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.
The first chart shows Daft rental index, marking in red circles all the cases where January posted an improvement on December (table below brings this out in numbers in terms of m-o-m changes in the index). Only one occasion – end of 2005 – was the case where this local peaking took place one month before the normal January peak. So this January is no exception here.
Some have argued that this January is different because it is the first reversal of the established trend. True, if we take the trend to mean 2007 peak to today. But if you look at the chart above, you notice that January shows exactly the same performance relative to preceding months and following months on the upward trend and on the downward trend. So I do not buy this argument that because we were falling before, a bounce today means a change in trend.
Notice the V-shaped segments? Aha, they too take place on end of 2007 to the beginning of 2008, end of 2008 to the beginning of 2009, and end of 2009 to, you’ve guessed it the ‘Great Improvement Month’ of January 2010. But here is more worrying thing: take a look at within-year trend lines for 2007, 2008 and 2009:
