In this short post I would like to emphasize the important role of the ECB (conditional) commitment for Outright Monetary Operations (OMT) in reducing tail risks and credit spreads in the Euro periphery bond markets. In order to do that I will analyze OMT in terms of option pricing and insurance.

The role and details of OMT are quite well known by now. The main factors that made the commitment so successful (without even having to implement them) were:

  1. The OMT portfolio will be pari passu with private bondholders. As a result, bonds purchases by the ECB do not create a senior debt-holder (as was the case for the SMP portfolio) while remittance of Eurosystem profits due to these operations allows troubled debt countries to effectively earn seignorage income and lower their debt servicing costs.
  2. Operations are conditional on an official bailout (which is usually accompanied by strict conditionality). Since bailouts tend to favor creditors at the expense of domestic citizens (with austerity measures targeting essential government services and private sector wages but usually not capital income and gains) they lower the risk of debt restructuring in the sense of making it much more difficult for the debtor country to prioritize its own citizens welfare. Furthermore, by having the ECB buy a large part of the country’s debt, private bondholders are not subordinated in the same way as a pure ESM bailout.
  3. The fact that the ECB will probably remit its OMT profits back to the debtor country plus the low interest rates in ESM loans (in contrast with the initial high rates of the Greek Loan Facility) mean that a large part of a country’s deficit reduction will come from interest expenses and not from savings in expenses or higher taxes with a much milder result on economic growth (and a positive impact on long-run debt sustainability).

Still a lot of people find it odd that OMT was able to lower spreads by such a large amount without any operations actually taking place in the bond markets. One has to realize that by committing to OMT, the ECB is essentially setting a ceiling on the spread of government bonds (although a bit vague) since any large increase in credit spreads will lead a country to ask for a bailout and an activation of OMT. As a result, a private bond holder is guaranteed that the price of her bonds will not fall lower than a specific floor, since in that case, she will have the option of ‘selling’ them to the ECB. In other words, the ECB is writing a set of ‘free’ put options on Eurozone debt, standing ready to buy bonds at current market prices after the relevant country has requested a bailout.

In order to look into the issue from a more technical angle, lets assume that the bond hazard rate (probability of default in a period conditional on survival until that period) follows an Ito process similar to the CIR process of interest rates (see Filipovic, chapter 13):

hazard processwhere W is a Wiener process. Given this process one can calculate the default probability which (although quite technical) obviously depends on the drift parameters (b,β) but more importantly on the volatility as well. As a result, if volatility is modeled in an autoregressive model such as GARCH(1,1), periods of high bond price volatility quickly lead to higher estimates of default probabilities. Since the default probability can be considered as the Ν(-d2) term of a credit risk put option (with a strike price equal to the expectation of the recovery rate), the model estimated probability can be used for option pricing and bond portfolio insurance.

By insurance I am referring to the policy of creating a synthetic put option (by shorting bonds) in order to insure a bond portfolio from downside risks.This has the advantage that the bond holder does not have to keep a matched book bond position but only short the proportion (determined by the default probability) of the portfolio needed to hedge against the tail risk of default (assuming of course that interest risks have already been hedged through an IRS for instance) while earning all upside gains. An increase in the default probability increases the proportion necessary to hedge the downside risk, a strategy that can create self-fulfilling issues since the bondholders sell when bond prices fall and might face difficulties in borrowing bonds (to short) through reverse repos.

By introducing OMT, the ECB becomes the writer of the above option (something very similar to a CDS) and removes the need for active hedging. This immediately reduces bond volatility (since bondholders do not need to increase their short positions) while a high σ actually makes the option more valuable and pushes bond prices higher. Periods of high volatility (such as the summer of 2012) are immediately followed by a drop in volatility under efficient markets. As long as the ECB commitment is not questioned, Euro bond prices include this put option and permanently increase in price by market forces without a need for any actual ECB operations.

Obviously, the stability of the ECB determination to implement unlimited bond purchases will play a decisive role in the future (given the recent German Constitutional Court case for instance) yet it is clear that at this point, OMT has played a decisive role in minimizing Eurozone tail risks and lowering Euro periphery countries debt costs.

UIP obviously stands for Uncovered Interest Parity. The following is a crude visualization of its explanatory strength. The graph depicts the difference between real 12-month Libor rates for Euro and USD against the change in the US/Euro exchange rate. An increase in the real spread should lead to a Euro appreciation with the two graphs moving in the same direction (data are monthly since January 2007):

real 12m-libor USD euro - exchange rate movement

It is quite evident that the two series are highly correlated (correlation coefficient of 0.65 with R² equal to 0.42). What is very interesting is the fact that the spread is driven by inflation differentials between the Eurozone and the US (as a result of current disinflationary forces in the Euro area), since nominal rates have converged in the two regions:

libor-euro minus libor-usd

Obviously the above graphs are rather crude and a better indicator of future inflation rates would be inflation swap rates. These might help explain recent exchange rate movements (which are not easy to explain in the first graph).

In any case, the relative unwillingness of the ECB to act upon the disinflationary forces in the Eurozone does have its toll on the exchange rate which might negate a large part of the improvement of the RER. How far inflation rates will remain weak is going to play a crucial role on future exchange rate movements.

I find studies of income inequality and economic growth especially interesting since, apart from anything else, they highlight the differences between the neo-classical consensus and the post-keynesian view of the world. In this context I found two papers by Simon Mohun published on the Cambridge Journal of Economics and focusing on income inequality due to supervisory wages growth and on capital productivity long-term movements very enlightening. The fact that the author uses simple accounting exercises instead of relying on heavy econometric work is also quite positive since it keeps the analysis simple and not easily questionable.

The author starts by looking at the evolution of the US profit share (defined as profits to the capital stock) since the early ’60s. The rate is decomposed in the profit share (profits to value added) and capital productivity (value added to the capital stock) using a simple chain rule:

pre-tax average rate of profit profit rate - profit share - capital productivity

What the author then does is to decompose the economy into ‘productive’ and un-productive sectors and the workers into supervisory and non-supervisory employees. It turns out that supervisory workers saw a large increase in their wage share especially after 1980 while non-supervisory workers experienced a large fall in their own share after a mild increase in the 1964-1979 period:

table 5 - growth in shares of MVA

If one expands the ‘capitalist class’ to also include supervisory workers which means that their wages should be included in the profit share, the actual path of the profit share turns out to be quite different than the original series:

profits and supervisory wagesAs a result, the ‘expanded’ profit rate actually shows a significant increase after 1980 with a large part attributed to the expansion of supervisory wages and not only to the increase of capital productivity:

expanded profit rate - profit share - capital productivityWhat should be stressed at this point though is that this expanded profit rate does not provide the financing means for an expansion in investment (which would be naively assumed to be the driver of the increase in capital productivity) but rather is appropriated by the supervisor ‘worker’ class.

In the second paper, Mohun takes a deeper look at capital productivity as well. Keeping with the productive/un-productive distinction, the capital productivity growth is decomposed into:

  • the expansion of the productive and un-productive fixed assets (which tend to explain a small part of the growth)
  • relative prices (between capital goods and general output) and
  • the ratio of labor productivity to capital deepening (the ratio of the capital stock to labor hours).

The findings on relative prices are in agreement with other studies on the subject which find that capital goods ‘got cheaper’ since 1980 and were a significant driver of the divergence between labor productivity and real wages. The author finds that during 1982-1998 relative prices contributed around 35% to the change in capital productivity:

price of net fixed assets and inventories relative to the price of output

The major driver though was the large change in capital intensity. While capital deepening (it is named technical composition of capital in the paper) grew close to 3% in the 1966-1982 period, it stagnated (-0.1%) in the 1982-99 period. Labor productivity growth remained roughly the same at 1.5% and 1.4% respectively.

table 5 - annual rates of growth - labor productivity - capital deepeningSo it seems that firms not only took advantage of lower capital goods inflation in order to increase their capital productivity but were actually able to maintain growth in labor productivity without investing into productive capacity (at least in relative terms). The paper speculates that this growth was achieved through the introduction of more efficient ‘management and organization techniques’.

In any case, the papers make it quite clear that the deepening income inequality since 1980 was driven primarily by the rise of the manager class whose renumeration grew at the expense of productive workers and normal profits. This growth was made possible by the lower relative fixed assets inflation and continued increases in labor productivity despite a complete reversal in capital intensity by corporations.

The above is also reflected in a more detailed study of income growth in the top income earners based on US tax return data:

Table 7 shows that the share of national income (excluding capital gains) received by the top 0.1 percent of income recipients increased from 2.8 percent in 1979 to 7.3 percent in 2005. Again, the shares received by executives, managers, supervisors, and financial professionals increased markedly, with the increase in the share of income among these occupations accounting for 70 percent of the increase in the share of national income going to the top 0.1 percent of the income distribution between 1979 and 2005. The pattern is similar in Table 7a when we include capital gains.

I ‘m going to take a quick look on the updated figures for Greek GDP 2013Q3:

Greek GDP 2013Q3 volume change

Obviously the lower volume loss is quite significant although it remains a fact that nominal GDP is still contracting at -5.9% (Q2 and Q3) with the lower volume contraction attributed exclusively to deeper deflation (which is now at -2.9%). Nevertheless, Gross Value Added is now dropping at -3.1%, almost half the rate during 2012. Looking into the expenditure breakdown the most obvious observations are:

  • Household consumption is still contracting significantly at -8.1%. The -6.6% change is attributed only to government consumption rising slightly at +0.1%.
  • Gross fixed capital formation is still at around -10/12% with inventories being the driver of the positive growth in GCF during Q3.
  • Exports of goods and services grew substantially (mainly exports of services) although imports also posted a positive sign, probably driven by the much larger tourist visits.

An alternative way to examine the GDP statistics is to calculate the relative contributions of each expenditure category:

Greek GDP 2013Q3 contributions to volume change

What is quite evident from the table above is that any positive contributions are the result only of inventories and the external sector (usually imports). During 2013Q3 household consumption contribution increased to -60% with the other two positive contributions coming from inventories (29.5%) and services exports (mainly tourism, 16.20%) while imports have now turned negative. Contributions of fixed investment and consumption will need to improve significantly in order for a Greek recovery to be sustainable.

Another interesting exercise is to take a look at the GDP deflators by category (nominal – real growth rates):

Greek GDP Deflators 2013Q3

Its is quite evident that especially during Q2/Q3, deflation accelerated significantly with rates close to -3%. Deflation is present in all expenditure categories while it seems that lower prices in exports are driven up to a point by corresponding import prices reductions. It is rather difficult to expect a turnover in the Greek recession without first observing a reversal of the deflationary forces in the major expenditure categories.

Overall, there are some marginally positive signs yet growth is the result of only a few categories (tourism and inventories) while the deepening deflation cannot easily be regarded as welcome news since it usually coincides with larger output gaps.

One recurring statement (usually related with the Euro-Drachma debate) is that the type of currency does not play a role, only the ability to efficiently produce competitive products and the presence of a modern institutional and organizational setting.

This type of reasoning is actually very similar to the ‘New Consensus’ (NC) macroeconomic view. The economy follows a supply-side driven natural growth path, subject to stochastic exogenous shocks which move the economy’s output gap far from zero and create inflationary (or disinflationary pressures). In a New Keynesian model, price and wage rigidities allow the central bank to change the short-term real rate (by changing the short-term nominal rate) which results in a deviation from the natural equilibrium (Wicksellian) rate of interest. This deviation eventually clears the output gap and returns the economy to its predetermined expansion path. The model as a whole contains the neutrality of money property, with inflation determined by monetary policy (that is the rate of interest), and equilibrium values of real variables independent of the money supply. The final characteristic is that the stock of money has no role in the model; it is merely a “residual.”

In essence, the NC world view can be summarized in the words of King (1997):

if one believes that, in the long-run, there is no trade-off between inflation and output then there is no point in using monetary policy to target output. …. [You only have to adhere to] the view that printing money cannot raise long-run productivity growth, in order to believe that inflation rather than output is the only sensible objective of monetary policy in the long-run” (p. 6)

The Keynesian view is quite different and stresses the fact that in reality the economy expansion path is not predetermined by supply-side factors, nor is money neutral. On the contrary:

  • Liquidity preference (see Arestis 2003) is an important issue. Financial assets are not close substitutes nor is credit risk negligible. As a result, relative prices and credit spreads play a decisive role since they determine the net worth of economic players (especially banks) and credit availability. Even the mere ‘creation of money’ by the central bank can have expansionary effects if it is targeted on specific, temporarily illiquid assets (with QE1 targeted on MBS being a strong example) since it expands the supply of ‘safe assets’.
  • Growth is to a large part endogenous while hysterisis effects are significant. The natural rate of growth is driven by demand growth (Thirlwall 1998) which generates hysterisis effects and path-dependence for the economy (Lavoie 2003). The NAIRU (if it exists at all) is closely related to the capital stock (since the elasticity of factor substitution is less than unitary) which suggests that effective demand and its effect on net investment strongly influences long-term employment (Arestis 2007).
  • Economic decisions are governed by genuine uncertainty and not by a known probability distribution, something evident especially in the case of long-term investment projects. Savings equal Investment only ex post and do not ‘drive’ expansion. That would require that while savers increase their preference for liquid assets, investors are more willing to part with liquidity, increase their leverage and hold actual illiquid assets (in the form of fixed investment and higher inventories), which is actually only possible if future profitability is increased and spare capacity is no longer available.

Even in the neoclassical tradition, post-2008 thinking acknowledges that monetary policy can have significant short and long-term effects on growth:

  • Long-term rates (which are relevant for investment) are not always closely linked to short-term money market rates, especially in stressed market environments. The central bank therefore needs to use balance sheet policies apart from setting the short-term rate in order to move long-term rate expectations.
  • The natural rate of interest is not known with any significant confidence level and is contingent on economic conditions, preferences and expectations (Federal Reserve 2001).
  • Disinflation (and even worse deflation) starting from already low inflation levels has strong effects on economic growth, since the output-inflation rate tradeoff is non linear (IMF 1998, Fed 1998), something which is highly relevant in the Greek case.

Furthermore, since the ECB target is of close to 2% annual inflation, strong deflationary expectations (which are now present in Greece) can only be considered a failure of its monetary policy. As long as the ECB does not act to correct this problem, it would be hard to suggest that monetary policy does not play a decisive role in the current Greek predicament.

Lastly, in cases of large real exchange rate devaluations (which is the stated target of the Greek adjustment program) the method of devaluation certainly plays a major role. Internal devaluations are usually followed by debt deflation effects with large output and employment losses and significant increases in non-performing loans and the (private and sovereign) debt burden (which is not deflated as are prices and income). External devaluations on the other mostly hurt the external sector claims while resulting in significant changes of the real exchange rate.

The following chart from the sdw facility of ECB shows that Greek deflation dynamics are ongoing and strengthening:

Greek Deflation

Ever since mid-2012 both the core inflation (HICP excluding energy and seasonal food) and the services inflation are in negative territory at an accelerating pace. Current core inflation figures stand at -2% while services at -3.5%. After dropping to -5%, durables goods inflation now reads  -3.5% showing relative signs of stabilization.

In general, core/services inflation rates of (negative) 2-3.5% can only suggest a very wide output gap which is certainly not an indication of imminent return to positive GDP growth rates. Furthermore, recent GDP figures show that nominal GDP/income continues to fall at close to -6% with the improvements in volume statistics being only the result of higher deflation (GDP deflator is now close to -2.5%). These are the typical elements of a debt deflation cycle with real debt burden increasing compared to a falling nominal income which eventually results in an increase of NPLs and debt-to-GDP readings and also to lower economic activity since consumers start to postpone purchases (especially of durable goods) in anticipation of lower future prices.

