2012 - The Year We All Learn To Live Dangerously

"Nihil sapientiae odiosius acumine nimio" (Nothing is more hateful to wisdom than excessive cleverness)
Petrarch, "De Remediis utriusque Fortunae"

Like Leo Messi charging his way through a packed Real Madrid defence, twisting now this way, now that, never stopping without being stopped, so did the Spanish sovereign debt surge forward, breaking directly into the red zone near the penalty box, provoking confusion and consternation amongst horrified EU officials and regulators forced to look on as it blindly sought to touch down somewhere well beyond the authorised 100% finishing line.

Spain's deficit has been much in the news in recent days. Both the target for this year and actual details of last year's outcome have been the source of much comment, scrutiny, and consternation, but the deficit itself will not form the primary subject matter of this post. What we will be concerned with here is debt, sovereign debt, and the current trajectory of the Spanish variant. In a recent article in the Financial Times Victor Mallet draws attention to the situation and shows how an excessive emphasis on deficits may sometimes mislead people into missing the bigger picture, since at the end of the day deficits are only interesting as they add to debt, and in the long run what matters - as we have seen in the Greek case - is whether or not the debt itself is sustainable.

Now Victor quotes me on two counts: the real size of Spain's debt, and the effectiveness of Spain's institutions.

“Spanish sovereign debt is already over 80 per cent of GDP,” said Edward Hugh, a Barcelona-based economist. “I think it’s getting nearer 90 per cent"......Mr Hugh also said the situation in Spain could not be compared to the confusion in the public accounts of Greece because much of the Spanish data are public and made available by the Bank of Spain, or can be deduced from official sources. But he added that the centre-right government’s transparency risked curbing Spain’s room for manoeuvre should the crisis deepen further.

Well, while it's the first claim that is controversial and in need of justification (and believe me Victor Mallet demanded to see the justification for the numbers before putting up the quote) let's start with the second one first as it forms an important part of the background. I think it is very important to understand that Spain is not Greece, in the important sense that the people in change do in fact normally know what is going on. They have auditors and inspectors whose job it is to know, and they do do their job. So the Bank of Spain know virtually everything there is to know about each and every one of Spains many banks and savings banks, about the state of their balance sheets, about the level of bad loans, etc etc. Naturally, knowing what they do, what they tell you is another matter.

Similarly in the case of the public administration, auditors and controllers are in place to constantly measure and follow the exectution of the annual budget at all levels, but again what they know is often one thing, and what they actually say publically is another. When Spain's bank regulators become worried about specific cases they try their best to put on a brave face and maintain confidence while looking for solutions somewhere behind the curtain. Similarly with the public administration, although in this latter case there may well be political reasons for allowing an overspend to continue, or even for encouraging it.

Let me take another example, from an area outside the financial system and beyond the realm of public finance: migration statistics.  Between 2000 and 2008 around 6 million irregular migrants arrived in Spain attracted by the prospects of work in the then (house) booming economy.

We know with some degree of accuracy the number of such migrants present (although not authorised to be) in Spain due to the existence of a system known as the "Padron Municipal" (or Municipal Register) which is managed via an electronic database. So we know how many migrants register, but how do we know that the migrants always register? Well this is the part which is "typically Spanish", since a far from innocent circularity has been created - all those present in Spain are entitled to free health treatment in the public health service, but in order to have a health card you need to register with the Padron Municipal. In addition, registration adds to the possibilities of being able to regularise your situation later, so the first thing virtually every migrant does is go to register. You see, that way the central adminstration has all the data to hand.

Well, you may say, that is fine, but how do we know the register doesn't overstate the number of migrants? In fact, at one point it did, since migrants were only obliged to confirm their continuing presence every two years. That was when the focus was on measuring who was coming in, but since the economic crash and the massive surge in unemployment, for a variety of reasons the emphasis has moved towards measuring who is still here. So the interval for address confirmations and things like that has changed, and most of those who don't have residence rights are now required to confirm their presence every few months, which means that Spain has some of the most accurate data on migrant flows to be found within the confines of the EU (and possibly anywhere).

Now, you might say, why be so meticulous in collecting all this information, why not follow the UK example, and require all those who lack authorisation to be in the country to leave? Well, this is Spain and not the UK (or Greece) and this is the point of the present rigmarole I am explaining, to give an idea of how things work in Spain, not to offer an analysis of the migration policy. Understanding that you can accurately measure something that officially doesn't exist is the key to understanding how the financial and public administration systems work, and unless you "get" this part, you will be lead astray by almost everything else.

The Omnipresence of "Dinero B"

Now, on the public accounts issue itself , I actually started digging into all this in the summer of 2010, and indeed posted an interim "report" at the time. So it is something of a mystery to me why all the hedge funds, journalists and bank analysts have taken so long in waking up to the existence of  "Spain's regional and local debt problem", especially since all the information on the topic is freely available on the Bank of Spain website. It seems to me that people see what they want to see at any given point in time, and this is the point of the Petrarch quote which starts this post. It comes from an Edgar Allen Poe short story, the purloined letter, and to cut a long issue short, a letter goes missing which no one can find, and the reason they cannot find it is precisely because it is lying there, right before them, on the living room mantelpiece.

"Nothing" remember, "is more hateful to wisdom (astucia) than true cleverness", which means if you try to go rummaging round round Spain for Goldman-Sachs-style interest-rate-swaps you will almost certainly leave empty handed. Handiwork here is all much simpler, and more artesanal than that, and therein lies the beauty and the sophistocation of the thing.

Hence, if you are someone who is really interested in trying to answer the question about just how high the present level of Spanish sovereign debt actually is (officially it was to have been 67.8% of GDP in December, but that estimate was made before the latest set of budget deficit "revelations" and when the estimate of 2011 GDP was rather higher than it turned out to be, so it is probably nearer to 70% now, even on the official Eurostat EDP measure) you should start here, with the Financial Accounts of the Spanish Economy. The part you really need is Chapter Two the "Financial Accounts" - actually, I will add in a small but revealing personal anecdote here, since when I sent all these links off to the IMF Spanish Mission Head back in the spring of 2010 he mailed me back saying "thanks a lot" - he plainly didn't know that this sort of thing existed., although the Spanish head of Global Financial issues for the IMF  - ex Bank of Spain man José Viñals - most surely did, but he simply hadn't seen fit to brief his colleague. As I say, this is how Spain works, you have to ask the right person the exactly right question, and make sure you don't get sidetracked. Otherwise you will learn nothing apart from a lot of useless and most likely thoroughly misleading  information.

But before we did down any deeper, just to let us all see where we are, why don't we make a small detour to Chapter 11 of the Bank of Spain's Statistical Bulletin, on General government liabilities. Excessive Deficit Procedure (EDP) debt. Now if we examine section 11.3  Liabilities outstanding and debt according to the excessive deficit procedure. Absolute values, we will find this most iluminating table.

Two important points should be drawn to the attention of the studious reader immediately, the fact that the right hand section refers to the Excess Deficit Procedure (EDP or officially recognised Eurostat) debt, and that the totals at the bottom of columns one and 15 are different. The number at the bottom of column one is approximately 877 billion Euros (or around 85% of Spanish GDP) while the number at the bottom of column 15 is 706 billion Euros, and this is the official Eurostat debt. So what makes for the difference? Well, as we will see, there are three main items - unpaid bills, public company debt, and Spanish sovereign bonds which are in the hands of the Social Security Reserve Fund. Now before going into all this further, I do want to make clear that I am not saying that this 877 billion euros is the total Spanish debt which should be counted as such. The number is simply orientative - a lot, but not all, of this is debt which will need to be consolidated - but in fact, and in addition, there are other "contingent liabilities" which will also need to be added in to get a complete reading..

But let's go one step at a time, and why not start with those famous "unpaid bills". Well, according to the Financial Accounts, at the end of the third quarter there were 72.9 billion Euros in unpaid bills (around 7% of GDP) which were more than 30 days overdue owed by the entire public adminstration (see this file here, bottom right second page - in fact there is a total of 87.5 billion Euros owing, but 14.6 billion is still within the term of normal trade credit). This breaks down as 27.7 billion Euros on the part of central government, 20.8 billion Euros from the regional governments, and 14.9 billion Euros for the local authorities. Much of this debt has been pending for months, if not years. It also makes the number of 35 billion Euros which is being bandied about in Spain for the credit lines to local authorities and regional governments seem quite reasonable and realistic. Of course, the central government itself still will need to put its own house in order.

The second main area of non-consolidated debt is the money owed by public companies, many of them loss making, and often entities which have been created without rhyme or reason at both regional and local authority level. As of the end of the third quarter of 2011 this debt amounted to 57 billion Euros (or 5% of GDP - see the memorandum item on the far right in this file), of which 32 billion Euros was attributable to central government, 15.5 billion Euros belonged to regional governments, and 9.4 billion Euros came from companies created by local authorities. There is no plan at present for dealing with all this accumulated debt.

Then, thirdly, we come to the social security reserve fund. Ai, the social security reserve fund! This is where the Spanish are supposed to be accumulating resources to help pay for their pensions. But the Eurostat accounting system being what it is, this is the last thing that is happening. Now according to this last report from the fund managers, at the end of 2010 the fund had assets valued at just under 65 billion Euros under its charge. Of this sum 56.6 billion Euros (or over 5% of GDP)  were invested in Spanish government bonds, while 7.8 billion Euros were invested in bonds of other EU states (principally Germany, the Netherlands and France).

Now doubtless the only reason the fund decided to invest the money it was holding in Spanish government bonds wasn't to help the administration hide some debt, probably the fact that risky Spanish bonds pay more than less risky German ones was also a consideration. But this whole thing is a farce, since while the Spanish people innocently believe that they have a partially funded pension system, nothing could really be farther from the truth. In general accounting terms the whole security area comes under the general budget, as was brought to light in the recent deficit numbers the new government brought to light at the start of January. Out of a total of 2.5% of GDP in unexpected deficit, 0.5% came from issues associated with the social security fund - which anticipated a surplus of 0.4% of GDP but finally turned in a deficit of 0.1% of GDP, as can be seen in the nice chart provided by the Ministry (below).

The shortfall was due to a number of factors. In the first place those newly entering the system are paid far more than those who are leaving (due to death or other reasons) - 35% more in fact, since the average monthly payment in 2010 was around 800 Euros, while the average payment to new entrants was 1,100 Euros. Secondly Spain's demography is working against the fund, since as the number of those working falls, and the number of elderly dependents rises, the ratio between the two falls. It is currently at around 2.4, and many experts estimate that the pension system will turn critical when the figure drops below 2.

Currently there are just under 17 million contributors, but the position is worse than it seems, since of these three million are unemployed, with their contributions being paid by another department, and these contributions will terminate when the individuals concerned exhaust their unemployment entitlements. According to Spanish public pensions expert José Mario Paredes Rodríguez, "the data on contributor pensioner ratios is totally misleading" given that the government continues to count as contributors those for whom it is making payments the "calculation is completely unreal since what we need to know is how many people are actually working per pensioner being supported.

So we really have a clear "robbing Peter to pay Paul" type situation, where the numbers are juggled but the debt remains. This risks associated with this situation was brought to light in the recent Greek debt restructuring, since one of the key issues driving Greek politicians to the negotiating table was the threat of seeing their pension fund reserves going up in smoke in the event of a hard default.

According to the Wall Street Journal:

"The total portfolio of Greek bonds that the Greek pension funds hold  is EUR27 billion," Venizelos said. "That portfolio is being replaced  with cash, with new, better bonds of much higher net present value and, further, the parliament has already approved the creation of a special public body through which to transfer public assets to the  funds," he added.

And to Bloomberg:

"The dilemma we are faced with is cuts so that we can stand on our own two feet, to save the country’s pension system and pensions, or economic collapse,” Finance Minister Evangelos Venizelos told opposition party lawmakers in Parliament today. Without the debt swap, the country’s pension funds would be wiped out, he said. The country’s central government debt, which doesn’t include debt  from local government organizations, state-run companies or pension  funds, was 368 billion euros at the end of 2011, the ministry said  today, amounting to 171 percent of the economy, according to Bloomberg  calculations".

And Then There Are The Contingent Liabilities


The trouble is, this still isn't everything. We also have the contingent liabilities of the state to think about. This - a groso modo - comes in four forms: bank debt guarantees, exposure to the financial system via FROB, the government Instituto de Credito Oficial (ICO) and the Electricity Tariff Fund FADE.

On the guarantee side, the latest data we have is for a total of 88.6 billion Euros at the end of the third quarter of 2011, but this number is almost certainly higher now, since the government has been guaranteeing debt on a number of fronts with the unique and exclusive objective that they could be taken over to the ECB to post as collateral in the LTROs. In any event, it is the Spanish state (and not the ECB) that is finally responsible for these loans should the relevant bank or other entity be unable to live up to its commitments.

In the case of  FROB (Fund For Orderly Bank Restructuring) the true extent of the government's exposure is hard to measure, since while the quantity actually provided by the fund to date is not large (14.8 billion Euros - see this presentation - and 9 billion Euros of FROB debt has been pre-capitalised) a number of savings banks are effectively nationalised while others that are dependent on FROB for loans may well need further intervention. So all we can safely say here is that the number involved is hardly trivial, and on just how "non trivial" the final number is the whole future of Spain's soverign debt will ultimately depend.

As far as the ICO goes, the organisation currently has an exposure of 27 billion Euros, all guaranteed by the state. Now much of this money has gone out in lending, and much of that lending will be returned, which is why this is a contingent liability. At the same time the present administration clearly see an enhanced role for ICO (helping the regional governments clear their backlog of unpaid bills, for example), and it is likely that the volume of debt will continue to grow.

Finally, we have the so called Tariff Deficit fund, or FADE (Fondo de Amortización del Déficit Eléctrico). Now despite the name, one thing the debt generated by this body doesn't do is fade (away), since it is growing month by month and year by year. The position is described in the literature as a debt being accumulated by consumers (some 24 billion Euros of it) which is guaranteed by the government. Like the state of their savings in the pension system, most electricity consumers are totally ignorant of the fact that they are acquiring this debt, or better put, that it is being acquired on their behalf. Essentially the situation arises since the government is reluctant to charge an economic price for electricity. Naturally, in a country running an energy driven current account deficit this is a highly questionable practice, but then, there you are.

Basically every month less money comes in in bills than is attributed to the accounts of the electricity companies. The shortfall is made up by borrowing. This borrowing is serviced - you got it - by taking some of the income from electricity bills. But naturally, as the deficit grows - currently it is about 24 billion Euros - more of the income stream is needed to service the exisiting debt, and - yup, you got it again - the deficit grows. The only real solution to this mess is to raise electricity tariffs, but in an environment of rising unemployment and falling wages there are going to be limits to what the government can do in this regard. So while I am sure that the EU will eventually insist tariffs are raised, it is hard to see them being raised far enough to pay off the accumulated debt, and so the government will almost certainly need to "swallow" this, which means - yup you got it again - another 2% or so on the debt account.

Just to round things off, there are some other little details, like public private collaborations in infrastructure. Take motorways for example, many of these (especially around Madrid) were planned at the height of the boom, when traffic was intense - the private sector are of course paid according to the number of cars who use the motorway. Now with the crisis the volume of traffic has fallen considerably everywhere (this is one of the few advantages I have noticed of all this difficult mess, it is now much easier to move around in Barcelona). And with the fall in traffic, incomes have fallen, to such an extent that the participating companies are no longer able to service their debt. Experts suggest the total quantity involved is around 4 billion Euros - peanuts you may think in comparison with the other things we are looking at, but as they say in Spanish "todo suma".

Much Ado About The Deficit

Now as Victor Mallet says, the basic motivation behind recent moves on the Spanish adminsitration front would seem to be to start to move this large backlog of debt (especially at the regional and local government levels) onto the table.

Madrid plans to arrange payment of up to €30bn in overdue bills for rubbish collection and other services owed by municipalities, a move that will benefit suppliers but will also help to expose the true size of the country’s public sector debt.

“It’s about restoring order, it’s about knowing what’s there and dealing with it once and for all,” Maria Soraya Sáenz de Santamaría, deputy prime minister, said after a cabinet meeting on Friday that agreed the first part of the programme.

But the great risk they are taking in doing this is raising the acknowledged debt level, up towards the "high risk area" of around 100% of GDP. When you add all the debt up we are already in the high 80% range, and two more years of "normal" deficit plus more funding for the financial sector should take it through the psychological barrier. Naturally investors are noticing this, and Prime Minister Mariano Rajoy's "gaffs", and at the end of last week the Spanish ten year bond spread with the Bund equivalent went above the Italian one for the first time since last summer.

So Spain is on a bad course, with recognised debt about to surge rapidly, while investor confidence in the current administration is slipping. Time for another "gamechanger" I think, since otherwise this car is about to crash.

Her mind in torment, wheeling like some lion at bay, dreading the gangs of investors and bond traders closing their cunning ring around her ready for the finish, Angela thrashed around looking for the rules and pacts that would save her embattled army. To no avail, her chariot struck a a rock which, like the one to the west of Grosseto which saw-off the unfortunate Costa Concordia along with her Captain, was on no known map, having not previously been measured, and she went hurtling down that crazed path which leads only towards a preappointed destiny with both history and oblivion.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

For Whom The Bailout Tolls

"On an optimistic view, that a deal was struck implies that neither side was ultimately willing to risk a Greek exit because they recognise that no one fully understands all the ramifications of such a decision. Under this scenario, when pressure again builds, the authorities will do the same: let Greece remain in the euro, even if it fails to keep to its adjustment programme. So, the reality of “bail-out II” means that, if the situation becomes critical, there will be a bail-out III". Sushil Wadhwani, writing in the Financial Times

 So Greece has finally been awarded a second bailout. One may wish the country will live to tell the tale.

According to IMF DG Christine Lagarde, speaking at the post agreement press conference, "It's not an easy (program), it's an ambitious one,". Never a truer word was said, and certainly not in jest. Not only is the program an ambitious one, it is more than probably a "pie in the sky" one too. The objective of 120% for Greek debt in GDP is totally unrealistic, not because it won't be attained (it won't), but because even if it were the country would still be in an unsustainable situation in  2020. So this is hardly something to be proud of, or look forward to.

