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The Greek Statistical Agency released a recalculation of the Greek GDP today. Real growth for 2011 was revaluated to 7.1% instead of 6.9%. The important change though was the fact that the actual current price GDP was lowered to €208.5bn instead of €215.1bn (as was the 2010 GDP to €222.15bn instead of €227.3bn).

Based on the 2011 data the GDP deflator was around 0.93%. Assuming a constant -0.1% deflator for 2012 and 2013 (per the latest budget draft) and a real growth rate of -6.5% and -4%, the relevant GDP figures will be around €194.7bn and €185.8bn (the ministry of finance was expecting a GDP of €193.1bn in 2013). According to the latest budget draft, government debt is expected to climb to €340.6bn in 2011 and €346.2bn, making the relevant debt-to-GDP figure 175% for 2012 and 186% for 2013. The ministry of finance was expecting 169.5% for 2011 and 179.3% for 2013.

I ‘ll be using the growth figures from the latest Debt sustainability baseline from the IMF Staff Report, mainly a nominal growth rate of 2.5% in 2014 and 4% for 2015-2020. I ‘ll also expect total privatization receipts in the relevant period to be €30bn.

The total nominal growth will be 30%, making the 2020 GDP €241.5bn. Assuming that the government debt grows to only €350bn (meaning that the budget is roughly balanced after 2013) and accounting for privatization receipts, the 2020 number will be €320bn, or 132% of GDP. If we allow for zero nominal growth during 2014, the 2020 figure drops to €235bn and the debt ratio climbs to 136%. It is obvious that even with the most optimistic projections, the actual debt ratio in 2020 will be 12-20% over the 120% target.

I really don’t see a way how the IMF debt sustainability report will be positive. It’s also very clear that the Greek problem is one of growth, not deficit reduction. Unless there’s a huge political compromise I believe that OSI will happen very soon, probably with the IMF pulling out of Greek funding completely in order to preserve its preferred creditor status. It also probably marks the end of IMF financing of Europe, with the ECB and the ESM becoming the main creditors from now on. In the short-term it’s credit negative for Greek debt although one can now bet that the OSI will actually happen which will support Greek bond prices.

The ECB finally released the details of the new bond buying program called Outright Monetary Operations. One of the things that made me wonder is the following: The ECB justified the new program on the grounds that convertibility risk does not allow the monetary transmission mechanism to work properly with periphery interest rates being much higher than the core and not reacting to ECB rate cuts. Nevertheless, the program will be activated for countries that request EFSF/ESM assistance and will only be used to assist current program countries to regain market access in the future. It sounds really strange to stress an urgent and real problem and use it to announce a program that will only be implemented in the future, under strict conditionality without addressing the current actual problem of high interest rates (evident especially in Greece and Portugal).

The fact that the SMP will remain senior while OMT will be pari passu to private holders is quite puzzling, especially since both are considered monetary instruments. As another commentator has stated, the ECB is not a preferred creditor (it only buys bonds in the secondary market) but a ‘preferred investor’. My feeling is that the ECB will eventually avoid participating in any other future debt restructures.

I ‘ve already stated my view on how to make ECB purchases more effective. The ECB should pledge to immediately remit any monetary profits (due to discounts and interest payments) to the issuing country, roll over its holdings (for as long as it considers the monetary mechanism not working properly) and issue ECB marketable debt certificates in order to sterilize its holdings instead of term deposits.

The OMT has definitely bought some more time to Euopean countries. Still, strict conditionality will only work to push periphery countries further into recession and eventually hurt debt sustainability by reducing GDP. On the other hand, the monetary union mechanisms do allow for large capital movements without threatening the survival of the Euro project while placing a cap on interest payment deficit (since Target2 liabilities only pay the ECB MRO rate). ECB bond buying and ESM/EFSF assistance are necessary parts of these mechanisms.

Since Friday, Spanish bond yields are clearly over the 7% threshold making market access and debt sustainability a challenge. I ‘ll take the opportunity to look into more details on the Spanish balance sheet regarding other residents.

The first table includes main liabilities to RoW based on BdE balance of payments data which are only available till 2012Q1 (they will be updated on 31 July):

What is clear is that the main driver of capital flight is a drop in securities investments. Money market instruments also show a large drop, mainly in the general government sector, although the relevant positions were already quite small. In my view this is a clear case of an asset class not being considered ‘safe’ anymore (in the Gary Gorton terminology) with investors moving out of it. Both the Spanish government and economy are now viewed as a higher credit risk instrument, with funding dropping both in the bond (Held to Maturity) and money market areas.

The same is evident if one looks at monthly flows of direct investment (with portfolio investment being the one mainly hurt):

Things are much clearer by looking at more specific data from the BdE (balance sheet data for the BdE and credit institutions), as well as the Spanish Treasury:

The first observation is the significant drop in RoW deposits in credit institutions, deposits which should mainly be considered as part of money market funding. The drop in securities liabilities is much lower than the one observed in the balance of payments data, suggesting that resident banks found new domestic sources of funding (most probably with the help of BdE).

On the government debt front, Treasury data show a large drop in RoW (permanent) holdings, which is covered by an increase in holdings by domestic credit institutions. By subtracting the Net position from the outright holdings, one can calculate the outstanding repo funding from the RoW. Repo funding reached a high in September 2011 but has dropped significantly ever since, especially during 2012. This is another indication of elevated counterparty/collateral risk which leads to a large ‘haircut’ in funding.

Adding up the drop in outright holdings and repo transactions, a large part of the external position (and target2 liabilities increase) deterioration can be explained by foreign investors moving away from the Spanish bond and repo market. The repo/money market drawback is evident in the balance of payments other investment data as well:

Clearly a warning sign is the large decrease in turnover in the outright transactions (bond) and repo markets since February. This was the main pattern observed in the Greek case, with outright trading coming to a halt and price discovery moving to the CDS market with bond yields following CDS spreads (instead of the opposite) since the derivatives market became the most liquid. One thing to keep an eye for is the CDS net notional. If that starts dropping with opposite movement in the gross notional that will mean that market participants are not creating any new net contracts (which ultimately require a short position on the underlying instrument) but only leverage existing contracts by shorting CDS while covering the position with an older long position. This would indicate an unwillingness to take the original credit risk and a difficulty in covering a short position in the bond market. The intermediation trade is probably a nice arbitrage trade since collateral will be provided by the original seller or the new buyer of the contract (depending on how CDS spreads move).

This chart for the Spanish CDS net notional (from ftalphaville) is not good. Current gross/net notional is $171.6/13.7bn while they were $163.2/13.9bn a month ago.

A positive number is the total government deposits available which stand at a little over €90bn. Given the current government debt redemptions schedule and net funding needs, the government does have some leverage in the short-term until probably October (when redemptions are €27.4bn), even if it cancelled all new auctions (except for T-Bills) since most of the redemptions actually concern t-bills (which i think can be covered by domestic credit institutions in any case). With that in mind, i don’t see an immediate reason for a full bailout, at least not until the ESM is allowed to be activated by the German constitutional court in September (since financing through the EFSF for sovereign needs would mean removing the Spanish guarantees). One can probably safely acquire (outright or as collateral in a repo transaction) any debt maturing until October.

The latest IMF staff report on the Greek economy contains a detailed analysis of the fund’s view on the economic situation in Greece and its future prospects. Key elements of the report include:

  • The economy is expected to contract by 5% in 2012, with the debt ratio leveling at 167% of GDP in 2013.
  • Bank recapitalization due to the PSI and NPLs is projected to approach 50 billion €, lowering gains from the PSI deal (actually government debt will increase since new funding for the period 2012 – 14 will be close to 173 billion €).
  • Budget adjustments of 2.75% of GDP are required for 2013 and 2014, in order to achieve a sustained primary balance of 4.5% of GDP (2012 balance projection is close to 1%).
  • Potential growth is calculated around 2%, while long-term growth is lowered to 1-1.5%, making long-term debt sustainability challenging.
  • ULC competitiveness deficit stands at 15% and is required to be eliminated within the next 3 years, mainly through real wage adjustments.

Overall, the task of stabilizing the Greek depression, without destroying the social fabric seems challenging (to say the least). Debt sustainability is based on almost impossible terms, which include strong continued fiscal consolidation of more than 5.5% of GDP,  closing of the competitiveness gap and a sustained rebound in economic activity within the following year.

What is very interesting is the fund’s own view on the capacity of internal devaluation schemes to produce working results, especially compared to the route of currency devaluation. In general, it seems that even the IMF is not sure about its own medicine having positive effects, while projected cumulative output loss is comparable to those of Argentina and Latvia.

IMF Internal Devaluation View

Internal devaluations are almost inevitably associated with deep and drawn-out recessions, because fixed exchange rate regimes put the brunt of the adjustment burden on growth, income, and employment. Depending on the size of the imbalances, the strength of adjustment measures, and the responsiveness of key macroeconomic variables, the duration of the initial adjustment period has ranged from 5 quarters (Hong Kong) to  15 quarters or more (Argentina before abandoning convertibility), while the depth of the downturn has varied from shallow growth recessions (Germany, Netherlands) to deep economic collapse accompanied by devastatingly high unemployment and emigration (Latvia).

Restoring competitiveness by way of internal devaluation has proved to be a difficult undertaking with very few successes. Countries with outright exchange rate devaluations usually recover faster.

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Country experience suggests several factors are needed for internal devaluation to work. The most important preconditions are an open economy with high factor mobility and a high degree of wage and price flexibility.

Despite deep nominal declines in wages and pensions, real effective exchange rate depreciations have been regularly only modest due to only limited pass-through to prices (Baltic states, Argentina, Greece). Furthermore, private sector corporations are more likely to cut employment than to fully adjust wages, even in fairly flexible labor markets (Latvia). It also takes a long time for resources to shift from the non-tradable to the tradable sector, and both persistent skill mismatches and lack of increased investments in the tradable sector preclude full factor reallocation (former East Germany, Latvia). External adjustment therefore works predominantly through import compression rather than an expansion of exports—and oftentimes imports contract long before any real depreciation of the exchange rate. Finally, the often observed deterioration in asset quality and large increases in non-performing loans suggest that balance sheet effects are not limited to outright exchange rate devaluation—they only materialize more slowly in the process of internal devaluation as incomes fall but debt service does not.

The experience of Argentina in 1998–2002 shows that an economy can get trapped in a downward spiral in which adjustment through internal devaluation eventually proves impossible, and the only way to an eventual recovery remains default and the abandoning of the exchange rate peg.

Argentina ended convertibility in January 2002, almost four years into a deep recession that saw a 20 percent cumulative loss in output, culminating in sharp increases in interest rates, bankruptcies, unemployment, and poverty; deep cuts in wages and pensions; deteriorating asset quality, and deposit runs. The banking system collapsed and economic activity came to a virtual standstill in the first quarter of 2002. Nevertheless, only one quarter later the economy embarked on a rapid and sustained recovery, achieving 8.5 percent average real GDP growth over the following six years. The pre-recession output peak was exceeded after three years. Interestingly, despite a large and permanent real depreciation of more than 50 percent and a significant price boom in Argentina’s agricultural export products during this period, net exports contributed positively to GDP growth only in 2002, before turning negative again in the following years.

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Kostas Kalevras

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