Water under the bridge

From that Eurogroup Greece prior actions draft still under discussion in the middle of the night in Brussels –

There are serious concerns regarding the sustainability of Greek debt. This is due to the easing of policies during the last twelve months, which resulted in the recent deterioration in the domestic macroeconomic and financial environment.

It’s a truly remarkable statement that concerns about the sustainability of Greek debt only arose in the last year, since the 2010 IMF bailout — an event that everyone, including the IMF, seems to have forgotten — was only rammed through by ignoring the normal IMF debt sustainability criterion.

UPDATE: The identical statement is in the final draft.

 

What Icelandic business practices can (possibly) tell us about China

Many controlling shareholders in China have pledged shares as collaterals for bank loans – this was a common practice in Iceland up to the October 2008 banking collapse. Now, this practice seems to be causing suspensions of trading in shares in China. If this is indeed a widespread Chinese practice the well-studied effects in Iceland provide a chilling lesson: when the steady rise of Icelandic share prices, both in banks and other companies stopped and prices fell this practice turned into a major calamity for the banks and companies involved. In hindsight, it was a sign of an incestuous and dysfunctional business environment. The Icelandic experience was well covered in the 2010 report by the Icelandic Special Investigation Committee, SIC, and provides food for thought for other countries where these practices surface.

One of the most stunning and shocking findings of the Icelandic SIC report was the widespread use of shares as collaterals for loans in all Icelandic banks, small and large but most notably the three largest ones – Kaupthing, Landsbanki and Glitnir.

It is necessary to distinguish between two types of lending against shares as practiced in Iceland: one is a bank funding purchase of its own shares, with only the shares as collaterals. The other type is taking other shares as collaterals.

These loans with shares as collaterals were mainly offered to the banks’ largest shareholders – in the big banks these were the main Icelandic business leaders – their partners and bank managers. In the smaller banks local business magnates who in many cases were partners to those Icelandic businessmen who operated abroad, as well as in Iceland. Thus, this practice defined a two tier banking system: with services like these to a small group of clients – that I have called the “favoured clients” – and then normal services for anyone else.

As a general banking model it would not make sense – the risk is far too great. But this lending mechanism and the ensuing stratospheric risks seem to have been entirely unobserved by not only the regulators in Iceland but also abroad where the Icelandic banks operated.

The SIC report, published 10 April 2010, explained in depth the effects of shares as collaterals: when share prices fell the banks could not make margin calls without aggravating the situation further. Consequently the banks lost their independent standing vis à vis their largest shareholders and clients – effectively, the banks and the business elite were tied to the same mast on the same ship and all would sink together in case the ship ran aground (as then happened).

Being familiar with the Icelandic pre-collapse situation it was with great interest that I read an article in the FT,* explaining what might be the reason behind the suspended trading in shares of almost 1500 Shanghai- and Shenzen-listed companies, mostly on the ChiNext stock exchange:

“Some analysts believe the suspensions are instead related to one of the scariest “known unknowns” surrounding the market meltdown — just how many controlling shareholders have pledged their shares as collateral for bank loans.”

If this is indeed the case the Icelandic experience indicates a truly scary outlook and dysfunctional Chinese banking. There might be further troubles ahead.

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Two year escape hatch

IMF Chief Economist Olivier Blanchard in a new blog post defending the 2010 Greece program against various criticisms, including the absence of debt restructuring –

Moreover, private creditors were not off the hook, and, in 2012, debt was substantially reduced: The 2012 private sector involvement (PSI) operation led to a haircut of more than 50% on about €200 billion of privately held debt, so leading to a decrease in debt of over €100 billion (to be concrete, a reduction of debt of 10,000 euros per Greek citizen). And the shift from private to official creditors came with much better terms, namely below market rates and long maturities.

Below the fold, a few relevant sentences from the IMF’s own ex-post evaluation of the 2010 Greece program, issued in 2013. Bottom line: what could be achieved in 2012 was severely constrained by what was (not) done in 2010, and the 2012 restructuring destroyed a core assumption of the 2010 program. In particular, when debt restructuring [private sector involvement (PSI)] was done, the hit on the remaining private sector creditors, including Greek banks, had to be larger because other private creditors were gone and official creditors that had taken on their debt, including the ECB, were off the table in the restructuring. It was then much harder for Greece to return to the market as the 2010 program had assumed, and the banks needed a lot more money to recapitalize.

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When extreme circumstances warrant setting up a lender of last resort within a larger currency union

From address by Professor Cormac O’Gráda, School of Economics, University College Dublin, to the Central Bank of Ireland Whitaker Lecture, 29 June 2011. The context is the Irish Free State’s 1 for 1 currency peg with the pound sterling, a continuation of the pre-1922 UK pound for Ireland –

The Emergency (World War II) also produced a defining moment in Irish banking history. Until then, Ireland’s lack of a central bank had not worried its joint-stock banks; on the contrary, they did not relish the idea. For over a century the Bank of Ireland had played the role of quasi-central bank, while looking on the Bank of England as its friend in need. Just a few days before the outbreak of war a delegation from College Green (Bank of Ireland HQ) traveled to London for reassurance about the availability of foreign exchange and the free repatriation of Irish bank assets held in London. In what must have been a difficult moment for the Irish bankers, the Governor of the Bank of England Montague Norman told them that:

notwithstanding the long and intimate relations between the two institutions he was not prepared to commit the Bank of England by promising to come to the assistance of the Bank of Ireland in an emergency of the nature under discussion. As an ordinary banking transaction there would be no question whatever about making an advance to the Bank, but in an emergency situation there was an important principal (sic) involved. The Bank of England looked upon Eire as a Dominion… Mr. Norman stressed the view that the Bank ‘whose centre of gravity was in Eire’ should look to their own Treasury or the Currency Commission to help them over difficult periods. Sir John [Keane, Deputy Governor of the Bank of Ireland] pointed out that the position in Eire did not admit of a solution in that way, as the [Irish] Treasury came to the Bank when it was short of funds, and the [Irish] Currency Commission was not a lender of the last resort. Mr. Norman then urged that as Eire was a separate political entity it should have a Central Bank of its own.

And so it took the Emergency and Montagu Norman to persuade the Bank of Ireland to switch its loyalty fully to the new state, and for the other joint stock banks to appreciate the need for an Irish central bank. The Central Bank Act followed in 1942.

The sterling currency union nonetheless survived up until Ireland joining the Exchange Rate Mechanism of the European Monetary System in 1979.

Low payoff from structural reforms in Greece?

The IMF has released a preliminary debt sustainability analysis for Greece — undertaken before this week’s cash crisis but after its adjustments to the numbers to take account of the deterioration in the relationship between Greece and its creditors since January. The document can be read cynically as the IMF using Syriza as an excuse to dump all the unrealistic assumptions in their earlier calculations, but it’s still helpful in spelling out those assumptions — which were there for everyone to see. Arguably the most incredible scenario was for growth (see Box 2):

What would real GDP growth look like if  total factor productivity (TFP) growth were to remain at the historical average rates since Greece joined the EU? Given the shrinking working-age population (as projected by Eurostat) and maintaining investment at its projected ratio of 19 percent of GDP from 2019 onwards (up from 11 percent currently), real GDP growth would be expected to average –0.6 percent per year in steady state. If labor force participation increased to the highest in the euro area, unemployment fell to German levels, and TFP growth reached the average in the euro area since 1980, real GDP growth would average 0.8 percent of GDP. Only if TFP growth were to reach Irish levels, that is, the best performer in the euro area, would real GDP growth average about 2 percent in steady state. 

That last assumption — 2 percent long-term growth — was the one that was actually in the program until now! These are of course results from an economic model that could be right or wrong. But that’s part of the political challenge of these lending programs: undertake massive effort on “reforms” and you might, if everything else goes well, get a not-especially-exciting growth rate. And the voters on Sunday don’t even know which set of “reforms” they are voting on, let alone their long-term consequences.

UPDATE: Note that the debt sustainability analysis is on the ballot on Sunday!

Europe muddles through: Mediterranean edition

This Politico piece of mine argues that Europe has talked itself around to sharing the effort to rescue shipwrecked migrants in the Mediterranean, having floated a variety of draconian threats to justify getting warships down there and then quietly backed out of them.

I hang this story on the voyage of HMS Bulwark, which started off by sitting the crisis out in Turkey, was then offered by the British to take part in some ill-defined military option, and ended up being congratulated by Defence Secretary Michael Fallon and, dear God, the Daily Mail for its role in the search-and-rescue operation.

Bulwark‘s deployment is up in a few days, and the government has promised to relieve her – however, the relief is HMS Enterprise, a specialised hydrographic survey vessel of all things, lacking Bulwark‘s flock of landing craft, vast flight deck, field hospital, or headquarters facilities. The answer is that the Italians have taken over the command, with the carrier Cavour offering many of the same capabilities (less from landing craft, more from aviation).

Operation Mare Nostrum from last year has, indeed, been internationalised, and this is a major policy change. But what a manipulative and twisted way we took to get there! The lessons for other major European issues, I trust, are obvious.

Greece and Iceland, controls and controls

Now that Greece has controls on outtake from banks, capital controls, many commentators are comparing Greece to Iceland. There is little to compare regarding the nature of capital controls in these two countries. The controls are different in every respect except in the name. Iceland had, what I would call, real capital controls – Greece has control on outtake from banks. With the names changed, the difference is clear.

Iceland – capital controls

The controls in Iceland stem from the fact that with its own currency and a huge inflow of foreign funds seeking the high interest rates in Iceland in the years up to the collapse in October 2008, Iceland enjoyed – and then suffered – the consequences, as had emerging markets in Asia in the 1980s and 1990s.

Enjoyed, because these inflows kept the value of the króna, ISK, very high and the whole of the 300.000 inhabitants lived for a few years with a very high-valued króna, creating the illusion that the country was better off then it really was. After all, this was a sort of windfall, not a sustainable gain or growth in anything except these fickle inflows.

Suffered, because when uncertainty hit the flows predictably flowed out and Iceland’s foreign currency reserve suffered. As did the whole of the country, very dependent on imports, as the rate of the ISK fell rapidly.

During the boom, Icelandic regulators were unable and to some degree unwilling to rein in the insane foreign expansion of the Icelandic banks. On the whole, there was little understanding of the danger and challenge to financial stability that was gathering. It was as if the Asia crisis had never happened.

As the banks fell October 6-9 2008, these inflows amounted to ISK625bn, now $4.6bn, or 44% of GDP – these were the circumstances when the controls were put on in Iceland due to lack of foreign currency for all these foreign-owned ISK. The controls were put on November 29 2008, after Iceland had entered an IMF programme, supported by an IMF loan of $2.1bn. (Ironically, Poul Thomsen who successfully oversaw the Icelandic programme is now much maligned for overseeing the Greek IMF programme – but then, Iceland is not Greece and vice versa.)

With time, these foreign-owned ISK has dwindled, is now at 15% of GDP but another pool of foreign-owned ISK has come into being in the estates of the failed bank, amounting to ca. ISK500bn, $3.7bn, or 25% of GDP.

In early June this year, the government announced a plan to lift capital controls – it will take some years, partly depending on how well this plan will be executed (see more here, toungue-in-cheek and, more seriously, here).

Greece – bank-outtake controls

The European Central Bank, ECB, has kept Greek banks liquid over the past many months with its Emergency Liquid Assistance, ELA. With the Greek government’s decision to buy time with a referendum on the Troika programme and the ensuing uncertainty this assistance is now severely tested. The logical (and long-expected) step to stem the outflows from banks is limit funds taken out of the banks.

This means that the Greek controls are only on outtake from banks. The Greek controls, as the Cypriot, earlier, have nothing to do with the value or convertibility of the euro in Greece. The value of the Greek euro is the same as the euro in all other countries. All speculation to the contrary seems to be entirely based on either wishful thinking or misunderstanding of the controls.

However, it seems that ELA is hovering close to its limits. If correct that Greek ELA-suitable collaterals are €95bn and the ELA is already hovering around €90bn the situation, also in respect, is precarious.

