4/10/15: Wither Capital: Why Euro Area Lacks New Investment Opportunities

Here is an unedited version of my 3Q 2015 contribution to the Manning Financial newsletter covering the topic of  capital investment in the Euro area.

Wither Capital: Why Euro Area Lacks New Investment Opportunities

Despite the positive signs of an improving economy, the euro area is hardly out of the woods, yet, when it comes to the post-crisis adjustments. The key point is that the cure prescribed for the ailing common currency area economies by Dr Mario Draghi might less than effective in curing the disease.

The key risk to the euro area today does not stem from the lack of funding for investment that ECB QE and other unorthodox policies target by attempting to flood the markets with cheap liquidity. Instead, they stem from the lack of sustainable demand for new investment.

Here are three facts.

One: between 1991 and 2001, Euro area member states were moderate net investors, with annual capital spending exceeding savings by 0.6 percent of GDP on average, close to the World average of 0.8 percent of global GDP. This meant that savings generated within the Euro area were finding opportunities for investment at home, and to attract some net investment from the rest of the world.

Two: over the period of 2002-2014,  annual investment in euro area was, on average, lower than savings by some 1 percentage point of GDP. And, based on the IMF forecasts, this gap is expected to increase to 3.5 percent over 2015-2020 horizon, even as economy officially recovers. This implies that the future euro area recovery will be driven not by investment, but by something else. Per IMF forecasts, this new driver for growth will be external demand for goods and services from the euro area, plus a bounce from the abysmal years of the crisis. In other words, new growth will not be anything to brag about at the G7 and G20 meetings.

Three: as investment demand dropped across the euro area since 2002, global savings excess over investment actually rose, rising from a net deficit of 0.8 percent of GDP prior to 2002, to a net surplus of 0.2 percent over 2002-2014 period and to a forecast surplus of 0.3 percent of GDP for 2015-2020 period. This suggests that returns on private investment are likely to stay low, globally, pushing down net inflows of capital into the euro area. Chart 1 below illustrates.

Investment Funding Lacking?

Taken together, the above facts suggest that the euro area does not lack funding for investment, but lacks opportunities for productive capital allocation. Consistent with this, QE-generated funding, is flowing not to higher risk entrepreneurial ventures and capital investment, but into negative returns-generating government bonds. And, in the recent past, liquidity was also rushing into secondary markets for corporate debt, to be used to finance shares buy-backs instead of new technology, R&D or product innovation, or old fashioned building up of productive capital.

As the result we are witnessing a paradoxical situation. Companies’ reported earnings are coming increasingly under scrutiny, with rising investor suspicions that sell-side analysts are employing 'smoke and mirrors' tactics to 'tilt' corporate results to the satisfaction of the boards. Corporate earnings per share metrics are being sustained on an upward trajectory by shares repurchases. All along, bonds markets are running short of liquidity even as ECB is pumping more than EUR60 billion per month into them.

Recent analysis of S&P500 stocks in the U.S. has revealed that the difference between adjusted earnings and unadjusted bottom-line earnings or net income has increased dramatically in recent years. Some 20 percent of all companies surveyed posted adjusted earnings more than 50 percent higher than net income. According to the report complied by the Associated Press and S&P Capital IQ, some companies reporting profit on adjusted earnings basis are actually loss making. European markets data is yet to be analysed, but given the trends, it won't be surprising if euro area leading corporates receive a similar 'tilt'.

Of Debt, Leverage & Loose Monetary Policies

All of this reflects cheap debt and leverage finance available courtesy of central banks activism.

Loose monetary policy, however, can provide only a temporary support to the financial assets. It cannot address the deeply structural failures across the real economies.

The key problem is not the short term malfunctioning of the monetary transmission mechanism between ECB record-low interest rates and real investment, but the exhaustion of the structural drivers for growth. Over the 1990s and early 2000s, European economies accumulated debt liabilities to fund growth in domestic demand (public and private investment and consumption). Now, even at extremely low interest rates, the system no longer is able to sustain continued growth in debt. Germany, Italy, the Netherlands and Austria - the net saving economies - are getting grey at an accelerating speed, reducing investors' willingness to allocate their surplus savings to productive, but risky, investments. Their companies, faced with slow growth prospect at home, are investing in new capacity outside the euro area - in Asia Pacific, Central and Eastern Europe, MENA and Africa.

The euro area has been leveraged so much, there is no realistic prospect of demand expansion here over the next decade.

As the result of this, surplus production generated in the saving countries has been flowing out to exports creating a contagion from domestic excess supply to external surpluses on trade accounts. Historically, reinvestment of surpluses converted them into investment abroad. The result was decline in interest rates worldwide. The Global Financial Crisis only partially corrected for this, erasing excess domestic demand and temporarily alleviating asset markets mis-pricing. But it did not correct for debt levels held in the real economy. In fact, current debt levels in the advanced economies are at the levels some 30 percent higher than they were during the pre-crisis period.

Neither did the surplus production and trade imbalances do much for a structural increases in productivity or competitiveness.

Since the start of the crisis, productivity growth declined in the euro area more than in any other developed region or major advanced economy.

At the same time, euro area's favourite metric – the unit labour costs-based index of harmonised competitiveness indicators – on average signaled lower competitiveness during the 2009-2014 period compared to the pre-euro era in eight out of the twelve core euro area states. Another two member states showed statistically zero improvement in competitiveness compared to pre-euro period.

The Key Lessons

The key lesson from the euro area's failed post-crisis adjustment is that debt overhang in the real economy compounds the problem of zero exchange rate flexibility within the common currency area. Flexible exchange rates allow countries to compensate for losses in productivity, competitiveness and for long term external imbalances. Flexible exchange rates also help to deleverage private economies whenever household and corporate debt is issued in domestic currency. In the case of the euro area states, this safety valve is not available.

Creation of the euro has amplified, not reduced, internal imbalances between its member states, while dumping surplus savings into global investment markets and contributing to the declines in the global return to capital and inflating numerous asset bubbles. Surplus supply euro economies, have in effect fuelled housing and financial assets bubbles in the ‘peripheral’ economies of the euro area.

The problem has not gone away since the burst of the bubble. Instead, it has been made bigger by the ECB policies that attempt to address the immediate symptoms of the disease at the expense of dealing with longer term imbalances.

Continuing with the status quo policies for dealing with these imbalances implies sustaining long term internal devaluation of the euro area. Table below shows the gap to 2002-2003 period in terms of overall labour competitiveness currently present in the economies, with negative values showing road yet to be travelled in terms of internal devaluations.

Large scale internal devaluations are still required in all new euro area member states, ex-Cyprus, as well as in Ireland, Italy, Belgium, Finland and Luxembourg. Sizeable devaluations are needed in Austria, France, Netherlands and Slovenia. Of all euro area member states, only Cyprus and Portugal are currently operating at levels of competitiveness relatively compatible with or better than 2002-2003 period average.

The problem with this path is that internal devaluations basically boil down to high unemployment and declines in real wages. In the likes of Ireland, for example, getting us back to 2002-2003 levels of competitiveness would require real wages declining by a further 16.7 percent, while in the case of Greece, maintaining current gains in competitiveness means keeping sky high unemployment unchecked. Political costs of this might be too high for the euro area to stay the course. And ECB policies can’t help much on this front.

An alternative to the status quo of internal devaluations would be equally unpleasant and even less feasible. This would involve perpetual (or at the very least - extremely long term) transfers from Germany, Austria and the Netherlands to the euro area weaker states. It is an unimaginable solution in part because of the scale of such transfers, and in part because the euro area core itself is running out of steam. Germany is now operating in an environment of shrinking labour force and rising army of retirees. The Netherlands and Austria are, potentially, at a risk of rapid growth reversals, as exhibited by Finland that effectively fell into a medium-term stagnation in recent years. Going by the structural indicators, even turning the entire euro area into a bigger version of Germany won’t deliver salvation, as the currency area combines divergent demographics: Berlin’s model of economic development is simply not suitable for countries like Ireland, Spain and France, and unaffordable for Italy.

The third path, open to Europe is to unwind the euro area and switch back to flexible currencies, at least in a number of weaker member states.

Speculations on the future aside, one thing is clear: euro area is not repairing the imbalances that built up over the 1998-2007 period. Even after the economic crisis that resulted in huge dislocations in employment, wages, investment and fiscal adjustments, productivity is not growing and demand is stuck on a flat trajectory.

Support from the ECB via historically unprecedented monetary measures and billions pumped into some economies via supranational lending institutions, such as EFSF, ESM and IMF are not enough to correct for this reality: euro area is new Japan, and as such, it simply lacks real opportunities for a new large scale boom in investment.

15/8/15: Russian External Debt: Big Deleveraging, Smaller Future Pressures

Readers of this blog would have noted that in the past I referenced Russian companies cross-holdings of own debt in adjusting some of the external debt statistics for Russia. As I explained before, large share of the external debt owed by banks and companies is loans and other debt instruments issued by their parents and subsidiaries and direct equity investors - in other words, it is debt that can be easily rolled over or cross-cancelled within the company accounts.

This week, Central Bank of Russia did the same when it produced new estimate for external debt maturing in September-December 2015. The CBR excluded “intra-group operations” and the new estimate is based on past debt-servicing trends and a survey of 30 largest companies.

As the result of revisions, CBR now estimates that external debt coming due for Russian banks and non-financial corporations will be around USD35 billion, down on previously estimated USD61 billion.

CBR also estimated cash and liquid foreign assets holdings of Russian banks and non-bank corporations at USD135 billion on top of USD20 billion current account surplus due (assuming oil at USD40 pb) and USD14 billion of CBR own funds available for forex repo lending.

Here are the most recent charts for Russian external debt maturity, excluding most recent update for corporate and banks debt:

As the above table shows, in 12 months through June 2015, Russian Total External Debt fell 24%, down USD176.6 billion - much of it due to devaluation of the ruble and repayments of maturing debt. Of this, Government debt is down USD22.1 billion or 39% - a huge drop. Banks managed to deleverage out of USD59.9 billion in 12 months through June 2015 (down 29%) and Other Sectors external liabilities were down USD88.8 billion (-20%).

These are absolutely massive figures indicating:
1) One of the underlying causes of the ongoing economic recession (contracting credit supply and debt repayments drag on investment and consumer credit);
2) Strengthening of corporate and banks' balance sheets; and
3) Overall longer term improvement in Russian debt exposures.

6/8/15: IMF Assessment of Russian Banks & Financial Markets

Alongside the Article IV (covered in three posts all linked here: http://trueeconomics.blogspot.it/2015/08/3815-imf-on-russian-economy-private.html), the IMF also released a series of technical papers, including one on the state of health of the Russian financial markets.

Top-level conclusion: "using a comprehensive index of financial development, to identify potential bottlenecks", the study "…finds that Russia’s financial markets are relatively deep, accessible and efficient, but that financial institutions, in particular banks, have much to do to improve their efficiency and create further depth. Russia could potentially gain up to 1 percentage point in GDP growth on average over the medium-term from further deepening and efficiency improvements. Policies towards this outcome include reducing banking sector fragmentation through consolidation via increased supervision and tightening capital standards; strengthening the role of credit bureaus and collateral registries to reduce information asymmetries; and removal of interest rate rigidities to foster competition."

Specifically, one key bottleneck is the distribution of sources for finance: "Russian companies rely much less on external financing in general and on bank financing in particular, to finance investment compared to their peers in Eastern Europe and Central Asia or in their upper middle income group. Typically, internal resources, state funds and controlling entities are responsible for financing up to 80 percent of business investment. As a result, banks contribute only 6 percent of funding for business investment, with the bulk of investment financed from retained earnings."

Couple of charts

Now, one can agree with IMF on the need for Russian companies to tap more diversified investment channels, but one has to also observe two key risks inherent in this suggestion:

1. Debt levels overall are low in Russian economy, and much of these are accumulated in controlling entities relations with enterprises - in other words - linked to equity and direct investment. This is good, as this allows enterprises more flexibility and better management opportunities with respect to cash flow and business activity;
2. Low debt levels also allow for absorption of political shocks that we are witness gin today, arising from political shutting down of Russian companies access to Western funding markets. If Russia is to retain meaningful risk buffers, accessing external finance via bond markets and equity markets abroad saddles Russian entities with higher risk of external shocks.

So IMF can propose, but I seriously doubt Russian companies will be rushing to borrow at a breakneck speed any time soon.

IMF uses a relatively new framework for assessment of the financial sector environment, the concept of financial development. "Financial development is defined as a combination of:

• Depth (size and liquidity of markets), 
• Access (ability of individuals to access financial services), and 
• Efficiency (ability of institutions to provide financial services at low cost and with sustainable revenues, and the level of activity of capital markets)."

So IMF main conclusion is quite surprising for those not familiar with Russian markets: "Russia’s financial markets are relatively developed but financial institutions lag behind in terms of efficiency and depth."

"Russia’s FD index (0.58) is higher than the average EM (0.37) and slightly lower than the average BTICS (0.64), a group of countries composed of Brazil, Turkey, India, China, and South Africa. …Russia scores much higher than the comparator groups for FM developments [Financial Markets development] as it features higher degrees of access and efficiency in the operations of its financial markets. Although the depth of financial markets is slightly lower than BTICS countries, it remains much higher than the average EM."

Big bottleneck is in financial depth, where "…financial institutions in Russia are comparatively dominated by the banking system, with fewer to non-existent assets, in percent of GDP, in pension funds, mutual funds and insurance industry. Moreover, the banking system lacks depth with domestic credit at about 50 percent of GDP being the lowest in the BTICS group."

Why? "With some 850 banks operating, the Russian banking system is highly concentrated at the top, and fragmented at the bottom":

• "The top three banks (state-owned) accounted for more than 50 percent of total sector assets at year-end 2014 while the top 20 banks accounted for 75 percent of total sector assets."
• "Lending is highly concentrated among the top 10 bank groups making about 850 banks contribute only 15 percent of total lending."
• "…VTB Group alone with 16 percent share of lending accounts for a similar share as the 830 remaining banks."
• "Most of the banks are small and act as treasury accounts for local firms, operating in particular in mono-cities."

This "…undermines lending to companies and SMEs as their ability to both extend credit and diversify across companies is limited while lending to consumers is usually the dominant form of credit."

What is there to be done to get Russian banking and financial systems up to speed?

IMF benchmarks the potential scope of reforms against the absolute best scenario (not scenario consistent with other comparative economies), which makes things sound quite a bit optimistic, or unrealistic. The menu is predictable and relatively straightforward:

• Cut the number of banks without impacting degree of competition. Which is easy to say, hard to achieve, and at any rate, Russian authorities have been doing as much, albeit slowly, for a good part of almost 2 years now.
• Increase supervisory pressures to remove even more banks out of the active list (again, has been ongoing since 2013).
• Improve quality of collateral registries to lower the cost of collateralisation for SMEs. Which, in part, will also involve improving existent system of credit bureaus.
• Link deposit rates paid by the banks to the banks' deposit insurance cover. In other words, remove Central Bank restriction on deposit rates quoted by the banks, but replace it with a restriction capping ability of highly risky banks to raise uninsured deposits. Which sounds like a good idea, assuming deposit insurance scheme is fully funded and solvent. Which, in turn, assumes no systemic crisis.
• Privatise state banks. Which is strange. IMF also notes that "there is no urgent need in Russia for large scale privatization, especially in light of the fragmentary evidence that public banks in Russia are not less efficient than private ones." And the Fund stresses the importance of economies of scale in delivering improved banking sector efficiencies. Which begs a question: what is to be privatised? Large state-owned banks? If they are privatised with a break up, the system will suffer risks to the efficiency. If they are privatised as they are, the system will receive private dominant players in the market which, arguably, will be no different from the state-owned ones in any meaningful way.

As usual for IMF: neat pics, cool stats, a small pinch of useful proposals and a list of predictable ideas that make sense… only if you do not spot their faulty logic…

3/8/15: IMF on Russian Economy: Private Sector Debt

Continuing with IMF analysis of the Russian economy, recall that
- The first post here covered GDP growth projections (upgraded)
- External Debt and Fiscal positions (a mixed bag with broadly positive supports but weaker longer-term sustainability issues relating to deficits).

This time around, let's take a look at IMF analysis of Private Sector Debt.

As IMF notes, economic crisis is weighing pretty heavily on banks' Non-performing Loans:

In part, the above is down to hefty write downs taken by the banks on Ukrainian assets (Russian banks were some of the largest lenders to Ukraine in the past) both in corporate and household sectors.

However, thanks to deleveraging (primarily in the corporate sector, due to sanctions, and some in household sector, due to economic conditions), Loan to Deposits ratio is on the declining trajectory:

Note: Here is a chart on deleveraging of the corporate sector and for Russian banks:

In line with changes in demand for debt redemptions, FX rates, as well as due to some supports from the Federal Government, banks' exposure to Central Bank funding lines has moderated from the crisis peak, though it remains highly elevated:

Illustrating the severity of sanctions, corporate funding from external lenders and markets has been nil:

And Gross External Debt is falling (deleveraging) on foot of cut-off markets and increased borrowing costs:

So companies are heading into domestic markets to borrow (banks - first chart below, bonds - second chart below):

Net:

1) Corporate external debt is falling:

2) Household debt is already low:

3) But the problem is that deleveraging under sanctions is coinciding with economic contraction (primarily driven by lower oil prices), which means that Government reserve funds (while still sufficient) are not being replenished. IMF correctly sees this as a long term problem:

So top of the line conclusion here is that banking sector remains highly pressured by sanctions and falling profitability, as well as rising NPLs. Credit issuance is supported not by new capital formation (investment) but by corporates switching away from foreign debt toward domestic debt. Deleveraging, while long-term positive, is painful for the economy. While the system buffers remain sufficient for now, long term, Russia will require serious changes to fiscal rules to strengthen its reserves buffers over time.

3/8/15: IMF on Russian Economy: Debt Sustainability

In the previous post, I covered IMF latest analysis of Russian GDP growth. Here, another key theme from the IMF Article IV report on Russia: fiscal policy sustainability.

In its latest assessment of the Russian economy, IMF has reduced its forecast for General Government deficit for 2015, from -3.69% of GDP back in April 2015 to -3.3% of GDP in the latest report. However, in line with new Budgetary framework, the IMF revised its forecasts for 2016-2020 deficits to show poorer fiscal performance:

In line with worsening deficits from 2016 on, IMF is also projecting higher government debt (gross debt, inclusive of state guarantees):

Still, the IMF appears to be quite happy with the overall debt and fiscal sustainability over the short run and is taking a view that over the next 2-3 years, fiscal policy must provide some upside supports to investment.

One of the reasons for this is that IMF sees continued strong buffers on fiscal reserves side into 2020, with Gross international reserves of USD362.4 billion and 374.8 billion in 2015-2016 amounting to 13.6 months of imports and providing cover for 496% and 281% of short term debt, respectively.

Furthermore, IMF expects debt levels to remain benign, both in terms of Government debt and Private sector debt as the chart above shows.

Note: I will cover Private Sector Debt developments in a separate post, so stay tuned.

Overall, 

1) External debt situation remains positive and is improving in the sector with weaker performance (corporate sector):

Note: above figures do not net out debt written to Russian banks and corporates by their parent and subsidiary entities located outside Russia, as well as direct investment / equity -linked debt.

