notes and things

Cyprus: A Small Country Raises Big Questions

Wed, 17 Apr 2013 21:34:57 +0300

Recent negotiations over Cyprus’ bailout plan tested the hard wrought stability of a union which seemed finally to have solved a few of its core problems.

Few imagined that the Mediterranean country’s financial problems, well known in advance, could rattle the European Union anew. Yet an economy approximately one tenth the size of Greece’s, where the estimated sum of a bailout package would reach a maximum of €18 billion, in relative terms a paltry sum, raised more existential problems for the euro.

Cyprus’ rescue could have been the culmination of two years of negotiations and institution building. It could have shown the world and indeed the European Union itself that it was finally able to handle these situations with little ado.

Yet old superstitions arose and instead of following on recent developments, the European Union and the International Monetary Fund decided to break assurances and introduce new contingencies, the consequences of which will only be fully known once a bigger euro country enters a period of instability.

Northern European countries believe that Cyprus’ economic policy structure has two undesirable elements to it.

First, it has an oversized financial sector. Cypriot bank assets are worth roughly seven times the island’s gross domestic product. Financial institutions choose to settle in Cyprus because it is part of the single currency union but has a lower corporate tax rate than most member states.

Second, it is a hub for Russian investors who wish to deposit their funds in the eurozone. This has created the perception of European taxpayers having to bail out a tax haven of the Russian oligarchy.

Even in ordinary times, saving Cyprus from the possibility of sovereign default would therefore have been difficult. With German elections scheduled for later this year, the bailout was all the more politically toxic.

The Cypriot bailout was preceded by half a year of negotiations about how to decouple the problem of indebted states from banks that might need financial aid to survive. One of the pieces missing from the framework is a European deposit guarantee that should alleviate the fears of savers in especially the south of Europe. If a bank there collapses, states, coping with high debts of their own, might not be able to compensate savers. A deposit guarantee scheme spanning the whole of the euro area if not the whole European Union would remove such uncertainty.

Instead of building on this framework, however, Cyprus was presented with something else entirely.

The first proposal from the European Union would have required all depositors to contribute to the refinancing of the banking industry. This meant a 9.9 percent tax on big savers and a 6.75 percent levy on deposits under €100,000.

Uproar ensued and capital controls were imposed to stave off a bank run. Parliament rejected the rescue plan unanimously. Only later did it emerge that the scheme had been suggested by Cyprus’ president Nicos Anastasiades who feared that if regular depositors were not included, big depositors would take a hit that could destabilize his country’s economic model.

The revised rescue plan safeguarded deposits under €100,000 in accordance with a 2009 guarantee pledge. The damage, however, was already done.

Even if the deposit guarantee was honored, the situation left many wondering what would happen if a similar situation occurred in a systematically more important member of the eurozone. If Cyprus, small enough to be bailed out, could consider a deposit tax, are savings in Italy and Spain safe? Just how solid is Europe’s deposit insurance promise anyway?

European leaders insisted in July 2011 that private sector involvement in the restructuring of Greece’s debt was “exceptional” and “unique.”

“All other euro countries solemnly reaffirm their inflexible determination to honour fully their own individual sovereign signature and all their commitments to sustainable fiscal conditions and structural reforms.”

The situation in Cyprus was different. Private investors were not directly involved in a sovereign debt restructuring. Yet given the context of the Cypriot bailout, the question for businesses and savers across Europe must be—how different?

The Black Swan in Tallinn

Sun, 05 Aug 2012 16:14:26 +0300

A relatively short distance of road leading in to the city centre of Tallinn has been a good reflection of the state of the country during these last few years. Just in the outskirts of town, before buildings start to consecutively become more and more frequent until they form the urban tunnel all big city roads are identified by, there is a housing / business development under the name of Black Swan (Must Luik). To my knowledge it had been bought from its previous owner – the complex had a café and other non-descript tenants - and the aim was to build apartments on the top floor with smaller businesses covering the ground floor. One of the conditions for the development was that the owner needed to renovate old Tsar-era houses that were adjacent to the lot.

Well, the ‘black swan’ event of 2008 occurred and the debt-fuelled housing bubble burst, leaving a derelict building site whose façade slowly lost any serious appearance. The old house was languishing and in terrible disrepair; that part of the roadside served to remind one of the difficult situation many Estonians were facing.

In 2012, the Black Swan development is finished. Just before I left Tallinn a new shop and café had been opened on the premise. The black façade looked new and the window-covered exterior reflected the park on the opposite side. The older house is renovated from the outside and its peak stands majestically over the buildings.

This is but one building that has seen its completion in a short time. Equally so has a new retail / office space opened up further down the sea-side road leading to the city centre. What does the nearby billboard advertise? “Having trouble selling your property? Contact us and we’ll get it sold.”

European Central Bank Signals Willingness to Intervene

Mon, 30 Jul 2012 00:42:46 +0300

The oscillations of the European debt crises have become quite familiar to those observing it. A country or national bank suffers from a negative spiral of debt and fading confidence. This is followed by a new nudge in the direction of deeper integration, or a bailout package is announced. A northern country which is fiscally sound then makes a controversial statement of refusing to cooperate on the terms proposed. This process muddles on until a new country or institution is in a dire situation. Like last year, summer holiday season generates the greatest divide between the political process and the factors that affect the crisis.

Quite apart from this has been the European Central Bank. For this reason, Mario Draghi, its president, recently caused a stir that reverberated far from the usual central bank watchers.

In a speech at an investment conference in London, Draghi went against two developments. First, central banks have historically been excruciatingly vague in their announcements regarding future action. Draghi’s speech was quite blunt. Second, the announcement can be interpreted as a commitment by the central bank to safeguard government bond yields from rising too high. This could in effect generate the expectation of future interventions in the bond markets, which may permanently lower yields. Of particular interest are the following passages.

“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

“Then there’s another dimension to this that has to do with the premia that are being charged on sovereign states borrowings. These premia have to do, as I said, with default, with liquidity but they also have to do more and more with convertibility, with the risk of convertibility. Now to the extent that these premia do not have to do with factors inherent to my counterparty—they come into our mandate. They come within our remit.”

The last paragraph especially seems to indicate that the European Central Bank will intervene when it expects yield increases to have little do with governments’ solvency rather other factors affecting the borrowing costs of eurozone states. Whether this is the central bank backing that many have been hoping to see remains unknown. Future interventions will not only indicate the extent of support but also show through what institutional setup it will come through.

Markets were quick to react nevertheless. Bond yields for both Italy and Spain have come down somewhat, despite news of rising unemployment in Spain and further complications in Greece. This is perhaps becoming the familiar role played by the bank: like the tremendous liquidity provision during 2012 December holidays, it may have once again taken a step toward saving the single currency.

European Banking Union Step Toward “Transfer Union”

Sat, 21 Jul 2012 23:15:11 +0300

In many European countries, two important but ailing institutions are currently interlinked: sovereign states and national banks. The interdependency between them explains in large measure why the continent’s leaders are contemplating a banking union.

A national bank tends to unofficially support its sovereign by buying government debt. An ailing financial system can by itself generate a large negative shock to the economy due to its function in allocating resources. This is especially true in Europe as it depends greatly on its banks for this function. Large, systematically important banks tend to be implicitly backed by their sovereigns. When either experiences considerable stress, the other suffers similarly.

The direction of causality is not always the same. In Ireland, a dysfunctional financial sector added too much debt to the sovereign when Dublin pledged to prop up its banks. In Greece, the amount of government debt generated a crisis which spread to its, and neighboring, financial systems.

When Mario Draghi decided in December of last year to provide an unlimited credit window to banks, it proved not enough to permanently instil confidence. Banks that have amassed assets on their balance sheet that may not look attractive remain fundamentally unstable. Indeed, given that the European Central Bank doesn’t necessarily operate as a “lender of last resort,” it has only put more strain on the balance sheets of sovereign states that are expected to save private banks from collapse. With this in mind, it was not a surprise that investors considered the €100 billion recently requested by Spain in support of its ailing banks as an addition to sovereign debt.

A banking union is seen as the next and a necessary step in “ever closer union.” In view of all the other options that have been debated, most prominently eurobonds, the fact that a banking union is seen as the least worst compromise is telling.

The nature of eurobonds is comparatively simple and it is difficult to mask the fact that some countries would benefit from the fiscal discipline of others. A banking union is indirect and adds layers of complexity to the bailout process. Like the covered bond purchases of the European Central Bank during the worst of the crisis or more recent interventions, the direction of funds and who provides them is not obvious.

A European banking union, governed by the European Central Bank, would seek to correct two pressing issues. First, as deliberated above, it would decouple sovereign and banks’ balance sheets. It would give power to the European Central Bank and the European Stability Mechanism to directly support banks without having to go through the sovereign of that country. A common framework for member states should be more than able to cover the balance sheets of banks that are deemed systematically important.

Second, one prominent issue and fear has been bank withdrawals in the countries that have come under the greatest pressure. A pan-European deposit insurance would reduce the outflow for banks where there is fear of a banking collapse.

In a more general sense it would also coordinate banking supervision and regulation. As the Bank for International Settlements states in its annual report (PDF):

The conclusion is hard to escape that a pan-European financial market and a pan-European central bank require a pan-European banking system. Put slightly differently, a currency union that centralizes the lender of last resort for banks must unify its banking system. Banks in Europe must become European banks.

With negotiations regarding the new framework beginning in September and the European Central Bank’s new powers coming to force beginning in 2013, there are a number of interesting aspects to pay attention to.

These changes will need to be defined and communicated for what they are—the reality of a “transfer union” will remain. In no way does a banking union and powers to directly recapitalize banks avoid this. Rather, as some banks are effectively shielded from the possibility of default, they may be induced to buy ever greater quantities of sovereign bonds.

Greek Debt Agreement Met With Cautious Optimism

Fri, 16 Mar 2012 20:30:00 +0200

As usual, article can also be found at http://bit.ly/ztYYlD

Last Friday saw the culmination of efforts that had started their official trajectory in the last days of July of last year when it was made official that Greece would be allowed to write off part of its sovereign debt.

Controversial at the time was the insistence on private bondholder participation, a demand that many felt increased the volatility in the sovereign debt market for all the countries that were vulnerable—Italy, Portugal, Spain.

Beyond this, the insistence by the European Central Bank that this would not trigger a credit event, effectively a way of claiming that Greek had defaulted, would not be allowed to happen. The rationale was that this would impede the ability of the bank to legally provide Greece with funds.

Following negotiations between the “troika” of the European Commission, the ECB and the International Monetary Fund, as well as various representatives of the stakeholders of Greek sovereign debt, a harrowing back and forth which often teetered on the brink of ruin, a settlement was finally reached with 85.8 percent of the bondholder value.

Beyond that, two out of three foreign Greek creditors agreed to debt swap. The new debt has potentially a very long maturity rate, up to thirty years, and the minimum loss on the original bonds will probably be more than 50 percent.

The Greek Government forced remaining bondholders into a Collective Action Clause which can retroactively force them to settle because the majority of creditors had agreed to the writeoffs and swaps.

