Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Friday, 30 March 2012

Eurozone's Perpetual Monetisation Machine

European leaders gather to debate and construct a hopelessly inadequate firewall in their attempt to contain a nuclear meltdown. Despite their pessimism, markets remain relatively sanguine. Even after the recent sell-off, yields and CDS spreads remain well below the distressed levels they reached at the end of 2011. The Euro has also recovered 6% from its recent lows. Market performance in the first quarter of this year is largely due to ECB’s LTROs. It took funding pressure off the banks, provided ammunition to the carry traders and injected misplaced optimism (otherwise known as hopium) into market participants. At some point, LTRO effects will wear off since hopium has a short half-life. Waning confidence will put the funding pressure back on as non-domestic investors pull back and carry traders panic as usual. So far there is nothing new. The same old pattern will reassert itself.

The crisis seems to be a death spiral with hope leading to confidence which degenerates into despair and hope again rising from the depths. But what is different about each successive spiral is the strengthening of the moral hazard engendered by each successive policy intervention. Therefore the sovereign-bank default correlations are tending to one as domestic banks take ECB’s money to load up on sovereign debt. Counterintuitively, this is the reason to be positive on the Eurozone. It benefits sovereigns as deficits are indirectly monetised through their banks. Moreover, as banks act as one to support the sovereign, this monetisation can continue indefinitely or until ECB pulls the plug.

The peripheral sovereigns have chanced upon the perpetual monetisation machine which can potentially keep insolvency at bay. The machine can potentially provide enough time for structural reforms to have an effect. It enables sovereigns to “miss” austerity targets in the short term as they try to turn their economies around. 

But as always, there is a problem. Domestic banks cannot expand their balance sheet to buy their entire sovereign’s debt. Since secondary spreads are a gauge of solvency, lack of confidence on part of non-domestic investors will lead to widening spreads and eventual breakdown. Even though Rajoy has the right idea about increasing the deficit in the short-term, investors aren’t going to wait around to see whether it works or not. A look at Ireland and Portugal makes it clear. They kept protesting that they didn’t need a bailout until investor stampede forced the EU to generously take IMF’s money and give it to them.

Supporting secondary market spreads is difficult. Guerrilla tactics of domestic banks making repo, and thus shorting bonds, expensive will not work. For one they do not have enough bonds and two, the widening is primarily due to investors selling what they own. The Eurozone only has two bullets which it can use against ‘evil speculators who do not appreciate the fundamental strength of the Eurozone’. The first is SMP and the second is the more nebulous intention of EFSF to buy bonds. The problem with the former is that it is collateral constrained. With the Bundesbank watching over its shoulder, the ECB has to sterilise SMP buying. If foreigners sell bonds and flee with their money, SMP leads to a horrible constriction of money supply. The problem with EFSF is that at present it is more of ‘don’t worry we’ll sort it out’ than an intelligent executable plan.

An argument can be made that as long as the perpetual monetisation machine supports the primary market, the secondary market is irrelevant. After all Greece continued to issue T-bills below 4% until the debt-swap. While true, it ignores the larger ramifications of stratospheric sovereign secondary market spreads. As the gauge signals distress, all non-domestic and even some domestic investors will head for the door. They will take their money out of not just sovereign bonds but all investments. Companies sweeping cash balances of their subsidiaries in peripheral countries daily are just one example. The result will be a devastating credit crunch and depression. Greece is a case in point having experienced 9 successive quarters of GDP decline without an end in sight.      

Therefore the perpetual monetisation machine critically depends on the market being in a continued hopium stupor. For the time being LTRO-induced buying achieved this objective. As VaR limits were cut and dealer inventories ran low, it was easy for relatively small traded volume to have an outsized effect. Therefore domestic buying ramped up bond prices causing momentum traders and benchmarked investors to follow. Unfortunately optimism requires economic data to validate it; and this is missing.

Summits and firewalls are at best irrelevant and at worst a distraction. The market will turn at the point when domestics run out of excess LTRO liquidity or their bid is matched in a greater size by non-domestic institutions. The former can happen if redemptions outpace new issuance or deposit outflow accelerates. At that point the co-operative mode in this version of Prisoner's Dilemma will break down. The latter depends on sentiment based on political developments and economic data releases. The perpetual monetisation machine may still run, as Greek T-bill issuance demonstrated, but it'll be running on empty and only for a short while.

Tuesday, 27 March 2012

India - It's the politics, stupid

India has fallen from grace in the international investor’s eye. The most visible, if imperfect barometer of investor opinion, the Indian stock market has been moribund. The scorching 21% rally at the start of the year has disintegrated. The rupee has also resumed its slide going back above 50 to a dollar. August publications such as the Economist have put the boot in.

The poor global macroeconomic picture has certainly contributed to the decline in growth but most of the blame lies with the sclerotic and cancerous political environment. Mostly everyone apart from the politicians agree with this diagnosis. However, investors care about prognosis not diagnosis. And this is where things get difficult.

The ‘India shining’ story has been spun well. It is a truth universally acknowledged that the rapidly growing, democratic colossus with favourable demographics and a huge middle class is all set to join the pantheon of global superpowers. The urban Indian especially has taken this story to heart in a fit of optimism bordering on exuberance. Even most critics assume that rise is inevitable, only the duration indeterminate. Therefore they helpfully offer constructive criticism to improve policy and achieve higher growth rates.

Unfortunately not only is the climb to superpower status long and arduous but there is no surety that is will be successful. An optimistic analysis which assumes away the middle-income trap shows that there are still two very different destinations that India can reach. India can be like the US, which is what most Indian policymakers and intelligentsia think, or it can be like Italy.

On the positive side, India has a young, innovative and entrepreneurial generation which is increasingly unafraid to take risks. The state’s power to stifle is greatly reduced in a knowledge-based service economy. Social and political awareness is on the rise as growth lifts more people to middle class. It is also aided by exposure to global trends through advances in technology. This creates pressure to reform through the democratic process. And just as happened in the west, a virtuous circular dynamic is created which leads to a rapid rise in national prosperity.

The rose-tinted view above ignores the sclerotic and cancerous politics hidden behind the sheen of democracy. And it is politics which will determine the eventual fate of India. A fractured polity full of misguided populists and demagogues will eventually ruin the country. The optimistic case is that India rolls back the state enough for Indian entrepreneurs to thrive. As with the US, this will minimise the impact of political corruption, backroom dealing and perennial electioneering on growth and people’s daily lives. The pessimistic case is that Indian politicians and crony capitalists refuse to surrender power and associated perks, shackling the economy into a new Hindu rate of growth (or the Rickshaw rate of growth as Economist calls it). This is the Italian case where a bickering, self-serving, fractured polity envelops the state in its malignant tentacles and drags it towards the abyss.

Unfortunately India seems to be heading in the direction of Italy. The state has not retreated enough from the economy to let the invisible hand function effectively and deliver growth. And the state is hobbled by a lack of courage and fresh ideas because the government at the centre is formed of a weak band of populists cobbled together. The only reason they can cling on is because the opposition is in much greater disarray. A fragmented voter base means that coalitions will continue to rule at the national level. Policy stasis, shady compromises and populist measures are inevitable along with endemic corruption. Advocates of reform and rolling back of the state from the economic sphere fail to recognise that sensible policy decisions are impossible in the current political atmosphere. As the current situation in Italy shows, weak governments are at the mercy of vested interests. Even as Italy tethers on the brink of insolvency, they fervently defend the status quo.

However, all is not lost. The recent regional elections have shown that government largesse does not win elections. This lesson along with the re-election of incumbents in well governed states holds hope for the future. It is imperative for effective governance to be re-established at the centre. However much the states may progress, without effective national leadership, the sum of the parts will never approach the potential of the whole.

