Friday, February 12, 2010

Tough Lough

Just a quick comment regarding the EU's rescue plan for Greece.
I stated previously that I don't believe Greece can handle the situation on its own (amid the scale of the problems on the one side and the difficulty to implement change in an an environment of substantial corruption, limited data quality and a high share of the black market economy on the other). Once you accept that Greece cannot go it alone and that there is no political will to let Greece default (as this would be just the start of a real speculative attack on other Eurozone members, similar to the Asian crisis), some sort of bail-out directly follows. I personally have been surprised by the timing of the rescue announcement (I rather thought this would come towards spring, i.e. after the sale of the new 10y GGB and around the time when there are big redemptions on maturing GGBs in April/May).

Be it as is, I do think that the promise for a rescue plan is going in the right direction:
a) There was (and still is) the risk that a bail-out would be done similarly to the bank bail-outs in 2008/2009, i.e. almost unconditional injection of money with no change in behaviour by those being bailed out. This would not do much to solve the problems at hand, would clearly aggravate the moral hazard issue and promote fiscal irresponsibility across the Eurozone. However, at present the impression is much more one of giving no money (yet) - just the explicit promise to lend once it becomes necessary - while at the same time demanding a more significant change in behaviour towards a sustainable fiscal path.
b) It does not constitute a bilateral deal (say between Germany/France and Greece) but involves the European Commission and also the expertise of the IMF. This is vital as the EC and IMF have more means to advise on and monitor the austerity measures, improve the statistics and state management tools as well as sanction non-compliance if necessary.

As a result, I think that the rescue plan should be seen in a positive light and does send rather strong signals to other Eurozone members to do more to bring their house in order.

However, one should not forget that to re-balance the Greek economy (as well as Spain, Ireland Portugal) will take several years. The challenges at hand are immense. Competitiveness needs to be restored, the current account deficit reduced, private sector indebtdedness needs to drop and house prices have further to fall amongst others. During this period, private sector demand will be weak. Furthermore and as a significant change to especially the past two years where fiscal deficits shot higher, demand by the state sector will be weak as well. In turn, domestic demand will be restrained for several years. The export sectors are not large and competitive enough to take up all the slack. As a result, real and nominal growth rates across the periphery promise to be exceptionally weak for a number of years. In such an environment, the corporate sectors in these countries will face an extremely challenging environment and one should prepare for a multi-year period of high corporate default rates across the periphery (and almost no capacity for a bail-out by the respective sovereigns).


  1. Dear Daniel,

    thank you once again for excellent research pieces.
    A number of commentators, your former colleague Dylan Grice among them, opine that the debt burdens in many countries has become unsustainable. Greece just offers a foretaste of what next should happen in Japan.
    In his recent paper Niels Jensen from Absolute Return Partners writes: "...the end game is approaching. If bond ivestors do not revolt in 2010, they will probably will in 2011..."

    What are your thoughts on that subject? How should bond investors position themselves in such a scenario?

    Kind regards


  2. Hi Mark,
    thanks for the questions. I hope I do have more time a bit later to answer in more detail.
    I saw the paper by Dylan Grice. Usually I really like his work. But this time, I think he did not really know what he is writing about. The chart you are referring to shows government debt including unfunded liabilites to be around 500% for a host of countries. The problem is, he does not give any insights into how this is calculated. But I assume that
    a) for Germany, these numbers are outdated and dont take into account the adjustment in the retirement age from 65 to 67 and the reduction in the entitlements. To my knowledge these two measures are worth approx. 100% of GDP.
    b) the general problem is that while the current debt has already been incurred and needs to be served, current unfunded liabilities are a totally different thing. As Germany has shown you can change these entitlements (essentially they default on part of their promises). But what is more, most continental European countries rely heavily on unfunded pension systems (I think it is called pay-as-you-go in English), i.e. the current cohort of workers is paying directly for the current renters. With this system you have always huge unfunded pension liabilities. But you should also see that you have huge future incomes (in the form of pension contributions by the future workers). What matters for the debt is the difference between these two cash-flow streams. By the way the same principle holds for other entitlements.
    But again, I can not tell for sure as he did not indicate how he calculated the numbers.
    On the end game: I think most countries will get through this via a multi-year period of low nominal growth but with little inflation. Only in the case of sovereign default/currency crisis do I see the inflationary bond-unfriendly outcome...

  3. Thank you



  4. Dear Daniel,

    I thought the absolute return paper still might be of interest to you. Here is the link: