Monday, November 29, 2010

The Euro After Greece and Ireland

As the Eurozone unveils both a rescue package for Ireland as well as a blueprint for dealing with sovereign debt crises post 2013, it is a good time to muse on the future of the euro as a currency.

To begin with, there were at least two design flaws in the euro, one economic, the other political (both were well known at the time). From an economic point of view, a common monetary policy works only under synchronized business cycles and similar inflation rates. The business cycles, however, were never too aligned in the Eurozone: from 2001 to 2007, the fastest growing country was booming at 5.8% a year, while the slowest was almost in recession, growing barely at 0.3%. Some countries needed tight monetary policy, while others would have benefited from monetary expansion.

Inflation too was varied. At any given year, the country with the highest inflation in the Eurozone had an inflation rate that was 3-4 times higher than the country with the lowest inflation. A basket of goods would have appreciated by 7% between 2000 and 2007 in Finland, while it would have appreciated by 22% in Greece. Average inflation was stable, but there was great variation among members, making a common monetary and exchange-rate policy too impractical for all.

The second flaw was political. While monetary policy was too rigidly similar, fiscal policy was too loosely dissimilar. The Eurozone included only high level fiscal boundaries – deficits should not exceed 3% of GDP and debt levels should be under 60% of GDP. But when countries started to exceed these limits in 2005, the Council of Ministers did nothing to punish them.

At issue was an ambiguity about what precisely a common currency meant. In theory, countries retained fiscal authority and had the freedom to run their own accounts. In theory also, the debts of a country were strictly its own. In practice, however, there was a great convergence in bond yields: the standard deviation in bond yields among the Eurozone members was 70 basis points in 2001. In 2007, it was 13 basis points. So by 2007, markets saw no difference in the riskiness of the debt of the Eurozone members. Greece was Germany and Ireland was France.

The problem was that there was no way to know what would happen if a country got in trouble. There was also no mechanism for the Eurozone to prevent a country from getting into trouble in the first place. Here, then, was a contradiction: the markets were treating debt created in the Eurozone as equal but the prudent members had no way to restrain the profligate ones.

The events of the past few years allow us to revisit those initial dilemmas. The synchronicity issue has proven to be extremely important. Higher than average inflation rates in Greece and Ireland, for example, fueled borrowing and undermined competitiveness. Rigid exchange rates will also hinder recovery as these countries cannot depreciate their currencies to make exports instantly more attractive. Instead, they will need to experience either outright deflation (Ireland) or slower than average inflation (Greece). For these macroeconomic challenges, nothing that has happened in the past twelve months has provided any solution.

On debt, the message so far is mixed. On one hand, the markets were foolish to treat Greek debt the same was as German debt. On the other, they were not. Germany did, in fact, step in to help. Greek debts did become European debts – at least for now. Spreads shot through the roof, indeed, but at the end, spreads measure not the riskiness of individual country bonds; rather, they measure the political appetite in Germany to keep bailing out the more spendthrift members of the union. And the volatile in that appetite is as high as the volatility in the spreads.

None of this is a surprise, and the founders of the euro were well aware of its limitations, though perhaps they may have under-appreciated the magnitude of the crisis in which some countries have found themselves. For some smaller countries, the membership in the euro has brought clear benefits, even though it has also entailed some real costs. A Greek poll in November showed that 60% of the people thought the country should default or restructure, but a full 69% thought that it should stay in the euro. No drachma longing here.

The question is more for Germany – does it benefit from the euro? Many people say that instead of Greece and Ireland leaving the euro, maybe Germany should. But the question is this, does it matter? Instead of asking, do the new provisions provide enough guarantees to Germany that it can restrain profligate spending, the question to ask is, does Germany’s commitment to bailing out a fellow European depend on euro membership?

If one looks at the rescue packages for the non-euro members of the European Union (Hungary, Latvia and Romania) all involved a combination of both IMF and EU money. Euro or no euro, bailing out fellow Europeans might happen either way. And euro or no euro, Germany and others need more measures to monitor behavior and punish excesses.

How can this monitoring coexist with basic principles of democratic government? As a matter of principle, it cannot. A Greek who votes for parliament and prime minister needs to know that these bodies will have power to wield – decisions on how much to spend and tax should come from politicians at home, not politicians and technocrats abroad. But this just in principle. In practice, this is precisely what happened to Greece: bureaucrats from the IMF, the ECB and the EC are telling Greece how to run its affairs.

I guess where all this brings us is this: the fundamental economic and political dilemmas that came with the birth of the euro have hardly been resolved. The market presumption that Greek debts are German debts was foolish – and then correct – until now at least. And the messy debates to avoid meddling in domestic fiscal affairs have become moot at the point when the sovereigns in crisis called for help. So much resolved and nothing resolved.

Sunday, November 28, 2010

Ireland versus Greece: A High-Level Comparison

Greece and Ireland in the same economic sentence - in normal times, this would be unthinkable, Europe’s economic darling and the black sheep. And yet Ireland is country number two in the Eurozone to seek an aid package. The story of the two countries could not be more different.

Unlike Greece, Ireland experienced both strong economic growth as well as improving public finances in the last twenty years. While Greece ran persistent budget deficits, Ireland made a concentrated effort to curb its debt. In 1987, public debt reached an all time high of 112% of GDP; by 2007, debt was just under 25%. During the boom years, from 1997 to 2007, the Irish government ran budget surpluses averaging 1.6% of GDP.

Also unlike Greece, Ireland experienced a sustained and material improvement in living standards. In the 1980s, the Irish had a per capita national income that was 60% of the European (EU 15) average. From 1990 to 2007, the Irish economy grew at an astonishing 6.4% a year - by 2007, Ireland had a per capita income that was 26% higher than the European average, trailing just Luxembourg, Denmark and Sweden.

So what went wrong in Ireland? Broadly speaking three things:

First, the economy was over-heating: the IMF believes that in 2007, Ireland grew at 7.1% above potential. Several distortions emerged as a result. Inflation was 70% above the Euro area average, producing negative interest rates from 2000 to 2007 and leading to a gradual erosion in competitiveness. Manufacturing wages grew much faster than in Ireland's trading partners: between 2000 and 2009, Ireland's manufacturing wages grew by 30% more relative to its trading partners. What is more, the Irish economy is deeply weeded to Europe and United States – a slowdown there had a disproportionate impact in Ireland.

Second, cheap credit produced a housing bubble. From 1975 to 1994, Ireland built ~23,500 homes a year; this number began to rise and in 2006, Ireland built more than 93,000 homes. While much of that growth replenished and upgraded the housing stock, it created at least three distortions. First, there was a rise in housing prices, which rose fourfold from 1995 to 2007. Second, construction made up 13% of national employment in 2007, up from 6-7% in the 1990s. And third, the banking sector became increasingly intertwined with real estate: in June 2010, more than 50% of credit outstanding was either to real estate and construction businesses or to residential mortgages.

The housing bubble was only the most extreme form of a rise in private debt. Irish households had a gross debt-to-income ratio of 108% in 2002; by 2009, this had grown to 200%. For non-financial companies, the debt-to-income ratio was just over 4; by 2009, it had grown to 10. To make this kind of lending possible, Irish banks relied increasingly on (short-term) loans. Irish banks had a gross external debt of $284 billion in Q1 2003, but that number grew to a high of $1 trillion in Q3 2009. At the end of Q2 2010, Irish banks had short-term liabilities of $610 billion, far above the $100 billion or so of government debt. As the Financial Times put it, “The trigger for Ireland’s bail-out was not the sovereign’s inability to borrow (it is funded well into 2011), it was the inability of Irish banks to refinance their borrowing in the wholesale markets.”

The third big problem was that fiscal policy was highly pro-cyclical. When the economy shrank, revenues plummeted while social spending took off. From relative balance in 2007, government spending rose by 12% between 2009 and 2007 while revenues collapsed by 20% in the same period. This demonstrated the country’s fiscal weaknesses: while Ireland had managed to run budget surpluses, the structure of revenues and expenditures changed in at least three ways.

First, there was a steady erosion in the tax base: in 2010, an estimated 45% of tax units were exempt from the income tax, up from 34% in 2004. According to the political economy narrative, this erosion was part of a grand bargain forged in the late 1980s and early 1990s whereby unions traded slower wage growth in return for lower taxes. Second, the tax system became increasingly dependent on "pro-cyclical" revenues such as corporate taxes, capital gains taxes and stamp duties. In 1987, according to the Honohan Report, these made up 8% of tax revenues; by 2006, they were 30% of the tax base. When the economy shank, therefore, tax revenues were hit hard. Third, the size of the public sector grew by 30% between 2008 and 2000 and public sector wages rose faster than private sector ones. Hence, there was more rigid expenditure in place when revenues dropped.

Putting all this together paints a very different picture. Where Greece faced chronic deficits and a high debt to start with, Ireland had been running surpluses and had paid down its debt. Both countries experienced higher inflation than the Euro average; this produced increased indebtedness in both countries, though the property bubble in Ireland was much more pronounced. While Greece’s main challenge is to infuse a stagnant economy with some dynamism and competition, Ireland just needs to regain some of its vibrancy. And lastly, while Greece’s challenge is mostly around government debt, Ireland’s challenge is to recapitalize its ailing banks.

IMF, Article IVs
Central Statistics Office 

Saturday, November 27, 2010

How Important is Shipping for Greek Trade?

Tourism and shipping are the two most important industries for Greece’s exports, and in 2009, ~57% of Greek exports came from either tourism or shipping. I have written about tourism in the past (see here); now, I wanted to take a quick look at shipping.

Shipping enters the current account both as a good and a service: the former refers to the buying and selling of ships, while the latter deals with maritime services provided by Greek companies. To understand Greek shipping means balancing out four separate pieces: (a) the money sent abroad to buy ships versus (b) the revenues generated from the selling of ships; and (c) the money earned by providing maritime services versus (d) the money spent to purchase maritime services (e.g. at ports, logistics, repairs, etc.).

If one looks at maritime service exports alone (c), there has in fact been a boom: at the peak in 2008, the Greek economy exported €17.6 billion worth of maritime services, a near doubling versus 2002 (€8 billion). But in net terms, the contribution to the current account grew from €4.4 billion in 2002 to €6.4 billion in 2008 – an important increase, but much less than would be expected from the gross growth in revenues.

The reason is twofold: first, Greek ship-owners have expanded their fleets, prompting a capital outflow to pay for these ships. In nominal terms, between 2002 and 2009, ship-owners spent almost €27 billion to buy ships – they also, however, earned around €10 billion by selling ships. So in the eight years from 2002 to 2009, Greece spent a net of €17 billion on ships – around 2.2 billion a year. Besides the increase in ship purchases, the Greek shipping industry also increased its purchases of maritime services from abroad (d): from €4 billion in 2002 to almost €6.5 billion in 2008 (at the peak). While the services account was still growing, the net increase was smaller than the gross one.

Putting all this together, therefore, shows a more nuanced role for Greek shipping in terms of the current account. The peak contribution came in 2004 and 2005 when charter rates were rising (see receipts) but before the Greek shipping industry started a massive fleet expansion program, which started in 2006 (where ship purchases doubled from €2.3 billion to €5 billion). Once the fleet expansion began, the contribution to the current account shrank. In fact, in 2007, at the height of the commodity boom, the contribution to the Greek current account was no greater than it was in 2002. After the drop in 2009, it was even lower.

Of course, there is more to life than the current account: the Greek-owned shipping fleet increased more than 50% since 2002 and shipping companies were able to continuously lower the age of the fleet as a result. But in terms of the Greek current account, the contribution of shipping has been steady and, after 2005, modest, at least insofar as its ability to constrain the country’s ballooning current account deficit.

Friday, November 26, 2010

Greece's Public Mood

A poll conducted early November and the latest short-term confidence indicators provide a glimpse into the national mood.
The consumer confidence survey registered its lowest point ever in October 2010 at -72 (the number is the difference between the responses which indicate positive answers versus negative ones: e.g. -100 means all responses were negative). This is by far the lowest point on record since the survey started in 1985, and it also marks a progressive deterioration in consumer confidence: in 2009, the average was -45.7, while in 2010, the average has been -61.7.
The individual indicators are bad as well. More than half of the respondents expect a serious deterioration in the economic position of their household in the coming 12 months, and almost two-thirds think that the country's condition will grow much worse in the same timeframe. More than two-thirds (69%) think it unlikely that they will save any money in the next 12 months; 85% think unemployment will worsen considerably; 91% think it unlikely to purchase a car and 93% think it unlikely to purchase or build a home.

Political polls show a similar pessimism. About two-thirds of the people are fed up: 66% of the people do not trust either the prime minister nor the finance minister to handle the economy. A similar share has no faith on the leader of the opposition either. No wonder the abstention rate reached almost two-thirds in the second round of local elections in November 2010 (combining pure abstention with those voters casting an invalid ballot).

What is also interesting is the view that people have about Greece's current position. About 60% of the public believes that the country should either renegotiate with its creditors in order to pay less (46%) or cease payments and default (14%). Only 23% believe that Greece should implement the reform program underway and pay back its debts.

When it comes to assigning blame, the following graph is telling: besides successive Greek governments, the public blames speculators and Greek banks most, while there is much blame thrown on Greece's EU partners and foreign banks. There is, however, a notable 44% that puts much blame on the Greek public - though at least in my experience this tends to mean "everyone else but me."
What do all these numbers tell us about Greece's condition? In general, there are three views on Greece: first is the view of the government which says "we are making unprecedented changes, give us time." Second is the view of international investors and pundits who tend to have a high level view of the "stylized facts" and who say "Greece is not meeting its targets." Third is the view of the Greek public. At best, the public can provide begrudging consent; at worst, it can oppose them. If we combine these numbers with the abstention rates, however, the message that comes across is this: "It's bad. We know it’s bad. And it will get worse. Not much we can do about it, but don't expect us to like it."

Thursday, November 18, 2010

Five Myths About the Greek Crisis

Greece is in a tough spot. No doubt about that. But not all the things said about Greece are true. Here are five myths about the Greek crisis.

Myth #1 is that the Greek taxpayer would be instantly better off if the country defaulted or restructured its debt. In fact, Greece is running a primary deficit in 2010 and 2011, so even if it spent no money on debt service, it would need to cut spending or raise taxes by more than it is currently doing in order to balance its budget. Only after 2012 does a default mean that the Greeks can spend more by not having to service debt (see here).

Myth #2 is that the Greek economy is derailing beyond expectation. In fact, the economy is shrinking at precisely the level that the Greek government and IMF forecasted it would when it lent money to Greece in May 2010. A 4% GDP reduction was expected for 2010 and the economy so far in 2010 has contracted by 3.7%. This is unpleasant, but it is not unforeseen (see here). And the program assumes it will get worse, forecasting a 2.6% GDP drop in 2011.

Myth #3 is that rising spreads on Greek bonds are a problem. The spreads on Greek bonds versus German bonds remain high and have risen lately. But these spreads have no immediate impact on finances (since Greece is not borrowing money at long maturities) and they are also the result of very low liquidity. So they do not say much about Greece at all (see here).

Myth #4 is that Greece is missing wildly its targets. In May 2010, the Greek government committed to reduce its budget deficit from €30.882 billion in 2009 to €18.691 in 2010, a 39.5% reduction. In the latest (October) budget execution bulletin, the government said that the deficit would reach €19.473 billion in 2010, which is a 36.9% reduction (see here). The revised deficit and debt numbers are going to make what is needed going forward greater, but this is a swing of more than €10 billion. This is huge progress and just below what was expected. Even the IMF noted that, “the program has made a strong start.”

Myth #5 is that because Greece ends the IMF program with a debt that is higher than it is today, this proves that Greek debt levels are unsustainable. Hardly. Greece ends up the program with a higher debt level than when it started – this is true and this is the nature of a country that is undergoing a fiscal consolidation that cannot happen overnight. Since the country needs to keep running deficits, its debt will rise.

But whether this means that Greece’s debt is unsustainable is another question. Whether Greece defaults is not a function of whether Greek debt will be 144% or 150% or 160% of GDP. Rather, whether Greece defaults will depend on (a) whether the reforms underway have taken root and (b) whether markets have an appetite for riskier bonds. In fact, if the latter is true, Greece could get off the hook even without the former.

Tuesday, November 16, 2010

How Dependent Are Greek Banks on ECB Funding?

In the past year or so, Greek banks are increasingly relying on funding from the European Central Bank (ECB) to shore up their balance sheets. Presumably, this is because Greek banks carry higher risks and they are thus “shut off” from the international banking system. But how important is ECB lending? And is that reliance on the ECB growing?

To begin with, the amount that Greek banks borrow from the ECB is not reported as such. Instead, when banks borrow from the ECB, they need to post collateral with the Bank of Greece; looking at that figure lets one gauge the amount that Greek banks have borrowed from the ECB.

The graph below plots that number since 2008. As is clear, there were two waves of borrowing – the first took place towards the end of 2008 as the economic crisis unfolded, while the second wave was from February to May 2010 as the Greek economy faced increasing scrutiny and pressure in international markets. Importantly, the absolute value of ECB borrowing peaked in July 2010, although the decline since then has been minimal.
 Looking at the sources of funding in more detail shows the following dynamics: since the end of 2008, the direct funding for Greek banks from non-Euro area Monetary Financial Institutions (MFIs) has declined by €15 billion (see here). Euro area MFIs have also reduced their lending Greece, although it was not until May 2010 that this happened. The ECB lending is a response to this reduced lending, but its magnitude is much greater than that, and the main driver for ECB borrowing is compensating for capital flight (see here).

 To put things differently, since December 2009, the balance sheet of Greek MFIs has increased by €62 billion. In part, this is a statistically overblown number because it includes some previously unrecorded securitized assets (€37 billion). The rest comes exclusively from the ECB which is enough to offset the decline in deposits and ensure that balance sheets keep rising. By September 2010, however, almost 18% of the assets/liabilities of Greek banks came from ECB – up from 10% in December and from 3% in September 2008.

Monday, November 15, 2010

Obsessed with the Spreads

The English word "spread" was almost non-existent in the Greek vocabulary nine months ago. By early 2010, however, the press and the public could talk about little else; what are the "spreads" doing today; how are the spreads reacting to the latest numbers; the spreads fell 50 basis points? Fantastic. They rose 20 basis points? Oh no - catastrophe. If there is one number that can capture the national mood, it is the "spread." But what exactly do spreads tell us about the Greek economy and its ability to avoid default?

By way of background, when people talk about spreads, they mean the difference in the yield on the 10-year government bond for Greece and the yield for the same bond for Germany. Simply put, the yield is the expected return for an investor holding a bond, and it is a function, among other things, of a bond's face value and its current price. If the bond's price falls, the yield rises. When yields rise, investors want a higher return to hold an asset. The graph below shows the yield on 10-year government bonds and, in effect, shows what interest rates investors require to hold Greek government bonds.

 The spread is the gap between this yield curve and the yield curve of the German government bonds. Given that German bonds are equivalent to a "risk-free" asset (and thus do not move much), the yield on Greek bonds and the "spread" follow similar paths (as you can see here).

Spreads were flat for a long period of time, but towards the end of 2009, they rose a bit and peaked in December 2009. Then, they fell again, reaching a low in May 2009. They started rising again in late 2009 and experienced a steady increase with the exception of two lulls: May 2010, after the Greek government announced it had reached a loan agreement with Europe and the IMF; and in September 2010 after the first positive review of Greece's progress by the IMF. Recently, however, the spreads have risen again, partly due to fears that a revision in Greece's deficit and debt figures will force the government to take further measures that will only deepen the country's recession.

But what precisely do rising spreads mean? They mean that investors demand a higher price for holding Greek government debt. But there are several caveats in turns of what this statement really means.

Greece is not really raising long-term funds in international markets: its funding needs are being met by the IMF and the European Union. Greece is indeed active in international markets, but its sole transactions since June 2010 have been in the short-term market with T-bills that have a duration of 13 or 26 weeks. The yields for these transactions are much lower since the fear of default is lower. Since Greece is not raising new funds, rising yields do not impact borrowing costs: what Greece owes investors is determined by bonds it has already issued.

Even so, don't the yields indicate the risk that investors attach to Greek bonds? In theory, yes. But since May 2010, the secondary market for Greek bonds has essentially disappeared. On average, in 2009, the trading volume for Greek bonds in the secondary market was €27.2 billion a month. In the first quarter of 2010, that volume had dropped to an average €23.4 billion a month. After May 2010, however, the trading volume collapsed to €1.4 billion a month. In other words, higher yields demonstrate higher perceived risk, but among a smaller group of active trades. They are therefore less meaningful as a price signal on what Greece would be able to theoretically borrow for if it went to the market.
There is one area where higher spreads matter: as collateral. When banks conduct transactions, they have to post collateral, and what others accept as collateral varies. If Greek government bonds are less desirable, they are less useful as collateral, and that can hamper transactions. At the same time, Greek banks have relied more on the European Central Bank, rather than commercial banks, for funding. For the ECB, the main parameters for valuing collateral are credit rating, maturity and liquidity - so higher yields may be less important.

Does that mean that spreads do not matter? Of course not. They are useful indicators of market sentiment, although they are not as telling as some analysts or the press seem to suggest. They tell a story in other words, but not the whole story by any means.

Sunday, November 14, 2010

Greek Budget Review: October 2010

The October Budget Execution Bulletin (in Greek, here) shows little change from the figures presented in September 2010. Revenues for the year until October were up 3.7% versus 3.6% in September – a modest improvement but still shy of the 8.7% target in place since September 2010. Expenditures remained 7% down versus last year, but are still short of a (revised) target of 7.8%.

Overall, the deficit is down 29.9%, which is one percentage point below the September 2010 figure (30.9%), and a full seven percentage points below the target of 36.9%. What is more, the budget balance reduction is the smallest that has been accomplished so far in the year, pointing to further difficulties in reaching the targets.

In other words, the story that has been shaping in the past few months remains: revenues are under-performing, with the state being unable to raise as much as it needs (see here for more details); expenditures are falling as much as forecasted, and often more – leading to higher targets; and the budget deficit is declining by slightly less than is forecasted, and the reduction in the deficit is getting smaller as time goes on.

Greek Economy Shrinking Exactly as Expected

The Greek statistical authorities just published their estimates for GDP in the third quarter of 2010: in real terms, the economy declined by 4.5% relative to Q3 2009 and by 1.1% versus Q2 2010. The authorities note that “the GDP rate of change between the quarters of 2009 and 2010 should be treated with caution, due to the discontinuity of General Government data series.” Still, this is not good news. However, the economy is shrinking at exactly the rate that it is supposed to be shrinking.

The Greek economy has been shrinking since Q4 2008. What is more, the rate of decline has consistently accelerated with only one data point – Q1 2010 – showing less decline than the previous quarter. In 2009, the economy shrank by 2.3% with the end of the year being worse than the beginning, and in 2010 so far it has shrunk by 3.7%.

It is important to understand, however, that this decline is exactly what the troika forecast when it agreed to lend money to Greece in May 2010. In fact, the real GDP growth forecast has not yet changed between what the authorities forecasted in May 2010 and what the government announced in its 2011 budget program in October 2010. Some data revisions may change that in the future, but the point is that the economic is shrinking exactly as planned.

Looking at that forecast shows that the 3.7% GDP decline so far in 2010 is very close to the 4% decline that the program assumes. Nor is the program sanguine about things getting better. In 2011, the economy is supposed to shrink further by 2.6%. It is not until 2012 that GDP growth will resume and even then the growth is assumed to be anemic at 1.1%. By 2013, the program expects the Greek economy to start increasing at healthier rates, above 2%.

This, then, is the most depressing and difficult part about the government’s handling of the program. The economy is performing more or less as expected and the squeeze felt by households and business is in line what was supposed to happen, which means one can hardly blame the government for things “going wrong.” And in fact, we still have at least another year of worsening conditions before things get better if all goes according to plan.