Source: Pew, Greeks and Germans at Polar Opposites, European Unity on the Rocks
June 6, 2012
Stereotyping Europe
No Comment Required!
Source: Pew, Greeks and Germans at Polar Opposites, European Unity on the Rocks
Source: Pew, Greeks and Germans at Polar Opposites, European Unity on the Rocks
June 3, 2012
Drugs, Dollars and Banks
Drug is a precious commodity but also a powerful social disruptor able to wreak havoc in a society and weaken it; it was used in the past in China during the Opium Wars to weaken the Qing Dinasty and accumulate huge profits for Britain or today in Afghanistan and many other Latin and African countries to fragment and destroy the social fabric and control its production and profits.
Political use of drugs
Drugs are a powerful weapon when deployed on a population, its many advantages include:
Drugs have many similarities with oil as well; the reserve currency for drug smuggling and transactions is the dollar, every drug transaction is practically paying a fee to the US Federal Reserve, not surprising that such a trade is protected by concerned governments all over the world.
If the Iraqi wars were fought for oil; Afghanistan was in part fought for opium and it started shortly after the Talibans started to destroy opium fields and banned drugs trade.
This is past history and it can explain why war to drugs is and will always be a lost war, no one is really interested to fight such a profitable business regardless of occasional moral proclamations broadcasted on TV.
New Drugs economy
The future of drugs is the new synthetic trade growing rapidly and evolving technologically to become independent from natural sources.
If the new Canadian producers of synthetic drugs will succeed the economical landscape of drugs could change rapidly in the following years, removing the difference between producers and consumers countries and allowing for mass production of drugs without need of natural resources and reducing the time to market and cross-border illegal trade.
Still now though who is profiting the most from drugs is the banking system who launder the profits and reap the hidden tax of the dollar as a reference currency in the case of USA.
Let us not forget that when the Euro was introduced a 500 Euro bill was created specifically for the necessities of smugglers, cartels and bankers, at that time the major aspiration for the Euro was to replace the dollar as preferred currency of choice for drug barons, arm dealers and robber barons.
The Guardian today added an interesting outlook (brief excerpt below) on where and how profits from this trade are done.
It will not raise any parliamentary discussion or moral debate on the war to drugs, the issue has disappeared slowly and silently from public debates while drugs have been more and more popularized by the media as socially acceptable if not socially cool, after all banks are drowning in debt, economies are collapsing then what better way to fill the empty coffers with an increased number of addicts and stupor their futures and fortunes away.
From The Guardian:
Political use of drugs
Drugs are a powerful weapon when deployed on a population, its many advantages include:
- docility of addicted population
- increase of economic indebtedness
- increased stress on health services and social services
- social fabric fracture and degradation
- massive outflow of capitals to foreign banking systems and suppliers
- increased corruption and illegality
- creation of an indentured service system
Drugs have many similarities with oil as well; the reserve currency for drug smuggling and transactions is the dollar, every drug transaction is practically paying a fee to the US Federal Reserve, not surprising that such a trade is protected by concerned governments all over the world.
If the Iraqi wars were fought for oil; Afghanistan was in part fought for opium and it started shortly after the Talibans started to destroy opium fields and banned drugs trade.
This is past history and it can explain why war to drugs is and will always be a lost war, no one is really interested to fight such a profitable business regardless of occasional moral proclamations broadcasted on TV.
New Drugs economy
The future of drugs is the new synthetic trade growing rapidly and evolving technologically to become independent from natural sources.
If the new Canadian producers of synthetic drugs will succeed the economical landscape of drugs could change rapidly in the following years, removing the difference between producers and consumers countries and allowing for mass production of drugs without need of natural resources and reducing the time to market and cross-border illegal trade.
Still now though who is profiting the most from drugs is the banking system who launder the profits and reap the hidden tax of the dollar as a reference currency in the case of USA.
Let us not forget that when the Euro was introduced a 500 Euro bill was created specifically for the necessities of smugglers, cartels and bankers, at that time the major aspiration for the Euro was to replace the dollar as preferred currency of choice for drug barons, arm dealers and robber barons.
The Guardian today added an interesting outlook (brief excerpt below) on where and how profits from this trade are done.
It will not raise any parliamentary discussion or moral debate on the war to drugs, the issue has disappeared slowly and silently from public debates while drugs have been more and more popularized by the media as socially acceptable if not socially cool, after all banks are drowning in debt, economies are collapsing then what better way to fill the empty coffers with an increased number of addicts and stupor their futures and fortunes away.
From The Guardian:
The vast profits made from drug production and trafficking are overwhelmingly reaped in rich "consuming" countries – principally across Europe and in the US – rather than war-torn "producing" nations such as Colombia and Mexico, new research has revealed.
The most far-reaching and detailed analysis to date of the drug economy in any country – in this case, Colombia – shows that 2.6% of the total street value of cocaine produced remains within the country, while a staggering 97.4% of profits are reaped by criminal syndicates, and laundered by banks, in first-world consuming countries.
Gaviria and Mejía estimate that the lowest possible street value (at $100 per gram, about £65) of "net cocaine, after interdiction" produced in Colombia during the year studied (2008) amounts to $300bn. But of that only $7.8bn remained in the country.
"It is a minuscule proportion of GDP," said Mejía, "which can impact disastrously on society and political life, but not on the Colombian economy. The economy for Colombian cocaine is outside Colombia."
The mechanisms of laundering drug money were highlighted in the Observer last year after a rare settlement in Miami between US federal authorities and the Wachovia bank, which admitted to transferring $110m of drug money into the US, but failing to properly monitor a staggering $376bn brought into the bank through small exchange houses in Mexico over four years. (Wachovia has since been taken over by Wells Fargo, which has co-operated with the investigation.)
But no one went to jail, and the bank is now in the clear. "Overall, there's great reluctance to go after the big money," said Mejía. "They don't target those parts of the chain where there's a large value added. In Europe and America the money is dispersed – once it reaches the consuming country it goes into the system, in every city and state. They'd rather go after the petty economy, the small people and coca crops in Colombia, even though the economy is tiny."
With Britain having overtaken the US and Spain as the world's biggest consumer of cocaine per capita, the Wachovia investigation showed much of the drug money is also laundered through the City of London, where the principal Wachovia whistleblower, Martin Woods, was based in the bank's anti-laundering office. He was wrongfully dismissed after sounding the alarm.
Gaviria said: "We know that authorities in the US and UK know far more than they act upon. The authorities realise things about certain people they think are moving money for the drug trade – but the DEA [US Drugs Enforcement Administration] only acts on a fraction of what it knows."
"It's taboo to go after the big banks," added Mejía. "It's political suicide in this economic climate, because the amounts of money recycled are so high."
The Small Earthquake that can bring Italy down
It is estimated that more than 3000 enterprises and factories have been damaged by those two earthquakes, after the first earthquake on the 20th of May all factories were checked for damages and were granted green light to resume production, unfortunately workers died under the rubble of crumbling warehouses when the second earthquake hit at 9 am on the 29th.
This time of course production in the factories has been stopped undefinetely until all structures are thoroughly checked for damages which could take months.
If we check a seismic map of Italy this area was considered as a safe one not requiring special precautions when building since no earthquake had been registered in the last 400 years.
Historically there was an extremely long series of earthquakes that struck the region in the 16th century and that went on for many years with hundreds of medium-low intensity earthquakes but not further activity since then.
It is true that most probably even if the area was highlighted as prone to earthquakes little would have changed in building practices, even critical areas prone to major earthquakes in Italy are still building with no seismic fail safe; corruption, carelessness and lack of rules are all ingredients to buildings being raised cheap and fast; ready to fall and boost the reconstruction business when disaster strike.
After all Italians still remember the laughs of joy of corrupt builders when informed of the earthquake of Aquila in 2009, transcripts of their phone calls were intercepted by Police in relation to bribery charges to former Berlusconi government officials.
Reconstruction is a major business for Italian builders; it boosts revenue and margins and incentivates them to build as bad as possible in order to increase the base of possible candidates, furthermore since even in case of proved negligence not even a builder has ever gone to prison, there is not even fear of retribution. This morally repulsive and economically destructive (for the society not for the builders) attitude has been dominant for many decades and it can explain why the most recent buildings are the first to collapse during an earthquake even before centuries-old historical buildings.
