Monday 29 November 2010

The Good News from Brussels: Extending Greece's EUR 110 bln Loan Term

Over the weekend, the Eurozone and IMF agreed on a EUR 85 bln bail-out for Ireland (the total sum includes IMF and Irish own contributions).

The excellent news for Greece is that its own loan repayment term has been extended from 5-6 years under the current agreement, to at least 10 years in total, i.e. to 2024. This is to harmonise its conditions with those of Ireland’s.

This is excellent news, because one of the main risks since the drafting of the EUR 110 bln bail-out has been the apparent impossibility of repaying the bailout and refinancing private sector loans in 2013 and 2014, which total EUR 70 bln in 2013 and EUR 76 bln in 2014.

This news should, however, also be viewed with caution:

·         The greatest threat now would be a diminishing appetite for further austerity and reform efforts: we should be reminded that so far, only the simplest of reforms have been enacted.

·         The total interest on the debt will continue to rise, with the bail-out itself at 5.2% on the normal loan term, and the debt to the private sector coming in at astronomical yields (under current conditions). This is not sustainable. It remains to be seen whether Greece’s purported primary surplus in 2013 and thereafter will be able to deal with this added debt load.

·         The continuing contagion in the financial market, and the unchanged severity of public deficits and debt in the OECD (together with longer-term economic decline and apparent political paralysis), means that conditions continue to deteriorate over the long term. What will the financial markets be like in 2013-2014? Hard to tell.

The government has gained some breathing room, and for this we should thank the feckless EU banking stress tests in the summer of 2010, and the apparent dissimulation of the Irish government on the true severity of its banking crisis. Or at least the Eurozone's apparent reaction to the latter. For once, PASOK has nothing to do with it. Eireann go braugh!

Sunday 28 November 2010

Watching the Decline

Since November 1st, I’ve been shuttling back and forth to Cyprus for a consulting project. From this vantage point, I’ve been able to monitor the remarkable decline of Greek political and economic fortunes from a more remote and objective viewpoint. The events of this past month have been staggering:

·         On November 14th, the second round of local and regional elections took place. It would seem that the lessons of the financial crisis have not been learned, since these elections proceeded in much the same way as those before, driven by personalities or party affiliations, without any practical plans or budgets on offer. Five of the six parties running differentiated themselves as being “anti-Memorandum”, as though their “resistance” against an act of Parliament was relevant, and as though our European creditors would be amused to learn that the legal conditionality of their bail-out loan to Greece was now being challenged, at least in the court of public opinion.

·         The elections themselves were carried out again the backdrop of a magnificent blackmail by the Prime Minister: “Vote PASOK, or I will call national elections.” Again, our European creditors were hardly amused—Papandreou backed down on the evening of the first round, claiming, somewhat weakly, that the results in the first round provided enough support. In any event, it would not seem that the voters themselves were convinced, since over 50% of them stayed home or cast a white ballot.

·         The elections themselves were prefaced by PASOK engaging in pre-election maneuvers of the worse kind. ERT announced the hiring of 640 staff (perhaps ERT’s 5 orchestras needed more trombone players); the Prefecture of Pireaus hired 67 workers; a range of other organisations announced or implemented last-minute hires.

·         On November 15th, Eurostat published its revised and final (they claim) estimate of Greece’s 2009 deficit. This included the addition of EUR 18 billion is semi-governmental organisation debt to the central government’s books, driving the deficit to 15.4% GDP, and total debt to 126.8% GDP. As predicted, the government deficits from 2006-2009 were increased as well. As the government’s 2011 draft budget succinctly states:

From EUR 168 billion in 2003, the total debt grew to EUR 298 bln in 2009, an increase of EUR 130 bln.

This debt level is obscene, and the fact that most of it occurred during the Karamanlis government’s 6 years in power is regrettable.

·         On November 18th, the government announced its 2011 draft budget. Given the deteriorating financial situation, the budget calls for a massive fiscal adjustment. With the 2010 deficit estimated at 9.4% GDP, the 2011 target has been set at 7.4% GDP, and 6.5% in 2012

·         On November 21st, Dora Bakoyianni launched her new, centre-right political party, “Democratic Alliance”. Its platform calls for a number of interesting policies, including a 20% flat tax, but makes no reference to how these will contribute to solving the debt crisis. Given Bakoyianni’s own record as Mayor of Athens, it is difficult to see how credible her calls are for transparency in the public sector, but this is not a problem unique to this politician or this political party.

·         Her political launch led to the expected paroxysms in Antony Samaras’ New Democracy, including the expulsion of one MP, and it would now appear that, following the left, the right will splinter as well. For all the good the right has been doing recently, I can’t say this outcome is the wrong one.

