Bro­ken trust...

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

Peo­ple are more likely to change their spouses than change their banks. The Greek cri­sis has tested this adage to the limit. For five years now, Greek banks have en­dured a “bank jog” of de­posits out of the do­mes­tic bank­ing sys­tem and into mat­tresses, for­eign ac­counts and even bit­coins. Amaz­ingly, how­ever, some EUR 130 bln in house­hold and busi­ness de­posits have stayed put. But when Greek banks re­open, who can doubt that the jog will turn into a run, or even a sprint?

If only a quar­ter of Greek de­pos­i­tors were to de­cide that keep­ing cash in in­sti­tu­tions li­able to be frozen for two weeks at a politi­cian’s whim is not for them, that would mean EUR 32.5 bln head­ing for the door. Mean­while, Greek banks have less than EUR 2 bln in cash at hand, ac­cord­ing to one re­port, which raises the ques­tion: how can the Greek gov­ern­ment con­ceiv­ably re-open its banks?

There are two pos­si­ble an­swers:

1) The Greek gov­ern­ment can­not re-open its banks in any nor­mal sense.

In­stead, Greece will have to fol­low the trail blazed by Ice­land and Cyprus of en­forc­ing cap­i­tal con­trols and lim­it­ing with­drawals. In both economies, such bank con­trols con­trib­uted to a sub­se­quent de­cline in GDP of al­most dou­ble digit mag­ni­tude. Strin­gent con­trols on the move­ment of cap­i­tal would surely have sim­i­lar con­se­quences in Greece. Add ex­treme fis­cal tight­en­ing—a mas­sive in­crease in value-added tax, and deep cuts in pen­sion ben­e­fits cou­pled with an in­crease in re­tire­ment age—to the mix, and it is hard to see how the com­bi­na­tion of cap­i­tal con­trols and tighter fis­cal pol­icy could do any­thing for Greek growth but trig­ger another col­lapse, ren­der­ing all fore­casts for tax re­ceipts and debt re­duc­tion in­valid. This sim­ple re­al­ity helps ex­plain the re­luc­tance of Europe’s pol­i­cy­mak­ers (or at least the eco­nom­i­cally lit­er­ate ones, which ex­cludes Fran­cois Hol­lande) to sign up to a plan that Greece would be ut­terly in­ca­pable of de­liv­er­ing.

2) Euro­pean pol­i­cy­mak­ers ask the Euro­pean Cen­tral Bank to back­stop Greece, pro­vid­ing Greek banks with un­lim­ited fund­ing.

In this sce­nario, it is likely that be­tween EUR 25 bln and EUR 50 bln would flow straight from the ECB’s print­ing presses into Greek pock­ets via Greek bank tell­ers. Hav­ing taken ad­van­tage of ECB liq­uid­ity to mon­e­tise a siz­able por­tion of Greece’s sav­ings, the Greek gov­ern­ment would then be free to leave the euro at a greatly re­duced cost—hardly a palat­able op­tion for Europe’s politi­cians.

In terms of their ca­reer prospects, the first op­tion—in essence “ex­tend and pre­tend”—is the least risky for the EU’s Euro­crats. Yes, it would con­demn Greece to many more years of eco­nomic stag­na­tion, just as it would con­demn the Euro­crats to more late night meet­ings in Brus­sels and Frank­furt over hol­i­day week­ends when ev­ery­one would rather be at the beach. But it would keep the show on the road for ev­ery­one else, and would not cause mas­sive dis­rup­tion (out­side Greece). Con­versely, the sec­ond op­tion— throw­ing a lot of good money af­ter bad—risks leav­ing pol­i­cy­mak­ers with egg on their face should Greece then de­cide to quit the euro in three to six months time. If Greece were to leave, who would want to be the fi­nance min­is­ter that signed off on the last line of credit worth tens of bil­lions of eu­ros?

All of which brings us to the ti­tle of this ar­ti­cle: “Bro­ken Trust”.

To­day, not only is the trust of the Greek peo­ple in their do­mes­tic fi­nan­cial in­sti­tu­tions com­pletely bro­ken—and with­out trust, it is hard for cap­i­tal­ism to func­tion, be­cause cap­i­tal gets hoarded in­stead of be­ing al­lo­cated. As we clearly saw over this week­end, the trust be­tween Euro­pean gov­ern­ments is also se­verely com­pro­mised. In turn, this raises the ques­tion: How long will for­eign in­vestors re­tain their trust in the euro as a sta­ble store of value?

Op­ti­mists ar­gue that an “ex­tend and pre­tend” so­lu­tion that al­lows the cur­rent show to re­main on the road is the most likely sce­nario. More­over, with few for­eign in­vestors over­weight eu­ro­zone as­sets, while ev­ery­one is over­weight the US dol­lar, such an out­come is likely to prove bullish for the euro in the near term. As a re­sult, the con­trar­ian trade would be to buy the euro and Euro­pean risk as­sets on the premise that the Euro­peans will once again man­age to “get it to­gether”.

Against that, the sorry spec­ta­cle of­fered to for­eign in­vestors over the past cou­ple of weeks and the con­tin­ued break­down in trust should, at the mar­gin, put more pres­sure on the ECB as the one func­tion­ing Euro­pean in­sti­tu­tion to get even more in­volved, and to print money ever more ag­gres­sively. All else be­ing equal, over time this should lead the euro lower.

So, per­haps the sin­gle most im­por­tant ques­tion for global in­vestors be­comes whether the euro’s March low of EUR 1.05 to the US dol­lar gets taken out. If it does, par­ity be­fore the year’s end will be­come a re­al­is­tic tar­get, with re­sult­ing im­pli­ca­tions for US Fed­eral Re­serve pol­icy tight­en­ing, the Nikkei’s out­per­for­mance, eu­ro­zone bond yields, etc.

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