Sunday 14 April 2013

Eurozone: debt restructuring is the name of the (end) game

The Eurozone periphery has a problem of excessive external debt. How to solve it?

Some argue that the Eurozone's financial crisis is a remake of the Asian financial crisis in 1997. Austerity and structural reform is all what is needed to generate a sustainable current account surplus, eliminate dependence from external financing, cut down external debt and win back confidence from international investors.

Is that true? 

Let's look at the numbers:

1. Here is a chart depicting the current account of the countries at the center of the Asian financial crisis (Indonesia, Malaysia, South Korea, Thailand):


One year after the crisis unfolded, all countries had positive current account surplus ranging from 4.5% (Indonesia) to 13% (Malaysia). All countries were able to achieve current account surpluses throughout the 5-year period following the outbreak of the crises.

Here is the same chart for Eurozone's peripheral member countries:

Today, five years after the outbreak of the Eurozone crisis there is just one peripheral country with a clearly positive current account surplus. It's Ireland. It's roughly 2% of GDP. 

By 2017, according to IMF estimates - and it's anyone's guess how optimistically biased they are - there will be four countries with a positive current account surplus: Ireland, Spain, Portugal, Greece. And the numbers, as a percentage of GDP, are: 4%, 2%, 0.5%-1%, 0.5%-1%, respectively.

If you still think that the Eurozone financial crisis is a remake of the 1997 Asian financial crisis, think again. And yes, having your own currency and the ability to devalue it does make a difference in terms of speed of external imbalances' adjustment.


2. Others may claim that although the Eurozone is not in Asia, the net external debt of Eurozone's peripheral member countries is such that with austerity and structural reforms the situation can be turned around within a reasonable timeframe.

What do the numbers say? This:

Current net external debt (as a percentage of GDP)

Portugal: 107%
Greece: 93%
Spain: 92%
Ireland: 92%
Italy: 22%

For the sake of comparison

France: 18%
Germany: -37% (the minus means that Germany is a net international creditor)

This demands one observation. One question. And one answer.

The observation is: in terms of external imbalances and level of competitiveness, Italy is a very different animal from the other peripheral countries it is normally associated with. Italy is France, not Spain. Not really a surprise if one thinks about Italy's very strong industrial basis.

The question is: in 800 years of (more or less well) documented financial history, how many examples exist of countries with a foreign currency denominated net external debt accounting for at least 90% to 100% of GDP that were able to avoid a debt restructuring or outright default (with foreign currency meaning one over whose issuance a country has no control)? 

And the answer is: z-e-r-o.

Therefore, the conclusion can only be that Portugal, Greece, Spain and Ireland will need a debt restructuring across the board, for both public and private debt, at some point over the next 2-3 years. With social discontent on the rise, this is the time left for structural reforms - all very much needed, but insufficient to reverse the country's external imbalances.


3. How to do the then unavoidable recapitalisation of Eurozone's banking sector following the periphery's debt restructuring?

The periphery's national governments will obviously not have the fiscal capacity to carry out bank bail-outs. With Eurozone's net public debt to GDP having just reached 90% - even economic powerhouse Germany is at 82% - and the social fatigue with bank bail-outs, don't expect the European taxpayer (via ESM) to be first in line to bear this burden. This leaves the private sector solution - arguably the only one truly compliant with a market economy, liberal democracy and open society - as the only one on the table:

- write-down of bank assets
- depositors up to Euros 100,000 are protected
- shareholders are wiped-out
- bondholders, both junior and senior, are bailed in and via debt-to-equity swaps become the new shareholders
- if this is not enough to fully recapitalise banks, depositors above Euros 100,000 are bailed-in and via debt-to-equity swaps become bank shareholders as well
- if this is still not enough, the European taxpayer (via ESM) will then, and only then, close the remaining gap


Does this sound pessimistic? For those who think it does, I can only say that I'm ready to happily change my views. For that to happen, I just ask for one single piece of evidence: show me one documented example of a country with a foreign currency denominated net external debt accounting for at least 90% to 100% of GDP that was able to avoid a debt restructuring or outright default in the past.

Until then, the numbers are on my side.

