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Interview of Jin Liqun, Chairman of China’s Investment Corp. (or CIC), China’s sovereign wealth fund, with $460 billion assets under management.
Jin offers his views toward Europe and her economic and political systems. He also explains why CIC is unlikely to inject large rescue investments as per European leaders’ request. I’d say Jin’s views toward Europe is quite typical in China.
Starting from 12″10′ in the video interview, Jin had some really strong (yet painfully true) comments toward European welfare system.
Similar to the soft budget constraints (or SBC) under former socialist countries, the budget rule under EU treaty is also “soft” in a sense that violating the rule won’t be really punished. Punishments, such as kicking the “rogue” member country out of the union, run contradictory to the political ambition of the European Union and would risk breaking the union altogether.
The other option is to rein in the government spending of the member countries. But that would require a centralized authority with direct control of the member countries, especially on their fiscal policies, i.e., how governments spend their money. At current stage, Europe is not ready for such radical change, which requires a big surrender of their own sovereignty. So what Europe will likely end up is a fake fiscal union with soft budget rules. The moral hazard problem is unsolved. Rest assured to see more budget rule violations in the future.
The following map from WSJ gives a very nice summary of how the union’s budget rule had been violated in the past.
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Now it looks like no matter what Europeans are trying to do, and how many summits politicians rush to put together, things just keep getting worse.
If PIGS (Portugal, Italy, Greece and Spain) were to ‘fly ‘, and debt contagion were to spread, and Europe’s Lehman moment finally to arrive, you probably want to at least have a slightest hint of where the next domino is likely to fall. That’s the purpose of this short post.
The following four charts are from researchers at BIS, including my former Brandeis teacher Steve Cecchetti. I suggest that everybody take a minimum of five minutes going through these tables. For nerds like me, I stick them on the wall in my office.
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Chris Wood shares his insights on what’s likely the endgame of European sovereign debt crisis.
He predicts it will be either a move from monetary union to fiscal union, or a complete breakdown of the Euro. He thinks the first scenario is more likely and Germany will eventually budge.
Then, Jim Rogers comes in with his thoughts:
According to WSJ, less than two weeks after European leaders unveiled an agreement that was designed to bolster confidence in the region, the yield on Italy’s 10-year debt drew close to the 7% mark, a line in the sand of both practical and psychological importance to the market.
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Psychologically, 7% has become a beacon due to the fact that Greece, Portugal and Ireland each sought bailouts soon after their debt reached these levels. While analysts said it is too simplistic to say that Italy will be forced to ask for support if its 10-year debt yields 7%, they said the recent selloff is taking the country to the tipping point.
A sharp slide in bond prices pushed yields to their highest levels since the inception of the euro. The two-year yield rose a staggering 0.60 percentage points to 6.04% while the five-year yield climbed 0.37 percentage points to 6.56%.The 10-year yield was up 0.27 percentage points to 6.60%, having hit a new high of 6.62% earlier Monday.
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Update 1 (on Nov. 10, 2011)
Italian gov. bond yields continues to soar, now above 7% threshold. See the chart from WSJ below:
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It seemed that Europe is gradually approaching its own Lehman moment. What’s different, compared to previously trouble of other smaller PIIGS, is that the latest escalation fed fears that the euro-zone debt crisis is starting down its most perilous path: going from a storm raging among small countries at Europe’s fringe to one that strikes a major economic power.
Also, Italy’s debt load of €1.9 trillion ($2.6 trillion) is the second largest in Europe, behind Germany’s, and the fourth largest in the world. Next year, more than €300 billion of debt comes due, and Italy must continually tap markets to refinance it.
The following graph was taken out from a recent report on Europe’s debt trajectory by GMO’s Rich Mattione. It pretty much summarizes the current dire situation in Europe.
Greece is not the only country in trouble. Italy is the real threat to the stability of Europe. If Italy falls, Europe falls.
Germany and France, the two largest economies in Europe, are relatively better positioned, but their government-debt-to-GDP ratios, 83% and 82%, respectively, will seriously constrain their ability to bail out the PIIGS (Portugal, Italy, Ireland, Greece and Spain). In contrast, Scandinavian countries enjoy the strongest position in all developed countries, with the debt-to-GDP ratio well below 50%.
