TEH BIIG PIKCHUR: 2013 EDITION (PREVIEW)

[This post is still under construction]

Dear friends,

It’s been ages since I wrote a proper post; we’re long past apologies so I’ll just explain that both my professional and personal life have become a lot more demanding; staying up till 4 am is no longer an option. Still, I’m aware I’m letting some people down and those of you who follow on Twitter surely know there’s a lot I could be discussing here that I simply choose not to. Please don’t take this the wrong way.

Still, some things need to be committed to the blog. A longtime reader has written to me recently wondering whether it’s not time to update my old scenarios page, since the blog’s third anniversary, and the year 2013, were at the time nearly upon us. He’s right and I rather cherish the opportunity.

PART I – EUROPE AND THE WORLD

The global economy grew by about $8.8tn between 2010 and 2012, which means that despite slowing growth and significant amounts of money printing (and only modest deleveraging outside of the US and a couple of other countries) it’s still roughly in line to grow into its balance sheet by around 2018. It’s particularly remarkable, though not surprising, how muted deleveraging has been in Europe – even countries such as Greece are as laden with debt as ever, juggling it between the private sector (where it can be destroyed relatively easily) and the public sector (where it can be refinanced relatively easily). 

This will begin to change in 2013-14 as the laggards join the deleveraging party through private and sovereign defaults, 'voluntary' haircuts, bank resolution, fiscal austerity, and indeed whatever other means are available to them.

The Worst Decent Countries in the World

The hunt is still on for the Worst Decent Country in the World - a position once held by Greece, which ensures never-ending demand for one's bonds regardless of short-term changes in the fundamentals, until the country blows up of course. Essentially we're looking for a country within the 'magic circle' of sovereigns that are seen as unlikely to default, but also riskier than the rest of their peer group of the same credit rating. The combination of higher yields for the same capital charge under Basel makes these bonds irresistible to banks.

As you can see on the graph to the right, Chile is currently in the sweet spot among emerging markets, while Slovakia occupies the same position among European sovereigns and Australia and New Zealand are soaking up demand in the Pacific. I should note here that I'm using the best-of-three credit ratings of sovereigns as opposed to any individual rating or a mean or median rating because best-out-of-three ratings are more closely correlated with bond yields than any alternative - a consequence of Basel which still largely determines the dynamics of demand for sovereign debt.

The Eurozone dominos fall

Back in 2010 when I developed the first batch of scenarios, I predicted that France would begin to feel the pinch as early as in 2012. Last year I also said that France is to the Eurozone endgame as iron is to stellar death; it's the point at which all guarantees have been tapped out and any further collapse will result in an explosion. The reason for this is that Europe is effectively underwriting itself and its collective solvency is not guaranteed as some federalists would like to think.

Therefore, it doesn't matter what collective guarantees (ESM, EFSF etc) its leaders come up with - the only effect of such guarantees will be to focus attention on the ultimate guarantors (see here, here and here). The ultimate guarantors are in any case France and Germany, and they can't bail everyone out; but investors are slow to come to terms with such realities. They really want to believe in ultimate creditworthiness just like some people want to believe in an afterlife. Therefore the creditworthiness of France (as the weakest of the two) will be tested now, not in one flight of vultures but gradually in the coming 2 years - perhaps to its limits. 

I don’t believe I got the magnitude of my original prediction right: I warned of a humiliating downgrade and a significant rise in borrowing costs. Sure enough, France did get downgraded by Standard and Poor's in January and by Moody’s in November (triggering a downgrade of the ESM and EFSF) and was put on negative watch by Fitch in December. By the end of 2013, it will no longer have any AAA-rating left and will probably be on negative watch with at least one of the Big Three, while French politicians will be fuming about evil specuLOLtors and the like (why not? There are people out there stupid enough to advocate a European Credit Rating Agency). And I don't mean Max Keiser by the way - although any man who writes this kind of stuff while on Putin's payroll will surely have no problem with EU governments rating themselves? 

Contrary to my prediction, however, the market reaction to all of this has been minimal so far, with France still paying historically low interest rates on its debt, making this carefully timed piece by the Economist sound a bit shrill and, well, British. You see, as my yields-v-ratings graph above demonstrates, France's long-term debt is trading as though it had lost its AAA-rating anyway (see right; ratings source; yields source), hence the lack of excitement. 