As for the India story, even though investors have been battered recently, the prognosis is not dire. Yet. Despite being meagre, the rickshaw rate of growth can sustain the nation in the short-term. India is also more resilient to exogenous shocks (apart from oil price shocks). Therefore there is potential for reasonable returns. The investment decision depends on the timeframe. For the short-term investor, India is not the best place and time to invest. It benefits from global “risk-on” which seems to be reaching a zenith right now. Apart from the domestic political uncertainty, the cracks appearing in China do not bode well. For the long-term investor who doesn’t believe in picking the top or the bottom and doesn’t mind an elephantine pace for returns to accrue, this is a good point to start averaging in (the market is down 37% from the peak in USD terms and P/E is a reasonable 15x). Of course an eye needs to be kept on the political developments. They will determine where the story ends.

Monday, 26 March 2012

Eurozone - EFSF, ESM Bazooka reloaded

Eurozone is heading for a Reservoir Dogs finish as Monti warned that Spain may reignite the European debt crisis. He in turn was warned on his labour reforms by CGIL (Italy’s biggest labour union) causing him to slow-track the reforms. Meanwhile Merkel has lowered her gun by allowing a temporary increase in the number assumed to be the size of the bailout funds. The fact that FDP (her coalition ally), who are opposed to increasing the bailout, have been hit might have something to do with it. Or it might be realisation of the TARGET2 bazooka being pointed at Germany by the periphery.

In any case, it is worth rechecking the sums in the bailout funds. The headline number is easy enough: €500bn ESM + €440bn EFSF = €940bn “Firewall”

This large number is to induce hopium confidence in the hearts of carry traders and prevent Italian and Spanish yields from reaching a point of no return. But then 31.93% of EFSF funds are guaranteed by Italy (19.18%) and Spain (12.75%) who are unlikely to contribute to their own rescue. This leaves EFSF with €299.5bn. Out of which €215bn (including the €35bn used to buy ECB SMP holdings) is pledged towards the rescue of Ireland, Portugal and Greece. Therefore, actual remaining firepower of the EFSF is €84.5bn. This makes the whole exercise about a temporary or permanent increase rather pointless.

At this juncture, the astute reader will interject and say that Italian and Spanish contributions should be taken out after the pledged amount since Italy and Spain have guaranteed that amount already. This would leave EFSF with €153bn. There appears to be merit in the argument. But Italy and Spain are hardly going to stand behind or further guarantee funds to Greece, Portugal or Ireland when they themselves are on the brink of disaster. Given the ‘joint’ nature of guarantees given by members to EFSF, Italy and Spain pulling out means others are forced to plug the gap (and then fight Italy and Spain in domestic courts). At that point unless EFSF funds are raised again, the gap will be plugged by utilising unpledged amounts. Therefore €84.5bn is a better estimate of remaining firepower.

So total “Firewall” funds = €500bn ESM + €84.5bn EFSF = €584.5bn “Firewall”

Now all that remains is to categorise this headline number into one of the following:
  1. Bazooka
  2. Heavy Machine Gun
  3. Automatic rifle
  4. .303 Bolt Action Rifle
  5. Revolver
For that, an idea on the relation between size of the economy, sovereign debt and bailout funds required will be instructive.

Ratio of total GDP of Greece, Portugal, Ireland to Eurozone GDP (nominal) = 6%
Weighted average debt/GDP ratio at the time of first bailout = 107%
Bailout funds required till date = €275bn (110bn first package + 130bn second package + 35bn ECB’s bonds taken up by EFSF) + €78bn + €85bn = €438bn
Italian GDP / Eurozone GDP = 17%
Italian debt/GDP = 120%
Spanish GDP / Eurozone GDP = 12%
Spain debt/GDP = 68%

Assuming same relation between GDP, debt and bailout funds,
Italy’s requirement = 438 * (17/6) * (120/107) = €1,392bn
Spain’s requirement = 438 * (12/6) * (68/107) = €557bn
Total = €1,949bn

IMF unwillingness to pour more money into Europe and elusive Chinese investment into peripheral debt means that the sum above will have to be borne by Europe itself. It is highly likely that official funds are “voluntarily” aided by the private sector in another demonstration of European public-private partnership.

