After the “shock and awe” aid package of the euro zone last Sunday night/Monday morning was announced we saw rallies in quite a few markets. Equity markets around the world surged on Monday and posted quite considerable gains, the Euro strengthened against the US $ and even the sovereign debt of Greece, Portugal, Ireland and Spain saw a rally as the European Central Bank began on Monday morning its new programme of purchasing them. So at first events seemed to be following the path of the euro zone defeating what they call the “wolf pack” and that evening the French Finance Minister Christine Lagarde appeared on the BBC’s Newsnight programme to crow about the success of her plan. However one phrase was used a lot by ministers and officials and it was “save the Euro” and indeed it briefly rallied above 1.30 versus the US dollar. However the Euro was sold as a currency throughout the week culminating in an 18 months low for it on Friday as pressures accelerated and this morning it is even lower at 1.228 versus the US dollar.
What has caused this?
There are several factors in the fall of the Euro exchange rate.
1. In terms of economic competitiveness the Euro zone actually needs a fall in its exchange rate. Countries such as Greece Portugal and Ireland need every bit of economic competitiveness they can find. Indeed the previous rally in the Euro was harmful to the economic competitiveness of the euro zone and was one of the causes of the sovereign debt crisis for the euro zone. To their credit markets have realised this and are pushing the Euro lower. So the politicians with their cries of “wolf pack” and (evil) speculators are fighting the wrong enemy with their rhetoric. Sadly with their poor track record in economic understanding I do no expect this to be the last time in this episode that they do this. Currency machismo is not what is required at this time.
So here is a thought for you often ignored, for the euro zone the fall in the Euro is a part of the adjustment mechanism that is required. Let us see when politicians wake up to this.
2. The “shock and awe” package has quite a few weaknesses in its composition. If you break down the 750 billion Euros you end up with a package of approximately 60 billion Euros which is probably backed by 30 billion Euros from the International Monetary Fund. I think the hyperbole and grandstanding in this has hit home. For example as the week developed David Lipski who is the Deputy Head of the IMF pointed out that it does not ring-fence sums of money for particular areas which questions 250 billion Euros of the funds. Also the Special Purpose Vehicle (SPV) which in theory would provide 440 billion Euros would take ages to activate and is something that could have been done in that time frame anyway. I wonder if it will ever be used. After all look at the trouble a 8.3 billion Euro contribution from Germany to Greece (later raised to 22 billion) caused in Germany. Does anybody actually believe that Germany would now pay around 120 billion Euros to the SPV? Anyway the “shock and awe” fund has nothing to do with the Euro exchange rate.
3. Moves made recently with the European Central Bank have reduced its credibility. Its President Mr. Trichet stated in January 2010 that its collateral rules would not be changed to benefit one country and in the past was very critical of the US Federal Reserve and the Bank of England for their Quantitative Easing Policies. He has now done the former and has started on the path towards the latter which I will discuss more later.
4. I also think that a more fundamental problem is troubling markets. For the stability package to work it needs a form of austerity and conditionality but these are likely to reduce economic growth in several areas in the euro zone. Yet what these parts of the euro zone most need is economic growth if they are to recover from this sovereign debt crisis. So there is a clear logical inconsistency in the rescue package.
Greece and Argentina’s experience
For those of you are unaware Argentina went through a similar experience to that of Greece back in 2001/02 and was the most recent experience of this type. Recently the Argentinian President Cristina Fernández offered this opinion on the involvement of the IMF in Greece ” “the same recipes they applied to us, which provoked 2001” and that the plan would have “terrible consequences” for Greece. In case you are wondering Argentina defaulted on her debts in 2002.
If you compare Greece with Argentina you quickly come to the conclusion that Greece now is in a worse position than Argentina was in back in the late 1990s which led to her default in 2001. For example Greece has a much higher level of indebtedness,she is more uncompetitive in world markets and the adjustment required in her fiscal position is higher. To put this into numbers here are some comparisons.
1. In terms of percentages of Gross Domestic Product Greece has a national debt of around 120% whereas Argentina had one of 62% in 2001.
2. In terms of fiscal deficit Argentina’s was just over 6% of GDP whilst Greece’s has just peaked at 13.6%
3. If you use a current account deficit as a measure of economic competitiveness then Argentina’s was under 2% of GDP whilst Greece’s is around 11%.
