“Perils of marking to market sovereign risk”

October 2011

(Part 1 of 3) Conversation with Thierry Apoteker, global economist, on – Can Europe pull back from the Greek abyss, and what needs to be done to do so.

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Here is the transcript of the video.

1. Europe’s crisis today

Emmanuel Daniel (ED): I’m doing this interview today at a time when the global economy is undergoing tremendous turmoil. The United States is still looking for its way to create jobs, to get its moribund economy up and running. Europe is technically in a mess, while regulators, central bankers, bankers and politicians are all at odds with each other in terms of how to solve the crisis that has engulfed the southern part of Europe. I’m very pleased to be able to speak today with one of Europe’s more prominent economists and someone who’s done a lot of research in how emerging market economies deal with global challenges on the economic front, Thierry Apoteker.

What do we make of what’s going on in Europe today? At which point do you think that the Greek, Italian, Spanish and Irish crises will start to find resolution? Assuming the bankers, central bankers, and politicians come to the table and strike a deal, what should that deal be?

Thierry Apoteker (TA): First of all we need to clarify what the issues are, because until we clarify exactly what the issues are it is very unlikely that the solutions will be up to the problem. One of the things that we have to be very careful about is to understand that Greece is a case apart. Spain, Italy, Ireland and to some extent, Portugal are totally different stories. Greece technically has to restructure its sovereign debt. Whatever indicator you take in terms of need for primary surplus and fiscal austerity is simply unachievable.

Therefore it means that you have to reduce the total value of debt. Now, how you do that? You have privatisation and you have the haircut for the banks or the bond holders, but this is a specific issue for Greece. Greece has a debt to GDP ratio which is 145%. It would need to have something like 15% of GDP as a primary surplus for five years in a row just to stabilise the level of debt. This is unachievable. Therefore, you need to treat the Greek case as a problem of solvency. Now, if you take Spain, Spain has a public debt to GDP ratio which is 60%, the lowest of the whole euro zone. Italy has a larger stock of public debt, around 100% of GDP, but has a primary surplus.

So, these two countries are far, far away from any solvency problems. Now, the question is that if markets and operators do take the two problems as one, then you get into a very serious mess, and I believe that this is what’s making the whole thing very complicated, hence this idea of ringfencing. You’ve probably seen the word on all markets during the past few weeks. How can we ringfence the Greek problem so that the market contagion and disfunctioning does not create problems that would be a totally different size – Spain, Italy, and tomorrow France?

ED: Would you then describe today’s global markets as being dysfunctional?

TA: Well certainly sovereign debt markets in Europe are dysfunctional today. And again, I want to highlight this confusion, which is very harming, between liquidity issues and solvency issues. Greece has a major solvency issue. You cannot get away without a haircut, one way or another. Spain, Italy, to some extent Ireland, to lesser extent Portugal, certainly France, do not have any solvency issue as of today, but they have large rollover requirements. Italy, for instance, has 30 billion euros per month on average to roll over in terms of sovereign debt. Now, if you are worried that it might be contagious from Greece to the other, then basically you stop providing the primary resources at the primary issues of this rollover of debt, and then you’re creating the same problem.

I would even go further, one step further. One of the roots of the problem, which unfortunately will not go out very soon, is that we have a zero interest rate policy in the US and almost zero interest rate policy in the euro zone. What does that mean? It means that, today, if you are an institutional investor and you have commitment to your fund providers of let’s say 4%-5 % annual return, what do you do? There is no safe assets that will provide anything close to those levels. Treasury bonds in the US are 2.2%. The German bund, which is a very small market by the way, pays 2.2%. Equity markets? Higher risk. Commodities? You don’t know. Emerging market? High risk.

So, what do you do to get these 4%-5% annual return that you’ve promised, that you’re committed to deliver to your fund providers? There is only one way to do it: you borrow money short-term. Very short-term. For instance, to the Fed. That costs you zero. And you look at assets where you can have a short term speculative debt. And when I say speculative, I say that in the economic sense. I’m not putting any value or judgment on that. But the only way to increase your return is to park a lot of your assets into very safe havens, which do not provide the adequate return, and for the rest of your assets to move on speculative bets, and so that’s what we call the churning of assets.

So, you start with an asset, with one asset. If you’re clever enough, you make sure there is a market sentiment towards that asset. That creates a kind of spiral in terms of price, negative or positive, it doesn’t matter. And then, when you believe that it’s up to a point, you exit and you look for another asset.

ED: Was this what the European Central Bank (ECB) was concerned about in the last two years when they did not bring rates down?

TA: Exactly. And that’s where we very strongly argue, and we’re very contrarian on that, that the zero rate policy of the Fed is fueling this financial volatility, which is denting confidence; and the declining confidence is creating the real economic problem. And what’s very interesting – if I may move just one second onto the US – is the question about the effect of quantitative easing on aggregate demand. So, what does that mean? It means that you’re creating the conditions for high financial volatility because if you can borrow at zero, obviously you can’t make a long-term bet because this is day-to-day funding.

Now it’s zero, so you make a bet on 15 days, one month, maximum. And then you do it with a huge leverage and huge bets. If I had to advise a hedge fund today, it’s not too difficult to make a killing on the sovereign debt market in Europe. What do you look at? You look at what other countries have a high redemption. So, you look at the schedule day by day. On October 24th you have a large refinancing for Spain; on November 15th it’s for Italy, and maybe you’ll find France also. You find countries that have huge rollover requirements. You obviously need to find countries where you have substantial debts.

If I take France, 80% of GDP. It’s a worry, but it’s certainly not insolvency. And you would, at the same time, look at the countries that have some political issues, either getting into election periods or getting some sort of coalition politics, what have you. A political debt. Then I would sell forward the interest rate before the redemption date. Let’s say one week before. I would start selling massively the bond on the forward market. That would raise the interest rates. Now, on the day of the redemption, of the rollover, interest rates are higher. Now the countries have no alternative. Either they issue short-term maturities or they accept the higher rates.

Then if it goes to the higher rates, the country immediately would have to announce higher budget cuts to compensate for this increase in debt servicing costs. Now, if you have higher interest rates and a tighter fiscal policy, you’re creating the conditions for lower growth. If you have lower growth and higher interest rates, then your fiscal sustainability deteriorates, so you started with the funding rollover speculative debt, and at the end of the day you have a self fulfilling prophecy where the solvency of the country is getting worse than before, but it has nothing to do with the country.

2. Part of the Euro resolution

ED: By describing it in that context, you actually add a level of complexity to this whole euro zone resolution. What you’re also suggesting is that that is probably why the euro zone cannot take on a quantitative easing model like the US, because the countries are smaller, because they are much more fragmented. The hedge funds can attack each one of the asset classes on their own. So, does that mean that the euro part resolution would be dramatically different from the way in which the US needs to deal with its problem?

TA: Well, yes and no. In terms of the quantitative easing, certainly one thing that we are very strongly recommending, including collaborating with some of the official bodies working on this solution, is that you need to cut the speculative debts at one point. If not, it’s a vicious circle because after one bet the interests are higher.

ED: So, why isn’t the euro zone doing that?

TA: The euro zone has only one central bank, but multiple treasuries, so there is not one area of euro bonds which would be common. There are two things which the euro zone is contemplating today, which would not be similar but akin to quantitative easing. One is the European Financial Stability Facility (EFSF). It’s going to be operational soon. Only Slovakia has not ratified the agreement.

ED: The composition of that fund is also going to be interesting.

