Greece: Let's try again

The latest iteration of the Greek saga offers little relief, except perhaps time.  It would however limit the participating banks’ losses to a maximum of 50%. 

 French banks have proposed a plan which apparently will be approved by German banks.   While its details have not been fully revealed, it would cover the maturities of Greek public debt held by banks and falling between 2011 and 2014 or around €60 billion. 

Under this plan, the most likely alternative would be for banks receiving €100 in repayments to keep €30.  The remaining €70 would be rolled into a 30 year Greek bond.  Greece would need to come up with €20 to buy AAA-rated zero-coupon bonds to be used as collateralize ensuring that, a maturity, the principal of the new 30 year Greek bonds will be repaid in full.

Since the participating banks keep €30 upfront, and since the present value of the collateral for the new bonds is €20, they insure that they will recover no less than 50%.

For the Greeks, the deal is less appealing.  They need to finance the 30% repayment, i.e. some €18 billion, and they need to buy the AAA zero-coupon bonds, i.e. another €12 billion.  In other words, Greece gets no reduction in debt.  Indeed, should its economic recovery materialize, the interest on its new bonds will go up.

The EU will likely have to come up with most of the 30 billion that Greece needs, getting it ever more committed to a successful rescue and more exposed to losses should a messy default become unavoidable.

What this plan does is buy time, time to set up the conditions for a more competitive Greek economy.  These would include less constraining labor laws, well thought out privatizations, pension reform, to name some key ones.  But does the plan incenticize the parties and is the burden sharing appropriate?

Some of the proponents of the plan have likened it to the Latin American Brady Plan.  Yes, the Brady bonds that were issued benefitted from rolling coupons guarantees and/or collateralized principal.  But unlike the Greek plan, they imposed ‘haircuts on the creditors.  Here, European taxpayers are picking up the tab.

Another area of concern is how “voluntary” the exchange of maturing bonds for new 30 year bonds will be viewed by rating agencies and the market.  Newspapers have reported informal contacts between European officials and rating agencies, whereby the former were appearing to warn the latter against ruling the exchange as a default.

I think it is fair to say that, if creditors were offered the chance to be repaid in full, they would jump at it.  If rating agencies stand firm, this plan will not work.  If they don’t, the European CDS market will likely be destroyed.  Would it be worth it?

Greece needs a debt reduction of at least 50% accompanied by a credible plan to improve its public finances and facilitate economic growth over time.  To that end, finding time is necessary, but it is not sufficient.

It is possible that the EU will reveal such a plan, but so far it has not and the latest effort is increasing, not decreasing the burden of the debt.

What are Greek bonds worth?

The benchmark GGB 6¼% of 2020 is selling at 51.735. The average closing price over the 12/31/10-6/15/11 period has been 64.2. At current prices, the market is saying that Greece can’t service a debt that reaches 160% of GDP and that the country needs to cut such debt almost in half. I agree. But the market also says that the inevitable restructuring will wipe 48% of the public debts outstanding. I disagree.
 

With over €300 billion of public assets potentially available for sale (according to Mr. Juergen Stark of the ECB board), it seems to me extremely difficult that Greece could convince private creditors and fellow EU members that half of its €320 billion in public debt be forgiven.

Nor should it. If it did, it and the rest of the EU would lose market confidence for a long time, and the weaker EU member countries would suffer serious financial dislocation. As it is evident from the current riots and the reticence of local politicians, imposing drastic austerity measures would be very difficult, and possibly unproductive.

The only viable alternative is an expanded asset sale and privatization program, one that would generate €100 billion in cash proceeds. This, coupled with a rescheduling of the remaining debt via longer maturities and below market rates (in all equivalent to a 15%-20% “haircut”), would effectively put Greece back on track.

The problem is that there would be a timing mismatch between Greek debt maturities and asset sales and privatizations. Nevertheless, this problem can be solved provided that the appropriate laws are passed, a credible time-table is agreed upon and (some) assets for sale are put into some kind of trust for the benefit of the EU members and supranational entities that would buy debt maturities and be repaid with the proceeds of privation and asset sales.
Initial popular sentiment may be against such a large asset sale. But if properly explained, it would be more palatable than more drastic austerity measures. Furthermore, popular approval could be gained by introducing a form of capitalismo popular (see earlier articles below) whereby Greek households would obtain attractive financing to participate in these privatizations.

