“We are not on the edge of a precipice”

Thus spoke Mariano Rajoy, the Spanish prime minister, this weekend.  As Wile-e-Coyote often demonstrates, our senses can easily be fooled; once a country enters the danger zone, circumstances can change very rapidly, so rapidly that reasonable plans are rendered obsolete and rational expectations turn to panic.

Unlike the US, Spain avoided the CDO and off-balance sheet madness.  Unlike Greece or Italy, Spain didn’t suffer from excessive sovereign indebtedness.  However, it built a huge real estate bubble financed with bank loans.  When the bubble popped, loans soured and banks became undercapitalized. 

Crucially, Spain let the problem fester for more than two years, failing to merge or close underperforming banks or to force the viable ones to recapitalize.  In that it was not alone in Europe; to this day, the only large bank that has had the courage to go to the markets for a large capital raising exercise at a huge discount to market price was Unicredit from Italy.  That share offering took place earlier this year, when markets were very difficult but still open at a (steep) price.

Having failed to recapitalize to absorb the impact of deteriorating real estate portfolios, the Spanish banks entered 2012 facing a new challenge:  sharply falling prices of their sovereign bond holdings (over 8% year-to-date) against which they had not been required to carry any capital.  By now, markets are closed and the capacity of the State to implement, on its own, a large forced recapitalization is doubtful.  ECB assistance alleviated the Spanish banks funding difficulties and gave Spain some time to prepare a new plan, but it didn’t improve solvency.

The problem is that markets may be slow to grasp what is actually going on, but once they do, they are likely to overreact.  As if this were not enough, it has transpired that some €97 billion of bank deposits left the country during the first quarter.  If the situation doesn’t improve quickly, that number is likely to rise much higher.  I remember a Brazilian lawyer I worked with, back in the 1980s, telling me that he kept essentially all of his money abroad in US dollars save for some minimum in local currency.  Right now, and unlike Brazil in the 1980s, it is perfectly legal for Spanish locals and multinationals operating there to transfer or hold money outside the country.  It is also much easier for individuals to drive across the French-Spanish border if need be.

Faced with this crisis, the Spanish government has made the surprising decision that it wouldn’t let any bank fail.  Why shouldn’t unviable banks be closed after paying off their depositors?  How does the government expect to keep all afloat when it doesn’t have the necessary money?  And if it needs to get funds from fellow eurozone members or the ECB, how can it expect to do so without signing a formal agreement carrying tough conditions?  Even if it is a partial simplification, I don’t think that German or French taxpayers will advance money to Spanish banks to, in effect, fund capital flight.

Clearly, the Spanish government has to do some thinking and needs to act quickly and decisively.  In my view, to be credible, it cannot maintain its stance of blanket support for its banking sector: it doesn’t have the money to back it up, is not likely to get it, and I don’t think that it should either: not all banks are systemically important and some examples must be made of the most egregious abuses.

Other European governments are also in the line of fire.  By now, an exit by Greece from the eurozone would likely be greeted with relief by the markets IF it were handled properly, meaning decisively and credibly.  For the eurozone to survive, the line has to be drawn somewhere, which means exercising solidarity.  If it is drawn to include Spain, Spain has to convince the likes of Germany, France, Italy and Benelux that it means business.  The firewall built by the core countries must also be credible.  This means that France in particular must provide a clear set of spending controls as well as growth-inducing policies.  And Italy needs to convince that it can take care of its own debts as well as shouldering its share of firewall building.

I am not convinced that the euro is viable long-term, whether its member count is reduced or not, but I think that a disorderly breakdown can be avoided. 

Back in the 1980s, faced with a mounting financial crisis, a well known Mexican finance minister said that the country was on the edge of the precipice but that it would overcome by taking a decisive step forward.  That particularly step was not taken, thank God, but Mexico did much to transform itself into a successful economy; the EU would benefit from studying how Mexico overcame its crises, in particular the so called tequila crisis of 1994.