News of the first strike briefly appaered on major international news while the second one was mostly unreported although it has the potential of accelerating the Italian economic crisis to new heights and consequently affect the entire eurozone economy.
Let us be clear if terrorists would decide to cripple the economy of Italy they would have chosen the same area; destroy or paralyze the industrial production of The Emilia Region is equivalent to destroying 1-2 % of the Italian GDP with a consequent spiralling of the crisis.
This area alone is the backbone of Italy's industrial system, firms producing almost everything from biomedical to mechanics to food processing, current damages are 2 billion euros but aside from this a prolonged production shutdown will cause immense stress to the Italian tax revenue with a consistent shortfall and an almost sure missing of the budget parameters requested by the European fiscal compact.
If earthquakes will go on for months or even years as geologists are predicting, those factories that were already deeply affected by the global economic crisis will be out of business causing a major blow to an already crumbling Italian economy.
Pity that a similar earthquake in places such as Japan or California would have been just a small inconvenience with little or no damages.
May 26, 2012
Greece Exit Scenarios
From Zero Hedge:
Scenario 1: Managed Greek exit; no contagion or financial market disorder
This is the most benign scenario with respect to a Greek exit, assuming away the major contagion risk. There is likely to be short term euro weakness, but a sharp initial sell-off would be deceptive and the weakness would be relatively brief once the contagion fears wore off.
Some argue that the euro would rally strongly off this development, arguing that the euro ex-Greece would be much stronger than the euro with Greece. This positive scenario would be a world in which the risk premium on other euro countries has been largely determined by the fear of contagion from a GREXIT, not issues related to other peripherals themselves. Once GREXIT occurred without damage, whether on its own or because of policy commitments, spreads would narrow and the euro would rally.
Absent such an unwinding of knock-on risk on other peripherals, the arithmetic of the euro zone divesting itself of the Greek 2% of the euro zone facing a major depreciation is not very exciting. If the new Greek currency depreciated 50% (a very round number), the implied boost to the surviving EUR with its stronger components would be about 1%, basically it’s overnight move.
The above is a very optimistic reading of what is driving peripheral spreads in other euro zone countries. If the concerns reflect risk associated with national debt in other peripheral countries, not primarily Greek contagion fears, then even if the fears abate, the fiscal concerns on remaining peripherals would prevent a major appreciation. So this benign scenario does not seem the most likely scenario by any means, nor is it likely that the euro’s problems are as Greece-centric as needed to make the euro outcome play out as described. That said, if the benign scenario plays out, EURUSD could rally significantly from current levels, trading closer to 1.45 or higher, but it just doesn’t seem very likely.
Scenario 2: Greece exits, contagion spreads to other peripherals
Greece repudiates the austerity of bailout and exits the euro zone. Contagion spreads to other peripherals.
This scenario entails months of profound economic and financial confusion during which the euro would be under constant pressure in our view. How the euro evolves depends on how euro zone policymakers deal with contagion risk and that depends on the post-departure policies that are followed.
Substantial euro downside could emerge from investor fears that other peripheral countries in the euro zone would drop out, raising the risk premium on their debt, and making it even less possible to hit fiscal and economic growth targets. A Greek dropout could be viewed as unfortunate but manageable, if the euro zone disintegration was viewed as stopping there at Greece, but the risk is that investors come to expect that other countries will follow. Such countries would experience the worst of all worlds, austerity, a risk premium that now builds in additional currency risk, but no control of exchange rate or monetary policy and no growth. Investors in that case would speculate that the cost of staying in the euro was too high for other countries as well.
The way to avoid this contagion and downward pressure on the euro would be to provide an absolute, non-conditional guarantee that no other country would drop out. This would be a spectacular transformation -- an ECB that is unwilling to act like the Fed morphs into the SNB.
Moreover, some clients have raised the possibility that investors would not believe even such a guarantee – at least not initially. They would argue that the example of Greek depreciation would induce even Mom and Pop in other peripheral countries to shift their deposits to Germany, the UK, the US or Switzerland because the downside from doing so if other peripherals do not drop out is low, and the downside from not doing so if there are further dropouts is tremendous. At a minimum this provides a big hole in peripheral banking systems that would have to be filled by the ECB – probably involving the ECB in far more open-ended risk than they have shown a willingness to take. It is unlikely that all the deposits would go to Frankfurt, so there is probably some direct downward pressure on the euro involved. The final element of the argument is that investors and residents will fear that the ECB can not bring itself to make such a permanent and potentially very expensive contingent commitment.