2) "...no sector shows maturity risk with short-term assets exceeding short-term debt in aggregate"

3) Fiscal stance appears to be expansionary, but moderate, with deficits below 4% of GDP forecast for the worst performance year of 2016.

4) "Exchange rate and liquidity risks are mitigated by the CBR's large reserve level"

Stay tuned for more analysis, including debt positions across various sectors.

27/7/15: IMF Euro Area Report: The Darker Skies of Risks

The IMF today released its Article IV assessment of the Euro area, so as usual, I will be blogging on the issues raised in the latest report throughout the day. The first post looked at debt overhang, while the second post presented IMF views and data on the euro area banking sector woes. The third post covered IMF projections for growth.

So let's take a look at the risks to the IMF's 'growth returns to Euro zone' scenario.


Per IMF: "Risks are now more balanced than in recent years when vulnerabilities dominated. On the upside, low oil prices, QE, a weaker euro, and rising confidence could bring larger than anticipated benefits. Downside risks include lingering weakness and low inflation, a potential
slowdown in emerging markets, geopolitical tensions, and financial market volatility, whether due to asymmetric monetary policies or contagion from events in Greece."

Now, let me translate this into human language:

1) Eurozone has no real drivers for current growth uptick (which is weak to begin with). Instead, all it got to brag about are: QE (extraordinary monetary policies); QE-induced weaker euro (beggar thy neighbours trade policies), some rising confidence (hopping mad global asset markets bidding everything up on foot of global QEs - extraordinary policies); and lastly - lower oil prices (that sign of global economy on a downward slide). Congratulations to all - hard work and enterprising are not required for this sort of growth.

2) Eurozone's abysmal growth is at a risk from:

• 'lingering weakness' (aka structural non-reforms that Europe worked so hard to achieve since 2008, we are all in tears… so lots of sweat, not much of gain here) and 
• 'low inflation' (a euphemism for consumers and investors on strike in this promised Land of Plenty); and 
• 'potential slowdown in emerging markets' (that thingy that makes oil cheaper - take you pick, Euro area: get crushed by higher oil prices in presence of EMs growth or get squeezed by lack of EMs growth in presence of low oil prices), 
• 'geopolitical tensions' (aka: Russkies not playing the ball with Good Europeans by refusing to buy their apples), and 
• 'financial market volatility' (wait: what on earth have we been doing since 2007 other than fight the said financial markets volatility? Looks like lots of successes here, if the said volatility is still a risk), 'whether due to asymmetric monetary policies' (in other words, if the Fed hikes rates too early too fast) or 'contagion from events in Greece' (would that be the same Greece that has been ring fenced and repaired? most recently this month?).

You have to wonder: IMF effectively says all risks that were in the euro area in ca 2011 are still in the euro area in ca 2015…

Now, recall that some time ago I said that the next step for Europe will be a fiscal / political union with less democracy for all and more technocracy for the few? (link here). And IMF does not disappoint on this too.

"Beyond the near term, there should be a concerted effort to accelerate steps to strengthen the monetary union and European firewalls. Fully severing bank-sovereign links would require a common deposit insurance scheme with a fiscal backstop, a larger and fully funded Single Resolution Fund, and easier access to direct bank recapitalization from the ESM. The greater risk-sharing implied by these measures should be underpinned by a strengthened fiscal and structural governance framework which could require possible Treaty changes. These reforms are desirable in any case, but accelerated progress could help bolster market confidence in the face of recent events."

What have we learned from the above? Why, of course that the frequent claims by the EU officials that Europe now has fully severed contagion links between banks and taxpayers are… err… a lie. And that common claims by the European officials that we now have a genuine monetary union infrastructure is also a lie. And that to make these two claims not to be a lie we will need something/rather that requires 'possible Treaty changes'… which is of course a political and fiscal union. So kiss that national sovereignty and self-determination bye-bye… assuming you still believe such exist in the Euro Land.

Here is full IMF risks assessment matrix:

Now, do some counting: out of 7 key risks, four have either high probability of occurring or bear high impact if they should occur or both.

Now, all of the above still generates a positive outlook under the IMF forecasts - positive, meaning GDP growth over 1.2-1.4 percent, never mind GDP growth anywhere near that of the U.S.

But then the IMF goes slightly gloomier and paints a "Downside Scenario of Stagnation in the Euro Area". Here we are getting some traction with highly probable reality by the highly diplomatic Fund.

"Subdued medium-term prospects leave the euro area susceptible to negative shocks. A modest shock to confidence—for example, from lower expected future growth, or heightened geopolitical tensions—that lowers private investment could affect households via labor income and wealth. Expectations of lower inflation at the zero lower bound would keep real interest rates high. For countries with high public debt, risk premia could rise, amplifying the shock and raising the risk of a debt-deflation spiral. Policy space would be limited with short-term interest rates at the zero lower bound and public debt high in countries with large output gaps (Bullard, 2013)."

What the above really means is that, given we are already in the environment of zero policy rates and unprecedented money printing by the ECB, any further shocks will have nothing offsetting them on policy side as

• Monetary policy has fired almost all its bullets already, and
• Fiscal policy has no bullets because of already high levels of debt, whilst
• Currency devaluation policy is not an option in the monetary union dominated by Germany.

Welcome to Hope Street where things can only go as smoothly as today, forever.

"An illustrative downside scenario, assuming lower investment for all euro area countries and increased risk premia for high debt countries, suggests that euro area output could be nearly 2 percent lower by 2020." Guess what: 2020 forecast growth is 1.5% (link here) which means that IMF is saying it will be -0.5% aka another recession.

"The main channels would be through higher real interest rates depressing investment and consumption as well as lower inflation and wage growth constraining adjustment within the euro area." Which means IMF is now fully buying into the Secular Stagnation (Demand Side) scenario I wrote about here.

"The impact would vary across countries with real interest rates higher in countries with weaker balance sheets. Fragmentation progress would reverse and public debt would increase more in high debt countries due to lower fiscal balances and nominal output. “Bad” internal rebalancing would follow, as current accounts in high debt countries would rise due to import compression. Lower inflation would worsen external imbalances, by forcing countries with large output gaps and imbalances to adjust through lower prices and employment."

Yeeeks!

So projections:

Double Yeeeeks!

21/7/15: Central Europe's Lesson: Fixed Euro or Floating Exchange Rates?

The EU report on economic convergence of the Accession States of the Central and Eastern Europe (CEE10) makes for some interesting reading. Having covered two aspects of convergence: real economic performance and financialisation, lets take a look at the exchange rate regime impact on convergence.

This is an interesting aspect of the CEE10 performance because it allows us to consider medium-term impact of euro on CEE10. 

Basically there were two regimes operating in the CEE10 vis-a-vis the euro: fixed regime (with national currency pegged to the euro) or floating regime (with national currency allowed to float against the euro).

First, recall, that "out of the five CEE10 countries which have adopted the euro by 2015, four (i.e. Estonia, Latvia, Lithuania and Slovenia) already operated under fixed exchange rate regimes in 2004. In their case, euro adoption did not represent an essential regime change with respect to the role of nominal exchange rate flexibility in the convergence process vis-à-vis the EA12." 

Now, EU Commission would be slightly cheeky in making this statement, since while in the first order effect this is true, in the second order effect (expectations), this is not true - a peg to the euro could have been abandoned in a severe crisis, albeit less easily under the regime of ongoing financialisation of the CEE10 economies via foreign banks lending; however, once euro is adopted, no devaluation is possible even in theory. And this is not a trivial consideration, since policymakers know that should they mess up in the longer run, there will be a risk of peg abandonment, resulting in direct, transparent exposure of their policies-generated imbalances for all to see and in serious embarrassment vis-a-vis their European counterparts. In other words, the threat of devaluation as a feasible option could have actually acted, in part, to make peg regimes more stable.

But let us allow EU Commission their assumption (undefined as such) and chug on...

From EU own analysis: "Based on the GDP per capita in PPS data, there was no significant difference in the speed of real income convergence to the EA12 between fixers and floaters over the past decade, but there was a large degree of heterogeneity within both groups. Rather than the type of exchange rate regime, a more important relationship existed between the speed of catching-up and the initial income level, with less developed countries in general converging at a faster pace. Accordingly, the fastest growing economies were, among the fixers, the three Baltic countries and, among the floaters, Poland and Romania. In addition, Slovakia, which recorded one of the best catching-up performances, floated its currency until euro adoption in 2009 and the bulk of its real convergence over the past decade actually materialised before 2009." 

What does this mean? That nature of growth during the period was similar for floating and fixed regimes: both were driven by catching-up of economies, most notably via capital investment. Being fixed to the euro or not, it appears, had no effect on rates of convergence.

But, remember, euro is about stability, not growth. So the key test, really, is in volatility of convergence path, not the path itself. Per EU Commission: "The real convergence path of floaters was in general smoother than that of fixers. This was mainly due to the more pronounced economic overheating in the latter group prior to 2008, which then also led to a larger set back during the financial crisis." Oops… so staying closer to euro hurts. Having fixed rates, hurts. Bubbles got worse in countries with pegged rates. That is not exactly an endorsement of the euro-led regimes.

There's a caveat: "Nevertheless, fixers were able to again largely close their GDP-gap to floaters by 2012, as they enjoyed an export-led recovery, supported by internal price adjustment, structural reforms and favourable export market developments." Yep, that's right: austerity and re-shifting of economy toward external sectors, rather than domestic demand is the miracle that allowed for the fixed rates regimes convergence. That, plus unmentioned, monetary policy activism. 

Still, the view of boom-to-bust euro-driven economy for the fixed rates regime remains. Not that the EU Commission will acknowledge as much.

"The extent of price level convergence over the last decade mainly reflected differences in the speed of catching-up. That said, the average household consumption price level of fixers remained close to that of floaters until 2008, but it became significantly higher in the post-crisis period, as comparative prices of floaters fell." In normal English: deflation hit fixers, while floaters avoided it. 

Core conclusion (despite numerous caveats): "Floaters appear to have been in general able to benefit from their monetary autonomy to achieve a higher degree of price stability. In the pre-crisis period, faster growth and related overheating gradually drove up inflation in fixers significantly above the average inflation rate of floaters. Subsequently, larger output drops and the inability to depreciate against the euro implied that fixers generally also experienced more pronounced disinflation. From late-2010, inflation in the two groups developed quite similarly on average, but the variance was higher among floaters."

So final note on interest rates. Remember - convergence of rates irrespective of risk is one of the poor outcomes of the euro introduction in the EA12, fuelling massive asset bubbles in Spain and Ireland, fiscal imbalances in Greece and so on. In CEE10: "Over the past decade the benchmark long-term interest rate on government bonds was higher on average for floaters than for fixers, both nominally and in real terms. This is partly a consequence of the higher average public debt level among the floaters, but to some extent it is arguably also related to more exchange rate uncertainty inherent in floating." 

EU Commission grumbling acceptance of reality is almost entertaining: "Generally, it takes longer to regain cost competitiveness via internal price adjustment [something that fixed rates economies are forced to do] than via nominal exchange rate depreciation [something that flexible rate economies have access to] and the initial shock to the real economy is more severe. However, the internal adjustment is more permanent as it requires a structural solution to the underlying problems, whereas the temporary boost generated by nominal exchange rate depreciation can actually postpone the reforms necessary for further sustained catching-up." You'd think that flexible exchange rate economies just can't ever compete with fixed rates economies. In which case we obviously have a paradox: Denmark and Switzerland vs Italy and Spain (or for that matter Belgium and France).

So the core conclusion is simply this: things are complex, but having a peg to the euro looks more dangerous in crises and in bubbles build up stages, than running flexible exchange rates regime. Who would have guessed?..

21/7/15: Eastern Europe's post-2004 Convergence with EU: Financialisation

In the previous post, I covered the EU's latest report on real economic convergence in Central & Eastern European (CEE10) Accession states. As promised, here is a look at the last remaining core driver of this 'fabled' convergence: the financial services sector (which drove the largest contribution to growth in pre-crisis period 2004-2008 and remained significant since).

In summary: debt is the currency of CEE10 convergence.

Let's start with Public Debt.

As the above shows, CEE10 debt rose during the crisis despite GDP uptick. Rate of growth in debt was slower in CEE10 than in the original euro area states (EA12), which was consistent with stronger CEE10 performance in terms of fiscal balances and lower incidence / impact of banking crises.

Scary bit: "The negative impact of the 2008/09 global financial crisis as well as the following euro-area sovereign debt crisis on financial conditions in the CEE10 revealed that, despite relatively lower general government debt levels (compared to the EA12 average), some CEE10 countries might still encounter problems to (re-)finance their public sector borrowing needs during periods of heightened financial market tensions as their domestic bond markets are in general smaller and less liquid".

