Monday, February 15, 2010

A Big, Fat Greek Swap?


First, let me correct a mistake I made in my previous post on the Greek fiscal crisis and neoliberal oligarchy. My stepfather wrote me from Brussels where he heard straight from the Greek finance minister that military spending accounts for roughly 4% of GDP, not 15% as was originally written in my previous post. I verified this statement and it is correct: Greece directs approximately 4.3% of its GDP to military expenditures. I apologize for this mistake.

Greece continues to be the hot topic in financial circles. In his Contrarian Chronicles, Bill Fleckenstein asks A big, fat Greek bailout?, and concludes:
As an aside, I think Greece itself is probably less of a problem than California and some other U.S. states might be -- though for the moment, the fact that we as a country have a printing press and no rules governing its use is carrying the day.

Perversely, when you've got a printing press running full throttle (as do the U.S., the United Kingdom and Japan), you can be as irresponsible as you want to be and your credit will be fine. But try to enforce a little bit of discipline, as the European Central Bank is attempting to do, and things go kablooey. As such, the PIIGS' predicament continues to push people toward the dollar.

Exactly how the situation sorts out is not knowable at this juncture, due to the myriad permutations involved. However, though it might be difficult to imagine that Europe's disparate nationalities will be able to row in the same direction, it seems unlikely that they won't. Consider how hard everyone worked to put the system together in the first place. In any case, whatever comes out of Europe on this score is sure to be a market mover one way or the other, or maybe both. A bailout plan for Greece was announced Friday, but the details were sparse.

Over at Project Syndicate, there were many excellent articles on Greece and the European Monetary Union. Nouriel Roubini writes on Teaching PIIGS to Fly and states:

Loan guarantees from Germany and/or the EU are less desirable than an IMF program, as it is very hard to design and credibly implement conditionality in such guarantees. IMF support, on the other hand, is paid out in tranches and is conditional on achieving various policy targets over time.

The Greek authorities and the EU had until recently denied the need for financing, owing to concern that it would signal weakness and create a stigma. That was a grave mistake. Fiscal adjustment and structural reform without financing is more fragile and liable to fail without a war chest of liquidity to prevent a run on public debt while the appropriate policies are implemented and gradually gain credibility.

At the same time, if Greece does not fully adjust its policies to restore fiscal sustainability and competitiveness, a partial bailout by the EU and the ECB will still be likely in order to avoid the risk of contagion to the rest of the euro zone and the consequent threat to the monetary union’s survival. A default by Greece, after all, could have the same global systemic effects as the collapse of Lehman Brothers did in 2008.

Sovereign spreads are already pricing the risk of a domino effect from Greece to Spain, Portugal, and other euro-zone members. The EU and the ECB are worried about the moral hazard of any “bailout.” But that is precisely why a credible IMF program that ties financial support to the progressive achievement of fiscal and structural reform goals is the right way to teach Greece and the other PIIGS how to fly.

Professor Roubini is a smart guy but if he thinks German/EU loan guarantees are less desirable than IMF financing and fiscal austerity, he is simply nuts. Accepting IMF financing is effectively "the kiss of death" if you're Greece.

Consider Ken Rogoff's comment, Can Greece Avoid the Lion?, where he writes:

A debt crisis is not inevitable. But the government urgently needs to implement credible fiscal adjustment, concentrating not only higher taxation, but also on rolling back some of the incredible growth in government spending – from 45% of GDP to 52% of GDP – that occurred between 2007 and 2009. The government must avoid relying too much on proposals for tax increases, which ultimately feed back on growth and sustainability. It would be far preferable to balance tax increases with some reversal of runaway government spending.

I have Greek friends who say that Greece is not alone. And they are right. Some countries are almost inevitably going to experience bailouts and defaults. One of the more striking regularities that Reinhart and I found is that after a wave of international banking crises, a wave of sovereign defaults and restructurings often follows within a few years.

This correlation is hardly surprising, given the massive build-up in public debts that countries typically experience after a banking crisis. We have certainly seen that this time, with crisis countries’ debt already having risen by more than 75% since 2007.

But, whereas we are likely to see a wave of defaults and IMF programs this time, too, fiscal meltdown does not have to hit every highly indebted country. Indeed, what a country like Greece should be doing is pulling out all the stops to stay clear of the first and second wave of restructurings and IMF programs. If it can, then perhaps watching other countries suffer will help convince the local political elite to consent to adjustment. If not, Greece will have less control over its adjustment and potentially experience far greater trauma, perhaps eventually outright default.

There is an old joke about two men who are trapped by a lion in the jungle after a plane crash. When the first of them starts putting on his sneakers, the other asks why. The first answers: “I am getting ready to make a run for it.” But you cannot outrun a lion, says the other man, to which the first replies: “I don’t have to outrun the lion. I just have to outrun you.”

Greece has yet to put on its sneakers, while other troubled countries, such as Ireland, race ahead with massive fiscal adjustments. Greece’s new Socialist government is hampered by campaign promises that suggested the money was there to solve the problems, when in fact things turned out to be far worse than anyone imagined. Unions and agricultural groups tie up traffic with protests every other day, hinting at possible escalation.

Most Greeks are taking whatever action they can to avoid the government’s likely insatiable thirst for higher tax revenues, with wealthy individuals shifting money abroad and ordinary people migrating to the underground economy. Greece’s underground economy, estimated to be as large as 30% of GDP, is already one of Europe’s biggest, and it is growing by the day.

