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May 26, 2012

Daily Photo: San Giorgio

Greece Exit Scenarios

From Zero Hedge:

Scenario 1: Managed Greek exit; no contagion or financial market disorder
This is the most benign scenario with respect to a Greek exit, assuming away the major contagion risk. There is likely to be short term euro weakness, but a sharp initial sell-off would be deceptive and the weakness would be relatively brief once the contagion fears wore off. 
Some argue that the euro would rally strongly off this development, arguing that the euro ex-Greece would be much stronger than the euro with Greece. This positive scenario would be a world in which the risk premium on other euro countries has been largely determined by the fear of contagion from a GREXIT, not issues related to other peripherals themselves. Once GREXIT occurred without damage, whether on its own or because of policy commitments, spreads would narrow and the euro would rally.
Absent such an unwinding of knock-on risk on other peripherals, the arithmetic of the euro zone divesting itself of the Greek 2% of the euro zone facing a major depreciation is not very exciting. If the new Greek currency depreciated 50% (a very round number), the implied boost to the surviving EUR with its stronger components would be about 1%, basically it’s overnight move.
The above is a very optimistic reading of what is driving peripheral spreads in other euro zone countries. If the concerns reflect risk associated with national debt in other peripheral countries, not primarily Greek contagion fears, then even if the fears abate, the fiscal concerns on remaining peripherals would prevent a major appreciation. So this benign scenario does not seem the most likely scenario by any means, nor is it likely that the euro’s problems are as Greece-centric as needed to make the euro outcome play out as described. That said, if the benign scenario plays out, EURUSD could rally significantly from current levels, trading closer to 1.45 or higher, but it just doesn’t seem very likely.
Scenario 2: Greece exits, contagion spreads to other peripherals
Greece repudiates the austerity of bailout and exits the euro zone. Contagion spreads to other peripherals.
This scenario entails months of profound economic and financial confusion during which the euro would be under constant pressure in our view. How the euro evolves depends on how euro zone policymakers deal with contagion risk and that depends on the post-departure policies that are followed.
Substantial euro downside could emerge from investor fears that other peripheral countries in the euro zone would drop out, raising the risk premium on their debt, and making it even less possible to hit fiscal and economic growth targets. A Greek dropout could be viewed as unfortunate but manageable, if the euro zone disintegration was viewed as stopping there at Greece, but the risk is that investors come to expect that other countries will follow. Such countries would experience the worst of all worlds, austerity, a risk premium that now builds in additional currency risk, but no control of exchange rate or monetary policy and no growth. Investors in that case would speculate that the cost of staying in the euro was too high for other countries as well.
The way to avoid this contagion and downward pressure on the euro would be to provide an absolute, non-conditional guarantee that no other country would drop out. This would be a spectacular transformation -- an ECB that is unwilling to act like the Fed morphs into the SNB.
Moreover, some clients have raised the possibility that investors would not believe even such a guarantee – at least not initially. They would argue that the example of Greek depreciation would induce even Mom and Pop in other peripheral countries to shift their deposits to Germany, the UK, the US or Switzerland because the downside from doing so if other peripherals do not drop out is low, and the downside from not doing so if there are further dropouts is tremendous. At a minimum this provides a big hole in peripheral banking systems that would have to be filled by the ECB – probably involving the ECB in far more open-ended risk than they have shown a willingness to take. It is unlikely that all the deposits would go to Frankfurt, so there is probably some direct downward pressure on the euro involved. The final element of the argument is that investors and residents will fear that the ECB can not bring itself to make such a permanent and potentially very expensive contingent commitment.
The EUR could begin to rally if the euro zone manages to ring-fence the other peripherals but so much damage will have been done by then that the EUR would begin its rally from a much lower level and probably not be anywhere close to the current level at the end of the year.
The optimistic view on contagion is that the ECB would not actually have to take on the risk if the commitment was ironclad enough. But if there is any degree of skepticism or if the ECB showed any hesitation, the risk-return would be in favor of capital flight and the euro would fall sharply and the ECB would face additional balance sheet risk. 
This is the problem that the euro faces on any dropout scenario, Even a small country dropout that has limited direct financial and economic implications for the euro zone could raise the stakes enormously with respect to other countries. Whether the euro goes up or down depends on whether the euro zone policymakers can bring themselves to make the needed open-ended commitment and convince the market that they will stick to it thick and thin even if the price tag rises. Given their inability to achieve timely consensus on policies that would have averted the pressures and been much cheaper, investors are likely to sell euros until fully convinced of policymaker resolve.

Scenario 3: Multiple peripheral countries exit, core remains
Our economists do not see this as a high probability scenario, but it is certainly discussed by FX investors. This is the scenario in which the likely dynamics of exit conflict the most with the long-term equilibrium. Define the long term as the point at which economies and exchange rates have moved back to their long-term equilibrium path. The euro of the surviving core will likely be stronger than its predecessor euro was. Consider that the deficit, debt and external balances will be much stronger than with the current euro. So one can make the case that the long term equilibrium value of this ‘core’ euro is much stronger, possibly even at the highs that were seen in 2008.
However, the short and medium term may last for an extremely long time and the dynamics over that period are very negative, not just for the peripherals that drop out but for the core that remains in. Consider that the peripheral countries are likely to drop out one by one, probably accompanied by economic and financial disruption. The impact will be felt on core economies and financial institutions as well, so whatever the long-term equilibrium, the path there will likely be accompanied by economic weakness at least until a stable core is formed and a path to recovery is envisioned – this can take a very long time and is probably well beyond an investible horizon. The high cost to both the dropouts and the remaining core countries is one reason that this is considered such an unlikely scenario.

Scenarios that boost the euro.
Only the first scenario above has a euro positive component relatively quickly after the Greek exit is realized and the probability is low that investors will look as benignly on the event as the scenario implies. 
The characteristics  that each of the euro-negative scenarios share is that each reflects an augmentation of euro zone risk. Even if the risk is accompanied by a relatively hawkish ECB perspective, the euro falls because investors are focused on the deep risks associated with euro breakup rather than marginal, and probably unsustainable, gains from a hawkish ECB.. The argument we would make is that global investors will cut the euro a lot of slack if extreme tail risk can be eliminated, even if the outcome involves a bigger balance sheet or other unorthodox policies.

Scenario 4: New Greek government embraces austerity plan
We are not so naïve as to think they would actually embrace austerity, but by accepting the plan, they would relieve investors of concern in the short term of a messy default, bank runs and immediate financial crisis. Investors would not necessarily view this as a good outcome objectively, but as a better and much cheaper outcome than the alternative of messy default and Greek euro zone withdrawal. Essentially a continuation of the status quo, the question is how long a period of tranquility such a compromise would buy. If investors are jaded and view it as a very short term patch before renewed strife the bounceback in the euro would be limited.

Scenario 5: ECB bond buying or Eurobond
Both of these take a step towards resolving what is a major failure of monetary policy in the euro zone -- Interest rates are simply too high. A GDP –weighted average 10year yields of non-program euro zone countries is more than 150bps higher than in the US or UK. This effective tightness of monetary policy is hardly justified by upward inflation or growth risks.
Were the ECB to buy bonds aggressively it is unlikely that investors would fight the ECB. Were the fiscal authorities to jointly issue an Eurobond, it is likely that core yields would go up and peripheral yields down – exactly the rate redistribution required to stimulate activity in the periphery and support their asset markets. This is likely to reduce tail risk and support the euro.
Looking at these two scenarios, it seems far more likely that the SMP buying will be renewed than the governments coming together and issuing an euro bond in the near term. It seems far more likely that the trillion EUR balance expansion of the ECB since mid-2011 would have been more effective buying cash bonds than operating through the LTRO.
Having put forward these proposals, we have to admit that they seem less likely than the ECB making an effort at reviving confidence by a bog standard rate cut or an additional LTRO. The political opposition to these measures means that even though they are likely to be the most effective in resolving the crisis, they are unlikely to be the first (or second) applied.

Scenario 6: LTRO or rate cuts
It seems unlikely to us that the euro zone’s underlying problem is that the refi rate is 1% rather than 0.5%, or 1.5% for that matter. A rate cut could be seen by the market as some sort of signal that further aggressive easing was coming, but by itself it seems more likely to stimulate activity in Germany than Spain. Nevertheless, it is possible that the cut could come and that the euro could even rally if the cut was viewed as complementary to other policy actions that euro zone policymakers were planning. If the cut was viewed as a substitute for more effective measures, the euro would probably resume its fall, possibly even accelerating in its decline. To paraphrase Crosby, Stills, Nash and Young – if you can’t use the policy that works, work with the policies you have. But the euro is hardly likely to respond positively.
Similarly, a third LTRO would tread a familiar path. So far, the two earlier LTROs have eased borrowing costs at the short end and led to a shortening of duration by peripheral issuers. An LTRO with a significantly longer maturity might encourage euro zone financial institutions to buy longer dated government bonds and bring down long term interest rates.  The first two helped stabilize and reduce bond yields temporarily but now they are back to where they were in the bad old days of November 2011, although not at the very peak of the crisis.
One reason the first two LTROs did not trigger a sustained drop in peripheral funding costs was the intensifying deposit flight which added to banks’ funding issues. We suspect that a pan-euro zone deposit guarantee, funded by the EFSF or ESM, could enhance the effectiveness of any future bouts of ECB lending as it will limit the outflow of bank resources. That being said, however, so far there is not much appetite for a Europe-wide safety net with the countries of the core reluctant to bankroll bank liabilities in the periphery. Moreover, the potential losses are extremely high if any country were to leave the euro zone and any country left out would almost be guaranteed to experience significant capital flight. If it could be implemented credibly (say with an ECB backstop) then the effectiveness of LTROs would not be undermined by deposit flight and banks might become more aggressive bidders for their sovereign's debt.
Potentially this could ease strains within the euro zone and generate both a global and euro zone risk rally, but to be implemented credibly would require a similar open-ended commitment to those discussed above, and such commitment have been hard to extract from euro zone policymakers.

Concluding remarks
Approaching a second round of Greek elections potential scenarios leave the balance of risks pointing towards a weaker EUR. In the long run, while there may be more favorable equilibriums, the path there we suspect will be very painful. At this stage a mixture between scenarios 2 and 6 seems most likely, with 1 a possibility on the outside – not very promising for the EUR unless policymakers surprise with decisiveness.

Eurozone Capital Flight

Citi' analyst Matt King has been monitoring the situation of bank assets in Europe and his results are most disturbing: "In Greece, Ireland, and Portugal, foreign deposits have fallen by an average of 52%, and foreign government bond holdings by an average of 33%, from their peaks.
The same move in Spain and Italy, taking into account the fall that has taken place already, would imply a further €215bn and €214bn in capital flight respectively, skewed towards deposits in the case of Spain and towards government bonds in the case of Italy.
Economic deterioration, ratings downgrades and especially a Greek exit would almost certainly significantly accelerate the timescale and increase the amounts of these outflows.

Below a summary of all the less than pleasant capital flows out of Europe's periphery.

 How far is the flock likely to run? In Greece, Ireland, and Portugal, foreign deposits have fallen by an average of 52%, and foreign government bond holdings by an average of 33%, from their peaks (Figure 18). The same move in Spain and Italy, taking into account the fall that has taken place already, would imply a further €215bn and €214bn in capital flight respectively, skewed towards deposits in the case of Spain and towards government bonds in the case of Italy (Figure 19).

Although large, if these flows occur slowly enough, they might not represent a major problem. After all, Portugal’s banks have managed to replace fleeing foreign deposits with domestic ones, and ECB repo should allow a further ramp-up in banks’ holdings of government bonds.

But we think the risks are skewed towards larger outflows occurring considerably more rapidly. Admittedly there are a great many unknowns, including the potential policy response. But none of these estimates allow for the possibility of domestic deposit flight. In the case of a Greek exit from the euro, that outcome seems highly likely. Nor is there any sign that the flight from Ireland and Portugal is diminishing (if anything, we expect the opposite).11 Moreover, banks’ appetite to buy further government bonds may prove limited if they start to suffer deposit flight – and all the more so if they suspect that deposit flight stems in part from their holdings of government bonds
Once the run (either bond or bank) starts, there is no stopping it:
Above all, though, we think capital flight, like so much in markets, is a self-reinforcing process. Provided other depositors and bondholders are grazing quietly, there is no reason to run. But as risks come ever more into the spotlight – whether through the TARGET2 imbalances, benchmark shifts or the threat of EMU exit in Greece – the unattractiveness of the risk-reward becomes ever more obvious.
What is the only possible outcome that will prevent this virtually catastrophic outcome?
To our minds, capital flight will stop only once there is decisive policy intervention. The longer investors have to wait for this, the more decisive it will need to be. Even a Euro area-wide deposit guarantee scheme might struggle to be credible if investors fear the incentives for redenomination are strong enough... Quite simply, investors in ‘safe assets’ need to be reasonably sure they will get their money back. Foreign investors in peripherals can no longer be sure of that.

OECD Better Life Index

The OECD's Better Life Index has been updated with some great new features. Worth checking if you want to compare countries and demographics on a vaste array of indicators.

Catolonia asking urgent bail-out to Madrid

News from Spain are becoming every day more surreal and worrying, if Bankia bailout was not enough cause for concern, now Catolonia the most prosperous region of Spain is asking for help to the central Spanish government. For those not accostumed with Spanish politics this is a major event. Catolonia has always been together with the Basque country at the forefront of a nasty fight to get independent from Spain or at minimum to gain exceptional autonomy in handling their affairs, to go back to Spanish central government begging for help can only be justified by a serious deterioration of the country finances, certainly the situation must be dire enough for Catalans to put aside their pride and ask help to the odious Madrid central government. Keep checking the Basque country if they will do the same than Spain is in real danger.

From Reuters:
Spain's wealthiest autonomous region, Catalonia, needs financing help from the central government because it is running out of options for refinancing debt this year, Catalan President Artur Mas said on Friday.

"We don't care how they do it, but we need to make payments at the end of the month. Your economy can't recover if you can't pay your bills," Mas told a group of reporters from foreign media.

The debt burden of Spain's 17 highly devolved regions, and rising bad loans at the country's banks, are both at the heart of the euro zone debt crisis because investors are concerned they could strain finances so much that Spain, the currency bloc's fourth biggest economy, will need an international bailout.

Catalonia, which represents one fifth of the Spanish economy, has more than 13 billion euros in debt to refinance this year, as well as its deficit.

All of the regions together have 36 billion euros ($45 billion) to refinance this year, as well as an authorised deficit of 15 billion euros.

Last year many of the regions financed debt by falling months or even years behind in payments to providers such as street cleaners and hospital equipment suppliers.

This year the central government provided them with a special credit facility from the Official Credit Institute, or ICO, to pay providers, of which Catalonia has taken 2 billion euros.

The provider credit lines from the ICO run out in June and the central government has pledged to come up with a new mechanism for backing debt from the regions, which have been mostly priced out of international debt markets since the Greek rescue in 2010.

Catalonia's Mas, from the centre-right Convergence and Union Party, said he is running out of options. In the past two years Catalonia has placed patriot bonds, at 4.5 percent to 5.0 percent, but he says the capacity for the people of the region to buy such bonds is at its limit.

A quarter of all Catalan savings are already in patriot bonds, he said.

The other option would be short-term financing from banks, but Catalonia's neighbour, the region of Valencia, recently paid 7 percent for a six-month loan, a level seen as unsustainable.

Catalonia's annual interest payments have already doubled in the last two years, to 2 billion euros this year.

Eurozone Debt Infograph

May 20, 2012

Daily Photo: La Fontana

Volcanoes eruptions that could change the world

Recent new of an increased activity of the Santorini Caldera is certainly bad news for crisis-stricken Greece although an eruption of Santorini as tragic as it would be for Greece and the Mediterranean is not the worst event to worry insurance companies and governments.
Below a list of the 6 nightmare volcanoes that could literally trigger catastrophe on a global scale in a relatively short timeframe.

1. KATLA (Iceland)
Last erupted: 1918
Effects of a major eruption: If Katla goes off, its eruption will be 10 times stronger than Eyjafjallajokull's. Katla's larger ash plume would shoot higher in the air and spread over larger areas of Europe for a longer period, with much more devastating effects on air travel and economic trade. An eruption could tip Europe's economy — perhaps even the world's — back into severe recession or a depression.
Likelihood: Fairly high. The two volcanoes, only 12 miles apart, tend to erupt in tandem, and Katla is slightly overdue in its 80-year cycle.
2. CUMBRE VIEJA (La Palma, Canary Islands)
Last erupted:
Effects of a major eruption: In 2001, U.S. and British scientists warned that a major eruption of Cumbre Vieja could cause the enire western flank of the volcano to fall into the sea, creating a "mega-tsunami" in the Atlantic. Traveling at 500 miles per hour, it would wipe out Florida, coastal Brazil, and parts of Europe with waves up to 160-feet high. 
The scientists say the "year to year probability" of a major eruption is low, but preparations should be taken anyway given the potentially cataclysmic damages.
3. MT. VESUVIUS (Italy)
Last erupted: 1944
Effects of major eruption: Famous for wiping out Pompeii and Herculaneum in 79 A.D., Vesuvius would do much greater damage today. About 3 million people live near the volcano, 600,000 of them in the "red zone." An eruption would kill at least 8,000 people and cause more than $24 billion worth of damage, according to Willis Research Network, which just named Vesuvius the most dangerous volcano in Europe. The ash would change weather patterns in Europe and leave the Naples area a "lifeless desert."
Likelihood: Scientists say Vesuvius is overdue for an explosion.
Last erupted: 2000
Effects of a major eruption: The third-tallest active volcano in the Northern Hemisphere, Popocatépetl is only 40 miles west of Mexico City and its 18 million inhabitants, and 30 miles east of Puebla, a city of two million. A large eruption could send deadly mudslides into the populous valleys below, creating "catastrophic" loss of life.
Likelihood: After an 80-year dormant period, Popocatépetl is showing signs of activity.
5. MT. TAMBORA (Sumbawa, Indonesia)
Last erupted: 1967
Effects of a major eruption: Tambora erupted in spectacular fashion in 1815 and changed weather patterns around the globe, causing "frosts in Italy in June and snows in Virginia in July, and the failure of crops in immense swaths across Europe and the America." The blow-up killed more than 71,000 people directly, and many more through famine and sickness.
Likelihood: Tambora is still active and, given its history and Indonesia's 222 million inhabitants, closely monitored.
Last erupted: 640,000 years ago
Effects of a major eruption: When the Yellowstone Caldera, or "supervolcano," in Yellowstone National erupts again, it will render a huge swath of North America, from Vancouver to Oklahoma City, uninhabitable. It would have incalculable human and economic consequences. The last eruption of similar magnitude — 73,000 years ago in Sumatra — plunged the entire planet into a decade-long volcanic winter and nearly wiped out the human race.
Likelihood: Geologists see signs that it could be preparing for another major blowout soon, although "soon" could mean thousands of years.

May 16, 2012

Daily Photo: Valletta Library

Housing Crisis Visualized

Will America Ever Recover From The Housing Crisis

Greece banking system is officially bankrupt

The latest opinion polls, as per Credit Suisse, show Syriza soar from 52 seats to a hugely dominant 128 seats.

Greece After Elections - current opinion polls...

Just few hours ago this was the biggest danger to the Eurozone a left party willing to reject the current status quo and repudiate previous contracts.
But things have been moving fast and ECB President Draghi just admitted that while the ECB Governing Council would like Greece to stay, they will not take any further extraordinary measures to save it.

Bloomberg: Draghi Signals ECB Won’t Keep Greece in Euro Area at Any Cost
European Central Bank President Mario Draghi indicated that while his “strong preference” is that Greece stays in the euro area, the bank won’t compromise on its principles to prevent an exit.

The ECB will continue to comply with the mandate of keeping price stability over the medium term in line with treaty provisions and preserving the integrity of our balance sheet,” Draghi said in a speech in Frankfurt today. Since the euro’s founding treaty does not envisage a member state leaving the monetary union, “this is not a matter for the Governing Council to decide,” Draghi said.

The comments are the closest Draghi has come to conceding Greece could leave the euro region. Greece faces a fresh election on June 17 that may boost parties opposed to the conditions of its international bailouts, raising the specter of its exit.

“The Governing Council’s strong preference is that Greece will continue to stay in the euro area,” Draghi said.

What does it mean it became just to clear when Reuters came out with the following piece of news:

From Reuters:
The European Central Bank has stopped monetary policy operations with some Greek banks as they have not been successfully recapitalized, euro zone central bank sources said on Wednesday.

The ECB declined to comment.

The ECB only conducts its refinancing operations with solvent banks. With no access to ECB funds, the banks concerned must go to the Bank of Greece for emergency liquidity assistance (ELA).

It was unclear exactly how many banks were affected.

One person familiar with the matter said four Greek banks' capital was so depleted they were operating with negative equity capital. According to its own rules, the ECB cannot provide liquidity to banks in such a situation.
What it means is that we are practically witnessing an attempt to control the default of Greece and the bankruptcy of its banking system which in a matter of hours or days unless by hook or crook something is implemented will happen.

Greece cannot bailout its banks, we are facing a total collapse of a banking system unless a sudden injection of money will materialize from somewhere.

Eventful days worth being monitored closely not only for Greece but for the entire world economy.