How quickly to lift – depends on type of controls

The Icelandic type of capital controls is typically difficult to lift because either the country has to make an exorbitant amount of foreign currency, not likely, a write-down on the foreign-owned ISK or binding outflows over a certain time. The Icelandic plan makes use of the two latter options.

Lifting controls on outtake from banks takes less time, as shown in Cyprus, because the lifting then depends on stabilising the banks and to a certain degree the trust in the banks.

This certainly is a severe problem in Greece where the banks are only kept alive with ELA – funding coming from a source outside of Greece. This source, ECB, is clearly unwilling to play a political role; it will want to focus on its role of maintaining financial stability in the Eurozone. (I very much understand the June 26 press release from the ECB as a declaration that it will stick with the Greek banks as long as it possibly can; ECB is not only a fair-weather friend…)

Without the IMF it would have been difficult for Iceland to gather trust abroad in its crisis actions – but Greece is not only dependent on the Eurozone for trust but on the ECB for liquidity. Without ELA there are no functioning Greek banks. If the measures to stabilise the banks are to be successful the controls are only the first step.

*Together with professor Þórólfur Matthíasson I have earlier written on what Icelandic lessons could be used to deal with the Greek banks. – Cross-posted at uti.is

Club within a club

Reuters

One official said Eurogroup chair Jeroen Dijsselbloem would make a statement following the meeting of the 19 before a further meeting of the 18 with creditor institutions, including the ECB and IMF.

Greece is excluded from that latter meeting. Greece is a member of the IMF. The IMF’s Articles of Agreement give the first of its purposes as –

To promote international monetary cooperation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems.

Is there a precedent for the IMF sitting in on a meeting of a currency union, minus one of its members, for the purposes of agreeing some kind of currency quarantine of that member?

Very, very foolish words.

This FAZ story, suggesting that Angela Merkel and Wolfgang Schäuble are not on the best of terms over negotiations with Greece and that Wolfi might even resign, should be read in the context of Merkel’s past career.

Schäuble wiederum habe nur zufällig von dem Treffen vorab erfahren und zwar nicht von der Kanzlerin, sondern weil ihm Lagarde davon erzählte, berichtet die „Bild“-Zeitung. Und zitiert einen anonym gebliebenen Berater Schäubles mit den Worten (über Merkel): „Das war eine Solo-Nummer von der Dame.“ Außerdem habe der Beamte in Schäubles Ministerium noch hinterher geschickt: „Merkel lässt sich gerade über den Tisch ziehen.“

So the Bild reckons Wolfi wasn’t invited to the meeting in Berlin where Hollande, Merkel, Juncker, Draghi, and Lagarde got together. (A Bild trigger-warning is probably appropriate, but still.) They also quote an anonymous source as saying “it was one of the lady’s solo numbers” and that Merkel “is getting the wool pulled over her eyes”.

All I can say here is: Watch out! Also, there’s this, which at least has a name attached to it and some direct speech:

„Wolfgang Schäuble geht keine faulen Kompromisse ein, er wird seine Glaubwürdigkeit nicht gefährden“, sagte der CSU-Politiker Hans Michelbach der „Bild“. Und fügte hinzu: „Und ohne Schäuble stimmt die Fraktion nicht zu.“

So, according to a CSU MP, Michelbach, the party won’t vote for anything Schäuble doesn’t support. The first problem here is that Michelbach isn’t in his party. The second, and much more important, is that there’s a word for grey men from Bavaria who patronise Angela Merkel: dead. Or at least mundtot. And just try re-reading that first quote. Either Bild really did make it up – not impossible for them – or someone really went out of their way to make trouble.

Everyone’s now rapid-rebutted the story, which of course they would have done if it was true. But nobody should doubt that she would get rid of Schäuble in a hot minute if that seemed expedient, nor that she’d be entirely willing to use SPD votes to crush Michelbach and Co, if she didn’t just call their bluff. That the AfD was last seen suing itself over whether to elect delegates to a party conference or find a hall big enough for the whole membership only underlines the point.

The graveyard is full of the indispensable, and the CDU chapel within it is full of grand sub-Helmut Kohl male egos who got in Merkel’s way.