Tuesday, September 13, 2011

A Big Fat Greek Divorce?

Christine Dobby of the Financial Post reports, Pondering a big fat Greek divorce:

Fears Greece will ultimately default on it debt roiled global markets on Monday leaving analysts scrambling to assess how it could unfold and what it might mean for the euro.

Efforts to keep the country afloat through bailouts and austerity measures continue, but Filippos Sachinidis, Greece’s deputy finance minister, said Monday its cash will run out in October.

With Germany pondering whether to keep propping up the struggling nation’s economy or pour its capital into its own banks to stave off exposure to Greek debt, the Mediterranean country’s fortunes are decidedly uncertain.

Against this backdrop, many are wondering about Greece’s place in Europe’s economic and monetary union and how it might exit, if at all.

“The talk of Greece being booted out of the eurozone will probably escalate,” said Marc Ostwald, foreign exchange strategist at Monument Securities Ltd. in London, England. “Once it’s defaulted, and given the likelihood of a seismic impact, I can’t really see anything else happening.”

However, Mr. Ostwald noted that there is no mechanism in the 1992 treaty that created the European Union to force any country out.

“And this is where it becomes inordinately complicated. Will they be pushed or will they go of their own accord? I think it’s a little bit academic,” he said.

Lena Komileva, global head of G10 currency strategy at Browns Brothers Harriman & Co. in London, England, agreed the odds of a Greek exit are high.

“A Greek default would bring back the risk of euro breakup,” she said.

But the pan-European economic marriage was not created with a possible divorce in mind.

“There’s really no exit clause written into these things. This was supposed to last forever,” said Michael Gregory, senior economist with the Bank of Montreal Capital Markets. “No one ever talked about ‘What happens if?’”

Mr. Gregory said if Greece does opt to leave the euro and reinstitute the drachma, the new currency will likely depreciate sharply from whatever level is initially established, providing both a small boost and a shock to the local economy.

“It’s almost unthinkable to go back to that, but as we’ve discovered over the past few years, you have to think about the unthinkable,” he said.

Whatever Greece’s position in the eurozone, if it defaults, the entire European banking sector is likely to take a beating.

“The big worry we have around the world is the contagion effect. Not so much through other countries defaulting but through the global banking system. That’s where the vulnerabilities lie,” Mr. Gregory said.

He noted that a Greek default alone — never mind the possibility of Irish, Portuguese, Spanish or Italian defaults — would be a major shock.

“Banks have been preparing for these kind of contingencies in Europe but still, like anything, the actual event happening would be a shock to investor confidence and business confidence,” he said.

“I think investors are beginning to hedge their bets a bit, which is why you’re seeing European bank stocks under pressure.”

Peter Morici, a professor at the Robert H. Smith School of Business at the University of Maryland, said a Greek default may be manageable on its own but it may not end there.

“What happens if you have several defaults? Will the European Central Bank be able to put $2-trillion on the books of the European banks the way the Federal Reserve put it on the books of U.S. banks? I don’t think they can.”

The banking sector is already under significant strain. While the non-financial sector of the eurozone equity market has fallen about 18% since the start of the year, the financial sector has lost about 37%, John Higgins, an analyst with Capital Economics, said in a note Monday.

On a positive note, however, Mr. Higgins noted that German banks have already priced in a lot of the bad news around faltering European economies.

“It seems quite likely that the banks will have significantly reduced their exposure to these sovereigns since the beginning of the year,” he said.

Those holding Greek government debt through bonds, however, are not likely to recover much of their investment if the country defaults.

“Recovery rates in a debt default never tend to be much more than 35% to 40%,” Mr. Ostwald said.

Mr. Ostwald noted, however, that the long-term outlook for the euro might be more positive, with Greece out of the picture.

“If you start kicking out all the weaker members, it could actually rebound quite sharply. In the first instance, I think the knee-jerk reaction would be a big sell-off.”

The initial chaos would likely last for months, he said.

I beg to differ with Mr. Oswald. The long-term outlook of the euro is not positive if you kick Greece out of the eurozone. Speculators will then move on and attack Italy, Spain, Portugal and after you kick out the so-called "PIIGS" all you are going to be left with is France and Germany.

I said it before and I will say it again, Greece must be part of the eurozone. Forget the fact that Greece is the heart of Europe, that Europe is forever indebted to Greece for reasons that go far beyond economics and finance, the truth is if they let Greece go, they're screwed and they know it.

