Showing posts with label debt sustainability. Show all posts
Showing posts with label debt sustainability. Show all posts

Thursday, July 9, 2015

Global Financial Crisis, Contagion and Grexit



Introduction

    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.


Conclusion

  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,” http://indianexpress.com/article/opinion/columns/trojan-loans/


[ii] Arvind Virmani, “Averting A Euro Meltdown: Sharing Global Responsibility,” December,  2011 https://docs.google.com/viewer?a=v&pid=sites&srcid=ZGVmYXVsdGRvbWFpbnxkcmFydmluZHZpcm1hbml8Z3g6MjE0NmYyY2U2N2YxMDg
[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

Tuesday, October 11, 2011

Fiscal Sustainability: Economic Theory vs. Market Fashions

In discussions of Fiscal Policy and Fiscal vulnerability I have repeatedly (over the past 25 years) come across a clash between Economic theory and Market Fashions.  The use of the word “Fashion” might suggest to some a harmless diversion a matter for amusement or entertainment, but a proper understanding of the economics is critical to dealing with the fiscal crises that threaten the World today. Let me illustrate this with four points that have a bearing on Fiscal sustainability.
The first basic principle of economics is the debt sustainability condition: g – r - Pd > 0 (g is the growth rate, r the real interest rate payable on sovereign debt, Pd is the primary deficit).  A sovereign’s debt is sustainable if the growth rate exceeds the real interest rate paid on the debt by the extent of the Primary surplus.  With few exceptions (e.g. William Buiter of Citi), the public discussion of debt sustainability has been carried out without reference to this basic essential data.  Unfortunately this is not new: Over the past 25 years I have often seen even highly respected institutions such as the IMF ignore this simple number when it did not fit with their conclusions and recommendations (which therefore inevitably turned out to be wrong).  Market fashion has shifted dramatically away from this measure since an empirical paper estimated” that 60% was the safe level of gross debt to GDP ratio for every country under the sun.  Subsequent work concluded that this was the safe level for Developing countries but the safe level for Developed countries was higher (90%?).  I am sure that there will many subsequent revisions and refinements to these estimates.  I call this a fashion not because these estimates are not useful, but because it has led to herd behavior in which analysts do not even think it worthwhile to produce and present the basic numbers for the sustainability conditions. It would seem to me that we can easily produce this data, not only for the US, Japan and European countries currently under pressure but also other economies with weak fiscal situations and poorer economic data. This will allow us to define the relative fiscal sustainability of different countries more accurately and identify the source of the problem, the better to deal with it.
Economic theory tells us that, the debt that is relevant to the fiscal sustainability issue is the net debt (debt net of assets) not gross debt.  This is such a simple and well understood (by private individuals) principle of economics that it is almost embarrassing to raise it in a professional context.  Yet public discourse over the last two years barely ever mentions the asset side of the balance sheet or presents the comparative net debt position of countries under stress.  When financial markets sense a crisis, even a minor temporary one, only the short term matters, as each market participant tries to be the first to unload its holding of the concerned sovereign debt or loans.  Only the gross debt, coming due and needing refinancing seems to matter to the markets.  If this is true, why call it a ‘market fashion’?  Because it is the obligation and duty of responsible analysts, including the international financial institutions, to focus not just on the short term but also on the medium and long term – the original definition of “sustainability”.  The short term can be dealt with by liquidity support, whether from the Country’s Central Bank or the IMF, it is or should be the medium term that determines sustainability.
The theorists who emphasize Net debt are quite aware of the problem of maturity mismatch between sovereign debt and sovereign assets (e.g. loans or bond debt and public companies or infrastructure assets) and about the difference in risk associated with the different type of assets (e.g. physical assets versus future tax obligations).  This cannot distract from the basic economic fact that fiscal solvency depends on the net debt position – a country or individual cannot be insolvent if its assets exceed its debt. Further, the fact that a country’s fiscal situation (as against an individual’s) can be sustainable with debt larger than its assets matters even in the short term, because it is possible to loan or sell some assets (perhaps at a discount) to meet short term debt obligations! The safety threshold of 60% or 90% gross Debt-GDP ratio will surely be refined if we put in the effort to determine net debt.   To say that we do not have a perfect measure of sovereign assets or net debt is an evasion; imperfect measures (for instance physical assets valued at depreciated book value) are better than no measures, if we are clear and transparent about the limitations.
The theory also makes a distinction between sovereign debt financed externally and that financed domestically, though mostly in a very elementary manner of differential interest rates. Some of us who have had to advise on fiscal control and fiscal debt issues and to face the consequences of bad or incomplete advice, have long asserted that external financing of sovereign debt is not worth the risk.  The advantage of lower nominal interest is very tempting economically and politically: However the exchange risk is likely to be neglected or ignored and the danger of sudden stops and reversals is very real.  The country can suddenly find itself at huge risk from shocks to global financial markets and overreaction to temporary problems in the domestic economy and polity.  In addition the valuation of assets that go into the determination of net debt, is likely to be asymmetric – foreign lenders to the sovereign are likely to value it much less than domestic debt holders relative to debt.   Besides the home bias and exchange risk, other factors include differential costs of using the legal system.
Recent, preliminary empirical analysis also suggests that the net external debt of a country has a positive effect on the volatility of capital flows (i.e. higher net debt more capital flow volatility).  In other words the lower the cumulative gap between domestic investment and domestic saving (Id-Sd) the more stable capital flows are likely to be.  This implies that higher domestic private and household savings are likely to lead to lower capital volatility lower risk to foreign borrowing (private and government) and a higher threshold limit for safe Debt-GDP ratios. The hypothesis is that (other things being equal), higher domestic private saving rates allow a country to sustain higher Sovereign Debt-GDP levels.[1]  If this is true it would certainly be useful to know the relative household and private saving rates of different countries, along with the other data mentioned above.  We would then be in a better position to judge relative fiscal sustainability and to identify the key problems and  focus on the policies that can make a difference.


[1] A currency union raises a host of other issues that need separate discussion.  The reference here is to countries with their own currency.

Friday, August 26, 2011

Fiscal Debt Sustainability

In my 25 years of interaction with multilateral financial institutions on fiscal issues, I have repeatedly made the following points (which remain valid till today): 1) That the simple rule that growth rate must be more than the real interest rate is a good guide to ensuring that debt GDP ratio declines over time. (2) Theory does not tell us what level of the debt-GDP ratio is optimal. A number of factors are important for judging whether this level is too high. Among these are, (a) The asset owned or the net debt-GDP ratio. In other words a country with a lower debt, net of assets, can sustain a higher gross debt-GDP ratio.  Given the financial innovation over the last 25 years, it is also necessary to emphasise that the liquidity, maturity structure and uncertainty/risk associated with the assets also matters! A further implication is that debt incurred for investment is more sustainable than if used for consumption and transfers. (b) The manner of financing of the debt, in particular the proportion financed by domestic as against foreign capita/savings.  Thus countries with higher private domestic saving rates can sustain a higher level of debt to GDP and vice versa! (c) The demand conditions in the economy relative to potential supply.  An economy sufferring from lack of effective demand (virtually all advanced economies today), need to balance policy measure to ensure medium-long run debt reduction, with investment in public and quasi public goods in the short run to ensure effective demand.  If this is not done, growth will suffer and debt-GDP ratios will end up higher than they could be!  However, in economies suffering from excess demand (several Emerging economies today) and inflation, immediate fiscal (expenditure) contraction can allow a more relaxed monetary policy that will sustain growth and accelerate debt reduction.