Dec 09

Greece high on deficit, got downgraded, now what?

By Ivo Sokolov Economics and Business, Politics 5 Comments »

Emil A. Georgiev wrote a comment in my blog that I think entails a new post in reponse. He said:

I believe the Emirates will make it, but what do you think about Greece – a member of the Eurozone?

Yes, Greece’s budget deficit, rating downgrades and potential problems with their sovereign debt rollover are somewhat alarming. The problem is not that they do not have the money to repay that debt (of course they don’t) — the problem is that they are supposed to refinance themselves from the market. And as the market lends only to prudent borrowers, at a 12,6% deficit Greece may not be considered an eligible one.

Yet when it comes to a Western European, Eurozone country make no mistake — that debt will be underwritten no matter what. On the one hand, the effects of a potential Eurozone sovereign default will definitely be Lehman-like, i.e. the systemic relevance of that sovereign default is paramount. On the other hand, the surplus liquidity that the ECB seems to be slowly and deliberately retracting (e.g. their announcements on the ‘enhanced credit measures’ from last week) can and will be channeled elsewhere when needed. They do not even have to go great lengths to inflate away that debt.

In the end of the day, no one will allow a small and highly leveraged country of such systemic relevance to go under. Not only Greek’s government, but also the whole Euro currency union is only as good as its credibility. The rating agencies’ response and ultimately the higher cost of borrowing will have to be sadly borne by the whole Greek nation. Putting a higher price tag on future borrowing for the whole Greek economy out of rating/market necessity will act more disciplinary than any legal constraints Brussels might impose on Greece. After all, if they had been following the Eurozone 3% GDP deficit guidline figures, they wouldn’t be in the mess they are today. I do expect though that there will be significant pressure on Greece to cut its public spending, should the EU/ECB really step in to bail out the Hellenic Republic of Greece.

By the way, what this also re-translates to is that Bulgaria’s aspirations to ERM II could be put to a halt for the forseeable future. Joining the EU once is a good deed, but entering the monetary union now might actually go far beyond the official Maastricht criteria. Thus, even if we consider that in a semi-deflationary environment Bulgaria meets all three criteria with a balanced budget (close but under the 3% mark), low inflation (to be in the top 3 lowest EU-wide if I recall correctly; seems somewhat achievable now) and low public debt (Bulgaria’s is way below the maximum of 60% of GDP required), Bulgaria might still not make it to the Eurozone out of political and country risk reasons. Even without the infrastructure and social expenditures of Greece.

In a nutshell, Greece will not default. As the saying goes, if you do not repay a € 1.000,- debt you have a problem; if you do not replay a € 10 million debt, the bank has a problem. In this case this bank is the ECB and the responsible account manager is the EU. They will surely get a hold of the situation, yet the “little Dubai” effect and the bad aftertaste of a popped property price bubble will continue to linger not only on Bulgaria and Greece, but also on any country that leveraged itself mostly through property sales, rather than industrial output in the recent years (such as Spain).

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Nov 21

Unconventional monetary policies: thinking of exit strategies

By Ivo Sokolov Economics and Business, Politics 3 Comments »

Today an interesting BIS working paper (292) was released. Anyone remotely interested in economics is probably by now aware that central banks all over the world have gone to great lengths to loosen monetary policy, not only by lowering interest rate levels. Otherwise technical terms such as ‘quantitative easing’, ‘credit easing’, ‘bank reserves policy’ (bank reserves do play a very special role, see the article) are thus commonly circulated in popular media and have almost gone mainstream. While it may be a stretch to call these measures unconventional, the extensive usage at central banks of means other than the interest rate as the main transmission channel of monetary policy has prompted many observers to label those measures creative money printing. Now that is something far more captivating to the general public than the dorky ‘quantitative easing’.

This new paper from BIS tries to classify and appraise the unconventional measures under the broad term balance sheet policies in order to differentiate them from conventional interest rate policies. They define the decoupling principle as paramount for our understanding of that differentiation — i.e. they stipulate that size and structure of a central bank’s balance sheet is independent of the interest rate policy that the central bank pursues.

This is particularly important as central banks need not unwind their balance sheets immediately after changing their interest rate policy, should the economy begin to recover and zero interest rates need to be abandoned. Similarly, the authors hold that specific separate exit strategies for the unconventional measures are necessary. As long as central banks have the same tools at their disposal as they had when creating these measures they can execute differently timed, decoupled policy exits.

I think that we will indeed see significant political pressures towards delays in cutting back on balance sheet policies. This relates merely to the fact, as highlighted by BIS, that central banks have certainly lost much autonomy from their governments and they have essentially taken a variety of further financial risks, including credit, market, exchange etc. Conflicting interests between the central bank and the goverment are hence very plausible. E.g. the government would like to inflate away its increased debt (think of the U.S.), but the central bank might want to get a hold of inflation at the same time (as soon as this becomes an issue).

Exit strategies will need to be well communicated in terms of intent and desired effect, so that their purpose is properly understood by the market, to render them effective. Technically, quantitative easing measures could be easily withdrawn just as liquidity facilities could no longer be extended. Higher collateral haircuts could be applied, etc. This should keep in control potential inflationary issues (at least in the short run; the longer run is more problematic and is explained in the aforementioned article). That is, if hopefully western economies start recovering faster and accelerated credit extension starts taking place, central banks will have the tools to prevent disproportionate and inflationary increase in the actual money supply in the wider economy. As I’ve seen in my current line of work, the ECB has started to pull out some liquidity facilities and has began to filter out eligible collaretal for refinancing much more carefully.

In the end of the day, central banks have also learned plenty. They will try to steer clear out of new imbalances.

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