But as Greece teeters on the edge of insolvency this week, Doug Saunders of the Globe and Mail reports that worries about Europe’s ability to hold its currency union together have shifted from a debt-crippled Greek economy to a German government that appears to be withdrawing from its economic responsibilities:
News on Monday that Greece is within weeks of running out of cash, and that Berlin is increasingly willing to allow Athens to fail, sent both the euro and European markets tumbling, with the German DAX down more than 2 per cent, France’s Cac falling 4 per cent and the euro falling to a 10-year low against the yen.

Greece is preparing last-ditch emergency measures this week, including a one-shot property tax, in a desperate bid to prevent an insolvency when the country runs out of cash in mid-October, and appears unlikely to meet the conditions for its next emergency loan.

Berlin has chosen this awkward moment to become embroiled in a highly charged political crisis over its response.

The shift was signalled on Friday, when Gunther Oettinger, the top German representative in the European Union, proposed that a bureaucratic invasion force be sent from Brussels to Greece to seize the struggling country’s assets “without regard to resistance.” (Mr. Oettinger also suggested that Greece and other debtors be forced to fly their flags at half-mast in Brussels.) Berlin papers characterized the proposal as a UN-style “blue helmet” operation; Greeks likened it to Germany’s Second World War invasion.

The same day, the German representative on the European Central Bank resigned, apparently in protest against emergency bailout purchases of troubled countries’ bonds. Most economists agree that far more such purchases are needed to stabilize the euro – along with a far looser interest-rate policy, something Germany has also resisted.

Then, on Sunday, officials close to Chancellor Angela Merkel’s Finance Minister, Wolfgang Schauble, suggested the forced “drachma-ization” of Greece – removing the country from the 17-nation euro bloc and reverting it to its former currency – was a plausible solution, even though such a move at this moment would devastate Greece and its neighbours and damage European banks.

On Monday, Ms. Merkel’s Economy Minister, Philipp Rosler, said “an orderly bankruptcy of Greece” should be considered – a day after Greek Prime Minister George Papandreou stood up to 20,000 protesters and vowed to do everything necessary to keep his country in the euro.

It is now apparent that many German leaders have given up on the project of keeping the euro together. This is deeply inconvenient timing, at a moment when most economists agree that any stable solution to the euro would require a far deeper engagement by Germany and other major economies, including big initiatives to share debt and fiscal instruments with their euro zone neighbours.

“It is not very helpful if German government members start talking out loud about a Greek insolvency,” the German edition of the Financial Times warned on Monday. “Even those members of the coalition who are skeptical … should have realized by now that such debates produce exactly the opposite of stability in the euro zone.”

While Ms. Merkel made efforts on Monday to tone down the increasingly hostile rhetoric of her colleagues, the core issue remains her government’s lack of political will. It is a problem that has persisted from the beginning, when Europe issued a €110-billion bailout to Greece early last year. Germans, and sometimes also French, insist on seeing the crisis as one of irresponsible southern countries imposing themselves on their wealthy neighbours.

By choosing to punish Greece rather than helping build a sustainable economy within the 17-nation currency union, Ms. Merkel’s colleagues would be denying their own deep responsibility in the crisis.

From the beginning, Germany used the initial strength of the deutschmark to position itself as the chief exporter and lender to its poorer neighbours, creating a situation where debt and obligations were piling up in the periphery.

Greece will never be able to escape the cycle of deepening debt and austerity measures until it is able to return to economic growth, or at least to stability. Instead, the opposite is happening: Rather than contracting by 3.8 per cent this year – the number upon which bailout plans were based – Greece’s economy is projected to plummet 5.3 per cent.

The large and patient investments required to turn Greece around would allow Mr. Papandreou to finish restructuring the economy without facing an immanent collapse. They would shore up the finances of neighbouring countries and reassure investors. And they would stabilize German banks and allow the euro’s members to find a path to stability and recovery some day.

“What was ignored for 10 years can’t be fixed overnight,” Ms. Merkel said Monday in a moment of considerable wisdom. “That means that we have to be patient.”

But, in general, large and patient investments are falling away from Berlin’s vision. The mood has turned to quick and decisive punishments, damn the consequences.

Right now Berlin has no vision. What really shocks me is that Germans, which already have a huge stake in the Greek economy, are not thinking long-term focusing on renewable energy projects in Greece and other investments which will pay off over the long-run. Instead, the rhetoric coming out of Germany is putting everyone on edge.

Importantly, as one twitter commentator wrote, markets are punishing European disunity. European politicians are looking increasingly incompetent and dangerously ignorant of what is at stake here. And as I stated in my last comment on the final chapter of this Greek tragedy, austerity isn't working in Greece; it will only ensure debt deflation and throw the country into an economic abyss. Ironically, with every new austerity measure, including the latest one which is dubious, the market keeps pricing in near certainty of a default.