So as you can see the IMF is being asked to sort a situation which is worse than one in which it failed…. There have been IMF papers written on this subject which suggest that a way out of this conundrum is a debt restructuring but the politicians of the euro zone will not countenance this for fear of contagion.
Greece and Economic Growth going forwards
There is a further problem for Greece as time passes. Regular readers will know that I think that official forecasts for economic growth in Greece have been too optimistic. Indeed the European Commission has recently published two different growth forecasts which is a good effort. However both are too optimistic as they only expect Greece’s GDP to fall by 3 or 4% respectively this year. Based on my analysis of Latvia’s experience in the hands of the IMF I feared that the number would be worse than this at say 6%.
However I have seen some analysis done by Daniel Gros (an economist who specialises in this area) who has done a calculation for how much he expects Greek economic output to fall for each 1% reduction in its fiscal deficit. His analysis leads him to believe that for each 1% of GDP decline in Greek government spending, economic output in Greece will fall by 2.5% of GDP. So if you put in a fiscal adjustment of 10% you get a fall in GDP of 25%. Now the analysis is a little simplistic but it is revealing as to the depths of recession we can expect and I feel it will be worse much worse than is being factored in now. You see if anything like this happens (and it is consistent with the experience of Latvia) then the numbers the IMF has calculated for a stable path for Greece simply fall apart. Having previously thought that Greece’s GDP could fall by 6% this year I now fear that it could fall by more and that next year is likely to be as bad.
Mr. Gros has also done an analysis of Greece’s austerity programme and he feels that some of it is simply not credible, so we can expect disappointments on this front too.
The European Central Bank
This has been a very difficult period for the ECB and the about turns forced on it by Europe’s politicians have damaged its credibility severely. However if we look at what has happened since the “shock and awe” announcement I think that we have further problems.
1. It has promised to sterilise its sovereign bond purchases but so far it has not. So at this moment in time we have full-blown quantitative easing in the euro zone.
2. It has not announced how much peripheral sovereign debt it will buy. To my mind this means that it does not know. It started to buy last week and bond prices in the relevant countries rose. However after a rumoured 20 billion Euros of purchases it stopped buying and on Friday peripheral bond yields rose again. For example in terms of ten-year government bond yields Greece rose from 7.47% to 8.28% and Portugal’s rose from 4.68% to 4.93%, even Spain’s rose from 3.97% to 4.07%.
So the minute it steps back yields rise again which means that one hope for the programme that it can buy and then step back has gone. If the ECB remains forced to keep buying when will it stop and how much will it eventually buy? We could end up with a socialization of peripheral sovereign debt and this crisis which has seen private sector debt moved onto public sector balance sheets is now seeing movements in public-sector balance sheets from the imprudent to the prudent. Yet another moral hazard.
There should be some more detail from the ECB on what it has done so far tomorrow and I wait to see it but compared with the Bank of England it has been much less transparent about its bond purchases so far.
The more I analyse Greece’s situation the more I feel that the rescue package for her is in fact a trap rather than a solution. The failure to incorporate a form of debt restructuring is likely to prove fatal to her efforts to get out of her current problems and may even lead to her defaulting. Perhaps the worst part of this is the continued troubling feeling that the whole policy is simply to move the problem to a time which will be more convenient for the European banking sector and that Greece and her people are merely a pawn in this game of realpolitik.
I have written before about the dangers for the balance sheet of the European Central Bank in her plan to purchase peripheral sovereign debt. She already had a balance sheet that was the lowest quality of the main central banks of the world. Last weeks developments when she stopped buying peripheral sovereign debt suggest that this programme is going to have to be larger than she expected and so her balance sheet quality will deteriorate further. A question comes to my mind, has anybody asked Europe’s taxpayers? After all there could be big bills coming from this if it goes wrong….
On a lighter note as a child I grew up watching Captain Scarlet. Therefore everytime I hear the letters SPV I think first of a Spectrum Pursuit Vehicle and not the new Euro fund. If Europe’s politicians and officials did not ever watch this programme they could probably do with a man who is indistructable or were they hoping their policy would acquire a similar sheen? And are market forces and speculators Mysterons in their mind?
Also there was a cautionary note for those expecting further short-term falls in the Euro exchange rate yesterday. You see the business section of the Sunday Times opened with a headline expecting it to go to parity with the US dollar. Having observed this paper over many years I have come to the conclusion that when it does this much more often than not it turns out to be a reverse-indicator.