And the correct answer to the categorisation question is none of the above. This probably isn’t even a pea-shooter.

Wednesday, 21 March 2012

Banks-v-Sovereigns: Old idea in new blog

Sovereign credit and health of the domestic financial system are usually interlinked. Imminent sovereign default can and does lead to capital flight and run on the banking system. Conversely, a banking crisis inevitably causes recession and worsening of sovereign finances. The current European sovereign debt crisis started as a banking crisis and has now engulfed both sovereigns and their banks.

One of the paradoxical consequences of this crisis and subsequent ECB support has been the reversal of integration in the European banking sector. This can be seen from:
  1. Obliteration of cross-border unsecured interbank lending
  2. Decrease in holding of peripheral sovereign bonds by foreign banks as domestics fill the gap
  3. Divestment of non-domestic operations to raise capital/reduce RWAs
  4. Market perception leading to sovereign and bank funding costs being linked
All these factors add to the imbalances tearing the Eurozone from within (and are the other side of the TARGET2 coin). Further macro-economic analysis of these will be undertaken in some future note. From a trading perspective, it is only important to recognize the strengthening sovereign-bank link and investigate how this might be exploited.

One of the ways that the sovereign-bank link can be used is in the hedging of sovereign quanto positions where dealers have bought EUR-denominated CDS and sold USD-denominated CDS. Instead of hoping for the market to die and their exposure roll off, they can buy sovereign CDS in USD and sell correlated bank CDS in EUR to create an offset. The same trade is also a way to cheaply create a position with low mark-to-market volatility and which pays off in case of crisis intensification.

The other way of exploiting the sovereign-bank link is in the case of nationalised banks or those who are guaranteed to be nationalised due to TBTF fears. Selling higher spread bank CDS and buying sovereign CDS earns carry while reducing outright credit exposure.

Given the increasing dependence of banks on their sovereign, intuitively in most cases credit spreads should converge as default correlation approaches 1. However, this is not the case as seen below in table 1 which shows the 16 most liquid European banks. Spreads for diversified groups such as HSBC, Santander, etc are expected to diverge but most of the others should not be much different from their sovereign. For example it is inconceivable that an Italian default will leave Banca Intesa unscathed as it earns about 80% of revenues from Italy and owns €60bn (~125% of equity capital) of Italian government bonds.

Table 1: 5Y CDS spreads for banks and their sovereigns
Sovereign (spread in bps)
Bank Spread (bps)
Difference (bps)
Italy (353)
Spain (408)
France (163)
Germany (68)
UK (62)
Switzerland (36)
Source: Bloomberg (Banks shown are all constituents of iTraxx® Financials index)

Non-convergence is not a relative value opportunity. The reason for such persistent spread divergence is due to demand and supply and other technical factors which are enumerated in the table below:

Reason for non-convergence of spreads
Highly levered/non-viable banking operation (eg. Icelandics, Irish)
Sovereign credit spread lower
PSI leads to sovereign default but bank bondholders are unaffected as banks are recapitalised/nationalised.
Bank credit spread lower
Currency difference between sovereign (USD denominated) and bank (EUR denominated) CDS. For a major Eurozone sovereign (i.e. Italy, Spain) EUR protection is worth much less.
Bank credit spread lower
Sovereign’s ability to engineer default through currency depreciation.
Sovereign credit spread lower

On this basis, Italian and Spanish banks should trade below their sovereign and UK, US, Swiss banks should trade above. The case for France and Germany is more complicated because of their being the main pillars propping up the common currency but without direct control of monetary policy. But, it can be argued that if it came to it, default through depreciation will be their preferred route as well. Therefore the market is correctly pricing relative value between banks and sovereigns. Even though default correlations are tending to 1, CDS technicalities prevent convergence.