After many months of waiting and the big credit rating agencies downgrading Greek debt to junk status, the International Swaps and Derivatives Association, the authority in determining if a credit event has taken place which would trigger credit default swaps, ruled that a credit event had indeed occurred here.

The outcome of this ruling seems to have been more optimistic than expected. The ISDA stated that the credit event was triggered specifically for Greece imposing its Credit Action Clause but the value of net CDSs this triggered is a relatively small sum, reaching $3.2 billion. This is less than 1 percent of the total bond value under consideration.

The ISDA also gave a clear ruling on what are the conditions for a credit event to take place. This may reduce uncertainty in the market and reassure CDS holders that their rights under contract are respected.

In the larger context of the European sovereign debt crisis, the swap as well as the second European Union bailout package coming into place and funds from the IMF being opened up, this could be the first good news in a very long time.

The Fitch agency even rated the new government bonds of Greece B-. Although weak by any standard, this is far from completely hopeless.

Also as a consequence of Frankfurt’s refinancing of European banks, the sovereign bond spreads for Greece and similar countries have gone down considerably, although recently the spread of Portugal went up.

Despite these relatively positive developments, the Greek people, suffering tough austerity measures, will continue to face reductions in pay, increased public sector job losses and a deterioration in living standards on top of high unemployment and underemployment.

According to the analysis conducted by the troika, with the debt swap, Greece may reach a gross domestic product to debt ration of 116 percent by 2020 and 88 percent in 2030.

These numbers go under the assumption that the last year of recession for Greece will be 2014 after which it could slowly recover and grow annually by 2.5 percent.

Given the extremely fragile nature of the situation in Greece, this is probably not the last time European countries will need to provide funds however. As public opposition to bailouts also grows, loans would probably be tied to increasingly stringent reform demands—the very sort of reforms that Greece has so far struggled to implement convincingly.

Dissertation writing is over for this time. Currently hoping that the nice people at the University of Amsterdam will deem me worthy of a place in their MSc Economics programme.

Final lap..

Thu, 02 Feb 2012 05:10:00 +0200

Less than a week left for my dissertation deadline. I am starting to find quotes of this nature worryingly amusing. Credit to R. Kroszner and BiS:

“Rather than a single bank accepting deposits from households and making commercial loans to firms or mortgage loans to other households, for example, the financial system has evolved so that a saving household might purchase shares in a money-market mutual fund that holds commercial paper issued by a bank that engages in a repurchase agreement with a securities firm that has a special purpose vehicle that issues asset-backed securities that funds a pool of residential mortgages and that purchases over-the-counter credit derivatives from other financial institutions to hedge its exposure to these securities and others in its portfolio, etc.”

People have complained that there are no pictures on my blog.....

Fri, 06 Jan 2012 03:04:10 +0200

People have complained that there are no pictures on my blog.. Chart maps EU27 countries and their annual budget deficit / surplus. Assessing the performance of Europe’s Stability and Growth Pact, where a country may not breach a budget deficit of -3%, a visually strong way to present it. (World Bank Data, European Commission)

European Fiscal Compact Could Be Challenged

Sun, 18 Dec 2011 03:07:39 +0200

I’m writing my dissertation currently, generating economics jokes I am too ashamed to write or mention. Beyond these silent nights, I am still writing for atlanticsentinel.com, do drop by.

With the recent appointment of a former European commissioner as head of Italy, a former vicepresident of the European Central Bank in Greece and the arrival of new leadership in Spain, the victory of the German path to save the euro was made even more explicit during last week’s summit.

While welcome that the euro countries are pushing for further integration, the problems with a plan dominated by long term structural change will remain. With bond rates still close to an unsustainable level for both Italy (6.85 percent) and Spain (5.83), events may trigger a serious deviation from the proposed path and force leaders to accept interventions while facing issues of moral hazard.

The solutions proposed at last week’s conference can be divided into short and long term aspects.

The long term aspects take the form of a fiscal compact which states that government budgets must be balanced or in surplus and will be regarded as such if annual structural deficits do not exceed .5 percent of nominal gross domestic product. This rule is required to be implemented on a constitutional or similar level and the European Court of Justice will be tasked with verifying that countries live up to it.

Beyond this, the summit focused on ways to enforce deficit reduction plans and future monitoring of national budgets. What is likely to come into effect is the ratification of national budgets by the European Commission before they move on to national governments for approval.

These proposals, while still far from concrete, will be supported by further fiscal integration and a deepening of the nature of cooperation between the European states.

In the short term, the latest agreement sees funding going to International Monetary Fund of about €200 billion to contribute to the crisis. This could be seen in the light of the failure to generate outside participation for Europe’s temporary bailout fund and it is hoped that non-European countries contribute to the fund once administered by the IMF. This may well provide resources that can be easily deployed without the difficult legal and political battles within the European Union.

Perhaps equally important, the proposals reaffirmed the notion that private sector losses on Greek sovereign debt were an exceptional circumstance that would not be considered in any future date for any other country. This may just be the words of chastised politicians and complications may arise as the IMF is always considered a preferred creditor, meaning that the money owed to the IMF is repaid first.

What shines in its absence is a well defined role for the European Central Bank. Given the growth numbers forecast for the eurozone, the pressure put on the currency union as a whole by ratings agencies and the size of debt financing for major countries in the years ahead, it is very likely that the central bank will need to step in for one reason or the other in an ad hoc fashion that may have dramatic consequences in the market.

This could change the longer term approach with its fiscal and political consequences. The framework has thus a considerable flaw. Of course, the absence of any inclusion of the ECB may be a way of making it appear that the bank acts independently of the political process, something which is especially important with the arrival of a new central bank president who has yet to prove its inflation fighting credentials.

