been 67.8% of GDP in December, but that estimate was made before the latest set of budget deficit "revelations" and when the estimate of 2011 GDP was rather higher than it turned out to be, so it is probably nearer to 70% now, even on the official Eurostat EDP measure) you should start here, with the Financial Accounts of the Spanish Economy. The part you really need is Chapter Two the "Financial Accounts" - actually, I will add in a small but revealing personal anecdote here, since when I sent all these links off to the IMF Spanish Mission Head back in the spring of 2010 he mailed me back saying "thanks a lot" - he plainly didn't know that this sort of thing existed., although the Spanish head of Global Financial issues for the IMF  - ex Bank of Spain man José Viñals - most surely did, but he simply hadn't seen fit to brief his colleague. As I say, this is how Spain works, you have to ask the right person the exactly right question, and make sure you don't get sidetracked. Otherwise you will learn nothing apart from a lot of useless and most likely thoroughly misleading  information.

But before we did down any deeper, just to let us all see where we are, why don't we make a small detour to Chapter 11 of the Bank of Spain's Statistical Bulletin, on General government liabilities. Excessive Deficit Procedure (EDP) debt. Now if we examine section 11.3  Liabilities outstanding and debt according to the excessive deficit procedure. Absolute values, we will find this most iluminating table.

Two important points should be drawn to the attention of the studious reader immediately, the fact that the right hand section refers to the Excess Deficit Procedure (EDP or officially recognised Eurostat) debt, and that the totals at the bottom of columns one and 15 are different. The number at the bottom of column one is approximately 877 billion Euros (or around 85% of Spanish GDP) while the number at the bottom of column 15 is 706 billion Euros, and this is the official Eurostat debt. So what makes for the difference? Well, as we will see, there are three main items - unpaid bills, public company debt, and Spanish sovereign bonds which are in the hands of the Social Security Reserve Fund. Now before going into all this further, I do want to make clear that I am not saying that this 877 billion euros is the total Spanish debt which should be counted as such. The number is simply orientative - a lot, but not all, of this is debt which will need to be consolidated - but in fact, and in addition, there are other "contingent liabilities" which will also need to be added in to get a complete reading..

But let's go one step at a time, and why not start with those famous "unpaid bills". Well, according to the Financial Accounts, at the end of the third quarter there were 72.9 billion Euros in unpaid bills (around 7% of GDP) which were more than 30 days overdue owed by the entire public adminstration (see this file here, bottom right second page - in fact there is a total of 87.5 billion Euros owing, but 14.6 billion is still within the term of normal trade credit). This breaks down as 27.7 billion Euros on the part of central government, 20.8 billion Euros from the regional governments, and 14.9 billion Euros for the local authorities. Much of this debt has been pending for months, if not years. It also makes the number of 35 billion Euros which is being bandied about in Spain for the credit lines to local authorities and regional governments seem quite reasonable and realistic. Of course, the central government itself still will need to put its own house in order.

The second main area of non-consolidated debt is the money owed by public companies, many of them loss making, and often entities which have been created without rhyme or reason at both regional and local authority level. As of the end of the third quarter of 2011 this debt amounted to 57 billion Euros (or 5% of GDP - see the memorandum item on the far right in this file), of which 32 billion Euros was attributable to central government, 15.5 billion Euros belonged to regional governments, and 9.4 billion Euros came from companies created by local authorities. There is no plan at present for dealing with all this accumulated debt.

Then, thirdly, we come to the social security reserve fund. Ai, the social security reserve fund! This is where the Spanish are supposed to be accumulating resources to help pay for their pensions. But the Eurostat accounting system being what it is, this is the last thing that is happening. Now according to this last report from the fund managers, at the end of 2010 the fund had assets valued at just under 65 billion Euros under its charge. Of this sum 56.6 billion Euros (or over 5% of GDP)  were invested in Spanish government bonds, while 7.8 billion Euros were invested in bonds of other EU states (principally Germany, the Netherlands and France).

