12/09/2011: CHF and the "soon-to-be-busted" peg

Some weeks ago I have addressed one of the core reasons why the CHF/Euro peg, announced last week by the SNB will not hold for longer than 1-2 months. Here are the previous links to:

1. Small Open Economy argument (link)
   
2. Small Open Economy as safe haven argument (link)

Since then, in last weekend comment to the Sunday Times, I outlined another core reason for the peg to fail - the SNB has been brandishing the war chest of some USD 230 billion of FX funds that it says will be delivered into the battle field to support CHF, should pressures on CHF/Euro cross continue to mount. Now, that number above is roughly 1/2 of the Swiss 2010 end-of-year M1 money supply.

• Imagine the scale of intervention and the resulting interest rates hikes that will be required to extinguish inflationary pressures arising from this?Up by 50-100%?
• Now imagine what will happen with CHF cross with the euro if the interest rates in Switzerland were to, say, rise by 50-100%? Correct - demand for CHF will go through the roof, undoing any CHF/euro supports erected before.
• And alongside this, imagine what the 50-100% increase in interest rates do to capital investment and corporate balancesheets in Switzerland? Again correct - corporates, spared by SNB peg from being destroyed by the exchange rate appreciation will now face the very same FX pressures as before, plus higher cost of capital

And now, folks, for the third weighty reason why SNB will be forced to abandon its peg. Medium-term promise of a devalued CHF coupled with zero interest rates (0-0.25% on 3mo Libor target against Euribor 1.56% comp) implies a huge incentive for carry trades origination in very short term run, while in the medium-term, expected long-term revaluation of the CHF creates an incentive to make carry trades very short-lived. Both are not so much the forces to drive demand up, but the forces to destabilize fundamentals-determined medium-term FX rates.

Good luck betting that CHF peg holds, my friends...

Economics 22/05/2010: More nonsensical German proposals

Thursday was another day of great ideas from Berlin on “How to wreck world financial infrastructure while earning little political capital: the Angela Merkel Way”.

For a couple of weeks now, global investors have shown Madam Chance-a-lot (oops… Chancellor) that Greek Tragedy rule 1 applies: If you want to write a tragedy, set up a story where an irrational, arrogant and morally reprehensible sovereign challenges the Gods. Inevitably, in Greek classical tradition, the Gods win, while having a laugh. Mrs Merkel’s epic battle with the markets is exactly that. Markets, like Greek deities, are inevitably going to prevail. And Mrs Merkel and the retinue of euro area leaders – bent on ring-fencing their own politically connected banking sectors and shielding them from any meaningful pain for the errors committed in the past – will lose. The only thing that still might be at stake here is the degree of vengeance the markets will deal to the EU, should the euro zone embrace German proposals. With every new ‘bright idea’ on punishing the markets coming, the likelihood of an awesome spectacle of the Gods punishment meted out to Europe is rising too.


Following new taxes and short selling ban (covered by me yesterday) Mrs Merkel has now unveiled her third pillar of the reform strategy: a European ratings agency. It’s bonkers, folks. Just as the rest of the European financial sector reforms proposals so far:

• EU Rating Agency will never be independent of political interference, so no one, save for the institutionalised writers in the EU official press will ever pay any attention to whatever the agency might produce. In so far as delivering anything usable by the market or by anyone, save Eurocrats, the EURA will be a complete waste of taxpayers’ money.
• EU premise for launching EURA will be as crooked as an old local authorities politico with development firm in his backyard. Germany has departed on the EURA trip from the assertion that Euro needs an agency that can honestly upraise the extent of fiscal risks on sovereign balance sheets. Were EURA to do so, its ratings will have to be even gloomier than those of the Big 3 private rating agencies.
• EURA is unlikely to have any serious competency in what it does because unlike the Big 3 it will never be a rating agency for non-EU sovereign debt. In other words, EURA, having no recognition of non-EU sovereigns, will be forced to look at the EUniverse, a subset of the world bond markets. Which makes a proposal equivalent to simulating a tsunami in a coffee mug.
• And, of course, as any other rating agency, EURA will be no more than a lagging indicator, which means that its musings on bond valuations are going to be read only by retired intellectuals, plus pensions funds with automatic quality mandates. And even then, EURA will be forced to follow, in the news hierarchy, the Big 3.
  

