Moodys on Japan and the Eurozone – Stating the Obvious

I shall openly admit that I have always found the exact role of the rating agencies a bit odd in the global financial system. I mean, do we really need them to tell us which bonds are good and which are not? I am not sure and what is more; rating agencies sometimes, if not all the time depending on their ability to stay in front of the curve, seem to wield a tremendously amount of power relative to their role as private actors (after all) in financial markets.

For example, they may ultimately decide whether bonds of a given Eurozone economy may be eligible for collateral at the ECB or, even more importantly, they may decide which sovereign bonds that are investment grade or not and thus whether big institutional investors can allocates there or not.

Yet, this reservation notwithstanding, the rating agencies do seem to be some of the only big ticket private market actosr who are able to state the obvious. Specifically in this context, the obvious is directing our attention to the the ongoing travails of some economies in terms of figthting the current crisis with fiscal stimuli while the yoke of population ageing and its effect on public finances steadily pushes the economy’s long term prospects into the sinkhole.

In this way, I don’t think people should be, or indeed that they have a right to be outraged by the continuing comments (and inevitable) downgrades. How could they possible act otherwise given that they are here and do what they do?

In this sense, the recent messages from Moodys on Japan as well as Greece and Portugal respectively sounds extraordinarily timely to me even if it is stating the obvious;

(Quotes Bloomberg, first Japan and then Portugal/Greece (Eurozone))

The replacement of Japan’s finance minister four months into the government’s term increases concern about the commitment to contain the world’s largest public debt burden, Moody’s Investors Service said. “Japan’s fiscal strategy unknowns deepen” with the appointment of Naoto Kan last week, Thomas Byrne, senior vice president of Moody’s in Singapore, wrote in a note yesterday.

Byrne’s stance contrasts with analysts at Goldman Sachs Group Inc. and Morgan Stanley, who said Kan has indicated a willingness to repair Japan’s finances. The 63-year-old deputy prime minister last week replaced Hirohisa Fujii to become the country’s sixth finance chief in 18 months, tasked with preventing a relapse into a recession while containing the debt. “The revolving door for leadership at the Ministry of Finance does not engender confidence that Japan will put together a credible fiscal strategy to reduce deficits and stabilize the massive government debt overhang in the medium term,” Byrne said.

Kan said on Jan. 7 that it will be a “challenge” to maintain fiscal discipline this year and he will try to secure funds to fulfill the ruling Democratic Party of Japan’s pledges without exacerbating the debt burden. The role change also “raises doubts” over the administration’s commitment to a 44 trillion yen ($480 billion) cap on new Japanese government bond sales for next fiscal year, Byrne said. Kan may “seek to further boost fiscal stimulus to an economy hamstrung by renewed and stubborn deflationary pressures,” he said.

(…)

The Portuguese and Greece economies may face a “slow death” as they dedicate a higher proportion of wealth to paying off debt and investors demand a premium to hold their bonds, Moody’s Investors Service said.

While the two countries can still avoid such a scenario, their window of opportunity ”will not be open indefinitely,” Moody’s said in a report today from London. Portugal, with a negative outlook on its Aa2 rating, has more time “to reverse this trend” while Greece “has significantly less time.” Moody’s cut Greece’s rating to A2 from A1 on Dec. 22.

The premium that investors demand to hold Greek debt instead of German equivalents is six times more than it was two years ago, and the spread has doubled since 2008 in the case of Portugal. Greece had the largest budget deficit in the euro region last year, more than four times the European Union limit of 3 percent of gross domestic product. Portugal’s debt load will account for 85 percent of GDP this year, according to the European Commission.

Naturally, the case of Japan and the Eurozone periphery diverges in a number of notable ways. For starters Japan has its own central bank which will be duly deployed to provide funding for the issuance of government bonds to the extent that private (or foreign) savings are not enough to satisfy demand. Moreover, and as Moody’s point 94% of Japanese debt is held by the country’s own residents. I find this point less convincing as a mitigating factor since a country may very well go bankrupt with the majority of debt owned by domestic actors. Think about this as simply marking Japan to market given the demographic outlook and thus scything the face value of all those bonds they issue domestically. I.e.e Japan would move from the third/second biggest economy in the world to the “..th”. However, since this would ultimately occur internationally through a sharp depreciation of the JPY, it would also boost Japan’s competitiveness considerably. More importantly Japan has a large external surplus which means that she is building up claims on the rest of the world in stead of the other way around.

This is not the case for the Eurozone periphery and apart from the obvious fact that Greece, Portugal, Spain etc do not benefit from their own central bank which they could collaborate with in the context of quantitative easing or a prolonged commitment to ZIRP, they are also net external borrowers. According to the data from the IMF, the average annual current account deficit as percentage of GDP between 1999 and 2008 in Greece, Portugal, and Spain was -8.6%, -9.1% and -5.9% respectively.

On this point I agree with Moodys and others that the risk of a sudden balance of payment crisis leading into short term default is not relevant at this point. Rather, the main issue lies in how to make headway on the public debt/fiscal front at the same time as correcting the external deficit which has to correct since these economies are now effectively export dependent. It is very important to understand the very dangerous and decidedly unattractive cocktail that these economies must now swallow and why it is exactly so because of the inability to use nominal exchange rate depreciation as a tool to correct the external deficit. In this sense, what these economies now have to do is to travel the ill-wanted route of an internal devaluation in which domestic price and wage deflation are deployed in order to restore competitiveness. But this is not all. They are consequently also now effectively forced, vis-à-vis the nudge and pressure from Moodys et al, to take serious steps to rein in public deficits and put long term finances back on track. Now, the dilemma should be clear at this point since, as we know, deflation increases the real value of debt and thus it is difficult to see how these economies are exactly to pull this off. We could say, that the Eurozone does not allow them the leisure of inflation to ease their path to recovery.

Now at this point, the Austrian police – aka haters of Fiat et al – will probably be flashing their lights and tell me to pull over. And so, as I pull over I will tell them that anyone seriously arguing that the inability of Greece et al. to use nominal exchange depreciation to correct is not an aggravating factor simply do not have the faintest idea of what export dependency means modern growth dynamics of ageing economies stuck in a fertility trap about to become a liquidity trap. Really, it is as simple as that and while not everyone can devalue at the same time to become dependent on the same exports (i.e. the real underlying problem as we move forward) we are about to find out what happens when the entire weight of adjustment has to fall on the domestic economy.

Having said this however, I would like to emphasize that while the Eurozone, for reasons just mentioned, may be far from perfect we cannot let it fall apart and thus an internal devaluation in Greece, Spain etc it is. As with the Eurozone itself, it will be a great experiment to see how and whether it will work to salvage these economies.

14 thoughts on “Moodys on Japan and the Eurozone – Stating the Obvious

  1. An excellent analysis.

    However, as I read your conclusion it becomes more & more obvious that neither Greece nor Spain nor Portugal have the political will, the political institutions or the social fabric to undertake the task you have set them.

    Expulsion (or a mutually agreed departure) from the Euro zone is surely the only way out.

  2. I agree with JohnOfEnfield. In addition to what he wrote, I would ask to whom should a national Government have its primary loyalty; to its own citizens or to foreign owners of its debt?

    This question could have different answers across countries. A country like the UK would suffer enormous long-term reputational loss if it defaulted on its debt or debauched its currency – by that I mean a deliberate debauch, not a free market decline in exchange rate.

    By contrast, somewhere like Argentina can default on its debts at will because the opinion of foreigners counts for nothing, investors have short memories, and the opinion of Argentines is important, since they own the nooses and the lamp-posts.

    It seems to me that Greece is in between. It does not want to penalise its citizens with an internal devaluation, which is going to feel a lot like a Depression, but it is constrained by Euro-membership.

    I think everyone is in a box here. If the ECB bails out Greece to let the Greek Government off the hook, it risks introducing moral hazard across all the weaker Euro members. But if the ECB does not bail Greece out, the Greek Government will be faced by almost impossible political choices unless it leaves the Euro. In fact, I think there are necessary steps Greece literally cannot take; how, for example, do you abolish corruption? Is there an app for that?

    My guess is that the ECB will choose keeping the Euro as a strong currency over keeping Greece as a member. And if Greece leaves, we could eventually see three or four more escapees, after which the Euro would be in a much healthier state, with membership restricted to countries that are actually capable of keeping to the rules.

  3. Stop, stop, stop jl!

    First, how you imagine the division of property after this divorce? Because EURO is backed inter alia by assets of Greece, Spain, Portugal, Ireland. If these countries will step at some moment to their own currencies and distrain EUR in their ownership as collateral, they will be much better off. And it will be difficult to stigmatise the Greek EURs, because they are the same as German EURs.

    If you think about some lengthy settlement, it can last sooooo long that the actuality of expulsion will be most probably lost when it will finish.

    Secondly, (even as I am not very well familiar with Central bank place in these countries,) it is to assume that they are pretty independent institutions. And can stay independent, because pressure on currency does not exist inside EURoland.

    The consequence of that is – Greece can probalby declare sovereign debt default, but there will be just no instruments to start a lengthy secession process from the Eurozone.

    If the ECB will threat with an expulsion scenario in this case, other issues are very questionable. Because Greece is important enough in order a gigantic leakage (financial, political, terror, military, U238) there will damage the whole EU.

  4. govs from Latvia: I understand quite well what you are saying. It would be like unscrambling eggs. I am not suggesting that anyone would do this on a whim.

    But consider for a moment; Lisbon introduces a formal process for leaving the EU. Are we saying you can leave the EU but not leave the Euro?

    You know, all currency unions have this same problem, and they have all come apart sooner or later. Dealing with who owns/owes what is just part of the issue.

  5. The experience of SU with “leaving by some members” was very destructive. Usually imperies, if somebody is allowed to leave, fall apart very soon.

    Montenegro is using EUR, but is not a member of EU. The big question here is not in using or not using EUR as domestic currency, the issue is – who can borrow at the ECB? For Greece this will be very crucial.

  6. “The big question here is not in using or not using EUR as domestic currency, the issue is – who can borrow at the ECB?”

