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Saturday, July 30, 2011

A Comparison with the USA

The Greek and American economies (and their respective problems) have very much in common. First, however, the differences.

America has the largest economy of the world (and Greece does not). While that is only a soft fact, it is an important soft fact. America is the world's only country which can print the currency in which it has its foreign debt (Greece obviously cannot). While that is unfair to the foreign holders of that debt, it is a great advantage for Americans. And, finally, America is an excellent place for foreign investment (and Greece is not). If foreigners no longer want to hold American debt instruments, they can invest the money in, for instance, buying all the S&P companies; half of Manhattan; perhaps all of Florida; etc. Now to the similarities.

Compared to 30-40 years ago, America has become radically de-industrialized. Goods which used to be manufactured in America are now being imported. An American quote from the 1970s: "If the Japanese want to work 18 hours a day in exchange for us signing promissory notes, that's fine with me". Well, it's no longer fine because the manufacturing jobs went to other countries as well. Greece never had that much manufacturing but much of the little that there ever was is now gone. Why? Because Greeks preferred signing promissory notes to other countries for imports instead of manufacturing themselves.

It is not a conscious decision to "sign promissory notes in exchange for other people's manufacturing". It just happens. It happens when other people's manufacturing becomes cheaper than one's own and when one has the creditworthiness to issue promissory notes at low interest rates.

When countries import more than they export, they incur a trade deficit. That trade deficit becomes a current account deficit when other incomes from abroad (like tourism) do not fill the gap left by the trade deficit.

A country's current account deficit represents the transfer of wealth from it to the rest of the world. The American current account deficit peaked around 7% of GNP; the Greek one was twice as high at its peak.

Free international trade is always cited as a major factor in creating wealth of nations because it leverages on the efficiencies of the division of labor. That is correct as long as international trade is more or less balanced over time. If international trade becomes structurally unbalanced, the following happens.

Some countries import the products they need (and lose jobs) and other countries manufacture and export them (and create jobs). The exporters generate cash from abroad which they have to lend to the importers so that those can continue to pay for imports. The consumption-addicted and no-fear-of-debt-minded American consumer became the importer; the hard-working Chinese with low labor costs became the exporter. America was drained of cash and China built it up. That way, the American consumer has been for decades now the major locomotive of world-wide economic growth. The price he paid for that was indebtedness. The price the Chinese paid was having to make loans to Americans.

The Greek consumer also discovered that it is more fun to let other people work and pay for their work/products with promissory notes. Thanks to the Euro, Greece assumed the same creditworthiness as, say, Germany and could borrow cheap money like there was no tomorrow. Germany accumulated cash which it had to lend, and it lent it to Greece. That way, Greece became a mini-locomotive for the creation of wealth in Germany.

The American mantra of the last decade has been: "We sell each other houses at inflated prices with money borrowed abroad" (and the real estate bubble built up). The Greek mantra was: "We sell each other souvlaki at inflated prices with money borrowed abroad" (and the whole country became a bubble).

"It takes two to tango!" International trade requires two parties who can benefit one another in order to create wealth for both. Remember the "opium war" of the 19th century. The British were crazy about tea from China and they imported it. The Chinese insisted on being paid in silver. The British scraped up every silver they could find and gave it to China as payment for tea. Instead of using that silver for buying, say, manufacturings from Britain, the Chinese refused to trade and sat on their silver. Britain ran out of silver and China accumulated it. Since the British did not want to stop drinking Chinese tea, they had to find other ways to get some of the silver back from China. They discovered that the Chinese loved opium as much as the British loved tea. So the British smuggled opium into China, received payment for it in silver so that they could use that silver to buy tea from China. And that lead to war.

America has been "ripped off by China" for decades now the same way that Greece was ripped off by, say, Germany since the Euro. However, the "ripping-off" needs to be clarified. If one people prefers high consumption with little work and another people prefers high work with little consumption, the "ripping-off" is a voluntary meeting of mutual interests. That system, however, can only work as long as the cash-receiving people are willing to lend that cash to the cash-paying people.

A country's Balance of Payments must balance. This is an issue of mathematics and not economics: never can more cash leave a country than enters the country in the first place. It may leave the country as wealth and it may return to it as debt but the accounts must balance!

Greeks may argue that a country like, say, Germany "owes" Greece to provide financing because Germany took profits on Greece by being able to export so much over the years. That is principally not false. However, the German profits were made by private sector exporters while the financing is provided by tax payers. Of course, from the Greek standpoint it is "German cash" but from the German standpoint it does matter from which pocket the cash comes.