And that is despite a major decline in long-term interest rates experienced across the region:

In addition, Gross External Debt has been rising in all CEE10 economies between 2004 and 2014, peaking in 2009:

Which brings us to private sector financialisation. Per EU: "CEE10 countries entered the EU with relatively underdeveloped financial sectors, at least in terms of their relative size compared to the EA12. This was the case for both market-based and banking-sector-intermediated sources of funding. In 2004, the outstanding stocks of quoted shares and debt securities amounted on average to just about 20% and 30% of CEE10 GDP, compared to around 50% and 120% of GDP in the EA12. Similarly, bank lending to non-financial sectors accounted for just some 35% of CEE10 GDP whereas it reached almost 100% of GDP in the EA12."

It is worth, thus, noting that equity and direct debt financialisation relative to bank debt financialisation, at the start of 'convergence' was healthier in the CEE10 than in the euro area EA12.

Predictably, this changed. "As the government sector accounted for the majority of debt security issuance in the CEE10, bank credit represented the main external funding source for the non-financial private sector."

"The CEE10 banking sectors have generally been characterised by a relatively high share of
foreign ownership as well as high levels of concentration. The share of foreign-owned banks and the market share of the five largest banks (CR5) in CEE10 countries remained relatively stable over the last 10 years, on average exceeding 60%. There was however some cross-country divergence as Slovenia stood out with a relatively low share of foreign-owned banks, which only increased to above 30% in 2013. At the same time, the Estonian and Lithuanian banking sectors exhibited the highest levels of concentration, with their respective CR5 averaging 94% and 82% over 2004-14. On the other hand, the role played by foreign-owned banks is rather limited in most EA12 countries while their banking sectors are in general also somewhat less concentrated, with their CR5 averaging around 55% over the last 10 years."

Which, basically, means that the lending boom pre-crisis is accounted for, substantially, by the carry trades via foreign banks: the EA12 banks had another property & construction boom of their own in CEE10 as they did in the likes of Ireland and Spain.

"The 2008/09 global financial crisis …proved to be a structural break in the overall evolution of bank lending to the non-financial private sector in the CEE10. As the pace of credit growth in the pre-crisis period was clearly excessive and unsustainable, a post-crisis correction was natural and unavoidable. However, credit to the NFPS increased by "only" some 13% between May 2009 and May 2014, with bank lending to the nonfinancial corporate sector basically stagnating while lending to the household sector expanded by
about 25%."

Shares of Non-Performing Loans rose quite dramatically, exceeding the already significant rate of growth in these in EA12 across 6 out of 10 CEE10 states.

The following chart shows two periods of financialisation: period prior to crisis, when financial activity vastly exceeded real economic performance dynamics; and post-crisis period where financial activity is acting as a small drag on real economic performance. This is try for both the CEE10 and EA12 economies, but is more pronounced for the former than for the latter:

In summary, therefore, a large share of 'real convergence' in the CEE10 economies over 2004-2014 period can be explained by increased financialisation of their economies, especially via bank lending channel. As the result, much of pre-crisis convergence is directly linked to unsustainable boom cycle in investment (including construction) funded by a combination of bank debt (carry trades from Euro area and Swiss Franc) plus EU subsidies. These sources of growth are currently suppressed by long-term issues, such as high NPLs and structural rebalancing in the banking sector.

The tale of 'convergence' is of little substance and a hell of a lot of froth… 

21/7/15: Eastern Europe's post-2004 Convergence with EU: Unimpressive to-date

EU Commission latest report on real economic convergence in the EU10 Accession states of Eastern and Central Europe (CEE10) sounds like a cheerful reading on successes of the EU and the Euro. The report overall claims significant gains in real economic convergence between the group of less developed economies post-joining the EU and the more advanced economies of the EU.

However, there are some seriously pesky issues arising in the data covered.

Firstly, consider the sources of convergence (growth) over the period 2004-2014.

As chart above shows, in 2004-2008 pre-crisis period, Private Consumption posted significant contributions to growth in all EU10 economies )Central and Eastern European economies of EU12 group). This contribution became negative in 6 out of 10 economies in the period 2009-2014. It fell to zero in 2 out of 10 and was negligibly small in another one. Poland was the only CEE10 economy where over 2009-2014 contribution of personal consumption was positive and significant, albeit it shrunk in magnitude to about 40% of the pre-crisis contribution.

Likewise, Gross Fixed Capital Formation (aka investment) contribution to growth also fell over the 2009-2014 period. In 2004-2008, investment made positive and significant contribution to growth in all CEE10 economies. Over 2009-2014, Investment contribution was negative for 7 out of 10 economies and it was negligible (near zero) for the remaining 3 economies.

Thus, about the only significant factor driving growth in 2009-2014 period was net exports - the factor that does not appear to be associated with investment growth.

As the result, overall growth rates have fallen precipitously across the region in 2009-2014 period compared to 2004-2008 period.

Gross value added across all main sectors of the economy literally collapsed over the 2009-2014 period across all CEE10 economies, with only Poland posting somewhat decent performance in that period compared to 2004-2008.

One thing to note here is that even during the robust growth period of 2004-2008, Agriculture - a significant sector for a number of CEE10 economies was largely insignificant as a driver for gross value added in all but one economy - Hungary, where agricultural activity strength in overall economic activity traces back to the socialist times (1970s reforms).

Market services activity registered robust growth in 2004-2008 across the region predominantly on foot of major expansion of financial services.

Adding farce of a comment to the real injury of the above data, per EU Commission report: "As a result of relatively higher GDP growth rates, CEE10 countries achieved significant real convergence vis-à-vis the EA12 between 2004 and 2014. The CEE10 average GDP per capita level in purchasing power standards (PPS) increased from about 50% of the EA12 level in 2004 to above 58% in 2008. After having declined somewhat in 2009, it increased gradually to some 64% of the EA12 level in 2014." Much of this convergence is really due to the decline in GDP in the rest of the EU, rather than to growth in GDP in the CEE10. Not that the EU Commsision would note as much.

"However, there was a considerable cross-country variation with the pace of convergence in general inversely related to initial income levels. Considering the three most developed CEE10 economies in 2004, Slovenia has not enjoyed any real convergence, while the catch-up was also relatively limited in the Czech Republic and Hungary (as also pointed out by e.g.
Dabrowski (2014)). On the other hand, relative GDP per capita levels in PPS increased by about 20 percentage points in Baltic countries, Poland, Romania and Slovakia. Nevertheless, Bulgaria, which started with the second lowest GDP per capital level in 2004, also only achieved a below-average pace of convergence of some 11 percentage points."

In simple terms, the above means that the core drivers for any convergence would have been down to reputational and capital markets effects of accession, rather than to real investment in future capacity, skills and knowledge. Building roads, using Structural Funds, and getting Western Banks to lend for mortgages seems to be more important in the 'convergence' story than creating new enterprises and investing in real jobs.

As the EU notes: "The rapid pace of economic convergence in the pre-crisis period partly reflected an investment boom. The average share of gross fixed capital formation (GFCF) in the CEE10 increased from below 25% of GDP in 2004 to above 29% of GDP in 2007 and 2008 while it remained below 24% of GDP in the EA12. This investment boom was stimulated by optimistic growth expectations and supported by external funding availability. …Although on average roughly half of GFCF consisted of construction both in the CEE10 and the EA12, housing accounted for only about fourth of construction activity in the CEE10, compared to more than 50% in the EA12. This could be interpreted as overall indicating a more productive investment mix in the CEE10 in the run-up to the 2008/09 global financial crisis." Or it can be interpreted as heavier reliance on EU Structural Funds and Convergence Programmes that pumped money into roads and public infrastructure construction. Which may be productive or may be irrelevant to future capacity, as all of us can see driving on shining new roundabouts in the middle of nowhere, Ireland.

Nonetheless, "The contribution of investment activity to real convergence was not sustained in the post-crisis period. The average share of GFCF in the CEE10 declined to about 22% of GDP in 2010 and then remained broadly stable up to 2014 (while it declined to below 19% of GDP in 2013-14 in the EA12) as growth prospects were reassessed and private funding availability tightened but investment activity in the region was still supported by substantial inflows of EU funds. ...On the other hand, the decline was overall broadbased
across all main asset types in the CEE10 while it was largely driven by a drop in housing
construction in the EA12."

On External Balance side, current account balances turned positive for the CEE10 only in 2013-2014, much of this due to contraction in domestic demand:

Meanwhile, FDI collapsed across all countries, ex-Slovenia (where FDI figure for 2009-2014 is distorted to the upside by banking sector flows). As EU notes: "Although net FDI inflows remained positive in all CEE10 countries they on average amounted to some 2% of GDP in 2009-14 (after having exceeded 5% of GDP in 2004-08)."

All together, the picture of economic convergence is there, but it is more characterised by convergence via financialisation and transfers (both public and private) than by organic growth. This conclusion is equally pronounced before and during the crisis period. Much of the 2004-2008 period convergence was driven by private debt accumulation and 2009-2014 period convergence was primarily driven by adverse growth environment in the rest of the EU, plus public debt accumulation. 

Note: I will be blogging on debt issues in the next post, so stay tuned.

You can access full report here: http://ec.europa.eu/economy_finance/publications/eedp/pdf/dp001_en.pdf.

20/7/15: Of 'Break-Even' Oil Prices & Russia

An interesting chart via Deutsche Bank Research putting break-even (fiscal budget) figures on oil prices for major oil producers:

Which puts Russian break-even at USD105 pbl.

Reality is: Russia has capacity to increase oil output further and has done so already (note that it is now world's largest oil producer). It can also raise some other exports volumes, though general global conditions are not exactly supportive of this. Which underpins revenue side of the budgetary balance somewhat.

Meanwhile, Russian Government own budgetary estimates put break-even price of crude at around USD80-85 pbl, not USD105 pbl, closer to UAE, than to Oman.

Worse, for Deutsche, Russian budget is expressed in rubles, not USD, which means that FX valuation of the Ruble to a basket of currencies (Russian exports are not all priced in USD) co-determines the break-even price. Moderating (albeit still very high) inflation and EUR trend, compared to USD trend, suggest falling 'fiscal break-even' price of oil for Russia.

There are too many variables to attempt to estimate effective and accurate 'break-even' price for oil for Russia.

What is, however, clear is that Russian current account (external balance) is in black and it is improving, not deteriorating. Latest Balance of Payments data shows current account surplus of almost USD20 billion in 2Q 2015. Over 12 months through June 2015, current account surplus is at 4% of GDP. The driver here: decline in imports (down 40% in dollar terms in 2Q 2015 y/y) outpacing drop in exports (down just under 30% y/y). In January-June 2015, trade surplus was USD70 billion (USD210 billion in exports, USD140 billion in imports).

Balance of payments is also being supported to the upside by a decline in capital outflows. 2Q 2015 capital outflows amounted to ca USD20 billion, predominantly comprising banks repayment of maturing foreign debt (remember, this improves banks' balancesheets and deleverages the economy). However, direct investment from abroad into Russian non-fianncial corporations rose over the 2Q 2015, resulting in an increase in foreign debt held by the non-financial sector.

Overall, Russian Central Bank shows foreign debt position at ca USD560 billion (or 30% of GDP) at the end of 2Q 2015 - basically unchanged on 1Q 2015 and down from USD730 billion at the end of 2Q 2014.

And another reminder to fiscalistas:

• Russian public (Government) external debt currently stands at USD35 billion. 
• State-controlled banks hold further USD90 billion in external debt (total banking sector external debt is USD150 billion and 60% of that is held by state-owned banks).
• State-controlled NFCs firms hold ca 40% of USD360 billion foreign debt written against Russian NFCs, or USD144 billion. 
• Accounting for cross-holdings and direct equity-linked debt, net foreign debt that has to be repaid at maturity or refinanced by NFCs and Banks owned by the Russian Government is probably around USD150-160 billion. 

Sizeable, but less than 12% of GDP even after including the official public debt and state-owned enterprises debts.

14/7/15: IMF Update on Greek Debt Sustainability

Predictably... following yet another leak... the IMF has been forced to publish its update to the 'preliminary' Greek debt sustainability note from early July. Here it is in its full glory or, rather, ugliness: http://www.imf.org/external/pubs/ft/scr/2015/cr15186.pdf?hootPostID=2cd94f17236d717acd9949448d794045.

As discussed in my earlier post here: http://trueeconomics.blogspot.ie/2015/07/14715-brave-new-world-of-imf-debt.html, Greek debt to GDP ratio is now expected to "The financing need through end-2018 is now estimated at Euro 85 billion and debt is expected to peak at close to 200 percent of GDP in the next two years, provided that there is an early agreement on a program."

Which means that "Greece’s debt can now only be made sustainable through debt relief measures that go far beyond what Europe has been willing to consider so far."

Under the current programme (running from November 2012 through March 2016) the IMF projected "debt of 124 percent of GDP by 2020 and “substantially below” 110 percent of GDP by 2022", specifically, the projected debt at 2022 was 105%. Now, the Fund estimates 2022 debt at 142% of GDP.

Furthermore, "Greece cannot return to markets anytime soon at interest rates that it can afford from a medium-term perspective."

Worse, on the current path "Gross financing needs would rise to levels well above what they were at the last review (and above the 15 percent of GDP threshold deemed safe) and continue rising in the long term."