TA: Well, it’s already done there. It would be slightly more than 20% for the Germans, about 20% for the French, and so on. But you would have €440 billion ($610 billion) capital plus authorisation to intervene up to €700 billion ($907 billion). Now, the critical question for the EFSF is twofold will they be able to take a leverage, that’s critical. In our view they should be able to take a leverage. Now, does that mean transforming into a bank? That’s very unlikely. Or allowing it to work a little bit like the IMF, which is not a bank but has an allowance for leverage. They can issue on the markets up to a certain leverage, which is usually much slower for the banks. So, if you assume that you would give a leverage of, let’s say, three to four to the European fund, and you’re talking about an equity base of €440 billion.

That gives you something around €2 trillion ($2.77 trillion). And if you have that, you have the firepower required to kind of counteract these speculative things. Now, the other element is who can intervene as a public body in the primary market. You have noticed that in the US the quantitative easing has not allowed the Fed to buy securities when they are issued in the primary markets. But in the US, it really doesn’t make much difference. The Fed is buying in the markets, the banks are selling to the Fed and then buying at the treasury. Now, the problem, exactly as you were saying, is we don’t have one unified euro bond market.

Even if the ECB was buying on secondary market, let’s say Greek debt, or Italian debt to the banks, the banks would not buy at the primary issue for the same borrowers because they would be afraid of piling another layer of bad debt. You need to have a public body, either the ECB directly, or the EFSF, which should be allowed on the primary market at primary issues. Now, this is very delicate. The ECB is prohibited in its status to buy on the primary markets.

ED: And so how would the banks then access this fund or use the fund to offload the debt that they already have in their books?

TA: Well, in terms of the offloading of, let’s say Greek debt. As you know, up to now, the ECB has already about €170 billion ($235 billion) in its portfolio of European sovereign bonds, so the ECB is buying on the market. Second, the ECB is accepting any sovereign as collateral, whatever its rating. Including Greece, despite the fact that it has been downgraded to junk. The ECB is still accepting that as collateral. But the collateral is not the same as buying on the market, because when you buy on the market the seller has offloaded that off its balance sheet; when it’s a collateral, you’re still technically the owner of the security.

So, the ECB has already intervened as a buyer on the secondary market and has massively intervened as a provider of liquidity against collateral provided in the form of sovereign debt, including that of Greece, but they need to go one step further, which is to break this circle of liquidity issues when you have large redemption date. So, for instance, Italy has a €35 billion ($48.5 billion) rollover of longer maturities next month. There should be a very clear signal from the authorities that if markets tend to be dysfunctional around that date, if authorities see the spreads on the Italian sovereign debt moving sharply before the redemption, they should be ready to buy the debt on the primary markets.

It’s a much more delicate thing from the political perspective because there is this very adamant view that if a central bank directly monetises the public deficit, then it has an inflationary risk. You might argue in these circumstances whether this is the true inflationary risk or whether the inflationary risk is really elsewhere, but the point I’m making is that as long as you have abnormal monetary policy in terms of interest rates, as long as you have very negative real short-term interest rates, you’ll have these vicious circles of liquidity leading to solvency issue, and I think that the authorities need to break the circle at some point, either by intervening directly in the primary issue if there is a lack of appetite, or intervening much more massively on secondary markets prior to the redemption date to make sure that the euro goes down.

ED: Now, if the EFSF is successful and is able to absorb all of that debt onto its own books, does that force a greater coherence in terms of fiscal policies between the European countries?

TA: Yes.

ED: Is this a forced way of taking the euro to the next level in a sense?

TA: Yes. If you look back at the history of the European construction, it started with that. The very first attempt of creating something common in Europe was called the European Community for Defense, and that was in 1954. The idea was that you have the Soviet threat on one hand, and you wanted to avoid the repetition of Franco-German wars. So some of our luminaries came up with this idea of having common defense; this was immediately rejected by politicians from all sides. It was less than nine years after the end of the war, so the idea for a French general to share defense with the enemy that you’d been fighting less than 10 years ago was rejected.

The strange thing is that this defeat of the European Community for Defense was the initial seed which the European policy makers, in all the 40 years after that, would think they’d need to go back to, in order to circumvent political obstacles through economic integration. So they started just three years after that with what they were calling at that time the European Community for Steel and Coal. And you would wonder why steel and coal, those are very small things, but the same politicians realised that steel and coal were the core industries of France and Germany, and therefore coordinating these very core industries would create the conditions for a next step.

