EUROPEAN STABILISATION BANK PROPOSAL

Meeting Of Heads Of State Or Government Of The Euro Area, Brussels, 7 May 2010
- the President of the European Council, Mr. van Rompuy, has convened Heads of State or Government of the Euro area for a meeting on the evening of 7 May in order to finalise the adjustment programme negotiated by the Commission, the ECB and the IMF with the Greek government and the financial support to Greece, as well as to draw the first conclusions on this crisis for governance of the Euro area.
Statement By The Heads Of State
• During the implementation Of The Support Package For Greece in February and in March, we committed to take determined and coordinated action to safeguard financial stability in the euro area as a whole.
• Following the request by the Greek government on April 23 and the agreement reached by the Eurogroup on May 2, we will provide Greece with 80 billion euros in a joint package with the IMF of 110 billion euros. Greece will receive a first disbursement in the coming days, before May 19.
• The programme adopted by the Greek government is ambitious and realistic. It addresses the grave fiscal imbalances, will make the economy more competitive, and will create the basis for stronger and more sustainable growth and job creation.
• The Greek Prime Minister has reiterated the total commitment of the Greek government to the full implementation of these vital reforms.
• The decisions we are taking reflect the principles of responsibility and solidarity, enshrined in the Lisbon Treaty, which are at the core of the monetary union.
Response To The Current Crisis
• In the current crisis, we reaffirm our commitment to ensure the stability, unity and integrity of the euro area. All the institutions of the euro area (Council, Commission, ECB) as well as all euro area Member States agree to use the full range of means available to ensure the stability of the euro area.
• Today, we agreed on the following :
• First, consolidation of public finances is a priority for all of us and we will take all measures needed to meet our fiscal targets this year and in the years ahead in line with excessive deficit procedures. Each one of us is ready, depending on the situation of his country, to take the necessary measures to accelerate consolidation and to ensure the
sustainability of public finances. The situation will be reviewed by the Ecofin Council on the basis of a Commission assessment by the end of June at the latest. We have asked the Commission and the Council to strictly enforce the recommendations addressed to Member States under the Stability and Growth Pact.
• Second, we fully support the ECB in its action to ensure the stability of the euro area.
• Third, taking into account the exceptional circumstances, the Commission will propose a European stabilization mechanism to preserve financial stability in Europe. It will be submitted for decision to an extraordinary ECOFIN meeting that the Spanish presidency will convene this Sunday May 9th.
• we have decided to establish a European stabilization mechanism. The mechanism is based on Article 122.2 of the Treaty and an intergovernmental agreement of euro area Member States. Its activation is subject to strong conditionality, in context of a joint EU/IMF support, and will be on terms and conditions similar to the IMF.
• "Article 122.2 of the Treaty foresees financial support for Member States in difficulties caused by exceptional circumstances beyond Member States' control. We are facing such exceptional circumstance today and the mechanism will stay in place as long as needed to safeguard financial stability. A volume of up to 60 billion euro is foreseen and activation is subject to strong conditionality, in the context of a joint EU/IMF support, and will be on terms and conditions similar to "In addition, euro area Member States stand ready to complement such resources through a Special Purpose Vehicle that is guaranteed on a pro rata basis by participating Member States in a coordinated manner and that will expire after three years, respecting their national constitutional requirements, up to a volume of 440 billion euros. The IMF will participate in financing arrangements and is expected to provide at least half as much as the EU contribution through its usual facilities in line with the recent European programs.

Greece Sovereign Crisis Resolved?

Martin Wolf's essay in today's FT (http://www.ft.com/cms/s/0/de21becc-57af-11df-855b-00144feab49a.html) is excellent. This discusses the cost benefits of the agreed $143bn multilateral loan to the Greek Government, much of which is really required to help secure the balance sheet solvency of Greek banks.
The data provided is also interesting. Note the table showing the difference between gross and net national debt, showing what is typically the case that one fifth to one third of national debts are internal to governments and should not really be considered when assessing national debts. In the UK's case, for example, when gross National Debt has reached 80% ratio to GDP, its net debt is only half this, and one wonders if that also includes another quarter of the debt currently owned by the Bank of England as a result of quantitative easing - probably so.A GREEK TRAGEDY
The definition of Greek Tragedy is a form of art based on human suffering that paradoxically offers its audiences pleasure. There is a large audience for the sovereign debt crisis of Greece that is taking perverse pleasure in holier than thou statements as if Greece may be classed in the same basket of felon's heads as Lehman Brothers! Righteous commentators blame Greece for being irresponsibly spendthrift and to link the state of public finances of UK to Greece etc. They are both right and wrong, but more wrong than right. Greece alongside Ireland were praised during its years of high economic growth for contributing positively to EU and Euro Area growth, punching much above their weight etc. Greece, under the assumed protection of the single currency and EU membership was merely operating a credit-led growth policy based on banks growing their mortgage business fast and lending to property developers, similar to the USA, UK, Ireland and Spain. Greece did so perhaps too enthusiastically and ran the highest trade deficit in the OECD financed by selling securitised loans to foreign investors and borrowing from foreign banks plus diaspora and tourist receipts.
Greek banks also invested massively on growing bank networks in nearby emerging countries to the benefit of developing those countries. The Central Bank of Greece tried to order the Greek banks to cut back on property exposure and lend more to productive industry and help reduce the trade deficit. But, as in UK, USA and elsewhere this is like asking addicts to volunteer for rehab. The advice was ignored when the same advice in Spain was responded to by the banks there, if somewhat late.
Arguably, the problems derive from Greece believing there is security is doing what much bigger countries were doing like USA and UK such discounting the risks of historically high trade deficits so long as these could be financed (the so-called "new paradigm for economic growth' overcoming boom & bust). It is hypocritical to blame Greece alone for its problems. When the Credit Crunch erupted it seemed for nearly 2 years that the fragility of Greece could remain below the radar of the bond markets. Greek bankers told each other that the Credit Crunch would probably by-pass them so long as Greece was counted among emerging countries when those were viewed positively. This was, of course, a massive self-delusion.
