Wednesday 2 December 2015

Spain: Uber-Iglesias and with Ciudadanos Podemos

We are less than three weeks away from the Spanish general election, which will take place on the 20th of December.

Polls abound. Candidates for Prime-Minister make proposals on a daily basis. Analysts debate passionately the possible election outcomes and government coalitions. And in the process the most important tends to be overlooked: the big transformation of Spanish politics already happened.

The driving force behind it has one name: Pablo Iglesias, the formidable leader of Podemos (a left-wing party. Note: "Podemos" means "We can"). In less than 24 months, almost single handedly, he disrupted the entire Spanish political establishment. As a result of what at some point looked liked an unstoppable rise in popularity, Pablo Iglesias / Podemos achieved the impossible trinity:

1. they forced the renewal of the leadership teams of Spain's main political parties. With the exception of Partido Popular (which is in government) the leaders of all main political parties are now 35 to 45 years of age. And the same applies to the vast majority of the top decision makers  in their teams.

These individuals rose to power 15 years ahead of "their time". In Spain, the 35-45 year old generation is much more international, better educated and prepared than the preceding ones. It is also the first since the 1930s civil war able to have a reasonable fact-based discussion about politics, society and economics, leaving the "fachas" vs. "rojos" childish, cartoon-like arguments on the sidelines. Coming to power 15 years earlier than expected is a blessing for Spain's political, economic and social development.

2. they (and new parties that erupted on the wake of Pablo Iglesias' "anti-establishment revolution") won the support of many discontent voters in Catalonia who would have otherwise voted  for pro-independence parties. This gives the new Spanish government to come out of the December election a 2-3 year window of opportunity to reform the country's constitution and accommodate Catalonia in a politically reformed Spain. Catalonia's secession, which looked unstoppable 2 years ago, can now be avoided. Avoiding the related political and economic turmoil is good news. Taking into account that one of Spain's main strengths is the dynamic resulting from the healthy rivalry between its main regions (and this doesn't apply only to football's Barça-Madrid) keeping Catalonia as part of a politically reformed Spain is very good news. For everyone involved.

3. they generated a new wave of interest and enthusiasm for politics among Spaniards, especially the young, and gave ordinary citizens new hope for a better future. Dreams, even when potentially unrealistic at inception, are essential to create a dynamic of positive change. And interest, hope and enthusiasm is all what is needed for new, innovative social and political movements to be born. Projects able to offer effective solutions for the problems Spain is facing.

Podemos only shortcoming is its economic illiteracy. It is a major shortcoming.

However, the disruption of the Spanish political establishment, and the new wave of political enthusiasm, triggered by Pablo Iglesias / Podemos created the space for new political movements to flourish. According to all polls, one of them became in the meantime a top 4 political party: Ciudadanos, the centrist party led by Catalan born Albert Rivera. It has an excellent economic and institutional reform programme (https://www.ciudadanos-cs.org/programa-electoral). More importantly, it is almost certain that it will be part of a future Spanish government coalition as no party will have an absolute majority. And if only half of its proposals are implemented by the new government Spain will be a benchmark for quality institutions and economic policy in 5 years time.

Whatever the outcome of the 20th of December election, one thing is clear: a country that is able to create political leaders of Pablo Iglesias' spectacular dimension and political movements capable of designing economic and reform programmes of the quality of that of Ciudadanos has a very bright future ahead. And should be proud of its very lively civil society.


Monday 28 September 2015

Independent Catalonia: the Spanish flag and Barça's greatness

Plebiscitary regional elections were held yesterday, 27th of September, in Catalonia. The coalition "Junts pel Sí" won (note: "Junts pel Si" comprises parties across the whole political spectrum solely united by their desire of Catalonian independence). And combined with the left-wing CUP party, also pro-independence (and anti-system), they have a majority of seats in the regional parliament. However, the combined votes of the pro-independence parties fell short of a majority of popular votes (48%). Where does this leave us? In a grey zone. What will happen next is not clear. Except that negotiations between the Spanish government and the new Catalan regional government will have to take place at some point to accommodate Catalonia's growing discontentment with the current status quo. Possibly something along the lines of a new-Spanish-constitution-creating-a-federal-state-followed-by-a-referendum-in-Catalonia-to-decide-on-be-part-of-a-federal-Spain-vs.-independence?

Whatever the next steps in the Catalan saga will be, it is time to ask the question: why do so many in Catalonia want to be part of an independent country? There are basically three reasons:

1. The "independence dividend". The pro-independence movement calculates that Catalonia pays EUR 16bn (c. 8% of Catalonian's GDP) more in taxes to the central government than it receives in benefits. We could discuss at length the appropriateness of the methodology used for the calculation (e.g. monetary flows vs. tax contribution-benefit method). However, we don't need to go that far to see what is at stake (for those who want to go into detail: CAT fiscal transfers).

The pro-independence movement assumes in its calculations that the Spanish government would have to continue to pay the pensions of Catalans, who paid their national insurance contributions into the Spanish social security system over the years, following independence. While 100% of the Catalan citizens' national insurance contributions post-independence would flow to the new Catalan government. The argument is that there is a "pension contract" between each individual taxpayer and the Spanish government that the latter has to honour. It is an apparently sound and compelling argument. And then it is not. It is disingenuous and wrong.

Spain's pension system (like basically all others in Europe) operates on a pay-as-you-go basis. Not on a funded basis. This means that pensions paid to current pensioners are financed from contributions paid by current workers. It is an inter-generational contract supervised by the state. The older generations pay healthcare and education for the younger ones while they are growing up, and once the latter enter the workforce they start paying the pensions of the former who retire.

In such a system, if the pensioners move to a new country after retirement (Germans, Swedes who decide to move to Spain after retirement or Spaniards who worked in Germany or Sweden and after retirement decide to move to Spain) the inter-generational contract remains intact. The pensioners will have reached an age where they will not make any additional (roughly speaking) contributions into the social security system anyway. No matter where they decide to spend their lives. And the younger generations remain in the country that pays the pensions. Working, paying their social contributions and keeping the pay-as-you-go system running.

Things change if a significant part of the entire population, young and old, working age citizens and pensioners, decide that the region where they live should become and independent country. In that case both the younger and older generations "move" to a new country. The younger generations of the "new" country will have to pay the pensions of the "new" country. Even because the shrunken number of young people in the "old" country, from which the "new" split off, will not be able to pay the pensions of both "old' and "new" country pensioners (the inter-generational contract would effectively be broken). So, the inter-generational contract remains in place but supervised by the newly created independent state and binding young and old generations of the "new" country.

Once you take this into account, the numbers change dramatically. Pensions paid in Catalonia amount to Eur 19bn per year. With the "new" independent Catalonia state having to pay for them the "independence dividend" turns into an annual "independence burden" of Eur 3bn.

The "independence dividend" is not the reason to become independent.


2. The construction of a new model state - the Sweden of Southern Europe

Spain has weak political end economic institutions. The judiciary is not fully independent. Neither is the press. Corruption abounds. Being part of Spain holds Catalonia, a more dynamic and entrepreneurial society, back. So the pro-independence argument goes.

Right.

Have there been notably less (proportionally to population size) corruption cases in Catalonia than in the rest of Spain in the last 10 years? 20 years? Is the Catalonian press less captured by corporate and political interests limiting its freedom of reporting and opinion? Are smaller countries, by design, less corrupt than larger ones? Is the former long-serving (23 years) president of the regional government (Jordi Puyol) not under investigation for money laundry and corruption? Has any president of the Spanish government (current or former) been under investigation for similar crimes? Do the political parties that comprise the coalition "Junts pel Sí" and the CUP party share a common political and economic agenda for the post-independence period?

The answers to all these questions are the opposite of what would be consistent with the "construction of Southern Europe's Sweden" pro-independence argument.

This leaves us with one last and powerful pro-independence argument:


3. Emotions, national identity

A large part of Catalans may feel that they are significantly different from the rest of Spaniards in the way they think, behave, approach life. That having their own language is a sign of a well defined and separate identity. These are all very respectable reasons to want to be independent. But then it should be made clear, and people be fully aware of it, that these are the reasons to want to be independent. Not something else.

This should also help to clarify what an independent Catalonia would likely to be politically, economically and socially in 20 years time (after a more or less long, more or less painful transition period). Looking at Spain's and Catalonia's history, at Spain's and Catalonia's path of development over the past 40 years of democracy and 30 years of EU membership, the conclusion seems reasonably straightforward: an independent Catalonia would tend to be more or less the same thing as a Catalonia part of Spain.

A prosperous country, just as the rest of Spain. More prosperous than today, just as the rest of Spain. With a 25%-30% higher GDP per capita than that of the rest of Spain, just as today. With stronger political and economic institutions, just as the rest of Spain. With a more independent judicial system, just as the rest of Spain. With a more independent press, just as the rest of Spain. Part of the Eurozone, just as the rest of Spain. With an ageing "native" population, higher retirement age and more immigrants, just as the rest of Spain. With a more innovative economy, just as the rest of Spain. A place with a high quality of live, just as the rest of Spain.

And with two important differences: there would be no Spanish flags hanging on official buildings. And FC Barcelona would have become an irrelevant club in European and world football.

Catalans should ask themselves the question which of the two differences does the more good to their emotions and sense of national identity. By answering it, they will know if they want to have an independent Catalonia. Or not.

Thursday 10 September 2015

Greece's 3rd bail-out: make or break?

Greece's third bail-out programme was given green light in August. All went according to plan. So far.

The relevant question now is: after the failures of the previous two, what are the risks of failure facing this one? There are four main risks:

1. The banking sector's comprehensive restructuring and recapitalisation doesn't take place

Greek banks need to write-off bad debts and be recapitalised to provide financing to the private sector. Without it no sustainable private sector driven economic recovery can start.

The third bail-out package includes Eur 25bn to recap the Greek banking sector. This accounts for around 6.5% of the Greek's banking system total assets. It should be more than enough to recapitalise the Greek banks properly.

Existing shareholders in some banks (all but National Bank of Greece?) will most likely be wiped out - sorry guys, the EU's Bank Recovery and Resolution Directive (BRRD) will only enter fully into force in January 2016 but given Banco Espirito Santo's bail-in precedent in August 2014, January 2016 is too close for the EU authorities to let shareholders off the hook. Bondholders (both junior and senior) will be (partially) bailed-in. But all will be ok.

The Greek banking sector not being comprehensively dealt with and recapitalised is not a risk.

2. Primary surpluses demanded by the Quartet (European Commission, ECB, ESM and IMF) are detrimental for growth

Too aggressive fiscal targets imposed on Greece by the Quartet could be too restrictive for public spending. Social unrest would pick up new momentum. Implementing the structural reforms agreed as part of the third bail-out package become an impossible task. The programme would fail. Again.