And IMF pours cold water over its own dream-a-little target of 3.5% primary surpluses for Greece. "Greece is expected to maintain primary surpluses for the next several decades of 3.5 percent of GDP. Few countries have managed to do so." Note the word decades! Now, IMF rejoins Planet Reality raising "doubts about the assumption that such targets can be sustained for prolonged periods."

In short - as I said earlier, politics not economics drive Eurogroup decision making on Greece. The IMF is now facing a stark choice: either engage with the euro area leadership in structuring writedowns (potentially also extending maturities of its own loans to Greece) or walk away from the Troika set up (and still extend maturities on its own loans to Greece).

Little compassion for the Fund, though - they made this bed themselves. Now's time to sleep in it...

5/7/15: Votes are in... What's next for Greece?

With over 75% of votes counted in the Greek referendum, 61.6% of the votes counted are in favour of 'No'.

So what's next? Or rather, what can [we speculate] the 'next' might be?

Possible outcome: Grexit

• This can take place either as a part of an agreement between Greece and Institutions (unlikely, but structurally less painful, and accompanied by debt writedowns, a default or both), or
• It can take place 'uncooperatively' - with Greece simply monetising itself using new currency (more likely than cooperative Grexit, highly disruptive to all parties involved and accompanied, most likely, by a unilateral/disorderly default on ECB debt, IMF debt, EFSF debt and Samurai debt. Short term default on T-bills also possible).

Either form of Grexit will be painful, disruptive and nasty, with any positive outcome heavily conditional on post-Grexit policies (in other words, major reforms). The latter is highly unlikely with present Government in place and in general, given Greek modern history.

Grexit - especially disorderly - would likely follow a collapse of the early efforts to get the EU and Greece back to the negotiating table. Such a collapse would take place, most likely, under the strain of political pressures on EU players to play intransigence in the wake of what is clearly a very defiant Greek stance toward the EU 'Institutions' of Troika. 

Key to avoiding a disorderly / unilateral Grexit will be the IMF's ability to get European members of the Troika to re-engage. This will be tricky, as IMF very clearly staked its own negotiating corner last week by publicly identifying its red-line position in favour of debt relief and massive loans package restructuring. The EU 'Institutions' are clearly in the different camp here.

EU Institutions will most likely offer the same deal as pre-referendum. Greece will be 'compelled' to accept it by a threat of ELA withdrawal, but, given the size of the Syriza post-referendum mandate, such position will not be acceptable to Greece.  In the short run, ECB can allow ELA lift to facilitate transition to new currency, but such a move would be difficult to structure (ELA mandate is restrictive) and will result in more debt being accumulated by the Greek government that - at the very least - will have to guarantee this increase.

Problem with Grexit, however, is that we have no legal mechanism for this, implying that we might need a host of new measures to be prepared and passed across the EU to effect this.

Which brings us to another scenario: Status Quo

In this scenario - no player moves. We have a temporary stalemate. Greece will be cut off from ELA and within a week will need to monetise itself with new currency. 

Why? Because July 10th there is a T-bill maturing, default on which would trigger a cascade of defaults. Then on July 13th there is another IMF tranche maturing (EUR451 million with interest). Non-payment of either will likely force EFSF to trigger a default clause. Day after, Samurai bonds mature (Yen 20bn) - default here would trigger private sector default. More T-bills come up at July 17th and following that interest on private bonds also comes up on July 19th (EUR225 million). And then we have July 20th - ECB's EUR3.9 billion due, with additional EUR25mln on EIB bonds. Non-payment here will nearly certainly trigger EFSF cross-default.

Most likely scenario here would be parallel currency to cover internal bills due, while using euro reserves and receipts to fund external liabilities. Problem is - as parallel currency enters circulation, receipts in euro will fall off precipitously, leading inevitably to a full Grexit and a massive bail-in of depositors prior to that. Political fallout will be nasty.

Most likely outcome is, therefore, a New Deal

This will suit all parties concerned, but would have been more likely if Greece voted 'Yes' and then crashed the current Government. This is clearly not happening and the mandate for Syriza is now huge. Massive, in fact. 

So there will have to be a climb-down for the EU sides of the Troika. Most likely climb-down will be a short-term bridge loan to Greece (release of IMF tranche is currently impossible) and allowing use of EFSF funds for general debt redemptions purposes. 

The New Deal will also involve climb-down by the Greek government, which will, in my view, be forthcoming shortly after Tuesday, especially if ECB does not loosen ELA noose. 

Bad news is that even if EU side of Troika wants to engage with Greece, such an engagement will probably require approval of German (and others') parliament. Which will require time and can risk breaking up already fragile consensus within the EU. In fact, only consensus building tendency in the wake of today's vote is for a hard stand against Greece. Even in an emergency, EU is very slow to act on developing new 'bailouts' - in Cypriot case it took almost a year to get a deal going. For Portugal - almost 1.5 months. Urgency is on Greek side right now, not EU's, so anyone's guess is as good as mine as to how long it will take for a new deal to emerge.

That said, short-term approach under the status quo scenario above might work, as long as:

1. Greece engages actively, signalling willingness to deal;
2. Greece does not monetise directly via new currency (IOUs will do in the short run); 
3. IMF puts serious pressure on Europe (unlikely); 
4. ECB plays the required tune and keeps ELA going (somewhat likely); and
5. There is no fracturing of the EU consensus (if there is, all bets are off).

In a rather possible scenario, EU does opt for a new deal with Greece, which will likely involve pretty much the same conditions as before, but will rely on removing IMF out of the equation altogether. In this case, EUR28.7 billion odd of Greek debt held by the IMF gets transferred to ESM. The same will apply to ECB's EUR19 billion of Greek debt. The result will be to cut Greek interest costs (carrot), and involve stricter conditionality and cross-default clauses (stick). Euro area 'Institutions' therefore will end up holding ca 73% of all Greek debt in that case. Terms restructuring (maturities extension) can further bring down Greek costs in the short run. 

The negative side of this is that such a restructuring & transfer will be challenged in Germany and Finland, and also possibly in the Netherlands. 

It is. perhaps, feasible, that a new deal can involve conversion of some liabilities held by the euro area institutions into growth-linked bonds (I am surprised this was refused to start with) and/or a direct conditional commitment (written into a new deal) to future writedowns of debt subject to targets on fiscal performance and reforms being met (again, same surprise here). Still, both measures will be opposed by Germany and other 'core' economies. 

Either way, two things are certain: One: there will be pain for Greece and Europe; and Two: there will be lots of uncertainty in coming weeks.

As a reminder of where that pain will fall (outside Greece):
Source: @Schuldensuehner