Europe’s debt-de­fla­tion dy­namic

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Amid all the talk of con­ta­gion and demon­stra­tion ef­fects em­a­nat­ing from Athens, there is a straight for­ward ques­tion that con­cerns in­vestors whose do­main spreads be­yond the lap­ping shores of the Mediter­ranean: is the Greek cri­sis, at its root, in­fla­tion­ary or de­fla­tion­ary? Given talk of new cur­ren­cies be­ing launched, the ob­vi­ous fear con­cerns in­fla­tion.

We would de­mur and sug­gest that a de­fla­tion­ary shock is un­fold­ing. This mat­ters es­pe­cially for in­vestors who are run­ning large fixed in­come po­si­tions. To be­gin with, con­sider a few facts: - Greece has for­eign debt of EUR 315 bln with 75% due to public in­sti­tu­tions.

- This debt is val­ued at face value since de­fault to public in­sti­tu­tions is not per­mit­ted.

- This debt is owned by the In­ter­na­tional Mon­e­tary Fund, the Euro­pean Cen­tral Bank and a syn­di­cate of Euro­pean na­tions.

Let’s con­sider these three in­sti­tu­tions and the im­pact that a “bad out­come” in Greece will have on their oper­a­tions.

It lent more to Greece than it has ever ad­vanced to a sin­gle state. As­sum­ing this ex­po­sure is writ­ten down by 50% then the IMF will face a dent in its cap­i­tal po­si­tion and may need to ask its share­hold­ers for a fresh in­fu­sion. The US re­tains a veto over de­ci­sions af­fect­ing the Fund’s cap­i­tal struc­ture, with this con­trol ex­er­cised by Congress. Given that the IMF has for years been badly run by anti-Amer­i­can French tech­nocrats, we’re sure that re­quest will go down well! As a re­sult, the abil­ity of the Fund to in­ter­vene in the next cri­sis has been se­verely cur­tailed—no more lines of credit to be of­fered against “good be­hav­iour”. The “Washington con­sen­sus” re­ally is dead and buried.

1. IMF:

2. ECB:

It is prob­a­bly the big­gest bag car­rier for Greek ex­po­sure. In the event that Athens de­faults, even par­tially, the re­sult will be to wipe out the ECB’s cap­i­tal base. Then a whole se­ries of tricky ques­tions will arise: must the cen­tral bank boost its cap­i­tal, or can it op­er­ate with a neg­a­tive cap­i­tal po­si­tion? And if it does op­er­ate with neg­a­tive cap­i­tal, will its board mem­bers be per­son­ally li­able should a new prob­lem emerge? It should be re­called that the ECB’s cap­i­tal is owned by cen­tral banks within eu­ro­zone mem­ber states. As a re­sult, any ECB re­cap­i­tal­i­sa­tion may re­quire mem­ber states to pony up for their own cen­tral banks. We can­not imag­ine much en­thu­si­asm at the Bun­des­bank, which will face an ad­di­tional hit due to its Tar­get 2 cred­its that are at­trib­ut­able to Greece. This would amount to the Ger­man tax­payer fund­ing another coun­try, which is pro­hib­ited by the coun­try’s con­sti­tu­tion.

3. Euro­pean na­tions and in­sti­tu­tions:

The al­pha­bet soup of in­sti­tu­tions and lend­ing pro­grammes cre­ated by those ever so smart euro­crats to help fi­nance Greece all amount to the same thing: these en­ti­ties are highly rated by the big rat­ings agen­cies and have is­sued lots of bonds bought by the world’s ma­jor fi­nan­cial in­sti­tu­tions. Un­for­tu­nately their as­sets are mostly parked in Greek pa­per, with a small amount of Span­ish and Por­tuguese bonds thrown in for good mea­sure. If en­ti­ties such as the Euro­pean Fi­nan­cial Sta­bil­ity Fa­cil­ity face the prospect of as­set im­pair­ment, might it be that bond­hold­ers launch law­suits against its share­hold­ers, i.e. E u r o p e a n gov­ern­ments? Quite quickly, the mar­ket would need to wres­tle with the real mean­ing of an “im­plied guar­an­tee” as it did with Freddy Mac and Fan­nie Mae dur­ing the 2008 fi­nan­cial cri­sis.

More­over, the ques­tion would arise of whether that part of Greece’s debt—di­rectly owned or guar­an­teed by Euro­pean na­tions—should be added to the global stock of gov­ern­ment debt? Such an even­tu­al­ity will grab the at­ten­tion of debt rat­ing agen­cies, which will likely clamor for more tax hikes and gov­ern­ment spend­ing cuts.

Per­haps the post-WW2 Bri­tish for­eign sec­re­tary, Ernest Be­van, put it best when com­ment­ing on the thorny ques­tion of how the nascent Coun­cil of Europe should ex­pand: “If you open that Pan­dora’s Box, you never know what Tro­jan horses will jump out.”

The prob­lem is that the week­end vote in Greece is likely to de­stroy the im­pro­vised le­gal struc­ture that was adopted as the euro cri­sis has mor­phed over the last five years. This process is likely to be highly de­fla­tion­ary just as it was in the 1930s when Irv­ing Fisher de­tailed the dy­nam­ics of a long term “debt-de­fla­tion”. We would ad­vise in­vestors to start ex­tend­ing the du­ra­tion of their US bond po­si­tions.

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