The Greek Election and the Role of Transparency

As most readers of this blog already know, there's a big election in Greece on Sunday.  The perception is that if Syriza wins, financial markets will panic, causing a flight to safety (lower bond yields in the US, Germany, and other safe havens combined with a large decline in stock prices).  At the same time, many think that if things get out of control, central banks around the world will inject liquidity to stabilize the global financial system.  Does that mean if New Democracy wins instead (the center-right party), the Greek situation will improve?  Unfortunately not.  As discussed in previous posts, there's no easy solution to the Greek problem.  To reassure financial markets, it must get its deficit under control, primarily through budget cuts.  However, budget cuts hurt the economy in the short run (and Greek unemployment already exceeds 22%) and the weaker economy that results could actually increase the deficit.  Does that mean it should engage in stimulus (whether through tax cuts or spending increases)?  Unfortunately, it's hands are tied since markets are already unwilling to purchase Greek bonds and finance deficit spending.

On a related note, what role does transparency play in crises?  Though some question the transparency of many governments, two countries stand out in recent years in terms of not being upfront about their financial conditions.  Many are aware that Greece "misrepresented" the size of its 2009 budget deficit (for example, click here).  That devastated its credibility and set it on the road to its current crisis.  What other country "misrepresented" its financial condition (for the answer, click here)?  Back in 2009, this country had just experienced a collapse in housing prices, but maintained that its banks were unaffected. Which country am I talking about?  Spain. This week, Spanish banks received a promise of a 100 billion euro bailout (I guess they really weren't in good shape after all).  Thus, the two countries currently bringing the most fear to global financial markets and policymakers are those that didn't face up to reality and instead tried to cover up the severity of their problems.  Lack of credibility gets punished in the form of higher interest rates (to compensate for higher perceived risk).

Unfortunately, we're not close to the end of this story.

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.

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.