Now doubtless the only reason the fund decided to invest the money it was holding in Spanish government bonds wasn't to help the administration hide some debt, probably the fact that risky Spanish bonds pay more than less risky German ones was also a consideration. But this whole thing is a farce, since while the Spanish people innocently believe that they have a partially funded pension system, nothing could really be farther from the truth. In general accounting terms the whole security area comes under the general budget, as was brought to light in the recent deficit numbers the new government brought to light at the start of January. Out of a total of 2.5% of GDP in unexpected deficit, 0.5% came from issues associated with the social security fund - which anticipated a surplus of 0.4% of GDP but finally turned in a deficit of 0.1% of GDP, as can be seen in the nice chart provided by the Ministry (below).

The shortfall was due to a number of factors. In the first place those newly entering the system are paid far more than those who are leaving (due to death or other reasons) - 35% more in fact, since the average monthly payment in 2010 was around 800 Euros, while the average payment to new entrants was 1,100 Euros. Secondly Spain's demography is working against the fund, since as the number of those working falls, and the number of elderly dependents rises, the ratio between the two falls. It is currently at around 2.4, and many experts estimate that the pension system will turn critical when the figure drops below 2.

Currently there are just under 17 million contributors, but the position is worse than it seems, since of these three million are unemployed, with their contributions being paid by another department, and these contributions will terminate when the individuals concerned exhaust their unemployment entitlements. According to Spanish public pensions expert José Mario Paredes Rodríguez, "the data on contributor pensioner ratios is totally misleading" given that the government continues to count as contributors those for whom it is making payments the "calculation is completely unreal since what we need to know is how many people are actually working per pensioner being supported.

So we really have a clear "robbing Peter to pay Paul" type situation, where the numbers are juggled but the debt remains. This risks associated with this situation was brought to light in the recent Greek debt restructuring, since one of the key issues driving Greek politicians to the negotiating table was the threat of seeing their pension fund reserves going up in smoke in the event of a hard default.

According to the Wall Street Journal:

"The total portfolio of Greek bonds that the Greek pension funds hold  is EUR27 billion," Venizelos said. "That portfolio is being replaced  with cash, with new, better bonds of much higher net present value and, further, the parliament has already approved the creation of a special public body through which to transfer public assets to the  funds," he added.

And to Bloomberg:
"The dilemma we are faced with is cuts so that we can stand on our own two feet, to save the country’s pension system and pensions, or economic collapse,” Finance Minister Evangelos Venizelos told opposition party lawmakers in Parliament today. Without the debt swap, the country’s pension funds would be wiped out, he said. The country’s central government debt, which doesn’t include debt  from local government organizations, state-run companies or pension  funds, was 368 billion euros at the end of 2011, the ministry said  today, amounting to 171 percent of the economy, according to Bloomberg  calculations".

And Then There Are The Contingent Liabilities

The trouble is, this still isn't everything. We also have the contingent liabilities of the state to think about. This - a groso modo - comes in four forms: bank debt guarantees, exposure to the financial system via FROB, the government Instituto de Credito Oficial (ICO) and the Electricity Tariff Fund FADE.

On the guarantee side, the latest data we have is for a total of 88.6 billion Euros at the end of the third quarter of 2011, but this number is almost certainly higher now, since the government has been guaranteeing debt on a number of fronts with the unique and exclusive objective that they could be taken over to the ECB to post as collateral in the LTROs. In any event, it is the Spanish state (and not the ECB) that is finally responsible for these loans should the relevant bank or other entity be unable to live up to its commitments.

In the case of  FROB (Fund For Orderly Bank Restructuring) the true extent of the government's exposure is hard to measure, since while the quantity actually provided by the fund to date is not large (14.8 billion Euros - see this presentation - and 9 billion Euros of FROB debt has been pre-capitalised) a number of savings banks are effectively nationalised while others that are dependent on FROB for loans may well need further intervention. So all we can safely say here is that the number involved is hardly trivial, and on just how "non trivial" the final number is the whole future of Spain's soverign debt will ultimately depend.

As far as the ICO goes, the organisation currently has an exposure of 27 billion Euros, all guaranteed by the state. Now much of this money has gone out in lending, and much of that lending will be returned, which is why this is a contingent liability. At the same time the present administration clearly see an enhanced role for ICO (helping the regional governments clear their backlog of unpaid bills, for example), and it is likely that the volume of debt will continue to grow.