Tackling the Greek debt problem, a look at the Chilean experience (Part 2)

In my previous note, I recounted how a country like Chile in the 1980s had solved its external debt problem better and more durably than its peers.  Two key contributors to its success were voluntary debt swaps and well conceived privatizations.  The debt swaps permitted Chile to reduce its foreign commercial debt by one third.  It now seems that the privatization route is gaining advocates when dealing with Greece.

Today, Mr. Juergen Stark, a European Central Bank board member, stated that Greece could privatize over €300 billion of assets, far more than the €50 billion it has agreed to.  To put this number in perspective, let us remember that the Greek public debt amounts to some €320 billion.

It is my view that privatizations should be the main focus of the Greek rescue.  Doing so would reduce the need for ‘haircuts”, and benefit all parties involved.  There are compelling arguments to choose this strategy.

To begin with, it would be excessively difficult to convince creditors to forgive as much as 50% (the number most often quoted) of the debt of someone whose sellable assets equal such debt.  No bank would agree to do so for any of its corporate debtors, nor would anyone of us, individually or as tax-payers.

While it may appear tempting for a debtor to erase half of his debts, the cost of doing so is usually much higher than imagined.  In the 1980s, after years of muddling through, Latin American countries reduced their external debts by less than one third through the issuance of new (Brady) bonds (the effective haircut ended up being much lower that anticipated because of the secular drop in interest rates worldwide).  It took a decade before markets were willing to buy new Latin bonds at a reasonable premium over US treasuries.  Russia played hard ball, extracting a 55% haircut from the holders of its hybrid Soviet bonds (IAN, PRINs) but escaped durable punishment from investors by excluding its more recent sovereign bonds from any restructuring.  In 2005, Argentina stiffed bond investors with an average 70% haircut and has yet to return to the international bond market.

A 50% haircut would make it very difficult for Greece to regain access to the financial markets.  It would discredit it for years to come.  It would make tax collection and the collection of debts by the Greek state very difficult: after all, if the state does pay its debts, what authority does it have to convince its citizens to behave better?  It would also destabilize other sovereign European debtors by association so that support from the rest of the EU would not be likely.  Finally, it is worth remembering that negotiating a haircut with hedge funds and other non-bank creditors that have little if any long-term interests to protect will not be easy.

Assuming that Greece could durably service a debt amounting to 80% of its GDP, it would need to cut its debt down by half, or some €160 billion.  Assuming further that a 15-20% haircut would be viewed by markets as acceptable retribution for imprudent lending, Greece would need to privatize at least €100-€112 billion in state assets.  This is double what is currently under consideration but less than a third of what Mr. Juergen Stark considers the privatization capacity of Greece to be.  I think it would be a big mistake not to pursue the route of enhanced privatization.

Timing would be an important factor.  There are some assets, such as blocks of shares in well run companies, which can be sold now.  But the Chilean example shows very clearly that companies earmarked for privatization should first be brought back to financial health.  In the case of Greece, some labor laws also need to be revamped to allow for stronger economic growth.  Once these laws are enacted, the value of privatization candidates would appreciate greatly.  Subject to appropriate legislation, some state companies earmarked for privatization could be put in a trust for the benefit of the likes of the ECB and IMF; these institutions could then retire maturing Greek sovereign debt, having secured appropriate collateral with the assets held in trust.  Such a scheme would allow for the timely reduction of the Greek debt while allowing time for corporate remediation so to speak.  

As in the case of Chile three decades ago, the Greek government would be well advised to implement some sort of capitalismo popular so that the Greek people could participate in some key privatizations thanks to low interest bank loans.  It would be fair for them to participate in some upside since they will have to bear their share of the downside of the crisis.  It would also help sell a strategy of private ownership and free markets which is key for a real economic recovery. 

It is very much welcome that an ECB member is prodding all the interested parties to consider voluntary debt reduction via the sale of state assets as the principal avenue for sovereign debt reduction.  Hopefully, this will redirect and invigorate a debate which had stalled lately.

And the winner is ....

With the sudden resignation of Dominique Strauss-Kahn, the position of Managing Director of the IMF is up for grab.  Europe is insisting that tradition should be respected and that the new MD should be a European.  Emerging markets, buoyed by their relatively stronger economies, argue that the time has come for a change and that the job should be awarded to one of their nationals.   The US position, as stated by Secretary Geithner, is that the nomination process should be open and quick.  And the winner is…

Since its creation in 1946, the IMF has always been led by a European and since 1963, a Frenchman has led the institution 74% of the time.  The European exclusivity stemmed from an informal arrangement between the original great economic powers.  The French preeminence came from its greater political weight within the European Community, at least through the mid 1990s.

Today, Europe seems to advance the candidacy of French Finance Minister Christine Lagarde.  She is the best European candidate, has been an excellent FM, has an international work background and would be an excellent MD.  But should Europe lead the IMF now?

Those in favor argue as follows: first, Europe remains the second largest economic bloc in the world and as such deserves to maintain its influence over key international organizations such as the IMF; second, since the current flash points are Greece, Ireland and Portugal, an European MD would be best equipped to deal with the crucial cultural and political dimensions of any workable solution.

The other side argues that emerging markets are far more important to the world economy than they were in the 1940s and even 1980s, that they hold massive international foreign exchange reserves and therefore that their time has come to step up on the world scene. 

They also argue (more discretely) that Europe has managed its public finances very poorly so that it is hardly in a position to lead by example and be recognized, albeit indirectly, as the guardian of financial orthodoxy.  No doubt, many Asians remember the (in)famous photo of MD Camdessus standing over a sitting President Suharto signing a financial aid agreement with the IMF.

As the largest contributor of capital to the IMF, the US will likely play the role of referee.  So far, it gives the impression that while it would endorse Mme Lagarde, it is waiting to see if the emerging economies can rally quickly behind a strong candidate.  In the tug of war for the brass ring, Europe seems to have won the first round, and emerging markets are yet to put their demand into action.

As much as I respect FM Lagarde, I believe that it may be time for the right non-European candidate.  Why?

1-      There is no doubt that the most immediate sovereign debt problems have arisen in Europe and that the list of European countries in need of assistance may grow.  Individual merits aside, a European MD will likely be second-guessed and suspected of bias; less so a non-European MD;

2-      The need for cultural understanding and links to the European political power structure may be overstated given that both the European Central Bank and the European Commission would be parties to any and all individual rescues and would provided such “local link”;

3-      Non European countries may also need assistance, in which case the argument by some for having a European at the helm of the IMF disappears;

4-      Finally, a candidate MD with a successful track record of handling a deep sovereign debt crisis would enjoy greater expertise and authority than one without.  In that regard, France didn’t go through such a crisis so that Mme Lagarde didn’t either.

I can think of a few candidates who would meet the above criteria.  In the 1980s, Chile went through a wrenching debt crisis.  It dealt with it on its own, with innovating strategies and sound budgetary policies, without the benefit of multilateral help or the provision of fresh international loans.  It emerged as the healthiest Latin American country, to this day.  While Greece and others would be well advised to study the Chilean restructuring model, it is highly unlikely that any of the architects of the Chilean “miracle” would be nominated given their association with the then military regime.

On the other hand, Mr. Guillermo Ortiz, who as FM (1994-1998) orchestrated the recovery of Mexico from the 1994 debt crisis, would be an ideal candidate.  As FM he was both decisive, cool and very effective.  While the crisis couldn’t have been overcome without substantial help from the US, Mr. Ortiz was very effective in negotiating and coordinating the steps that led to eventual success.  Subsequently, as President of the Central Bank of Mexico (1998-2010), he consolidated the gains, stabilized the peso and contributed greatly to Mexico receiving an investment grade rating for its external debt.  As a Mexican, he comes from an economy big enough to give him credibility in the eyes of G7 countries; he also brings along the ability to work well with the US.

In the end, I feel that the decision will boil down to how fast the biggest emerging countries can line up behind a candidate of the stature of Mr. Ortiz.  If they do, he can and should be elected as the new managing director of the IMF.  If they can’t, Mme Lagarde will likely go through.  Either way, the world will be well served.