·         These events have led the government to announce a panic-ridden search for additional sources of expenditure cuts and revenue increases. Unfortunately, it is difficult to see how this will happen given the implementation record to date, and when Ministers such as Louka Katseli or Dimitris Reppas continue to pander to the unionised public sector.

But these facts, dismal though they are, regrettably confirm the longer-term trend:

a.       Greece’s public debt at end-2009 starts at EUR 298 bln, but the deficit target set out in the 2010 estimate and 2011 budget is based on each government component meeting its targets. So far, this has not been happening. Social security funds, hospital debts, and the debt of other entities such as the Hellenic Railways Organisation or the Agriculture Insurance Funds continue to rise. The government itself manifests a cash flow debt of at least EUR 7 bln, which until now has been met by payment delays and delays in VAT reimbursements.

b.      The major problem affecting Greece is not necessarily the public debt, but four far more serious, systemic “debts”:

·         The lack of political will among Greece’s political elite, and even within the governing party, to implement painful yet necessary reforms.

·         The lack of a competent, value-driven civil service capable of right-sizing itself and developing a meritocratic approach.

·         The lack of a comprehensive approach towards reducing corruption and prosecuting past instances of corruption. The fact that major cases such as Siemens, Skaramanga, MAN, Vatopedi, hospital procurement, military procurement, and many other cases remain unresolved or even unprosecuted is an insult not just to Greek taxpayers, but to our European creditors, who are increasingly wondering whether they should pay for the orgy of crime which has occurred for years, and apparently continues.

·         The fact that the Greek professional and commercial classes continue to avoid paying their fair tax assessments, while making increasing use of standard tax avoidance (e.g. by not reporting income), or “legal” tax avoidance, using offshore structures.

c.       The micro- and macro-economic environment against which Greece is making its reforms appears to be almost ignored. We are working in an environment characterised by three major trends:

·         The long-term trend of declining international competitiveness, both within Greece, but also within the EU. In this environment, Asian producers are increasingly winning market and value share, and climbing the innovation ladder. Greek and wider European producers, in contrast, rely excessively on protected markets or subsidy schemes, most of which nurture sunset industries such as agriculture or cotton textiles, while penalising (through regressive tax systems) future industries.

·         The fact that we are not fighting against the deflation of one bubble, but two. The first bubble is the high sovereign debt issues which characterised most countries in the past 10 years, and which are regrettably set to continue into the future. The second bubble is the fact that nearly every sector in Greece (and Europe) is characterised by massive overcapacity, at a very time when public and private sector consumption must fall to balance excessive debt. Much of this overcapacity is value-destroying (based on sunset or protected industries) rather than value-creating, or is based on the import of Asian products (textiles & garments, electronics).

·         The fact that the primacy of the state as a means of development is still followed avidly in Europe, and particularly in Greece. This is despite the fact that state spending in Greece has crowded out and distorted (through corruption, regulation and subsidies), private sector investment, and created much of the overcapacity mentioned. Until the dead hand of the state relinquishes its rigor mortis grip, we cannot expect serious economic development, i.e. development based on commercial viability rather than government subsidies, protectionism or crony capitalism.

I believe that the changes sought by the PASOK government are necessary. But I also believe they are doomed to fail. Neither the Greek political system nor Greek society appears aware that they are operating in a deeper, wider, global economy characterised by a fundamental paradigm shift in competitiveness, demography and debt. The Greek budget forecasts, while an improvement over previous years, suffer a massive credibility deficit and implementation risks, not to mention further hidden system debt. And all the time, the interest on EUR 340+ billion public debt keeps rising, while the threat of default looms as it is highly unlikely the markets will be prepared to resume lending to Greece by 2013 at the levels needed to refinance its debt.

We should therefore see the situation as it really is, rather than as we would like it to be, and prepare for the inevitable. In this case, we should prepare for the worse. 

Sunday 14 November 2010

The Return of the Bond Vigilantes … and Financial Common Sense?

This past week saw the return of the bond vigilantes in force, as Irish yields were pushed up to nearly 9% on Thursday, driving up yields in Spain and Portugal as well. In Greece, Prime Minister George Papandreou’s threats to hold an early election resulted in Greek yields rising to over 11%. His retreat from this position last Sunday, after extensive and well-merited criticism from Eurozone partners, was made under the cover of what could only be described as anemic results in the first round of regional elections.

This coming week will see a likely exacerbation of the public sector funding crisis, at least on the Eurozone periphery. On Monday 15 November, Eurostat announces the revised Greek debt levels for 2009 and presumably for earlier years. Ireland is being pressured to take action by announcing plans to access the European financial stability mechanism before the Eurofin meeting on Tuesday, 16 November.