What could prove to be of greatest consequence is that this summit gave tentative signs that European countries will now actively need to answer the question of what European integration looks like and how much of it they are willing to tolerate. In this regard, Britain has already done much damage to the integration process by refusing to participate in last week’s proposals. Three other countries have also gone to their respective parliaments for final approval.

Those are sobering actions that could have wide consequences on the future political map of Europe.

Europe’s “Comprehensive” Plan Raises More Questions

Mon, 31 Oct 2011 13:41:32 +0200

Article can also be found on Altanticsentinel: http://bit.ly/vGG4VM

On Thursday morning last week, negotiations had finally come to a close. After a week of meetings between European leaders and parties involved in the continent’s sovereign debt crisis, a “comprehensive” package was presented to the world.

The summits were a response to three interconnected issues that had been discussed profusely before the summit—the worsening situation in Greece, recapitalization of European banks and safeguarding Italian and Spanish creditworthiness.

The situation in Greece has continued downward, where, despite parliamentary support for additional austerity measures, there has been an intensification of strikes and unrest.

The frictions that arose between European reformers and the Greek Government in October revealed a slower pace than expected for implementing reforms and the difficulty of reaping the benefits of those reforms. The country’s economy is expected to contract by 5.5 percent this year and it may see growth again in 2013, when debt will peak at 186 per cent of gross domestic product.

This week’s negotiations saw the continuation of an agreement that was reached between eurozone leaders in July when they planned a 20 percent “haircut” of Greek debt. Last week, they ordered that private investors accept a loss of 50 percent. The bigger amount reflects the deteriorating situation in Athens and it is estimated that the writeoff will contribute to a debt level of 120 percent of GDP by the end of this decade.

The size of Europe’s temporary bailout fund is expected to increase from €400 billion to €1 trillion. Although the problems of Greece became known almost two years ago, it was not until this summer that fears over a big country defaulting reflected itself in increased lending costs. As long as the risk was contained to the smaller peripheral economies, there was no systemic risk to the whole system. However, an Italian or Spanish default would be disastrous and therefore policy makers have been looking for ways to implement a big enough “bazooka” so the bigger economies will be shielded from speculative runs.

Lastly, in order to shore up eroded confidence in European banks and safeguard them from a partial Greek default, a strenghtening of the banking industry will require a mandatory “temporary buffer” that will see a majority of Europeans banks implementing a core capital ratio of 9 percent (an extra €108 billion) over nine months. This capital is in line with the Basel III framework and is a relatively narrow and safe definition of capital.

Given the size and nature of the package, all three parts rely on factors which will be hard to live up to. For Greece, the stated aim of a debt level of 120 percent of GDP in 2020 (which, incidentally is the current level of Italian sovereign debt) means growth of 4.5 per cent in 2013, and then 3 percent up til the year 2020. This assumes that a fragile and complicated reform process will be successful at the current time frame.

The chosen method, a voluntary haircut of 50 percent of private bond holders, was the last part of the package to be agreed on and seen as a victory for German chancellor Angela Merkel and French president Nicolas Sarkozy. This left bondholders either to deal with an unorganized Greek default, which would prove catastrophic for the world economy, or a guaranteed loss of 50 percent in a relatively ordered environment.

Questions will remain regarding the consequences of this move. It is meant to make sure that the European Central Bank can keep lending to Greece (it will not lend to a country that has defaulted) and prevent cedit default swaps from being triggered.

However, investors use credit default swaps to hedge against risk and if expectations are risen that this avenue is not possible for other debt, investors may start demanding higher yields, raising the borrowing cost of other European countries.

The European Financial Stability Facility on the other hand has an uncertain future. Although there is a specific aim to bolster the size of the fund, it seems it will be done through the same financial engineering tools that developed a bad reputation during the financial crisis. Where this is not the case, it is hoped that developing countries will contribute through the International Monetary Fund yet there is fear in Europe that China’s participation will imply political bargaining as a price of participation, particularly changing the status of China to a market economy which would prohibit Europe from maintaining its anti-dumping barriers against it.

The biggest worry is that even with a €1 trillion fund, it would still not be able to safeguard a country such as Italy, with sovereign debt totalling €1.9 billion and €300 billion to roll over next year with rising borrowing costs. Italian ten year bond rose from 5.86 per cent to 6.06 after Thursday.

With a prime minister who has lost credibility in the eyes of all participants, there is a fear that the Italian Government will not be able to implement the reforms that are needed to convince a risk averse market of its ability to improve its fiscal standing.

What makes this crisis so frustrating for the rest of the world is the fact that the tools for solving the eurozone crisis already exist. The ECB could be given many more powers to guarantee Italian and Spanish bonds; it could lend to the EFSF and provide it with virtually unlimited supply of funds. The issuance of Eurobonds would essentially guarantee a more stable rate for the countries with high costs. The ECB could purchase the bonds of banks in the currency area. Yet, as the consequences are so far reaching, there is considerable political opposition.

The current process, led by Chancellor Merkel, is a gamble on how long Europe can muddle through and a test of the ability of euro countries to manage the reforms that are necessary to regain fiscal balance in the long term.

Eurobond Issuance Thwarted by German High Court

Mon, 19 Sep 2011 13:01:00 +0300

A shorter article coincides with my first day of studies, hmm. Can also be found at atlanticsentinel.com

José Manuel Barroso, president of the European Commission, announced last week that the European Union’s executive body would soon release a report on the issuance of Eurobonds. Joint sovereign bonds for the nations of the eurozone could help stem Europe’s escalating debt crises. It would provide funding for countries that have been cut off from the market and virtually guarantee the solvency of countries at risk, including Italy and Spain.

