4/5/2012: Fitch Bells: Ringing de Panic?

Yesterday, Fitch Ratings issued an interesting report, titled "The Future of the Eurozone: Alternative Scenarios". The report sounds alarm bells over what some markets participants have thought of as a 'past issue' - the risks of contagion from Greece to the Euro area periphery.

Fitch Ratings core view is that the eurozone will 'muddle through' the crisis, surviving in its current composition,  while taking 'gradual steps towards closer fiscal and economic integration'. 


The interesting bit comes in the discussion of possible alternatives and the associated probabilities of these alternatives. According to Fitch, there is rising (not falling, as we would expect were LTROs and Greek debt restructuring, plus the Fiscal Compact and the ESM working) risk of a protracted growth slowdown or political shock or some other shock triggering either a possible facilitated Greek exit from the Euro or a disorderly Greek exit from the common currency.


And, crucially, according to Fitch, this risk cannot be discounted. 


This bit is where Fitch's assessment is identical to mine and contradicts that of the majority of Irish 'green jersey' economists: the tail risk of a disorderly unwinding of the euro is non-zero and rising, while the disruption or cost associated with such a outcome is by far non-trivial. Prudent risk management policy would require us to start contingency planning and addressing the possible realisation of such a risk. Instead, we are preoccupied in navel gazing through the lens of the Fiscal Compact, and not even at our own 'navel', but at the European one.


Fitch view is that a full break-up and demise of the euro is probabilistically highly unlikely. This belief is based on Fitch foreseeing large financial, economic and political costs of a break-up. More interestingly, Fitch determines that a partial break-up of the euro zone - with one or more countries exiting the common currency -  would "risk severe systemic damage, although cannot be discounted". 


For those thinking we've done much to resolve the systemic euro crisis (by doing much we usually mean creation of EFSF and agreeing ESM, deploying LTROs and restructuring Greek debts, and putting in place the Fiscal Compact), Fitch has some nasty surprises. Basically, Fitch believes (and I agree with their assessment here), that "additional measures will be needed to resolve the crisis. These are likely to include some dilution of national fiscal sovereignty [beyond the current austerity programmes and Fiscal Compact], potentially some partial mutualisation of sovereign liabilities [basically - euro bonds of sorts] and resources [some transfers to peripheral states], as well as measures to enhance pan-eurozone financial supervision and intervention, combined with further institutional reforms to strengthen eurozone economic governance". Basically, you can read this as: little done, much much much more to do still...


It gets worse.


Of all the alternative scenarios presented, Fitch believes that the most likely scenario will involve a Greek exit, with Greece re-denominating its debt in a new currency and default on its bonds again. Per Fitch, the core danger will be to Cyprus, Ireland, Italy, Portugal and Spain based on:

1. Greek exit creating an 'exit precedent' for the already distressed economies
2. Greek default impacting adversely other peripheral countries banks (especially true for Cyprus)
3. Greek default increasing the risk of capital flight from the countries
4. Greek default triggering a run on peripheral bonds just around the time when the 2013 'return to markets' horizon is in the crosshair.

Just as I usually do in my presentations on the topic, Fitch distinguishes two potential paths to Greek 'exit' - a structured and unstructured or 

• an "orderly variation with an effective eurozone policy response and minimal contagion" and 
• a "disorderly variation", involving "material contagion to the periphery and a significant increase in contingent liabilities facing the core".

Ouch, I must say, for all the folks who lost their voice arguing that my views are 'unreasonable' and 'scaremongering'. Sorry to say it, risk management approach to dealing with reality requires taking a probabilistically-weighted expected costs scenarios of the downside into the account. Simply shouting "all is sustainable here, nothing to bother with" won't do.

22/4/2012: Irish Crisis Requires Drastic Action, but Not a Euro Exit

In light of Prof Paul Krugman's comments concerning the desirability of the GIIPS remaining in the euro earlier this week, the Sunday Independent has asked myself (amongst other commentators) to provide my opinion on Prof Krugman's proposed solution. Here is the link to the published article and below is an unedited version of my comment:

In his article, Paul Krugman puts forward what he terms an alternative solution to the current course of policies, chosen by the EU in dealing with the Sovereign debt and financial sector crises. The core of his argument boils down to the need for the EU ‘peripheral’ states, notably Greece, Spain, Portugal, and potentially Ireland, to exit the euro and restore national currencies.