Into the silicon core 

Just as with Greece, it takes more than just fundamentals to sink a sovereign; markets don't want to believe in sovereign defaults, and the bigger the sovereign, the bigger and more aggressive the denial. So you need a combination of domestic events and contagion of some sort - even Greece might have taken a while longer to blow without the Dubai default, the 2009 elections and government audit, or the 2008 riots. 

Now I'm less familiar with France's social dynamics than many readers, so I won't bother trying there. Just read this whenever you can. I’ll stick to contagion, and it just so happens that we now have a proper set of data to help determine who France is vulnerable to. The top exporters of bond yield contagion to France are Belgium, Austria, and the Netherlands, according to this excellent report by N. Antonakakis and K. Vergos (see cheat sheet below). I’ve ranked the three in order of contagion potential but also in reverse order of creditworthiness. Somewhere between these three is what one might call the silicon core of the Eurozone supernova - that last stage of fusion before iron and kaboom.

Contagion from Belgium to France is my most likely nightmare scenario, for many reasons. First, as the table to the right shows, Belgium is the non-PIIG most exposed to PIIG contagion. Second, it is one of the Euro sovereigns least able to raise taxes - Belgium can only raise about 1.8% of GDP more in taxes than it did back in 2010, according to Trabandt and Uhlig (2012), which I discuss here. 

Note, however, that according to these calculations, it will take real interest rates of 5.9% (or nominal of about 8.1%) to make Belgium insolvent - a long way off from today's below zero real rates, perhaps, but it took Greece just under a year and a half to cover this distance in basis points during our own sovereign debt crisis. I would say that, from the moment Belgium seriously hits the headlines, this is the amount of time it will take for France to be in trouble.

Finally, as you can see on the table to the right (source here), Belgium is up to its neck in bank guarantees – at 84.2% of GDP its guarantees are more extensive than Greece’s, or indeed any other European nation’s apart from those of Ireland and, oddly enough, Denmark. Famously, Belgium and France share an interest in the now-nationalised Dexia, with Belgium shouldering just over half of the bank's troubled assets and the repeated bailouts of the bank as well as underwriting its short- and medium-term financing. All this for a bank that still has more than a fifth of its credit risk exposure tied up in the PIIGS. Add these contingent liabilities to Belgium's debt and it doesn't look so sound anymore. Especially since it's about to go into recession.  And did I mention secessionist politics? And a recent history of being ungovernable? So there you go folks, Belgium is the link between France and the PIIGS and the link is about to tighten into a noose in the next two years. 

The plot, of course, thickens. As per our contagion cheat sheet above, any trouble in Belgium bad enough to truly reflect on France will first have to bounce off Austria - Belgium's no. 1 importer of contagion and incidentally France's number 2 source of contagion too. 

Recall that Austria, despite its generally healthy-ish financials, has more debt (as a % of GDP) in the hands of foreigners than Italy, which is why Italy keeps dodging the debt crisis bullet. Austria also has an additional problem - high exposure to Eastern Europe, where Austrian banks often dominate the market. So a perfect contagion storm will involve rising NPL rates in Eastern Europe coupled with sovereign debt pressure on Belgium, all of which could happen in 2013. Based on the latest data on non-performing loans, I'd say watch out for bad debt in Croatia and Romania. 

The Roadmap to Nowhere

2013-14 will be the years in which the EU's massive drive towards federalism hits a significant roadblock. By this I don't mean the usual cases of UK Euroscepticism or even the knee-jerk reactions of bailed-out countries. I mean a proper, mainstream current of integration skepticism. The beginnings of this were already evident in late 2012, when EU leaders delivered their road map to fiscal and economic integration.Check out the chorus of disappointment from federalists here and here, and an amazing analysis closer to my own heart from Protesilaos Stavrou here.

You see, apart from their dangerous assumption that Europe is collectively solvent, Europe's leaders and many of their cheerleaders are also mistaken in believing that a federal Europe would be seen as a saviour by the hard-pressed peoples of Europe.
I must concede that Europeans' desire for a faster-integrating 'Europe' has never been more ardent (see right), and it's important to note that this desire has risen fastest in the countries worst hit by austerity (see p. 70 here). This should be great news for federalists.