The announcement seems an attempt on the part of the commission to direct decisions away from individual states toward the political process of the EU. As the crisis has developed, the central forces have been Germany and France, Europe’s two largest economies. Although their leadership role allows decisions to be made quickly, it has also generated a sense of disorder as there has not been a clear understanding as to who is ultimately responsible. Equally, the EU has failed to provide a clear unified voice during the crisis, exacerbating market uncertainty.

While political decisions that relate to the whole of the union should undoubtedly have the consent of those they affect, Germany is in a position of power. As the strongest economy in the eurozone, the sentiment of the government in Berlin will decide whether there is or isn’t a Eurobond.

A recent German supreme court decision ruled that although the bailout measures undertaken by the country to avert a sovereign default in Greece, Ireland and Spain were lawful, further action that would impact Germany fiscally needs the approval of the federal parliament before it can be implemented.

The ruling not only frustrates the pace of future resolutions; it also reduces the probability of there being an issuance of Eurobonds in the near future. Germany has been a reluctant paymaster of this crisis and it believes that any issuance before reforms have been enacted will diminish the incentive to restructure.

As such, the issuance of Eurobonds will likely be a question for the future. If the euro manages to come out of current troubles unschated, with countries ready to accept the reforms needed in order to bring the economies of the European Union into balance, Eurobonds may well be one of the expressions of European integration.

Of bonds and Eurobonds

Tue, 23 Aug 2011 14:48:00 +0300

Crashing OS’s (evil Ubuntu), new city and new work (lovely Edinburgh), and other commitments, has left me with little time to write recently. Yet, with such an interesting August, how can one resist?

Article can also be found at Atlanticsentinel. http://t.co/n2F1gwW

Without appearing too philosophical, it may be safe to state that the economic and political choices currently facing Europe’s leaders are those of choosing a future identity.

With the debt ceiling troubles in the United States and the unconvincing resolution to the European debt crises, markets have moved dramatically the last few weeks. As the share prices of core euro banks are losing a large amount of value and the cost of sovereign debt has increased spectacularly, there are grave concerns over the current outlook. There are questions of how long the euro can muddle trough without forcing a drastic change in its whole economic and political structure. As George Soros said in an interview recently, “financial markets have a very safe way of predicting the future. They cause it.”

The pressure from markets have a number of consequences for the countries most affected. Outside of the fad of so called austerity economics, the countries most in need of running deficits are, due to markets current risk aversion, unable to do so. This not only hinders their ability to take advantage of automatic stabilizers that in downtimes smoothen demand and reduces the pressure of unemployment; it also takes away the choice of stimulating the economy which could make the contraction and the structural changes that are necessary to emerge from it less painful.

For a more technical and immediate problem, the pressure recently put on France may reduce its credit rating. If that there were to happen, the AAA rating of the European Financial Stability Facility, which derives its funding from eurozone countries and thus its creditworthiness from them, may be at risk, possibly increasing the cost of funding for the vehicle.

With uncertainty in the markets and the immense pressure sovereign debt is currently under, the proposition of a so called Eurobond has been recommended from a variety of sources. The Eurobond would be a financial vehicle backed by the entire euro area. As such, instead of each country auctioning its debt and paying the interest markets supply to them, all countries would use the same vehicle to finance deficit spending, thus paying the same price.

This was practically a reality prior to the 2007 financial crisis when peripheral countries were able to borrow at close to the same price as Germany. Interest rates for countries as Greece, Ireland and Portugal rose sharply in the wake of the financial turmoil when markets began to worry that they might not eventually be able to pay back their debts. These countries, in fact, teetered on the brink of bankruptcy and had to be bailed out by their fellow eurozone nations.

Since most countries in the single currency area are economically stable, a Eurobond would enable the least competitive among them to receive funding from the markets, substantially lowering the costs for countries that are currently in trouble.

There are objections of the sort that a Eurobond, much like when the Germans replaced their mark with the euro, is to sacrifice the benefits of a prudent economy, and possibly not only raising the cost of their own borrowing, but effectively subsidizing the economies of southern countries at their expense. This would create a moral hazard where peripheral economies, loath to implement structural reforms, would be able to borrow on the good credit of others.

While an abstract objection, none of the more serious propositions of how a Eurobond would be structured resemble that description. Most suggestions have come up with ways to embed into the bond tools that would enforce the fiscal rules of the Stability and Growth Pact that few countries have ever lived up to, including Germany and France.

One particular suggestion would see the creation of “blue” and “red” bonds, whereby the blue bonds backed by all euro countries could only be issued up to an amount equaling 60 percent of GDP—a safe amount of debt to handle. Red bonds, by contrast, would not be backed and cost more. This would encourage countries to keep the size of their debt within limits as the interest rates on red bonds may well be punishing.

No matter the potential structure of a Eurobond, there are two great obstacles. Under the Maastricht Treaty, which created the eurozone, subsidizing other euro countries is effectively forbidden as it would disrupt the “systems competition” envisaged by the currency’s founders. They wanted to incentivize countries in the single currency area to pursue structural changes in their labor laws and entitlement programs so as to remain competitive. Amending the treaty would be highly undesirable given the enormous strain imposed on European governments by past treaty revisions. Considering present circumstances however, this may not be the most pressing issue.

A more urgent problem is the resolute German resistance to Eurobonds. The German attitude reveals not only a resistance to the risk of having to pay more to borrow but calls into question the future of the currency union. As far as Berlin is concerned, the Eurobond is a question for future generations. Before it could become reality, there has to be a higher degree of economic and political integration first.