Coming back to the two ideas elucidated above, a long CDS position in Italy versus a short CDS position in ISPIM effectively hedges Italy quanto risk. Moreover, as a position in its own right, it benefits from not being a “naked” short on Italy which might displease the regulators. A return of scepticism will cause both spreads to widen out but because Italy is an important constituent of the Eurozone, the EUR will fall a lot relative to the USD reducing the losses on the ISPIM leg. This also works for Spain where the Latam diversification of its two largest banks (rather the market’s perception of it) is an added benefit. 

Selling CDS on RBS/LLOYDS and buying it on UK (in EUR) enhances the carry for little extra risk. The chances of them becoming independent or being liquidated are slim in the medium term. They should be priced as a National Banking Service rather than the entities which they were at the time of the credit crisis.

Thursday, 15 March 2012

Eurozone: Questioning the rally

Volatility is down, equity markets are up, peripheral bonds are rallying. European leaders seem to have solved the crisis. At least that’s what they’re telling voters. In this case, the cognitive bias of optimism has been elevated to the level of delusion. And not for the first time. Historical records are missing but I’m pretty sure that Roman officials tried to assuage residents that the crisis was over even as Alaric’s army was streaming down from the hills in 410AD.

This scepticism over “the solution” stems from the following:
  1. Trading volume is down sharply – this is an indicator of indecisiveness and lack of risk appetite amongst investors and dealers not a mark of confidence.
  2. Peripheral bond rally has been led by domestic buying and short covering – Draghi’s LTRO has funded moral hazard buying triggering stop losses, momentum buying and buying on fear of underperforming benchmark.
  3. Greek debt burden is still unsustainable and the economy is performing worse than expected – retail sales fell 11% YoY in December, Industrial production declined 5% YoY in January, GDP fell 7.5% in 2011 (6% was expected) and unemployment is now 20.7% jumping from 17.7%. Argentina defaulted 6 months, 20 days after its “voluntary” debt swap. Can Greece break the record?
  4. Peripheral economies are also performing worse then expected as illogical and unattainable austerity targets make a bad situation worse. Perversely large and increasing debt/GDP ratios mean that austerity will be forced one way or another.
  5. TARGET 2 imbalances aren't correcting – this is an indicator of private capital flight out of the periphery.
  6. The political decision-making process is still fractured and slow – decisions made due to peer pressure build up resentment and stress which boils over at the worst possible time.
Nothing goes up or down in a straight line (except perhaps Madoff’s returns) and current European sovereign credit spreads are no exception. Unless ECB monetises, the current calm rally will soon end. The same pattern has been repeated since 2007 – a tear inducing violent rally followed by a relatively calm period and the realisation that it isn’t over, not by a long shot. The only exception was 2009. This is not 2009.

Wednesday, 14 March 2012

Gold – Bug squashing time?

Goldbugs have a simple narrative: Fiat currencies are being debauched systematically by the central banks and therefore the only store of value left is gold. As gold prices have risen higher and higher, this has become more accepted as a fact than an opinion. Since nothing catches the public’s attention like a parabolic rise in prices, investors, both large and small, have rushed in to participate in the latest gold rush. Thus expectations of a price rise have become self-fulfilling.

The investment banking machine recognised the potential of goldbug propaganda and swung into action. There are more than 600 listed ETFs linked to gold available to ‘invest’ one’s hard earned money. Although no prospectus states that “It is an undertaking of great advantage but no one to know what it is”, but given the actual dynamics of some funds it would not be wholly inaccurate.  

Warren Buffett tried to sober up the party in his annual letter to shareholders (excerpt below) to no avail.
The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.
This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.
The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.
What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.

Buffett’s focus on the unproductive nature of gold for rejecting it as an investment does not directly counter the goldbug argument of it being a store of value. In the post-credit crunch bleak economic environment where deleveraging is the norm and sovereign defaults inevitable, clinging to a known store of value is a natural and intelligent investment decision. Unfortunately, gold’s attraction as an investment has more to do behavioural quirks than rational decision making. In the language of neuroscience, investor's brain is using the limbic system (used for automatic emotion-driven decisions) rather than the pre-frontal cortex (used for deliberative and reason-driven decisions). 