Finally, we have the so called Tariff Deficit fund, or FADE (Fondo de Amortización del Déficit Eléctrico). Now despite the name, one thing the debt generated by this body doesn't do is fade (away), since it is growing month by month and year by year. The position is described in the literature as a debt being accumulated by consumers (some 24 billion Euros of it) which is guaranteed by the government. Like the state of their savings in the pension system, most electricity consumers are totally ignorant of the fact that they are acquiring this debt, or better put, that it is being acquired on their behalf. Essentially the situation arises since the government is reluctant to charge an economic price for electricity. Naturally, in a country running an energy driven current account deficit this is a highly questionable practice, but then, there you are.

Basically every month less money comes in in bills than is attributed to the accounts of the electricity companies. The shortfall is made up by borrowing. This borrowing is serviced - you got it - by taking some of the income from electricity bills. But naturally, as the deficit grows - currently it is about 24 billion Euros - more of the income stream is needed to service the exisiting debt, and - yup, you got it again - the deficit grows. The only real solution to this mess is to raise electricity tariffs, but in an environment of rising unemployment and falling wages there are going to be limits to what the government can do in this regard. So while I am sure that the EU will eventually insist tariffs are raised, it is hard to see them being raised far enough to pay off the accumulated debt, and so the government will almost certainly need to "swallow" this, which means - yup you got it again - another 2% or so on the debt account.

Just to round things off, there are some other little details, like public private collaborations in infrastructure. Take motorways for example, many of these (especially around Madrid) were planned at the height of the boom, when traffic was intense - the private sector are of course paid according to the number of cars who use the motorway. Now with the crisis the volume of traffic has fallen considerably everywhere (this is one of the few advantages I have noticed of all this difficult mess, it is now much easier to move around in Barcelona). And with the fall in traffic, incomes have fallen, to such an extent that the participating companies are no longer able to service their debt. Experts suggest the total quantity involved is around 4 billion Euros - peanuts you may think in comparison with the other things we are looking at, but as they say in Spanish "todo suma".

Much Ado About The Deficit

Now as Victor Mallet says, the basic motivation behind recent moves on the Spanish adminsitration front would seem to be to start to move this large backlog of debt (especially at the regional and local government levels) onto the table.
Madrid plans to arrange payment of up to €30bn in overdue bills for rubbish collection and other services owed by municipalities, a move that will benefit suppliers but will also help to expose the true size of the country’s public sector debt.

“It’s about restoring order, it’s about knowing what’s there and dealing with it once and for all,” Maria Soraya Sáenz de Santamaría, deputy prime minister, said after a cabinet meeting on Friday that agreed the first part of the programme.
But the great risk they are taking in doing this is raising the acknowledged debt level, up towards the "high risk area" of around 100% of GDP. When you add all the debt up we are already in the high 80% range, and two more years of "normal" deficit plus more funding for the financial sector should take it through the psychological barrier. Naturally investors are noticing this, and Prime Minister Mariano Rajoy's "gaffs", and at the end of last week the Spanish ten year bond spread with the Bund equivalent went above the Italian one for the first time since last summer.

So Spain is on a bad course, with recognised debt about to surge rapidly, while investor confidence in the current administration is slipping. Time for another "gamechanger" I think, since otherwise this car is about to crash.
Her mind in torment, wheeling like some lion at bay, dreading the gangs of investors and bond traders closing their cunning ring around her ready for the finish, Angela thrashed around looking for the rules and pacts that would save her embattled army. To no avail, her chariot struck a a rock which, like the one to the west of Grosseto which saw-off the unfortunate Costa Concordia along with her Captain, was on no known map, having not previously been measured, and she went hurtling down that crazed path which leads only towards a preappointed destiny with both history and oblivion.
This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Wednesday, February 22, 2012

For Whom The Bailout Tolls

"On an optimistic view, that a deal was struck implies that neither side was ultimately willing to risk a Greek exit because they recognise that no one fully understands all the ramifications of such a decision. Under this scenario, when pressure again builds, the authorities will do the same: let Greece remain in the euro, even if it fails to keep to its adjustment programme. So, the reality of “bail-out II” means that, if the situation becomes critical, there will be a bail-out III". Sushil Wadhwani, writing in the Financial Times
 So Greece has finally been awarded a second bailout. One may wish the country will live to tell the tale.

According to IMF DG Christine Lagarde, speaking at the post agreement press conference, "It's not an easy (program), it's an ambitious one,". Never a truer word was said, and certainly not in jest. Not only is the program an ambitious one, it is more than probably a "pie in the sky" one too. The objective of 120% for Greek debt in GDP is totally unrealistic, not because it won't be attained (it won't), but because even if it were the country would still be in an unsustainable situation in  2020. So this is hardly something to be proud of, or look forward to.

And then there is growth. Ah yes, growth. Noone really has any idea how this will be achieved, and of course without it even the (un)ambitious 120% goal is way out of reach. But beyond the details, I have serious doubts whether Greece itself is now rescuable. I don't mean the financial dimension, I mean whether or not the country will even raise its head again. The social fabric and the country's reputation is being so destroyed, that it is hard to see serious investors getting back into the country again, with or without that much needed internal devaluation.

Young people will simply vote with their feet and leave, leaving an ever more unsustainable pension and health system. A common story these days along Europe's periphery, but still, Greece definitely seems destined to be the worst case scenario.

Perhaps the best simple summary of what just happened was written by Annika Breidthardt and Jan Strupczewski in their Reuters report:

"The complex deal wrought in overnight negotiations buys time to stabilize the 17-nation currency bloc and strengthen its financial firewalls, but it leaves deep doubts about Greece's ability to recover and avoid default in the longer term".
We have just bought some time for the rest of us, while Greece is sent off to default and beyond. The Troika representatives didn't "sign off" on the new deal, they effectively washed their hands of the whole messy situation. Naturally Greece won't be able to comply with the conditions, and at the next review, or the one after, the country will be face to face with the inevitable.

The Details.

  • Greece has agreed to be placed under permanent surveillance by an increased European presence on the ground, and it will have to deposit funds in an escrow account to service its debt to guarantee repayments. effectively this will rule out future defaults against the private sector. This is why Europe's leaders think this agreement will end contagion, there will be nothing to "contage". But the problem simply becomes worse, since any default now will be against the official sector, and they are not nice, friendly people to default on.

  • The European Central Bank agreed to help the process by distributing its profits from bond-buying. A Eurogroup statement said the ECB would pass up profits it made from buying Greek bonds over the past two years to national central banks for their governments to pass on to Athens "to further improve the sustainability of Greece's public debt."  The bond holdings of the ECB and national central banks from their investment portfolios (about 12 billion Euros) and the Security Markets Programme (around 40-45 billion Euros) are to be swapped for instruments that appear to be exempt from any future  Collective Action Clauses. They will be repaid at face value, albeit with an understanding that the profits accruing from this repayment plus coupon payments will be transferred to governments via the various  National Central Banks. This money can then be passed to Greece in the form of a transfer. The importance of this arrangement is that it reinforces the subordination of private sector bond holders to central bank buying. Moreover, it is not clear that there is any obligation for the national governments to give these income flows from Greek restructuring back to Greece, and if this proves to be the case this outcome would simply amplify the subordination of private investors.
  • Private bondholders are being asked to accept more losses than originally postulated. Private sector holders of Greek debt will take losses of 53.5 percent on the nominal value of their bonds. They had previously agreed to a 50 percent nominal writedown, which equated to around a 70 percent loss on the net present value of the debt. This being said, all is still far from clear. The IMF document detailing the underlying economic assumptions for Greece assumes a 95% participation rate in the PSI. This outcome seems unlikely, especially in light of the increased haircut for private investors in the new deal, which was implemented in order to reduce Greek debt/GDP to the targeted 120% by 2020 from the 129% it would reach according to earlier PSI assumptions. What this implies is that those dreaded Collective Action Clauses may still be needed sometime early next month to ensure no hold-outs, and if this happens it is quite possible that CDS will trigger. So we are not out of the woods yet, it seems.

  • The latest IMF document reaffirms its view that Greece is unlikely to be able to access the market in its own name during the programme period until at least 2020, "and it is assumed that financing needs are met by Greece’s European partners on standard EFSF borrowing terms", if good policies are maintained. One problem  the IMF mentions here is important, and that  is the fact that future debt issuance would be subordinated to the currently being restructured pool of debt. This would obviously make it hard to sell bonds to new investors even in the most favourable of circumstances.

  • As if this wasn't enough in the way of headaches, the latest IMF document also suggests that  Greece is likely to need additional funding well before 2020. The Fund outlines two scenarios: a "base" case whereby Greece may need an additional 50 billion Euros during the period 2015-20 given that the new 136 billion Euro support package will only meet Greece’s funding needs until 2014. They also cite a more bearish case involving slower-than-targeted growth and fiscal consolidation, whereby debt/GDP only declines to 160% by 2020 rather than the targeted 120%, in which case Greece would require a further 109 billion. Hence far from having put Greece off the EU radar, the new debt deal only marks the end of the beginning, and we still need to get through to the beginning of the end.  
  • In terms of timescale, the private creditor bond exchange is expected to be launched on March 8 and complete three days later, according to Greek sources. That means a 14.5-billion-euro bond repayment due on March 20 would be restructured, allowing Greece to avoid default.

    In fact the important point to note is that the vast majority of the funds in the current program will be used to finance the bond swap and ensure Greece's banking system remains stable; some 30 billion euros will go to "sweeteners" to get the private sector to sign up to the swap, 23 billion will go to recapitalize Greek banks. A further 35 billion or so will allow Greece to finance the buying back of the bonds. As Annika Breidthardt and Jan Strupczewski point out in their article, next to nothing will go directly to help the Greek economy.

    The main purpose of exercise - apart from trying to close off contagion - was to reduce Greece's debt to a point that the IMF would be able to continue funding. It will be recalled that the whole second bailout issue was put on the table when the IMF reported that it would be unable to continue with the first bailout since its own regulations stipulated it could not continue with programme payments to a country whose debt path was not sustainable. Their economists must have had to swallow some to be willing to sign off on the sustainability of this one. But such are the political pressures people are facing.

    The Sacrificial Lamb

    It is hard to remember a time when such an important decision was taken where so many of those participating were expressing the view the solution was not going to work. Thus conservative leader Antonis Samaras, a strong contender to become next prime minister, stressed that the rescue package's debt-reduction targets could only be met with economic growth. "Without the rebound and growth of the economy ... not even the immediate fiscal targets can be met, nor can the debt become sustainable in the long-term."

    Hardly inspiring words from the person who is most likely to have to take responsibility for all of this.

    Naturally Europe's leaders are more concerned about their own backyard than they are about what actually happens to the Greeks. "It's an important result that removes immediate risks of contagion," Italian Prime Minister Mario Monti is reported as telling a news conference.

    Swedish Finance Minister Anders Borg effectively summed the cynicism of the whole position up like this: "What's been done is a meaningful step forward. Of course, the Greeks remain stuck in their tragedy; this is a new act in a long drama. "I don't think we should consider that they are cleared of any problems, but I do think we've reduced the Greek problem to just a Greek problem. It is no longer a threat to the recovery in all of Europe, and it is another step forward."

    But as Sushil Wadhwani suggests, rather than overcoming contagion, what the agreement does is give a whole new twist to the issue of contagion. In particular, the general impression that has been generated is that Germany’s leadership will now make almost any concession in order not to have to look for the Euro exit door, and the others, starting with the highly intelligent Mario Monti, are beginning to sense this. Even Spain’s Mariano Rajoy has caught-on, and seen he can negotiate a relaxed deficit target for 2011, despite the fact that the country missed last year’s target by a large margin. So we may well now see a chain of events were one country after another sets out to test the patience of the "core". And in addition (see below), the Greek contagion problem is a long way from being over.

    Eternal Life on LTRO "Cool Aid"?

    Meawhile, the impact of recent policy changes at the central bank should not be underestimated. In particular, the latest decision to implement two 3 year Long Term Repo Operations has been very important, and is a short term game changer.

    Distressed sovereigns can, for the time being fund themselves, even if the commercial banks are only really inclined to bid at the short end, and may well be exaggerating the extent of relief provided by buying short term bonds in an attempt to store liquidity to meet their own future wholesale financing needs.