No solution will be easy, but some are better than others. Under most reasonable scenarios, Greek public debt should trade well above current prices.

We hold no position, long or short, in Greek debt.

Peru: Looking to the future

The day after Ollanta Humala was voted the next president of Peru, the Lima stock market dropped by a record 12.5%.  Was such a move justified?  What should investors make of the new president?

In our view, given how much Peruvian stocks had risen over the previous decade and how real the political uncertainty now is, the selloff was not irrational.  As to whether investors standing on the sidelines should capitalize on the correction and buy, we would advise to wait at least six months.

President Humala, like his Venezuelan counterpart, led a military revolt against a democratically elected government; that was in 2000.  Like him, he has openly stated his wish to transform the society of his country, essentially by increasing the participation of the state in the economy and transferring more of the country’s revenues to the poor.  In the early days of the 2011 presidential campaign, Mr. Humala announced that he would seek to amend the Peruvian constitution, revise upward the taxes and royalties levied on the mining sector (the largest contributor to the economy) and nationalize private pensions.  As the presidential race tightened, Mr. Humala adopted a more moderate line.

The Peruvian political class has made a very visible show of solidarity with the new president.  This, in our view, has been both to calm markets and to insure that the new president remains within the main stream.   Mrs. K. Fujimori, whom Mr. Humala defeated in the second round, stressed that she would go to his campaign headquarters to congratulate him.  Outgoing President A. Garcia promised support and encouraged the population to rally behind the new president.  He also suggested that President D. Rousseff from Brazil come to the inauguration and talk with Mr. Humala.

Mr.Humala may turn out to be a progressive but moderate president.  Time will tell.  Nevertheless, a study of history, in both Europe and Latin America, shows that aspiring leaders driven by a strong ideology tend to fulfill the promises they made in their younger days.

President Evo Morales of Bolivia had promised to regain control of the oil and gas and mining industries, and he did so shortly after he was elected via a nationalization which, in the case of oil and gas, amounted to an expropriation (no compensation was paid for the assets seized, foreign oil companies that agreed to stay in Bolivia would be paid for their future services, those that didn’t stay would get nothing).  He also promised to substantially improve transfer payments to the poor and he did so.

President Chavez of Venezuela promised a similar vision, one of socialism entailing deep involvement of the state in the economy.  However, perhaps advised by Fidel Castro, he adopted a more gradual strategy of change; in his first cabinet, he appointed both revolutionary companions and mainstream figures (retaining Mrs. M. Izaquirre as economy minister); deeper political changes were secured via referenda and a new constitution.  When President Chavez first moved to increase his control over the economy, he targeted local groups, insuring that foreign companies and governments would stay put.  Then he went after foreign oil, cement and other multinationals.  Some of the biggest conflicts with oil multinationals took place eight years after President Chavez was first elected.

The moral is that political leaders who are driven by deeply felt ideologies tend to remain true to them through most of their lives.  Of course, history doesn’t repeat itself.  President Morales took President Lula by surprise when he nationalized the assets of Petrobras.  Such a move is unlikely to be repeated today.  President Chavez was very careful in how he reshaped the economy of Venezuela; but such a stealth strategy would be more difficult to implement today.

One argument that is often advanced by optimists is that leaders with a social agenda, and committed to improving the condition of the poor, must insure that their economy prosper so that they create the revenues they need.  But this reflects the thinking of a pragmatist, not of someone driven by ideology and committed, first and foremost, to social change.  Lenin reneged on Russia’s foreign debt and nationalized all land estates; the Venezuelan economy under President Chavez has performed very poorly.  Clearly, social transformation was the prime goal of these two political leaders, not social-democracy.

