Greece - exit, stage left?

Will Greece exit the eurozone?  There is an increasing probability that it may occur, depending on the results of the upcoming election in June.  Rather than consider whether they will leave the eurozone, let's consider what it may look like if they do leave.  In some ways, there's no parallel to a country leaving a major currency union such as the eurozone.  However, some lessons can be drawn from the Argentine default of 2001 and the experiences of several countries during the Asian financial crisis of 1997-98.  What do these 3 sets of countries have in common (Greece, Argentina, developing economies of Asia)?  All had fixed exchange rates which were unsustainable.  Though there are clearly differences in terms of the economic and financial situations, Argentina and the Asian economies were forced to abandon fixed exchange rates, resulting in extreme depreciations of their currency.  The short-term effects were devastating, resulting in severe recessions and high inflation.  The second round effects depended in part on the policy response, perceptions of global investors, and the strength of the global economy.  Argentina defaulted on its debt and was locked out of the global financial market for years (until it negotiated a deal with many of its debtors).  Even today, Argentina pays a high risk premium (high interest rates on its bonds), partly due to its default and partly due to its economic policies.  On a more positive note, the significant depreciation of their currencies (Argentina and Asian economies) helped to restore competitiveness, planting the seeds for an economic recovery.  The strong global economy of the late 1990s helped many of the emerging economies of Asia rebound.  Similarly, the global economic boom helped Argentina recover in the mid-2000s.

What does this mean for Greece?  Besides being heavily indebted, the Greek economy is not globally competitive for a variety of reasons.  To become competitive, unit costs must be reduced significantly and/or its currency must be devalued.  Since it's part of the eurozone, its currency can't decline as much as is necessary.  Thus, unit costs must be slashed either through increased productivity or reduced labor costs.  Since productivity increases take time (and changes in policy), the focus is on reducing labor costs.  When this is combined with the austerity required as part of the bailout packages, it is easy to see why Greece is experiencing a depression (unemplyment over 20%, negative economic growth for the last 4 years, etc.).  If Greece left the Eurozone, there would be considerable pain, but unit costs would not need to be reduced as much (competitiveness would be enhanced in part by a cheaper currency instead of lower costs).

So if replacing the euro with the drachma takes the pressure off of reducing unit costs (less need to eliminate jobs and/or cut wages), why not just do it?  A bank run is already taking place in Greece as depositors fear that the value of their bank accounts may drop significantly if they are redenominated into drachmas instead of euros.  As money leaves Greece and moves to other countries, there's less funds available to finance investment in Greece, reducing both short-term and long-term economic growth.  In addition, exchange rate risk will rise (the drachma will be less stable than the euro), leading global investors to require higher interest rates to invest in Greek debt.  Of course the default itself will also increase the risk premium of Greek debt.  In addition, Argentina and the developing economies of Asia both benefitted from a strong global economy to boost exports.  Few economists expect the global economy to grow rapidly any time soon.  In particular, Greece's largest trading partners (countries in the EU) are expected to struggle for years to come.

Even though this is a long post, it still only scratches the surface of what a Greek exit from the eurozone would entail.  Regardless of whether Greece remains in the eurozone or not, it will need to undertake significant economic reforms to become more competitive and achieve a sustainable recovery.  In future posts, we'll examine the debate between austerity vs. growth as well as other issues related to the European debt crisis.

Stress Tests for Banks, More Bad News from Europe, and Weakness in China

Income and Spending: Plenty of news this morning, much of it raising serious concerns, so let's start with "pretty good" news.  After declining for 3 straight months, disposable income adjusted for inflation rose in October.  However, growth in consumer spending slowed down to 0.1%, increasing the personal savings rate to 3.5% (still a very low rate).

Stress Test: Late yesterday, the Fed announced a new stress test for the 31 largest banks.  The test involves determining if the banks will be able to handle various severe economic and financial  situations including (1) a recession similar to 2008-2009 when economic growth shrank in excess of 8% for a quarter at an annualized rate with an overall decline of 5% before beginning a recovery; (2) a worsening of the European debt crisis; and (3) a 52% decline in stock prices over the next year.  Banks that don't pass the test will be required to boost their capital.  The Fed wants to ensure that US banks will be ready for any potential crisis so as to limit the damage to the economy and avoid a repear of 2008.

Europe: Speaking about Europe, add Germany to the list of countries having difficulty selling its bonds.  At an auction this morning, Germany had to pull just over one-third of its bond offering due to a lack of interest (rather than pay a significantly higher yield).  Given that Germany is supposed to be the risk-free benchmark in Europe, if investors perceive risk in Germany, the debt crisis is reaching a new stage.  Meanwhile, the aggregate purhcasing manager's index for Europe continued to indicate a contraction in European manufacturing.

China: Finally, China's purchasing manager's index came in at its lowest level since 2009 (48), indicating contraction in its manufacturing sector.  This raises concern as to whether China will experience a soft or hard landing in the months to come.  Given sluggishness in the US and extreme weakness in Europe, a significant slowdown in China would add to risks to the global economy.