There are signs that this is indeed what will follow from a recent meeting in Paris where Chancellor Angela Merkel and President Nicolas Sarkozy announced that they would work to harmonize tax rates between their countries and urge fellow eurozone governments to meet regularly to coordinate fiscal policy.

Some see this as the emergence of a core euro bloc that is integrating at a more rapid pace within the European Union. This could ultimately mean two tiers of eurozone members—a stronger middle, run by Germany and France, and those countries that are currently on life support who would be kept out of the integration process until they are ready.

While the energy displayed by Merkel and Sarkozy is commendable and shows that the euro area has the political will to find a solution that both reassures and deals with its democratic deficit, one wonders how long the currency union can muddle trough without implementing major reforms that would calm the markets.

Eurozone Crisis Enters New Phase

Mon, 01 Aug 2011 22:57:00 +0300

Once again, the good people at Atlanticsentinel.com have given me some space to write. The text below can also be found at http://bit.ly/pgRI6C

The last two weeks have proven interesting for people who follow the unfolding situation in Europe for two separate events.

On July 15, the European Banking Authority released reports on the health of the European banking system. These “stress tests” measured the stability of banks by evaluating their ability to hold a minimum amount of core capital when set against economic situations similar to a prolonged recession. Another function for these tests was to establish which banks were exposed to Greek sovereign debt and thus enhance trust among financial institutions, as banks are wary of lending to each other if the extent of exposure is unknown.

On July 21, eurozone leaders came together and agreed on far reaching measures that were the most convincing for rescuing Greece to date.

Although these two events have provided transparency, time and confidence, a number of issues remain unresolved. Indeed, the reason that a relatively weak compromise on averting bankruptcy for Greece could be met with great relief in financial markets may be a lack of clear political direction within the singly currency area. There are crucial questions still unanswered and there is real risk that the framework may be the seed of an unfavorable outcome.

The larger outlines of the deal are well known by now. Greece has been alleviated of the burden of relying on the market for funds for a considerable time. This was achieved by a combination of support from the European Union and the International Monetary Fund and a voluntary, private sector rollover and debt swap.

After much controversy, private sector involvement was introduced partly to make the resolution feasible in Germany to continue providing funds for Greece. Although this solution entails writing off a share of the original value due to investors, for the time being it effectively removes the fear of a disorderly default that would lead to contagion. Fear of a “Lehman Brothers” moment has disappeared for banks exposed to Greek debt.

Important was also the lowering of the interest rate of Greece’s debt to 3.5 percent which will apply to Ireland and Portugal as well, in the hopes that this relief can keep them safe from further intervention. Lastly, the summit saw a widening of the powers of the European Financial Stability Facility, a financial vehicle that was granted the power to intervene if a country in the eurozone is under financial duress. This “European IMF” may prove to avert the dangers of a self fulfilling crisis for the countries that are still deemed to be at risk.

Positive news as this is, the foundation which this solution relies upon is fragile. Although Greece will have funds at its disposal for the time being, it does little to increase the competitiveness of the Greek economy. Even with the latest package, debt to GDP ratios will still be higher than those of Italy at 120 percent. If Greece’s economy is not reformed in the coming years, it could need another bailout in the future.

A worry with wider implications is found in the words of the summit’s communiqué (PDF) which states that,

As far as our general approach to private sector involvement in the euro area is concerned, we would like to make it clear that Greece requires an exceptional and unique solution.

All other euro countries solemnly reaffirm their inflexible determination to honor fully their own individual sovereign signature and all their commitments to sustainable fiscal conditions and structural reforms…

This is currently the only guarantee that private investor debt in countries with similar problems will not face a similar write off as was the case with Greece.

For the market this will create uncertainty as the promise comes from the same leaders whose credibility is in shatters. What market uncertainty implies is hard to say at present yet when Moody’s recently further downgraded Spanish sovereign debt, it cited the possibility of future private sector involvement as one of the main concerns. Also worrying is that since Greece’s write off will be voluntary, it does not trigger credit default swaps. The trigger may have the effect of raising borrowing costs for other highly indebted economies as investors shift to the CDSs of their debt, thus leading to higher volatility in debt spreads and increased market jitters.

What emerges from the past weeks is that no scenario is impossible. Although many important steps were taken in bringing clarity to the situation, we have yet to see the final outcome. Many saw these resolutions as a step toward further integration of the eurozone however it is unclear how strong the popular mandate is for such a development. The short term outcome will likely entail more last minute compromises, high stress put forth by the markets and a new financing plan for Greece. The depth of last week’s political efforts does offer some optimism for a more coherent path forward.

Europe Aims to Regulate Credit Rating Agencies

Thu, 14 Jul 2011 13:01:05 +0300

I’ve had the good fortune to be asked to contribute to atlanticsentinel.com. Below is my first contribution.

Among the many culprits appearing after the great recession were the credit rating agencies. Their negative effect on the financial system has been well documented, both externally and internally by the agencies themselves. Indeed, the quick updates on European sovereign debt are justified by arguing that the industry wants to mend the mistakes of the recent past in that it was not responsive enough. The international community is actively working on ways to regulate the credit rating agencies because of the weaknesses that were revealed after the crisis and the effect that rating downgrades have had on the fragile debt situation of a number of European countries.

Originally set up to rate the probability of a company, country or financial institution defaulting, the current scope of their involvement in the economic system is far greater. What has proven especially important is the way the agencies operate and the artificial power they have obtained over deciding who is allowed to invest in a company or country. The agencies are so powerful because Basel II, the international framework for banking rules (now supplanted by Basel III) requires a positive rating from the agencies in order for public and pension funds to invest in them. In effect, if a country does not have a positive rating, it may not be eligible for investment by other sources.