In the case of Argentina, a pair of massive IMF loans in 2000 and 2001 ultimately only delayed the inevitable harsh adjustment, and made the country’s ultimate default even more traumatic. Like Argentina, Greece has a fixed exchange rate, a long history of fiscal deficits, and an even longer history of sovereign defaults. Nevertheless, Greece can avoid an Argentine-style meltdown, but it needs to engage in far more determined adjustment. It is time to put on the running shoes.

In his comment, Europe's Trojan Horse, Barry Eichengreen writes:

All of this raises the obvious question: Was the real mistake creating the euro in the first place? Since I was one of the few Americans to advocate a single European currency, you would be justified in asking: Am I having second thoughts?

My answer is no, creating the euro was not a mistake, but it could still be a mistake in the making. The Greek crisis shows that Europe is still only halfway toward creating a viable monetary union. If it stays put, the next crisis will make this one look like a walk in the park.

Completing its monetary union requires Europe to create a proper emergency financing mechanism. Currently, other member states can provide assistance to Greece only by bending the rules, which prevent them from lending except in response to natural disasters or circumstances beyond a country’s control. This heightens uncertainty. When Europe’s leaders do help, it makes the public and markets think that they are being dishonest. If it is the Lisbon Treaty that creates these problems, then the Lisbon Treaty should be changed.

Moreover, assistance should come not just with conditions, but with temporary control of the national budget by a committee of “special masters” appointed by the European Union. Mere promises by the recipient, history tells us, are not enough.

No doubt, countries to which these measures are applied will express outrage. Well, no one is forcing them to take the money. Worried about moral hazard? Here’s your solution. Note also that this would also be a much more effective disciplining mechanism than the defunct Stability and Growth Pact.

You might well ask: how would Californians feel if their state was forced to turn over its budget temporarily to a special master appointed by President Barack Obama’s administration? Actually, they would probably feel okay.

The special master would not be a fellow Californian, but he would be a fellow American. People would understand that he was acting in the interest of the state as well as the country. They would also be reassured by the fact that California sends representatives to Washington, D.C., where the special master’s marching orders would be issued.

Europeans don’t do these things because they see themselves as Greeks and Germans first. They don’t interfere in the “sovereign prerogatives” of other member states. Germany is especially reluctant, given memories of its World War II conduct, not least in Greece.

Well, if Europe is serious about its monetary union, it will have to get over its past. It needs not just closer economic ties, but also closer political ties. Those running a strong emergency financing mechanism will have to be strongly accountable. They will have to answer to a strong European Parliament.

German Chancellor Angela Merkel’s constituents hate bailouts, because they know that it is they who will be doing the bailing. They oppose anything that smacks of European political integration.

But Germany is not innocent of responsibility for this crisis. It demanded an extraordinarily independent and unaccountable central bank that is now running an excessively tight monetary policy, aggravating the plight of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain). Germany’s enormous current-account surplus aggravates their problems further. Germany has also done too little in terms of fiscal stimulus to support the European economy.

Germany has benefited enormously from the creation of the euro. It should repay the favor. It should push for the creation of an emergency lending facility, and for political integration to make that feasible. It should provide more fiscal support. And who better to press for a more accountable European Central Bank?

The Greek crisis could be the Trojan horse that leads Europe toward deeper political integration. One can only hope.

Finally, the FT reports that the EU demands details on Greek swaps:

A key focus for authorities, according to Mr Altafaj Tardio, would be whether the currency swaps, a derivatives transaction, had been calculated based on prevailing market rates.

Goldman Sachs, Morgan Stanley, Deutsche Bank and other investment banks arranged complex transactions that enabled the Greek government to raise cash for budget spending without having to classify the proceeds as public debt.

One of the biggest of such deals was a securitisation in 2001 in which Greece raised €2bn backed by grants the finance ministry expected to receive from EU structural funds.

Italy, Spain and Portugal used similar forms of off-balance sheet accounting as they sought to keep their budget deficits within the 3 per cent of gross domestic product mandated by the eurozone.

The Commission said on Monday that the Greek government failed to disclose information about the currency swaps to a Eurostat team that visited Athens in September 2008 to monitor Greece’s debt management.

But Greeks with knowledge of a 2002 currency swap and a series of asset-backed securitisation deals – all carried out under the previous Socialist government that held power between 2000 and 2004 – disputed that contention.

“Eurostat knew all about these deals, which were perfectly legal at that time. We didn’t keep them secret,” said a former senior Greek finance ministry official.

George Papaconstantinou, Greece’s finance minister, told a meeting of the European Policy Centre think-tank: “The kind of derivatives contracts that are being reported by some newspapers were, at the time, legal and Greece was not the only country to use them. They have since been made illegal, and Greece has not used them since.”

He added: “The current government has neither mandated not considered any instrument which is not compliant with Eurostat rules.”

A Eurostat representative declined to say which transactions were subject to the group’s request, or whether it was focusing on the work of specific banks.

The focus on Wall Street, first detailed in a New York Times report, came as the Commission on Monday moved to tighten control over member states’ book-keeping. It approved proposals that would strengthen Eurostat’s hand to audit governments’ finances and ensure they provided accurate data. Those measures will now go to the European Council for consideration.

Tyler Durden and Marla Singer over at Zero Hedge have done a masterful job going over the interplay between the rating agencies and the rating of the Goldman underwritten swap agreement securitization SPV known better as Titlos PLC. It's an absolute must read analysis.

It also makes me wonder whether Goldman called its preferential clients (big global macro hedge funds) ahead of the debacle to warn them of the upcoming triggers that would rattle the euro, Greece and the PIIGS's sovereign debt markets. I am looking forward to seeing whether Spain's probe into CDS/FX speculative trading uncovers any inappropriate trading. Stay tuned.

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