Monday 1 April 2013

Cyprus: FT's Wolfgang Münchau and Gavyn Davies are missing the point

Even good men, have bad days. Wolfgang Münchau and Gavyn Davies are the living proof of it.

In today’s FT, Wolfgang Münchau argues that bail-ins “à la Cyprus” would only be logic if there was already a fully-fledged Eurozone banking union in place”. Gavyn Davies says that "the critical separation of sovereign from bank debt, promised in the Eurozone summit last June" is not being complied with "leaving the vast majority of the current banking problem still lying at the door of member states, and therefore the separation of sovereign from bank debt would not be achieved"

Is that right?

Let’s start from the beginning: whenever the problem is one of excessive debt and there is no realistic way to grow out of it, as is right now the case in many Eurozone countries, the way to solve it is through comprehensive debt restructuring followed by a thorough recapitalisation of the banking sector.

So, the questions are:

a) Why should the taxpayer foot the entire bill of the banking sector's recapitalisation? Why should an European banking union be designed to fully bail-out banks' shareholders and creditors with taxpayer's money (via the European Stability Mechanism’s – ESM)?

b) Shouldn't taxpayer's money only be used to close the gap left, if any, once shareholders and non-secured bondholders (both junior and senior) have been bailed-in and debt-to-equity swaps taken place, with the bondholders becoming the new shareholders?

c) Is a European banking union not perfectly compatible with debt restructuring and banking recapitalisations along the following lines:

1. Debt restructuring across the board for both private and public debt

2. Resolution and recapitalisation of the then insolvent banking sector done via bail-ins of shareholders, all non-secured bondholders and only the then potentially left gap with European taxpayer's money (i.e. ESM money)?

d) Once the banking sector is recapitalised and solvent, is it not the ECB's job to provide unlimited liquidity to counter potential capital flights? Once recapitalised the banking sector should be solvent, shouldn't it? But then there is no risk for the ECB in lending it money. Once things have calmed down, the recapitalised banks will be able to assess normal market financing and repay the ECB, won't they?

e) The only grey zone is what to do with uninsured bank depositors (> Eur 100k). Then again, if there are no bondholders to be bailed-in (as in the case of Cyprus) doesn't it make sense to bail-in, at least partially, the large depositors before taxpayer’s money is used to recapitalise the banks?

f) Why and how exactly wouldn’t a Eurozone banking union working along these lines comply with "the critical separation of sovereign from bank debt, promised in the Eurozone summit last June"? And "leave the vast majority of the current banking problem still lying at the door of member states, and therefore the separation of sovereign from bank debt would not be achieved"?

By forcing bail-ins of shareholders and private creditors and closing the gap left with ESM money, national  governments' resources are not being used (with the exception of the national governments' contribution to the ESM) to recapitalise banks. I can't see any more effective way to break the link between sovereign and banking sector than this one. And I wonder, how can this be seen differently?

g) Germany is afraid of agreeing to a fully fledged baking union now, because it fears that it will lead to a situation where the European (led by the German) taxpayer, via the ESM, ends up footing the entire bill of the unavoidable European banking sector's recapitalisation following the unavoidable EU periphery's public and private sector debt restructuring over the coming years. And in a market economy, no European banking union should be designed to fully bail-out banks' creditors with taxpayer's money (ESM). Private sector participation has to come first. After all, in a market economy, freedom and responsibility go hand in hand. The decision makers (shareholders, non-secured bondholders, uninsured depositors) have to be held accountable for their actions.

Then again: if a proper and fully-fledged European banking union will allow for the bail-in of shareholders, unsecured bondholders (both junior and senior) and even uninsured depositors above Eur 100k, with the European / German taxpayer only closing the then still potentially left recapitalisation gap, Germany will be surely happy to agree to such a banking union.

If the problem is winning Germany's agreement to a comprehensive banking union, the problem is then solved. Isn't it?


PS Links to Wolfgang Münchau and Gavyn Davies today's articles:


http://www.ft.com/cms/s/0/1e4547c8-9554-11e2-a4fa-00144feabdc0.html?ftcamp=published_links%2Frss%2Fcomment%2Ffeed%2F%2Fproduct#axzz2PCeHAYLX

http://blogs.ft.com/gavyndavies/2013/03/31/preventing-contagion-from-cyprus/