Appear to have put the EMU back together again.
I outlined in a previous post (here) what I thought would be necessary to put a (medium-term) end to the European sovereign debt/banking crisis. Overnight announcements out of Europe present a rough draft of what I was looking for: a considerable "voluntary" write-down of Greek debt, plans to recapitalize Europe's banks, and an expanded EFSF. The details are sketchy and need fleshing out, but all of the requisite pieces are there. While this package does nothing to address the longer-term structural issues in the EMU (see previous post here), it seems to be sufficient to give that can a good punt down the road.
Markets appear to agree with my analysis. Credit spreads dropped, and equities rallied fiercely - the Eurostoxx index was up 6%! The marginal moves in short-term European bank funding costs were somewhat unsettling (sorry no imbedded charts, but you can see the one-year EUR-USD basis swap here, couldn't find a chart of the 3-month Euribor-OIS spread), but I expect these to tighten as the mechanics of the bank recapitalizations emerge and are implemented.
Smooth sailing for now. Let's forget the pending European recession and the childish partisan politics being played on the American deficit super-commission - those are concerns for another day.
Showing posts with label Peripheral Debt. Show all posts
Showing posts with label Peripheral Debt. Show all posts
Thursday, October 27, 2011
Sunday, October 16, 2011
A Europlan that Works
Winston Churchill once remarked that "American can always be counted on to do the right thing... after they have exhausted all other possibilities." While the veracity of this statement is certainly up for debate, it seems to apply to European policymakers in today's context.
Over the last 18 months a litany of ineffective plans have been drafted and implemented to deal with the sovereign debt crisis. Leaving various nuances aside, these plans are pretty effectively summed up by the following: (1) Provide country X with Y billion euros in loans at below-market rates, (2) force austerity on country X, (3) declare that country X is illiquid rather than insolvent and reiterate commitment to no bankruptcies in the euro area (4) on the basis of illiquidity rather than insolvency, have the ECB purchase country X's bonds. Keen minds in financial markets saw through each of these plans (Macro Man has offered a concise analysis of the failings of each plan), and the market disruptions they were designed to end always re-emerged.
The most recent bout of market instability differed from those which preceded it in that it posed an immediate existential threat to the European banking sector. This seems to have finally woken European policy makers up to the scale and severity of the problem. A series of meetings (and subsequent statements/announcements), as well as various leaks have offered observers a glimpse of the plan being negotiated. It appears to include the following:
It is important to point out that the plan, in the form outlined above, would not address the longer-term structural issues I outlined in my earlier post. However, it would mitigate the more immediate threat, giving policy makers time to make the necessary adjustments to the legal structure governing the euro area (I am not particularly optimistic that the necessary changes will be made, however that is a discussion for another day).
Over the last 18 months a litany of ineffective plans have been drafted and implemented to deal with the sovereign debt crisis. Leaving various nuances aside, these plans are pretty effectively summed up by the following: (1) Provide country X with Y billion euros in loans at below-market rates, (2) force austerity on country X, (3) declare that country X is illiquid rather than insolvent and reiterate commitment to no bankruptcies in the euro area (4) on the basis of illiquidity rather than insolvency, have the ECB purchase country X's bonds. Keen minds in financial markets saw through each of these plans (Macro Man has offered a concise analysis of the failings of each plan), and the market disruptions they were designed to end always re-emerged.
The most recent bout of market instability differed from those which preceded it in that it posed an immediate existential threat to the European banking sector. This seems to have finally woken European policy makers up to the scale and severity of the problem. A series of meetings (and subsequent statements/announcements), as well as various leaks have offered observers a glimpse of the plan being negotiated. It appears to include the following:
- A forced Greek default, with a haircut of 40-50%.
- A commitment that no other countries will be allowed to default (this will require either a larger EFSF or more bond purchases by the ECB to be credible).
- Bank recapitalizations. There is to be a new round of stress tests including a much harsher set of assumptions surrounding sovereign debt valuations. Where the estimated 200 billion euros necessary to get all European banks to the targeted 9% tier 1 capital under the stressed scenario will come from is to be determined, but it seems that there are enough good credits in Europe to raise the money.
It is important to point out that the plan, in the form outlined above, would not address the longer-term structural issues I outlined in my earlier post. However, it would mitigate the more immediate threat, giving policy makers time to make the necessary adjustments to the legal structure governing the euro area (I am not particularly optimistic that the necessary changes will be made, however that is a discussion for another day).
Thursday, September 29, 2011
European Blow-Up Risk - Hedge Edition
If you were looking to hedge European meltdown risk in the CDS market, who would be your reference entity of choice?