All Eyes on Europe

There has been some reasonably good news about the US economy in recent weeks (for example, higher retail sales, increased industrial production, and fewer new claims for unemployment), but all eyes are on Europe.  Economists generally think much of the eurozone is or soon will be in recession. The size of the impact depends on how deep a recession takes place.  Economists at Wells Fargo have released a study examining the exposure of each state to the European economy.  More importantly, the debt crisis is beginning to spread, resulting in higher risk premiums for virtually the entire eurozone other than Germany.  MoneyWeek, a financial magazine based in the UK, provides nice charts of bond yields on European sovereign debt, updated several times day.  Not only have bond yields risen for the "hish-risk" countries (Greece and Portugal), but Italy and Spain have seen significant increases and now France is experiencing a spike in the spread of its bond yields relative to Germany, reflecting significant increases in perceived risk (see chart from Bloomberg below): 



The contagion is spreading.  High debt, weak economic growth, and rising yields are a lethal combination for an economy.  There's many more difficult decisions to make and much more pain to come in Europe and possibly elsewhere.

All eyes on Italy

In recent years, the concern was for the debt crisis involving the three little pigs (Portugal, Ireland and Greece); little in terms of the relative size of the economies. A big fear was whether it would be spread to the larger economies of Spain and Italy. Now it's spread to Italy and action needs to take place quickly to limit the damage.

The European Debt Crisis spread to Italy a little fast than some anticipated.  Much has written about it elsewhere (for example, here's a Bloomberg story about the crisis and the impact on growth in Europe), but let's summarize the key issues.  Italy is the third largest economy in the eurozone (behind Germany and France), much larger than Greece and there aren't enough funds currently available to "bail" it out.  Though the Italian budget deficit is "only" about 4% (high by pre-crisis standards, not that high by current standards), it's national debt is about 120% of GDP (very high, second to Greece in the eurozone).  In addition, growth is expected to be very weak for years to come, limiting its ability to finance its debt.  Combine that with a lack of confidence in the Italian government to adequately address the problem (contain debt while promoting economic growth) and you have the next round of the debt crisis.  In recent days, interest rates on Italian debt soared passed the critical 7% threhold.  Each of the other pigs needed bailouts after yields on their bonds rose past 7%.  So what matters is the amount of debt, the cost of financing the debt, and the ability to finance the debt.

Reuters has a nice debt spiral calculator for Italian debt.  You can use it to estimate the policy response necessary to stabilize Italy's debt-GDP ratio given certain assumptions which you can adjust.  For example, if nominal GDP grows by 2.5%, current policy would stabilize debt at its current high level (120%) at an interest rate of 5.6%.  At an interest rate of 7%, it would need to make significantly more budget cuts just to keep the debt from rising (reduce spending on other items in order to pay the higher interest on the debt).

As of this morning, things have stabilized a little as the European Central Bank intervened in financial markets by purchasing existing Italian bonds (it's prohibited from buying new bonds), helping to push rates on some bonds to below 7% (one-year, five-year).  This doesn't solve the problem, but may help to buy a little more time to try to develop a solution.  Meanwhile, Italy was able to auction new one-year bonds at a rate of 6% (compared to market rates of 8% yesterday, but 3.5% at the previous action).  Also, the Italian government is putting approval of its budget on the fast track (try to approve it this weekend) and plans to follow its passage with the formation of a new government.  Unfortunately, this story is still unfolding.

Greece - Now What??

Just a few days after agreeing to a deal, the Greek Prime Minister announced that he plans to hold a referendum on the deal, probably in January.  Other European leaders as well as financial markets were caught by surprise, leading to renewed concern about whether Greece would experience a disorderly default.  The latest estimates are that Greece needs funding by December, otherwise it may have difficulty making debt payments.  Obviously, delaying approval of the agreement until January poses a problem.  In addition, it is generally agreed that if the vote to approve the deal was held today, it would fail.  Prime Minister Papandreou is counting on convincing Greeks that this is the best deal possible and is essential to helping Greece make it through the next few years.  In the short term, two key events stand out.  European leaders are meeting today (Wednesday) to discuss the situation.  On Friday, the Greek parliament is going to have a vote of no confidence.  The Prime Minster's party holds a 2-seat majority and, if he loses the vote, the government will fall and elections for a new government will need to take place.  The likely result would be continued uncertainty until a new government is in place.  How will financial markets respond to such an event?

How risky is Greece?  The yield (interest rate) on one-year Greek government bonds is 227% (note: the yield on the one-year US government bond is 0.1%).  The question is whether there will be an orderly haircut or disorderly default by Greece and how will that affect the global financial system.