Credit-boom growth was hugely positive in transforming the living standards and quality of life in Greece, allowing it to catch-up fast, like Ireland, with EU per capita GDP average. Ireland operated an extreme credit-boom catch-up growth too with banks lending too much to mortgages and property, even more than UK banks that lent 70% of domestic loans to mortgages and property. The differences were that Ireland ran the highest trade surplus in the EU while extremely paradoxically also the highest payments deficit, and the UK generated a large financial services external surplus to off-set its more trade deficit. Greece was hoping to emulate the UK by how its banks were investing in cross-border retail banking but failed abysmally to get its banks to support export industries, while its main competitive advantage, its huge shipping fleet increasingly operated in tax, borrowing and GDP terms off-shore. Greece's enormous trade deficit is as much a long term failure caused by the choices of banks of who and what to lend to as by government, but also very much an outcome of false assurances from the EU and the models they followed of the USA, UK, Spain and Ireland. Germany's position in the whole matter is self-serving and hypocritical too insofar as its trade surpluses require there to be countries running deficits. It's excessive lending to business borrowers instead of mortgage and consumer borrowers leaves its banks vulnerable to funding costs so that the worse the sovereign risk costs of deficit countries are the lower are the borrowing costs of its banks and corporates. Greece is a mere pawn in a bigger global game. The main points of Wolf’s article are:
After months of costly delay, the eurozone has come up with an enormous package of support for Greece. By bringing in the IMF, at Germany’s behest, it has obtained some additional resources and a better programme. But is it going to work?
It is a package of €110bn ($143bn) (over a third of Greece’s outstanding debt), €30bn of which will come from the IMF (far more than normally permitted) and the rest from the eurozone, enough to take Greece out of the (borrowing) market for more than two years.
Greece promises to reduce government borrowing by 11%/GDP over 3 years, on top of cuts already taken earlier, with the aim of to reach 3%/GDP deficit by 2014 (13.6%/GDP in 2009). Cuts are 5¼%/GDP annually for 3 years. Pensions and wages will be cut then frozen for 3 years. Seasonal bonuses abolished. Tax rises = 4%/GDP. Gross national debt will peak at 150%/GDP.
This is far less unrealistic than the first deal. The fantasy of a mild contraction this year followed by steady growth is gone. There will be cumulative decline in GDP of 8% (rough forecast). The new plan sets 2014 as the target year instead of 2012.
There is to be no debt restructuring; and the ECB will suspend the minimum credit rating required for the Greek government-backed assets in its liquidity operations, thereby offering a liquidity window to Greek banks.
The alternative was default in paying debt interest, but it would have to narrow its primary budget deficit (before interest payments), by 9-10%/GDP immediately, far more brutal than Greece has now agreed. With default, the Greek banking system would collapse. It can instead gain the time to eliminate its primary deficit more smoothly.
It is likely that Greece will however have to run a primary budget surplus of 4.5%/ GDP, with revenue of 7.5%/GDP devoted to interest payments. Will the Greek public bear that burden year on year? With huge fiscal retrenchment without exchange rate or monetary policy offsets, Greece is likely to experience a prolonged slump. Would structural reform work e.g. huge fall in labour costs to gain a prolonged surge in exports to offset the fiscal tightening, or a hugely higher financial deficit of the private sector? That seems inconceivable. If nominal wages fall steeply, the debt burden would worsen.
Greece is being asked to do what Latin America did in the 1980s, which led to a lost decade, the beneficiaries being foreign creditors. As creditors are now paid to escape, who will replace them? This package will surely fail to return Greece to the market, on manageable terms, in a few years. More money will be needed if debt restructuring (forgiveness and or longer maturity and or lower rates) is ruled out.
For other eurozone members, the programme prevents an immediate shock to their fragile financial systems. It is overtly a rescue of Greece, but covertly a bail-out of banks – and unclear that it will help other member states now in the firing line.
Investors could well conclude that the scale of the package required for tiny Greece and the overwhelming difficulty of agreeing and ratifying it, particularly in Germany, suggest that further such packages are going to be elusive. Other eurozone members might well end up on their own. None is in as bad a condition as Greece. Several have unsustainable budget deficits and spiking debt ratios. In this, their situation does not differ from that of the UK and US. But they lack the same policy options.
This Greek Tragedy, in short, is not over nor confined to Greece. For the Eurozone, two lessons - first, it has a choice – either it allows sovereign defaults, however messy, or it creates a true fiscal union with strong discipline and funds sufficient to cushion adjustment in crushed economies – Mr Willem Buiter (Citigroup Chief economist) recommends a European Monetary Fund of €2,000bn; and, second, adjustment in the eurozone is not going to work without offsetting adjustments in core countries. If the eurozone is willing to live with close to stagnant overall demand, it will become an arena for beggar-my-neighbour competitive disinflation, with growing reliance on world markets as a vent for surplus. Few are going to like this outcome.
The crises now unfolding confirm the wisdom of those who saw the euro as a highly risky venture. These shocks are not that surprising. On the contrary, they could have been expected. The fear that yoking together such diverse countries would increase tension, rather than reduce it, also appears vindicated: look at the surge of anti-European sentiment inside Germany. Yet, now that the eurozone has been created, it must work. The attempted rescue of Greece is just the beginning of the story. Much more still needs to be done, in responding to the immediate crisis and in reforming the eurozone itself, in the not too distant future.

DANGER WARNING: WHEN BOND ISSUERS PLAY FOR TIME

The famous British economist A.C.Pigou, whose equilibrium theories became part of the neo-conservative view of monetarism, was a KGB agent-recruiter and passionate climber. He knew it can be as dangerous in deciding how to descend a difficult mountain as to climb it; the inclination is to use the same hand and foot holds coming down as were made going up. All holds that sap your strength or might give way under strain have to be correctly judged as merely temporary, not a fit subject for betting on the better purchase value of delaying decisions. When poor health meant he could no longer risk taking potential recruits climbing he entertained them instead to cream teas by the river as his suitability test. In both tests he who hesitated was lost.
A STITCH IN TIME SAVES NINE
Bank and Corporate bond issuers are repeating the mistakes of the credit crunch by hoping for lower spreads if they delay a few weeks or months! This is irresponsible and dangerous! How did such postponements trigger the credit crunch and recession?
One analogy comes from the question behind Obama's health care reform: if medicines cost money and are expensive, and instead of taking doses regularly as prescribed do you save money by waiting longer between dosages; do you risk a worse sickness?
It is inevitable that in business the main medicine is money, and the medicine cabinet is the bank.
Just as many medicines deal only with symptoms while buying time for the body to heal itself, so too does borrowing buy future time to pay for investments made now. As the world trade imbalance became extreme between credit-boom economies, that ballooned household debt backed by rising property wealth, and export-led economies, that suppressed household wealth and lent heavily to industrial companies, banks in both types of economy became over-lent, one to property, the other to production. We know how household and finance lending grew enormously in credit-boom economies, but so did it too in export-led economies e.g. Germany. Germany and China with the world's highest trade surpluses and described as awash with savings, do not have great financial resources internally. Their banks are also vulnerable from lending too much to business as UK and US banks lent too much to property. China has desperately tried to maintain its growth by expanding credit and now is rightly frightened about this, about how poorly Chinese manufacturers can service their debt and is cutting back. The credit crunch put a stop to the previous extreme imbalance in the pattern of world trade and its deficit financing. In credit-boom economies the banks went global, serving an international market (globalisation) that is only partly evidenced by banks' assets in ratio to home country GDP.BANKS POSTPONE DECISIONS AND FALL INTO WORSE LOSSES: examples
1. Economists saw the economic cycle peaking in 3Q 2005 and cyclically turning down a year later. To global macro-economists (of which there are precious few) the extreme imbalances in world trade were obviously unsustainable for much longer. Investment returns in property especially fell below bank deposit rates, and GDP growth in credit-boom economies slowed. Property markets peaked: sales dried up; prices falling patchily at first, then nationwide in the USA. Bankers smoothed the problem by upping issuance of securitised bonds to make mortgage lending self-financing short term and in credit derivatives leveraged up to chase paper-profits in unrealised asset gains as net disposable incomes and savings fell. Any banks who could borrow more by issuing bonds did so. They postponed the onset of 'Anglo-Saxon' credit recession by 1-2 years.
2. US and UK banks had $30 trillions of foreign balance sheets a ratio of 50% to world total output and 100% of world trade - that dominated the world's trade imbalances financing and international funding of banks round the world. They postponed withdrawing that liquidity until 2008-09 when it shrank by $3 trillions. The following graphic only shows the dominance of UK and US banks in private customer lending.3. After June 2007, when asset backed securities issued by banks were day after day downgraded following Moody's fixing its false ratings model. Moody's had graded half of all securitised asset-backed loans. Fixing its model and then regrading all of these sent the market values of the banks' bonds tumbling and directly triggered the credit crunch of interbank lending becoming too expensive to sustain banks' interest margins. Banks needed typically 1.5% lending margins. When margins fell to 0.5% (50bp), the banks sought 150bp from fees alone from lower quality tranches ABS. When the quality of bank bonds became exposed, bank shares weakened internationally and continued falling for 22 months. From August 2007 the interbank market for financing banks' funding gaps became expensive. 4. In Summer '07, Northern Rock with £110bn assets and the highest funding gap (between deposits and loans) based on growing aggressively several times faster than the growth of deposits, found, like many banks, that it could not book forward refinancing at rates to maintain its aggressively low interest rate margin and tried to postpone doing so in hope that funding rates would soften, but its board insisted on going to Bank of England for liquidity support - that became public thanks to the BBC. There was a run on the bank that became a worldwide news spectacle.
5. Q1'08 Bear Stearns collapsed when it failed to meet collateral margin calls. Other banks like Citicorp, HBoS, UBS, WaMu, M-L, and others face short-seller attack based on rumours they cannot economically refinance their borrowings at a price needed to maintain their lending margins, especially in corporate loans.6. Many banks bet that the fall in bank shares and in asset backed securities and credit derivatives would be temporary because underlying net cash flows remained strong e.g. Lehmans and RBS buying more stressed assets because they looked cheap, and Barclays trying to do so but luckily failing! UBS dumped loss-making assets into customers' 'profits-only' savings accounts! But they were wrong and had under-estimated the impact on their balance sheets and capital of write-downs and growing loan-loss provisions. Some banks had backed their contrarian wishful thinking by maximising their leverage to the extent of breaking the rules and limits on capital reserves and risk diversification, most especially Lehman Brothers. September '08, Merrils, AIG, Lehman Brothers, and HBoS, followed by RBS and Fortis, and others need emergency saving; they have hit absolute cash-flow insolvency. Lehman (with £0.8tn of claims against it) is allowed to collapse and $2.5 trillion of failed trades (were sellers had gone short) hit money markets. Central banks have to balloon their balance sheets (both sides) to save national and international banking system.
7. The inter-bank funding market spread, already expensive but slowly falling, in Q3 & Q4 '08 spiked and funding dried up almost totally - The Credit Crunch - requiring central banks to step in and replace private funders by taking banks' loanbooks (securitised or simply 'covered) as collateral for central bank counterparty assets.
At the time I said, and in hindsight it became clear, that had banks accepted the higher cost of funding refinancing as their notes became due, which would have proved temporary, their realised profit fall or losses (also temporary) and capital reserve loss, would have been a mere fraction of the losses they did incur.
The banks would have had to rapidly and radically adjust their business models. They resisted this or simply did not know how to or even lacked the management authority within their sprawling financial conglomerates to do so?
CORPORATE BOND ISSUERS
Denied bank loan growth and suffering balance sheet deteriorations, corporate borrowers found themselves having to offer junk bond rates at 9% typically, or double the spiked rates that the banks had refused to accept! Since April 2009 equities began recovering and bank funding rates softened, but in expectation that rates will significantly fall further, now many companies are deferring the renewal of committed revolving credit facilities.
Instead of simply accepting the price today, they are speculating, betting, living in hope that an improving market leads to better pricing, terms, and maturity. They have rapidly it seems failed to draw the lessons of, or forgotten, how at the peak of the credit crisis, revolving credit facilities - to fulfill their purpose as standby liquidity in the case of unforeseen events or to maintain the current balance of both sides of their balance sheets. As companies faced acute operating stress,drying of the bond, securitization and commercial paper markets, that meant changes in bank lending capacity and behaviour, revolving credit became the most critical factor in
corporate liquidity, just as it did for banks.