In my view, such a course, undertaken in cooperation with the EU member states and the ECB is a correct one for Greece, and possibly Portugal, but is not an option for Ireland, and the rest of the periphery. The reason for this is that unlike Greece and Portugal, Spain and Ireland are suffering not so much from the Sovereign debt overhang, but from a private and banking debts crisis. Resolution of these latter crises will not be sufficiently helped by an exit from the euro, primarily because private debt deflation will not be feasible for debts already denominated in euro. In addition, exiting the euro will entail significant economic and reputational costs to an extremely open economy, like Ireland, reliant on FDI and high value-added euro-related services, such as IFSC.

Two years ago, prior to the completion of the contagion from banking debts to Sovereign debt, exiting the euro was a workable solution, albeit a disruptive and a costly one for Ireland. Today, such an exit will require default – most likely an unstructured and disorderly – on both Sovereign and private debts, with simultaneous collapsing of the Exchequer funding and the banking sector. This will lead, in my opinion, to a disorderly unwinding of the entire economy of Ireland.

Professor Krugman is correct in his analysis that “continuing on the present course, imposing ever-harsher austerity on countries that are already suffering depression-era unemployment, is what’s truly inconceivable”. He is also correct in stating, that, “if European leaders wanted to save the euro they would be looking for an alternative course.”

The new course that the European and Irish leaders must adopt is the course that will preserve and strengthen Irish participation in the Euro zone economy, not push Ireland out of the common currency. This course requires a number of steps to be taken by Irish and European authorities in close cooperation with each other.

The first step is to recognize that Ireland’s economy is suffering from a private (namely household) debt overhang and the incomplete nature of the banking sector restructuring here. This means making a choice: either Ireland continues down the current path, with economic adjustments to the crisis stretched over decades of pain, or we jointly, with our European ‘partners’, take real charge of the economic restructuring. The former path implies that Ireland will be sapping Euro area monetary and fiscal resources for many years to come, while being unable to implement deep reforms due to the lack of supportive economic growth and facing continued risks of a Sovereign default. The latter path means that we take a quick, sharp correction in our private debts and get back onto the growth path.

The second step is to devise a solution – most likely via the ECB (to avoid placing burden of our adjustment on European taxpayers) – to write down significant proportion of Irish mortgages and other household debts while simultaneously allowing the banks to deleverage out of the household debts. This can and should be achieved by the ECB canceling all of the Central Bank of Ireland ELA and a part of Irish banks borrowing from the ECB itself and using these cancellation proceeds to write down household debt. Delivering such a deleveraging will open up room for stabilizing Government finances, as reduced debt burden on private balancesheets will allow Ireland to divert resources to paying down Sovereign debt, while a new cycle of domestic investment and growth can commence, allowing for structural reforms in the economy (covering both private and public sectors).

The third step is to create a long-term warehousing facility – within the ESM – to roll over existent Government debt so Ireland will have a period of 10-15 years within which this debt can be reduced without the need to face uncertainty of market funding. This would be primarily a cash flow management exercise. ESM lending rates should be set around funding cost plus administrative margin, or in current terms around 3.0-3.2% per annum, saving Irish Exchequer up to €3.4 billion annually in interest repayments, which can be diverted to more rapid paying down of the national debt. Hardly a chop-change, under conservative assumptions, this approach will allow Ireland to save over €27 billion in funds from 2013 through 2020, reducing overall nominal debt levels by 11.6% by 2020 compared to status quo scenario.

Combined, these policy steps will be able to put Irish economy and Exchequer finances on the security platform from which structural and longer-term reforms can take place without undermining economic growth potential. In addition, good will extended by the EU to Ireland under such a co-operative and coordinated approach to the crisis will assure continued Irish support and participation within the EU. This, in turn, will assure that Ireland can play an active and positive role in the Euro area growth and sustainable development in years to come. Exiting the euro today is neither necessary, nor sufficient for restoring Irish economy to growth. Resolving our debt crisis is both feasible and the least-costly part of the solution to the broader Euro area crises. 

17/4/2012: GIPS vs Default Countries

New IMF forecasts are out for the WEO April 2012 database and so time to update some of the charts. This will happen over a number of posts, but here is the chart I used in today's presentation on the future of Irish banking and financial services.

The chart shows the impact of the current crisis in GIPS against Russia, Argentina and Iceland post their defaults. It sets pre-crisis income expressed in US dollars at 100 and then traces back years of crisis.