In a sense, the game is on already.  Mainstream figures hope that President Rousseff of Brazil will steer President Humala towards a moderate path where social transfers are financed via economic growth rather than nationalizations and the take-over of private pensions.  Initially, President Chavez was uncharacteristically discreet in his comments, but then truer to form in declaring that Mr. Umala's victory had been over bourgeois capitalism.  Even if reality were to push him toward the center, President Humala would have to contend with the promises he made and the expectations of his followers and allies.  One only has to look at the pressure applied by some in the Democratic Party on President Obama, no leftist he, to gauge the potential problem. 

Finally, another area deserving of attention will be the new president’s regional foreign policy.  A long standing source of conflict is the Guerra del Pacifico which pinned Chile against Peru and Bolivia in the 1880s.  Chile won.  While Chile and Peru subsequently reached agreement regarding contested territorial borders, Peru is disputing some of its maritime borders before the International Court of Justice in the Hague and Bolivia continues to demand from Chile direct access to the Pacific Ocean.  These issues resonate in all three countries, and President Humala has been quite vocal about the border issue and also the Guerra del Pacifico itself.  How he will handle this matter now that he is president will matter a great deal.

It is important to note that President Humala was democratically elected in a vote which had a very high  turnout of 70%.  Yet, there are enough uncertainties regarding future policies that a prudent investor should wait until he can make a more educated judgment regarding political risks.  Furthermore, current Peruvian stock valuations are not so low that the urge to invest can't be resisted.

Tackling the Greek debt problem, a look at the Latin American experience

The EU is promising a comprehensive proposal to tackle the Greek debt by the end of June.  If Greece were an isolated case, such a proposal would have been on the table a long time ago.  But it is not.  Portugal and Ireland are in similar dire straights, although for different reasons: Ireland was sunk by its banking sector and a speculative boom in construction, but at least it did produce rapid economic growth for a decade.  Portugal’s main problem, like Greece, is that its economy is not competitive and therefore stagnant.

What holds the EU back is how to reduce the Greek public debt, improve the prospects of the Greek economy without creating financial upheaval in the Union.  While the markets price a “haircut” of 40% to 50%, which would bring the debt back to 80% of GDP, this is not a viable option.  The reason is that a haircut that large is uncomfortably close to reneging on debt.

In 2005, Argentina could force a 70% haircut, on average, because its actions were an isolated case in Latin America and retail investors were significant holders of its debt.  Nevertheless, it has been blocked from issuing new bonds in the international markets ever since.  Furthermore, expectations from international investors were low to begin with.

But since European governments and institutions have been deeply involved in the Greek debt workout strategy, a 50% haircut by Greece would be viewed as bearing their stamp of approval (or demonstrating impotence, which would be worse).  As any credit trainee knows, credit risk depends on a debtor’s ability and willingness to pay.  Given the high participation of the Greek state in the economy and therefore the considerable assets it owns and could sell, a 50% haircut would be construed as an unwillingness to pay.

The fallouts would affect Ireland and Portugal, and likely extend to the whole Union except for Germany.  The status of the euro as a reserve currency would also be tarnished.  Therefore, unless the process veers out of control, this is not an option.

The most viable alternative is to maximize the sale of state assets, demonstrating the country’s willingness to pay within its means.  Any haircut, and there are valid arguments for a haircut of 15%-20% to spread the pain, would be to back-stop the assets sale/privatization efforts.  The assets sale is also more conducive to reactivating the economy than debt haircuts or excessive tax increases.

As I wrote in previous notes, there still will be the need to design strategies to make the Greek economy more competitive by identifying areas where it holds competitive advantages, but at least it would be from a stronger base, one where the private sector is a larger contributor and where the state demonstratively offers a stable legal and regulatory framework.  Chile in the 1980s rather than Argentina in the 2000s is the example to follow.

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.

Tackling the Greek debt problem, a look at the Chilean experience

Greece continues to remain in limbo, with the ECB opposing a debt restructuring while some of the financially stronger European countries are favoring it.  The stumbling blocks seem to be fears of contagion, the impact on European banks, doubts as where Greek economic recovery would come from and implementation risks.  This reminds me of Latin America in the 1980s when policy makers were trying to pick to right time to devalue: the answer was, and remains, that such time doesn’t exist.

As decision makers dither, the financial conditions in Europe are only getting worse.  At prevailing yields, Greece couldn’t borrow long term if it wanted to.  The discount at which Greek debt is traded indicates that investors believe that a large “haircut” is inevitable.  We are fast approaching the moment when fears and rational expectations meet.

All parties would be well advised to consider the case of Chile in the 1980s, when that country was faced with massive financial and economic problems.  Not only did it solve them (without any help from multilateral agencies such as the MF or the World Bank or from the international banking community), it emerged, and remains to this day, the healthiest economy in the region.

The first element of the solution was to tackle the budget gap with old fashioned cost control.  As this was not sufficient, the government also embarked on a program of privatizations, with a twist. 

It is important to note that these privatizations were not rushed as the decision was made to bring the candidates back to financial health first.  This had several benefits: getting a higher price for these assets, establishing a good track record and winning lasting support for free markets from a large segment of the population.  Helping ordinary people become shareholders, often referred to as capitalismo popular, worked as follows.  Some of the largest state enterprises were sold to both strategic corporate investors and the public at large.  Because these enterprises had healthy finances, they could commit to pay substantial minimum dividends for a period of several years.  The public was offered low interest financing to buy into these privatizations, with the minimum dividends set at a level that was sufficient to pay the interest due on the financing and then some. 

To make significant reductions in the external debt, the government created two programs, one for existing foreign creditors (Chapter XIX) and another for Chilean residents (Chapter XVIII).  These programs allowed for the purchase of foreign debt at a discount.  Non-residents were allowed to remit the principal value of their investment after ten years.  Residents were not. 

If the external debt that was swapped for local pesos had been issued by the State, the discount was non-negotiable, otherwise it was up to the parties to negotiate it.  Typically, bank debt was swapped at a discount of around 25%.  As the program progressed, and the economy started to recover, the discount shrank.

   

To my knowledge, this swap program has been one of the most successful voluntary debt exchanges ever.  It helped reduced eligible foreign debt by US$ 7 billion out of a total of US$ 20 billion.  It helped local firms repay their external debts, and foreigners participate in privatizations or new projects.  It had two important corollary benefits: (1) rebuilding foreign investor confidence as the program was rigorously but fairly and consistently executed, and (2) serving as a crucial pump primer for new large strategic investments; large multinationals would often fund their initial capex using Chapter XIX rules and then follow up with entirely fresh foreign resources.  As a senior executive with a large US multinational at the time, I can testify as to how well this program worked.

None of these efforts would have brought about a lasting recovery unless Chile had been able to boost its exports.  I say exports because the Chilean population being small and not well off, it couldn’t offer a big enough market for above average economic growth.  Again, unlike many countries that had focused on import substitution, Chile took a strategic approach to exports by focusing on its comparative advantages.

It is ironic that ITT played a crucial, albeit indirect, role in this.  When it exited Chile, a small portion of its capital was unregistered with the Central Bank and therefore couldn’t be repatriated.  These were the days of capital controls.  ITT decided then to use these monies to seed what became the Fundacion Chile.

Over the years, Fundacion Chile acted as a catalyst in many of the important strategic development efforts of the country.  Besides acting as a think tank, the Fundacion educated would-be entrepreneurs and provide seed capital (literally).  The first major endeavor was the creation of a strong forestry sector.  This was followed by the creation of a fruit growing industry geared to exports which was fully operational by the mid-1980s.  The next major effort was the creation of the salmon farming industry. 

Each of these strategic projects was built on sustainable competitive advantages (fast growing pine trees, season inversion in the southern hemisphere and phytosanitary conditions provided by the Pacific and the Andes, cold pure waters of the southern Pacific); each developed into a multi-billion dollar industry.

Times are different, but Chile and Greece have much in common, such as small size, eccentric locations, excessive indebtedness, difficulties in obtaining outside financial assistance.

So the experience of Chile is very useful for solving Greece’s problems.  It shows that creditors will subscribe to a debt reduction program if it offers sufficient guarantees and has good chances of success.  It shows that governments must secure the backing of a large portion of the population by ensuring that both sacrifices and benefits are shared among all parties.  Finally, it shows that even a small country can find and exploit its competitive advantages.    

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.