In response to Mrs Merkel’s expensive (and it is expensive, from the point of view of European economy and taxpayers – see here) populism, Canadian finance minister told Mrs Merkel into her face last night that his country would not take part in either one of the three European policy follies. You see, Canada has a healthy banking system. And it has the intellectual and policy capital to understand that finance is crucial to country economic prosperity.

Americans, like Canadians and the Brits, think that the idea of a transaction tax is downright potty. All three have done the right things in trying to reform their banks. The EU, so far, is staunchly refusing to do the same. Why should the sane join the outright gaga club of countries that keep preserving rotten banking system at the expense of the real economy?

Even Finnish finance minister is saying Germany’s short sale ban had surprised everybody, unpleasantly. Finns can see through the German plans to the point where a Tobin tax on financial services will exert adverse selection against smaller exchanges in favour of the larger ones (again, see more on this here).

Why? Because the problem with financial institutions today has nothing to do with volatility in financial assets prices. It has everything to do with reckless lending by the banks and the willingness of bondholders to underwrite excessive borrowing (including that by the sovereigns). In the real world banks are willing to write poor loans because they and their shareholders and bondholders know that they will be rescued by the state, should things go pear-shape. And, of course, governments always oblige. Look no further than Nama. Wrecking regulatory vengeance on the markets in order to address the problems with the banks – as Mrs Merkel is doing – is hardly a way forward.


Only a massive scale intervention by the ECB, going most likely well beyond simple sterilization of €20 billion of sovereign bonds purchased by the bank so far, has pushed the euro up against the dollar. But at what cost, one might wonder, especially in the environment where deflation is creeping back into the US stats? I don’t have the data on ECB operations this week, but something was certainly hitting the markets for FX and bonds. Of course, sterilizing and supporting currency are two individually costly propositions. But for ECB to engage in this double game for a prolonged period of time will spell significant drying up of the liquidity. It is like an overweight elderly amateur playing alone against, simultaneously, Roger Federer and Rafael Nadal. The result will be painful, quick and devastating.

Sterilized cash can be re-injected into the banks reserves, without cash hitting the streets, but that would only mean more real money being trapped in the liquidity sucking spiral of government financing via ECB lending to the banks. We’ve been there for the last 24 months and it is not pretty.


In addition, there is a pesky issue of the US position. In effect, Japan, China, Germany and the entire euro zone are playing beggar-thy-neighbour game with the US by artificially suppressing the cost of their exports to America. The problem, as I have pointed out before (here) is that this requires US consumers to start borrowing again to sustain massive trade deficits. If this fails to materialise, and it is hard to see how it can, then the entire pyramid scheme of global trade will collapse. In the end, the double dip, this time caused by trade tensions and falling exports, is on the cards for all, as undervalued currencies in the three major powerhouses of global trade will prevent their consumers from expanding their own imports demand.

Such an outcome, however, will be preceded by a significant pain for Europe’s domestic economy. While a 10% devaluation of the Euro against a basket of global currencies can be expected to lead to a significant boost in Euro area economy (ca +0.7% in year one after devaluation and up to +1.8% in year 4), this exports-led growth will be associated with massive increases in the interest rates (+85bps in year one, to +220bps in year 3). These estimates are taken from Econbrowser (here). Obviously, the rest of the world will be just cheering EU and Mrs Merkel in this destruction of economic growth... or not?

Economics 20/05/2010: Germany's new plan for Europe

“Berlin means business” says Spiegel about the latest plans by German Government for an EU-wide revision of fiscal and financial architecture.

This Tuesday, “EU finance ministers announced efforts to both rein in hedge funds operating in Europe and to introduce a tax on financial transactions”.

Wait a second, folks – take Ireland: a sick financial system with plenty of financial services taxes, including a stamp duty on transactions, all the way down to bank cards levies. Has the presence of the Tobin tax here helped to prevent the crisis? Will it work in Europe? Not really. Why? For several reasons:

1. Tax is avoidable by offshoring trades outside the EU. The effect of this will be – higher cost of capital raising for companies, selection bias in favour of larger companies in access to the capital market (AIG advantage anyone?), lower after-tax returns to investors and higher cost of financial services to all of us. Falling listings in Europe and greater state pensions reliance. Which part of this equation makes any economic sense?
2. The tax will not fund sufficient insurance provision against the need for future bailouts. When you think of the magnitude of bailouts we’ve witnessed, the levels of taxation would have to be so high, there will be no financial markets in Europe left.
3. The tax will, however, fund general Government spending in the Eurozone. Which, of course, means more of our money (yes, yours and mine – as long as we have pensions, savings, investments or if we work for companies that have listed shares or have plcs as their clients…) will be going to noble causes of public sector retirement and wages packages, social welfare spending, politically motivated pet projects, and so on.
   