Then it all went along that way: when initially the Europeans touted the idea of a single market, single market did not only mean that you have zero tariff, but also that you wouldn’t have any safe guarding clause. Now, every economist at that time knew that you could not do that if you had free floating exchange rates because you don’t have any safeguarding clauses. Let’s look at the anecdotal evidence: if Italy devalued the currency by 20%, then FIAT made a killing in the French car industry and Renault was threatened. So, when there was the idea and preparation for single markets, almost all economists started to sound alarm bells and asked how that can be managed with a fully floated exchange rates.

Needless to say, one or two years after that it happened. There was the Italian devaluation, a lot of outcry in France and Germany, and along came the idea: we need to coordinate exchange rates. Then we had the European monetary system, and then there was the creation of the euro. Because when you have a fully integrated commercial area, you need to have some sort of currency coordination. Now, when you have currency coordination, all economists will tell you that it won’t work unless you have a fully homogeneous region, which obviously Europe is not. And between Greece and Germany you have large differences. Not much more than between, let’s say, Nebraska and Massachusetts. But still, when you have differences in structures of economies, you know you can’t have a common currency without some sort of fiscal coordination.

Now, when we created the euro, the simple idea of relinquishing monetary sovereignty was very difficult. It was very painful for all of our politicians. Now, to add to that, to relinquish fiscal sovereignty, that was too much. So, we put this fiscal sovereignty to the side. Everybody knew that if you had one major shock, there would be so many asymmetries in the reactions to the shock that we would need to come to that. And we are there.

ED: But as you know, the Anglo-Saxon interpretation of the situation is that, yes, you may well be forcing the issue of fiscal coordination, but that still doesn’t solve the potential problem of Greek default.

TA: Yes, agreed. But you can say the same thing about the fact that a single currency and one treasury in the US did not prevent California from going bankrupt. Has the US collapsed because of that? Has California been expelled from the dollar zone? No. To have a local administration going bankrupt – you have that everywhere. New York went bankrupt in 1975. Nobody thought that, well, New York is bankrupt, they should exit the dollar zone.

3. Europe absorbing a Greek bankruptcy

ED: Can the banking system in Europe absorb a Greek bankruptcy?

TA: Yes. Absolutely no problem at all. Let’s be very clear on that. The total GDP of Greece is 3% of the whole euro zone GDP. The total public or sovereign debt of Greece is €325 billion ($450 billion). On that you have already €140 billion ($194 billion) which are in the bail-out plan. So, we’re talking about something which – if you take only the banks – we’re talking about something which is in the order of €90 billion to €100 billion ($124 billion to $138 billion). Now, let’s assume that we go far beyond the July 21st plan, which basically looks for an agreement for about 20% loss in net present value of the debt. Let’s assume you go for a 50% haircut. You’re talking about a €50 billion ($69 billion) loss, spread over the whole euro zone banking system.

That’s quite easy. There’s absolutely no problem on that. The problem is that if you have a contagion to Italy and Spain, then you’re talking about much bigger animals, and then you indeed will have systemic issues in the European banking industry. And here we come to the very beginning of our conversation: we need to clearly separate the problem of Greece – and again I say Portugal might be in the discussion – from the heavyweights. Spain, Italy and France are in a totally different case, where the issue is liquidity, yields on the bond markets, and they have no rollover problem.

If you agree with that, it means that you don’t have to have substantial discount on either the Spanish, the Italian or the French debt. If you don’t have these discounts, you don’t have the losses in the banks. If you don’t have the losses in the banks, and if it’s only the Greek problem, it’s fully manageable.