If international trade does not become structurally more balanced, the world will become more separated into the "have's" and "have-not's". The "have's" will have many jobs and lots of cash, and the "have-not's" will have diminishing jobs and lots of need for cash. Germany and China will be among the "have's" and America and Greece will be among the "have-not's". Given the positive soft facts surrounding the American economy, it will continue to attract other people's cash for much, much longer than Greece. Given the negative soft facts surrounding the Greek economy, the voluntary inflow of cash has already stopped.

Americans and Greeks can congratulate themselves for having contributed to the creation of jobs and wealth elsewhere. The price they paid for that is indebtedness to people elsewhere.

The only long-term solution to these problems is to seek ways how international trade can become structurally more balanced so that wealth creation becomes structurally more balanced.

Monday, July 25, 2011

Participation of Private Banks

The details of the deal can be summarized as follows:

Banks can swap half of their junk-rated Greek assets 1:1 into AAA-rated 30-year assets with a fixed interest rate of 4,5% (the interest, however, remains "Greek risk").

They can do the same with the other half except that on this swap they must assume a discount "economically equivalent" to 21% of the net present value (NPV). How that discount will be calculated (NPV of what? perhaps even including foregone income?) remains unclear.

If banks were to sell their Greek assets in the secondary market today (if they could be sold in the first place), they would at best receive 50% of the nominal value. Under the above deal, the banks are likely to receive (adjusted for the various elements of the plan) an estimated 85-90% of the nominal value.

Mr. Ackermann announced with a solemn expression on his face that this deal "is very hard for us". After having made this accouncement, he probably retreated to a private meeting with his colleagues and opened champagne bottles!

Friday, July 22, 2011

Was is a good deal?

The Prime Minister needs to be congratulated on his public performance at EU levels during the last months. Until Merkel/Sarkozy finally sat down last Wednesday to do some serious business (note that there was no leak after their meeting!), it seemed like there was a EU-kindergarden on one side and a polished professional who kept his poise all the time (and didn’t talk nonsense) on the other. Congratulations!

Of course, the Prime Minister now faces the challenge to explain to Greeks why, with all that new money to come, the government will have to save even more in the near future.

More importantly, the Prime Minister needs to be aware that the present joy will last only until the next time that the Troika needs to make a compliance check (September/October?). That will be the time when Greeks have returned from the beaches to find out that, among others, their energy costs for the winter will sky-rocket.

Also, the Prime Minister needs to be reminded that any solution to the Greek problem stands on 3 pillars; they are inertwined and if only one of them fails, the entire construct will fail. These pillars are: government spending and public debt (much progress has been made here), the banking sector (capital flight) and the private sector (de-industrialization). The latter 2 pillars have not yet been addressed at all.

The deal reached is a good one for Greece in as much as it lowers the government’s interest expense and reschedules debt maturities coming up during the next 3 years for 15 years. It is an excellent deal for the banks because their loan maturities during the next 3 years will be paid and any new loans they may have to make “voluntarily” during this time will be guaranteed by the EU.

For the tax payers it is “more of the same” (i. e. spend more money to bail out banks).

Whether or not it is a good deal for the Greeks depends entirely on what the next steps by the Greek government are regarding the banking and private sector. If the government believes that reducing the spending and implementing step-by-step measures (like privatizations, gradual liberalization moves, etc.) will eventually trickle down and make the economy grow, then it is mistaken.

The government must implement a comprehensive economic development plan which must be based on curtailing imports through import substitution projects, financing those new projects with foreign investment and stopping capital flight.

Thursday, July 21, 2011

After today's decision by EU-elites

Let's see what possible alternatives there are:

Debt forgiveness: hopefully not!
Result: no debt was forgiven.

A new bank tax: hopefully not!
Result: there will be no bank tax.

More money like in the past: hopefully not!
Result: there will be more money. Not quite like in the past (longer terms, lower interest rates) but it is still more money for the primary purpose of repaying private lenders.

A complex financial scheme to convert bad paper into good paper: hopefully not!
Result: no such scheme.

Private sector participation: hopefully yes! (but not the way the French Plan stipulates).
Result: details are not known yet. It appears that the private sector will accept longer terms but will be guaranteed by the EU. It also appears that it will reduce interest rates.

Rescheduling debt: hopefully yes!!! 50% of the present debt should be rescheduled out to 20 years and interest on that should be capitalized and payable upon maturity! The remaining debt should be rescheduled out to 5-10 years with minimal interest payments during the first 5 years.
Result: basically no rescheduling of existing debt (from what is known so far). The new money will be for 15 years and replaces debt which matures. Thus, it does stretch the debt profile.


Overall assessment: this summit was surprisingly well orchestrated (no news leaks before the summit!). The "Operation Transfer of Private Sector to Public Sector Risk" has its budget increased by 109 billion EUR. The Greek government remains solvent. Nothing was announced regarding plans for the Greek banking sector and the economy. Before these 2 issues are addressed and resolved, one cannot speak of a solution of the problem.

Before today's decision by EU-Elites

Let's see what possible alternatives there are:

Debt forgiveness: hopefully not!

A new bank tax: hopefully not!

More money like in the past: hopefully not!

A complex financial scheme to convert bad paper into good paper: hopefully not!

Private sector participation: hopefully yes! (but not the way the French Plan stipulates).

Rescheduling debt: hopefully yes!!! 50% of the present debt should be rescheduled out to 20 years and interest on that should be capitalized and payable upon maturity! The remaining debt should be rescheduled out to 5-10 years with minimal interest payments during the first 5 years.

Tuesday, July 19, 2011

Bill Rhodes on Europeans

William R. ("Bill") Rhodes is probably the world's most competent expert on sovereign debt reschudulings. In a recent interview with The Economist he said the following:

“One of the things: you’ve got to have the Europeans speak with one voice. You can’t have this bickering publicly because all it does is undermine the positions, scare the hell out of markets and make life a lot more difficult than it should be”.

Nothing needs to be added to this!


On Debt Reschedulings

The major difference between Greece’s debt today and Argentina’s in the 1980s is that Argentina’s debt then was mostly bank loans (about 500 banks worldwide) whereas Greece’s debt is mostly public bonds.

When debt takes the form of bank loans, a rescheduling is “relatively easy”: one knows all the lenders and one sits down with them to agree on a solution. In practice (and in simplified form) this means the following: each of the 500 banks reports to the Steering Committee the amount of its loans outstanding; the Steering Committee adds up the numbers and structures a new consolidated loan for the total. This new loan is, of course, a totally “voluntary” new loan which has one primary purpose: to repay the existing loans outstanding. The efficiency of such a structure is enormous: instead of having to deal with 500 banks individually, the borrower now deals only with the Steering Committee. The payment terms under the new consolidated loan are structured in line with the expected payment capacity of the borrower. The Loan Agreement defines Events of Default which reserve the lenders the right to intervene should things not develop as expected. However, the risk of default can be managed because it is under the control of the lenders to declare default or not.

When debt takes the form of public bonds, the rescheduling challenge is enormously greater. First, one does not officially know the holders of the bonds. Financial institutions can declare their holdings but they are not required to do so. In consequence, the holder of a bond can choose to remain anonymous which makes it impossible to involve him in any rescheduling. Secondly, the potential number of bond holders (including private investors) is likely to be so large that one cannot get all of them into a conference hall to agree on something (and if only one of them disagrees and declares default, it becomes messy; refer to Argentine bonds of 10 years ago).

Here, lawyers are challenged to find solutions. At the end of the day, a solution must be found where the number of authorized decision-makers can be reduced so that they all fit into a conference hall. It is possible but very difficult.

The rest of the process is the same as with private bank loans. A new bond is issued which the present bond holders agree to buy “voluntarily” and the proceeds of that bond are used to repay existing bonds. The terms are negotiated and structured in similar fashion as with private bank loans.

In neither of the 2 scenarios does a “haircut” become an issue. The existing debt must de jure be preserved at its nominal value even though it may today appear impossible for the borrower to ever repay the entire new bond. A forgiveness of debt may be the unavoidable result at some point in the future but – in the interest of principle and precedent - one has to try for many years to avoid it. The same economic effect of a haircut (reduction of debt service) is achieved by rescheduling principal payments way into the future and by capitalizing interest and making it payable upon maturity.

The lenders, of course, have to write down the value of the new bond to market prices today. Whether or not the bond becomes worthless in the end or recovers value depends entirely on the success/failure of the restructuring of the economy.

Monday, July 18, 2011

Letter to Mr. Jean-Claude Trichet, President of the ECB

Dear Sir:

your comments in today’s FTD can be interpreted to mean that anything other than continued EU-financing for Greece would be unacceptable to the ECB. I hope I misunderstood because, if not, you might as well have said that anything other than continued bail-out’s of banks on the part of the EU would be unacceptable to the ECB.