4. The tax will retard economic development in Europe. One of the reason why European banks are so sick is because European companies are heavily reliant on banks lending. European businesses are based on loans, not equity - in other words, they are based on debt. Vast amounts of debt. And when such culture of financing collides with an asset bubble drivers of exuberant expectations, banks balance sheets swell with bad loans. The new tax will only perpetuate this inherently inefficient utilization of equity financing across Europe. Which means less growth, fewer businesses and fewer jobs.

Next, of course, in the line of fire are the hedge funds. They had to be reined in because… no wait, remind me, why exactly? Hedge funds did not cause the current fiscal crisis (they have no control over the Governments’ borrowings and spending), nor did they pollute banks balance sheets or caused the property bubbles. Why are they a target then? Because for European leadership, ‘Doing right’ means ‘Doing politically easy’. Hedgies have no strong lobbyist interest behind them, unlike the banks, property developers, sovereign bondholders, sovereign bond issuers, farmers, trade unions and public 'servants' - all who inhabit the vast ques to the trough of Government subsidies. So here you are – we attack a bystander to pretend that we are tackling the criminal in sight.

After hedgies, came in other imaginary villains. On Tuesday night the EU banned naked short-selling and the trading of naked credit default swaps involving euro-zone debt. Oops.. before Tuesday night we knew what markets were betting on into the future – the short positions revealed actual expectations with the power of having real money put behind them. Now we do not. This, per EU leaders, is some sort of transparency. Socratic cave analogy comes to mind.

The EU ban target two types of trading that “have been blamed for exacerbating the financial crisis and Europe's sovereign debt crisis.” Actually, IMF explicitly said (here) in its report last week that the entire CDS markets - not just short sales in these markets - were not enough to cause the crisis. Never mind - EU leaders know how to deal with independent advice from international experts. Any hope, then, that Mrs Merkel's pipe dream of 'independent budgets oversight' (see below) can come true in this land of pure politicization of everything - from rating agencies, to traders, to investors?

It turns out, folks, that European crisis was, after all, not about absurdly high levels of public debt carried by PIIGS, nor by fraudulent (yes, fraudulent) deception by some Governments of investors about the true extent of national deficits. It was not exacerbated by the decade-long low growth recession across the Euro area, nor by a recent severe depression that afflicted Euro area economies. Nope. The cause of this, per Mrs Merkel & Co, were investors who were betting on all of these factors adding up to an unsustainable fiscal and economic situation in Europe. Off we fighting the evil windmills, then, Don Quixote from Berlin!


Worse than that, on top of the ridiculous policies decisions made over the last two days, Chancellor Merkel has also been working hard “on far-reaching changes to the treaty underpinning Europe's common currency, the euro.” Per Der Speigel, “Merkel would like to see increased monitoring of member states' annual budgets, the introduction of stiff sanctions for those in violation of euro-zone debt rules and the suspension of voting rights in the European Council. Furthermore, Germany wants to establish bankruptcy proceedings for insolvent euro-zone countries.”

Really? I wrote about the actual chances of any of this working to the desired effect in the earlier post (here). But now we have some details to the plan:

“According to the document, Germany would like to see annual budgets in euro-zone countries undergo a "strict and independent check." Berlin proposes that the job be taken over by the European Central Bank or by a collection of economic research institutes.”

Now, the problem with this part is that there are no independent organizations in Europe left. The ECB is now a full hostage to Europe’s push for retaining fiscal sovereignty while maintaining unsustainable prolificacy. ‘Institutes’ Mrs Merkel has in mind are a host of EU-funded ‘Yes, Minister’ organizations that populate the realm of economic policymaking on the continent (with a number of them operating in Ireland). By-and-large, they have no capability of delivering anything of real value, let alone anything independent. Even the likes of the OECD – a very capable organization with some degree of independence – is not free from European political interference.

"Euro-zone member states that do not conform to deficit reduction rules should temporarily be disallowed from receiving structural funds," the draft reads. In extreme cases, that funding could be permanently eliminated.”

Imagine Greece today, receiving €110 billion bailout today, being told, ‘Naughty! We will withhold some €5 billion in funds.” Apart from being unrealistic, this idea is potentially quite dangerous. Structural funds go to finance infrastructure and other longer term investment programmes. Many of these rely on co-funding from the Member States and/or private partners. All have private contractors. Impose this potential penalty and cost of public projects financing will have to rise due to uncertain nature of the funding stream.

Withholding these funds will either be meaningless (if the funds withheld are small, as it will cause no damage and will have no power of prevention) or it will cause an economic mayhem as bills go unpaid and workers lose jobs (in which case the sanction will be undermining the process of fiscal recovery and triggering more bailouts).

In short, the threat is either toothless or self-defeating. Either way – it is a cure that threatens to make the disease incurable.

Two more proposals are mentioned in the Spiegel.

“Earlier this month, Schäuble had mentioned the possibility of suspending member states' votes should they find themselves in violation of European debt rules, an idea which is mentioned in the draft proposal.”

This should make wonders of the EU efforts to strengthen its democratic legitimacy. And would this extend to suspending MEPs powers too? European court judges? Commissioners? Where does the buck stop? Should this come to pass, Italy, Greece… no wait – at 60% debt to GDP level, virtually the entire EU will be suspended (see table here). Who will end up voting in Europe? Germany won’t – its own debt/GDP ratio is 72.5%... Ditto for the deficits benchmark.

Finally, per plan: “Should all else fail, the draft calls for a plan to be established for euro-zone members to declare bankruptcy.”

Err… what? Hold on – bankruptcy? Given that the EU own rules to date have so spectacularly failed to contain debts and deficits from breaching EU-own rules, that would be a collective bankruptcy then… One presumes with Germany in tow?

Economics 15/02/2010: Ireland and the Euro

Sunday Times, February 14, 2010.

Like a namesake of Federico Fellini’s 1983 classic, E la nave va (And the ship sails on), the Greek debt saga continues its course toward the increasingly inevitable default. Another week, another impenetrable web of announcements, and no real solutions. At this stage, the EU’s ability to resolve the crisis is no longer a matter of markets trust and the reputational costs for the euro are becoming more than evident.

So much so that conservative and forward-looking ECB is starting to think of contingency planning. A source close to Frankfurt has told me earlier in the week that some ECB economists are contemplating the likely run on the euro leading to a 20-25% devaluation of the currency to bring it virtually to parity with the dollar. If that happens, an interest rates hike of 50 basis points or more will be a strong possibility sometime before the end of Q3 2010. A derailment of the nascent economic recovery in the core euro zone countries will be virtually assured.
The plan, currently under discussion at the EU level, involves a guarantee on Greek debt, plus a package of subsidised loans both underwritten by other euro zone countries (re: Germany). The problem is that this is unlikely to be enough.

Greek problems are not cyclical and will not go away once the markets calm down. Country structural deficit, in line with Ireland’s is around 60-70 percent of the overall exchequer annual shortfall. And unlike Ireland, Greece is facing an acute problem refinancing its gargantuan public debt. Worse than that, the latest revelations concerning the complex derivative contracts used by the Greek authorities to hide a significant share of its deficit over the recent years clearly show that the country will have to be much more aggressive in scaling back its annual deficits in order to be able to issue new bonds. The EU latest plan does not facilitate any of these measures. Neither does it have a credible enforcement mechanism. Should Greece decide at any point in the future to renege on its obligations under the rescue package, the entire crisis will be replayed tenfold. And the threat of this gives the Greeks a trump card against the EU Commission under collective guarantees.

Thus, currently, there are only three economically feasible structural solutions to the ongoing crisis in the euro area.

The best option would be a massive injection of liquidity across the common currency area. Minting a fresh batch of euros worth around €1-1.5 trillion and disbursing the currency to the national Governments on a per-capita basis would allow the PIIGS some breathing room in dealing with their deficit and debt problems. At the same time, countries like Germany, with more fiscally sound public spending habits, would be able to use this money to stimulate domestic demand and savings through tax credits and investment.

The drawback of such a plan is that it can reignite inflationary pressures within the euro area. This risk, in my view, is misplaced. Given structural weakness in consumer demand and continued cyclical weakness in new business investment, it is unlikely that much of the freshly-minted cash will go anywhere other than savings. Incidentally, with most the money flowing back into the banking sector, the ECB can then use this increase in deposits to close down some of the asset-backed lending positions that euro area banks have built up with Frankfurt.