And then there is growth. Ah yes, growth. Noone really has any idea how this will be achieved, and of course without it even the (un)ambitious 120% goal is way out of reach. But beyond the details, I have serious doubts whether Greece itself is now rescuable. I don't mean the financial dimension, I mean whether or not the country will even raise its head again. The social fabric and the country's reputation is being so destroyed, that it is hard to see serious investors getting back into the country again, with or without that much needed internal devaluation.

Young people will simply vote with their feet and leave, leaving an ever more unsustainable pension and health system. A common story these days along Europe's periphery, but still, Greece definitely seems destined to be the worst case scenario.

Perhaps the best simple summary of what just happened was written by Annika Breidthardt and Jan Strupczewski in their Reuters report:

"The complex deal wrought in overnight negotiations buys time to stabilize the 17-nation currency bloc and strengthen its financial firewalls, but it leaves deep doubts about Greece's ability to recover and avoid default in the longer term".

We have just bought some time for the rest of us, while Greece is sent off to default and beyond. The Troika representatives didn't "sign off" on the new deal, they effectively washed their hands of the whole messy situation. Naturally Greece won't be able to comply with the conditions, and at the next review, or the one after, the country will be face to face with the inevitable.

The Details.

• Greece has agreed to be placed under permanent surveillance by an increased European presence on the ground, and it will have to deposit funds in an escrow account to service its debt to guarantee repayments. effectively this will rule out future defaults against the private sector. This is why Europe's leaders think this agreement will end contagion, there will be nothing to "contage". But the problem simply becomes worse, since any default now will be against the official sector, and they are not nice, friendly people to default on.

• The European Central Bank agreed to help the process by distributing its profits from bond-buying. A Eurogroup statement said the ECB would pass up profits it made from buying Greek bonds over the past two years to national central banks for their governments to pass on to Athens "to further improve the sustainability of Greece's public debt."  The bond holdings of the ECB and national central banks from their investment portfolios (about 12 billion Euros) and the Security Markets Programme (around 40-45 billion Euros) are to be swapped for instruments that appear to be exempt from any future  Collective Action Clauses. They will be repaid at face value, albeit with an understanding that the profits accruing from this repayment plus coupon payments will be transferred to governments via the various  National Central Banks. This money can then be passed to Greece in the form of a transfer. The importance of this arrangement is that it reinforces the subordination of private sector bond holders to central bank buying. Moreover, it is not clear that there is any obligation for the national governments to give these income flows from Greek restructuring back to Greece, and if this proves to be the case this outcome would simply amplify the subordination of private investors.
• Private bondholders are being asked to accept more losses than originally postulated. Private sector holders of Greek debt will take losses of 53.5 percent on the nominal value of their bonds. They had previously agreed to a 50 percent nominal writedown, which equated to around a 70 percent loss on the net present value of the debt. This being said, all is still far from clear. The IMF document detailing the underlying economic assumptions for Greece assumes a 95% participation rate in the PSI. This outcome seems unlikely, especially in light of the increased haircut for private investors in the new deal, which was implemented in order to reduce Greek debt/GDP to the targeted 120% by 2020 from the 129% it would reach according to earlier PSI assumptions. What this implies is that those dreaded Collective Action Clauses may still be needed sometime early next month to ensure no hold-outs, and if this happens it is quite possible that CDS will trigger. So we are not out of the woods yet, it seems.

• The latest IMF document reaffirms its view that Greece is unlikely to be able to access the market in its own name during the programme period until at least 2020, "and it is assumed that financing needs are met by Greece’s European partners on standard EFSF borrowing terms", if good policies are maintained. One problem  the IMF mentions here is important, and that  is the fact that future debt issuance would be subordinated to the currently being restructured pool of debt. This would obviously make it hard to sell bonds to new investors even in the most favourable of circumstances.

• As if this wasn't enough in the way of headaches, the latest IMF document also suggests that  Greece is likely to need additional funding well before 2020. The Fund outlines two scenarios: a "base" case whereby Greece may need an additional 50 billion Euros during the period 2015-20 given that the new 136 billion Euro support package will only meet Greece’s funding needs until 2014. They also cite a more bearish case involving slower-than-targeted growth and fiscal consolidation, whereby debt/GDP only declines to 160% by 2020 rather than the targeted 120%, in which case Greece would require a further 109 billion. Hence far from having put Greece off the EU radar, the new debt deal only marks the end of the beginning, and we still need to get through to the beginning of the end.  
• In terms of timescale, the private creditor bond exchange is expected to be launched on March 8 and complete three days later, according to Greek sources. That means a 14.5-billion-euro bond repayment due on March 20 would be restructured, allowing Greece to avoid default.

In fact the important point to note is that the vast majority of the funds in the current program will be used to finance the bond swap and ensure Greece's banking system remains stable; some 30 billion euros will go to "sweeteners" to get the private sector to sign up to the swap, 23 billion will go to recapitalize Greek banks. A further 35 billion or so will allow Greece to finance the buying back of the bonds. As Annika Breidthardt and Jan Strupczewski point out in their article, next to nothing will go directly to help the Greek economy.

The main purpose of exercise - apart from trying to close off contagion - was to reduce Greece's debt to a point that the IMF would be able to continue funding. It will be recalled that the whole second bailout issue was put on the table when the IMF reported that it would be unable to continue with the first bailout since its own regulations stipulated it could not continue with programme payments to a country whose debt path was not sustainable. Their economists must have had to swallow some to be willing to sign off on the sustainability of this one. But such are the political pressures people are facing.

The Sacrificial Lamb

It is hard to remember a time when such an important decision was taken where so many of those participating were expressing the view the solution was not going to work. Thus conservative leader Antonis Samaras, a strong contender to become next prime minister, stressed that the rescue package's debt-reduction targets could only be met with economic growth. "Without the rebound and growth of the economy ... not even the immediate fiscal targets can be met, nor can the debt become sustainable in the long-term."

Hardly inspiring words from the person who is most likely to have to take responsibility for all of this.

