Euro Zone Survival Risk, World Financial Turbulence and World Economic Slowdown
Carlos M. Pelaez
© Carlos M. Pelaez, 2010, 2011
Executive Summary
I World Financial Turbulence
IA Financial Risks
IB Fiscal Compact
IC European Central Bank
ID Euro Zone Survival Risk
IE Appendix on Sovereign Bond Valuation
II Global Inflation
III World Economic Slowdown
IIIA United States
IIIB Japan
IIIC China
IIID Euro Area
IIIE Germany
IIIF France
IIIG Italy
IIIH United Kingdom
IV Valuation of Risk Financial Assets
V Economic Indicators
VI Interest Rates
VII Conclusion
References
Appendix I The Great Inflation
Executive Summary
The international financial system and the world economy are facing an important crossroad. There are three critical aspects of the movement toward an unknown shock: I World Economic Slowdown; II European Sovereign Debt Crisis; and III Financial Turbulence
I World Economic Slowdown. The JP Morgan Global All-Industry Output Index produced by JPMorgan and Markit in association with ISM and IFPSM registered improvement in Nov, increasing from the low of the recovery in Oct of 51.3 to 52.0 in Nov (http://www.markiteconomics.com/MarkitFiles/Pages/ViewPressRelease.aspx?ID=8909). There was acceleration in both manufacturing and nonmanufacturing in the US with composite activity growing at highest rhythm since Mar. Joseph Lupton, Global Economist at JPMorgan, finds that the combination of low employment and level of new orders could imply continuing global growth below trend in 2012. The closer the world economy moves toward standstill the higher the probability of a contraction. This blog follows indicators of regions and countries that account for about three quarters of world economic output.
II Resolution of the European Debt Crisis. Even after the measures adopted by the European Council (2011Dec9) there is uncertainty of the reactions in financial markets and subsequently on the global economy. There are three types of actions in Europe to steer the euro zone away from the threats of fiscal and banking crises: (1) fiscal compact; (2) enhancement of stabilization tools and resources; and (3) bank capital requirements. The first two actions consist of agreements by the Euro Area Heads of State and government while the third action consists of measurements and recommendations by the European Banking Authority.
1. Fiscal Compact. The “fiscal compact” consists of (1) conciliation of fiscal policies and budgets within a “fiscal rule”; and (2) establishment of mechanisms of governance, monitoring and enforcement of the fiscal rule.
i. Fiscal Rule. The essence of the fiscal rule is that “general government budgets shall be balanced or in surplus” by compliance of members countries that “the annual structural deficit does not exceed 0.5% of nominal GDP” (European Council 2011Dec9, 3). Individual member states will create “an automatic correction mechanism that shall be triggered in the event of deviation” (European Council 2011Dec9, 3). Member states will define their automatic correction mechanisms following principles proposed by the European Commission. Those member states falling into an “excessive deficit procedure” will provide a detailed plan of structural reforms to correct excessive deficits. The European Council and European Commission will monitor yearly budget plans for consistency with correction of excessive deficits. Member states will report in anticipation their debt issuance plans. Deficits in excess of 3 percent of GDP and/or debt in excess of 60 percent of GDP will trigger automatic consequences.
ii. Policy Coordination and Governance. The euro area is committed to following common economic policy. In accordance, “a procedure will be established to ensure that all major economic policy reforms planned by euro area member states will be discussed and coordinated at the level of the euro area, with a view to benchmarking best practices” (European Council 2011Dec9, 5). Governance of the euro area will be strengthened with regular euro summits at least twice yearly.
2. Stabilization Tools and Resources. There are several enhancements to the bailouts of member states.
i. Facilities. The European Financial Stability Facility (EFSF) will use leverage and the European Central Bank as agent of its market operations. The European Stability Mechanism (ESM) or permanent bailout facility will be operational as soon as 90 percent of the capital commitments are ratified by member states. The ESM is planned to begin in Jul 2012.
ii. Financial Resources. The overall ceiling of the EFSF/ESM of €500 billion (USD 670 billion) will be reassessed in mar 2012. Measures will be taken to maintain “the combined effective lending capacity of EUR 500 billion” (European Council 2011Dec9, 6). Member states will “consider, and confirm within 10 days, the provision of additional resources for the IMF of up to EUR 200 billion (USD 270 billion), in the form of bilateral loans, to ensure that the IMF has adequate resources to deal with the crisis. We are looking forward to parallel contributions from the international community” (European Council 2011Dec9, 6). Bailouts “will strictly adhere to the well established IMF principles and practices.” There is a specific statement on private sector involvement and its relation to recent experience: “We clearly reaffirm that the decisions taken on 21 July and 26/27 October concerning Greek debt are unique and exceptional; standardized and identical Collective Action clauses will be included, in such a way as to preserve market liquidity, in the terms and conditions of all new euro government bonds” (European Council 2011Dec9, 6). Will there be again “unique and exceptional” conditions? The ESM is authorized to take emergency decisions with “a qualified majority of 85% in case the Commission and the ECB conclude that an urgent decision related to financial assistance is needed when the financial and economic sustainability of the euro area is threatened” (European Council 2011Dec9, 6).