These are the final primary surplus targets agreed between Greece and the Quartet: -0.25% of GDP for 2015 (a primary deficit) vs. 1% (surplus) that was agreed earlier in the summer; 0.5% in 2016 vs. 2% agreed earlier in the summer; 1.75% in 2017 vs. 3% earlier; 3.5% in 2018 vs.....3.5% earlier.

And there will be surely some willingness to accommodate a deviation from the agreed 2015 primary surplus target to take into account any unexpected adverse effects on GDP growth following the bank closures and imposition of capital controls in July. As long as the Greek government implements the agreed structural reforms for 2015.

There is hardly anything too aggressive and demanding here. So, no significant risks on this topic either.

3. Public debt restructuring will not take place

A silent and significant debt restructuring has been taken place since 2011 as I showed in detail some time ago (http://cubismeconomics.blogspot.co.uk/2014/12/greece-what-now.html). And more is to come via maturity extensions and lowering of interest rates as long as the new Greek government implements the agreed reforms. And as soon as the first review of the third bail-out programme is favourably concluded.

With an average maturity of 31 years the loans of the new bail-out programme are a clear signal of where the debt restructuring journey is going.

Absence of further debt restructuring is clearly not a risk.

4. Lack of political will to implement agreed reforms

Mr. Tsipras went as close to the edge of the Euro cliff as one could possibly go. Seeing the Grexit abyss he stepped back and agreed to a new comprehensive third bail-out package. If we wins the upcoming general elections (20 September), and forms a majority government, not implementing something that he agreed to is surely not a realistic scenario to contemplate. Even if of one argued that he only agreed reluctantly to some of the measures in the MoU, the electoral victory would give him the mandate to implement them.

What if the opposition (ND led government) wins the election? Not much changes. With the pro-Grexit parties likely to end up with only 15% to 20% of the votes, any Greek government will have a clear mandate to do whatever it takes to stay in the Euro. And after the dramatic quasi-Grexit events in July, that plain and simply means implementing the agreed reforms.

Greece being Greece, not all agreed reforms will be implemented. However, even if the implementation ratio is 50% (instead of the rather 10% in the past) that would be good enough.

Arguably Syriza winning now would be a superior outcome for mid to long-term policy continuity purposes. If after 3-4 years in government Syriza lost the general election in 2018-2019, a new ND-led government (potentially in coalition with Potami) would tend to continue along the roughly same economic path as defined by the third bail-out programme. No dramatic reversal of economic policies would take place allowing Greece to reap the full benefits of the difficult reforms implemented in the meantime. The same cannot be said with the same degree of confidence if Syriza loses this election and wins the next one. There is always the possibility that at that point in time even a more moderate Syriza tries to reinvent the wheel, once more, and reverses some of the reforms implemented in the meantime.

Then again, will it make any substantial difference for reform implementation over the next 18-24 months who wins the 20 of September election? Not really. The Quartet's first review on the progress of reform implementation will take place in November. Greece will pass. Further debt relief will then be conceded by the EU. And the ECB will be able to extend its QE programme to the purchase of Greek government bonds. With bond spreads narrowing, capital controls slowly being lifting, foreign investors returning to the country and the economy starting to recover, Greece could well be 2016's economic suprise of the year. And with a cyclical-adjusted PE of under 5x, Greece's equity market could do much better than most expect over the next 18 months.

No one ever said that Greece is a boring country. And rightly so: over the coming 18 months it is likely to continue to be a box full of surprises. This time good ones.

Tuesday 25 August 2015

China: a remake of 2008's global financial crisis?

I appreciate the arguments that there are pockets of excessive debt in the Chinese economy (local governments, real estate). And that a mis-allocation of capital (both private and public investments generating returns below the cost of capital) has been taken place in some sectors of the economy (public infrastructure, heavy industries).

However, I cannot see how all that can lead to a major economic and financial crisis in the country until the mis-allocation of capital translates into sustainable current account deficits. And makes China dependent on external financing.

My opinion on China's imminent economic implosion remains the same as in March 2014. Please read:
Don't be fooled by the availability bias


Monday 13 July 2015

A-Greek-ment: the day after

The medicine Greece has to take now is very unpleasant and aggressive. The way it is being administered by the Eurozone - even if they had objectively speaking all the reasons to do so - shockingly humiliating.

But let's not forget that it was Syriza who put Greece in its hopeless negotiation position. Greece was the fastest growing Eurozone economy in 2H2014. It was running a primary surplus. A current account surplus. The economy was turning the corner. And debt relief via maturity extensions & lowering of interest rates (plus refinancing of ECB held bonds and IMF loans) after June 2015 was implicitly on the table. 

But Tsipras & Varoufakis were not on top of the numbers. Otherwise, they wouldn't have put debt relief at the top of their Eurozone agenda after all the debt relief that had already taken place since 2012 (http://cubismeconomics.blogspot.co.uk/2014/12/greece-what-now.html). And the one that was implicitly agreed to take place after June 2015. The priority should have been to implement reforms, win the other Eurozone's countries trust, and then ask for additional, substantial, debt relief.

