October 29, 2011

The EuroZone Crisis and Wednesday's Summit Agreement

Taken primarily from The Daily Capitalist:

Some take-aways of the EuroZone crisis and Wednesday’s summit agreement:

  1. It isn’t over.
  2. The European Monetary Union’s (the “EMU”) is a failure.
  3. They spent too much (and it still wasn’t near enough) and can’t possibly repay the debt.
  4. Banks will need to be bailed out.
  5. They will print money.

In order to understand the EU summit “breakthrough” we need to understand how the players in the EuroZone look at it. Last week a leaked confidential assessment of the problem that was prepared by the IMF was published by Linkiesta’s Fabrizio Goria. The document revealed the IMF’s private assessment of Greece and the requirements for a bailout.

Here is a summary of how the IMF sees the problem:

  1. The Greek economy is increasingly adjusting through recession and related wage-price channels, rather than through structural reform-driven increases in productivity. This is due to “administrative capacity limitations in the Greek government” which is a diplomatic way of saying that the Greek government can’t pull off the reforms.
  2. In keeping with experience to date under the program, it is assumed that Greece will take longer to implement structural reforms, and that a longer timeframe is necessary for them to yield “macroeconomic dividends” (i.e., economic growth). They paint a dismal picture as Greece falls into a severe recession.
  3. Greece won’t raise as much money as projected through privatization of public assets. Through 2020, total privatization proceeds would amount to €46 billion, instead of the €66 billion assumed.
  4. They assume that Greece will run fiscal surpluses starting in 2013 but note that it requires “sustained and unwavering commitment to fiscal prudence by the Greek authorities."
  5. They won’t be able to return to private markets to finance their debt until after 2020. This will require “official financing” (i.e., a bailout from the solvent eurozone members) of €252 billion through 2020.
  6. They are very concerned that Greece will not meet these targets because their economy and government is not robust enough to withstand economic shocks (low growth, high interest rates), thus throwing off the entire projection on which the bailout is based. If this occurs, then Greece may not be able to go back to the markets to refinance its debt until 2027.
  7. In order for Greece to have “sustainable” debt levels, the following needs to happen:
    1. Generous official support (up to €440 billion under the worst case scenario), and
    2. At least a 50% haircut to their debt, which requires cooperation from its private bank creditors. This would get Greece down to a debt level of 120% of GDP by 2020. Under the worst case scenarios, they see the debt level rising to 208% of GDP.
  8. Another requirement is €30 billion of support for creditor banks to recapitalize.

As you can see, these policy conclusions are based on assumptions that someone in the IMF just made up. Anyone that’s seen the riots going on in Greece or who’s read anything about the situation there knows that the Greek people have no intention of making any concessions with regard to their “promised” standard of living (the problem with socialism is that you eventually run out of other people’s money). Like all projections, especially ones going out more than a few years, they are fictions and are impossible to verify or have any confidence in. Yet, if you look at these assumptions, this is what the summit participants are basing their agreement on.

Here is what happened Wednesday at the summit:

The European Financial Stabilization Facility (the “EFSF “) will issue bonds over-guaranteed by EMU members. These bonds will be issued in exchange for the Greek bonds (which are, in effect, in default). They will also be used to back the bonds of Spain, Italy, Portugal and most probably others – it just depends upon what timetable one is talking about operating under.

In order to get all member guarantors in line, the deal had to include bond creditors taking a 50% hit.

The private bank creditors were never really happy about this. It does several things to them (not the least of which is an earnings hit), but mainly it also reduces their Tier 1 capital - any EMU sovereign bond may be counted as Tier 1 capital at face value no matter what the market value is. And now, by taking a 50% haircut, the banks need to boost their core capital.

Late Wednesday night in direct talks with Angela Merkel, Nicolas Sarkozy, and the IMF’s Christine LaGarde, the chief negotiator for the Institute for International Finance, the bankers’ lobbying entity, reached an agreement with the group. In exchange they got several assurances. One of them is that they would get €30 billion of “official funding” to help stabilize their Tier 1 capital. One estimate says they need €106 billion of additional capital (two-thirds of which is related to Greece, Spain and Italy). They will be required to have a 9% Tier 1 capital ratio by July, 2012. They also got assurances from their respective governments that they would not be allowed to fail. Remember that they have also financed other sovereigns on the brink. It was literally a game of chicken and they blinked when threatened with Greek default, which could spread to other sovereigns whose debt they hold.

For the Greeks, they get a temporary reprieve and a total of €130 billion of additional funds (up from €109 billion). They are supposed to reduce debt to 120% of GDP by 2020 (per the IMF assessment) and carry out structural reforms. 120%! It will soon be apparent that this target will never be achieved.

All of the parties know that the €440 billion won’t be enough. So the French are out raising money from non-EMU members with the hope they can increase the fund from €780 to €1 trillion. Thus their trip to China to beg Hu Jintao for money. The Chinese are experiencing a kind of schadenfreude over this whole thing, secretly enjoying their new power role in international finance as the Europeans go hat in hand to them for contributions for the EFSF. And it’s just mind-boggling that China is now perceived as a rescuer after they have very willfully and meticulously destroyed the manufacturing economies of the U.S. and Europe. China has said they will contribute, but they have also said they want something in return: Stop complaining about the Chinese currency exchange rates. The Chinese fear that their “contribution” will be perceived as a bailout of the West and that won’t be popular with Chinese citizens. They are entirely correct in that assessment.

The bottom line is that the Europeans are piling debt on top of debt, except that the new bonds will be paid on demand with the sovereign guarantees of EFSF. This is not popular with German and French taxpayers since they will account for almost 50% (48.51%) of the Facility. Add in Italy’s 18% and these three countries are on the hook for a potential €530 billion. Don’t think for a moment that this won’t have repercussions for every politician come election time.

You can be assured that ultimately some part of this will be monetized by the ECB. Presently they have bought €169.5 billion euros in bonds so far, starting with Greece, Ireland and Portugal last year, then extending the coverage to Italy and Spain in August. This little detail wasn’t mentioned in the summit statement. Yesterday, Jean-Claude Trichet’s ECB successor, Italy’s Mario Draghi said the ECB remains “determined to avoid a poor functioning of monetary and financial markets.” Which means they will print if needed.

Don’t expect George Papandreou’s socialist PASOK government to adhere to the agreement. It’s farcical to think that they will come close to meeting their economic targets, even in a best case scenario because they wil not institute the necessary free market reforms that will spur future growth. It will also not be easy to dismantle the elaborate social welfare system there without more political unrest.

And Greece is not the only problem. Spain and Italy are large economies and face similar problems, just not quite on the scale of Greece’s. It all comes down to their ability to fund their excessive debt. Even France is being warned about its credit rating.

The EMU is built on a weak foundation. They allowed in countries that according to the Maastricht Treaty were not supposed to run deficits of more than 3% of GDP, yet they all did, even Germany. They allowed their members to spend and borrow without regard to economic reality and now the money has run out. I think that it’s a foregone conclusion that the EU is going to bail out their debt through inflation by printing money. That’s what countries do, unlike people and companies which default and go through bankruptcy.

It’s a mess. And it’s not over.

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