Grexit now more likely after latest Eurozone ‘deal’

The Eurozone has announced  what the headlines refer to as a ‘deal’ on Greece , emerging  from yet another all-night negotiating session. History suggests that agreements reached in the wee small hours by sleep deprived participants can look very different to at least some  bleary eyed negotiators in the clear light of day, but that aside the agreement is  quite extraordinary, and breaks new ground in terms of euro zone governance. Indeed, such is the departure from previous discussions with debtors that, if anything, it increases the risks of Greece leaving the euro.

The text of the Euro Summit on Greece opens with a statement on  the need to rebuild trust with the Greek authorities and to that  end  Athens has to pass legislation, by Wednesday 15 July, on a range of measures, including pension reform , changes to the VAT system, the independence of  the state statistical service and the setting up of a Fiscal Council. In addition the legislation should include ‘quasi-automatic spending cuts in case of deviations from ambitious primary surplus targets’ and by the following week new laws  changing the civil justice system. The ECB will maintain the existing level of ELA for a little longer, to focus Greek minds, while the banks will remain shut.

Upon a satisfactory conclusion of the above, and subject to the approval of ESM member states, negotiations may start on a new loan, but Greece has also to set out a timetable for the implementation of  another raft of reforms, including further changes to the pensions system and  significant moves to liberalize retail markets , the professions, labour markets and the financial system. The energy transmission mechanism is also to be privatized, and in that context the text also proposes  an unprecedented step, in that Greek assets are to be sequestered into a separate fund for privatization, with the intention of raising €50bn, to be used to finance the recapitalization of the banks, to run down debt and to fund investment.  Moreover, Greece also has to undo some of the legislation brought in by the new Administration  and is required to ‘consult and agree with the Institutions on all relevant areas before submitting it for public consultations or to parliament’

The Hellenic Republic will also have to seek a further IMF loan and a total bailout figure of €82bn to €86bn is envisaged, although the text also notes that fulfilling the initial conditions does not guarantee that a  loan will follow. The Eurogroup may consider debt extensions and changes to interest rates but ‘ nominal haircuts on the debt cannot be undertaken.’

Some might consider all of this a move to shift Greece towards a Northern European style market economy and one consistent with euro membership  while others have already branded it as a ‘coup’, with the Eurogroup  accused of seeking regime change . The degree of interference and control from Brussels is certainly a new departure as is the idea of preconditions before negotiations can even begin. The latter certainly increases the risk that political support in Greece will not materialise, particularly as the electorate have already rejected a less severe version of the measures now mandated. In addition, implementing reforms, even if passed by parliament, may prove extremely difficult , if not impossible.  A debt write down is also not on offer, even though many, including the IMF, see the debt situation as effectively unsustainable.

Perhaps the most striking development over the weekend was the German proposal that Greece could take a 5-year timeout from the euro area. Leaving aside the practicality of such a move the fact that it was put into the open ( although not in the final text)  shows that Grexit is no longer seen by some creditors as a disaster, Indeed, the ‘take it or leave it ‘ tone  of the offer is also striking (‘the risks of not concluding swiftly the negotiations remain firmly with Greece’) and one can only conclude that the probability of a Greek exit from the eurozone has increased, either  through a Greek rejection of the proposals or via some creditors still  baulking at what they see as the futility of throwing good money after bad.

When Debtor Fatigue meets Creditor Fatigue

The euro has always been a politically driven project, and the inevitable economic fault lines that emerged  as it expanded  have been met with a surprisingly strong will on the part of  member governments to maintain the single currency. That determination has surprised markets and often confounded analysts , although  any decisive political action has often emerged from crisis meetings in the early hours of the morning. Decision making in such an environment raises issues of democratic accountability and  risks serious policy errors ( for example the determination to prevent a sovereign default within the EA) and  post-meeting disagreements on what was actually signed off ( see Ireland’s belief that the ESM would be able to retrospectively recapitalize banks). The euro is also now left with fiscal rules  and constraints which are  both extraordinarily complex and lacking in credibility; no one believes that a euro member will be fined for a breach and the Commission has repeatedly backed down when faced with one of the larger member states, notably France .

In the absence of a fiscal union the euro member states have funded bailouts for sovereigns who have lost market access, first directly (as per the first Greek loan) and then through the EFSF. Initially the loans carried relatively high interest rates ( as a form of punishment for fiscal impropriety) but that soon changed as debt sustainability came to the fore, an issue of particular importance to the IMF, which was brought on board  to help design loan programmes and the incorporated conditions.

The Fund’s modus operandi is to  project what it considers to be a sustainable medium term debt ratio  and then derive the required primary fiscal surplus needed to get to that target, given other assumptions including economic growth. Those assumptions can prove spectatularly wrong , and they did in Greece ; the  negative impact on the economy of the required fiscal contraction was much greater than envisaged (  GDP fell 25%, a depression rather than a short lived recession) and  the  forecast €50bn receipts from privatization failed the matrialise ( the figure to date is around €3bn).

Such programmes also assume that creditor governments can deliver the required primary surpluses, however large and sustained they are deemed to be , and ignores the electorates role. Debtor fatigue can set in. In most  countries that has been confined to  (growing) opposition parties but in Greece resulted in a new government pledging an end to austerity, new loans, a debt write down and ongoing euro membership,

Much of that is not in the gift of the Greek authorities to deliver (who knows what electorates can decide )  and that debtor fatigue is now meeting creditor fatigue, which has not been eased by the unusual negotiating stance adopted by the Hellenic Republic, which some characterise as driven by game-theory and others see as inconsistent and bordering on farce. The creditors are not united, it has to be said, with France notably sympathetic to Greek requests, although most , to date at least, appear willing to see Greece exit the euro, such is the lack of faith in Greece’s ability to deliver reforms or to meet the terms of any new loan. Some of that hostility emanates from other debtor countries fearful of the impact of a perceived Greek success on their own political futures- we are all creditors now, it would seem.

Any new money, should it materialise,  will come from the ESM, and that requires a unanimous decision by the Board of Governors, made up of member states. Consequently  any one country can prevent disbursement. In addition, ESM debtors are required to be in a programme which it is envisaged would involve the IMF, so Greece’s default with the fund poses a difficulty.

The Greek crisis has also highlighted the Lender of Last Resort issue . The ECB is not willing to fulfill that role unconditionally and has limited the amount of emergency liquidity the Central Bank of Greece can provide to its banking system. So the ECB, despite its claims to the contrary, emerges as a key player; its actions put pressure on the Greek government to reach an agreement with the creditors and could be the  catalysts for  Grexit, as the pulling of ELA would require Greece to print its own notes to fund the economy.

The markets have shown little in the way of panic reaction to  the Greek saga  and probably feel that some compromise will emerge to keep Greece in the euro, if only because such last-minute deals have been the norm in recent years. Whatever the outcome the stark emergence of debtor and creditor fatigue into the light is a profound  development , and one which is likely to have significant longer term implications for the euro regardless of any short-term fix.

 

The Euro, Capital Flows and Speculative Trades

Quantitative Easing is generally seen as being negative for the currency in question, and the evidence would seem to support this, albeit not in all situations (sterling, for example). The ECB certainly believes that to be the case, the rationale being that lower bond yields in the EA will prompt investors to seek higher returns abroad, so resulting in portfolio outflows and hence selling of the single currency. The euro has certainly depreciated, both in broad trade weighted terms and against the other majors, and in May was 9.5% below its trade weighted value a year earlier, incorporating a 19% fall against the US dollar and a 12% decline against sterling.

Yet we also know that short-term currency moves can be strongly influenced by speculative positioning, with traders shorting a currency in the belief that QE should  be negative for its FX value, which then sets up something of a self-fulfilling prophecy for a time , as any initial weakness then prompts further selling given that momentum trading appears to be the predominant style at the moment. Data in the Commitment of Traders weekly report from the CFTC ( incorporating  FX futures ) provides a useful guide to speculative  positioning, and from that it is clear that the market started to build a very large short position in the euro/dollar last autumn and one which increased further  following the QE announcement in January.  The position peaked at a  record high in late March, at the equivalent of €28bn, and has unwound sharply since  to currently stand at €11bn, the lowest in almost a year. So the  initial fall in the euro and recent recovery would seem to owe something at least to speculative trades.  It is also worth noting that the unwind of the euro shorts coincided with a strong increase in short yen positions and a fall  in the yen against the US dollar.

What about more fundamental drivers of the euro, as captured in the Balance of Payments? The first point to note is that the EA runs a current account surplus, largely reflecting a positive merchandise trade balance, and one which is growing; the surplus rose to €212bn in 2014 and amounted to €245bn in the twelve months to April 2015, the latest data available. That surplus would therefore generally put upward pressure on the currency unless offset by capital outflows, which brings us back to the ECB’s hope that QE will stimulate such flows.

There has certainly been a significant change in terms of net  portfolio flows. with a net outflow of €160bn in the twelve months to April 2015, against a net inflow of €50bn in the year to April 2014. Moreover, outflows do indeed tend to be in terms of bond purchase, with  EA buying of foreign debt instruments  amounting to €119bn in the first four months of this year alone, which alongside some modest selling of other assets resulted in a rise in total portfolio outflows of €109bn.  Yet QE has also been associated with a significant rally in European stock markets, and  the same period has seen portfolio inflows of €76bn,  including €96bn in equities. So since the announcement of QE the outflow from debt investors has been offset to a fair degree by the inflow from equity investors albeit still leaving a net  portfolio outflow of  €33bn in the four months to end-April.

Direct investment flows also matter, however,  and here again the first four months of 2015 have seen strong inflows, amounting to €86bn, offsetting outflows of  €35bn to give a net inflow figure of  €51bn.  So net capital flows in total (portfolio plus direct) are small  to date  this year and actually a net positive (€19n) which added to a cumulative current account surplus of €69bn implies a inflow of €88bn. The errors and omissions on the BOP data can be very large and there are other financial flows associated with the banking sector but on the basis of the available figures  it is difficult to build a case that QE has led to the flows anticipated by the ECB or on a scale which might have led to a significant euro weakness. It is early days yet, of course, and higher US rates later in the year may trigger greater bond outflows, or indeed an outcome from the Greece negotiations which is seen as negative for the single currency.

 

 

The Future of the Euro

I was recently involved in a panel discussion on the euro at  the Cass Business school on March 3rd 2014, hosted by the London Irish Graduate Network. Tadhg Enright was in the chair and the other participants were  Graham Bishop and Martin Wolf from the FT.  Although there were no set speeches I took the opportunity to gather some thoughts on the euro, produced below.

The euro is now well into its second decade, having survived what appeared to be an existential crisis, and by most attributes of a sound currency can be viewed as a success. This is particularly true for the euro as a store of value; its internal purchasing power has been supported by stable and low inflation around 2% per annum and its external value has also been broadly maintained over time-the trade weighted exchange rate is currently about 5% above its level at birth according to BIS data. Yet few would argue that the original eleven members fulfilled the criteria normally required for an optimal currency area and the economic performance across those countries has hardly been uniform; Finland recorded a 20% rise in real GDP per head from 1999 to 2013 according to IMF data, followed by Germany (19%), Austria and Ireland (18%), in contrast to the zero growth experienced by Portugal over that period and the 3% fall seen in Italy. Of course we will never know how they would have performed absent the euro but it is clear that monetary policy at least has been far from optimal for individual countries- a simple Taylor rule, for example, would suggest that rates were far too low in Ireland in the first half of the noughties. Adjustments to imbalances are also clearly asymmetric, with the burden solely on debtor countries to shift resources to the external sector while creditor countries are not required to expand domestic demand to make that adjustment less painful. The notion of punishment for miscreants is a strong undercurrent in creditor country thinking and the penal rates on the original official loans from the Troika to those in bail outs were only abandoned as the threats to solvency became stark.

Differences in regional growth rates are not unusual of course and can persist for long periods. One can point to the fifty US States as an example, although a shared culture, language, legal and education system allows for mobility of labour and capital, which is not the case for the euro. The Federal budget in the US also acts as an automatic stabilizer, providing a partial cushion for weaker States in a way that is impossible in Europe given that the EU Budget is only around 1.5% of GDP.

Currency unions generally evolve from political initiatives rather than any compelling economic case and the euro clearly fits that model-remember all EU members are supposed to adopt the currency when meeting the entry requirements (although currently 2 have opt outs and a third, Sweden, an implicit opt out) which implies a membership of at least 25 over time, from the current 18. The flaws in the original construct have also been exposed: the monetary union created is part of an economic union but each country was left with fiscal sovereignty and control of its own banking system and, crucially, without a Lender of Last Resort such as the Fed or the BoE. Consequently the eruption of the global financial crisis from 2008 put huge stress on euro peripheral bond markets as, to some degree, those governments were borrowing in a ‘foreign’ currency, backed only by their ability to raise tax revenue in euros, as they had no mechanism to print euros to meet debt obligations. The ECB and the main government players also saw the explosion in fiscal deficits as the cause rather than a symptom of the crisis and confused investor concern about specific credit risks with an attack on the currency, pledging that ‘no euro bank will default’, so compounding the sovereign debt issue and the ‘doom loop’ between sovereigns and banks. That view had a particularly profound implication for Ireland, with the State injecting €64bn or some 40% of GDP into the banking system, with equity holders and sub-debt holders shouldering some of the bank losses. Ireland also had ‘first mover disadvantage’ as it is now proposed that senior debt holders can be ‘bailed in’, a policy then prohibited by the ECB.