The EUR could begin to rally if the euro zone manages to ring-fence the other peripherals but so much damage will have been done by then that the EUR would begin its rally from a much lower level and probably not be anywhere close to the current level at the end of the year.
The optimistic view on contagion is that the ECB would not actually have to take on the risk if the commitment was ironclad enough. But if there is any degree of skepticism or if the ECB showed any hesitation, the risk-return would be in favor of capital flight and the euro would fall sharply and the ECB would face additional balance sheet risk.
This is the problem that the euro faces on any dropout scenario, Even a small country dropout that has limited direct financial and economic implications for the euro zone could raise the stakes enormously with respect to other countries. Whether the euro goes up or down depends on whether the euro zone policymakers can bring themselves to make the needed open-ended commitment and convince the market that they will stick to it thick and thin even if the price tag rises. Given their inability to achieve timely consensus on policies that would have averted the pressures and been much cheaper, investors are likely to sell euros until fully convinced of policymaker resolve.
Scenario 3: Multiple peripheral countries exit, core remains
Our economists do not see this as a high probability scenario, but it is certainly discussed by FX investors. This is the scenario in which the likely dynamics of exit conflict the most with the long-term equilibrium. Define the long term as the point at which economies and exchange rates have moved back to their long-term equilibrium path. The euro of the surviving core will likely be stronger than its predecessor euro was. Consider that the deficit, debt and external balances will be much stronger than with the current euro. So one can make the case that the long term equilibrium value of this ‘core’ euro is much stronger, possibly even at the highs that were seen in 2008.
However, the short and medium term may last for an extremely long time and the dynamics over that period are very negative, not just for the peripherals that drop out but for the core that remains in. Consider that the peripheral countries are likely to drop out one by one, probably accompanied by economic and financial disruption. The impact will be felt on core economies and financial institutions as well, so whatever the long-term equilibrium, the path there will likely be accompanied by economic weakness at least until a stable core is formed and a path to recovery is envisioned – this can take a very long time and is probably well beyond an investible horizon. The high cost to both the dropouts and the remaining core countries is one reason that this is considered such an unlikely scenario.
Scenarios that boost the euro.
Only the first scenario above has a euro positive component relatively quickly after the Greek exit is realized and the probability is low that investors will look as benignly on the event as the scenario implies.
The characteristics that each of the euro-negative scenarios share is that each reflects an augmentation of euro zone risk. Even if the risk is accompanied by a relatively hawkish ECB perspective, the euro falls because investors are focused on the deep risks associated with euro breakup rather than marginal, and probably unsustainable, gains from a hawkish ECB.. The argument we would make is that global investors will cut the euro a lot of slack if extreme tail risk can be eliminated, even if the outcome involves a bigger balance sheet or other unorthodox policies.
Scenario 4: New Greek government embraces austerity plan
We are not so naïve as to think they would actually embrace austerity, but by accepting the plan, they would relieve investors of concern in the short term of a messy default, bank runs and immediate financial crisis. Investors would not necessarily view this as a good outcome objectively, but as a better and much cheaper outcome than the alternative of messy default and Greek euro zone withdrawal. Essentially a continuation of the status quo, the question is how long a period of tranquility such a compromise would buy. If investors are jaded and view it as a very short term patch before renewed strife the bounceback in the euro would be limited.
Scenario 5: ECB bond buying or Eurobond
Both of these take a step towards resolving what is a major failure of monetary policy in the euro zone -- Interest rates are simply too high. A GDP –weighted average 10year yields of non-program euro zone countries is more than 150bps higher than in the US or UK. This effective tightness of monetary policy is hardly justified by upward inflation or growth risks.
Were the ECB to buy bonds aggressively it is unlikely that investors would fight the ECB. Were the fiscal authorities to jointly issue an Eurobond, it is likely that core yields would go up and peripheral yields down – exactly the rate redistribution required to stimulate activity in the periphery and support their asset markets. This is likely to reduce tail risk and support the euro.
Looking at these two scenarios, it seems far more likely that the SMP buying will be renewed than the governments coming together and issuing an euro bond in the near term. It seems far more likely that the trillion EUR balance expansion of the ECB since mid-2011 would have been more effective buying cash bonds than operating through the LTRO.
Having put forward these proposals, we have to admit that they seem less likely than the ECB making an effort at reviving confidence by a bog standard rate cut or an additional LTRO. The political opposition to these measures means that even though they are likely to be the most effective in resolving the crisis, they are unlikely to be the first (or second) applied.
Scenario 6: LTRO or rate cuts
It seems unlikely to us that the euro zone’s underlying problem is that the refi rate is 1% rather than 0.5%, or 1.5% for that matter. A rate cut could be seen by the market as some sort of signal that further aggressive easing was coming, but by itself it seems more likely to stimulate activity in Germany than Spain. Nevertheless, it is possible that the cut could come and that the euro could even rally if the cut was viewed as complementary to other policy actions that euro zone policymakers were planning. If the cut was viewed as a substitute for more effective measures, the euro would probably resume its fall, possibly even accelerating in its decline. To paraphrase Crosby, Stills, Nash and Young – if you can’t use the policy that works, work with the policies you have. But the euro is hardly likely to respond positively.
Similarly, a third LTRO would tread a familiar path. So far, the two earlier LTROs have eased borrowing costs at the short end and led to a shortening of duration by peripheral issuers. An LTRO with a significantly longer maturity might encourage euro zone financial institutions to buy longer dated government bonds and bring down long term interest rates. The first two helped stabilize and reduce bond yields temporarily but now they are back to where they were in the bad old days of November 2011, although not at the very peak of the crisis.
One reason the first two LTROs did not trigger a sustained drop in peripheral funding costs was the intensifying deposit flight which added to banks’ funding issues. We suspect that a pan-euro zone deposit guarantee, funded by the EFSF or ESM, could enhance the effectiveness of any future bouts of ECB lending as it will limit the outflow of bank resources. That being said, however, so far there is not much appetite for a Europe-wide safety net with the countries of the core reluctant to bankroll bank liabilities in the periphery. Moreover, the potential losses are extremely high if any country were to leave the euro zone and any country left out would almost be guaranteed to experience significant capital flight. If it could be implemented credibly (say with an ECB backstop) then the effectiveness of LTROs would not be undermined by deposit flight and banks might become more aggressive bidders for their sovereign's debt.
Potentially this could ease strains within the euro zone and generate both a global and euro zone risk rally, but to be implemented credibly would require a similar open-ended commitment to those discussed above, and such commitment have been hard to extract from euro zone policymakers.
Concluding remarks
Approaching a second round of Greek elections potential scenarios leave the balance of risks pointing towards a weaker EUR. In the long run, while there may be more favorable equilibriums, the path there we suspect will be very painful. At this stage a mixture between scenarios 2 and 6 seems most likely, with 1 a possibility on the outside – not very promising for the EUR unless policymakers surprise with decisiveness.
Scenario 1: Managed Greek exit; no contagion or financial market disorder
This is the most benign scenario with respect to a Greek exit, assuming away the major contagion risk. There is likely to be short term euro weakness, but a sharp initial sell-off would be deceptive and the weakness would be relatively brief once the contagion fears wore off.
Some argue that the euro would rally strongly off this development, arguing that the euro ex-Greece would be much stronger than the euro with Greece. This positive scenario would be a world in which the risk premium on other euro countries has been largely determined by the fear of contagion from a GREXIT, not issues related to other peripherals themselves. Once GREXIT occurred without damage, whether on its own or because of policy commitments, spreads would narrow and the euro would rally.
Absent such an unwinding of knock-on risk on other peripherals, the arithmetic of the euro zone divesting itself of the Greek 2% of the euro zone facing a major depreciation is not very exciting. If the new Greek currency depreciated 50% (a very round number), the implied boost to the surviving EUR with its stronger components would be about 1%, basically it’s overnight move.