One of the more radical ideas proposed by the European Union is the creation of a “European Credit Rating Foundation” that would decrease the power of the three main raters of sovereign debt which are all American. Yet its creation seems ill devised and an attempt to solve a political problem that is to a large extent caused by a flawed regulatory framework to begin with. If one of the main problems of the current system could potentially be solved by removing the regulatory power of the rating agencies, it is questionable if setting up a new ratings agency would be a valuable part of a solution.

An important aim to credit rating regulation is improving competition. This is partly justified by the fact that the “big three”—Moody’s, Standard & Poor’s, Fitch—make up 95 per cent of market share and their earnings are well above anything suggesting a healthy market. Strengthening competition, it is argued, would increase transparency and prevent the big three from dominating the market.

Some European politicians also argue that since the companies are all based in the United States, they are not in a position to rate European markets properly while the timing and content of recent downgrades may have been politically motivated.

The first and more serious problem is complicated by the fact that increased competition has a host of other problems, mainly that it may exacerbate the issue of customers picking the rating agency that would give them the highest rating. The more firms there are to chose from, the bigger the chance of rating inflation.

The second part deserves less attention—the credit raters have offices in Europe, with European staff and have had the habit of buying up successful local European agencies with the knowledge and expertise they provide. The introduction of a European foundation, or any other agency for that matter, need not be an answer to the proposed problem.

The aim to regulate the credit rating market is nothing new as the EU has pursued this goal since the early 1990s. The agencies’ prevalence in today’s headlines shows how sensitive the market is to uncertainty and the power the ratings agencies have when downgrading sovereign debt. Thus they are heavily criticised for deciding on ratings days before important political negotiations take place, further increasing uncertainty. European regulation states that this is one of the main problems with the framework, outlining how a host of structured financial instruments had their ratings radically downgraded when the financial crisis occurred, implying both a lack of stability and a flawed system that did not provide accurate ratings.

True as this certainly is, one needs to remember that the situation did not apply to sovereign debt ratings which did not come out of the recession with the same tainted reputation. It is also important to consider how sensitive markets would be to perceived political influence if the EU were to be seen to exert pressure on a new agency. The purpose of it entering the market could therefore quickly be seriously damaged.

Considering these issues—Basel II rules giving credit rating agencies power over creditworthiness, the likelihood of ratings inflation with increased competition, the sensitivity of perceived political pressure over ratings—the EU could do better by partly or completely reducing the power given under Basel II (which the big three don’t oppose) so that investors are not told what to do and need to take other factors into consideration. This, as well as working on ways to reduce the inherent conflict in having issuers pay the agencies for a ratings could reduce many of the problems faced by them. This seems to be a situation where the EU can do so much more with less.

Will the Euro survive?

Mon, 13 Jun 2011 14:58:00 +0300

The problematic part with writing an article about the survival of the Euro is the speed with which there is a change to the situation. Last time I was taking notes the prime minister of Portugal, Sócrates, had just resigned as parliament had voted down a budget for more austerity measures, leading to the acceptance of EU and IMF participation in meeting its debt obligations. The True Finns had not yet won a considerable number of seats in Finland, The Green party had not yet ousted the Christian Democratic Union in Germany’s Baden-Württemberg and the situation in Greece had not deteriorated to the point where debt restructuring is slowly being recognised as an option by the major institutions. These factors, although separate incidences, point to essential parts at the heart of the matter. Despite some alarmist news about Greece considering leaving the Euro-area and more countries facing the same challenges, the Euro is probably here to stay. Yet as European integration moves forward, the tangible scepticism of the citizens in the EU is likely to make the project more hollow.

In many ways, asking the question is of little practical significance to anyone at this point, as the economies involved constitute just a tiny fraction of the Euro-areas combined GDP (Greece, 2.5%, Ireland and Portugal both approximately 1.25% each), and as long as bigger economies are not in a similar situation, the potential fallout is always too small to encapsulate the whole currency union. Yet what one needs to keep in mind is that the issue is not about the threat of one country but the structural imbalance between, crudely, northern European economies and the southern ones. If one looks at it from this light, the economies of Italy and Spain need be included, and the possibility of a break-up is immediately bigger.

The factor above needs to be seen in conjunction to what southern countries experienced joining the EU: Krugman discusses this in more general terms and Blanchard (PDF) uses the example of Portugal, where the prospect and eventual entry into the Euro lead to a boom where, due to the belief that joining the Euro was a sign of safety, interest rates went down, demand and foreign capital entered the market creating the resources for private and government debt and consumption. However, the fundamental issues of the Portuguese economy were not altered and once the country converged to take into account of lower lending costs, the economy returned to its slow growth, high unemployment and looming deflation - now with alarming amounts of debt. Had Portugal its own currency, it could devalue - increasing export competition and reducing the friction and time it takes to lower wages and prices (when this option isn’t available), reducing the extent and breadth of unemployment and low growth.

Thus the existing framework is understood as the main problem for the proper workings of the Euro-zone. The complete breadth of the question needs to be understood in a space where the workings of the institutional mechanism of the project itself can be seen as an added boost to the build-up of the crisis and the reasons why a country would suffer perhaps unnecessary much and long for its troubles. Recent interest rate increases by the ECB have been a good example of these imbalances - as many northern countries are growing very fast, inflation is creeping up, the rate increases add further strain on the economies of Greece, Ireland and Portugal that are in most troubling circumstances.