Behavioural follies are injurious to one’s wealth. Therefore the main goldbug argument has to be deconstructed to determine the investment decision. The first assertion is that gold is a store of value since the economic environment will continue to be bleak. The second related assertion is that western central banks will continue to debauch fiat currencies to re-start economic growth. In light of better than expected US economic data and resumption of growth there, the argument starts failing at the first assertion itself. Pointing to anaemic growth to support the argument is not enough since such a slow recovery is expected after a huge housing crash (as Reinhart and Rogoff have pointed out in their seminal work). The European situation may be dire but it will impact Euro’s purchasing power not gold’s price in dollars. The second assertion is on stronger footing. Despite tough words, central bank actions have been to debauch their currencies. However, as recent Fed actions have demonstrated, resumption of economic growth will make it a moot point.

The third assertion implicit in the goldbug argument is that gold will continue to be a store of value in a scenario of economic collapse. Even this does not stand up to scrutiny. Wealth is a derivative of power. It does not exist independently and it cannot exist in opposition to the established power. A desperate government will confiscate its citizen’s wealth one way or another. If fiat currencies are deemed to be losing legitimacy against gold then gold will either be confiscated (Roosevelt’s 1933 order is a case in point) or trade in it will be regulated. It is true that a black market can exist where gold is a medium of exchange. However, in the event of an economic collapse, the value of gold with respect to basic necessities will decline. At the moment an ounce of gold can buy hundreds of tins of canned beans but it certainly won’t in the dystopic goldbug worldview. And it most definitely won't if everyone holds gold and very few hold canned beans.

The fourth assertion in the argument is sponsored by the friendly neighbourhood investment banking team. Their claim is that financial contracts linked to gold are as good as gold. Since buying and storing physical gold is a drag, financial contracts ease the burden of sagacious investing. In these egalitarian times no one need fear that they are missing out on a "hot" investment. Not only is the legitimacy of contract law in an economic emergency questionable (as EU has demonstrated to Greek bondholders) but also the ‘links’ are sometimes tenuous and come with other hidden risks (counterparty risk for example). Financial contracts are a speculative instrument sold as an investment product to the masses. This has resulted in a wave of money flooding into gold and the consequent parabolic rise in price.

Upon reflection, gold’s sheen is wearing off. As Buffett sagely noted, gold makes no sense as a fundamental investment. And now even the technicals seem to be going against the goldbugs as gold trades below it 200, 100 and 50-day moving averages (see graph).

Thursday, 8 March 2012

Euro: Even the resilient fall eventually

Shorting the Euro has been the masochistic trade of the year. In spite of the Eurozone hurtling towards event horizon, Euro is roughly unchanged against the US Dollar since the beginning of 2011 (Graph 1). The usual explanation touted for this extraordinary resilience is Bernanke’s commitment to debauch the dollar to defend his PhD thesis.

Graph 1
This is only a partial explanation at best. The ECB has also expanded its balance sheet, even if it isn’t as much as the Fed. More importantly, it has expanded it through lower quality assets – eg. Spanish home loan ABS vs US Treasuries and US MBS. Therefore if the exchange rate was solely dependent on currency debauchery then Draghi’s LTROs would have succeeded against Bernanke’s QEs in depreciating the Euro.[1] To know why so many smart people have thrown in the towel on the Euro short trade we have to go back to basic macroeconomics.

The Balance of Payments (BoP) identity is:

BoP = Current Account balance + Capital Account balance

Where; Current account balance = Exports – Imports
Capital account balance = Change in foreign ownership of domestic assets – Change in domestic ownership of foreign assets

Standard macroeconomics assumes BoP to be equal to zero. This has to hold in the long term but in the short-term non-zero BoP adds or subtracts from a nation’s reserves (foreign exchange mainly). As an example if in a given year, a country is a net importer with no foreign capital inflows then it will deplete its reserves. This imbalance can only occur as long as there are reserves. Once reserves are exhausted then either imports stop to balance BoP or foreign capital flows in to finance the imports. 

Since exporters, importers, foreign and domestic owners of capital are not coordinating with each other how does BoP balance? This is where national currency’s exchange rate (FX rate) comes into the picture. To simplify, a nation can either have a floating market-determined exchange rate or a fixed officially-mandated exchange rate.

In the case of the floating rate, a BoP imbalance is adjusted through the FX rate. Going back to the earlier example, a current account deficit unmatched by a capital account surplus will not only lead to reserve depletion but also depreciation of the nation’s currency. This would have the following consequences:
  1. It would make imports expensive reducing demand
  2. It would make exports cheaper increasing demand
  3. It would make the country’s assets cheaper for foreigners increasing foreign capital inflows
  4. Finally it would make foreign assets more expensive reducing domestic capital outflows.
Therefore FX depreciation acts as a self correcting mechanism to balance BoP.

In a fixed rate regime, BoP imbalance is borne by reserves. Official policy attempts to manage reserves by either devaluing the currency in case of a BoP deficit or by official investments abroad to create a capital account deficit (revaluation is rare).

Now coming back to the Eurozone and looking at it as a single entity, the lack of Euro depreciation makes sense. Current account deficit for the block is close to zero with the average of the last two years being -0.43% of GDP (Graph 2). The capital account is also close to zero (Graph 3). Therefore there is no fundamental reason for the FX rate to appreciate or depreciate significantly. This is also consistent with what has been observed.
Graph 2

Graph 3

However, the Eurozone is neither a monolithic block nor a sovereign nation. Within the Eurozone each country operates as if under a fixed exchange rate regime with pooled foreign exchange reserves. A net importer’s central bank can obtain foreign currency from a net exporter’s central bank through the ECB. As long as the overall Eurozone current account balances, there is no need for balancing at the individual country level. Therefore German surpluses and peripheral deficits can continue ad infinitum. This ex-Eurozone foreign trade is similar to different areas within a country and is not of much interest.

Due to the lack of fiscal union, the interesting part is that for intra-Eurozone transactions each country operates as if it has infinite reserves. Monetary union assures a country with intra-Eurozone current and capital account deficits that it can operate without fear of running out of reserves. This is a function of the esoteric TARGET2 (Trans-European Automated Real time Gross settlement Express Transfer system) balances. The deficit nation incurs TARGET2 liabilities, i.e. its central bank gives an IOU to the surplus nation’s central bank for the imported goods/capital transfer. The simplified schematic below gives a concrete example.

It is not necessary for TARGET2 liabilities to increase purely due to current account deficits. Usually a capital account surplus balances a current account deficit as the schematic shows. 

The problem arises when the capital account is in balance or deficit. Theoretically, TARGET2 liabilities can keep piling up until the deficit nation runs out of collateral for these IOUs. But this can never happen because of two reasons. The first is that collateral acceptability is largely decided by the deficit nation’s central bank within given guidelines. The second is that the central bank’s power to provide ELA (Emergency Liquidity Assistance) against any collateral it deems fit. Even Plato’s guardians would find it difficult not to succumb to this moral hazard if the republic was in danger. 

Applying this theoretical edifice to observed reality makes Euro’s resilience understandable. It also explains German discomfiture with widening collateral criteria since their TARGET2 assets become secured on lower quality assets (if they can be called secured at all). Moreover, it explains what is in store.

Peripheral current accounts with the exception of Ireland are all in deficit and have been for the last decade. Until the start of the sovereign debt crisis these deficits had been financed by the private sector of Northern European states and the rest of the world. This was the convergence trade which culminated in Greek CDS trading at less than 20bps (0.2%) differential to German CDS in 2006. However with the onset of the crisis, private capital flows started reversing. Now even domestic capital is stampeding out as can be seen from the reduction in bank deposits. Private capital been replaced by official TARGET2 liabilities as the means to finance current account deficits. Because capital flight has been largely contained within the Eurozone (out of peripherals into Germany) it has not impacted the Euro exchange rate. But at some point this will change.

Two alternative scenarios can occur in future (see diagram below). The first is an internal wealth transfer which sees TARGET2 liabilities torn up. This can take place through various mechanisms and would be equivalent to a fiscal transfer from northern Europe to the peripherals. It would be largely FX neutral. The second is capital flight out of the Eurozone as people realise that German, and northern European, strength is superficial. According to JP Morgan half of Germany’s net investment abroad is its TARGET2 assets. A Greek exit would render €111bn of TARGET2 assets with northern European central banks worthless. As Jean Paul Getty shrewdly observed, fall of debtors leads to a fall of their main creditors as well.

The second scenario will lead to a free fall of the Euro and is looking likelier of the two due to political mismanagement and brinkmanship. 

[1] The 1% interest rate differential is not worthy of consideration. The volatility adjusted return is laughable for any serious investor/trader.

Tuesday, 6 March 2012

Greece: CDS is the pawn in a game of chess

The Eurozone crisis is running along predictable lines. Unsurprisingly, Venizelos has revealed that the “voluntary” Greek debt swap is actually an offer that cannot be refused. This was after a pathetic grand total of 12 institutions signed up for the IIF’s complicated loss-taking exercise. According to the IIF these holdings represent a “substantial” part of the €206bn of private sector holdings. If that is indeed the case, all these institutions should fire their risk manager/trader without delay. It would probably boost their enterprise value more than any convoluted swap agreement.

The amazing and unexpected part of the Greek debt swap saga is that Greek pension funds, the civil service union and some Greek banks are resisting signing on the dotted line according to the FT. The pension funds claim the Greek central bank invested their cash reserves in bonds without consulting them. Talk about chutzpah.

Given the situation, it seems like CACs will be used to force losses thus triggering CDS. So the critics can rest easy, CDS is not worthless (yet). This whole fuss about ‘why isn’t CDS triggering’ was slightly perplexing. No less a man as Bill Gross voiced this question even as his firm voted that there was no credit event. The reason for the non-trigger is simple: No losses have been imposed (it has been all “voluntary” so far remember). Also, insertion of a CAC by itself is not a credit event. It is the use which binds all holders which constitutes a credit event. Just because someone has a gun and threatens to use it does not mean they are guilty of murder yet.

The event that will determine the fate of sovereign CDS is the auction settlement after the inevitable trigger. The fear is that all old Greek bonds are swapped for new ones which trade close to par. This would imply that CDS buyers lose a mammoth 70 points ($7m per $10m notional) from their marks. It may lead to defenestration of traders left holding basis packages. Moreover, it would call into question the entire sovereign CDS market as the market realises EU’s desire to punish the evil CDS speculators. Of course, sovereign bonds will become unhedgable. But the main buyers are now domestic banks and asset managers tied to the mast of index benchmarks. The former have just taken out 1trn of fresh money from the ECB to play the carry trade and the latter just care about losing less than the index.

It is possible that Greece leaves a few bonds unswapped to enable auction settlement at the fair impaired price so that hedges retain value. This was done in the case of Anglo-Irish where the Irish government intelligently decided that CDS was not the enemy. Unfortunately political stakes are higher now and intelligence commensurately lower.

However, there is a way out from the EU’s derivative killing fields and ISDA is likely to take it. There is going to be a period of time between the activation of the CACs and the exchange of old bonds for new. If the auction occurs in between these two events then the auction settlement price will be the price of the impaired Greek-law bonds. CDS gains would mirror bond losses preserving the hedge and more importantly the relevance of CDS. ISDA may be conflicted but it is not suicidal.

Of course, EU can ban trading and ownership transfer of Greek bonds post CAC activation. That would be check mate.