Update on the European Debt Crisis

Europe made another attempt at solving its debt crisis with its most comprehensive plan to date.  The initial reaction of financial markets was quite positive (for example, the German stock market was up over 6% on Thursday).  What is the plan and is the problem "solved"?  The basic elements include private investors in Greek debt taking a voluntary 50% haircut.  A 50% haircut means that those that purchased a 10,000 euro bond will receive only 5000 euros back (50% loss).  Private investors may be willing to accept this because it's better than receiving even less.  Greece likes it because it reduces thier debt load.  Why make it "voluntary"?  Since it's voluntary, Greece won't officially default on the debt so, among other things, credit default swaps won't be triggered (they can be seen as insurance against default, so without an official default, there's no need to pay the insurance.

In addition, Europe will modify and expand the European Financial Stability Facility (EFSF); a fund established in a previous solution to the crisis.  Under the new plan, the EFSF will be used to insure against the initial losses of future haircuts (reducing the risk of bonds somewhat since losses to investors will be reduced somewhat).  The hope is that this will keep interest rates relatively low by limiting the risk of bonds (normally need higher interest rates to compensate for higher perceived risk; so less risk results in lower interest rates).  The second change in the EFSF involves introducing new investment vehicles (i.e., bonds) that will be purchased by sovereign wealth funds (i.e., China, Brazil, etc.) that will provide more funds for future bailouts.  Ideally, if investors knew that there were funds available to bailout Greece, Portugal, and others, they will feel more secure about their investment and thus be more willing to buy bonds at a relatively low interest rate. 

The haircut is a good thing.  Private investors know that there's a risk of buying bonds and are compensated in the form of higher interest rates.  Greece cannot sustain their bond payments, so holders of Greek bonds should suffer a loss (they knew the risk when they bought the bonds).  For now, I'll side step the issue of whether the market determine the amount of the loss.  Regarding the new investment vehicles, will it raise enough funds to be successful?  Many think that China (and Brazil) will be willing to help finance it in exchange for more influence in multilateral organizations.(IMF, etc.).  In addition, will it raise enough funds to convince investors that there's enough funds in case of other countries needed haircuts (Portugal?  Italy?).

Finally, European banks are given to June to increase capital ratios to 9%. Among the ways they can do it are be issuing equity (investors buy new stock which provides the banks with more funds) or by tightening lending and holding onto more deposits. Most analysts expect banks to primarily follow the latter approach, which will mean credit will become harder to come by in Europe, contributing to the likelihood of a recession in Europe.

Did it solve the problem?  Probably not.  It gives Europe more time, but much more work needs to be done to get the debt problems under control.

Spectator's Guide to the Euro Crisis

The NY Times has an interesting graphic, "A Spectator's Guide to the Euro Crisis" which includes information about the financial linkages between nations in Europe (as well as US bank exposure to the eurozone).  It also explores possible scenarios for how the crisis may evolve (best case, worst case, and likely scenarios).  Simon Johnson (former IMF economist, currently at MIT) provides comments about the graphic as well as an analysis of the European financial crisis (a policy brief from July 2011).

The guide does a nice job illustrating the interconnections of the global financial system and how problems in one country can reverberate around the world.

Consumer Deleveraging

The Wall Street Journal has an article (subscribers only as of Saturday morning), "Americans Debt Cutting Hampers Growth," which states that "Household thrift sparked by the financial crisis three years ago has proved surprisingly persistent and is a key reason the recovery that began in 2009 has been so weak."  To economists who study the effect and aftermath of financial crises, this is not a surprise and is a major reason why they have forecasted a sluggish economy for years to come since the start of the crisis.  Consumers accumulated a large amount of debt leading up to the crisis and now must deleverage to get their debt under control.  What led to the accumulation of debt?  Most people know the story by now.  The housing bubble made people feel wealthy, encouraging people to tap into that wealth through home equity loans, 100% (or more) financing of homes, etc.  When the bubble burst, the wealth was gone but the debt remained.  It will take an extended period of time to get debt back in line with wealth, thus constraining economic growth for years to come.  Here is a chart that compares the growth of household debt during recoveries from recessions since 1950.  As you'll notice from the chart, this time was different.

A few comments on Europe and Credit Markets

Europe continues to be a major concern for the global economy.  Today, Fitch downgraded Italy and Spain while earlier in the week, Moody's downgraded Italy.  Meanwhile, the French and Belgian governments promisted earlier in the week to bailout and/or restructure Dexia (a bank with ties to both  governments).  European leaders have begun to discuss recapitalizing banks to prepare them for "restructuring" of Greek debt, which seems to be just a matter of time (November or December?).  This is an important step to limit the potential damage of a Greek default (prepare banks for losses on sovereign debt), but it should have taken place a long time ago, particularly when Europe conducted stress tests for its largest banks (you may recall that Europe conducted stress tests on banks earlier this summer, but neglected to account for a possible/likely default by Greece).

The global financial system is showing more stress than any time since the end of the financial crisis in 2009, as evidenced by increasing credit spreads for investment-grade debt globally as well as high-yield debt in the US.  Given the fragile financial environment, corporations have chosen to step back from issuing bonds, thus hindering investment plans and economic growth.  Clearly, the US and global economies are facing many headwinds, but resolving the European debt crisis is essential to restoring economic stability.