Thursday, May 13, 2010

The European Bailout - Shucks and Woe!

Late Sunday night, European leaders announced they had reached an understanding on stabilizing their currency and debt markets. It was a "shock and awe" bailout package of close to USD 1 trillion... It's amazing how easily the number rolls off the tongue now. The trillion is now the new billion.

The markets have reacted exceedingly well for now, but who actually benefits from this bailout? Is it Greece, or are they too far gone? Is it Spain, Portugal, Ireland and Italy because they still have some time? Or is it the bankers who lent to these countries, knowing their credit quality was suspect, but secure in the belief they could coerce government(s) into underwriting their losses? Following the money is always an easy way to figure this out...

As far as Greece is concerned, very little changes. The newly created multinational agency will underwrite Greece's future debt obligations. This will include new debt issued to finance it's fiscal deficit and refinancing of old debt which is due to mature in the near future. For Greece, this means lower interest rates on their borrowings which will help. What this will not do for Greece is help reduce their debt burden. It will not penalize it's lenders even though they lent to Greece knowing it's fiscal position. Greece's Debt-GDP ratio will continue to remain unsustainably high in the near future. And even though it looks as if it can be reduced by going thru an extremely painful deflationary process to improve it's finances, it's just not that simple.

Balancing the budget is not good enough anymore. Greece has to start generating primary surpluses of a magnitude greater than the deflationary impact of the austerity required to do so AND 1.25 times its average interest rate (currently 8%) for it to reduce it's debt-GDP ratio. The math isn't simple because it's iterative in nature but just as an example, Greece will have to turn from a primary deficit of 8.6% of GDP to a primary surplus of 10% of GDP while ensuring that its GDP does not shrink to maintain it's Debt-GDP ratio. It'll need to do more to reduce it. So Greece will remain where it is, with default being it's best option, either now or sometime in the future.

Spain, Portugal, Ireland and Italy aren't that badly off yet. Their Debt-GDP ratio is better than that of Greece and all they have to ensure is that it doesn't grow. Given the above example, once  again, it's not as simple as it sounds. They may not be candidates for default just yet, but one needs to bear in mind that they are just a few percentage points of GDP away.

The European Bailout package has fallen into a classic trap. It mistakes a solvency crisis to be a liquidity crisis. Yes, it can ensure that all these countries will get the funds they need to meet their debt obligations, but it doesn't address why they couldn't raise the money without help. While Greece is already insolvent, most of the others are on the brink and giving them access to cheap funds only delays the inevitable.

And it ensures that banks get paid in full. Since all maturing debt will either be underwritten, or provided, by the new entity created for this purpose, the burden of eventual default will be borne by those financing this entity, the European taxpayers. As far as the IMF's contribution is concerned, the burden of it's losses will be borne by each and every IMF shareholder, including India. So banks walk away unhurt while taxpayers across the world assume unnecessary risk. Doesn't that make you wonder who we're ruled by?

The only "hope" the package holds out is that of monetary expansion. If the ECB were to start expanding money supply by unsterilized purchases of bad Euro government debt and sparks off inflation in the process, Greece and the other countries may not have to worry about deflation as much. But if the ECB were to do so, not only would it be going against it's anti inflation mandate, it would end up weakening the Euro. This could result in developing countries devaluing their currencies to retain competitiveness in Europe. With the US still struggling for competitiveness, prospects of a sustainable recovery would all but vanish and the world will be back to 2007.

Except, this time around, it won't be financial sector bankruptcy we will be dealing with. It will be sovereign default.

This note was posted on my Business Standard Blog on May 11, 2010.

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