Parsing CDCC data gives us an indication of how others are hedging this type of exposure - French CDS. Initially, I found this surprising: if you are worried about your exposure to Italy or Spain, wouldn't it make sense to go long their respective CDS? On second thought though, this move appears quite rational. Assuming that Italy and Spain are too big too bail out (that is certainly the perception on the street), then it is reasonable to assume that if either of their bond markets collapse, the French government would be the next domino. So why pay a higher spread for Italian or Spanish CDS when French CDS provides essentially the same hedge? I think that my interpretation is strengthened by the fact that net notional exposure to France took off in July and August, as Italy teetered on the brink
Another interesting nuance of the data is that CDS exposure to Greece and Portugual have fallen substantially this year. Could it be the case that all those lawyers that the EU have hired to avoid a technical default are undermining market confidence in whether Greek/Portuguese CDS will actually payout in the event of default?
Parsing CDCC data gives us an indication of how others are hedging this type of exposure - French CDS. Initially, I found this surprising: if you are worried about your exposure to Italy or Spain, wouldn't it make sense to go long their respective CDS? On second thought though, this move appears quite rational. Assuming that Italy and Spain are too big too bail out (that is certainly the perception on the street), then it is reasonable to assume that if either of their bond markets collapse, the French government would be the next domino. So why pay a higher spread for Italian or Spanish CDS when French CDS provides essentially the same hedge? I think that my interpretation is strengthened by the fact that net notional exposure to France took off in July and August, as Italy teetered on the brink
Another interesting nuance of the data is that CDS exposure to Greece and Portugual have fallen substantially this year. Could it be the case that all those lawyers that the EU have hired to avoid a technical default are undermining market confidence in whether Greek/Portuguese CDS will actually payout in the event of default?
Friday, June 17, 2011
Working Assumptions and Predictions
Well at long last, it is time to get this blog started up again. Third time the charm?
I suppose the best (and easiest) way to go about this is to articulate the assumptions which impact my worldview and expectations of how the global economy will evolve moving forward:
1) Greece and Ireland are insolvent. The only way out of their current situation will be debt restructuring. The current policy is quite clearly to roll maturing privately-held debt onto the books of the solvent core EU members, in anticipation of a restructuring at a later date. It is unfortunate that the precarious state of the European banking sector does not allow policy makers to force a restructuring of privately held debt (and let the cards fall where they may) but that is the status quo, and the current policy strikes me as the least-bad of policy makers' options. Domestic politics in both the core and periphery nations are the biggest threat to the current policy prescription, but I am guardedly optimistic that it will be sustained until a restructuring is a containable event. I think it is incredibly unfair that German taxpayers will have to shoulder a considerable amount of this burden, but it is a necessary evil.
Once the EU emerges from the slow burn of the peripheral debt crisis (if it does at all), there will have to be a dramatic move towards fiscal union in order for the common currency to be tenable. However, I fear that the electorate in member countries will be unwilling to accept this and therefore am not confident in the long-term sustainability of the Euro as a currency. That being said, I do understand the significant benefits of regional integration and expect regional currencies to be a more common phenomenon moving forward (say on a 50-year time frame)
2) The emergence of the Tea Party in the United States has made a responsible discussion of the U.S. budget deficit a near-impossibility before the next presidential election. Any Republican presidential hopeful must pander to the hard right's overzealous anything-but-tax-to-fix-the-deficit dogmatism and cannot be seen as cooperating with Obama on anything if they are to succeed in the Republican primaries. Diddo for any Republican who will be seeking re-election in the near term. Fortunately, I don't see this as cataclysmic for the Treasury market. Perhaps some risk premium will be priced in (and rightly so), but I do not foresee a Greece-like spike in yields anytime soon (sorry Gross et al).
3) I don't believe the hype about China. Yes they have grown 10% annually for 30 odd years. No, it cannot be sustained for the next 30. Anyone who tells you otherwise is either a fool, or has an ulterior motive for doing so. Over the last 3 years, there has been an unprecedented surge in lending without enough/any analysis of borrowers' credit worthiness. The result has been massive investment in what will turn out to be overcapacity and totally unproductive infrastructure. We are already witnessing the first ramifications of this in the form of spiking non-performing loan ratios, and it is going to get much worse before it gets better.
That being said, I am a long-term China bull - a chart of fixed capital per capita in China vs the West is all I need - but there are going to be some pretty nasty surprises in the short term, which will shift long-term output projections downward. Trend growth will also prove to be closer to 7% than 10%.
4) There has been an accelerating shift over the last 150 years from a world where capital was very scarce and real interest rates were high, to a world where capital is abundant and real interest rates on high quality investments are much lower. This is the necessary by-product of enormous gains in economic efficiency, which has lead to higher aggregate savings as an ever-expanding proportion of the population produces more than they consume and are thereby able to save for the future. While the implications of this shift are surely enormous, they are also not immediately apparent to me. If financial markets manage to allocate this capital more efficiently, it should allow for more entrepreneurial ventures and positively impact total factor productivity. Holding inflation constant, this will allow for more leverage across the economy, from the consumer through to the government, as the cost of debt service declines. This final dynamic strikes me as one of the most under appreciated dynamics at play in the global economy and warrants significant analysis by both private and public decision makers.
5) Finally, over the long term, as there is a transition to a more multi-polar world, I expect a re-emergence of realpolitik and a shift to the right across the Western world as a number of liberal ideals which (while both admirable and generally desirable) will lose priority in a more adversarial global community.
I suppose the best (and easiest) way to go about this is to articulate the assumptions which impact my worldview and expectations of how the global economy will evolve moving forward:
1) Greece and Ireland are insolvent. The only way out of their current situation will be debt restructuring. The current policy is quite clearly to roll maturing privately-held debt onto the books of the solvent core EU members, in anticipation of a restructuring at a later date. It is unfortunate that the precarious state of the European banking sector does not allow policy makers to force a restructuring of privately held debt (and let the cards fall where they may) but that is the status quo, and the current policy strikes me as the least-bad of policy makers' options. Domestic politics in both the core and periphery nations are the biggest threat to the current policy prescription, but I am guardedly optimistic that it will be sustained until a restructuring is a containable event. I think it is incredibly unfair that German taxpayers will have to shoulder a considerable amount of this burden, but it is a necessary evil.
Once the EU emerges from the slow burn of the peripheral debt crisis (if it does at all), there will have to be a dramatic move towards fiscal union in order for the common currency to be tenable. However, I fear that the electorate in member countries will be unwilling to accept this and therefore am not confident in the long-term sustainability of the Euro as a currency. That being said, I do understand the significant benefits of regional integration and expect regional currencies to be a more common phenomenon moving forward (say on a 50-year time frame)
2) The emergence of the Tea Party in the United States has made a responsible discussion of the U.S. budget deficit a near-impossibility before the next presidential election. Any Republican presidential hopeful must pander to the hard right's overzealous anything-but-tax-to-fix-the-deficit dogmatism and cannot be seen as cooperating with Obama on anything if they are to succeed in the Republican primaries. Diddo for any Republican who will be seeking re-election in the near term. Fortunately, I don't see this as cataclysmic for the Treasury market. Perhaps some risk premium will be priced in (and rightly so), but I do not foresee a Greece-like spike in yields anytime soon (sorry Gross et al).
3) I don't believe the hype about China. Yes they have grown 10% annually for 30 odd years. No, it cannot be sustained for the next 30. Anyone who tells you otherwise is either a fool, or has an ulterior motive for doing so. Over the last 3 years, there has been an unprecedented surge in lending without enough/any analysis of borrowers' credit worthiness. The result has been massive investment in what will turn out to be overcapacity and totally unproductive infrastructure. We are already witnessing the first ramifications of this in the form of spiking non-performing loan ratios, and it is going to get much worse before it gets better.
That being said, I am a long-term China bull - a chart of fixed capital per capita in China vs the West is all I need - but there are going to be some pretty nasty surprises in the short term, which will shift long-term output projections downward. Trend growth will also prove to be closer to 7% than 10%.
4) There has been an accelerating shift over the last 150 years from a world where capital was very scarce and real interest rates were high, to a world where capital is abundant and real interest rates on high quality investments are much lower. This is the necessary by-product of enormous gains in economic efficiency, which has lead to higher aggregate savings as an ever-expanding proportion of the population produces more than they consume and are thereby able to save for the future. While the implications of this shift are surely enormous, they are also not immediately apparent to me. If financial markets manage to allocate this capital more efficiently, it should allow for more entrepreneurial ventures and positively impact total factor productivity. Holding inflation constant, this will allow for more leverage across the economy, from the consumer through to the government, as the cost of debt service declines. This final dynamic strikes me as one of the most under appreciated dynamics at play in the global economy and warrants significant analysis by both private and public decision makers.
5) Finally, over the long term, as there is a transition to a more multi-polar world, I expect a re-emergence of realpolitik and a shift to the right across the Western world as a number of liberal ideals which (while both admirable and generally desirable) will lose priority in a more adversarial global community.
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