Naturally Europe's leaders are more concerned about their own backyard than they are about what actually happens to the Greeks. "It's an important result that removes immediate risks of contagion," Italian Prime Minister Mario Monti is reported as telling a news conference.

Swedish Finance Minister Anders Borg effectively summed the cynicism of the whole position up like this: "What's been done is a meaningful step forward. Of course, the Greeks remain stuck in their tragedy; this is a new act in a long drama. "I don't think we should consider that they are cleared of any problems, but I do think we've reduced the Greek problem to just a Greek problem. It is no longer a threat to the recovery in all of Europe, and it is another step forward."

But as Sushil Wadhwani suggests, rather than overcoming contagion, what the agreement does is give a whole new twist to the issue of contagion. In particular, the general impression that has been generated is that Germany’s leadership will now make almost any concession in order not to have to look for the Euro exit door, and the others, starting with the highly intelligent Mario Monti, are beginning to sense this. Even Spain’s Mariano Rajoy has caught-on, and seen he can negotiate a relaxed deficit target for 2011, despite the fact that the country missed last year’s target by a large margin. So we may well now see a chain of events were one country after another sets out to test the patience of the "core". And in addition (see below), the Greek contagion problem is a long way from being over.


Eternal Life on LTRO "Cool Aid"?

Meawhile, the impact of recent policy changes at the central bank should not be underestimated. In particular, the latest decision to implement two 3 year Long Term Repo Operations has been very important, and is a short term game changer.

Distressed sovereigns can, for the time being fund themselves, even if the commercial banks are only really inclined to bid at the short end, and may well be exaggerating the extent of relief provided by buying short term bonds in an attempt to store liquidity to meet their own future wholesale financing needs.

Basically, the liquidity provided, in conjunction with the all important flexibilisation of the collateral rules, has enabled banks to make provision for their wholesale funding needs right through from now to 2015, at which time there will doubtless be another round of LTROs, and who knows, they could even have a longer term than a mere three years. The days when banks saw it as a stigma to have recourse to ECB liquidity, and when journalists entertained themselves making fun of packaged used car loans being offered as collateral in Ireland by the Australian bank Macquarie are now long gone, as are the times when anyone really imagined that any sovereign bond from a country losing the minimum rating qualification of at least a single A from one agency would not be available for use as collateral at the central bank.

And this liquidity policy knocks yet another of the old chestnut endgames straight out of the window too, since it makes deposit flight within the Euro Area as a whole a much smaller problem. German and other core country deposits can be recycled - via wholesale finance provided at the ECB - as a substitute for the missing peripheral ones. Naturally this measure does not unblock the credit crunch problem, but it does reduce immediate systemic pressure. So, if the Euro system is inherently unstable, and unsustainable, a mire from which no one wants to exit since fear of the unknown always trumps hatred of the known, how does it all finally unwind? The implicit market assumption that Portugal will follow Greece into default comes as no surprise. If Greece is to be given an ongoing debt pardoning programme then surely in Portugal is going to want one too. And then there will be Ireland, and so on. Yet all of this is contemplatable, what is not contemplateable is that the people who live in these unfortnate countries will continue to accept whatever is trown at them, come what may. You only need to look over in the direction of Hungary to see that these no-growth austerity programmes have a sell-by date. But what will follow will surely please no one.

The Club No One In Their Right Mind Would Leave


But what about Greece itself? Logic suggests that they will be unable to meet the terms of their new agreement, and that we will soon be back to where we started, or will we.

Feelings that what we are seeing today will only be a short interlude are based on a combination of three factors: a) a recognition that even a reduction of debt to GDP to 120% by 2020 may well not be sustainable; b) a recognition that after the formal bailout is awarded there will still be ongoing programme reviews, and the country will struggle to comply with the conditions; and c) the fact that the implementation of the Private Sector Involvement debt swap will probably mean changing the jurisdiction under which Greek debt is denominated from mainly Greek law in the majority to international law in the totality. This latter point is undoubtedly the most important, although being able to grasp its full implications implies an understanding of the first two.

Essentially, if the unsustainability of the Greek debt path and the inability to comply with conditionality are accepted, then a further default will be inevitable, but such a default will undoubtedly be a very, very hard one, and most likely an uncontrolled one. In the first place if the country were to leave the Euro after the debt swap, then the new Greek bonds could not be converted to New Drachma (or equivalent) by a weekend session of the Greek parliament, and the country would have to default on bonds denominated in Euros, which would presented them with all kinds of problems.

Secondly, given the terms of the debt swap, and the condition of an escrow fund to protect the interests of private bondholders, then the only liabilities on which the country could still default would be those commitments it has with the official sector, which means defaulting on the IMF, the ECB, the EU and Germany. These would not be especially nice people for the country to default on, since if Greek reaches such a point the country would almost surely be made an example of, which means effectively establishing a pariah state.

The EU certainly wouldn't be sending in the social workers and psychologists to help them cope with this massive tragedy, which also implies that investors generally would be inclined to steer clear. Realising this, and having taken the decision not to default now, short of seeking allies among other rogue states (the North Korea path) the country’s leaders have probably taken the decision to stay in as long as they can. But then it is worth remembering the old Greek saying that “whom the gods would destroy, they first make mad”, by which I mean we could well see extreme factors at play in Greek politics - the extreme right, the extreme left, and the military - before they then all go rolling off the cliff together.

Or maybe Greece will decide to default and stay in the Euro, printing its own Euros at the national central bank along the lines of the Emergency Liquidity Assistance precedent. That would surely create a mighty mess, (they could even carry out the internal devaluation by subsidising Greek wages) and would leave the onus of kicking them out on their European partners.

Whichever the appointed path, such a scenario would have important geopolitical implications, since surely the EU could not let Greece become a nice place, given that then Portugal would immediately say "I want one of those", and so on and so forth along the daisy chain. In the meantime private capital will be steadily forced out of periphery sovereigns like Spain and Italy, and the ECB will ultimately have to provide. But we have already crossed the Rubicon on this, and there is no real turning back. Ongoing debt restructuring will continue, as none of the really troubled economies can either grow or sustain their existing debt. I mean, who can now really believe that Spain won't be asked in six months time to prepare another set of reforms (the latest batch have "destined to fail" written all over them), and six months later another one, and so on, until eventually the country is where Greece is now?