The above is a very optimistic reading of what is driving peripheral spreads in other euro zone countries. If the concerns reflect risk associated with national debt in other peripheral countries, not primarily Greek contagion fears, then even if the fears abate, the fiscal concerns on remaining peripherals would prevent a major appreciation. So this benign scenario does not seem the most likely scenario by any means, nor is it likely that the euro’s problems are as Greece-centric as needed to make the euro outcome play out as described. That said, if the benign scenario plays out, EURUSD could rally significantly from current levels, trading closer to 1.45 or higher, but it just doesn’t seem very likely.
Scenario 2: Greece exits, contagion spreads to other peripherals
Greece repudiates the austerity of bailout and exits the euro zone. Contagion spreads to other peripherals.
This scenario entails months of profound economic and financial confusion during which the euro would be under constant pressure in our view. How the euro evolves depends on how euro zone policymakers deal with contagion risk and that depends on the post-departure policies that are followed.
Substantial euro downside could emerge from investor fears that other peripheral countries in the euro zone would drop out, raising the risk premium on their debt, and making it even less possible to hit fiscal and economic growth targets. A Greek dropout could be viewed as unfortunate but manageable, if the euro zone disintegration was viewed as stopping there at Greece, but the risk is that investors come to expect that other countries will follow. Such countries would experience the worst of all worlds, austerity, a risk premium that now builds in additional currency risk, but no control of exchange rate or monetary policy and no growth. Investors in that case would speculate that the cost of staying in the euro was too high for other countries as well.
The way to avoid this contagion and downward pressure on the euro would be to provide an absolute, non-conditional guarantee that no other country would drop out. This would be a spectacular transformation -- an ECB that is unwilling to act like the Fed morphs into the SNB.
Moreover, some clients have raised the possibility that investors would not believe even such a guarantee – at least not initially. They would argue that the example of Greek depreciation would induce even Mom and Pop in other peripheral countries to shift their deposits to Germany, the UK, the US or Switzerland because the downside from doing so if other peripherals do not drop out is low, and the downside from not doing so if there are further dropouts is tremendous. At a minimum this provides a big hole in peripheral banking systems that would have to be filled by the ECB – probably involving the ECB in far more open-ended risk than they have shown a willingness to take. It is unlikely that all the deposits would go to Frankfurt, so there is probably some direct downward pressure on the euro involved. The final element of the argument is that investors and residents will fear that the ECB can not bring itself to make such a permanent and potentially very expensive contingent commitment.
The EUR could begin to rally if the euro zone manages to ring-fence the other peripherals but so much damage will have been done by then that the EUR would begin its rally from a much lower level and probably not be anywhere close to the current level at the end of the year.
The optimistic view on contagion is that the ECB would not actually have to take on the risk if the commitment was ironclad enough. But if there is any degree of skepticism or if the ECB showed any hesitation, the risk-return would be in favor of capital flight and the euro would fall sharply and the ECB would face additional balance sheet risk.
This is the problem that the euro faces on any dropout scenario, Even a small country dropout that has limited direct financial and economic implications for the euro zone could raise the stakes enormously with respect to other countries. Whether the euro goes up or down depends on whether the euro zone policymakers can bring themselves to make the needed open-ended commitment and convince the market that they will stick to it thick and thin even if the price tag rises. Given their inability to achieve timely consensus on policies that would have averted the pressures and been much cheaper, investors are likely to sell euros until fully convinced of policymaker resolve.
Scenario 3: Multiple peripheral countries exit, core remains
Our economists do not see this as a high probability scenario, but it is certainly discussed by FX investors. This is the scenario in which the likely dynamics of exit conflict the most with the long-term equilibrium. Define the long term as the point at which economies and exchange rates have moved back to their long-term equilibrium path. The euro of the surviving core will likely be stronger than its predecessor euro was. Consider that the deficit, debt and external balances will be much stronger than with the current euro. So one can make the case that the long term equilibrium value of this ‘core’ euro is much stronger, possibly even at the highs that were seen in 2008.
However, the short and medium term may last for an extremely long time and the dynamics over that period are very negative, not just for the peripherals that drop out but for the core that remains in. Consider that the peripheral countries are likely to drop out one by one, probably accompanied by economic and financial disruption. The impact will be felt on core economies and financial institutions as well, so whatever the long-term equilibrium, the path there will likely be accompanied by economic weakness at least until a stable core is formed and a path to recovery is envisioned – this can take a very long time and is probably well beyond an investible horizon. The high cost to both the dropouts and the remaining core countries is one reason that this is considered such an unlikely scenario.