But in fact it isn't. For the first time ever, the European institutions have actually been unpopular in net terms since November 2011. And this isn't me talking, it's the Eurobarometer itself (this is also where the Eurodynamometer data for the first graph have come from). The interactive search tool provided by the EB website is a treasure trove of information but I particularly like the graphs to the right.

Anyway, the folks at Gallup have looked at the data in some detail in the latest edition of the Eurobarometer and seem clear that only France and Germany have registered marginal increases in faith in the European Institutions - and not all of them either.

So let me get this straight - people, especially in austerity-hit countries, want more Europe. In practice, though, more Europe is only ever delivered by more powerful European Institutions. But people, especially in austerity-hit countries, also want less of the European Institutions! Any guesses what it is that the Sainted People of PIIGland (and eventually other countries too) want?

Correct. They want money. Other people's money. The people will be sold 'Debt Relief Europe' and will end up with something completely different from what they were hoping for. Presumably armchair federalists  will queue up to explain how wrong this perception is and manage expectations? Probably not. They will campaign, as Prof. Varoufakis does, for the ECB to hoover up Europe's debt instead, and for the EIB and EIF to take up (and dramatically boost) its collective investment budget. As I'll explain later, I believe they'll see at least part of their wishes come true.

Rethinking austerity

Perhaps the biggest fiscal policy shift of 2012 was the IMF’s admission (right) that fiscal multipliers were much larger during recessions than it had assumed in the recent past – about three times as large in fact. One way of interpreting this is to say that ‘austerity doesn’t work,’ but I beg to differ.

First, it shows that any bubble sustained for long enough is bound to build a rent-seeking (and supposedly private) sector around it, much like a coral ecosystem will colonise the hull of a sunken ship. Second, it shows that countries with easy access to liquidity must take advantage of this luxury to adjust slowly – but not take it for granted and avoid adjustment. Essentially, fiscal slippage is a bit like Captain Hindsight – it reminds governments many years down the line that they should have made the tough calls earlier, when their economies were still growing.

Then again, high levels of both leverage and public sector spending mean that even very mild doses of austerity can plunge countries into recession – when further austerity presumably becomes unsustainable. The result is that it’s probably too late for most OECD countries to turn their public finances around – those that are not trapped in austerity are instead merely prisoners of their liquidity, until this runs out of course. 

To cross-reference this, it's useful to look at this excellent paper looking into the demand for 'developed' country sovereign debt, and particularly the two graphs on the right: 

Essentially, these suggest that are only four OECD economies in the world right now that are enjoying the dubious luxury of both maintaining very high levels of debt and delaying austerity - the US, the UK, Germany, and Japan. Even France has spent much of the last couple of years on the naughty step, although demand for its debt has since improved substantially.

The rest will just have to suck it up and keep cutting. However, they will probably learn from the examples of Greece and others that, while levying taxes is easier and quicker than cutting government spending, it must be avoided at all costs as the effects of tax hikes are much worse than those of cuts. In fact, the best experiments will likely be with a combination of cuts to both tax and spending - effectively returning more income to the private sector, as opposed to government or its debtors.

The figures below (presented here, an event in which I ended up replacing one of the speakers) show the level and content of consolidation planned by OECD countries from 2012 to 2015 – some of this will by now have come to pass, but most remains to be delivered. Note that the smaller the initial level of consolidation, the more countries have relied on spending cuts. But once a country tries to cut more than 2% of GDP per year – more or less – it becomes very difficult to deliver consolidation without relying significantly on tax increases too. And then, as readers will recall, there’s a limit to how much countries can tax too – Italy, for instance, simply cannot deliver the amount of tax revenue planned for 2015 no matter what the government does, so prepare for more fireworks. Essentially, austerity will both fail and triumph over the next two years. Country after country will join the club and country after country will see their best-laid plans succumb to fiscal slippage.

 

With austerity failing to reduce the debt burden in much of Europe, I believe the consensus is likely to shift in favour of better spending, not necessarily less spending. In particular, I believe that public investment will receive a substantial boost in austerity-hit countries, but tied to substantial conditionality. The rationale behind this is that, with monetary policy at its current super-accommodative levels, public investment provides better stimulus than public consumption (see meta-analyses of fiscal multiplier studies here and here). 