You threaten to no longer accept Greek bonds as collateral for extending credit to the Greek banking sector. That is something the ECB should have done already 2 years ago in order to trigger timely attention to the real problem. Not having done that is one of the major reasons why the process is now more or less out of control.

The threat now to no longer accept Greek bonds as collateral is a bluff which is almost asking to be called. You know very well that the same day that the ECB does that, it would have to close its doors (or rather: then the governments would indeed be forced to replenish its capital).

I trust you know how Mr. William R. (“Bill”) Rhodes feels about the present actions on the part of EU/ECB-officials and politicians; if not, listen to his interview in The Economist. Having been involved with Bill Rhodes during the Argentine reschedulings during the 1980s, I feel qualified to say that he is the world’s most renowned expert on debt reschedulings.

Any payment difficulty (be the borrower a company or a country) is, at the start, an issue between borrower and lenders. Governments can (and should!) steer that process behind the scenes but officially they only come in at the end of the process and not at its beginning. That way, the lenders remain “on the hook” from the outset and this must be a conditio sine qua non. The fact the EU/ECB have jumped the gun and, thereby, assumed responsibility from the start is a case of irresponsibility versus the public of gigantic proportions!

The Greek debt must not be forgiven and it must not be refinanced by tax payers. Instead, it must be rescheduled in such a way that everyone can as soon as possible devote resources and brain power to the issue which is at the crux of everything: the re-industrialization of the Greek economy. Without that, everything else is like rearranging chairs on the deck of the Titanic!

Saturday, July 16, 2011

Ekathimerini - Debt Restructuring/Default

The article by Stavros Lygeros describes the alternatives of what can/should be done with the debt accurately. One finds very few commentaries/announcements (be that by journalists, EU-politicians or Central Bankers) which state the facts so accurately. Instead, they seem to prefer to portray financial Armaggeddon. I would like to add some further aspects and/or clarifications.

First, a debt restructuring and a debt forgiveness (“haircut”) are 2 completely separate things. The former is the most natural thing in the world when a borrower is no longer able to service his debts. The latter is an absolute exception and should be a “no-no” for a country which is a member of the EU.

Secondly, the idea behind a haircut is to reduce the borrower’s debt service burden. In the case of a corporation which has to prepare a balance sheet, a haircut may be mandatory in order to avoid an over-indebtedness in terms of accounting (which would trigger bankruptcy). A government does not prepare a balance sheet. Instead, it accounts for actual incomes/expenses. Thus, if a government restructures its debt in such a way that principal and interest payments are deferred way into the future, it has the same economic effect as a haircut. As Mr. Lygeros correctly states: “It is the efficacy of a debt restructuring that is important, therefore, rather than the form it will take”.

Thirdly, there is a difference between private debt (loans from banks) and public debt (bonds). With private debt, a consensual restructuring of debt is under no circumstances an event of default (the whole idea of a consensual restructuring is to avoid such an event).

Fourthly, whether or not a consensual restructuring of public debt constitutes an event of default is under no circumstances so clear as everyone says it is. Here, one would have to commission a task force (rating agencies, accounting boards, lawyers, accountants) to see how an event of default could possibly be avoided. Personally, I am certain that it can be (the rescheduled Latin American bonds did not constitute an event of default with the exception of Argentina which repudiated debt outright).

Fifthly, the fact that Germany needs to plead that private banks share the burden is a joke! In a debt restructuring, the existing lenders have to share ALL of the burden, i. e. they are “stuck” with their existing exposures and hope not to have to put in too much Fresh Money. EU-politicians and Central Banks have managed to turn the principles of a normal debt restructuring upside down in the last 1-2 years!

Sixtly, “fiscal reform in combination with a consensual restructuring that will render the debt serviceable is required”. Yes, it is. But it alone won’t solve the problem. While the government indeed needs to cut its expenses, it also has to increase its revenues. Tax increases in a depressive economy won’t do the revenue side a bit of good. Reducing tax evasion would do the revenue side a lot of good but that is a separate and extremely complex issue. The only thing which will improve the revenue side on a sustained basis is a growing private sector economy which will increase tax payments without increasing tax rates.

Finally, and most importantly, what is missing in all the debates so far is a proposal to get the private sector economy going again. My own proposal is to start new production for import substitution and finance this with foreign investment (offshore funds of Greeks) where the investors are protected by a new Foreign Investment Law of constitutional rank and guaranteed by the EU so that the foreign investor does not carry any political risk.