Scenarios that boost the euro.
Only the first scenario above has a euro positive component relatively quickly after the Greek exit is realized and the probability is low that investors will look as benignly on the event as the scenario implies.
The characteristics that each of the euro-negative scenarios share is that each reflects an augmentation of euro zone risk. Even if the risk is accompanied by a relatively hawkish ECB perspective, the euro falls because investors are focused on the deep risks associated with euro breakup rather than marginal, and probably unsustainable, gains from a hawkish ECB.. The argument we would make is that global investors will cut the euro a lot of slack if extreme tail risk can be eliminated, even if the outcome involves a bigger balance sheet or other unorthodox policies.
Scenario 4: New Greek government embraces austerity plan
We are not so naïve as to think they would actually embrace austerity, but by accepting the plan, they would relieve investors of concern in the short term of a messy default, bank runs and immediate financial crisis. Investors would not necessarily view this as a good outcome objectively, but as a better and much cheaper outcome than the alternative of messy default and Greek euro zone withdrawal. Essentially a continuation of the status quo, the question is how long a period of tranquility such a compromise would buy. If investors are jaded and view it as a very short term patch before renewed strife the bounceback in the euro would be limited.
Scenario 5: ECB bond buying or Eurobond
Both of these take a step towards resolving what is a major failure of monetary policy in the euro zone -- Interest rates are simply too high. A GDP –weighted average 10year yields of non-program euro zone countries is more than 150bps higher than in the US or UK. This effective tightness of monetary policy is hardly justified by upward inflation or growth risks.
Were the ECB to buy bonds aggressively it is unlikely that investors would fight the ECB. Were the fiscal authorities to jointly issue an Eurobond, it is likely that core yields would go up and peripheral yields down – exactly the rate redistribution required to stimulate activity in the periphery and support their asset markets. This is likely to reduce tail risk and support the euro.
Looking at these two scenarios, it seems far more likely that the SMP buying will be renewed than the governments coming together and issuing an euro bond in the near term. It seems far more likely that the trillion EUR balance expansion of the ECB since mid-2011 would have been more effective buying cash bonds than operating through the LTRO.
Having put forward these proposals, we have to admit that they seem less likely than the ECB making an effort at reviving confidence by a bog standard rate cut or an additional LTRO. The political opposition to these measures means that even though they are likely to be the most effective in resolving the crisis, they are unlikely to be the first (or second) applied.
Scenario 6: LTRO or rate cuts
It seems unlikely to us that the euro zone’s underlying problem is that the refi rate is 1% rather than 0.5%, or 1.5% for that matter. A rate cut could be seen by the market as some sort of signal that further aggressive easing was coming, but by itself it seems more likely to stimulate activity in Germany than Spain. Nevertheless, it is possible that the cut could come and that the euro could even rally if the cut was viewed as complementary to other policy actions that euro zone policymakers were planning. If the cut was viewed as a substitute for more effective measures, the euro would probably resume its fall, possibly even accelerating in its decline. To paraphrase Crosby, Stills, Nash and Young – if you can’t use the policy that works, work with the policies you have. But the euro is hardly likely to respond positively.
Similarly, a third LTRO would tread a familiar path. So far, the two earlier LTROs have eased borrowing costs at the short end and led to a shortening of duration by peripheral issuers. An LTRO with a significantly longer maturity might encourage euro zone financial institutions to buy longer dated government bonds and bring down long term interest rates. The first two helped stabilize and reduce bond yields temporarily but now they are back to where they were in the bad old days of November 2011, although not at the very peak of the crisis.
One reason the first two LTROs did not trigger a sustained drop in peripheral funding costs was the intensifying deposit flight which added to banks’ funding issues. We suspect that a pan-euro zone deposit guarantee, funded by the EFSF or ESM, could enhance the effectiveness of any future bouts of ECB lending as it will limit the outflow of bank resources. That being said, however, so far there is not much appetite for a Europe-wide safety net with the countries of the core reluctant to bankroll bank liabilities in the periphery. Moreover, the potential losses are extremely high if any country were to leave the euro zone and any country left out would almost be guaranteed to experience significant capital flight. If it could be implemented credibly (say with an ECB backstop) then the effectiveness of LTROs would not be undermined by deposit flight and banks might become more aggressive bidders for their sovereign's debt.