    Yes, of course. There is nothing unique to the Euro here. Several countries have used the US Dollar as their – or one of their – domestic currencies over the years, without being able to borrow at the Fed.

    But let’s not lose sight of the point here. There are certain economic and fiscal disciplines on Euro-area members – which were said to be necessary for the smooth running of the Euro – and some members can’t remotely keep to them. My point is not that there is something “wrong” with this, but simply that sooner or later all concerned have to decide what to do about it. Do you want to be a member of a currency that imposes pain on your citizens? Does the currency system want members who can’t adhere to the necessary disciplines?

    If a member state can tolerate internal deflation – including wage and Government spending reductions – then fine, but I think we have to ask; if they could not keep to the rules in good times, what will it cost their citizens to do so in times of recession and reduced tax revenues.

    I think we can forget all this stuff about “empires”. The EU is not – yet – even a federal system. Shedding a Euro-member will be embarrassing but not fatal.

  7. The only problem with internal devaluation is the lack of experimental evidence of any successful cases of it. Unfortunately there seems not to be a monetary Caladrius bird able to forecast which country will recover through internal devaluation and which not.

    The internal devaluation (ID) in Latvia shows very obviously that the macroeconomic side of ID is not a problem. It is possible to inflict very harsh macroeconomic austerity measures, comparable with the Great Depression. Some indicators will respond very quickly, for instance, male employment in Latvia has fallen to the lowest level in recorded history.

    But the real impact of ID does not show any convergence towards better competitiveness. If consumption is depressed, firms just lay off en mass people, but they do not reduce prices. Many market segments become monopolised due to dying of firms, we can not speak about „prices” anymore there. As EULER-HERMES has left Baltic countries, imports slow and also the production using imported inputs, so competitiveness only decreases.

    The PPI just don’t fall, this is the real problem. Slight reduction (1,5% for 2009) is attributable only to reduction in energy prices, and do not improve the position against Germany. The relative position only worsens.

    There seems just not to be a microeconomic mechanism at place leading to much awaited improvements in competitiveness by ID. The theorem about equivalence of normal and internal devaluation lacks any proof at the moment.

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  9. Actually, I think there are quite severe problems with internal deflation compared to currency devaluation.

    If the country I live in devalues its currency, or the market does, I and my fellow citizens take an automatic pay cut in international terms, the economy becomes more competitive, imports become more expensive and domestic manufacturing and services should see a boost, not immediately but in time, and then tax revenues start to rise, which helps the fiscal position. Apart from that, most things stay the same. My debts remain at the same level, assuming they are in the national currency, so my debt burden does not change, at least in the short to medium term.

    On the other hand, with a domestic deflation, some or all of government spending, wages, and social benefits are reduced. On average, my debts are now greater in wage-related terms, because incomes have fallen, and the kinds of adjustments to import and export prices tend to happen over a longer period of time – wage cuts take longer to feed through to trade figures than a currency devaluation does – so I don’t see the same boost to employment, at least in the short-run, and so tax revenues don’t recover as fast.

    Subjectively, there is also the factor that a currency devaluation is over and done with once it happens, whereas internal deflation requires determined Government action over a long period of time. That’s over-simplified, but I am trying to say that the political and social “cost” of internal deflation is greater.

    Of course, currency devaluation can be over-done. If you take it to the point where you can’t afford to import new investment capital goods, that’s too far.

    For what it’s worth, the UK tried internal deflation in 1931, and it led to quite serious unrest and a fleet mutiny; and later the same year they gave up and left the Gold Standard with a currency devaluation of around 25%, and from then on began to recover from the Depression fairly rapidly compared to the rest of the World. By contrast, France stayed on the Gold standard and more or less stagnated. Make what you will of that; I’m not sure you can substantiate a strong cause and effect, but it is suggestive.

  10. Is there any place I can place a bet on Portugal’s economic preformance? ‘Cause I’m the biggest pessimist in the country, but these analysis I’ve been reading in the international press lately, comparing Portugal and Greece… they’re so missing the point I could certainly make some easy money with some bets.

  11. To summarise the comments so far then: –

    There is no real alternative but to allow Greece to leave the Euro, with a suitably large bribe, and let devaluation of their currency to take place according to the rules of the market. Internal deflation is too slow and too vulnerable to social unrest and other substantial distortions.

    Portugal next, followed by Spain and then Italy (the UK is already out).

  12. So, if an english town or region is experiencing problems with debt, is there no alternative but the expulsion from the pound?
    I do not think that is the case.
    In the case of the euro, I think that if there is a problem with external debt and there is a need of devaluation, it would be preferable a devaluation of the euro.

  13. The ties (physical, social, cultural & economic) that bind an English town or region to the UK are a far far deeper than those that bind Greece to the Euro.

    The social stresses that deflation would cause in Greece will put immense strain on their political system. Deflation is not a viable way out of their problem.

  14. “if an english town or region is experiencing problems with debt”

    If a town goes that deep into deficit, the national government will step in, remove the mayor and send somebody to take over the town.
    The problem is that if things are taken to an extreme the EU can merely expel a member. If the same extreme is reached in England with respect to a town, the army will be sent in.

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