External balance sheet interdependence

In the previous post I stated that gross external financial positions were not a problem if they proceeded at a fundamental pace and if countries accepted that they cause greater interdependence. However when they proceed precipitously, like in the case of Cyprus, they are a cause of concern.
There can be other causes than sudden inflows and outflows to precipitous changes in the external gross assets-liabilities positions. For example the adoption of a new currency. Take Germany, a large net external creditor of the euro-area, and assume it changes currency and adopts the Thaler. As a benchmark consider the case where only residents use the Thaler and all non-residents have a different currency, euro, dollar, yen, etc etc. The figure below from the Bundesbank shows the external position of Germany (GDP is around 2600 €bn). The figures are different from those in Eurostat who reports for Germany a 6100 €bn  asset position and 5000 €bn liability position for 2012. In any case Germany is a net creditor when assets and liabilities are valued in euro. With a change in currency there can be three possible cases:

1. the Thaler exchange rate with the euro is fixed at 1:1, in this case nothing substantial changes in the balance sheet,
2. the Thaler exchange rate with the euro (and all other currencies) is above parity (devaluation of Germany), in this case the value of the assets increases and the value of the liabilities decreases. Germany's international investment position improves, 
3. the Thaler exchange rate with the euro (and all other currencies) is below parity (revaluation of Germany), in this case the value of the assets decreases and the value of the liabilities increases. Germany's international investment position worsens.

The size of the gross positions is a multiple of GDP. Therefore even a small revaluation or a small devaluation causes a large balance sheet shock.

  

Cyprus, moral hazard and financial integration

Herbert Spencer: "The ultimate result of shielding man from the effects of folly is to people the world with fools"

Charles Kindleberger: "Such a view is understandable in a Darwinian age"

The possibility of extending the conditions of the Cyprus bail-out plan to other eurozone economies have increased uncertainty. The extinction of one of the two large Cypriote banks could have been anticipated. The tax on deposits above 100000 euro was unexpected.

Moral hazard

The rational for taxing uninsured depositors is that investors should bear the cost of the bail-out and not the tax-payers. If the policy authorities do proceed differently, say with a more traditional bail-out, the investors will feel protected and will continue to profit without bearing risk. It is again the moral hazard argument illustrated by the two introductory quotes: the reckless microeconomic behaviour of some investors cannot be insured by society. This reasoning is without question in our "Darwinian age". Nevertheless during the current crisis losses had to be absorbed by society to tame the macroeconomic consequences of some reckless investments. The reasoning is that society's  costs of inaction would in some cases exceed greatly the ex-post salvaging. This reasoning is also without question in our Social Welfare maximisation age. The only logical way to handle this trade off is to have skilled and knowledgeable policy makers supported by comprehensive, precise and timely analysis.

Cyprus

Let me go back to Cyprus. The narrative is that one or two banks (basically the financial sector) have engaged in a "casino" economic model: attracting external funds (read Russian, Uk, etc) offering high interest rates on deposits in a very favourable tax environment and engaging in reckless investments (read Greece). The casino appellation is important because it identifies a particular economic model, probably unique in the eurozone and suggests that the policy response of taxing uninsured deposits could only be extended to other casino models. No casino, no tax. I dismiss the suggestion to use in non casino economies similar measures without argument.

On the macroeconomic side, Cyprus behaves like a standard (very) small open economy in a currency area  with large current account deficits (they entered in 2008 in the euro, they are 865000 people and GDP is around 4.5 billion euro). They were hit by the crisis and when the flow of external funds suddenly stopped the economy stalled and the unemployment rate went to the roof (from 4 to 14 percent).

However when we look at the financing of the current account (the financial account) we see a massive and very rapid inflow of portfolio investment and "other investment" (a residual voice of the financial account which is not a residual because of size…). In the graph portfolioa_y is the stock of portfolio investment assets over gdp (while _l stands for liabilities, direct_y is net direct investment, iip_ is international investment position over gdp). Ex-post, this sudden inflow of short-term funds (true, a few quarters after the entry in the euro, but also simultaneously to Lehman brothers death) should have been contained. 

Policy makers might want to focus more on this huge and fast movement of capitals rather than on the size of the gross external positions. Gross external financial positions are a reflection of financial globalisation (see this older post) and are not a problem if they proceed at a "fundamental" pace (like in the other eurozone countries) and if we accept they cause greater interdependence. After all we read everyday that we live in Financial times.    

Siamo Europei

A recent survey published by Il Corriere Della Sera shows that 74% of the electors favours the permanence of Italy in the eurozone. The error margin is said to be 3.5%. Notably the percentage of young electors that favours the euro is larger (you need to go to the website).

 

Structural versus nominal deficits

Fiscal sustainability is a necessary condition for economies to function.
The conditions for sustainability are objective. For example, the difference between the rate of income growth and the interest rate on sovereign debt, and/or the path of fiscal deficits/surpluses, determine if the fiscal stance is sustainable (meaning that the inter-temporal budget constraint of the government holds).
These conditions are objective but linked and linked in an uncertain way. They are linked because a change in the path of deficits or surpluses affects both the growth rate of income and the interest rate on sovereign. They are linked in an uncertain way because the size of the effects appears to depend on the state of the economy.
The conditions for sustainability are also subjective. Conditional on the uncertainty, the path of deficits and surpluses must be credible. The capacity of a government to control tax revenues and expenditure is key.
The focus on structural deficits and surpluses in the new fiscal treaty allows governments to have fiscal plans conditional on uncertainty. This is most welcomed as it increases the probability of success of the plans and therefore their credibility.


   

The pace of internal devaluation in Portugal

Beware, this is wonkish.
How long does it take for the competitive disinflation, also known as the internal devaluation, to occur in Portugal? The question is relevant for it is the market based mechanism to adjust to external imbalances within the euro. Here is an attempt to estimate the pace and the required adjustment. Starting the projection from the fourth quarter of 2011(when the unemployment rate was at 14.1 percent) I project an increase of the unemployment rate between 4 and 6 percentage points and an improvement of the real exchange rate of approximatively 5 percentage points, both in 20 quarters. Obviously shocks will happens and policies will be taken and the actual path will be different (as they have been in 2012). Nevertheless the forecasts can be interpreted as a counterfactual path in the absence of new shocks and policies and therefore should be of some guidance in designing policies aimed at rebalancing the external adjustment.

After the Mayan

Rising wages in Germany "also contribute to eliminating imbalances within Europe."

Wolfgang Schauble, Germany Finance Minister 

as quoted in the Spiegel (here)

External financing and crowding out

INE has just published the Quarterly Sector Accounts for the third quarter, showing that for the first time in any quarter this century the net lending of the Portuguese economy has turned positive. In the year to 2012Q3, the net borrowing of the Portuguese economy amounted to just 1.1 billion euro, when in the year to 2011Q3 those needs amounted to 12.3 billion euro. An adjustment of 11 billion euro, or 6.7 percent of GDP, in one year, is an enormous external adjustment, and it was much higher than expected. For instance, the May 2011 IMF projections forecasted that by 2016 the Portuguese economy would still have external net borrowing of 1% of GDP. Why was Portugal's external adjustment so strong in the first year of the adjustment program?

The net lending of the Portuguese economy is equivalent to the sum of the current account and the capital account of the balance of payments. Since, by definition, the balance of payments always balances, it is also equivalent to the negative of the financial account. When there are no financing constraints, the real economy determines the financing needs, i.e. the top part of the balance of payments determines the bottom part. However, in a financing crisis, when there are strong financing constraints, the availability of financing is binding, implying that it is the bottom part of the balance of payments that determines the top part. The domestic agents must reduce their expenditure to the available financing, even if they had higher expenditure plans.

The INE data provides some evidence that financing was a binding constraint for Portuguese households. In the past, private consumption has always been smoother than disposable income, implying that in recessions consumption fell by less than disposable income, and the savings rate declined. However, this was not the case in the year up to 2012Q3. Private consumption fell by 3.4%, while disposable income fell by only 1.4%, relative to the year up to 2011Q3. While negative expectations may have played a part, this anomalous behavior is likely to have been determined by a binding financing constraint. Non financial corporations have also decreased their financing needs by 5.3 billion euro in the same period, while gross value added has fallen by 1 billion euro. It seems that the Portuguese economy has been operating under a binding external financing constraint, which is not surprising if one remembers that the immediate cause for the signing of the Financial and Economic Adjustment Program with the troika was the lack of financing for the Portuguese government and banks.

If the Portuguese economy is under a binding external financing constraint, and if the financing constraint is not specific to any domestic sector, then there is full crowding out of fiscal policy. Any increase in the public sector financing needs must be matched by a equivalent reduction in the private sector financing needs. In other words, if the external financing constraint is fully binding, the size of the budget deficit does not have any influence on domestic demand. If this is the case, then the fiscal policy that would foster private consumption and investment would be a reduction of the budget deficit. Under these circumstances, the government could reduce public expenditure as quickly as possible, in order to allow for sufficient financing to be available for the private sector, without decreasing GDP or increasing unemployment.

information on the Portuguese economy

Students at Nova School of Business and Economics produce regularly analysis and data on the Portuguese economy, in areas connected closely with the Memorandum of Understanding, so we have now:
- a report on the Portuguese banking sector,
- a report on the Justice System,
- a report on the labour market,
- a report on the housing market

Facts on nontradables in the Portuguese economy

The rise of nontradable sectors has been mentioned as one of the causes of low economic growth and external imbalances at the root of Portugal’s current predicament – João Ferreira do Amaral and Vítor Bento were among the first to ring that alarm bell. The ECB, the EU and the IMF (troika) seem to share the same view. The 2012 OECD Economic Survey of Portugal has also stressed the need for eliminating the distortions that tilted the Portuguese economy towards low-productivity domestically-oriented sectors. Recently, the President, Aníbal Cavaco Silva, and the Minister of the Economy, Álvaro Santos Pereira, have also been calling for the re-industrialization of the Portuguese economy.    

In a joint paper with Pedro Bação, we describe the main trends and jumps in the evolution of nontradable sectors, since the mid-1950s, using four different databases to shed light on different dimensions of this issue. From our analysis we stress the following points:

1. Despite the pattern of the growth of the share of services being similar to that observed in other developed countries, since the early 1990s it has been significantly larger than in most countries.

2. The shift to nontradables in Portugal has been fast and it occurred essentially at the expense of agriculture in the period 1953-95, and essentially at the expense of industry in the period 1995-2009.

3. In 2009, the share of nontradables (defined as the sum of services plus construction) in total GVA reached 68%, if we exclude open service sectors, and 81.1%, if we treat all service sectors as nontradable.

4. More than half of the change towards nontradables since joining the European Union took place in the period 1988-1993.

5. Finally, we show that construction and services facing a strong Government demand were the main drivers of the increasing weight of nontradables in the Portuguese economy since 1986.

TAP: post-scriptum

I am glad and grateful that Exame Expresso and Jornal de Negócios yesterday followed up on the issue of TAP’s valuation in Gérman Efromvich's offer. They did the public interest a huge service. Mr. Efromvich’s bid was greedy, but he is pragmatic. He knows that if there is a second competitive sale process he is very unlikely to win the prize (TAP) even if he bids €2bn-€3bn and he would have to wait perhaps a year.  

He now faces a dilemma:

·         He may well try to “get the deal clinched” and “everybody happy” by offering anywhere from €500mn to €1bn (rather than €20mn). But he knows this will leave the sell side feeling like fools;

·         He may lobby in the expectation that the government powers ahead with the current offer – a real possibility with this government - , but this likely is, from his perspective, too risky a gamble;

·         He could, of course, walk away,   … but ...

·         He could also bid €2bn-€3bn and argue that the government would not get more if it decides to reopen the sale process.

So, how will this saga play out?

For the record, in my view, given the role of TAP to Portugal’s export sector, the government shouldn’t sell TAP at this point. 

Germán Efromovich’s offer for TAP

According to Jornal de Negócios, the only bidder for the privatization of TAP has made a revised final offer to acquire TAP which, not surprisingly, is lower than the original non-binding offer since he is the only bidder for TAP. According to JN, the government is disappointed but wants to negotiate which says a lot about whoever is handling the negotiation on the Portuguese government side, as I shall argue below.

Jornal de Negócios states that the Germán Efromovich is offering to assume TAP’s debt of €1,2bn (TAP’s net debt is in fact €1,05 bn, about 60% of which concerns its fleet leasing debt) and to inject €300 mn in the company. He would then pay as little as €20 mn to the government for the (complete?) ownership of the company, but according to Jornal de Negócios he wants to pay even less than the €20mn.

Maybe there are additional details not reported by Jornal Negócios, because typically this type of acquisitions are based on EBITDA (Earnings before interest depreciation and amortization) multiples. But if Jornal de Negócios is correct, Gérman Efromovich’s bid looks very very low – TAP seems much more valuable, as I shall argue below.

Ricardo Arroja wrote a very interesting post in Insurgente about TAP’s privatization, which called my attention because he looked at the balance sheet of TAP. Thus, Ricardo Arroja’s post made me curious and I analyzed TAP’s balance sheet.

Now, first, one correction to Jornal de Negócios. Germán Efromovich is not assuming any of TAP’s debt. TAP’s balance sheet already assumes that debt, i.e., TAP has assets which are worth about €300 mn less than its liabilities (including the €1,2bn debt). Any buyer would likely keep TAP’s debt on its balance sheet since in this way the buyer can maximize the return on investment and optimize his tax bill.

Now everyone assumes that TAP is over-indebted and worries about TAP’s negative equity. But businesses do not need positive equity levels to function. What they need is positive cash flows. TAP has positive operational cash flows and EBITDA and has managed to stabilize debt levels.

More important, TAP’s debt levels do not seem high at all for a company of its dimension. TAP’s interest and leasing costs are a small fraction of the company’s total costs, which means that capital, while important, is not the key variable for TAP’s business.

Perhaps the following example will clarify my point. If TAP uses half of the €300mn capital injection proposed by Germán Efromovich to increase its working capital, and the other half to reduce its stock of debt, its financing costs would fall by about €9mn, or by about 0.4% of the company’s total costs, i.e., by a negligible amount. This signals that while further capital is helpful – and might help TAP expand or better hedge fuel cost risks - , TAP will likely be able to thrive in the future even without any capital injection.

I do not have information on TAP's most recent financial numbers. However, the 2011 balance sheet indicates that TAP is in a situation where slight operational improvements in revenues and slight decreases in costs will result in a marked improvement of its results and reflect favorably on its balance sheet. A 5% increase in revenues and a 5% decrease in operational expenditures will likely result in improvement to EBITDA of about €250 million per year, or about 70%-80% of what Germán Efromovich wants to pay for TAP.

TAP’s EBITDA in 2011 was €106mn. A purchase price based on a multiple of 10 of the 2011 EBITDA seems a fairly run of the mill (modest) valuation for the company. It would mean TAP would be worth about €1bn, which less the €300mn capital injection means a sale price of about €700 mn. But if an improvement in EBITDA of €250 million relative to the 2011 performance is assumed, then TAP would be worth €3.2bn (already net of the capital injection).

But I am likely being conservative here. Gérman Efromovich owns airline companies. This means he is likely to obtain significant synergies between his different airlines.  Greater synergies mean larger EBITDAs, which mean TAP is likely much more valuable for this entrepreneur than the €3bn I estimate above.

In my view, TAP is on course – bar unexpected shocks - to become systematically profitable in the short term. Germán Efromovich will get his investment back very quickly. He is a shrewd investor and if he succeeds in his bid he will have a very high return on his investment.

But he must be innerly laughing at the apparently “naïve” selling side (i.e., the Portuguese negotiators) who are begging him to condescend to give a few more millions of euro or even possibly willing to pay Germán  Efromovich to get rid of TAP.