And if the private sector either can’t, or won’t accept the degree of involvement being asked of it, then the ECB will be taken out of the official sector, and somehow or other find a way to swallow the losses. At least that's the way things could work for the time being.


Destroying European Democracy?


The principal issue impeding exit is not the one of the presence of sunk costs from years of membership, but rather existence of non-linear credit and currency impacts - in either one or the other direction – impacts which could not be envisaged in the pre-Euro era during which most of the critics of the common currency cut their theoretical teeth.


The only conceivable way a deliberate decision to leave could actually be taken would be as a result of one or more of the respective agents being actually driven “insane” by the constant painful efforts involved in trying to retain the pin in that grenade they are holding as they are driven to ever more desperate efforts in a vain attempt to try to stop it going off in their face. Could, for example, Hungary’s leader Viktor Orban be about to offer us an early prototype for the kind of road map which some of the participants might need to follow in order to reach the point whereby they actively decide to leave? In Hungary’s case, of course, the departure would be from the EU, not the Euro, but the point is effectively the same, since the farewell party would most certainly acrimonious, where the possibility of regulating the exit would be limited, and where the end product would almost certainly be the creation of a pariah state.

For the inevitably defaulting participants, given the total determination not to have official sector restructuring, leaving the Euro would more or less automatically mean a sharp break with both the EU and the IMF and in all probability the United States. If we take Greece as an example, and assuming the currently proposed PSI debt swap goes forward, the country will almost certainly see the jurisdiction of its debt shifted from national to international law, making converting sovereign debt instruments into New Drachma (or whatever) impossible, and given the creation of an escrow account to pay the private sector creditors, the only meaningful possibilities for default would be against the official sector – the ECB, the IMF and the EU member states – and clearly such a development would not be well received, among other reasons due to the precedents which could be created for other struggling countries who might wish to follow the same path.

So the list of probable allies for an exiting country – Venezuela, Bolivia, and North Korea come to mind, or nearer home Serbia, Belarus and Ukraine – would not be entirely alluring. The difficulty is that after the ending of the cold war, the world is rather short of role models for developed economies who want to pursue unorthodox policies, especially if they are engaged in a disorderly default causing considerable discomfort for most of their “first world” peers..

On the other hand, those with more stable, internationally competitive economies will not readily wish to surrender this condition, and since they have clearly benefited significantly from membership of the currency union they will be unlikely to offer themselves as candidates for departure. In a post Euro world they would face the likelihood of trying to export their way forward while labouring under the constraint of a substantially over-valued currency.

So with no one leaving, and everyone elbowing the other in the rush to say "I'm not going" there really only is one way all this can end, isn't there?

Global Manufacturing Steadies As She Goes, Or Does She?

The year got off on a much better foot than might have been expected, at least as far as global manufacturing is concerned.  As the JP Morgan report puts it:

"The global manufacturing sector continued to record belowtrend growth at the start of 2012. At 51.2 in January, the JPMorgan Global Manufacturing PMI™ rose to a sevenmonth high, but remained below its long-run average (51.8). Manufacturing output expanded for the second successive month in January, as new orders rose for the first time since last August".

"The cyclically sensitive new orders-to-inventory ratio also moved higher, reaching a ten-month peak. Although rates of expansion for both output and new orders were the fastest since last June, they were still only modest at best. Growth of production was recorded in the US, Japan, Germany, the UK, India, Eastern-Europe, the Netherlands, Austria, Canada, Switzerland, Turkey, Brazil, South Africa and Denmark".

"International trade volumes improved for the first time in six months during January. Growth of new export orders was led by India, the US and Turkey. China, Japan and the UK all reported modest increases, in contrast to the declines seen in the Eurozone, Russia, Canada, South Korea, Taiwan and Brazil".

So the fall in global manufacturing has flattened out, even though the bounce back has more of a dead cat look about it than anything else. As usual in recent months the report was very much a mixed bag.

Core vs Periphery Monotony?

Euro Area results were divided between the core countries which moved timidly back towards expansion, and those on the periphery where conditions were simply less recessionary than they had been at the end of last year.

Surprisingly both Greece and Ireland bucked the trend and deteriorated, with the contraction in Greek output setting another series record for the country. Personally I have long held-and-expressed doubts that the people responsible for administering the Greek programme (namely the Troika) knew what they were doing, but I now find it hard to see how anyone else can still seriously maintain that they do. Avoiding Euro collapse, and total financial armageddon and all those horrid things are most worthy objectives, but I think the Greeks will simply have to learn to live with an economy whose back has been broken, and where possibilities of things getting back to normal are slim. Someone said to me this morning, but "time cures, doesn't it Edward?" Unfortunately I think the responsible answer is that this time it won't.

Then again, the Greek situation is not news to the Troika who have long claimed their programme wasn't working because the Greeks weren't cooperating, but the Irish result might have thrown a rather larger bucket of cold water over their hopes, since it  suggests that despite all those optimistic pronouncements the country is a long way from being out of the woods.

In his comment on the Irish Manufacturing PMI survey data, Brian Devine, economist at NCB Stockbrokers said:

“The first NCB PMI of 2012 has got a familiar feel to it; domestic demand continues to drag and export orders continue to expand. The headline composite index contracted for the third month running (48.3 from 48.6), with output contracting more sharply than last month (47.3 from 48.7). New orders overall continued to contract (46.8), but export orders expanded once again (50.9). 2012 is going to be the fifth year in a row in which domestic demand will contract and if GDP is to expand, Ireland will need an improvement in the euro area economy in H2 2012.”

And I think this is the whole point all along the periphery, the excessive debt overhang makes their economies almost entirely export dependent, yet after years of credit-driven consumption-abuse their economies are totally distorted and their manufacturing industries are just not big enough to do the work. Ireland`s industrial base is in better shape than many, but even in this case expanding exports coupled with falling domestic demand simply means the economy flatlines.  Ireland's central bank now expects GDP to grow just 0.5% this year, while the fiscal deficit target is still a hefty 8.6% of GDP, so not much in the way of "bang for the buck" there. The country's debt will now surely peak above the 118% currently anticipated by the IMF due to the lower growth expectation, and it is hard to see the country achieving debt sustainability without the kind of debt assistance being given to Greece, and which markets increasingly expect will be offered to Portugal.

