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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.
1. IMF: 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. This is highly deflationary.
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. This is highly deflationary.
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. European 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. This is highly deflationary.
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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