Thursday, July 9, 2015

Global Financial Crisis, Contagion and Grexit


    The worst Global crisis since the “Great depression”, hit the World in 2008.  The “Great recession” triggered by the Global Financial crisis(GFS) fundamentally changed the external environment, while the Euro countries continued to believe that the World was undergoing just another cycle like the dozens they had seen & dealt with in the post-war period. Thus in our view (as ED IMF 2010-12), their economic approach and solution to the fiscal problem, of putting overwhelming emphasis on austerity was fundamentally flawed and highly likely to fail in the absence of a quick return of the World economy to high growth and moderate inflation. A speedy return to higher growth, was however, made impossible by the flawed emphasis of the governments/politicians of the Euro Area, UK and the US on hard & immediate fiscal squeeze on their own economies, thus reducing global demand and exacerbating the global excess capacity in tradable goods and services. On the supply side China, continued to create new capacity in manufacturing by pumping credit into the economy, offsetting the natural process of depreciation and obsolescence that would have gradually reduced total capacity.

Greece Loan

  A number of High Income European Countries including Greece, were among the worst affected by the GFS & associated recession.  The IMF changed its rules, to make loans to Greece that were > 10 times the ratio limits applicable to loans made to developing countries during the previous 50 years. The only argument for making such an exception was to minimize the risk of contagion to other vulnerable European countries such as Portugal, Ireland and Spain. An IMF ED(a professional economist) pointed to the flaw in the economic analysis and projections underlying the Greek loan:  “The scale of fiscal reduction without any monetary policy offset is unprecedented… (It) is a mammoth burden that the economy could hardly bear.  Even if, arguably, the program is successfully implemented, it could trigger a deflationary spiral of falling prices, falling employment, and falling fiscal revenues that could eventually undermine the program itself.  In this context, it is also necessary to ask if the magnitude of adjustment…is building in risk of program failure and consequent payment standstill… There is concern that default/restructuring is inevitable.”[i]

Austerity or Fiscal Reform

   Our experience of the Asian & Latin American crises, had taught us that that the domestic private and international sovereign debt overhang had to be dealt with quickly and effectively, to stave of a “Balance sheet recession” and give the economy a chance to recover.  Further, that growth recovery depended critically on offsetting required Govt. expenditure compression (austerity) by expenditure switching (real depreciation and/or monetary easing). Clearly both the global demand situation and domestic supply side had to be conducive to produce a sustained increase in net exports and investment to stimulate and sustain growth.  In the absence of exchange rate flexibility in Greece (PIIGS), austerity could only work by reducing the real wage rate. Given the deflationary post crisis situation, austerity would reduce not just the nominal wage rate(w) but also the price level(p) thus having (at best) a small effect on the real wage rate(w/p). We concluded that restoration of Greek competitiveness within the euro zone would require a level of austerity that was socially and politically infeasible.   We therefore argued that in Greece(& contagion candidates) the focus should be on fundamental fiscal (tax and expenditure) reform, which would put it on a sustainable fiscal path through a gradual reduction in expenditures and increase in tax ratios, which follow from such reform(e.g. of Pensions). Instead of an immediate reduction of government expenditures, the focus should be on limiting and reducing the growth of expenditures, perhaps in some cases to zero and not on cutting everything drastically. The overemphasis of the Trioka on “austerity” distracted attention from more fundamental fiscal reforms that still remain unimplemented by Greece.

Lender of Last Resort

    There were three other issues critical to success of Greek macro adjustment.  The immediate problem for Greece and other Euro zone countries in danger of contagion was the absence of a normal Central Bank or lender of last resort. The European Central Bank was hemmed in by rules and constraints that kept it from acting like a normal Central Bank (FRB, USA; BOE, UK; RBI, India). We argued that contagion couldn’t be stopped unless the ECB got complete freedom to lend to illiquid but solvent Euro area Banks and financial institutions (Virmani(2011)[ii]  This problem was gradually solved after the appointment of Mario Draghi as the Head of the ECB in November 2011 and the risks of contagion have been largely eliminated due to ECB empowerment and tightened financial regulation. However, subsequent to the No vote in the Greek referendum, the ECB has raised the collateral requirements for providing liquidity support to Greek Banks. Greece is therefore effectively without a Central bank to fulfill the lender of last resort function for its Banks and payment system. If this support is not restored, Greece has no option but to reintroduce its own currency (Drachma) and Central Bank.
    The introduction of currency has two parts: Bank deposits(financial deposits), which can be converted instantaneously into Drachma, and by letting the market set a Drachma-Euro exchange rate. If a one to one conversion is done and the market exchange rate is 1.3 Drachamas to the Euro, say, then the implicit haircut on all deposits is 30%. The second part is for the Greek Central bank to get Drachmas printed and then offer to exchange Euro cash held by the public for cash in Drachmas, at the market exchange rate. To minimize disruption, the Euro would continue to be legal tender in Greece, but all  prices would have (gradually) to be specified in Drachmas.

Debt Sustainability

     The second important problem was Greece’s Sovereign debt.  It was very clear to us in 2010, that Greek debt was unsustainably high i.e. there was no credible time path of nominal GDP growth that would result in a sustained & continuing decline in the Debt-GDP ratio (Virmani (2011) op cit). Without a substantial debt restructuring, resulting in an effective reduction in the present value of outstanding debt, any delay in debt reduction/restructuring would worsen the debt problem. Thus we argued that IMF, Euro and other sovereign loans would merely result in repayment to private lenders and a substitution of private by public debt.  Those who facilitated Greek government profligacy would get away without bearing the consequence of their bad decision or sharing in the pain of adjustment. This is precisely what happened.  The debt crisis reappeared as predicted and a partial debt write-off occurred in 2012, with a Trioka mediated agreement between private lenders and the Greek government.  It was too little too late. The Debt-GDP ratio moved back to its earlier peak, triggering the loan default to the IMF and the latest crisis of 2015.  Any agreement that does not reduce the present value of Greek debt, will constitute another postponement of the inevitable (i.e kicking the can down the road).

Structural Reform.

   Finally there was and still is the problem of broader economic reforms to improve the competitiveness of the Greek economy.   It is often alleged that the Greek economy is riddled with monopolies and oligopolies. The policy & regulatory structures that encourage monopolies and oligopolies must be reformed urgently to encourage new entrants and promote competition in product markets. This includes privatization of State owned companies.  Labor reforms, including anti-work incentives in the pension rules must be modified to make labor markets more flexible. Whether Greece remains in the Euro or leaves it, fiscal and economic reforms will be essential for restoring economic growth.[iii]

Effect on India

        The Greek crises, being a mixture of economic and political factors (dozen Euro countries) has created great uncertainty in the investing community. This uncertainty affects most of the World including India, and is likely to continue for the duration of the crisis. Normally such financial uncertainty leads to heightened liquidity needs in Europe, the sale of Indian equity and an outflow of capital and exchange rate depreciation. This time there is an offsetting factor.  If the crises slowed EU recovery, as is likely, the expected outflow of capital from India to the EU could be inverted. Thus as I predicted a week ago, India could have a rise in equity markets cum capital inflow on one day and the opposite another day, for the duration of the Greek crisis.[iv]
        From a medium term perspective, the conventional Wisdom is that the Greek economy is too small a part of the Euro area, the EU and the World to have any effect on the economy.  In my contrarian view the Greek crisis, is likely to slow Euro recovery and thus affect India’s exports to it.[v]  Further a setback to EU recovery would also affect its exchange rate with USA and other countries. This could be a factor in the US FRB’s decision on the QE program in September. If Euro growth slows sharply, leading to capital inflow into US and USD appreciation (indicating a natural tightening of monetary policy) the FED could effectively moderate the anticipated rise in interest rates. This would offset any negative effects on Indian exports and growth from the Euro slowdown.
   The main long term lesson of Greek crisis for India is to eliminate its revenue and fiscal deficit and thus eliminate the major policy driver of the increase in net external indebtedness. Cyclically adjusted revenue deficit should be reduced to zero by 2020 and the cyclically adjusted fiscal deficit should be reduced to zero by 2025.


  For a permanent solution of the Greek crisis there are five things that have to be set right simultaneously: (1) Structural reforms of markets to improve the competitiveness of the Greek economy, (2) Fiscal reforms: Including revenue neutral tax reforms that lead to an improvement in the tax GDP ratio over time and expenditure reforms that increase the ratio of investments to transfers and reduce expenditure-GDP ratios over time. (3) A debt reduction that puts debt-Gdp ratios on a sustained downward path given realistic projections of nominal GDP (4) Austerity light: A let up by moralists on imposition of pain on the Greek people, which will actually reduce nominal GDP growth and raise GDP ratio back to higher levels.  (5) Complete liquidity backup of Greek banks by the ECB (ie monetary policy).
     Creditors are right to insist on (1) and (2), as Greece cannot revive within or outside the Euro area without them. Creditors are wrong to oppose (3) and (4) as without them the Euro crisis will be back within the next three years.  Without (5) Grexit is effectively already here, as the banking and payments system cannot survive without a central bank to provide liquidity.

A shorter version of this article appeared on the editorial page of the Indian Express on Thursday July 9, 2015 under the banner, “Trojan Loans,”

[ii] Arvind Virmani, “Averting A Euro Meltdown: Sharing Global Responsibility,” December,  2011
[iii] Interestingly many of these reforms are similar to or parallel those suggested for India in the 1990s.
[iv] DD News,Mark Lynn, 10 pm Monday June 29th & TV Today, Karan Thapar, 30th June 2015.
[v] Op cit

No comments: