Why The Greece Episode Means More Inflationism

``The European capital market institutions would not be able (or even willing) to step up to the plate and negotiate a restructuring. The ECB is not allowed to. And the EC is not up to it. There is an alternative -- the IMF has specific experience in this regard. But, allowing the IMF in would be an admission that the Euro area has not quite made it as currency union. The IMF, given its historical origin with exchange rate mechanisms, would convey a message that the big Euro players would not like to see. It would tar the reputation of the Euro even if there are no contagion effects on other PIIGS. Moreover, allowing Greece out of the Euro (or kicking) it out would be even worse. That is why, I think, the Germans will pay up. They will pay to maintain the reputation of the Euro. Americans underestimate the commitment to the Euro.” –Paul Wachtel Thoughts on Greece's debt problems

Prior to last week’s intermission, we noted that like the Dubai debt crisis, the Greek dilemma would seem like a political issue more than an economic one and therefore, as we suggested, would be resolved politically.

And by politically, we meant that arguments for sound policies or by imposing harsh or rigorous discipline against a wayward member of the EU would be subordinate to the practice of inflationism.

And as per the mainstream, the most recent volatility in the global markets had been mostly attributed to either the prospects of a contagion from the risks of a Greece default or from the attempts of China to wring out inflation out of its system.

Nevertheless, we have not been convinced by verity of the alleged cause.

While key benchmarks across asset markets have indeed broadly deteriorated then, which somewhat did raise some worries on my part, the correlation and the supposed causation did not seem to square [see Global Market Rout: One Market, Two Tales].

If indeed there had been a generalized anxiety over a contagion of rising default risks from sovereign debts, then sovereign CDS AND sovereign YIELDS, aside from corporate and bank lending rates would have spiked altogether!

In addition, considering the scenario of a run from sovereign securities, the contagion should have been largely a regional dynamic and paper currencies would not have been seen as the safe shelter, since the major currencies of the world have all similarly afflicted by the same disease!

What happened instead was a palpable shift to the currency (US dollar) of the lesser affected nation (the US) which somewhat resembled a “flight to safety” paradigm of 2008. With the trauma from the recent crisis along with automatic stimulus response [as discussed in What Has Pavlov’s Dogs And Posttraumatic Stress Got To Do With The Current Market Weakness?] some have mistakenly labeled the recent events as the unwinding US dollar carry trade.

Yet, as CDS and yields went on the opposite course, Baltic stock markets soared and gold plummeted validating our observation that the precious metal, which has served as man’s money throughout the ages, has been exhibiting a tight correlation with the Euro or a proxy thereof, instead of deflation or inflation signs [see When Politics Ruled The Market: A Week Of Market Jitters]. This tight correlation appears to have been broken last week! (see figure 3)

Figure 3: stockcharts.com: Gold-Euro Break, US 10 Year Yield, JP Morgan Emerging Debt Fund

The contour of the Euro and Gold trendlines has been the same over the 6 months up until last week!

Since gold has served as lead indicator of asset markets since the depths of 2008, including the recent selloffs, any resumption of an upward trend by gold is likely to be signs that asset markets will be headed higher soon.

Ergo, Gold above 1,120 should likely serve as my trigger for a buy on equity markets.

Moreover the major US sovereign benchmark, the 10 year Treasury yield (TNX), in spite of the recent stock market setback has remained stubbornly high. Also the JP Emerging Market Debt Fund (JEMDX), in spite of the recent China and Greek jitters, remains buoyant.

In other words, those expecting a repeat of 2008 or of a deflation scenario appear to be in a wrongheaded direction.

What seems to be in place is that the markets seem to be looking for a reason to retrench or has been reacting to the discordant tones from the mixed messages transmitted by the political and bureaucratic authorities. In short, if markets had been recently buoyant out of a flood of global liquidity then qualms over a liquidity rollback appear to be the major concern.

Inherent Defects In The Euro

Any major liquidity rollback for developed economies would most likely be deferred, with the Greek and the PIIGS issues signifying as one of the principal reasons.

Remember since the PIIGS is a political issue then any attempt to resolve the Greek crisis will be political.

Professor Paul Wachtel in a New York University forum captures it best, ``It is not Greece, it is the Euro. A troubled small country can be shrugged off but a currency area is either whole or not. The Germans will pay up to keep the Euro area in tact.”

True. A united Europe has been a longstanding project since the close of World War II. Monetary integration has been in the works through the European Monetary System since March of 1979.

So the Euro isn’t just a symbolical currency that can easily be jettisoned, instead it is a sense of pride for the major European economies that make up the core of the European Union. Hence it won’t be easy to dismantle a pet project for Europe’s social democrats.

However since the Euro is another monetary experiment it comes with inherent flaws in it.

For instance, the inclusion of Greece to the European Union has effectively bestowed subsidy privileges to her by the European Central Bank (ECB) even prior to this crisis via an intraregion carry trade.

Where the interest rate spread of Greek sovereign instruments had been wide relative to core Euro members, European banks bought Greek bonds and used them as collateral to extract additional loans from the ECB. Spendthrift socialist Greece, in turn, took advantage of this easy access to money to fund lavish public expenditures.

As Philip Bagus explains, ``The banks buy the Greek bonds because they know that the ECB will accept these bonds as collateral for new loans. As the interest rate paid to the ECB is lower than the interest received from Greece, there is a demand for these Greek bonds. Without the acceptance of Greek bonds by the ECB as collateral for its loans, Greece would have to pay much higher interest rates than it does now. Greece is, therefore, already being bailed out.

``The other countries of the eurozone pay the bill. New euros are, effectively, created by the ECB accepting Greek government bonds as collateral. Greek debts are monetized, and the Greek government spends the money it receives from the bonds to secure support among its population.”

The latest US centered bubble exacerbated the carry trade and the intraregion subsidies of the PIIGS which eventually rendered European banks as highly sensitive to a PIIGS default (see figure 4).

Figure 4: Bloomberg: Shot Gun Wedding

According to Bloomberg’s Chart of the Day, ``Banks in Germany and France alone have a combined exposure of $119 billion to Greece and $909 billion to the four countries, according to data from the Bank for International Settlements. Overall, European banks have $253 billion in Greece and $2.1 trillion in the so-called PIGS.”

So not unlike the US, the European Union will most likely persist in subsidizing subprime PIIGS and the European banking system at the expense of the rest of its society.

And also not different from the US, the risks of unsustainable welfare states will likely be a part of the currency and asset equation.

NYU’s Mario Rizzo bluntly writes, ``People like to deny reality when it is unpleasant. This is not just a problem of bad leadership. It is a problem that goes to the heart of the fantasy world the typical voter lives in. Buy reality bites. Let’s see how it does so in the next few years.” (bold highlight mine)

Moreover, the underlying systemic subsidies incent European member state beneficiaries to expand spending. Obviously such feedback loop mechanism of incremental subsidies and deficit spending will ultimately be untenable.

Again from Philip Bagus, ``For the member states in the eurozone, the costs of reckless fiscal behavior can also, to some extent, be externalized. Any government whose bonds are accepted as collateral by the ECB can use this printing press to finance its expenditures. The costs of this strategy are partly externalized to other countries when the newly created money bids up prices throughout the monetary union.

``Each government has an incentive to accumulate higher deficits than the rest of the eurozone, because its costs can be externalized. Consequently, in the Eurosystem there is an inbuilt tendency toward continual losses in purchasing power. This overexploitation may finally result in the collapse of the euro.” (bold emphasis mine)

So perhaps it wouldn’t be systemic rigidities that could undo the Euro, as preeminent monetarist Milton Friedman warned about [or the tradeoff between ``greater discipline and lower transaction costs outweigh the loss from dispensing with an effective adjustment mechanism”] but the untenable cross subsidies and systemic inflationism inherent within the system.

Easy Monetary Policies To Continue

And the political response has been as what we had expected.

An article from Bloomberg says Europe will use former US Treasury Secretary Hank Paulson’s “Bazooka” approach to deal with Greece, ``European leaders closed ranks to defend Greece from the punishment of investors in a pledge of support that may soon be tested. German Chancellor Angela Merkel and her counterparts yesterday pledged “determined and coordinated action” to support Greece’s efforts to regain control of its finances. They stopped short of providing taxpayers’ money or diluting their own demands for the country to cut the European Union’s biggest budget deficit.”

Like short selling, the blame has always been pinned on the markets. However, as discussed above, the woes of the PIIGS exhibits a structurally flawed monetary system.