The key assumption on which Syriza based their entire Eurozone strategy - a Grexit would lead to massive financial contagion and therefore force the Eurozone/Troika to make material concessions - was flawed. And, once again, they were not on top of the numbers. Otherwise, they could have falsified and rejected the assumption by running them (http://cubismeconomics.blogspot.co.uk/2015/06/grexit-and-risks-of-financial-contagion.html). Or, more philosophically, by simply asking themselves what was the worst that could happen if their assumptions proved wrong. And if there wasn't an alternative strategy that offered similar upside in case of success but much more limited downside in case of failure. But they didn't. Now we have a sad story to tell.

However, as sad as the story may be, let's not fool ourselves: the main responsibles for it are Tsipras / Varoufakis / Syriza and their very, very poor strategic decision-making. At the receiving end of the now needed additional austerity will be ordinary Greek citizens - the ones Syriza allegedly wanted so much to help and protect.

Thursday 9 July 2015

Greece: a response to Martin Wolf

A response to Martin Wolf's Financial Times article "Grexit will leave the Euro fragile" published on 8 July 2015 (http://www.ft.com/cms/s/0/4e5ef8c0-23df-11e5-bd83-71cb60e8f08c.html#axzz3fHpBbv34)


Dear Martin,

banks / private creditors shouldn't have been bailed-out and should have suffered the full losses of a Greek debt restructuring. Agreed. 

However, you are missing a few points: 

(i) there was a bail-in of banks / private lenders in 2012. The net present value of the resulting debt relief amounts to Eur 100bn, i.e., around 50% of Greek GDP.

(ii) you argue "the financing provided by the Troika was of negligible benefit for Greece". You are wrong. 

Greece was running both a public deficit and a current account deficit of over 10%. Even if the banks/ private lenders had borne the full burden of a Greek debt restructuring, Greece would still have had to deal with this twin deficit. Without the financing provided by the Troika the adjustment would have had to take place in a few weeks or in a few months at best. The resulting massive spending cuts in such a short period of time would have led to a rapid collapse of the Greek economy (assuming a public spending multiplier of 2 - a conservative assumption in an economy cut off from external financing - public spending cuts accounting for 10% of GDP would have led to a 20% sudden collapse in GDP).

The financing provided by the Troika gave the Greek authorities the chance to adjust more slowly. The consolidation of public finances - the so-called austerity - would always drag the GDP down. Structural reforms (reform the judicial system, open up protected sectors to competition, fight tax evasion....) would push up GDP by attracting foreign direct investment (FDI). To be fair, Greece has implemented a massive austerity programme. But it barely delivered on structural reforms. The unwillingness to touch vested interests is not the Troika's or Eurozone's member countries fault.

(iii) you implicitly state that the Troika hasn't so far provided any meaningful debt relief to Greece. You are wrong again. As Paul De Grauwe shows: http://www.voxeu.org/article/greece-solvent-illiquid-policy-implications And as I had written in 2014: 

On a different note, the risk of financial contagion from a Grexit is now zero. It would be very different in 2010 or even 2012. But in the meantime the Eurozone has put mechanisms in place that make a contagion impossible. As a result, only countries that do not want to stay in the Eurozone will leave. There is no way that financial market forces can push a country out. Here is why: http://cubismeconomics.blogspot.co.uk/2014/12/greece-what-now.html

The time has come for Greece to ask itself why it wants to stay in the Eurozone. You cannot impose reforms on a sovereign state unwilling to be reformed. And If Greece doesn't really want to reform, its Eurozone membership turns into a mere political prestige project. It has much more costs than benefits. In this case, let's face reality and be honest with oneself: EU membership outside the Eurozone is the best option for Greece. As well as for the Eurozone, and European Union, as a whole.

Sunday 28 June 2015

Grexit and the risks of financial contagion

Availability bias. Representativeness heuristics.

When trying to anticipate future events we tend to be over-influenced by what we tend to view as similar (representativeness) recent dramatic events, which are - precisely because of their dramatic character - strongly present (availability) in our memory. We then tend to extrapolate almost linearly the sequence and consequences of the events we are currently faced with from those past, and perceived as similar, events.

This explains why many today think that Grexit will be Eurozone's Lehman moment. They are wrong.

The FED initially downplayed the consequences of defaults on subprime real estate loans and the contagion risks arising from the financial system's high degree of connectivity. The line of though was a simple one: if subprime real estate loans just accounted for 1%-2% of the total banks' balance sheet size, there was no way that a collapse of this market segment could have meaningful adverse consequences on the whole financial and economic system. This proved to be a major error of judgement.

The European authorities, and first and foremost the ECB, have a complete different view about Grexit. They know that the Greek economy may be tinny in the context of the Eurozone but that the risk of contagion via the sovereign bond market is significant. As a result, they have put in place a massive firewall (ESM and ECB's QE programme) that effectively stops at inception any risk of contagion.

There will be in the very short-term (this and next week) turmoil in financial markets following the call for what can be perceived as an In/Out (of the Euro) referendum by the Greek government. Stock markets will fall. Spreads between peripheral and German sovereign bonds will widen. Investors (read hedge funds) that will be betting on a widen of the spreads will make money. As the market moves their way, they will increase their positions. And then, at some point, the ECB will intervene massively and force the spreads to narrow down again. Investors betting on a widening of the spreads will burn their fingers. And stop playing the game. Some of the more savvy investors will not even start to play it as they understand that this is not a pure economic game. It is a game with an overwhelming political dimension. And that commander-in-chief Mario Draghi has de-facto unlimited resources to squeeze any profits out of tentative short-Eurozone players "a la John Paulson".