 

Bank of Greece Balance Sheet

Bank of Greece released its balance sheet for October 2013:

Bank of Greece Balance Sheet Oct 2013

One has to acknowledge that the data point to a relative stabilization. MRO borrowing was lower €1.3bn while ‘Other claims’ dropped about €1bn. This was reflected in both the Target2 (-€2.7bn) and banknotes (-€0.3bn) liabilities. Although haircuts remained relatively stable, the €1bn fall in ELA contributed to a fall of €12bn in posted collateral.

Current Account

Bank of Greece also released data on the September current account. Looking into various categories a few clear conclusions are:

  • The trade balance is still driven mainly by fuel imports and exports with exports higher by €0.64bn in the first 9 months and imports down €1.5bn for an overall improvement of more than €2.1bn.
  • Other goods exports are showing considerable signs of weakness with the total increase in the first 3 quarters being only 3.6%. Imports actually increased in September compared to one year ago, probably due to the stronger tourist wave. It seems that other goods might end up posting only a marginal total improvement during 2013.
  • Tourist revenue has been the main sector posting healthy growth this year. They increased €1.34bn although transport revenue was lower €1.13 leaving the total services income only slightly higher (+€0.2bn or +0.9%).
  • What is quite worrying is the fact that profit/interest/dividends payments abroad are already higher than last year both for the 9-month period and September. The PSI effects are over and interest payments are again a drug on economic growth.
  • EU receipts have played a major role in improving the current account with funds being higher by €1.63bn.

In general, although a few sectors show considerable strength (mainly tourism and oil exports), other goods exports are stalling while import contraction has reached its limits and cannot provide any further relief. Given the above trends it seems that the external sector will not be able to assist during the final 2013 quarter and won’t be the growth engine for 2014.

This will be a quick update on Greek deposits based on relevant Bank of Greece statistical data (the table below provides monthly flows):

Greek deposit statistics Jan - Sep 2013

The (rather evident) observations are:

  • The overall increase in total deposits is attributed only to the increase in government deposits (due to inflows from abroad). Net of government deposits, the total change during the 3 quarter period is -€4.4bn.
  • The main driver has been the change in deposits of non-Euro area residents (-€4.2bn). It seems that immigrants are slowly moving their deposits abroad.
  • NFC have been losing deposits indicating that their financial position is still deteriorating.
  • Household monthly flows do not show any clear pattern. Nevertheless, flows were negative during the whole summer period with the loss escalating to almost €1bn in September.
  • As a whole the private sector has been losing deposits ever since June with no sign of a reversal in flows.

All in all, the deposit flows do not point to any signs of stabilization in the economy. On the contrary, coupled with the recent significant reduction in deposit rates, the non-financial private sector financial position is worsening both in terms of stocks and flows.

It’s been a rather long time since I last took a look into developments in Euro area central bank balance sheets so it is a good opportunity to do an update.

General Trends

First, here’s a table (source eurocrisismonitor) with the Target2 balances for the major Euro area NCBs. What is quite evident is that during the second half of 2012 and the start of 2013, Target2 balances were reduced significantly, with the pace slowing down considerably in the last few months. Current levels seem to mostly be a function of current accounts (surpluses) rather than actual financial flows. Especially Germany has stabilized around €575bn with Spain and Italy at €280bn and €210-230bn (for a total of nearly €500bn).

Euro NCB Aug 2012-2013

Spain

The above stabilization is clear if one looks at the detailed data of the Spanish NCB (BdE):

BdE Balance Sheet Aug 2013

Lending to MFIs through MRO/LTRO has stabilized since May something reflected on the Target2 net balance. During the start of 2013, the drop in refinancing operations was accounted by the reduction in the deposit facility from €47.4bn in January to €3.1bn in June. This should be considered a positive development since it probably reflects the fact that Spanish banks do not need any large liquidity buffers any more and are able to more actively use private money markets. Nevertheless, current Target2 figures seem to be quite sticky with current(+capital) account balances driving any changes.

Greece

Bank of Greece actually provides quite detailed monthly financial statements which can be used to draw important conclusions:

Bank of Greece Balance Sheet Aug 2013

During 2013, the main BoG asset categories have been on a downward trend, although the pace is rather slow with a reduction of close to €10bn in the Jun-Aug period. The positive fact is that this decrease has been driven by lower demands of ELA, which has dropped from over €30bn in January to a bit less than €12bn currently. The main counterpart of the reduction has been the Target2 balance which went from €87bn in January to €54bn in August, a result of various factors such as the current account surplus of recent months, inflows from the Greek Loan Facility and some inflows of private deposits. Banknotes have not exhibited any significant changes.

On the other hand, data on collateral haircuts is quite disturbing. Collateral only dropped from €219bn to €188bn, with the overall haircut increasing from 51% to 61%. This is mainly reflected by ELA which currently carries a haircut of close to 90%! Given the current size of MRO (€61bn), its haircut (25%) and current securities holdings of Greek MFIs (close to €77bn), it seems that Greek banks have posted most of their securities holdings as collateral for ECB regular refinancing operations while keeping credit claims for ELA. Current ELA collateral is close to 50% of the loans registered on their balance sheets as assets.

The 90% haircut is obviously very worrying for two reasons. First, it means that the ability of Greek MFIs to cover any liquidity shocks (due to a capital outflows scenario for instance) is quite limited: At 50% haircut they should be able to provide collateral for additional €60bn in liquidity while the current 90% haircut will limit them to only around €10-15bn. Secondly, haircuts of this size, cast doubt on the asset quality of posted credit claims. If Bank of Greece only accepts collateral at 10% of its face value, that fact should provide a hint of what the correct recovery rate is for the relevant loans (in case of debtor defaults). In general, it seems that current asset quality of Greek MFIs is extremely low while Target2 liabilities are still quite high.

ELSTAT updated its early flash estimate for the Greek 2013Q2 GDP with revised detailed data. Since I had analyzed the original release, let’s take a look at what has changed since then:

Table 1

Volume change is now -3,8% compared to the original estimate of -4.6%. This is attributed completely to the nominal GDP growth rate which registered at -6.1%, far less than the original -6.9%. The GDP deflator estimate is unchanged, yet nominal values have been revised upwards which is certainly a positive development.

Table 2

Only the income method is not provided in constant prices so I will focus on this one. Labor compensation is still highly negative at -13.9% (from -14.1% in 2013Q1) and the same happened for Gross Operating Surplus/Mixed Income (-3.5%). What actually increased was… taxes, which increased 5.5% and subsidies 10.3%. So it seems that income of both labor and corporations did not post and positive developments with the slowdown in the nominal change explained by taxes (on production and imports).

Table 4

Gross Value Added decreased with a lower rate, as well as household consumption (and general government). Gross fixed capital formation is still negative (with no significant change) at -11%, although the rate is half that observed till 2012Q2 (when it was over -20%). The positive impact of inventories during the previous two quarters was not repeated in this one.

In the field of net exports, exports (of goods and services) only posted an increase of 0.9%, negating any hope of an ‘export-led recovery’. What actually declined with higher speed was imports, at -11.8%, compared to -7.7% during the previous quarter.

Conclusion

My personal opinion is that households are starting to hit their ‘autonomous consumption’ limits. Although their income is still falling with roughly the same rate, they are not able to adjust their consumption to current income in the same magnitude anymore. Although this will tend to redistribute income and wealth from low income households to corporations and employed persons, it will also slowly put a floor on the current recession. Import contraction and outright deflation will also help (the currently implied inflation rate in household consumption is close to -1%).

On the other hand, autonomous factors (investment, exports, government consumption) do not point to any upcoming demand boom. On the contrary, despite the extreme drop in the ULC-based REER, exports volume growth is mostly negative (2012Q2 – 2013Q1) or just barely positive.

One last thing to note is that, ever since 2012, the adjustment process is happening mainly through labor compensation, rather than corporate profits. Compensation is around -12% to -14% per quarter while GOS has stabilized around -2,5-3,5%. This is a very large and important income redistribution process which will have long-term effects. As long as consumption is the major source of demand (and investment is a function of current and expected consumption), households will eventually become ‘income-constrained’ and unable to increase their consumption in the future.

Greek National Accounts Income Approach Quartely Changes

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