Finally, TAP is one of the country’s largest exporters and plays a key role in one of the country’s leading export industries (tourism). It also is one of the main airlines for connections to Portuguese language countries in Africa and South America (CPLP), some of which are also Portugal’s fastest growing export markets. Portugal’s adjustment requires a huge improvement in external trade for the current or any other adjustment program to succeed. From a macroeconomic policy making point of view one does not want to play around casually with one of the key players in our export industry precisely at this time in History. But none of this appears to be of any relevance to our decision makers.

Banking Union and the supervision of 6000 banks

"Nobody believes it will work. Nobody believes any institution will be able to supervise 6,000 banks.” Wolfgang Schauble, Germany’s finance minister, FT 2012

"Our specific responsibilities include the oversight of about 5,000 bank holding companies, including the umbrella supervision of large, complex financial firms; the supervision of about 850 banks nationwide that are both state-chartered and members of the Federal Reserve System (state member banks); and the oversight of foreign banking organizations operating in the United States."Chairman Ben S. Bernanke,The Federal Reserve's role in bank supervision, Before the Committee on Financial Services, U.S. House of Representatives, Washington, D.C. March 17, 2010

I concede that 6000 > 5850. Not that 6000 >>> 5850.

P.S.
Question: how many Polish banks are...Polish?

Portugal and the welfare state, step 1

A recent article in the Financial Times (Portugal grapples with cost of welfare state) addressed recent statements by the prime minister on the reforms in the public sector.
The starting point was the statement a couple of weeks by the minister of finance on the (apparent) difference between what people want to pay in taxes and the welfare state benefits they want.
The discussion on the role and size of the state and how it is funded (and not the components of the welfare state) is a much needed debate in Portugal. But it cannot be done until February or March if it is  supposed to include the views and desires of the Portuguese population and if its to go beyond cut expenditures across the board.
The challenge for the discussion is how to be cut in terms of what the Government does - not only the always-mentioned quest for efficiency in Government provision of services but also which ones are to be provided by the Government.
This goes beyond knowing which charges people should pay when using Government services. And forces the need for clarification of concepts and roles of Government spending. One the more common errors of perception, which is also present in the financial times article, is people saying they could afford to pay more for health care at point of use - meaning usually that people accept income-based payments at the point of use. Fine. But the mistake is that such charges are usually a very small portion of total funding required, user charges account for less then 2% of total funding needs in the National Health Service. Increasing user charges to cover say 20% would probably lead most people to complain about it. Even the largest single user charge, use of emergency room in central hospitals, is about 10% (or less) of average cost of such episode - this is 20€ user charge mentioned in the FT article. The second aspect of this mistake is conceptual - redistribution  should mainly be done at the funding level, not at the point of use. If there is some correlation between income and need of health care (use), then payments at the point of use according to income may help, but they also destroy the insurance value of protection against uncertainty of health care expenditures. And this role is neglected (wrongly) in most popular statements.
From other areas we are likely to face good arguments for Government intervention, meaning that a careful discussion needs to be made.
Recognizing the importance of this discussion the prime minister said that a baseline proposal for cuts will be provided by February but changes are possible until the Summer, before the next budget proposal is built. This is reasonable. Sets a default situation, and then it is up to the political forces and to society to improve on it. Being too assertive at this stage will not allow for a proper discussion. Let's hope the Portuguese people can do it.

The IMF’s rosy public debt projections*

I have analyzed and replicated the IMF’s Debt Sustainability Framework for Portugal provided in the adjustment program review reports (a table in the IMF Country Reports for Portugal). This IMF review report table contains the IMF projections for the levels of Portugal’s public debt from 2012 through 2030. The IMF review reports are the data sources for all graphs below.

In my opinion, the IMF’s debt projections should be interpreted as the “objectives” for the evolution of the levels of public debt, should the adjustment program perform as planned.

As is well known, the key condition to assure debt sustainability is that the economic (nominal/real) growth rate is higher than the (nominal/real) interest rate on the stock of debt.

The key points of my short analysis are:

•         Even if the everything goes according to the troika and government plan, public debt dynamics seems barely sustainable, falling below 100% of GDP only around 2025
•         Each review has resulted in the worsening of the public debt trajectory (please see figure below).

•     This is to some extent explained by increases in the initial stock of debt – for example, resulting from Eurostat-mandated changes in the universe of public sector enterprises included in the consolidated accounts of the public sector. But one additional important explanation is that the adjustment program has had a worse than expected impact on economic growth resulting in lower growth projections with each review (please see figure below)

• 
  
•     Maybe I missed something, but I could not replicate the debt levels for 2014 and 2015. The difference in 2014 and 2015 debt levels explains 94% of the deviation between my 2030 estimates (debt at 88% of GDP) and the IMF's 5th review projection (84.8% of GDP)
•     The IMF has, in each successive review revised interest rates lower (see figure below). (Addendum) Francesco Franco pointed out that at least some of the reductions in interest rates follow from the reduction in EU loan rates to Portugal - the 215 basis point EFSF margin was reduced to 0 - (Bloomberg’s David Powell recently noted what he called the "mysterious" reduction in interest rates from the 4^th to the 5^th review report, and this had me look at the evolution of interest rates in all IMF review reports). 

•       Moreover, the debt trajectory is not really robust (see figure below). In fact, if nominal growth rates from 2012 turn out to be lower by one percentage point and the average interest rate from 2015 on to be higher by one percentage point than assumed by the IMF, the debt levels would rise by 2030, not fall.

The “Fazit”: Portugal’s sovereign debt is on a clearly unsustainable trajectory.  The IMF public debt projections fail to consider the impact on public debt trajectory of the external adjustment that is necessary to assure a sustainable external debt trajectory. The IMF external debt projections contained in the review reports are in my view, not realistic and not feasible at all. But that is a subject for another discussion.

*revised version.

The War of the Multipliers

One month ago, the IMF presented evidence that structural macro econometrics models used by international organisations are underestimating current fiscal multipliers. Last week the European Commission presented evidence that focusing on the euro area the IMF results need to be interpreted with caution. To EC study acknowledges that there are good reasons why the fiscal multipliers can be larger in the current environment but also says that she finds no evidence of underestimation of those, al least when focusing on the euro area countries. 

More precisely the EC study argues that (I quote):

1."the forecast errors over the 2010-11 period have been predominantly underestimations of higher-than-expected growth in 2010, which were in fact associated with stimulus measures in that year";

2. "when controlling for increases in sovereign-bond yields the correlation between forecast errors and changes in the fiscal stance breaks down."

Reason 1. says that the fiscal multipliers may be underestimated, but this is due to countries that have adopted a stimulative fiscal stance (I would add: good for them!). Furthermore these stimuli are temporary in nature and imply higher multipliers than those due to permanent fiscal consolidations.

The empirical exercise is performed using structural fiscal balance, a measure that is constructed to filter out temporary factors from the actual fiscal balance. The reason why negative forecast errors in the structural fiscal stance are associated with temporary fiscal changes while positive forecast errors in the structural fiscal stance are associated with permanent fiscal changes eludes me. If this was true I would look at structural fiscal balance measures suspiciously.  

Reason 2 is harder. In the EC study, adding as an explanatory variable the change in government yields, the underestimation result disappears.

The explanation is as follows:

"…the negative coefficient for the fiscal stance in the first regression should not be interpreted as an underestimation of the fiscal multiplier but rather as capturing a negative response of investors to possibly insufficient fiscal effort in countries with severe debt problems." 

I would argue that the case for reverse causality is strong: were the yields reflecting the preoccupation of the markets for a not strong enough fiscal consolidation or for a not strong enough economic growth? In the latter case the regression suffers from an endogeneity problem (see IMF footnote 3) and the coefficients estimates would be biased. 

Here I report the benchmark results using the IMF and the EC data for the euro area countries. (GFE is cumulated growth forecast errors and FCFE is cumulated fiscal consolidation forecast errors). 

Notice how the estimates are close. The main differences in the two datasets appear to be: 1. the presence of Luxembourg in the EC data, and 2. a significant difference (sign and size) in the forecast error of the fiscal consolidation of Ireland.