To put numbers to the story:

- Portugal, the first country at risk of contagion in case of a Grexit, has a total public debt of around Eur 200bn

- Around 45% of it is held by the Troika. This leaves Eur 110bn being held by private investors

- Let's say that 100% of the Portuguese sovereign debt is turned over a 12-month period (a generous assumption given that many of the debt is held by pension funds and retail investors, who don't trade it actively). This would mean less than Eur 10bn of Portuguese public debt being traded each month

- The ECB only has to intervene at the margin to influence the price setting. Let's say that it would have to buy 25% of the average monthly traded volume of Portuguese sovereign bonds to stabilise their price and narrow down sovereign spreads to a pre-determined level. This would amount to interventions of Eur 2.5bn per month. The ECB QE programme alone allows Mr. Dragi to buy up to Eur 60bn of Eurozone sovereign bonds on a monthly basis

- On could always argue that the ECB will need to buy sovereign bonds from other countries as well. Sure. But then again: (i) there would be Eur 57.5bn left (approx. 96% of total available resource) to buy sovereign bond markets of other countries; (ii) if the ECB stops contagion to Portugal (arguably the weakest link in the chain) it will stop contagion from Portugal to other countries. Or are we saying that investors would be asking more yield to buy Spanish and Italian government bonds than Portuguese ones?

Cutting a long story short, with the safety mechanisms that Eurozone's authorities have put in place no country can be forced out of the Euro by financial market forces. Only countries that don't want to stay in the Euro will leave.

And if a Grexit does occur, with the devastating short-term consequences for the Greek economy visible to everyone, there won't be any other country willing to follow Greece out of the Euro.

Dear candidates to become Eurozone's John Paulson, I wish you luck. Dear Alexis Tsipras & Yanis Varoufakis, if your strategy is to put pressure on the Eurogroup via financial contagion of a potential Grexit to reach better deal terms, I wish you luck as well. To all of you: even a lot of luck will not be enough.

Sunday 12 April 2015

Eurozone: a tale of good deflation

A sudden, unexpected fall in aggregate demand - impacting all sectors of the economy - leaves firms with an excess of inventory. To get rid of it, they are forced to lower prices. However, if for some reason (well understood or not) consumers expect further reduction in prices of goods and services going forward they delay their consumption decisions, leading to even more excess inventory and the need for even lower prices to clear it. Consumers' prophecy becomes self fulfilling. As a result, firms are forced to sell their products below production costs (or at least with much lower profit margins) and their profitability turns negative (or at least falls significantly). Cuts in production and staff ensue. With unemployment rising and consumers' disposal income falling, private consumption and aggregate demand drop further and so do consumer prices and firms profitability. A negative economic spiral is set in motion and an economic depression is the likely outcome.

The logic policy advise is therefore unambiguous: authorities, starting with central banks, should fight deflation with all their might. This is standard economics. And all very sensible.

But what happens when we are faced with a situation where the fall in consumer prices follows an initial across the board cut in salaries in the economy? The cut in firms end-consumer prices will not lead to a deterioration in their profitability as their cost base will have been lowered as a result of the adjustment in labour costs in the first place. The generalised fall in prices of goods and services in the economy (deflation) will in turn partially restore the consumers' lost purchasing power that occurred at the time cuts in salaries took place. Deflation in this case should not delay consumption decisions. On the contrary, consumers should use their partially restored purchasing power to happily spend more. Higher consumption will translate into higher aggregate demand and real economic growth. And given the private consumption's multiplier effect the real economic growth should more than offset deflation and therefore translate into positive nominal growth as well. With nominal GDP increasing debt levels should become more, not less, sustainable.

Putting it differently: the negative impact on consumption, real and nominal GDP, debt sustainability will occur at inception of the salary cuts. It is a negative aggregate demand shock. The subsequent deflation will partially reverse this negative impact. It is a positive aggregate supply shock (as it has lower production costs at its origin). It will lead to more private consumption and economic growth (real and nominal). This is then "good deflation".

The reason why the concept of "good deflation" is absent of standard economics textbooks is simply because when thinking about deflation the mainstream economics' line of reasoning starts with a sudden, out of the blue, fall in aggregate demand. If the whole deflation process is instead triggered by a wide-ranging adjustment in salaries across the economy the concept of "good deflation" is a perfectly realistic one. Or are we saying, for the sake of argument, that after a 50% fall in salaries across the whole economy it is better for aggregate spending purposes that the consumer faces a 5% increase in consumer prices the following year instead of a 20% fall?

Needless to say, I think that the Eurozone is going through a process of (moderate) "good deflation". Could I be wrong?

This question will be easy to answer. If deflation goes hand-in-hand with a fall in retail sales over the next 12 months, I will be wrong. If deflation ends up being accompanied by an increase in retail sales, the idea of "good deflation" will be correct. As of today, the numbers show that Eurozone's deflation set in around December 2014 (-0.2% YoY; followed by -0.6%, -0.3% and -0.1% YoY in January, February and March 2015, respectively). And that retail sales started to pick up significantly in......December 2014 (3.2% YoY; followed by 3.2% and 3.0% in January and February 2015, respectively). The same picture emerges when looking at the Eurozone's peripheral countries data, where deflation set in more intensively and earlier on (in 1H2014. In the case of Greece as early as 1H2013).

So, we can discuss all day long the sense or nonsense of the "good deflation" concept. But for the time being the numbers are on my side. In 12 months time we'll see.

In the meantime, enjoy Mario Draghi's inflation fighting giant QE programme.

Thursday 19 February 2015

Dear Yanis (Varoufakis): act Greek before becoming German

Germany is more than open to discuss anything and everything with the new Greek government about maturity extensions, lowering of interest rates and reduction of the primary budget surplus. As part of a new financial assistance programme.

What Germans are not willing to discuss, and will not discuss, are changes to the existing programme. It's not because they are stubborn, unreasonable and don't get it. It is simply because they don't want to create a precedent. If whenever a new government is elected in an Eurozone country the terms and conditions of existing programmes are up for negotiation the whole Monetary Union construct becomes unmanageable. Agreements at Eurogroup level, once reached, are binding for the countries that agreed to them until expiry date. No matter what government succeeds the one that negotiated the terms of an assistance programme. A new government will have the chance to negotiate new terms once an existing programme expires.

The new Greek government, and surely the prime-minister Alexis Tsipras and finance minister Yanis Varoufakis, being new to EU politics and not "speaking" German have difficulty in understanding this. And by being very honest, and (too) loud, about what they think is right and wrong are wasting their energy and losing a lot of goodwill from their fellow Eurozone counter-parties.

But the solution to the problem is not that difficult: 

Dear Yanis, accept the extension of the current programme without changes and then do what previous Greek governments always did - just implement half of it. We are only talking about a 4 to 6 months period. In the meantime, use all your energy to negotiate the terms and conditions of a new programme that truly reflects the new Greek governments views about Greece's needed structural reforms. So that you and your government can commit to and deliver 100% of it.

You will find out that Germans are much more flexible, reasonable and understanding than they are portrayed to be.And once the Greek government starts to fully deliver on its new programme you will discover that Germans can also be very supportive. Engage with them.


Monday 16 February 2015

Greece-EU agreement: not today but eventually

There are some ideas circulating around about Greece defaulting on its official debt, staying in the Euro and issuing IOUs (effectively a parallel currency) to run a more expansionary fiscal policy.

Let's keep the feet on the ground for two minutes. 


The problem for the Greek government is not related to its ability to spend more once it has defaulted while staying in the Euro. With a 4.0%-4.5% primary government budget surplus expected for 2015, the Greek government has enough room to increase spending following a default on its official debt (80%-85% of total).

The problem is twofold:

1. It's banking system being cut off from ECB financing. This can be possibly solved by imposing capital controls. Not an elegant solution but a solution.

2. The external financing constraint. Greece is running a current account surplus of 0.5%-1.0% of GDP. Once it defaults, the current account surplus will actually increase as interest payments to foreign (official) creditors stop being made. This will allow to finance the initial additional imports of good and services that a more expansionary fiscal policy will trigger.

However, as the economy starts to grow it will need to import more to sustain the growth. Current account deficits will ensue. But without access to external finance - who will lend money to a country that just defaulted, even if only on its official debt, and since 1980 has run current account surpluses only in 2013 and 2014 ? - these deficits cannot be financed. No current account deficit can be run. And this will put a limit on growth and employment creation. Goodbye Syriza popularity.

The only way to overcome the external constraint sustainably over time is by broaden and expanding the country's export basis. This in turn can only be done via attraction of massive amounts of foreign direct investment (FDI). But a country that just defaulted will be able to do everything but attracting massive amounts of FDI.

Cutting a long story short, without structural reforms to attract FDI and to broaden its export basis Greece will never be a highly developed, modern, prosperous country. With or without default. With or without Grexit.

And the question then is: will it be easier to carry out the needed structural reforms within the discipline-pressure-conditional support-framework provided by the Euro or outside the Euro? Who says outside the Euro is ignoring Greek history.

As Syriza's government surely doesn't ignore Greek history, understands economics and is led by a smart political operator (here more on the topic), it will eventually reach an agreement with the EU for a new financing programme (lower primary budget surplus and further debt maturity extensions / lowering of interest rates in exchange for structural reforms).

Will it happen today, 16 of February 2015? I don't think so. The members of the new Greek government may be intelligent and well intentioned but they are inexperienced operators coming from another universe: lifelong academics and lifelong politicians. They have no executive experience at the highest level. And this means that they will be more likely than not poorly prepared for today's Eurogroup meeting. Able to do a lot of talk but with very little structure. And without structure and solid quantification of reality negotiations can't reach a swift conclusion.

But don't panic. Eventually an agreement will be reached. Just not today.



Thursday 5 February 2015

ECB vs. Greece: a bumpier journey but no change in the final destination

Starting on the 12th of February 2015 the ECB will stop accepting Greek government bonds as collateral for liquidity provided to Greek banks. Does this mean that Grexit is nigh? No.

Greek banks will continue to have access to the ECB's Emergency Liquidity Assistance (ELA). To put things in perspective, Greek banks' have currently borrowed EUR 8bn (at most) from the ECB using government bonds as collateral. Including Pillar I and Pillar II bonds (government guaranteed bonds issued by Greek banks) an additional EUR 25bn has to be taken into consideration in our analysis. A total of EUR 33bn of ECB financing to Greek banks will thus be cut off.

Greek banks' deposits currently amount to approx. EUR 150bn. In June 2012, when the risk of a Grexit reached its peak, Greek banks had borrowed EUR 160bn from the ECB via ELA. Currently, they have borrowed EUR 5bn. There is everything but a shortage of available liquidity for Greek banks.

Should the ECB cut off the Greek banks access to ELA at some point, and a bank run ensue, capital controls would have to be imposed by the Greek government. But Grexit would still be far from inevitable. Grexit would only become a possibility in case no political agreement about debt-restructuring-in-exchange-for-structural-reforms was reached between the Greek government and the troika (especially the EU). This is extraordinarily unlikely (less than 1% probability in my view) as I explained in my last post Is Mr. Tsipras going to Hollywood?

Cutting a long story short, the ECB can make the journey bumpier for both the Greek economy and the Greek financial markets but the final destination will not change. Only politicians can change it.

They almost certainly won't.

Monday 2 February 2015

Is Mr. Tsipras going to Hollywood?

Let's say that the new Syriza-led Greek government does not reach an agreement with the "troika" of European Union / ECB / IMF on the renegotiation of its debt. Let' further assume that it runs out of cash to pay its private sector creditors by the end of June 2015 (this assumes that until then the ECB will not cut off the liquidity provision to Greek banks, which will use it to refinance approx. EUR 10bn of maturing T-bills over the period). What options will it be left with?

Basically three:

1. The Tsipras led government decides to leave the Eurozone. With 70% of the Greek population opposed to this option, Syriza would in fact lose the political mandate it won in the 25th of January elections. Massive country-wide street protests would force the government to resign. Greece would be back to square one. A new government would reverse the decision and agree to a new "troika" financing package with more onerous strings attached as negotiated in a position of greater weakness. A one-sided government decision to leave the Eurozone is not an option.

2. Mr. Tsipras calls a referendum to decide on leaving the Eurozone. As emotionally as the "let's leave" campaign may be run, it is unlike to swing the current pro-Euro 70%-majority into a minority. Greek people, as unhappy as they may be with the "troika" imposed austerity, do perceive the Euro as a protection mechanism against local politicians random decision-making and corruption. And that it provides a framework for future sound(er) political decision-making and foundation for a modern and more prosperous economy.  Following a defeat in the referendum Mr. Tsipras would be forced to resign. Greece would be back to square one with events likely to unfold as mentioned in point 1. A referendum on an Euro exit is not really an option for Mr. Tsipras either.

3. Greece defaults but stays in the Eurozone. After years of austerity, Greece is running a current account and government budget primary surplus. Meaning: it is not dependent on international financing to meet its public spending needs (interest payments apart) and to pay for its imports. It's banks are dependent on ECB financing, which would be cut off shortly after the Greek government defaulted on its public debt. This could force Greece out of the Eurozone. However, this would only be the case if Greek banks needed new financing / liquidity as a result of massive capital outflows. Imposing capital controls would likely avoid it. The refinancing of existing ECB liquidity wouldn't be an issue - Greek banks would simply not repay the existing loans to the ECB invoking Greek government imposed capital controls and thus render any refinancing unnecessary. Greek could stay in the Euro despite defaulting on its debt.

Let's say that this would actually work and the Greek government would spend the primary budget surplus (4.0%-4.5% of GDP in 2015) in social programmes. GDP would grow, aggregate demand would increase but so would the demand for imports. With the current account surplus running at just around 1% of GDP, external financing would be required to pay for the higher level of imports. Who would provide it? Not the "troika", obviously. But neither would private investors (even if no default had occurred on privately held Greek debt by then) given the existence of capital controls and the uncertain outcome (and impact on private investments) of the stand-off with the "troika". With no foreign direct investment (FDI) flowing into the country to broaden its export basis and no portfolio inflows either, the external restriction would soon be felt by the Greek citizens: growth would be limited, access to external goods and services constrained. After maximum two years, it would be obvious to everyone that this strategy didn't allow the country to overcome its economic crisis. Syriza's popular support would erode. And Greece back to square one.

So, what is the alternative to not reaching an agreement with the "troika"? Simple: reaching one. How difficult will it be to do so? To answer this question we need to analyse what Mr. Tsipras wants and what the "troika", and especially the European Union, wants in exchange.

Mr. Tsipras essentially wants to (i) ease the burden of Greece's EU held public debt (65% of total) and (ii) be able to increase public spending to finance social programmes (e.g. free healthcare, housing, electricity, heating for the hardest hit by the economic crisis).

How difficult will it be to achieve these goals? It shouldn't be too difficult:

(a) A formal debt haircut will not happen. It is politically (given the difficulty to explain it to the creditor countries' electorate) and legally (no-bailout clause of Maastricht treaty) infeasible. But a soft and hidden haircut is perfectly doable. In fact it has been done over the past 4 years via maturity extensions and lowering of interest rates of EU held Greek public debt. The maturities of EU loans started being 7 years in 2010 and have been pushed to over 30 years in the meantime. The interest rate came down from Euribor + 5.5% to Euribor + 1.5%, with a 10-year interest payment moratorium (on 50% of total debt), and Euribor + 0.5% (on 15% of total debt). As a result, Greece is now paying annual interests amounting to 2.4% of GDP on its debt, which accounts for 175% of GDP. For the sake of comparison, Germany's interest payments on its public debt amount to 1.9% of GDP. France's 2.1%. Spain's 3.2%. Portugal's 4.2%. Ireland's 4.3%. Italy's approx. 5%. And back in 1998, the last year before the Euro came into existence, Greece was paying 7.4% of GDP in interests (at the time Greece's public debt accounted for 95% of GDP).

Extending maturities to 50 years with interest rates lowered to Euribor + 0.5% and a 10-year moratorium on interest payment on all the EU held public debt is perfectly achievable. And this would be a massive de facto (soft and hidden) debt haircut.

(b) Greece will be running a government budget primary surplus of 4.0%-4.5% as percentage of GDP in 2015. If the EU agrees to let Mr. Tsipras spend and additional 4% of GDP in social projects the primary surplus should shrink not to 0%-0.5% of GDP, but to......2.0%-2.5% of GDP given the public spending's likely multiplier effect in an economy not cut off from international financing (4% of GDP in public spending with a 1.3x multiplier and a 40% average tax rate on each extra Euro of GDP would generate additional tax revenues accounting for 2% of GDP).

The European Union in turn should happily agree to such extra spending. As long as it gets two things in return:

(c) Mr. Tsipras has to commit to nor roll back the structural reforms implemented in Greece over the past 4 years.

(d) Given that further significant cuts in the Greek public-administrative apparatus will be difficult to be agreed to and implemented by a Syriza government, Mr. Tsipras has to strongly commit to an overhaul of the tax system in order to fight tax evasion (estimated at 25%-30% of Greek GDP) and rise tax revenues. A strong commitment of this nature will likely imply agreeing to let a group of EU tax experts, jointly supervised by the Greek government and EU, move to Greece with a wide ranging mandate to redesign the country's tax system and put in place powerful institutions and mechanisms to fight tax evasion.

By obtaining (a) and (b) Mr. Tsipras can portray himself domestically as the great XXI century Greek hero who freed Greece from the "EU/German oppression". He will have delivered on his promises in record time. With FDI and international portfolio investments flowing into Greece a robust economic recovery will ensue. Mr. Tsipras popularity and political success will be guaranteed until at least the next general elections and an absolute majority will be an almost certainty. Will committing to (c) and (d) to get (a) and (b) be asking too much from Mr. Tsipras?

Mr. Tsipras and his economic team surely know that (c) is needed for long-term robust and sustainable growth, that the most difficult part of the job is done and that Mr. Samaras and Pasok will be blamed for it for years to come. Not him. He will just reap the benefits of the carried out painful structural reforms. Regarding (d), fighting tax evasion and vested interests is popular in Greece. And potential intrusive behaviour from an international task force of EU tax experts surely a low price to pay to obtain (a) and (b).

To assume that Greece will not reach an agreement with the "troika", and especially the EU, is equivalent to assume that Mr. Tsipras is an irrational political operator, completely driven by a radical ideological economic unsound agenda and with neither sense of reality nor pragmatism. A mental basket case.

Can someone who is stripped of a reasonable sense of pragmatism become prime-minister in a Western European democracy at the age of 40? Can someone who hasn't a firm grasp of reality lead what was an irrelevant political party to power in just four years? Can someone be the undisputed leader of such an ideological diverse group of people as Syriza's members without being a very rational and smart political operator?

Answering these question with a yes might be reasonably sensible in a Hollywood-type environment. However, Hollywood is the place where House of Cards is considered a high quality political series. In the real world House of Cards is just the Twin Peaks of the XXI century: cinematography of exceptional quality, very good first episodes and then a sudden turn which makes it a spectacular offence to common sense and intelligence.

It is very much unlikely that Mr. Tsipras goes to Hollywood any time soon.

Friday 23 January 2015

QE: Super Mario says "jump" and Eurozone equities say "how high?"

Mario Draghi did it again.

Let's quantify and keep it simple:

1. EZB's QE programme will start in March 2015 and run for at least 19 months, until September 2016, inclusive

2. The ECB will buy EUR 60bn of Eurozone government bonds, ABS and covered bonds on a monthly basis. Almost EUR 1.1trn on a cumulative basis over the 19-month period

3. EUR 1.1trn account for:

a. Approx. 12% of Eurozone's government bonds outstanding nominal value

b. Approx. 19% of Eurozone's total stock market capitalisation

c. Approx. 25% of Eurozone's free-float stock market capitalisation

d. Approx. 33% of Eurozone's blue-chip free-float stock market capitalisation (DAX, CAC40, FTSE MIB, IBEX35,....)


So, the question of the day is: where will banks, pension funds, mutual funds & Co invest the proceeds from the disposal of Eurozone government bonds to the ECB? 

Answer: with Spanish 10-year government bonds yielding less than 1.4% and Italian's less than 1.6%, covered bond yields back to pre-2008 levels and the same applying to corporate bonds (incl. high-yield) the excess liquidity will end up in the Eurozone stock market. Assuming that the overwhelming majority of it - let's say 80% - will flow into the most liquid stock market segments (blue-chips), it means that approx. 25% of Eurozone's major stock market indices free-float will be bought up by the direct participant in ECB's QE. And the pricing effect will unavoidably trickle down to small and mid-caps.

For the sake of comparison, FED's QE3 announced in September 2012 and which run until October 2014 accounted for approx. 12% of US' total stock market cap (vs. 19% for the Eurozone). The S&P 500 rose 50% over the period. The US stock market was more expensive then than the Eurozone stock markets are today (on a CAPE basis: USA/S&P500 21.5x vs. Germany 20x; France 16x, Spain 12x; Italy 11x, Austria 9x, Portugal 8.5x, Greece.....3x).

Conclusion: Super Mario is giving you a late Christmas present. To take it up you just have to buy Eurozone stocks. 

Belated Merry Christmas everyone!