Although the whys and hows have been thoroughly discussed, no-one has been more cited regarding the irreversibility of joing the Euro than Barry Eichengreen. Firstly, the prospect of leaving the Euro would come with grave political costs, the political and financial credibility of a nation that left would surely diminish and if it were to remain in the EU, it would be treated as a second-class citizen in EU-matters. At the time of writing there was little evidence of this happening – Eichengreen cites Denmark and Sweden as countries who, although not members of the Euro, have remained important players in European co-operation. Yet, as the Economist writes, there is a potential rift appearing as meetings amongst specifically Euro-members are increasing, with policy issues covering the Euro-zone are discussed keeping the non-Euro members outside. If this does indeed transform into an important institutional framework it would provide further complications for a voluntary outsider.

Secondly, and most importantly, a country leaving the Euro to effectively devalue would face economic agents that were aware that whatever currency the country introduces will be at a lower value than the Euro. Because of this people would shift their assets from national banks to ones denominated in Euro’s so as to not lose the value of their assets. An equal situation would occur in the sovereign bond-markets leading to, in Eichengreens words: “the mother of all bank runs.” There have obviously been devaluations before in history, and Argentina in its last crisis showed that capital controls can be quite successful in hindering this prospect, yet one wonders how effective these would be given the fractured nature of much of today’s banking.

The Euro then, a proxy for further European integration, is very likely to stay. And in my eyes not primarily for short-run economic reasons, important as they are. Now, not knowing German certainly leaves me out of some very important dynamics, but it is telling how Germany, as the strongest member of the Euro-zone, has led the process of Greek “bailouts”. The EU, lacking an effective institutional framework for matters such as these, the political battle has taken place inside Germany where Merkel has had to say one thing while doing the opposite; denying the possibility of further German help for Greece to placate frustrated citizens while at the same time working to further ways to alleviate Greece’s crisis. This was probably part of the reason the CDU lost one of its longest held bases to the Green Party this year. Obviously, Germany does not do this out of charity- if Greece would default German banks who hold a lot of Greek debt would add more strain to their balance sheets.

Despite of these issues or because of them, there is real political will to use this moment to increase the integration of the Euro-zone and reduce the short-comings of the current framework by making the European project and its institutions move forward. It is telling in what language, in this situation, the political elite of Europe are using; where the crisis of institutions is not seen mainly as a misfortune, but as the catalyst for more integration. Speech by the president of the ECB Jean-Claude Trichet.

However, the price of overreaching to this degree will not be small. Increasingly, European countries are facing populist parties with a growing voter base (one commentator likened it to the Tea-party movement for people who prefer a social safety net) who are hostile to either “bailing out” other European countries, the idea of a currency union or the European project and its institutions. At this point one can only speculate at the size of their potential power and how they would work to undermine the EU. Yet the ugly outcome may entail a more integrated, yet hollower, European project.

Numbers in perspective

Sat, 23 Apr 2011 17:58:00 +0300

Studying for my environmental economics exam has meant that quite some time has been devoted to The Stern Review and its economic implications. According to the Guardian, Stern updated his original assessment that 1% of annual world GDP would need to be allocated towards measures to move to a low-carbon economy, to 2% of annual GDP. In this context the scale is hard to grasp. However, a light hearted exercise might bring some light to the scope of that figure. World GDP (current USD) in 2009 was $58 trillion ( $10^12$ ).

Two per cent of that is $1.16 trillion. Keeping this sum in mind while reading this article, perhaps what China should do is to aggressively fund a project beneficial to us and posterity. (Well, for almost three years.)

The EU and enlargement

Mon, 11 Apr 2011 20:25:44 +0300

This was originally written for my application to MEU2011 which I was not able to attend due to an exam. However, it seems to fit a first post quite well.

“Speak softly and carry a big stick, you will go far.” The proverb often emerges in foreign policy contexts and has been understood as a way of advocating usage of both soft and hard power. Although in proportion to its importance in the world, the EU lacks much of the latter yet has an abundance of the former. It is therefore remarkable what it has achieved in the countries wishing to join the EU. The use of soft power, through the entry negotiation process, has shaped the policy direction of potential entrants.
The prospect of joining the EU has opened up negotiations in a diverse set of areas, ranging from border conflicts between Cyprus and Turkey, bringing war criminals to justice for atrocities committed during the break-up of Yugoslavia as well as a focus on minority rights. In this regard the European Union certainly needs to continue with its enlargement process, furthering the important progress it has made, and signal to the countries in question that enlargement is a possibility.
At the same time, the recent financial crisis has brought to the agenda a number of fundamental issues regarding the identity of the union, and recent expansions have undoubtedly been part in precipitating this identity crisis. An aspiration for the architects of the union has always been to provide a framework for the European countries to prosper so they would not cling to the potentially destructive nationalistic aspirations of past times. A more united Europe, with the characters and cultures of each single nation yet with the same broad goals surely has a prominent place in today’s world, with the capacity and resources to contribute on issues that affect us all.

Recent developments in a number of European countries have shown a tendency to look more ambiguously if not with hostility at the European project; nationalist parties have become a mainstream reality in a number of countries in Europe today, with agendas to reduce the depth of the EU.
Equally relevant is the problem of having a single currency for an economic zone whose economies are structured very differently. Many northern countries have recovered well from the recession while a number of countries in the south have yet to solve their fiscal problems. Being tied to the common currency leaves few attractive options to regain competitiveness. This dynamic has shown to be volatile, where the stronger economies have little interest in reducing the imbalances in a coherent and unified way. It is hard to imagine that the countries currently lagging will accept long periods of depressed wages and other potential ills following from an ‘internal devaluation’.

As such, there are wide unresolved issues needing solutions, and what has been argued is for a central fiscal authority. Recent developments have shown that there is neither political will nor mandate to reach that level of unity.

In this climate where important questions regarding the relationship between nation states and the community as a whole are left unanswered, further enlargement would merely increase the factors in an unformulated question.