Potentially this could ease strains within the euro zone and generate both a global and euro zone risk rally, but to be implemented credibly would require a similar open-ended commitment to those discussed above, and such commitment have been hard to extract from euro zone policymakers.
Concluding remarks
Approaching a second round of Greek elections potential scenarios leave the balance of risks pointing towards a weaker EUR. In the long run, while there may be more favorable equilibriums, the path there we suspect will be very painful. At this stage a mixture between scenarios 2 and 6 seems most likely, with 1 a possibility on the outside – not very promising for the EUR unless policymakers surprise with decisiveness.
Eurozone Capital Flight
Citi' analyst Matt King has been monitoring the situation of bank assets in Europe and his results are most disturbing: "In
Greece, Ireland, and Portugal, foreign deposits have fallen by an
average of 52%, and foreign government bond holdings by an average of
33%, from their peaks.
The same move in Spain and Italy, taking into account the fall that has taken place already, would imply a further €215bn and €214bn in capital flight respectively, skewed towards deposits in the case of Spain and towards government bonds in the case of Italy.
Economic deterioration, ratings downgrades and especially a Greek exit would almost certainly significantly accelerate the timescale and increase the amounts of these outflows.
Below a summary of all the less than pleasant capital flows out of Europe's periphery.
The same move in Spain and Italy, taking into account the fall that has taken place already, would imply a further €215bn and €214bn in capital flight respectively, skewed towards deposits in the case of Spain and towards government bonds in the case of Italy.
Economic deterioration, ratings downgrades and especially a Greek exit would almost certainly significantly accelerate the timescale and increase the amounts of these outflows.
Below a summary of all the less than pleasant capital flows out of Europe's periphery.
How far is the flock likely to run? In Greece, Ireland, and Portugal, foreign deposits have fallen by an average of 52%, and foreign government bond holdings by an average of 33%, from their peaks (Figure 18). The same move in Spain and Italy, taking into account the fall that has taken place already, would imply a further €215bn and €214bn in capital flight respectively, skewed towards deposits in the case of Spain and towards government bonds in the case of Italy (Figure 19).
Once the run (either bond or bank) starts, there is no stopping it:
Although large, if these flows occur slowly enough, they might not represent a major problem. After all, Portugal’s banks have managed to replace fleeing foreign deposits with domestic ones, and ECB repo should allow a further ramp-up in banks’ holdings of government bonds.
But we think the risks are skewed towards larger outflows occurring considerably more rapidly. Admittedly there are a great many unknowns, including the potential policy response. But none of these estimates allow for the possibility of domestic deposit flight. In the case of a Greek exit from the euro, that outcome seems highly likely. Nor is there any sign that the flight from Ireland and Portugal is diminishing (if anything, we expect the opposite).11 Moreover, banks’ appetite to buy further government bonds may prove limited if they start to suffer deposit flight – and all the more so if they suspect that deposit flight stems in part from their holdings of government bonds
What is the only possible outcome that will prevent this virtually catastrophic outcome?Above all, though, we think capital flight, like so much in markets, is a self-reinforcing process. Provided other depositors and bondholders are grazing quietly, there is no reason to run. But as risks come ever more into the spotlight – whether through the TARGET2 imbalances, benchmark shifts or the threat of EMU exit in Greece – the unattractiveness of the risk-reward becomes ever more obvious.
To our minds, capital flight will stop only once there is decisive policy intervention. The longer investors have to wait for this, the more decisive it will need to be. Even a Euro area-wide deposit guarantee scheme might struggle to be credible if investors fear the incentives for redenomination are strong enough... Quite simply, investors in ‘safe assets’ need to be reasonably sure they will get their money back. Foreign investors in peripherals can no longer be sure of that.
OECD Better Life Index
The OECD's Better Life Index has been updated with some great new features. Worth checking if you want to compare countries and demographics on a vaste array of indicators.
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