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Daniel Gros at WSJ asks the interesting question:
The real question is: Would a messy (and massive) default under which the country refuses to repay in full signify the end of the euro?
Yes and no.
A messy default would certainly end the ideal of the euro area as a club whose members are all equal and work toward a common goal, namely the stability of the common currency. Membership in such a club protects against financial problems, because members are supposed to behave well and help each other in case of unjustified speculative attacks. Although the EU Treaty says that members are not liable for each other’s public debt, there is an implicit political commitment, as we see right now, to provide emergency help.
The quid pro quo for this solidarity is of course the expectation that all members abide by certain standards, for example those embodied in the Stability and Growth Pact, that aim to limit budget deficits and debts. The continuing misreporting of fiscal data by Greece has already severely damaged this ideal. But the “club” could still be saved if Greece undertook a determined national effort to service its debt and avoid a messy default.
However, even a messy default by Greece alone would not necessarily mean the end of the euro area. The day after a formal default, Greek banks would no longer have access to the regular monetary policy operations of the European Central Bank. The ECB could no longer accept their collateral, Greek debt, which would immediately have less than junk status. The country would thus effectively cease to be part of the euro area. Its status would resemble that of Montenegro, which adopted the euro as legal tender without officially being a member of the single currency zone.
In Greece, following a messy default, euro notes and coins would still circulate in the economy, but one euro on a Greek bank account would no longer be automatically equivalent to one euro on a bank account elsewhere in the euro area, as Greek banks might immediately become insolvent and thus be shut out of the payment systems. Until Greek solvency has been re-established, the euro zone would thus de facto have lost one of its members—although the Greek Central Bank head would still sit on the Governing Council of the ECB, and the Greek finance minister would still be a member of the Euro Group, with his country’s normal voting powers intact.
The Greek economy would collapse, but the impact on the rest of the single currency zone should be minor, given that the country represents only about 2% of the euro area’s GDP and is not home to any systemically relevant financial institution.
In many ways, a Greek default would leave the euro zone in better shape. Its institutions would probably be strengthened, because it would have become clear that the framework is strong enough to withstand the failure of one of its members. Tolerance toward deficit violations and inaccurate reporting would be much reduced. The club would have been transformed into a federation whose peripheral components can be told to “get lost,” so to speak. As a result, majority voting would tend to replace consensus as the normal way of decision-making.
The potential monkey wrench is contagion. The main reason Germany is now agreeing to accelerate the Greek bailout package is that tension on Spanish financial markets has arisen over the past several days. In contrast to Greece and Portugal, Spain (and even more so Italy) are indeed “too big to fail.”
Will contagion prove fatal? The fundamentals of Spain and Italy, especially their self-financing capacities, are much stronger than in Greece and Portugal. Moreover, neither Spain nor Italy would gain much from a default, since most of their public debt is held by their own citizens. A default would thus not lower the foreign debt of the country. For Greece, by contrast, 90% of all public debt is held by foreigners, who could be expropriated by a default.
However, markets can at times be irrational. The real test of the euro area is thus not Greece, but whether it can protect members that do not have an insolvency problem from speculative attacks.
The signals are so far mixed. After an initial bout of generalized nervousness in February, when it first became clear that the second leg of the financial crisis could imply sovereign default, financial markets have increasingly differentiated among the weaker members of the euro area. Risk premia have tended to move together in the same direction, but with completely different orders of magnitude. The spreads on Spanish bonds have increased, but they remain less than one third of those of Greece, with Italy even lower.
The fate of euro is not being decided in Athens, but in Madrid and Rome.
Marty Feldstein thinks Greek default is inevitable. I think default is one possible outcome, and the alternative is for Greece to ask EU to be “kicked out” of European Union, so it can depeg itself from Euro zone and use monetary policy to stimulate its own economy.
Sovereign debt quality as measured by debt-to-GDP ratio.
(hat tip: US Global Investors)