    Basically, the liquidity provided, in conjunction with the all important flexibilisation of the collateral rules, has enabled banks to make provision for their wholesale funding needs right through from now to 2015, at which time there will doubtless be another round of LTROs, and who knows, they could even have a longer term than a mere three years. The days when banks saw it as a stigma to have recourse to ECB liquidity, and when journalists entertained themselves making fun of packaged used car loans being offered as collateral in Ireland by the Australian bank Macquarie are now long gone, as are the times when anyone really imagined that any sovereign bond from a country losing the minimum rating qualification of at least a single A from one agency would not be available for use as collateral at the central bank.

    And this liquidity policy knocks yet another of the old chestnut endgames straight out of the window too, since it makes deposit flight within the Euro Area as a whole a much smaller problem. German and other core country deposits can be recycled - via wholesale finance provided at the ECB - as a substitute for the missing peripheral ones. Naturally this measure does not unblock the credit crunch problem, but it does reduce immediate systemic pressure. So, if the Euro system is inherently unstable, and unsustainable, a mire from which no one wants to exit since fear of the unknown always trumps hatred of the known, how does it all finally unwind? The implicit market assumption that Portugal will follow Greece into default comes as no surprise. If Greece is to be given an ongoing debt pardoning programme then surely in Portugal is going to want one too. And then there will be Ireland, and so on. Yet all of this is contemplatable, what is not contemplateable is that the people who live in these unfortnate countries will continue to accept whatever is trown at them, come what may. You only need to look over in the direction of Hungary to see that these no-growth austerity programmes have a sell-by date. But what will follow will surely please no one.

    The Club No One In Their Right Mind Would Leave

    But what about Greece itself? Logic suggests that they will be unable to meet the terms of their new agreement, and that we will soon be back to where we started, or will we.

    Feelings that what we are seeing today will only be a short interlude are based on a combination of three factors: a) a recognition that even a reduction of debt to GDP to 120% by 2020 may well not be sustainable; b) a recognition that after the formal bailout is awarded there will still be ongoing programme reviews, and the country will struggle to comply with the conditions; and c) the fact that the implementation of the Private Sector Involvement debt swap will probably mean changing the jurisdiction under which Greek debt is denominated from mainly Greek law in the majority to international law in the totality. This latter point is undoubtedly the most important, although being able to grasp its full implications implies an understanding of the first two.

    Essentially, if the unsustainability of the Greek debt path and the inability to comply with conditionality are accepted, then a further default will be inevitable, but such a default will undoubtedly be a very, very hard one, and most likely an uncontrolled one. In the first place if the country were to leave the Euro after the debt swap, then the new Greek bonds could not be converted to New Drachma (or equivalent) by a weekend session of the Greek parliament, and the country would have to default on bonds denominated in Euros, which would presented them with all kinds of problems.

    Secondly, given the terms of the debt swap, and the condition of an escrow fund to protect the interests of private bondholders, then the only liabilities on which the country could still default would be those commitments it has with the official sector, which means defaulting on the IMF, the ECB, the EU and Germany. These would not be especially nice people for the country to default on, since if Greek reaches such a point the country would almost surely be made an example of, which means effectively establishing a pariah state.

    The EU certainly wouldn't be sending in the social workers and psychologists to help them cope with this massive tragedy, which also implies that investors generally would be inclined to steer clear. Realising this, and having taken the decision not to default now, short of seeking allies among other rogue states (the North Korea path) the country’s leaders have probably taken the decision to stay in as long as they can. But then it is worth remembering the old Greek saying that “whom the gods would destroy, they first make mad”, by which I mean we could well see extreme factors at play in Greek politics - the extreme right, the extreme left, and the military - before they then all go rolling off the cliff together.

    Or maybe Greece will decide to default and stay in the Euro, printing its own Euros at the national central bank along the lines of the Emergency Liquidity Assistance precedent. That would surely create a mighty mess, (they could even carry out the internal devaluation by subsidising Greek wages) and would leave the onus of kicking them out on their European partners.