Draw-down of revolving credit commitments was historically considered a red flag viewed as a precursor to bankruptcy. As bank credit tightened and undrawn overdrafts were cut in the credit crisis, covenant violations, revolving credit maturities, or simply the capacity and willingness of banks to fund their commitments undermined the accepted practice of incorporating undrawn revolving credit capacity into an aggregate liquidity number.
As the uncertainties of the crisis grew, drawing down on revolving credit agreements became more commonplace and was often viewed as a prudent strategy as opposed to an unequivocal warning sign. At the depth of the crisis, revolving credit commitments extended by the banks became often limited to 364-day or two-year facilities as a result of bank capital ratio stress and negatively viewing corporate credit risk.
Corporates found that bank facilities only provided short-term liquidity protection and added to refinancing risks that in a prolonged period of high uncertainty (in trade, business and capital markets) undrawn credit facilities no longer offered long-term standby liquidity to weather the economic cycle and/or other credit risks.
BANKS RESTRUCTURING (SHRINKING) BALANCE SHEETS
Banks' balance sheets behave pro-cyclically, ballooning in cycle peak years, then suddenly shrinking in recession shcok and being slow to grow again in recovery years.
In the initial two years of the economic upswing after 2001 it was not loan demand, but reduction in bad loss provisioning that drove banks' earnings, followed by sharp rises rising on the warm air of the newsflow on corporate profits, plus aggressive cost-ratio cutting.
The rise then levelling out of loan demand and credit defaults falling to low default rates (dramatically lower default risk, easiest to achieve when new loans are easy or cheap), junk credit spreads fell from around 20% to below 8%. Unsurprisingly, bank share prices doubled in 2003 in six months, smartly outperforming the broader market.
Capital investment and bank lending to support this grew in the export-led countries. Utilisation rates in the US, Germany and Japan all moved higher along with profits for the corporate sector.
The UK and USA household credit cycle peaked in 2005. When recession was obvious by end of '07 and into '08, corporate debt expanded for a while even when the household sector's began to slow and residential property prices fell. Then, beginning with property developers, corporate debt looked very risky. But, the embarrassment of the corporate sector appears deeper but shorter lived than the household sector. UK and
US house prices appear now in Q1 '10 to be slowly on the rise. With greater backlog of orders, US firms are no longer cutting working hours, and unemployment rates are only edging higher after having moved up substantially in '09. In the UK, unemployment is a third less than normally be expected.
Some rise in consumer confidence is feeding through to the housing market, but based on a preponderance of buying properties at heavy discount and a lot of bank-owned properties being held off the market. Home sales are off their lows and, most importantly for banks, house prices appear to be forming a bottom. With a sharp reduction in loss provisioning, bank earnings ought to rise through 2010.
The steep yield curve is currently exceptionally helpful for the banks; about half of bank assets are lent at long- term rates, and 3-month LIBOR is c.50bp. As banks hold the line against growing loans (that fell 8% in 2009 by US and UK banks), banks can add to their Treasury holdings to further benefit from the yield curve. UK and USA Bank holdings of Treasuries have risen by $half a trillion over the past year and will increase substantially more to build up capital buffers.
In doing so, however, shrinking their loan books, the banks are not helping economic recovery. They are putting their narrow interests first and using new regulatory requirements to do so. Corporate bond issuers appear to be joining in the deleveraging, which means delaying capital investment, and now on top of this also delaying new net corporate bond issues?

EUROPEAN MONETARY FUND

European Commission President Jose Manuel Barroso at a media conference on Europe 2020 at EC HQ Brussels, March 3, 2010. The European Commission will eventually announce ways to safeguard the stability of the 16 nations that share the euro, to stem problems such as Greece's debt crisis from threatening Europe's currency union.
16 states are in the Euro Area (also called Eurozone) and are requested by Germany and France to consider creation of a "European Monetary Fund," a fund that could help euro-member countries converge more on the Maastricht Treaty criteria, which apply as ceilings for all EU members, not just those in the Eurozone. Germany and France first announced they were considering a European Monetary Fund on 8th March, describing this thinking as seeking new safeguards against the kind of eurozone instability created by Greece’s debt crisis. Support for an EMF for the Euro Area to be modelled on the IMF, was revealed at the weekend by Wolfgang Schäuble, German finance minister, who told Welt am Sonntag newspaper that Berlin wanted more eurozone policy co-ordination. This is absurd from a practical economic perspective - if all Euro countries followed Germany's policy lead i.e. export-led growth, then unemployment will remain high and Germany's policy would have to change.The idea of EMF is a good political move! It heads off the embarrassment to the Euro Area Council and the ECB of Greece seeking help from the IMF, and if any other Euro Area states, such as Portugal, Ireland or Spain, do the same. It also heads off criticism especially of the European Central Bank (ECB), which ought to be fulfilling that same function, and provides another route for funding by EU states and private banks to route soft loans indirectly. All expect sovereign crises to be inevitable, the inevitable result of governments taking on some of the burdens of private over-indebtedness.
Sovereign debt crises are associated with countries that have very high national debt to GDP ratios. But that is not the issue; it is trade deficits and private and government cross-border borrowings i.e. loan pricing pressures from lenders. Japan’s debt ratio of about 190%/GDP is very high, but because it is has a large trade surplus it is a net creditor nation. The US with National Debt of 83%/GDP with most of the world's trade deficit is a debtor nation, but secured by the $US dollar's global currency role denominating more than half of all trade and international financial transactions. The Greece crisis is also deficit-led, but small in EU or global terms. It will not cause lasting damage to the Euro or European Monetary Union, but ushers in some long-run changes within the Euro Area that may go in one of two ways, either towards severe growth tightening or towards more flexibility? The Euro Area as a whole has a 'national' debt ratio of 78%/GDP (the line towards which the UK is now headed). But those above that line that have high trade deficits (not Italy despite its over 100%/GDP debt ratio) i.e. Spain, Ireland and Greece (which may be joined by the UK) all planning unprecedented tightening - the next five years will be a test of political-economic courage for all European leaders. So far they do not appear to be able to disengage from domestic sabre-rattling or flag-waving - it is like an economic phony war. Will it turn into a real ideological war over economic policy and beggar-the-neighbours or cutting off noses to spite faces real economic damage? The IMF has been given such a role by G20 in which the EU is a full participant. nevertheless it is embarrassing for the Eurozone to be shown politically prevented from helping member states in difficulty while the IMF can do so. The Greece sovereignty crisis is probably only the first of several.
