Sunday, 30 May 2010

The Euro Austerity Club

The Malta Independent on Sunday - 30 05 2010

In an article I wrote in this series two months ago, I posed the question whether the euro monetary union would still be around in 20 years’ time. I had answered my own question stating that “it could disappear much sooner than 20 years unless the whole structure under-pinning the euro is urgently and thoroughly reformed.”

Two months ago this seemed rhetorical. Events since then have brought the issue to the forefront following the emergency bailout euro countries had to organise for Greece to avoid a sovereign default, which would have brought financial chaos that would have made the Lehman debacle look like a walk in the park. Doubts about the sustainability of the euro monetary union are being expressed openly as never before. The foreign exchange value of the euro has fallen by nearly 12 per cent against the US dollar over the last two months and, notwithstanding Greece’s bailout and a pledge for a trillion dollar stability fund as a defence against market assault on the next weakest links in the monetary union, instability remains.

The instability is not so much sourced by the fall in the foreign exchange value of the euro. On the contrary, this could be a stabilising factor offering some sort of solution as it renders euro countries more competitive on the global scene. What is generating instability is that the bailout of Greece, and the promise of bailout for other weak links, addresses only the liquidity problems of such sovereigns but does pretty little to address the underlying and more serious solvency problems.

 If Greece is over-indebted, switching its existing debts to banks and private investors to loans from fellow sovereign countries in the euro system and the IMF does little to solve the underlying problem. It just swaps one debt for another. The liquidity problem is addressed but the underlying solvency problem remains. This has kept international bond markets jittery about Greece’s long-term ability to service its debts, to whomever they are due, and about the ability of the next weakest links like Portugal, Spain, Italy and Ireland, the countries mostly exposed to international investors’ swings in risk appetite, to have unhindered access to finance to bond markets for smooth operations of their debt management programmes. And international investors have good reasons to be concerned.

The euro monetary union can only survive if the member states operate a harmonised fiscal policy alongside the common monetary and interest rate policy. Members of the monetary union are like runners in a three-legged race whose legs are tied together with a somewhat elastic rope. They have to move forward in harmony if not in perfect synchrony. The bailout packages augur the exact opposite. Given the conditions associated with such bailouts, the phenomenon of a two-speed Europe will be made even worse. Greece, Spain and Portugal will be suffering deep recessions while Germany continues to rev its export engines without apologies, aided as it is by the fall in the euro’s external value.

The two-speed nature raises problems for setting a common ECB monetary and interest rate policy. These problems already existed but will become more accentuated. Spain, Portugal and Ireland are suffering the consequences of the ECB keeping low interest rates to accommodate the German economic recovery programme when domestic conditions in the periphery countries would have necessitated higher interest rates to avoid dangerous speculation and bank exposure to an artificially inflated real estate boom. The property bubble has exploded with a vengeance in Ireland, Spain and Portugal, causing gummed up financial markets, a shaken banking sector, high unemployment, a deep recession and a sudden and huge increase in public budget deficit, mostly due to loss of revenue from subdued economic activity at a time when social triggers of unemployment and social payments are activated.

The gap in two-speed Europe grows wider. While Germany, France, The Netherlands and other Nordic EU members gain a competitive advantage from a devalued euro, which make their exports more competitive, the Euro-Med members of the monetary union, forced as they are by bailout conditions to address their public finances, will see their economies move in reverse gear into a recession. Will Europe tolerate rising unemployment and austerity measures (including wage cuts, wage freezes and reduced entitlements) on the periphery while Germany continues its export driven economy? Will the elastic rope binding together the euro members in a single monetary union be stretched to the point of rupture?

When pressure builds up beyond a certain level something will have to give. In an effort to avoid such rupture, many Euro-Med members are taking harsh austerity measures that were considered politically suicidal before the Greek near-death experience. Greece’s problems seem to have conditioned public opinion in Spain, Portugal and Italy to accept austerity measures before it is forced on them by bailout conditions.

The question we should be asking ourselves is whether Malta needs to join this austerity club?  It is true that our saving ratios permit us to finance all public deficits internally without any access to international bond markets. But a debt is a debt and it is never inadvisable to follow good financial housekeeping policies. 

Firstly, we desperately need to establish what our true deficits are by bringing on balance sheet all the off-balance sheet financing. Secondly, we need to take a pretty hard look at entitlement and payroll costs and see what is sustainable and what is not. Nobody is suggesting wages or entitlement cuts but in these troubled conditions, where we could very well be forced to import a recession, freezes of public payrolls and entitlement programmes should be on our agenda too. But most of all, it is well overdue that our politicians stop selling us pipedreams with unrealistic expectations for universal free health care, early retirement on the flimsiest of excuses, and state funding of students’ stipends on top of free college educations which cost citizens of richer countries an arm and a limb. It’s a pious hope!

If our politicians can’t even properly manage an EU-funded education programme, shattering the dreams of several hundred of our students who were practically packing their bags to attend overseas training programmes, just imagine how much they can plan for long-term sound public financial housekeeping. In the end, for politicians, long term is till the next general election. Regretfully, this is often too short to make serious structural adjustment programmes.

Sunday, 16 May 2010

Deliver us From Evil

The Malta Independent on Sunday - 16 05 2010

If your house was on fire, would you continue to behave according to the routine rules and rituals that apply when things are normal? That is exactly what Jean Claude Trichet, the president of the European Central Bank (ECB), tried to do on Thursday, 6 May when addressing the international press at a conference following the ECB decision in Lisbon to keep interest rates steady at one per cent.

A banker’s currency is credibility. If he loses it, his balance sheet, strong as it may be if underpinned by credibility, gets tattered. Bankers, especially central bankers, should beware of over-promising and under-delivering. By nature they are extremely cautious, to the point of being boring. In a fiat currency economy, the credibility of the central bank is all we have to preserve our faith in the value of money. If the credibility of the central bank is questioned, the currency is heading for trouble.

The euro is a very particular currency. It is not underpinned by a single treasury. It shares a common monetary policy operated by the ECB for all euro member countries but each country has its own national treasury and is responsible for its own fiscal policy. No currency can outsmart any degree of stability if monetary policy and fiscal policy operate in conflict rather in harmony. So the euro was launched with a potentially fatal flaw. Its monetary policy was centrally decided in a supra-national manner, whereas fiscal policy was decentralised at national level.

Euro member states defended their fiscal sovereignty with the gluttony of those who like to have their cake and eat it too. Euro membership gave credibility for members to borrow easily and cheaply with little restriction on their fiscal latitude to ensure they operated prudent fiscal policy in support of the common currency.

It was not meant to be that way. The Stability and Growth Pact (SGP) was meant as a discipline for euro member countries to aim for a neutral budgetary position with maximum deficits to stay within three per cent of GDP at the bottom of the economic cycle. Accumulated national debts were also supposed to be kept within 60 per cent of the GDP or to move determinedly towards that level if countries were above it at the point of joining the monetary union. The SGP was, however, a loose expression of intent without real measures of discipline to enforce it. In theory, countries could have been fined for transgression but no country ever paid a cent in fines. It also depended on the goodwill of member states to report faithfully their fiscal position rather than embark on political games to hide the deficit through delayed payments, anticipating revenues, and the use of strange financial derivatives which magically convert present debts into a future stream of payment obligations, thus helping to push the can down the road rather than do what’s necessary here and now.

The financial crisis of 2007-2009 brought the chickens home to roost for many euro countries who were either over-exposed to the property and financial sector (Ireland and Spain), or who were reckless in their fiscal rectitude, most especially Greece. A new incoming Greek government, following a landslide election win last October, brought the shocking revelation that the Greek deficit had blown out to 13 per cent of GDP, if figures are properly reported, and that the debt level was some 115 per cent of GDP, mostly owned to foreign banks and investors and with maturities that constrained the Greek government to have a regular presence on the international financial markets to roll over existing loans and borrow new money to cover the recurrent deficit.

International investors were horrified by the EU’s and ECB’s inability to enforce the SGP and to look beyond the reported figure. What was the governor of the central bank of Greece doing at the ECB table if he could not warn about the bomb building under his own feet, with borrowings far greater than the reported deficit and with such huge exposure to short term external debt` In the end it is not only the level of the debt that matters but also how it is financed. Japan handles much larger debt to GDP ratios, but all its debt is financed internally – the private sector lending to the public sector, (much as we do here in Malta), without any resort to external borrowing. That is much more manageable.

International investors had always worked under the unspoken assumption that no euro country would be allowed to default and that co-members would come to the rescue of any member in trouble. This assumption started being questioned as stronger euro countries initially tried to pretend that this was a domestic Greek problem that the new government could solve by itself through fiscal adjustment without any external help. Politicians seeking to shift blame for their own deficiencies often refer to international investors as speculators, vultures, locusts, and similar derogatory terms. In reality, investors are in the market to make money and when they see increased risk they start pricing it.

If doubt was created that Greece would be left on its own to sort out its fiscal mess, investors would start demanding much higher yields on Greek debt to take account of the increased default risk. When the yield on Greek debt in comparison to the benchmark German version widened beyond belief (the effective yield on a two-year Greek Bond reached some 18 per cent pa), and when the Greek disease started infecting other Mediterranean countries, particularly Portugal and Spain, the EU realised that not only could Greece not reform on its own (who can reform while paying 18 per cent pa interest on its debt`), but the EU needed the expertise of the IMF to apply the proper medicine and provide political cover from the ire of the Greek population at large that has been short-changed by its political class. But as weeks rolled by, with endless negotiations extracting round after round of Greek concessions on fiscal austerity, investors’ doubt on the sustainability of such inhuman austerity measures increased, especially as street protests in Athens turned into riots that claimed the innocent lives of three bank employees. By 6 May, when the IMF/EU package for Greece was ready and simply awaiting the approval of the German Parliament the next day, the market continued to price Greek bonds to default and Portugal and Spain’s bonds with an increased risk of default.

It was clear to anyone experienced in this field that the markets were ready to take on Portugal as the next weakest link as soon as the Greek package was approved in such a laborious manner. In simple terms, the European debt markets were on fire and were earnestly awaiting soothing reassurance from the ECB that what was done for Greece would be done without hesitation for any other euro country that needed assistance. Instead, Trichet totally fumbled and tried to pretend that the house was not on fire and all was bright and sunny.

His emphatic assertion that the ECB governors had not even discussed taking any extraordinary measures to reassure the markets was interpreted as a challenge to the bond market to test the resolve of EU member states to stand behind those of their own that had run into financial trouble. Friday, 7 May shaped the European sovereign default nuclear version equivalent of the financial devastation from Lehman Brothers bankruptcy in the US in September 2008. Trichet’s misjudgement had some benefits. From across the pond, President Obama and Treasury Secretary Geithner warned their counterparts in Europe that panic needed strong action (a bazooka) not nonchalance (a water pistol).

Over the weekend, the EU leaders and the ECB did what it had taken months to do in much smaller proportions for Greece. Faced with the imminent prospect of a total freeze of international banking system unless extreme measures were announced before Asian markets opened for business on Sunday night European time, the EU leaders responded with atypical vigour. Crisis forced fiscal harmonisation through the back door.

While on the face of it fiscal sovereignty remains with the individual state, once their debts are now notionally or formally guaranteed by the Stability Fund put together in co-ordination with the IMF, it is obvious that borrowings will be under strict scrutiny of the Stability Fund. For all I know, Trichet’s fumbling could have given the euro system the fiscal pillar it was missing to sit stably on a tripod of common monetary policy, low inflation and controlled borrowings. That’s until some brainy investment banker comes up with some colourful financial derivative through which a country can spend without instant borrowing. Like a securitisation proposal for our Citigate project. God deliver us from evil.

Sunday, 2 May 2010

If it Quacks

If it Quacks

2nd May 2010

The Malta Independent on Sunday

Alfred Mifsud

If it looks like a duck, if it swims like a duck and if it quacks like a duck then there must be a very, very high probability that it is a duck. If it is all huddled up, silent and motionless, it does neither prove nor disprove that it is a duck.

If it looks like a duck, if it swims like a duck and if it quacks like a duck, than whoever argues that this does not constitute scientific proof that it is a duck and vehemently concludes that it is not a duck, is only making a fool of himself.

This duck riddle came to mind after reading the NAO report on the Enemalta contract to extend the capacity of the Delimara power plant. What this report states in quite plain language is that if corruption were a duck, this one quacks, swims and looks like one even though it does not have scientific evidence that it is a duck.

The government’s general attitude that NAO’s statement that ‘it did not come across any hard and conclusive evidence of corruption’ sanitises the whole affair is as laughable as the winning bidder’s local representative suffering amnesia when questioned by the NAO. Does he conclude dozens of such agreements every week and cannot be expected to remember such details?

This one quacks and someone should pay the political price for it either now or later when the electorate eventually is called on to give judgement through the ballot box. Prime Minister, the choice is yours.

Government resistance to publish the full contract only makes the quacks louder. What sort of argument is it that government would only publish the contract if the winning bidder agrees to it? Are winning bidders starting to dictate our governance standards? If the government committed itself on contract to keep it confidential, then it went beyond its remit as it is spending taxpayers’ money, not its own, and taxpayers have a right to maximum transparency in matters other than crucial national security issues. So any such non-disclosure clause only adds to already serious, very serious, suspicions of corruption.

The events unfolding in Greece show how reality can be delayed but never altogether avoided. This Greek tragedy also shows that the longer reality is avoided the harsher the consequences when ultimately the chickens come home to roost. The Greeks and their children will now have to pay for the lack of governance with which their country has been governed. The bond market this week showed that it has no respect or appetite for political platitudes and for the games, which normally go on in countries like Greece, where problems are hidden, statistics falsified, and corruption and inefficiency are loosely tolerated.

Corruption and tax evasion are twin brothers. They reinforce each other as institutionalised corruption makes tax evasion socially acceptable. The argument tax evaders generally wash their conscience with is ‘why should I pay taxes if the government just spends it without due governance’. Tax evasion then feeds corruption as it becomes more economic to hide revenue rather than expose it to high tax rates which evasion enforces on the economy. The more people evade taxes the higher the taxes on those who have no option but to comply.

Once corruption and tax evasion become institutionalised they reinforce each other and gradually become a way of life; one does it because everybody does it. The last man standing would justifiably ask himself why he should be the only fool complying when all the rest, taxpayers and those in charge spending the taxes collected, are all at the circus.

When that is allowed to happen the country will gradually go to the dogs, especially if it has to finance its largesse through foreign borrowing. Is it not a humiliation for Greece to have its bond rating reduced to junk status, to have the yields on its bonds (resulting from a sharp fall in the prices of its sovereign bonds) higher than those of Venezuela and far, far higher than Nigeria’s?

What can be more humiliating for the Greeks than to see their country having to pay interest rates three times higher than Turkey pays on its sovereign bonds because the market is judging that Greece sovereign default risk is now much higher than that of traditionally junk-rated Turkey?

What has all this got to do with the Delimara power station contract? It has. If no one can explain why the Malta government should sign a contract where the penalty for cancelling the contract is atrocious and reportedly higher than the value of the contract, then this country is well on its way to Athens.

I remember a similar situation with the contract the PN administration had signed in the early nineties with Skanska related to the first San Raffaele contract, for what eventually evolved into Mater Dei Hospital. It would have been cheaper for the incoming Labour administration of 1996 to cancel the Skanska contract and plan afresh for a single project unifying the intended San Raffaele and the existing St Luke’s, except for the fact that the Skanska contract had huge penalty clauses in case of cancellation. Is this not a simple trick to ensure that contracts negotiated by one administration cannot be revised by a following administration? Where in the private sector do we see penalty clauses like these?

This one quacks, and if the government continues to defend the indefensible, then our country and the whole economy are well and truly en route to Greece. No long-term vision can undo the problem created by the abuses here and now, and by the present lack of governance. When the roof caves in, then there will be no doubt that we are well and truly surrounded by ducks.