Germany Not As Strong As It Might Be
 

Even the German manufacturing report gave reason to be cautious. The index reading was mainly up because the current output component was up, and this component was up because backlogs of work were reduced at a faster rate despite the fact that incoming new orders declined. And why did manufacturers reduce backlogs more quickly despite falling orders? Because they feel that the debt crisis has turned the corner, and that things will now improve. Despite the evident positive contribution made by the ECB 3yr LTRO they may well still be in for a rude awakening.

As the report says:

"The increase in the headline index was primarily driven by a robust rebound in output growth at the start of 2012. Production levels rose for the first time in four months and at the fastest pace since June 2011, led by an upturn in both intermediate and investment goods output. Higher output volumes were supported in part by greater work on unfinished business in the manufacturing sector. This was highlighted by backlogs of work falling in January for the fifth month in a row".

"Meanwhile, new orders continued to decline at the start of the year, although the rate of contraction was relatively modest and the slowest in the current seven-month period of reduction. Latest data indicated that the decline was driven by a marked fall in new work received in the consumer goods sector".

"A further solid drop in export sales contributed to the overall fall in new business levels in January. Lower levels of new work from abroad have been seen in each of the past seven months, largely reflecting weaker global demand and uncertainty about the economic outlook. In line with recent trends, lower new export orders were recorded across all three market groups monitored by the survey".

And as Chris Williamson, Chief Economist at Markit puts it in his general Eurozone comment:

“Anecdotal evidence from survey respondents indicates that much of the improvement appears to be based on business and consumer confidence reviving, in the belief that the worst of the region’s debt problems are behind us and that a new credit squeeze may be averted. As such, the outlook remains very much dependent upon further progress in resolving the crisis.” 

Chris Williamson is absolutely right  the situation is extraordinarily fragile, and much depends on how the Euro debt crisis evolves. The ECB's 3 year LTRO has stuck a finger in the dyke for the time being, but without more decisive moves to reform the Euro Area's institutional architecture for how long will it last?

Booming EMs

Among emerging markets the situation is very different, and Brazil and India are now both showing real signs of recovery. The recovery in maufacturing is significant, but the composite indexes (which cover both services and manufacturing) show a really strong surge in activity.

Curiously, only this week the Columbian central bank started intervening in the currency markets again, buying dollars in an attempt to stem the rise in the peso which is starting to crimp export competitiveness.

Emerging market nations such as Colombia have faced a flood of cheap money in recent months as near-zero interest rates in developed markets prompt investors to seek higher yields, pushing up their currencies and strengthening their economies. The peso has firmed almost 7 percent this year, making it one of the best performing currencies among the world's 36 most-traded, partly thanks to strong foreign direct investment inflows. The dollar purchase program, which previously ran through September 2011, would re-start on Monday, the bank said in a statement.

The Euro As A Global Funding Currency?

So as core European banks ramp up their deposits at the ECB, and credit conditions on the periphery continue to worsen, a lot of the extra liquidity being generated either at the ECB or the Fed is simply seeping out and fuelling demand in emerging markets, which is a plus for exports, as long as your manufacturing industry is big enough and competitive enough for this to matter. As I say, much of the European periphery is facing an outright credit crunch as banks tighten their credit standards. The FT's John Dizard put it this way:

There was a lot of earnest chitchat last week about the ECB’s Euro Area Bank Lending Survey, which reported a tightening of lending standards and a decline in the demand for credit. The results, in the bureaucratic tradition of false precision, were reported to accuracies of one percentage point. So, for example, the report tells you that credit conditions were tightened on 42 per cent of long-term loans in the last quarter of 2011, compared to 20 per cent in the preceding quarter.

What the ECB’s survey did not tell you was what is meant by “tightening”, and exactly where in the euro area this undefined tightening occurred, and, where it did not occur. Let me put it this way: if you are a German machinery exporter, your bank just cut the cost of your receivables financing. If you are a Spanish commodities trader or Italian aircraft lessor who had a line of dollar credit from a French bank, you are probably out of luck.

In an article entitled "ECB ‘saves’ banks as economies sink" Edward Chancellor makes similar points:

Over the past couple of months, the cost of Italian two-year debt has fallen from 7 per cent to around 3 per cent. As investors’ fears abated, the share prices of European banks rebounded. The vicious cycle that gripped Europe’s financial system appears to have ground to a halt.

Unlimited access to ECB money means Europe’s banks will have cash on hand to repay any loans that become due this year. Since deposit outflows can quickly be replaced with ECB funds, the periphery is less vulnerable to bank runs. Now that the liability side of their balance sheets has stabilised, European banks will not be in such a rush to dispose of assets.

At around 1 per cent, LTRO money is also very cheap. Barclays estimates that lower funding costs will boost the earnings of eurozone banks by 4 per cent. Clever bankers may do even better – Italy’s Unicredit, for instance, is using money from the ECB to repurchase its own hybrid bonds at a large discount. Increased profits reduce the amount of equity capital that the banks will need to raise. More stable share prices diminish the risk of dilution for bank shareholders.

Mr Draghi’s largesse, however, cannot cure all of Europe’s woes. Within the eurozone, banks have becomes increasingly reluctant to lend across borders. Banks in the core of Europe are reportedly still looking to reduce exposure to the more spendthrift members of the currency union. On its own the LTRO is unlikely to reverse this financial Balkanisation. European banks remain massively leveraged. They will continue to shrink their balance sheets, albeit at a more measured pace.

Nor can a wave of Mr Draghi’s monetary wand remove the eurozone’s macroeconomic imbalances. Much of the periphery remains uncompetitive relative to Germany.

The latest Euro Area Bank Lending Survey reports that 35 per cent of banks tightened lending conditions to European non-financial corporations. The money supply in the periphery contracted by 4 per cent in the year to November. Spanish industrial production fell by 7 per cent over the same period. The dire economic prospects for the periphery are exacerbated by Germany’s insistence on fiscal austerity.

The ECB’s action has brought a liquidity crisis to an end. But it is unlikely to spur lending in the real economy. Until the economies of Europe’s periphery start to grow, concerns about their solvency will continue.

So what is happening? Well the massive liquidity easing engaged in by the Federal Reserve in the US and the Wall of Money sent out by the ECB has loosened credit conditions, but not in the intended economies. We have been here before during QE1 and QE2, but if you look at the first chart in this blog (the global manufacturing one) you will see that we are hardly getting a "mountain" of growth, indeed at this moment what we have is little more than a bump in the road (on aggregate).

Confidence is back globally, as fears of an imminent Euro unwind recede,  and "risk" is "on again". Cheap liquidity available for tapping in over-indebted developed economies is flowing into rapidly growing emerging markets again, risking yet more distortions in their developing economies. One sign of this is the Columbian iattempt to stem the rise in the peso which would furher crimp export competitiveness. In general "carry is king" once more, and the Euro has even becoming the funding currency of reference. To cite William Kemble-Diaz in the WSJ:

Canny foreign-exchange investors are increasingly tempted to borrow euros to fund bets in higher-yielding currencies, even though it is a lot cheaper to borrow dollars.

The combination of low European Central Bank interest rates that are likely to fall further, and growing confidence that the euro is set for a big slide this year, lines the currency up as a good bet to sell in search of juicier bets elsewhere. In the market’s parlance, that makes it a funding currency, equivalent to nailing a “for sale” sign on its fence.

It is an unusual role for the common currency, and one normally grabbed by the dollar and yen. While low, ECB interest rates at 1% are still four times higher than, say, the U.S. Federal Reserve’s, so when investors feel broadly confident the euro usually rises as traders are drawn to its higher returns. Now, though, a poor outlook for the currency’s value and quirks in the interbank borrowing market mean typical trading patterns are being turned on their head.
The three-month euro-dollar basis swap, which is a function of spot and forward foreign-exchange prices and prevailing interest rates as well as a bellwether for dollar funding stress, has improved to minus 86 basis points from as low as minus 165 basis points in late November, when worries about “another Lehman” filled the air.

But that figure remains deep in the red when, if all were well, it would be closer to zero. For market participants seeking a funding currency, that, combined with the euro’s weak outlook and slowing euro-zone economy, makes for an increasingly tantalizing combination.

(See Bloomberg's Masaki Kondo and Hiroko Komiya on the same topic here).


China The Odd Man Out?


But even here we find yet another anomaly. While many emerging markets are beginning to boom, China (oddly) failed to spring back,. This suggests the country may really be feeling the housing slowdown/bust pinch.

This is a possibility that Global Insight's Alistair Thornton definitely entertains.

In combination with better-than-expected numbers out of the United States and what would appear to be an improving situation in Europe, a relatively mild slowdown in China would prove a boon for global markets. Unfortunately, the situation is not entirely positive, despite some signs of resilience in China's deceleration. IHS Global Insight has picked out a few "behind-the-scenes" indicators which give a slightly different take on the macro climate.

While it is important to note that micro indicators do not necessarily have macro implications, they can help shed light on nascent trends, particularly when there is a modicum of scepticism about the quality of Chinese data. Taking a cue from Vice-Premier Li Keqiang, who when Party Secretary of Liaoning joked that China's provincial GDP figures were "man-made", we first turn to freight volumes at major coastal ports. China's export growth has been suffering under the weight of unravelling demand in advanced economies, and growth in freight volume sagged considerably in November—down to 8% y/y from October's 16%. This suggests lacklustre demand both overseas and, to some extent, in China, which will drag on growth going forward.

To give him an indication of the state of domestic activity, Alistair took a look at cement production widely regarded as a key feeder for the nation's property sector, which itself is a key component for investment and the wider economy. What he found was that cement production growth slid to 7% y/y in December (see chart above), down from 11% in November and 17% in October. T

This also fits in with data showing a recent contraction in real-estate construction and anecdotal evidence suggesting an extremely weak project pipeline. More worrying, he found that machine production and machinery sales indicate a severe contraction in construction activity to come.

While metal-cutting machines sound an obscure piece of kit, they are an integral part of China's construction and investment economy. They are highly pro-cyclical, with the global downturn of 2008–09 pulling production growth to around -30% y/y, before ultra-loose credit policy and construction activity buoyed growth to over 50% in 2010. As of November, however, y/y production growth has been negative, with December's figures sinking to -11%.

While this demonstrates receding construction activity, the pull-back in machine production has not yet reached the nadir seen in 2008–09. Sales of excavators, on the other hand, have fallen below those depths, reflecting the intense pressure stacked on the real-estate sector. With data from China Construction Machinery Business Online, smoothed using a three-month moving average, we can see that sales growth contracted almost 40% y/y in December.

Little Momentum In Non-Europe Developed Economies

Moving back to the developed world, Japan showed marginal growth, but far from sufficient to help the country overcome the growing sovereign debt problems. The strong yen and the weaker demand from both Europe and China is clearly taking its toll, despite many earlier predictions of a "V shaped" bounce back.

As Alex Hamilton, economist at Markit and author of the report said in his comment:

“January PMI data suggest that the sector has begun 2012 on a firmer footing following a year in which supply chain disruptions emanating from March’s earthquake and flooding in Thailand disrupted firms’ production plans. However, the survey findings paint a relatively flat growth picture, and demand for Japanese manufactured goods remains muted. Although new business and new export orders both returned to growth in January, rates of expansion were marginal. Companies cited sluggish demand from China and Europe as the principal drag on new export order growth. Some respondents also mentioned persistent yen strength, which made the cost of imported items relatively cheaper and by doing so contributed to an easing in the pace of input price inflation to a 15-month low.”

 And finally, even while the US manufacturing sector continued to grow in January, the momentum behind the expansion remained far weaker than in earlier post-recession activity bursts.  Hence the substantial fiscal deficit plus the promise of keeing interest rates near zero till at least the end of 2014 are still having a hard time producing output growth, with the implication that the Economic Cycle Research Institute US Recession call may not turn out to be as "loony" as many appear to think it is.