In Greece, the crisis illuminates the worsening stage of the country’s public finances. New measures on public expenditure and revenue will have to be announced given the shortfall in revenues in 2010 and the fact that many financial and policy measures have so far not been implemented.

Concealed by the election furor is the fact that the European Commission has called upon Greece to pay back illegal state aid or improper disbursements in Common Agricultural Policy subsidies, agricultural insurance, investments in rail terminals and a range of other projects, which may reach a level of EUR 650-800 mln in 2010 alone.

In 2010, the Troika has decided to add OSE’s EUR 10 bln debt to the central government’s books (presumably over several trailing years) as well as the debt of other semi-governmental organisations. I forecast these additions driving Greek public debt to a level of 150-152% of GDP by end-2010.

This level may even be overshot, as media sources announced yesterday that, according to initial reports by the Hellenic Statistics Authority, 2009 GDP was probably lower than expected, at EUR 233 bln rather than EUR 240 bln.

Adding the 2011 expected deficit level brings the 2011 Greek public debt to at least 160% of GDP in 2011, and 168-170% of GDP in 2012.

The greatest threat, therefore, will be in 2012-2013, as I have already stated in a number of posts here. In 2013, Greece will have to pay back the first installment of the EUR 110 bln bail-out package which, together with rollovers or repayments (impossible to imagine given the current budget levels) of remaining private sector debt, will reach EUR 70-80 bln.

It is impossible to assume this level of funding will materialise. There will be three likely scenarios which emerge:

a.       The loan term of the current bail-out package will be extended to 6-8 years, with a second bail-out package of at least EUR 80-100 bln to cover bonds maturing in the next 2-4 years. In this case, we can anticipate an austerity programme in place to 2020.

b.      A rescheduling of the bail-out package will take place, together with an orderly restructuring of Greek debt to private sector organisations. In this case, the haircut will have to be on the order of 45-50% for this to have any real impact. A condition for this will be a budget surplus in Greece, enabling it to at least service part of the EUR 110 bln bail-out package.

c.       A total collapse of funding for Greece, leading to a disaster scenario where no further bail-out packages are possible, and where no further private sector loans are forthcoming.

We should not discount the third option. Our tendency at present is to focus on investor sentiment turn-around in individual markets on a time scale of months. Yet the public finance situation in most OECD countries is deteriorating rapidly, and by 2013 will have reached crisis levels absent the successful implementation of major austerity packages.

In this category, I particularly place Italy (likely public debt 128% GDP in 2013) and the United States (likely public debt 118% GDP in 2013).

Official Italian debt-to-GDP was already over 115% in 2009, with a 2010 deficit forecast at 5%. Given the likely impending collapse of the Berlusconi government and the fact that there is no clear political majority or political will for public sector reform in that country, it is difficult to understand why Italian bond yields are so far below Spanish ones.

In the United States, the total public debt limit was lifted to $ 14.3 trillion earlier this year. While President Obama’s Fiscal Responsibility Commission recently recommended $ 3.8 trillion in debt reduction, the divided Congress makes it highly unlikely that any rational decisions will be taken. Together with the QE2 package of $ 600 bln announced by the Federal Reserve and underlying economic weakness in unemployment, housing prices and foreclosures, we should expect that the risks of future lending to the US government will rise. Perhaps these will be offset by a currency decline or yet another “safe haven” flight to “quality”, but I would not place too much hope in this.  

We may, however, find ourselves in a “new normal”, where public debt levels of over 100% GDP are the norm, and where bond yields rise by 1-2 percentage points, without an adverse economic impact. This scenario would be similar to boiling a frog by slowing increasing the temperature in the pot, rather than pitching it directly into the boiling water. Either way, the frog gets boiled.

To summarise: there is nothing on the intermediate-term horizon which suggests to me that Greece will be able to repay its debts in 2013 as predicated by the EUR 110 bln bail-out. The quality of the regional election campaigns ending today, and of the general political debate over the last 6 months, has been abysmally low, with political parties refusing to accept reality and engaging in immoral electoral promises which have no hope of being realised.

Regrettably, exactly the same political climate exists in the United States or Italy. There is a total lack of political will to focus on the root causes of economic problems, and implement solutions. I have a higher regard for the economic reform being undertaken in the United Kingdom or Ireland, despite the major risks of the size of the fiscal adjustment being planned.

Together with the Franco-German proposal for making financial institutions bear a share of responsibility for future public finance defaults, and all the ingredients appear to be in place for major problems ahead.  

(c) Philip Ammerman, 2010