ED: Now, let’s superimpose the American problem on the euro problem right now. There is no thinking in the US to give up this quantitative easing model, and the impact that they have on the rest of the word is unsustainable. You’ve got a dollar which is collapsing, you’ve got emerging markets that are not importing, and so on. What do you think the US needs to do in order to play its part to counter a cyclical problem?

TA: Well, there again, let me go one step backward. If you look very precisely at the speech of Ben Bernanke at Jackson Hole this summer, it was very interesting. Not for what he didn’t say basically about the quantitative easing, but he gave a very impressive lesson on cyclical analysis. It’s very clear and step-by-step: Where do we stand in terms of cyclical analysis? He said there are basically four things: to have recovery you need to have a pent up demand. In a crisis you have a collapse in housing, fixed investment or durable goods consumption; now, when the collapse has lasted for a long time, you have this pent up demand because you need to move up. Then you need confidence. Then, once you have confidence, you have production and jobs.

ED: That’s under a natural cycle.

TA: Exactly, and then you have credit, which gives leverage.

ED: But this is not natural.

TA: When you make a very simple checklist on these four elements: pent up demand, confidence…

ED: All of which do not exist.

TA: I disagree – only confidence is lacking, because the pent up demand is huge. Just to give you an example: since 2008, the issuance of building permits in the US has been roughly 500 thousand per year. Now, in the US, because of demographics, you have 1.5 million new households every year. So, it’s already three years now, during which you’re not creating even one million new houses, or let’s say flats, or what have you. So that creates a pent up demand. Now, for production, employment and income, I also beg to differ. You’ve probably seen last week that not only was last month’s figure quite positive for employment, but there were substantial upward revisions for the summer months which were so shaky.

The economic indicators came out much better than expected, and importantly, if you look at disposable income, not withstanding the fact that between 2007 and now the unemployment rate was multiplied by two, quite strange enough, the level of real disposable income today is higher than we had just before the crisis. So, we have a recovering income despite the unemployment, and that’s partly because of these social transfers that President Obama put in place. So income is there. Production, yes and no, but certainly it’s not a crisis. Even employment, you might say, is not as negative.

In terms of credit, we’re not in a credit crunch anymore. If you look at monthly or weekly outstanding loans in the US, it’s not been positive for a couple of months, except for real estate, where it is difficult to measure because in the outstanding you also take the foreclosure and the bankruptcy, for example. So, the fact that you have negative figures on changes in outstanding loans doesn’t mean a lot. But if you look at loans to corporate and consumer credit, we are again in positive territories. We are not yet back to the level of credit we had before the subprime crisis, but we are certainly not in the doldrums and decline in outstanding loans.

In these four critical steps of cyclical recovery, the one which is lacking is confidence. And then you have the problem of politicians. When you’re in a very uncertain environment, in which people on the streets are not sure of anything, then either the politician postpone any spending, or they need to have a clearer view of what the next step is. Now this is up to the politicians to give this view and to say well, this is where we go and this is how we go there. Now, I’m a macro-economist, I’m not a politician; but I would certainly say that the primary responsibility today, of politicians, is to give a clearer view on what are the next steps and therefore to create this kind of confidence-building measures. If confidence picks up even slightly, that’s enough for the recovery. It won’t be very strong, don’t take me wrongly – it will be a sub-potential slow moving recovery, but there’ll be no double dip.

ED: Just for the sake of timeliness, and also for the sake of completeness, let’s look at the impact of all this on emerging markets. The situation in a lot of emerging markets, especially the ones that have a very strong banking industry, is that they are highly liquid, they have good domestic economies, and so on. What do they make of this development, especially in terms of the impact of the dollar crisis?

TA: If you look at the emerging markets, and especially Asia, there are a couple of things that are important. One is that you have transmission effects, which are large, and whatever we say about the rebalancing in the world, you still have the US, the EU, the central economies accounting for half of the world’s GDP. Therefore, if you have a serious problem there, you can’t have the other half being immune, so transmission effects are there, and we have basically three such areas.
One is through trade, and Asia is partly immune to that. Asia, being a significant trading partner, will feel some transmission impact, but it’s partly immune to the effect because of the growing intra-regional trade, which is helping.

ED: Do you think that intra-regional trade has come out to be a countervailing force?

TA: It can take up part of the slack, but not the whole thing.

ED: But it’s already become a factor?

TA: It’s already there, definitely. We see that because, for instance, we see that between Eastern European countries, which are much less integrated as we have them in Europe, the trade is collapsing; whereas, so far, in Asia, we see a slowdown in growth rates, with China moving from 29 to 20% growth rate in exports, Korea moving from 24% to 19%. So yes, you have this slowdown if I look at the latest September figures. But you don’t have a collapse, and I think that part of the reason is that, indeed, you have this intra-regional trade which is partly taking up the slack.

ED: Okay. Trade is one thing.

TA: The other is liquidity in banking. Now, there again, only a few Asian countries are very dependent on European banks for short-term interbank loans, and I would single out Korea as being more fragile, because Korean banks have relied heavily on international banks for funding and a very significant share of that comes from European banks. So, if European banks have major problems and want to reduce the size of their balance sheet, they would probably cut their lines. Now, if Korean banks are mature enough to find the funding elsewhere, that could in turn create some problems, including problems in the currency, because that would mean asset outflows…

ED: But they already have an exposure to the US and to the dollar.

TA: Exactly. But the rest of the Asian banks do not rely that much on the interbank markets. Many of the large markets, for example China, obviously are net creditors to the interbank markets. Even in countries like Indonesia or Thailand, while the recourse of domestic bank to funding from the European banks is not nil, it’s not big enough to create major waves or major problems in terms of liquidities of these banks. So, again, there would be some transmission impact through there, especially for countries that would possibly run into or already have significant foreign borrowing requirements. I’m thinking about India. Certainly a country like India, where we have a significant current account deficit plus amortisation of foreign debt, would need to get some funding from the markets. Now, if the banks are all but closing their international exposure because they have to shrink their assets.

ED: But somehow India has been able to benefit from the yen carry trade.

TA: So that might be slightly at risk. And the third channel of transmission is simply asset correlation, and we have to realise that in a globalised world, by definition, as financial institutions are investing worldwide, if you have one problem in one market, the institution itself will reallocate its portfolio, and that will mean transmission effect to other markets. Now, we’ve run with our quantitative models very precise correlation measurement. Surprisingly, we see that the correlation between Asian markets and world markets is much higher when Europe is in trouble than it is when Europe is not in trouble. This is despite of the fact that the correlation is much higher with Wall Street. So, the correlation is with the US markets, but the degree of correlation increases when you have problems in Europe.

ED: Why is that?

TA: Again, that’s a statistical exercise. It relates to these asset allocation processes within large institutions in which US institutions do play a major role. So it has to deal with dollar portfolio management within large US mutual funds…

ED: Which are themselves complex because they’re not just dealing out of the US but they’ve got huge portfolios out of Europe as well, so.

TA: Exactly. Again, I think it goes back to what we’ve been talking about. Europe is still fragmented as a financial market. You don’t have anything like a single market – neither for equity, nor for bonds and short-term notes. Therefore, when you have a problem in one country, it creates a lot of reallocation of funds, and this can also have an impact on emerging markets. So, in that sense, the more Europe is in trouble, the higher the correlation of the transmission effect from the West is to Asia.

So, you have this very large transmission effect, and when we look at different countries, suddenly Korea is more fragile, and I might say Taiwan is slightly more fragile. Also India, for the reasons we mentioned, slightly more fragile. On the other hand, you have countries that are less fragile. And I don’t say that the following countries are totally immune, since no country would be immune. But these are probably more resilient. I’m talking about Indonesia, China. We’re certainly not among those who think that China will have a hard landing, even though we certainly believe there would be a soft landing.

So China, Indonesia and the Philippines. These countries do appear slightly more resilient today. They are slightly more evolved to weather the storm than the others.


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