Time for European leaders to shape up to the challenge

The challenge I refer to is how to keep the Euro monetary system together and how to make it sustainable for the longer term.

It is in everybody's interest that this is achieved, as the consequences of failure are just too great:

• If any member is forced to leave the Euro the markets will certainly start challenging the Euro longevity and will start considering it as a loose fixed exchange regime rather than as indissoluble monetary union.  The question of who comes next will unavoidably force the market to test the hypothesis.
• If the Euro monetary union dissolves the sustainability of the EU will also be challenged.
• From dissolution all members would suffer.  
• Debtor nations will suffer default, blockage out of the international capital markets for a long time, and sharp devaluation of the domestic currency which will be large and will hurt mostly the fixed income earners who are least able to carry the burden.
• Creditor nations will see their home currencies appreciate forcing instant loss of competitiveness just at a time when European demand will shrink making it a strong double blow.
• Countries in distress will have to introduce strict capital controls and adopt beggar thy neighbour policies which will fly in the face of all that the EU stands for and would threaten the achievements of the last half century.
• Countries in distress will seek help from wherever they can get it, including the devil if one exists.  Russia and China would be most pleased to oblige if in the process they can weaken European Unity and weaken the security arrangements which tie the European continent with the West.

So firstly European leaders, especially those in core countries which are in a Creditor position, are failing in making no effort to explain to their electorates the severe consequences of risking a Euro dissolution.

They are also failing in not raising the sensitivity of their electorates to the huge benefits that they are having from the Euro crisis.   Just consider that Germany, whose debt to GDP is well over the 60% Maastricht limit, is now paying negligible interest rates  on debt as it gets renewed and this week the German Bund - 5 years slipped into negative territory i.e. lenders are paying the German Government for the privilege of lending it money.

Also Germany is running a 7% of GDP surplus on its Balance of Payments which would not have been possible without the Euro monetary union as the Deutsche Mark would have appreciated to self-correct such disequilibrium.  This huge surplus is keeping the German economy humming with export orders.

So all in all, if the Creditor country leaders were to make their electorates aware and sensitive to these huge benefits, then the need to restore equilibrium inside the Euro monetary system by dual action from the deficit a much as from the surplus side would be much more evident and acceptable.

It is in everybody's interest that Debtor nations apart from helping themselves, which is a pre-requisite, are given help so as to make their economy grow sustainably.   Restructuring in the absence of economic growth is well neigh impossible.  Without economic growth Debtor nations will default, hurting themselves and their Creditors, and bring the Euro monetary system to a premature demise.

The Euro members must learn from The Marshall Plan not from the Versailles Treaty.

They all have to do more

In order to resolve the Euro problem ( I would not call it Greece problem as the issues involved are much wider than Greece) everyone involved has to do more.




Greece needs to:

• commit itself unequivocally to repayment of their loan obligations.
• commit itself to restructure its economy and especially to prop up its tax compliance and collection mechanism and to stamp out corruption which is stifling economic growth.
• commit itself to taking business friendly measures to attract FDI.  This has to include privatisations already agreed upon even if they are delayed to ensure that the best possible return is obtained.
• commit itself to taking measures to dismantle monopolies and to make its economy more flexible, in particular its labour market which cannot continue to protect those who have jobs at the expense of those who are unemployed and blocked out of the labour market.
• commit itself to a reasonable ( even if reduced from what was committed to earlier) primary balance on its budget and in its balance of payments.

Creditor nations have to realise that:

• Any union without an element of solidarity is not a union at all and will eventually destroy itself.
• Problems of debtor nations have to be addressed through real economic restructuring but in the context of growth rather than blind austerity.
• Where austerity is needed it should be spread in a socially acceptable manner rather than being carried disproportionately by the bottom layers of society.
• Restoration of equilibrium needs action also from the surplus side not just from the deficit side.

European Union should take the initiative for:

• The European Stability Mechanism ( ESM) taking a primary role in resolving the problems between debtor and creditor nations, in particular:

1. The Troika ( EU, IMF and ECB) should be replaced entirely by the ESM who will keep the IMF only in a consultative role.
2. All debts of countries under bailouts held bilaterally by EU countries and by the ECB should be transferred at original cost to the ESM who will fund this by issuing cheap long term bonds which will be bought by the ECB instead of their QE program ( which could create more problems than it solves).
3. All debts of debtors nations with debts exceeding 100% of their GDP should be converted into long term contingent GDP coupon bonds - where the interest rate is variable to the GDP - whilst the capital remains intact and repayable in equal annual instalments after an initial moratorium of say 10 years.
4. Countries with structural Balance of Payments surpluses ( e.g. Germany who are consistently running 7% GDP  BoP surplus and evidently taking extreme advantage of the weakness of the Euro currency caused by problem countries) should pay a fixed percentage of their BoP surplus as non-refundable contribution to the ESM.
5. The ESM will use the contributions received as in 4. above in order to reward problem countries with an element of debt foregiveness if they reach benchmarks proving their economic recovery - thus rewarding sacrifice as results will start to show.

Expecting debtor nations to resolve their problems without a burden sharing arrangement is the best way to ensure that the Euro has no future.

Greek exposure and resolution

How are Euro area countries exposed to a Greece default
		EFSF guaranteed exposure to Greece	Bilateral loans	Max. Loss on ECB exposure	In % of GDP
		EUR bn	EUR bn	EUR bn#
Germany		41.3	14.2	55.5	2.0%
France		31.0	11.2	42.2	2.0%
Italy		27.3	9.7	37.0	2.4%
Spain		18.1	7.0	25.1	2.4%
Netherlands		8.7	3.2	11.9	1.8%
Belgium		5.3	2.0	7.3	1.9%
Austria		4.2	1.6	5.8	1.8%
Portugal		*	1.4	1.4	0.8%
Finland		2.7	1.0	3.7	1.8%
Ireland		*	0.9	0.9	0.5%
Slovakia		1.5	**	1.5	2.0%
Slovenia		0.7	0.3	1.0	2.6%
Estonia		0.4	**	0.4	2.1%
Luxembourg		0.4	0.2	0.6	1.2%
Cyprus		*	0.1	0.1	0.8%
Malta		0.1	0.1	0.2	2.0%
Total		141.7	52.7	194.4	2.0%
*	exempted as under bailout
**	exempted by special arrangement
#	share of losses suffered by the ECB
Source: UBS,IMF, Bloomberg February 2015 _______________________________________________________________________ Malta stands to be hit by about 2% of GDP in case of a Greek default.   This is more than much richer Luxembourg, Netherlands, Belgium, Austria and Finland and much more than Cyprus, Ireland and Portugal who were exempted due to their being under balilout assistance themselves. Now one can understand why it  is in our interest that a fair compromise is reached with Greece which however does not involve any haircut or write-down. This can be done.  How? Let us list the points that everybody seems to agree upon, or at least should agree upon, and around which some sort of compromise could possibly be built: Greece needs to restructure their economy and make it competitive and sustainable not so much for the benefit of their creditors but mostly for their own sake. There is no future in playing the desperate role of bringing the roof on all if Greece is not allowed to continue living beyond their means. Greece cannot sustain a debt of 175% of GDP and some sort debt easing is absolutely necessary as a quid pro quo for Greece doing what really needs to be done to restructure their economy. Euro countries and Euro institutions that lent money to Greece cannot and should not take a loss on their loans to Greece. This seems like squaring a circle but in fact it can be done with some flexibility and creativity and not only for Greece but for all countries for a portion of their debt which exceeds 100% of their GDP: All direct bilateral loans and the bonds held by the ECB are to be refinanced at original cost by the ESM ESM is to finance this by issuing zero coupon long term bonds which will be acquired by ECB through their QE operations. Better to focus QE on such measure rather than buy bonds of countries who do not need any Central Bank buying their bond ( e.g. Germany and Malta) The refinanced bilateral loans to the extent that they reflect excess of debt to GDP over 100% are to be converted into long term contingent coupon bonds with coupon linked to GDP performance. Such contingent coupon bonds are to carry warrants that in case of non-respect of warranty conditions the bonds will become repayable on demand. As further incentive, linkages are to be made where the higher the contingent coupon payable ( reflecting success in economic restructuring leading to economic growth) the more investment is to be allocated to Greece under the Juncker Plan and its successors or extensions. Euro countries with strategic surplus in their Balance of Payments are to be compelled to pay non-refundable contributions to a contingency fund within the ESM to build a reserve against possible loan losses. This is in recognition that surplus members are gaining advantage through their Euro membership which they would not have gained if they had maintained their national currency. There is space for a good and sustainable compromise after the parties get tired playing their dangerous games of chicken.

Two games of chicken: Ukraine and Greece

In addition to the game of chicken being played regarding Greece's debt restructuring and its future in the Euro monetary system, another one even more tragic is being played over Ukraine.


Let's analyse the two problems which are so serious that it is very improper to call them games as they both involve people's destiny and choices between life and death.

Let's start with Ukraine:

What Ukraine wants:

• To safeguard its territorial integrity and have safe borders with neighbours
• To live at peace with its neighbours including Russia
• To adopt a long term plan to integrate itself within the EU and with the West via NATO membership.

What Russia wants:

• To keep Ukraine within its sphere of influence
• To take full control over Crimea where it holds a strategic Russian military base
• To protect the interest of ethnic Russians in Eastern Ukraine
• To keep Ukraine out of NATO and the EU and keep it as a territorial buffer between Russia and NATO countries.

What the West wants:

• To extract Ukraine from Russian sphere of influence
• To safeguard Ukraine sovereignty and their ability to decide their own destiny
• To extend NATO to Russia's border

Obviously many of these objectives are conflicting and as a consequence Ukraine is gradually slipping into a proxy war between the West and Russia.  Russia is clearly supplying arms and resources to ethnic Russians in eastern Ukraine to help them overcome Kiev's determination to impose its sovereignty over the region.   The West is now considering supplying arms to Kiev to protect the integrity of their sovereign territory.  This inevitably causes escalation possibly leading to a full scale conflagration.

The West is escalating sanctions over Russia in the hope these would force Russia to scale back its hostility towards the Kiev government,  but sanctions normally do not work at all, and if they do, they take a long time.  On the contrary sanctions are helping Putin to maintain his popularity at home and cover at a lot of his faults by blaming sanctions by the West that  are depicted as Western tools in their bid to dominate Russia.

A possible compromise has to include the following:

• Ukraine's sovereignty has to be restored over all its territory including Crimea.
• Crimea is to be leased on a very long term basis to Russia as China had leased Hong Kong to UK
• Ukraine is to adopt a constitution that gives substantial political and economic autonomy to its Eastern Regions
• Constitution has to provide that any decision for Ukraine joining NATO has to be approved by a UN supervised referendum and in any case NATO will not breach the autonomy given to the Eastern regions.
•  Borders between Ukraine and Russia are to be supervised by UN international peace keeping force.

________________________________________________

And now to Greece.

What Greece wants:

• Renegotiation of all agreements which will involve substantial easing of Greece debt load 
• Respect for their fiscal autonomy 
• Restructuring with emphasis on economic growth rather than crushing internal demand
• Investments to promote increase in Greece economic capacity

What the EU wants:

• Respect of all agreements signed with previous Greek government including austerity measures and privatisations.
• Negotiation of renewal of the austerity package beyond February 2015 as Greece has no real possibility of otherwise financing themselves on the capital markets.   This may involve further conditionality.
• Greece to perform substantial economic restructuring needed particularly involving fiscal enforcement and tax collection.

These positions are obviously conflicting and if no compromise is found Greece will default on its debt leading to it being forced out of the Euro if not altogether out of the EU.   Neither Greece nor the EU want a forced exit out of the Euro which could have unquantifiable and severe unintended consequences which could be as big as Lehman's default in 2008.   In fact the risk of GREXIT ( Greece exit form the Euro) is the most effective, probably the only, negotiating tool that Greece has in conducting negotiations with the EU, Germany in particular.

So ultimately it seems we are heading towards an ominous game of dangerous brinkmanship.    It need not and should not be so. 

Let us list the points that everybody seems to agree upon, or at least should agree upon, and around which some sort of compromise could possibly be built:

• Greece needs to restructure their economy and make it competitive and sustainable not so much for the benefit of their creditors but mostly for their own sake.   There is no future in playing the desperate role of bringing the roof on all if Greece is not allowed to continue living their means.
• Greece cannot sustain a debt of 175% of GDP and some sort debt easing is absolutely necessary as a quid pro quo for Greece doing what really needs to be done to restructure their economy.
• Euro countries and Euro institutions that lent money to Greece cannot and should not take a loss on their loans to Greece.

This seems like squaring a circle but in fact it can be done with some flexibility and creativity and not only for Greece but for all countries for a portion of their debt which exceeds 100% of their GDP:

• All direct bilateral loans and the bonds held by the ECB are to be refinanced at original cost by the ESM
• ESM is to finance this by issuing zero coupon long term bonds which will be acquired by ECB through their QE operations.   Better to focus QE on such measure rather than buy bonds of countries who do not need any Central Bank buying their bond ( e.g. Germany and Malta)
• The refinanced bilateral loans to the extent that they reflect excess of debt to GDP over 100% are to be converted into long term contingent coupon bonds with coupon linked to GDP performance.   Such contingent coupon bonds are to carry warrants that in case of non-respect of warranty conditions the bonds will become repayable on demand.
• As further incentive, linkages are to be made where the higher the contingent coupon payable ( reflecting success in economic restructuring leading to economic growth) the more investment is to be allocated to Greece under the Juncker Plan and its successors or extensions.
• Euro countries with strategic surplus in their Balance of Payments are to be compelled to pay non-refundable contributions to a contingency fund within the ESM to build a reserve against possible loan losses.  This is in recognition that surplus members are gaining advantage through their Euro membership which they would not have gained if they had maintained their national currency.

There is space for a good and sustainable compromise after the parties get tired playing their  dangerous games of chicken.

Let the games begin

On 2nd January 2015 I posted an article titled:

Preparing for the Greemany  (Greece and Germany) high stakes game of chicken

post 02 01 2015 preparing-for-greemany-high-stakes-game

Following last Sunday's result of the election in Greece and the election of Syriza to  government with a strong electoral mandate to address the unending economic distress, through growth rather than austerity, it means now that the dangerous game of chicken can begin.

Both sides have spent the first week digging in their heels.    From the German side the message was repeatedly that Greece has to honour agreements signed with the Troika ( IMF, EU Commission and ECB) to restructure its economy as a precondition for any concessions to lighten up the debt burden.   From the Greek side  the government has made it clear that it means to be faithful to the electoral mandate and does not feel committed to the austerity accepted by previous governments which crushed the Greek economy and sent unemployment to levels so socially offencive levels that made Syriza an automatic desperate choice for the Greek electorate.

This game of chicken is a very dangerous one.   It could very well lead to dismantling of what has been achieved by the European Union in its six decades of existence.    Something must be done to find a compromise honourable to both sides, a compromise that can build on sound foundations to make the European project the choice of the people, a European project that leads to a union among its people rather than becoming  as presently, a source of division.

There are three main issues that must be addressed:

1. Economic restructuring is needed and Greece cannot go back to its old ways of high public sector employment and low private sector investment where debts do not matter and tax evasion and corruption is tolerated rather than fought.

2. No country can redeem itself properly if its debt to GDP levels exceed significantly the 110% level. Even at this level it is only sustainable in a context of low interest rates.  A higher interest rate context will make the sustainable level even smaller possibly not far off from the 60% level enshrined in the Maastricht Treaty.

3. Economic restructuring can only be successfully delivered in the context of economic growth rather than one of austerity.  Economic restructuring requires a high dose of productive investment to stimulate the process of creative destruction, the phasing out of uncompetitive operators at a time where investment delivers new opportunities for economic growth, for new jobs and for new opportunities.


Any compromise which is not based on this tripod will be defective, unsustainable and will probably solve problems temporarily whilst creating bigger ones for the future.

Within this framework let me map out how a sustainable and honourable compromise can be found if the players move away from the current deadly game of chicken.

a. Greece must honour in substance, if not in all its details, the agreements it has with its international creditors, mostly IMF, EU institutions and EU countries.   Greece must continue to deliver a primary surplus in its fiscal budget and a surplus in its balance of payments position.  If the new government in Greece prefers to achieve this aim through better enforcement of tax collection which permits financing of social measures to ease the pain for those who are carrying a disproportionate load of the restructuring burden, that is a decision which rests within the sovereignty of the Greek government.

b. Greece must pursue an economic model which allows more space to private investment both domestic and international.   Government should have no qualms of moving away from its role of operator and adopt a regulatory stance. Privatisation must be not ideologically challenged but if properly executed without a suspicion of corruption, can be a useful ingredient in the creative destruction and economic growth model,

c. Greece creditors, mostly EU institutions and EU governments, must release Greece from the debt trap it is currently captured in as a quid pro quo for Greece pursuing sensible economic policies as above outlined.     In spite of private sector debt write off in 2012 the size of Greece debt to GDP has continued to increase and has now reached 175%.  Clearly the austerity recipe has delivered the opposite results from those intended.

d. The debt of all Euro area countries (not just Greece) exceeding 100% - 110% of GDP should be taken over by the ESM (European Stability Mechanism) against full reimbursement to present creditors and such debt is to be swapped to contingent 50 years bonds with a front 10 year moratorium and without a fixed coupon rate.   The coupon rate is to be variable and  contingent to the level of GDP growth registered by the debtor nation so that the debt burden remains sustainable.

e.  ESM is to finance such funding through cheap loans provided by the ECB ( better than the 1 trillion QE which is much less effective) and through contributions that countries enjoying structural balance of payments surpluses are to be obliged to make to the ESM to provide a cushion for any potential losses on its contingent bonds.    This is an equitable recognition that those countries that are enjoying structural balance of payments surpluses are enjoying a disproportionate benefit from their Euro membership given that had they, like Switzerland, been still in command of their domestic currency they would have lost competitiveness through automatic revaluation of their currencies.

f. Deficit countries who participate in such sustainable economic restructuring and growth plans should receive priority in financing of productive infrastructure investment through the EFSI of the Juncker Plan which again could easily be financed through the ECB. Countries enjoying strong economic growth and chronic balance of payments  surpluses should allow countries in distress such priority access to EFSI funding.

Let the games begin.  Not the deadly game of chicken but the serious games leading to sustainable  restructuring of the EU economy, greater solidarity, and greater determination by countries in distress to close the gap between their distress and the economic fortunes of surplus countries locked up in the same currency union.