This is where Varoufakis and other Federalists will begin to see their wishes granted. In fact, the EIB has somehow seen fit to give us a recap of its support for Greece recently, while the EIF is thinking mostly in regional terms. This is in any case just the beginning. Together the two sister institutions have one of the last remaining AAA-ratings in Europe; they are going to use it.

The ECB capitulates

6 September 2012 will be remembered by many as the Day the Bundesbank Died. The novel Outright Monetary Transactions (OMT) mechanism effectively allows the ECB to buy unlimited amounts of Eurozone sovereign debt from the secondary markets, provided these purchases are sterilised through sales of other bonds. A very detailed roundup of the critical reception of OMT can be found here. I believe I can add three points to this.

First, I'm sure I'm not the first person to point this out but sterilisation is an aspiration; it depends on finding enough buyers for the bonds one is trying to sell, at the time when one needs to sell. More importantly, it's failed before and will fail again, except on a larger scale. When it does, the markets will smell inflation.

Second, if the OMT is anything like the ECB's previous bond market operation, the SMP, then it could fail to work in the manner described. Remember, the ECB is not trying to finance sovereigns though bond purchases, hence its commitment to staying within the secondary market. The OMT is, rather, supposed to fix securities markets enough for the ECB to be able to do its job. You see, that was the idea behind the SMP too. Its explicit purpose (see here too) was to restore the monetary policy transmission mechanism by 'addressing the malfunctioning of security markets' through additional liquidity. R-iiiight. Importantly, as the Eurosystem is, after all, made up of the national central banks, this meant that it was up to them to purchase as they saw fit.

Unfortunately, a recent evaluation shows that this was not the way purchases really worked. . It wasn't liquidity that drove purchases, the researchers say: it was yields. Yields explained 85% of the variation in purchases. Here's what they have to say about this, in detail:

"We conclude that the ECB applied rather simple “rules of thumb” when purchasing Greek sovereign bonds. Most notably, it focused on bonds with larger outstanding volumes and higher yield spreads. In contrast, bond liquidity does not seem to be systematically related to bond purchases. Our findings also suggest that ECB bond purchases had a large causal effect on the yield spreads of the bonds that it purchased. These findings may be relevant for policymakers, as well as for investors currently holding distressed bond of Eurozone  peripheral countries."

So, essentially, the ECB was targetting its purchases in order to increase the prices of PIIGS bonds. Simple.

But there is a bigger problem here, which I don't think many people have pointed out. Unless the ECB is very careful, sterilisation could itself exacerbate sovereign risks. Bear in mind, the ECB can only purchase the debt of a bailed-out country under the OMT. So suppose Belgium asks for assistance. Given what we now know about the France-Austria-Belgium triangle, the ECB would never try to sterilise Belgian bond purchases with sales of French or, even worse, Austrian debt, because that would drive up their yields and end up pushing Belgian bond yields back up. Of course it would presumably never sell PIIGS debt (no buyers, very bad politics, the list goes on), although that's arguably what it should do, to minimise the amount of contagion back to Belgian bonds. It can only sell Core country bonds, and preferably those of a big sovereign with fairly liquid bonds. If, on the other hand, it relied on countries like Germany too much for its sterilisation practices, it would face an outcry. So it's France to the rescue again, with a hint of contagion spilling back out to Belgium but also to the rest of the Eurozone. To cut a long story short, the ECB would effectively have to save peripheral countries at the terrible price of weakening the already weak guarantees holding the Eurozone together. Good luck with that.

PART II: GREECE

Greece is no longer a problem - everyone else is

One consequence of the findings of Antonakakis and Vergos (2012) is that Greece is now broadly insulated from the rest of Europe, with bond yield spillovers from Greece to the rest of Europe and vice versa at truly minimal levels.  In fact, the countries that are both most vulnerable to Euro-contagion and best placed to contaminate Europe right now are Belgium, Italy and Spain, in that order.

Put simply, none of the things happening in Greece are now likely to create contagion in Europe. This is because Europe now has a plan for fiscal consolidation, a safety net of sorts for sovereigns and banks and a banking union underway, as well as a more activist Central Bank than people would have expected a year ago.