The fact that Greece fudged its numbers to get into the Euro membership serves as damning evidence of EU’s incompetence. Investors don’t just punish nations without any basis. Investors get burned for making the wrong decisions.

On the other hand, bilking taxpayers, misrepresentation and mismanagement are enough justifications for punishment, not only from investors but from the resident political constituency. True, international sanctions won’t likely work as policymakers are too tied up rescuing each other.

Of course, tightening of monetary policies today won’t help the cause of the EU or the US from executing bailouts and rescues of their political patrons. Hence we can expect deferred “exit strategies” and even extended quantitative easing programs.

Oh, did I just mention the US as possibly help fund a Greece bailout? Yes, apparently. This according to Financial Times, `` European governments are expected to turn increasingly to US investors to help them meet their funding requirements as record levels of bond issuance make it harder to attract buyers.” (bold highlight mine)

So whether it be the IMF (where the US has the largest exposure representing 17% of voting rights) or direct participation from US investors we can expect somewhat the US to be a tacit part of the rescue team. Sssssssshhhhh.

Perhaps, some Asian nations as China may take part in it too.

What do you expect, it’s a paper money system! Government central banks can simply print money and channel them into sectors or economies in dire straits, in the hope that the money printing has neutral effects.

All the imbalances we’ve just spelled out here is a medium to long term perspective, which means they aren’t likely to unravel anytime soon.

But it is one of the risks that should be reckoned with overtime.

For the meantime, the triumphalism of the Philosopher’s Stone or the alchemy of turning lead into gold will likely still work its interim or immediate wonder. That’s why it has been the preferred du jour priority option by policymakers.

And importantly, that’s why it gives confidence to the global political authorities to do all their redistributive programs.

Meanwhile, expansionary policies from the EU and the US are likely to continue. And this should help support the asset markets.

Central And Eastern Europe’s “Sudden Stop” Fuels US Dollar Rally

``Big government reforms, bailouts, stimulus, and “change" in general create negative expectations of the future along with a great deal of uncertainty. This leads to inaction and fear — the preconditions for a crash in the stock market. All it needs now is the appropriate trigger.” Mark Thornton, Unhinged

Except for some currencies such as the Norwegian Krone, British Pound or the Swiss Franc, the US dollar surged against almost every major currency including those in Asia…the Philippine Peso included. (Be reminded this has nothing do with remittances)

Since the forex market is a huge liquid market, with daily turnover of nearly $ 4 trillion dollars, this means there has been an intense wave of ex-US dollar liquidation. And to see such a coordinated move suggests that the global financial system could be faced with renewed dislocations in a disturbing scale. So the likely suspects could be either major bank/s in distress, or a country or some countries could be at a verge of default.

Central an dEastern Europe’s “Sudden Stop”

With no major spike in the major indicators which we monitor, such as the Libor-OIS, TED Spread, EURIBOR 3 month, Hong Kong Hibor, BBA LIBOR 3 months and 3 MO LIBOR - OIS SPREAD, the epicenter of last week’s pressure appears to emanate from the Central and Eastern European (CEE) region.

Regional credit spreads and Credit Default Swap (CDS) prices soared, as credit ratings agency the Moody’s issued a warning last week of the possibility of credit ratings downgrades in the region’s debt amidst a deteriorating global economic environment, See figure 1.

Figure 1: Danske Bank: CEE Under Pressure

According to the Danske Bank, ``Credit spreads have had a hard time during the week – especially for banks. The investment grade CDS index, iTraxx Europe, currently trades at 174bp up from 154bp last Friday. The high yield index iTraxx Crossover currently trades at 1085bp up from 1070bp last week. The senior financial index has also widened considerably and now trades at 152bp. As long as sovereign CDS prices are under pressure CDSs on senior bank debt are also likely to suffer as the two are heavily interlinked due to the various state guarantees on bank debt.”

The turbulence affected every financial market in the region; the CEE currencies crumbled, regional bond markets sovereign spreads widened, and regional equity markets tanked see figure 2.

Figure 2: Danske Bank: Emerging Europe currencies slump, Euro bonds

All these resemble what is known as the “sudden stop” or capital stampeding out of the region.

Somehow the CEE crisis approximates what had happened in Asia 12 years ago or what was labeled as the 1997 Asian Financial Crisis.

Central and Eastern European Crisis A Shadow of the Asian Financial Crisis?

So what ails the CEE?

As in all bubble cycles, the common denominator have always been unsustainable debt. And unmanageable debt acquired by the banking system and Eastern European households during the boom days had been manifested through burgeoning current account or external deficits. And these deficits had been balanced or offset by a flux in capital flows, mostly bank loans see figure 3.

Figure 3: Emerging Europe Crisis versus the Asian Crisis

The Bank of International Settlements (BIS) makes a comparison between the present developments in Emerging Europe with of Asia 12 years ago.

From the BIS, ``The crisis was preceded by rapid growth in credit to the private sector, with a significant share of loans denominated in foreign currency. East Asian economies also recorded large current account deficits, mainly induced by the private sector. These deficits were financed by strong debt inflows, which reversed sharply following the crisis. A further similarity lies in exchange rate policies. Prior to the crisis, East Asian economies had fixed nominal exchange rates (in their case against the US dollar). Moreover, the economies relied heavily on a single foreign creditor – Japanese banks. Emerging European countries currently show a similar level of dependence on a few European banking system creditors. For example, claims by Austrian-owned banks are equivalent to 20% of annual GDP in the Czech Republic, Hungary and Slovakia, while claims of Swedish-owned banks on the Baltic states are equivalent to 90% of their combined GDP. An adverse shock to one or more of these foreign banks could result in them withdrawing funds from emerging European countries.”

So the emerging similarities seen in both crises have been strong debt inflows, fixed nominal exchange rates and the concentration of source financing.

As the above chart shows, FDIs (red line) and Bank loans/Debt (blue line) composed most of the inflows in Emerging Europe (left window) whereas the Asian crisis bubble (right window) was almost entirely financed by debt from bank loans.

According to BIS, one marked difference for the strong capital flows in Emerging Europe had been due to the “strengthening in GDP growth and policy frameworks due to closer EU integration.” Plainly put, the integration of many of these countries into the Eurozone facilitated capital flows movement in the region, which may have abetted the bubble formation.

Moreover, another important difference was that Asian debt was principally channeled into the corporate sector while the liabilities in Emerging Europe have been foreign currency related.

Like the recent debacle in Iceland, Emerging Europe’s households incurred vast mortgage liabilities through their banking system in unhedged foreign currency contracts (mostly in Euro and Swiss Francs), which was meant to take advantage of low interest rates while neglectfully assuming the currency risk. In short, Emerging European households engaged in the currency arbitrages or otherwise known as the CARRY TRADE.

So when the sharp downturn in economic growth occurred, these capital starved economies failed to attract external capital, hence, the net effect was a drastic adjustment in their currencies which prompted for a capital flight.

Households which took on massive doses of foreign currency liabilities or loans saw their debts balloon as their domestic currency depreciated.

And it is not just in the households, but foreign investors too which incurred substantial exposure through local currency instruments. Morgan Stanley estimates Turkey, Hungary, Poland and Czech having non-resident exposures to equities and bonds at 30%, 18%, 17% and 10%, respectively.

Thus, the sharp gyrations in the currency markets have accentuated the pressures on the underlying foreign currency mismatches in the region’s financial system.

Another source of distinction has been the degree of exposure of the Emerging Europe’s debt to the European banking system. As noted by the BIS above, the Asian crisis further undermined Japan’s banking system, which provided the most of the loans, at the time when its domestic economy had been enduring the first leg of its decade long recession. On the hand, over 90% of the distribution of loans $1.64 trillion loans held by Emerging Europe have been scattered between the European and Swedish banks.

Doom Mongering: Will Eastern Europe Collapse the World?

Nonetheless this has been the key source of pessimism in media, especially by doom mongers whom have alleged that the failure to salvage East Europe will either lead to a worldwide economic catastrophe or to the disintegration of the Euro, as major European economies as Germany and France may opt NOT to bailout the crisis affected union members or union members whose banking system are heavily exposed to Eastern Europe of which may lead to cross defaults and culminate with a collapse in the monetary union.

In addition, they further assert that due to the huge extent of financing requirements, the IMF would deplete its funds and may be compelled to sell its gold hoard in order to raise cash. And to prim their narrative, they’ve made use of the historical parallelism to bolster their views or as possible precedent; the Austrian bank collapse in 1931 triggered a chain reaction which ushered in an economic crisis in Europe during the Great Depression years.

We are no experts in the Euro zone and Emerging Europe markets, but what we understand is that these doomsayers appear to be inherently biased against the Euro (on its very existence, even prior to these crisis), or alternatively, have been staunch defenders of the US dollar as-the-world’s-international-currency-standard, and have used the recent opportunities to promote their agenda.

Moreover, these doom mongers appear to be interventionists who peddle fear to advocate increased government presence and interference, which ironically has been the primary cause of the present predicament.

Be reminded that the fiat paper money system exists on the basis of trust by the public on the issuing government. Conversely, a lost of faith or trust, for whatever reason, may indeed undermine the existence of a monetary framework, such as the US dollar or the Euro. Thus rising gold prices are emblematic of these monetary disorders and we can’t disregard any of these assertions.

Although, for us, the claims of the tragic collapse from the ongoing CEE crisis could be discerned as somewhat superfluous.

One, the argument looks like a fallacy of composition- as defined by wikipedia.org-something is true of the whole from the fact that it is true of some part of the whole (or even of every proper part).

Figure 4: BIS: Foreign Liabilities Varies Across EM Regions

The CEE debt problem has been interpreted as something with homogeneous like dynamics, where the assumption is that every country appears to be suffering from the same degree of difficulties even when the economic structures (leverage, deficits etc.) are different.

They even apply the same logic to the rest of the world including Asia, where, as can be seen in Figure 4, have different scale of foreign liabilities exposure.

Two, because a large part of the Emerging Europe’s banking system is owned by European banks (see Figure 5) some have alleged that European governments have been indiscriminately pressuring their domestic banks with exposures to Eastern Europe to abruptly reduce or pullback their exposure to these countries, such as Greek banks in Balkans. There may be some cases, but a wholesale withdrawal would seem unlikely.

Figure 5 BIS: Foreign Bank Ownership in Emerging Markets

Yet according to the BIS, ``a large part of most emerging European banking systems is foreign owned. These banking groups appear to be financially strong currently, as reflected in standard –albeit backward-looking – measures of financial strength such as capital adequacy ratios and profitability. The foreign subsidiaries should have better risk management techniques in place, more geographically dispersed assets and, in principle, good supervision (from the home country on the consolidated entity).” [bold highlight mine]

Three, emerging markets have been reckoned as “more inferior and risk prone” asset class compared to the securitized instruments sold by the US.

As the Europe.view in the Economist magazine aptly remarked, ``Foreign-currency borrowing by east European households was seriously unwise. But it does not compare with the wild selling of sub-prime mortgages in America that turned balance sheets there to toxic waste. It may be necessary to restructure some of these loans, or convert them into local currency (perhaps with statutory intervention). That will hurt bank profits. But it will not mean American-style write-offs. Bank lending to foreign companies based in eastern Europe is still a good business.”

Divergences Even Among Emerging Markets?

While it could be true that some European banks could be heavily levered compared to their US counterparts and has significant exposure to the CEE region- where the latter seem to be encountering an Asian Crisis like unraveling due to outsized external deficits, large internal leverage and foreign currency mismatches in their liabilities- it is unclear that the deterioration in the financial and economic environment would result to an outright disintegration of the Euro monetary union or trigger an October 2008 like contagion across the globe.

Figure 6 Danske Bank: EM Stock markets

The fact that EM stockmarkets have been performing divergently as shown in figure 6, where LATAM (blue), Asia (apple green), CIS (Commonwealth of Independent States-gray) appear to be recovering, while the CEE (red) and MSCI (dark green) index are down, hardly implies of a contagion at work yet.

Moreover, as we earlier noted, credit spreads of major indicators haven’t seen renewed stress and seems to remain placid despite the recent CEE ruckus.

Thus from our standpoint the present strength of the US dollar encapsulates the ongoing Emerging Market phenomenon called the “sudden stop” or capital “flight” (resident capital) or “exodus” (non-resident capital) from the region, which has siphoned off the availability and accessibility of the US dollar in the global financial system which has probably led to the steep rally in the US dollar almost across-the-board.

We believe that 2009 will be a year of divergence as concerted policy induced liquidity measures will likely have dissimilar impact to all nations depending on the economic, financial markets, and political structures aside from the policy responses to the recent crisis and recession.

Even among Emerging Markets such divergences will likely be elaborate.