    Whichever the appointed path, such a scenario would have important geopolitical implications, since surely the EU could not let Greece become a nice place, given that then Portugal would immediately say "I want one of those", and so on and so forth along the daisy chain. In the meantime private capital will be steadily forced out of periphery sovereigns like Spain and Italy, and the ECB will ultimately have to provide. But we have already crossed the Rubicon on this, and there is no real turning back. Ongoing debt restructuring will continue, as none of the really troubled economies can either grow or sustain their existing debt. I mean, who can now really believe that Spain won't be asked in six months time to prepare another set of reforms (the latest batch have "destined to fail" written all over them), and six months later another one, and so on, until eventually the country is where Greece is now?

    And if the private sector either can’t, or won’t accept the degree of involvement being asked of it, then the ECB will be taken out of the official sector, and somehow or other find a way to swallow the losses. At least that's the way things could work for the time being.

    Destroying European Democracy?

    The principal issue impeding exit is not the one of the presence of sunk costs from years of membership, but rather existence of non-linear credit and currency impacts - in either one or the other direction – impacts which could not be envisaged in the pre-Euro era during which most of the critics of the common currency cut their theoretical teeth.

    The only conceivable way a deliberate decision to leave could actually be taken would be as a result of one or more of the respective agents being actually driven “insane” by the constant painful efforts involved in trying to retain the pin in that grenade they are holding as they are driven to ever more desperate efforts in a vain attempt to try to stop it going off in their face. Could, for example, Hungary’s leader Viktor Orban be about to offer us an early prototype for the kind of road map which some of the participants might need to follow in order to reach the point whereby they actively decide to leave? In Hungary’s case, of course, the departure would be from the EU, not the Euro, but the point is effectively the same, since the farewell party would most certainly acrimonious, where the possibility of regulating the exit would be limited, and where the end product would almost certainly be the creation of a pariah state.

    For the inevitably defaulting participants, given the total determination not to have official sector restructuring, leaving the Euro would more or less automatically mean a sharp break with both the EU and the IMF and in all probability the United States. If we take Greece as an example, and assuming the currently proposed PSI debt swap goes forward, the country will almost certainly see the jurisdiction of its debt shifted from national to international law, making converting sovereign debt instruments into New Drachma (or whatever) impossible, and given the creation of an escrow account to pay the private sector creditors, the only meaningful possibilities for default would be against the official sector – the ECB, the IMF and the EU member states – and clearly such a development would not be well received, among other reasons due to the precedents which could be created for other struggling countries who might wish to follow the same path.

    So the list of probable allies for an exiting country – Venezuela, Bolivia, and North Korea come to mind, or nearer home Serbia, Belarus and Ukraine – would not be entirely alluring. The difficulty is that after the ending of the cold war, the world is rather short of role models for developed economies who want to pursue unorthodox policies, especially if they are engaged in a disorderly default causing considerable discomfort for most of their “first world” peers..

    On the other hand, those with more stable, internationally competitive economies will not readily wish to surrender this condition, and since they have clearly benefited significantly from membership of the currency union they will be unlikely to offer themselves as candidates for departure. In a post Euro world they would face the likelihood of trying to export their way forward while labouring under the constraint of a substantially over-valued currency.

    So with no one leaving, and everyone elbowing the other in the rush to say "I'm not going" there really only is one way all this can end, isn't there?

    Sunday, February 19, 2012

    Quick Reality Czech

    The Czech Republic is the first economy in central and eastern Europe to slide back into a full technical recession during the current downturn (evidently it is unlikely to be the last), with a 0.3 per cent quarter-on-quarter GDP decline in the last three months of 2011, after a 0.1 per cent drop in the previous quarter.

    The news, announced last Wednesday, is interesting but not entirely unexpected given the export dependence of the country's economy, and in particular on exports to the eurozone, which also saw a GDP contraction in the fourth quarter. Still, it is curious that the country which arguably has one of the strongest in the region was the first to slide back into contraction.

    The country has a strong and competitive export sector, which normally drives growth forward. The problem with export driven economies is that once external demand (in this case mainly from German industry) weakens, domestic demand is not strong enough to maintain the growth dynamic.Thus such economies are inherently unstable. Unfortunately this is a pattern we are going to see more and more of now that domestic demand is only a real driver in relatively few EU economies (Poland, France, possibly Sweden).