Two other solutions involve introduction of a parallel ‘weak’ euro for PIIGS, or an outright bailout of Greece, Portugal, and possibly Spain and Ireland, through a partial pay-down of these countries debts. Both would have dire consequences for the euro itself.

The logistics of running two parallel currencies within a block of countries under a single-handed management of the ECB will produce more than confusion in the markets. The monetary policy required for the ‘weak’ euro state would entail interest rates at roughly triple those in the ‘strong’ euro countries, with the resultant potential for an explosion of carry trades unfolding within a single monetary union.

In addition, there is no mechanism by which either Greece or any other country can be compelled to switch to a ‘weak’ euro. In Ireland’s case, being forced into a ‘weak’ euro will be a disaster for the longer term prospects of maintaining strong presence of the US and UK multinationals here who rely on out full membership in the common currency club to drive their transfer pricing.

An outright paydown of the PIIGS debts – no matter how tough the EU Commission gets in terms of talking up ‘conditional lending’ and ‘direct supervision’ provisos of such an action – will result in an unenforceable lending from Germany to the PIIGS.


From Ireland’s point of view, however, the inevitable outcome of all possible alternatives for dealing with Greece will be devaluation of the euro close to parity with the US dollar. And here may lie the best news Irish exporting firms have heard since the beginning of this recession.

Given the dynamics of our exports-producing sectors, Ireland desperately needs a shot in the arm to stay alive as economy through 2010.

Per CSO, our MNCs-dominated modern manufacturing – the source of most of our goods exports – has managed to post a spectacular 14.5% seasonally-adjusted drop in production in Q4 2009. Pharmaceuticals output declined a 7.5% in the last quarter, while computer, electronic and optical equipment sector – another pillar of our exporting activities was down 14.9% in December 2009. It all points to growing weakness in exports-driven high value added segment of our manufacturing. In short, Ireland can use a serious devaluation of the euro on the exporting side.

But a silver lining never comes without some cumulus clouds in tow.

A devaluation – while a boom for exporters – will act to reduce consumer spending and, through higher cost of imports, will further reduce income available for domestic savings and investment. Given the already abysmally low levels of personal consumption, it is highly likely that this will trigger more household defaults on debt and mortgages.

Furthermore, a devaluation can trigger rising inflation across the euro area which, once imported into Ireland, will undermine the gains in competitiveness achieved during the current crisis. For comparison, consider the case of Ireland v Greece. In his recent note, NIB’s Chief Economist, Ronnie O’Toole highlighted the fact that between mid 2008 and the end of 2009, Irish consumer prices have fallen some 4.6%. In contrast, Greece saw its prices rise some 2.3% over the same period. Of course, falling price levels imply that it is much easier for companies and governments to cut nominal wages. A new bout of inflation induced by the EU solutions to the Greek crisis can wipe out this advantage.

Alas, no one so far has noticed that in both, Ireland and Greece, a cut in nominal wages in line with inflation will do two things. One – it will leave real wages – the stuff that private sector producers really care about – intact. And it will be a magnitude of 3-4 times too little for repairing the Exchequer balance sheet. With both countries facing a 2010 deficit of 10-11% of GDP, a 5% cut in public sector wages is equivalent to applying Bandaid to a shark bite.

And a rise in euro area inflation will have an adverse impact on Irish exporters. Despite devaluation, many of our MNCs and indigenous exporting companies buy large quantities of raw and intermediate inputs from abroad. The rise in the cost of imports bill will partially cancel out the gains in final prices achieved due to devaluation. This is especially significant for the companies trading in modern higher value-added sectors, where geographically diversified multinationals use Ireland as a later stage production base with intermediate inputs coming from other EU countries and the US.

Lastly, a devaluation of the euro close to the dollar parity is likely to trigger monetary tightening by the ECB, with interest rates rising by 50 basis points in the next six months. Coupled with reduced provision of new liquidity by Frankfurt, the resulting credit crunch on the Irish banks will trigger a massive jump in the burden of mortgages here. Needless to say, even with booming exports, Ireland Inc will be in deep trouble as trade credits, corporate funding and personal loans will be pushed deep into red by rising costs of borrowing.

At this stage, we really are caught between a rock and a hard place.