Monday, May 3, 2010

Quick Fix or More Quack Remedy?

Rehan Syed, head of portfolio management at the ABN AMRO Private Bank in Dubai. writes in UAE's The National, Quick fix for Greece is more a quack remedy:

When it comes to the debts of distressed countries such as Greece, a quick fix is a quack fix.

I view the optimistic news of Greece’s bailout through a pessimist’s filter: it is but a stopgap solution to a profound problem that is likely to recur. The big question remains: how will Greece, whose debt well exceeds its GDP, and other free-spending nations such as Portugal, Spain and Italy, which are the next-weakest links in the EU chain, squash their debt to safe levels? Will this southern quartet of desperate debtaholics” quiver for another quick fix after wallowing for a few more years in their uncompetitive stasis? I label the EU-IMF quick fix “my big fat Greek Band Aid”. Such aid, in the absence of extensive economic restructuring, can only delay the day of reckoning.

Meanwhile, Germany, the soberest sailor in a world of inebriated indebtedness, has signalled its sentiments: not only that it has minimal sympathy for Greece but also that the other wayward southern nations should not expect quick bailouts should they find themselves in a corner like Greece’s. Germany was goaded because it is the strongest economy in Europe, having toiled tirelessly for the past half century to build an enviable export platform that has helped it regain its Teutonic strength.

The creditors are counting on the Greeks to summon unprecedented political will to pursue severe austerity measures, pay higher taxes and reduce bureaucratic torpor to invigorate business activity. Even in the unlikely event that all three actions are accomplished over the next three years, the core problem of the structural uncompetitiveness of Greece and other southern European economies remains, which suggests dreadful sequels to the current drama.

When debt of this magnitude mounts in economies as uncompetitive as these, there is a real risk of the situation degenerating into a debt trap and eventual default, as occurred with Argentina last decade. So, did it make sense for Germany and others to throw good money after bad? Also, the domino theory drives the fear of moral hazard: will this Greek bailout prompt similar handouts to Portugal and Spain tomorrow?

Perhaps if Greece had defaulted, as some experts dared it should, it would have gained breathing space to coerce reform and restructuring upon its coddled citizens, and eventually earn its way back into the EU’s graces.

Much of the Greek debt is held by European institutions and a default with a sizable haircut would have punched a hole through the balance sheets of many, an eerie resemblance to Lehman’s demise, and which would require a bailout of a different set of “too big to fail” corporate targets. Nevertheless, by painfully shifting the moral hazard of bad debt from the sovereign level to the corporate level, it would ultimately benefit the EU’s debt management capabilities. But the bailout die has been cast and the onus is now on the Greeks to execute with austerity to benefit posterity.

Uncompetitiveness is rooted in the lack of political will. It did not appear overnight and will not be resolved quickly either. Even before it joined the European Monetary Union in 2001, Greece’s fiscal deficit was higher than the tolerance threshold of 3 per cent of GDP. With competition mounting over the past decade from clever and cheap Asian rivals, compounded by the unhelpful rise of the euro, Greece and its southern European cousins are likely to remain under both cyclical and secular pressure. The competitive reality is that too many countries are relying on an export-led model to grow.

The burden of excess sovereign debt is a global challenge of historic proportions, which has been festering slowly due to the lack of political will to run a balanced budget. For example, looking back at halcyon 2007, the US had been running a fiscal deficit for a majority of the previous two decades, thus unsurprisingly accumulating a debt-to-GDP ratio of more than 60 per cent. For the next few years, the US is projected to run fiscal deficits of somewhere between US$1.5 trillion (Dh5.5tn) and $2tn per year, which is more than 10 per cent of GDP. This would drive its ratio up from about 85 per cent today to about 110 per cent by mid-decade.

The Europeans, too, failed to save for the rainy years. France and Germany, which label themselves as the responsible EU members, had debt-to-GDP ratios of about 65 per cent after a prosperous decade ending in 2007, exceeding the EU’s Maastricht Treaty threshold of 60 per cent.

Broadly, across the euro zone, the fiscal deficit next year is expected to average 7 per cent of GDP, which exceeds the EU recommendation of 3 per cent of GDP, and the debt-to-GDP ratio is expected to climb to about 120 per cent by 2015, double the Maastricht-set safe level. If that bleak forecast materialises, the Europe of tomorrow might look like the Greece of today.

In our backyard, Dubai, where debt-to-GDP ratio is not dissimilar to that of Greece, was fortunate to get a big Band-Aid fix from Abu Dhabi but will now need to reinvent its business model to restore growth. Both Greece and Dubai need to cut the cost structure, enhance competitiveness and rev up revenue to a level where positive cash flow is generated to pay down debt to safe levels. Both need to act far faster and smarter than has been publicly proclaimed – but is there the political will needed to push through the prerequisite policies? If Greece and Dubai had control of their currencies, a speedy solution might be devaluation, which could quickly restore competitiveness. Lacking such a policy tool, a more likely outcome would be slow and grinding deflation, as recently experienced by Portugal, which, if accompanied by an undifferentiated and uncompetitive business model, would only drive the economy deeper into debt.

Greece’s bailout was undeserved but happened anyway because the stronger European nations were too nervous about collateral damage to allow default. But by solving one problem have they created another?

Analogies abound: by bailing out Long Term Capital Management in the late 1990s, the US central bank created a moral hazard that amplified the housing bubble; cleaning up Japan’s zombie banks a decade ago might have averted the long and difficult dance with deflation; most recently, bailing out Bear Stearns created false comfort and worsened the impact of the credit bubble when Lehman failed.

Had the unspeakable occurred, which is to say, had Greece defaulted, it would have reduced debt faster by forcing a haircut upon creditors, sent a stiffer must-do message to its indolent civil servants and opened up valuable political space for radical economic restructuring.

Creditors hope such bitter medicine will be administered anyway, and time will tell if the citizenry finds it sufficiently palatable. So, what investors will now count on is precisely that which has been absent thus far: the political will to catalyse the change and endure the pain.

Investors remain skeptical as evidenced by the fact that the euro dropped despite the bailout package. Watching the news out of Greece, I'm also skeptical that these measures will pass as Greek workers step up the fight against austerity.

And troubles in southern Europe are hitting home for many of the 2.4 million Canadians with origins in Greece, Portugal, Italy and Spain. And they loathe the PIGS acronym (I hate that acronym too).

Finally, all is not well here in Canada. Writing for the National Post, Stephen Donald argues that pension reform should focus on the modest and middle-income private-sector worker because a “go slow” approach will not work.

On Monday, Canada's Minister of Finance, Jim Flaherty, proposed changes to federally regulated private pension plans that will "enhance protection for plan members, reduce funding volatility and modernize the rules for investments by pension funds":

The changes proposed today are in respect of regulation and complement the legislative changes in Bill C-9, which was introduced in the House of Commons on March 29, 2010. These changes are part of the comprehensive package of reforms announced on October 27, 2009.

“The volatility in financial markets in recent years has shown us that changes are needed to enhance protection for plan members and modernize the rules for pension fund investments,” said Minister Flaherty.

The amendments to the Pension Benefits Standards Regulations, 1985 include:

  • A new standard that uses average—rather than current—solvency ratios to determine minimum funding requirements. This will soften the impact of short-term market fluctuations on a plan’s solvency funding requirements.
  • Limiting contribution holidays unless the solvency ratio exceeds full funding plus a new solvency margin, set at a level of 5 per cent of solvency liabilities. The practice of taking contribution holidays was widespread in the past and added to the underfunding of pension plans.
  • A modernized investment framework that removes the limits on the amounts pension plans can invest in resource and real property investments. This will offer greater latitude in building a prudent fund portfolio.

“These amendments will allow sponsors to better manage their funding obligations and give them greater flexibility in terms of investment allocation, in order to fulfill their funding obligations,” said Minister Flaherty.

The amendments are being released for public comment. As I stated at the Senate Standing Committee on Banking, Trade and Commerce, forget contribution holidays unless the solvency ratio exceeds full funding plus a new solvency margin, set at a level of 25% of solvency liabilities, in line with the Income Tax Act limit.

But these "quick fixes" will do little to shore up Canada's pension system. Just like Greece, we are headed down the wrong path. Our day of reckoning will eventually arrive, and when it does, public sector workers will feel the same pain that Greek pensioners are feeling now.

To believe otherwise is to delude yourselves that this global pension Ponzi scheme will go on forever. It simply won't, and that is something you should all be preparing for now that times are good. If you wait for a Greek catastrophe to strike, it will be too late.

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