The euro crisis precipitated a series of emergency, ad-hoc and sometimes contradictory policy responses  by the Eurogroup and the ECB, with the latter eventually promising to do ‘whatever it takes ‘ to save the currency, including  a conditional pledge to buy secondary market sovereign debt in unlimited amounts, in contrast to the misconceived and half-hearted Securities Market Programme. The commitment has never been tested but the market response indicates that investors probably perceive that the euro now has a Lender of Last Resort, at least of a sort, and is comforted by that fact, shrugging off doubts about its legality and degree of support within the Governing Council, although that sanguine view may change as events unfold. The fall in peripheral bond yields  may also be driven by investors giving some probability to  QE eventually emerging from the ECB.

The conventional view among commentators is that the euro project has now to evolve into a banking union and ultimately a full fiscal union. Steps have been taken in terms of the former, albeit hesitant ones, with the burden of bank resolution still State dependent for up to a decade. The tide of public opinion in Europe also appears to have shifted away from Federalism and so the concept of debt mutualisation is a long way from realization. Moreover, new euro fiscal rules will further limit discretionary budgetary policy within member states, so leaving governments and hence electorates with no macro tools to affect aggregate demand; domestic policy levers can now solely impact the supply side of the economy given the loss of sovereignty over fiscal, monetary and FX policies.

The conventional wisdom on banking and fiscal union requires political agreement on the way forward and it is by no means certain that electorates will support these moves. Indeed, the risk remains that debt fatigue or creditor fatigue will eventually result in the election of governments willing to risk leaving the single currency even though the costs of exit are seen as high and the outcome uncertain. What would Ireland do, for example, on a break up- a floating punt is unlikely so would it anchor again with sterling or adopt some range against the DM, as in the ERM? That uncertainty and perceived costs of exit may well continue to trump discontent within most or all the debtor members of the euro and the stagnation evident in the French economy may help precipitate a more expansionary monetary and fiscal mix in Europe – the respective performances of the US and UK economies relative to the euro area since the Great Recession surely cannot be put down to supply side responses alone.  One can never say that the fear of euro exit will always be the case, however, and that the single currency will inevitably survive in its present form.  Yet it is foolish, as some have done, to predict the date and time of exits as it will be political events that will determine the euro’s fate, which is appropriate for what is, after all, a political construct.

Stagnation and relative performance in the euro area

The new year has brought greater optimism in relation to the global economic outlook, with a number of international economic organizations revising up their growth forecasts or indicating that such a move is imminent. Time will tell whether the more upbeat mood is warranted ( the last few years have seen initial forecasts subsequently revised down) and it is noticeable that the ECB remains very cautious on prospects for the euro area, pointing to downside risks, although the Bank is in line with the consensus in expecting a modest upturn, with growth of 1.1% forecast for this year and 1.5% in 2015, following a 0.4% contraction in 2013 and a 0.6% fall the previous year. Those figures refer to the euro area as a whole, of course, and are a weighted average of the constituent countries, and as such can hide significant variations across the zone.

Indeed, the divergence in  relative economic performance since the inception of the euro in 1999 is extraordinary. Eleven countries adopted the single currency at that time (the total has now risen to eighteen following Latvia’s entry at the turn of the year) and some of that initial group has prospered while others have stagnated, as measured by real GDP per capita. According to the IMF’s data on the latter , Finland has been the best performer over that period, with  real income per head rising by 20%, marginally outstripping Germany (19.4%) . Austria is in third position, at 18%, followed by Ireland in fourth, with a cumulative gain of 17.6% despite a sharp decline since 2007. These figures are better than that achieved by the major advanced economies over the same period, led by the UK at over 16% followed by the US around 15%,

The figures cover a fourteen year period and so even the strongest performance, such as  that of Germany, translates into  annual average  growth in GDP per head of 1.25% with the majority of the original eleven euro members not achieving 1% per annum. France is notable in that regard, with average growth per head of only 0.6% and a cumulative increase of just 8.7%, putting it in eighth position. That is only marginally better than the that of Spain, which is often portrayed as a chronically poor performer. Portugal is viewed through a similar lens but the data is still surprising, showing zero growth in Portuguese real income  per head since 1999. Yet that dismal statistic is dwarfed by the figures for Italy, as real GDP per capita is actually 3.5% lower now than it was at the birth of the single currency.

Economic growth in the medium to long run is the product of growth in the labour force  and the capital stock alongside technological progress so this pronounced divergence in performance could be put down to  respective differences in these ‘real’ factors  and not to the single currency per se- hence the emphasis from the ECB and the European Commission on ‘structural’ reforms in the euro area, which one takes to mean measures to boost the supply side of the economy and potential growth. Yet it is also undeniable that some countries have found it very difficult to cope within a monetary union dominated by a super-efficient industrial powerhouse and it is remarkable  that the electorates in those economies  have apparently learned to live with that stagnation.