    Even after the relatively bounce-back, Czech GDP was still below the pre-crisis peak in the second quarter of 2011, before it fell into recession again.

    Exports as can be seen from the chart below really surged during the first phases of the recovery, but since mid 2011 they have effectively been stagnating (second chart showing 3 month averages).

    Fixed capital investment and construction activity, on the other hand, have fallen back substantially since the crisis, and look unlikely to recover in the short term.

    Another interesting detail about the Czech economy is the fact that although the country runs a very healthy trade surplus, strong negative income flows on the current account means that the country actually runs a current account deficit. The reason for the deficit is interesting I think, since the whole external account only balances due to strong FDI and equity inflows plus reinvested earnings.

    What this means is that the net international investment is deteriorating, and the day earnings are not retained and reinvested, that day the country will start to have a problem.  It seems to me that this kind of model, and especially for a country with an ageing population and weak domestic demand is not sustainable, one-way inbound FDI is not a development model for a mature economy.

    Czechs need to save, and then invest elsewhere to generate income to help support their pensions and health system. This is the whole problem with ageing societies in the east of Europe, the low levels of accumulated savings they inherited  due to their earlier  history makes them very vulnerable.

    In addition, the country is steadily accumulating a stock of sovereign debt as the need for a fiscal deficit has been created to support demand. Accumulated debt is still low, but it has grown sharply since the crisis, and remains on an upward path. The deficit was around 4% of GDP in 2011, and looks set to stay at the same level this year. More importantly the deficit is in danger of becoming structural (that is to say inbuilt into the country's economic growth) and may be hard to eradicate without a serious fiscal effort and a period of significantly under par growth.

    The Czech Republic has its own currency (the Koruna) whose value tends to fluctuate in accordance with global risk sentiment (rather than for any local fundamentals) and has rebounded sharply (despite the fact that central bank interest rates have been held at 0.75% for many months now) as risk sentiment has risen following the 3 year ECB LTRO development.

    Despite the very low interest rates, inflation is well under control. In December the EU HICP was running at an annual 2.8%.

    Credit has slowed, but it is hard to tell whether this is not more the result of slow ongoing domestic delaveraging rather than any real shortage of funds to lend. Certainly there is no sign of a Baltic style credit crunch.

    Looking at the manufacturing PMI, the industrial sector has been stabilising along with the rest of the EU, and the rate of contraction both in output and new orders is slow, so the economy should continue to stagger forward OK although there are few signs of an outright recovery, which will need to await a significant upturn in the Euro Area.

    Obviously one of the key nagging questions is why the country is so export dependent. I have correlated this phenomenon with rising median population ages (like in Germany or Japan - in fact the Czech Republic looks awfully like Japan without the current account surplus) since the Czech Republic (along with Slovenia) has one of the oldest populations in Eastern Europe.

    Others explain the phenomenon culturally - the Czech's are a nation of savers, unlike the Estonians whose reckless spending lead them into a housing boom/bust (do note the irony, please).
    Sylvie Pekarova, a 33-year-old pharmaceutical researcher in Prague, has no debt. She doesn’t even own a credit card.

    Consumers like Pekarova have helped the Czech Republic avoid the fate of the euro region, which is grappling with a debt crisis now into its third year. With private borrowing at half the euro region’s average, the country now boasts interest rates that are lower than 10 of the currency-bloc’s 17 members. That’s helping the government’s drive to sell benchmark Eurobonds, which started this week.

    “It’s this feeling that if something goes wrong, you don’t want to be stuck with debts you don’t know how to pay back,” Pekarova, who lives in a rented apartment in central Prague, said in an interview. “Borrowing money for things like going on a holiday doesn’t make sense.”
    So anyway, you can take your pick according to the model which takes your fancy. But I do wonder about the relative predictive power for investors of models which use cultural biases and those which simply take ageing populations. Which societies among the African underdeveloped economies will be the big new savers of the future, and which will be the spendthrift bankrupts? Median age analysis at least has the advantage that it makes prediction reasonably easly - Spain, for example, is about to become a nation of savers - but I wonder how those who use cultural analysis go about identifying the unexpected new savers we will see come 2020?