I want the German, French and US policymakers reading this comment to get it through their thick skull: there is simply no choice in the short-run but to allow the ECB to do exactly what the Fed is doing but to do this, you need a fully functional eurobond market backed up by Germany and France. According to the French magazine Challenges, the latest news is that Merkel is prepared to give a green light to eurobonds.

I certainly hope so because Europeans have been dragging their feet far too long on this eurobond solution. Never mind what Ray Dalio and other skeptics claim about "kicking the can down the road," the market is demanding solutions and fast and succinct action. Importantly, if Europe doesn't get its act together, Carl Weinberg, the chief economist at High Frequency Economics is right, the debt crisis will lead Europe into a depression that will mean soaring unemployment, deflation and zero interest rates for the foreseeable future:

The true cost of a euro zone default is impossible to know beforehand due to the huge amount of CDS (credit default swaps) that have been written, according to Weinberg.

"This is a shock that easily spread around the world quickly, as did the hit from Lehman," he said.

Having spent 2 years offering up solutions to the crisis that have fallen on deaf ears, Weinberg has been looking at how the European Central Bank and national governments can react at this point.

"The most important thing the ECB can do at this time is to use its repo facility to ensure that all banks have enough cash to operate regardless of their short-term solvency or longer-term prospects," he said.

"The ECB will have to buy a dominant position in all PIIGS bond markets, sterilize those purchases by absorbing cash, and then return that cash to banks in long-term repos," said Weinberg, who expects such a move to add 2 trillion euros to the ECB's balance sheet.

Given the euro zone has so far balked at creating some kind of TARP fund and cannot even agree on the scale of the European Financial Stability Fund, Weinberg said governments will have to come up with individual schemes to recapitalize the banks.

"Not all will be able to do so. For stronger fiscal players, like Germany and France, funding can likely be found to create national banking support systems," said Weinberg, who believes attempts at fiscal consolidation be "torn asunder".

For the PIIGS, things will much tougher. "If the IMF can invent a facility to lend money to bankrupt governments with no hope of repayment, it may be able to help," he said. "Otherwise, most PIIGS banks will fail, and no credit at all will be available in these countries."

This will mean cold turkey with governments forced to live within their means, according to Weinberg.

"Let the Tea Party in the United States watch this experiment carefully," said Weinberg who believes such action would mean far lower government spending, incomes, demand and employment.

With US and UK banks likely to have big on and off balance sheet exposure, Weinberg warns all they can do is prepare for the worse.

"There is no place to hide from this, at least not in the Euroland. German banks are no safer than Greek ones in this disaster scenario. The myth that bunds are a safe haven from Euroland debt woes will be proven wrong the minute the first German bank announces that it needs public help to recapitalize it," he said.

Gold will offer the safest haven, according to Weinberg, who fully expects Europeans to move cash under their mattresses in early phases of this crisis.

"The beneficiaries of this flight of cash out of Euroland will be the hot economies of Asia, notably China, India and Korea." said Weinberg.

Remember my central thesis following the 2008 crisis: central bankers, policymakers and financial oligarchs will do whatever it takes to avoid another financial meltdown and a prolonged period of debt deflation. That's why I continue to trade risk assets and I'm short gold and volatility even though it feels like the world is about to blow up.

Just more "shock and awe" so the wolves on Wall Street can feast and expand their profits. The run on the euro is getting overdone, and despite the rhetoric coming out of Germany, I think Europeans would be completely and utterly embarassed if they kicked Greece out of the eurozone, setting off a possible debt domino that would lead to to breakup of eurozone as we know it. At the end of the day, Germans will swallow their pride and bite the Greek bullet. If they don't, they will look like total fools and shoot themselves in the foot.

Finally, Andreas Koutras sent me an interesting comment on Greece which he wrote for In Touch Capital Markets. I urge my institutional readers to register and read that comment carefully, especially the scenarios he goes over. Andreas also shared this thought:"QE is not allowed by the constitution of the EU and the problem with sterilizing is that after 400bln the ECB loses the monetary policy. i.e. there is more money in the system and banks dont rely on the ECB for cash. Therefore no more repo!".

Not sure about that. At the end of the day, there is no choice but to make the necessary changes to the EU constitution and introduce eurobonds. Most divorces are messy, which is why I continue to believe that the big fat Greek debt swap which played a big part in this debt crisis will not lead to a big fat Greek divorce. There is simply too much at stake for the global economy if they let Greece sink. Anyone who thinks otherwise better be prepared to live with volatile markets dominated by large speculators who are already preparing to attack the sovereign debt of their next victim. The only endgame from booting Greece out of the eurozone is deflation and depression, not just for Greece and Europe, but for the rest of the world.

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