This EMF idea comes hard on the heels of Greece saying it will appeal for IMF help if Euro Area states and the ECB cannot help it with loans. Some €26bn of ECB short term (1 year) loans were provided to Greek banks. They have to be repaid starting in June, and cannot be simply rolled over because the ECB decided to stop issuing any more such short term loans in December last. Further loans have been agreed but on conditions of public sector spending cuts that are causing protest riots and strikes almost daily in Athens and elsewhere. Greek banks and the central bank need about $200bn to cover trade deficit and funding gap financing. US commercial banks hold $156bn of Greek banks' notes. Private sector borrowing should not be confused with public sector, or the latter if it is high looked at without considering the context, such as the tag placed on this chart. If structured like the IMF, the EMF could provide some stability tools that the euro needs, and that the ECB in Frankfurt is, for political rather than economic reasons, constrained from providing. The European Bank for Reconstruction and Development (EBRD) in London seems to be overlooked in this? EMF is also a sign of Europeans wanting to decouple from what they perceive to be Anglo-Saxon finance and economics.
The Greek crisis has weakened the Euro. If more Euro states seek loans from the IMF that is a further threat to the Euro.
When the currency was born in 1999, it was obvious to all that one weakness was the lack of a federal political entity supporting the ECB. To fill this gap in terms of states' budget deficits and debts, all EU states signed the Maastricht Treaty that set limits of 3% ratios to GDP as the ceiling for annual budget deficits. But, enforcement penalties were ambiguous. The markets are finding a way to exert the punishment and still arbitrage between different EU and Euro Area members even though a single ECB central rate and single currency denominated bonds was supposed to stop markets from differentiating and attacking any of the member states individually - that was the purpose of the Euro. It is not working so long as the ECB is not acting on behalf of the whole Euro Area regardless of different budget settings and different growth strategies. Policy differences should be addressed outside of the ECB, not inside. Would an EMF be any different; would it be less picky and less political?
The problem boils down to some countries pursuing export-led growth (mainly Germany) and others credit-boom growth rquiring them to finance rising trade deficits e.g. Grece, UK, Ireland, Spain. While Germany focused on integrating its Eastern regions and on exports, but doing nothing otherwise to stimulate domestic growth, other countries grew by bank borrowing and lending secured by rising property values and needing to sell securitised banking assets and borrowing to finance their trade deficits, of which Greece had proportionately the highest. From the perspective of Portugal, Spain, and Greece, and a few others, they considered themselves to be in economic catch-up mode, and following the example of Ireland's property credit boom.Note the stagnant and falling property prices of Germany showing how it traded the idea of household home-ownership and household wealth for export-led growth i.e. keeping domestic consumer demand depressed, going for high savings and international creditor status instead of what might be called democratic prosperity - the stated goal followed by USA, UK etc.
Yet, so long as this seemed to be working, the credit boom economies of Spain, Greece, Ireland were praised for their above average contribution to total EU and Eurozone growth. There was no concern expressed in EU economic reports about these countries trade deficits or eventually unsustainable housing booms until the asset bubbles burst. A clear demarcation arose between the centre of the EU and its periphery. But this is no different from the picture worldwide, and where cerdit-boom economic growth translates not into high public sector or national debt, but very high private sector debt - that is the real long term problem that economics and its politics have to now consider centre-stage and not leave lingering in the background as hitherto.
When you click on the next graphic to see it full size, you should be amazed to see the differences in size of countries dictated by how much has been loaned to, borrowed by, private sector. Note how small countries are proportionate to their population and economic size e.g. even Japan and shockingly China (which since this graphic has doubled private sector loans, but still this remains small. Proportionately small lending to the private secotr shows economies that are externally very dependent and that have done relatively less or little in deepening and broadening their domestic economies in terms of per capita incomes and actual per capita household wealth. Europe's Mediterranean countries - now called the "PIGS" (Portugal, Italy, Greece and Spain) - are accused of having less fiscal discipline than Germany. This is unfair in the case of Italy, whose problems derive from opposite reasons to the others; Italy did not follow credit-boom growth, but at the same time found it could not generate an export-led growth model like Germany's. Italy, like France, kept its external account roughly in balance. The 'I' in PIGS should stand for Ireland. The advent of the euro gave Ireland, Spain, Greece and Portugal low real interest rate shocks, that fuelled credit-booms - and were for years highly beneficial, but could not continue in 2008 and 2009. The result was gigantic housing and other property asset bubbles. Italy had modest productivity performance and grew its economy to overtake that of France in GDP and trade, if falling behind Germany at a rate of almost 3% a year. Italy's budget discipline was good, but carrying a high national debt ratio. Its banks remained extremely prudent - too much so! Greece (and Cyprus), with the far to go to catch up with the EU GDP per capita average did so rapidly. But the result was a trade deficit approaching 20% ratio to GDP, by far the highest in the OECD.
Greek banks became heavily borrowed and invested strongly in bank subsidiaries in SE Europe to whom the banks lent about $150bn. Other EU countries' banks also invested in growing banks in central Europe and Russia, providing total liabilities of about $1.5 trillions. The EBRD, ECB and others are much concerned about how the central European economies are performing and whether the banks are remaining solvent.
With the EMF proposal, it should be possible to design a fund that solves this problem - but, only if it is able to build up a substantial balance sheet of probably at least €500 billions, when it would overtake the EBRD and rival the ECB in funding.
If the EMF behaves like the IMF (and World Bank) it could force Greece and any other country that needs loans from the fund to restructure their economies and budgets. This would involve cutting back the public sector, capping wage rises, undermining labour unions, and possibly privatizations of public utilities - condiions that would do more than blow the froth of economic growth! The second achievement of such an EMF could be the creation of a bank bailout process that is at least as onerous as required by European Commission rules to protect fairness in the Single Market. There is an irony here that the Single Market and a single currency do not allow member states (regions) to divert from a rigid average or lowest common denominator norm.
Last week, ECB decided to maintain some support for the Euro Area banking system in light of the Greece controversy. ECB President Jean-Claude Trichet said, "We considered it was exactly appropriate taking into account the present situation." When pressed on what present situation he meant, he said he meant concerns over Greece. For at least the next 7 months, funds to keep banking operations running smoothly over seven-day periods would continue to be available in unlimited quantities at the ECB's rate, currently 1pc. But that does not change the repayment deadlines of the Greek banks! Athens' need to raise €20bn (£18bn, $27bn) in April and May to finance expiring debt is likely to widen spreads above the 300bp that Greek bonds incur above equivalent German Bunds.
On ECB overnight money, Trichet said the rate banks charged each other would not rise much in the short run. The overnight rate is currently at 0.32pc and the ECB regards this as very cheap money. Actually, of course, the insurance spreads on Greek debt and bank debt remain high at about 300-400bp, and while they should fall over the years, they may rise again in the coming months. Although bond spreads have narrowed since the launch of the latest austerity package that is the cause of splits within the governing party, street protests and Thursday's strikes, Greece currently has little choice but to pay 300bp more than the equivalent German bond – a premium that Greek government officials rightly say is unsustainable.From next month the ECB will return to the pre-crisis practice of offering three-month loans to the banks at a variable, instead of a fixed rate. When the 7 months are up, the ECB will decide whether and how to bring overnight rates back to normal condition of slightly above the benchmark rate. By then the banks aided by the ECB will have to have financed the ECB's "exit" strategy - of particular importance to Irish banks, the heaviest users of ECB loans of more than €50bn(January). As ECB soft loans end, interbank interest rates will rise before the ECB raises its own rate.
Irish banks used last 12-month loan at a fixed 1pc offered by the ECB in December. Banks must repay the first of these fixed loans in July - a total eurozone repayment to the ECB of €442bn, actually a reverse swap, taking collateral back and giving back ECB bills plus interest and fees. From other sources at the same time they will need to borrow finance to fill their funding gaps at that time, which will have grown by over €400bn.
The ECB described this process as a new stimulus measure, described as lending back "covered bonds" it bought during the crisis, saying this will help banks borrow funds on the market. If Orwell was alive and writing today he would describe such language-spin of the banks as 'newspeak'. The credit crunch was essentially banks unable to use their covered bonds to borrow against from other banks at economically viable rates i.e. at margins below what they can safely lend to customers at. The banks have to hope that for some reason interbank lending will in the next few months turn positive from negative and at spreads that are realistic for borrowers to accept.With the bonds markets continuing to be jolted by sovereign risk news, part of the recovery in equities has to be a flight from bonds? The long 9 months of recovery in fixed income assets prices extending to sub-investment grade and sub-prime RMBS has come to an end. Price spread volatilities including credit risks are 15-40%.
The media are complicit in such misdirections. The Bank of England decided this month, for a second month, not to resume what the media persist in calling its "money-printing" programme of buying government debt from banks. Apart from the purchases being designed not to be from banks, having called its actions as Quantitative Easing, it may be no wonder that the news media try to explain this by calling by the misnomer "printing money".

WORLD ECONOMY DILEMMA

Reported in the FT: Forecasts in the OECD’s latest Economic Outlook imply that in 6 of its members (the Netherlands, Switzerland, Sweden, Japan, the UK and Ireland) the private sector will this year run a surplus of income over spending greater than 10% ratio to GDP. Another 13 will have private surpluses between 5% and 10%. The latter includes the USA, with 7.3%/GDP. The eurozone private surplus will be 6.7%ratio to GDP and that of the OECD as a whole 7.4%. In the USA, In the eurozone, it is forecast at 5.5%/GDP and in the OECD at 7.3%. Actually this is also a product of private savings rising as the counterpart to public sector higher borrowing, after change in the external account balance.
Moreover, the shift in the private sector balance between 2007 and 2010 is forecast to be 9.7% in USA, and exceed 10%/GDP in no fewer than 8 OECD member countries. It is also forecast to exceed 5%/GDP in another 8. Martin Wolf commenting on this says, "Depression threatened. Note that such huge shifts towards frugality will have occurred, despite the unprecedented monetary loosening. While the latter helped prevent a still-greater collapse in private spending, the huge fiscal deficits, largely the result of automatic stabilisers, have been no less important. If governments had tried to close fiscal deficits, as they attempted to do in the 1930s, we would be in another Great Depression."
Wolf then asks, "So how do we exit? To answer the question, we need to agree on how we entered. A big part of the answer is that a series of bubbles helped keep the world economy driving forward over the past three decades. Behind these, however, lay a credit super-bubble, which burst in 2008. This is why private spending imploded and fiscal deficits exploded."
I explain what he means by the bubbles in terms of credit boom growth later below.
Wolf continues, "Now, after the implosion, we witness the extraordinary rescue efforts. So what happens next? We can identify two alternatives: success and failure.
By “success”, I mean reignition of the credit engine in high-income deficit countries. So private sector spending surges anew, fiscal deficits shrink and the economy appears to being going back to normal, at last. By “failure” I mean that the deleveraging continues, private spending fails to pick up with any real vigour and fiscal deficits remain far bigger, for far longer, than almost anybody now dares to imagine. This would be post-bubble Japan on a far wider scale. Unhappily, the result of what I call success would probably be a still bigger financial crisis in future, while the results of what I call failure would be that the fiscal rope would run out, even though reaching the end might take longer than worrywarts fear. Yet the big point is that either outcome ultimately leads us to a sovereign debt crisis. This, in turn, would surely result in defaults, probably via inflation. In essence, stretched balance sheets threaten mass private sector bankruptcy and a depression, or sovereign bankruptcy and inflation, or some combination of the two. I can envisage two ways by which the world might grow out of its debt overhangs without such a collapse: a surge in private and public investment in the deficit countries or a surge in demand from the emerging countries. Under the former, higher future income would make today’s borrowing sustainable. Under the latter, the savings generated by the deleveraging private sectors of deficit countries would flow naturally into increased investment in emerging countries."
Martin Wolf recognised and repeats here what Lord Turner at the FSA and others, but not all, know that the credit crunch has its origins in extreme world trade imbalances that developed in the past decade, extreme differences between credit boom (CB) growth economies (that he calls deficit countries) and export-led (EL) growth economies (that he calls high-income countries).
In CB economies (USA above all, also UK, Spain, Ireland, Greece etc.) increasingly the trade deficit was financed by banks selling asset backed securities directly and indirectly to the EL economies (Germany, Japan, China etc.). The CBs grew by boosting domestic consumption and housing wealth thereby drawing in more and more net imports, while the ELs grew by exports and by capital investment (especially in China's case).
The world, and within it the EU, was polarised by two growth policy extremes, between CBs with a rampant internal growth impulse and ELs profiting from CBs by remaining heavily baised to external growth impulse; everyone else can be placed in a mixed continuum somewhere in between.
Martin points to the dilemma we face now. This reduces to how to avoid simply returning everything to how it previously was? He suggests we do this by CBs investing more and ELs consuming more. The CBs and ELs have to shift, or even reverse, their stances, essentially to rejoin the rest of the world in a mixed policy of trying to balance external and internal growth.
For die hard monetary policy managers, I'm sorry for them if they find such an explanation with its focus on external account and trade too much like Keynesiansm of the past, unpalatable, deeply unfashionable for their modernist technocratic-monetary taste. Martin ends by saying China must boost its consumption. It tried last year and has taken fright because the credit liberalisation went to boost infrastructure and capital investment further which is it knows and recognises already structurally far to high a % of GDP. The country’s banking regulator has told lenders to cut back on credit, especially non-recourse loans to local governments’ financial arms in an attempt to reduce future bad loans. China remains reluctant to boost wages and give up (not until it knows it absolutely must) its low-wage cost competitiveness. It is hooked on economic good news as its main global brand image, like a cocaine addict, desperately unwilling to look at the truth behind the advertised facts that might necessitate revising its economic size downwards by at least 40%! Yet, even with its large population, how it expects to become genuinely the world's second biggest economy with wages at $6,000 beggars understanding.
China, in pursuit of its healthy aspirations to lead the BRICS and join the OECD country club, should enforce its 40-hour week legislation and encourage its population to aspire to more leisure and a higher quality of life. But, the same is also true of highly developed EL economies, Germany and Japan. They need to do far more to actively examine their own internal barriers to higher consumption and internal job creation.
The CBs are far less averse to changing their growth stance that the ELs with their classic conservatism of why do anything different when I have plenty of money lying in the bank?
We may have to wait for China to experience an almighty asset bubble burst and then for the German-led Euro Area's regular recession bus to arrive in about 2 year's from now.
What will shake Japan out of its tree should not be yet more loss of self-confidence, but a recognition that it is time to take its profits and spend that domestically to give its hard-working people the reward of a decade or so of a good time. Of course, the USA tried in vain saying that to Japan for decades without response, and no doubt that is the model that inspires China.
Wolf points to further implications, "Yet exploiting such opportunities would involve radical rethinking. In countries like the UK and US, there would be high fiscal deficits over an extended period, but also a matching willingness to promote investment. Meanwhile, high-income countries would have to engage urgently with emerging countries, to discuss reforms to global finance aimed at facilitating a sustained net flow of funds from the former to the latter. Unfortunately, nobody is seized of such a radical post-crisis agenda. Most people hope, instead, that the world will go back to being the way it was. It will not and should not. The essential ingredient of a successful exit is, instead, to use the huge surpluses of the private sector to fund higher investment, both public and private, across the world. China alone needs higher consumption. Let us not repeat past errors. Let us not hope that a credit-fuelled consumption binge will save us. Let us invest in the future, instead."

GREEK CRISIS

Leaving aside questions of how big the black market and smuggling is in Greece, or whether it has used several questionable techniques for disguising the country's true GDP/GNP, debt and deficit, or the passionate left/right politics, Greece is being singled out as the comparative example within the EU whereby the other states may feel only relatively virtuous. What did the country's economy really do and what was the cost benefit to it of Euro membership? Greece's Prime Minister warned his country’s debt woes are a ‘European problem’. But he issued a plea for EU help as deeper-pocketed nations led by Germany continued to wrangle over what kind of rescue is appropriate. Spain, Ireland and Portugal are thought to be most vulnerable to a loss of confidence among investors as they grapple with massive debt mountains. Spain is the most worrying case given the size of its economy. Economists at BNP Paribas estimate that bailout costs of Europe’s fiscal crisis could be £280bn, of which nearly £175bn is attributable to Spain. In Greece's case the requirement is only a few tens of €billions.PM Papandreou says, ‘We are a country which cannot alone deal with the speculation. So this has become a European problem, because if we do have a major problem, this could create a contagion for other countries too who are not to blame,' which is putting the matter kindly. There are some domestic policy problems. Germany’s Finance Ministry yesterday says it has no specific plans to help Greece after a magazine claimed eurozone governments may offer £22bn of financial aid. In fact, that much they have already supplied. It is a test for the flexibility and integrity of the Euro Area idea. It is also a domestic political test in a country, and Athens especially, where political protests are a well-honed art form. Greece has a massive shipping sector, biggest port in the Medittaranean, valuable tourism, and reliable agricultural exports, but not enough to balance the external account at a tolerable level. These and other productive industry sectors did not grow their borrowing or were denied loans by the Hellenic banks that were obsessed like banks in UK, USA, Spain, and Ireland with mortgage boom, but also growing their banking networks in Turkey and the Balkans.
In Greece's case, fast growth in home ownership was a new and novel experience, especially exciting for the economy, part of its catch-up with the aggregate average of the EU. Greece has been much transformed for the better by its decade of fast credit-boom growth. It embraced credit-boom, but the external trade deficit rose to 18% ratio to GDP, the highest in the OECD. This would not have been possible without Euro membership that secured it from currency risk, but could not help it to balance its external account better. Yet, for most of the last decade the economy felt very positive.
Doom-monger economists like myself and real banking experts recognised the boom must eventually end and the property bubble would burst - as it did, if later than for UK and USA, and 90% of bank capital, as I predicted in 2006 for 2009-2012 for several banks including the Central Bank, would be nominally wiped out - at least until debt recoveries and economic recovery would restore matters. Warnings and advice to restructure lending by the Bank of Greece in 2006 and 2007 to the commercial banks were ignored. The banks securitised a fifth of their loanbooks, grew their funding gaps, just like banks elsewhere were doing, and thereby financed the trade deficit to worsen, and grew their property lending gloriously, just like Ireland. And like Ireland, while recognising the perilousness of the situation Greece expected the Euro Area economy would take care of them and the Euro Area economy would bounce back. The ECB did not, however, prove as flexible and as resolute as The Bank of England and The Federal Reserve in scaling up to deal directly with the Credit crunch.
The Euro Area's members like Greece and Ireland that had for some years been the fastest growing and much above average contributors to general Euro Area growth might have felt they had the right to special temporary emergency help when the crisis hit them - a false hope. One intersting difference surprisingly between Ireland and Greece is that the problems of Greece not Ireland were able to knock 50 points off the S&P 500!
What Greece like Ireland under-estimated was the implication of their central banks not having access to their own money market facilities, which had been given over to the ECB. This has meant that unlike UK and USA, bank bailouts had to be negotatiated with ECB or paid for by special loans from EU/ECB or paid for on-budget by bond issuance - most painful in Maastricht terms. It is the fact of having to resort to on-budget bond issuance that makes the deficit and debt ratios especially high, but as sanguine realists have commented, this is a small and temporary problem in the wider scheme of EU-wide economic concerns.
The Bank of Greece had before the crisis advised its member banks to lend more to help exporters and reduce the share of their loanbooks dominated by property. This remains urgently important advice. We must hope that the Greek banks take this advice seriously and now act upon it.

G20 AGENDA STALLING - DAVOS NEWS

UK Chancellor Alistair Darling said on Friday UK would not join in any European effort to bail out Greece. This sounds harsh - Darling is no Lord Byron for Greece a la 1820s or no Churchill sending in the british and French fleets in 1916, and BEF in 1941 and the Fleet for some bombardment after WW2, times when Greece was in crisis. Greece should be hlped by other Euro area economies. The UK has much to do given the disproportionately large share of EU financial services in its jurisdiction - additionally perhaps it might get round one day to helping Ireland and being less beligerent with Iceland.
Darling has pledged not to use differences in global financial regulations to promote the City of London. That's nice - in fact some would say he has been doing more than that and making London somewhat less attractive - which to me doesn't matter much either way. Others, however, are not so legalistic. It is part of EU law that no EU state should seek to beggar its neighbours or create competitive advantages for its financial sector. Yet, The Mayor of London and other Conservative figures and supporters are saying the opposite that their priority must be to enhance the ttractiveness and competitive advantages of London. fact is they don't know how to do that and would be foolish to imagine that less regulation would do it. the matter is not so simply defined. Calculating the cost/benefits of regulation is business terms is very hard to do. In repeating my view on Greece, Darling said, when answering questions about a possible EU bail-out of Greece at Davos, that it is a problem as one for the eurozone i.e. the Euro currency states and the ECB, not the wider European Union. (For analysis of Greece see my blog: http://monetaryandfiscal.blogspot.com) “The euro area has primary responsibility for anything that might be happening. We are not involved in that,” he said, reminding all that the UK's 'economics' decision (which I supported for good reasons that are technical not political or cultural) to stay out of the single currency means it is not part of the Euro Grouping that discusses eurozone affairs, adding “It is in the interests of the eurogroup they provide whatever assistance [is required].”
The chancellor also made it clear that Britain’s decision not to follow either the proposed US banking levy or the “Volcker rule” (banning proprietary trading by, and hedge funds within, banks) was not an attempt to steal financial services business to London from New York. He said: “I don’t want someone coming to our country because they are avoiding some legitimate concern somewhere else.” This sounds good and good for Dublin!
The chancellor’s main purpose in Switzerland was to meet with banks and urge the all to hasten reforms of banking and global economic management, issues on which he sees backsliding in the G20 agenda. I defined the G20 agenda into 90 tasks, which others have picked up and now bandy about as what is to be done. But, many of the tasks require a lot of detailed work; they involve major changes to what is traded on or off exchanges, to ratings agencies, and not least building new regulatory oversight bodies and then bring in the rest of the world to be fully in agreement and participative. The macro-economic and macro-financial models to underpin all this are however totally not there, and have not been planned yet and those that are underway are game-theory network risk models for dealing with single bank failures - so we do not yet have any governmental efforts behind trying to understand the credit crunch and recession comprehensively in macro-model or macro-prudential model data terms. This means that many policy objectives cannot be followed with support of deep analysis that is globally competent.Darling said, “The process is presently going through the Basel Committee at a rate I believe is far too slow. We simply don’t have years to sort this problem out. We need to sort it out later this year”. Big models take at least two years! He deplored, according to the FT, the possibility that the main Basel committee recommendations on banking reforms may be delayed from the present timetable of this autumn. “They might slip into 2011 and that would be very, very bad.” Darling was equally concerned that the G20 framework for balanced and sustainable growth, the international action to address global trade imbalances, was also mired in the mud - think of Flanders and The Western front, main Street versus wall Street with attrition all along the line. Referring to both G20 processes, he said: “There needs to be a sense of urgency that frankly has been absent over there in the last few weeks.” I totally agree, but that's not what happens when the Eurocrats and civil servants generally have to do more than juggle competing opinions.
His comments reflect those aired yesterday by Angel Gurria, secretary general of the OECD, who may wonder whether the IMF that is at the heart of the G20 agenda has the firepower for the job and needs OECD in Paris with all its massive brainpower to weigh in too, who said: “I don’t think anything of substance has been done during the crisis to correct global imbalances. It was the crisis itself that reduced imbalances”. If she meant global imbalances in finance she is of course on another planet. She meant global trade imbalances that astute economists know lay at the root cause of the crisis. Trade flows are definitely like scattered jigsaw pieces thrown into disarray. It'll be some time before we see how those pieces fall and that is what is gnawing at the long nails of Forbidden City mandarins in Beijing as they scroll through their beautiful painting of economic statistics. on that no small matter see http://bankingeconomics.blogspot.com/ Time to sell east buy west?