3. Bank Capital. The European Banking Authority (EBA) finds that European banks have a capital shortfall of €114.7 billion (http://stress-test.eba.europa.eu/capitalexercise/Press%20release%20FINAL.pdf). To avoid credit difficulties, the EBA recommends “that the credit institutions build a temporary capital buffer to reach a 9% Core Tier 1 ratio by 30 June 2012” (http://stress-test.eba.europa.eu/capitalexercise/EBA%20BS%202011%20173%20Recommendation%20FINAL.pdf 6). Patrick Jenkins, Martin Stabe and Stanley Pignal, writing on Dec 9, 2011, on “EU banks slash sovereign holdings,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/a6d2fd4e-228f-11e1-acdc-00144feabdc0.html#axzz1gAlaswcW), analyze the balance sheets of European banks released by the European Banking Authority. They conclude that European banks have reduced their holdings of riskier sovereign debt of countries in Europe by €65 billion from the end of 2010 to Sep 2011. Bankers informed that the European Central Bank and hedge funds acquired those exposures that represent 13 percent of their holdings of debt to Greece, Ireland, Italy, Portugal and Spain (GIIPS), which are down to €513 billion by the end of IIIQ2011.
The column “Net Debt USD Billions” in Table ES1 is generated by applying the percentage “General Government Net Debt % GDP 2010” to “GDP USD Billions,” using IMF data. The total debt of France and Germany in 2010 is $3853.5 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $3531.6 billion. There is some simple “unpleasant bond arithmetic” in the two final columns of Table ES1. Suppose the entire debt burdens of the five GIIPS countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $7385.1 billion, which would be equivalent to 126.3 percent of their combined GDP in 2010. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 224 percent if including debt of France and 165 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing out other euro zone countries so that they do not default on French and German banks.
Table ES1, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %
| Net Debt USD Billions | Debt as % of Germany Plus France GDP | Debt as % of Germany GDP | |
| A Euro Area | 8,018.6 | ||
| B Germany | 1,893.0 | $7385.1 as % of $3286.5 =224.7% $5424.6 as % of $3286.5 =165.1% | |
| C France | 1,960.5 | ||
| B+C | 3,853.5 | GDP $5849.2 Total Debt $7385.1 Debt/GDP: 126.3% | |
| D Italy | 2,042.8 | ||
| E Spain | 688.0 | ||
| F Portugal | 203.3 | ||
| G Greece | 436.1 | ||
| H Ireland | 161.4 | ||
| Subtotal D+E+F+G+H | 3,531.6 |
Source: calculation with IMF data http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx
III Financial Turbulence. There is a new carry trade that learned from the losses after the crisis of 2007 or learned from the crisis how to avoid losses. The sharp rise in valuations of risk financial assets from 2003 to 2007 after the first policy round of near zero fed funds rates and quantitative easing by the equivalent of withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China, events such as in the Middle East and Japan and legislative restructuring, regulation, insufficient growth, falling real wages, depressed hiring and high job stress of unemployment and underemployment in the US now with realization of growth standstill recession. The “trend is your friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets driven by the carry trade from zero interest rates with fluctuations provoked by events of risk aversion. Table ES2, which is updated for every comment of this blog, shows the deep contraction of valuations of risk financial assets after the Apr 2010 sovereign risk issues in the fourth column “∆% to Trough.” There was sharp recovery after around Jul 2010 in the last column “∆% Trough to 12/09/11,” which has been recently stalling or reversing amidst profound risk aversion. “Let’s twist again” monetary policy during the week of Sep 23 caused deep worldwide risk aversion and selloff of risk financial assets (http://cmpassocregulationblog.blogspot.com/2011/09/imf-view-of-world-economy-and-finance.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html). Monetary policy was designed to increase risk appetite but instead suffocated risk exposures. After the surge in the week of Dec 2 and mixed performance of markets in the week of Dec 9 there are now only three assets with negative change in valuation in column “∆% Trough to 12/09/11:” NYSE Financial minus 3.5 percent, Japan’s Nikkei Average minus 3.3 percent and Shanghai Composite minus 2.8 percent. The highest valuations are by US equities indexes: DJIA 25.8 percent and S&P 500 22.7 percent. Michael Mackenzie and Robin Wigglesworth, writing on Oct 21, 2011, on “Us earnings tell story of resilience,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/c44187d4-fb1f-11e0-bebe-00144feab49a.html#axzz1bVlVmY6d), analyze the strong earnings performance of US companies that explains the recovery of the DJIA by 24.1 percent from the trough and of the S&P 500 by 21.7 percent. Mackenzie and Wigglesworth quote S&P Capital IQ that a blended average of actual and forecast earnings on IIIQ2011 relative to IIIQ2010 could show growth of 14.6 percent. The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. Before the current round of risk aversion, all assets in the column “∆% Trough to 12/09/11” had double digit gains relative to the trough around Jul 2, 2010 but now most valuations show increases of less than 10 percent: European stocks index STOXX 50 is now 1.2 percent above the trough on Jul 2, 2010; Dow Global is 7.5 percent above the trough; Dow Asia Pacific is now higher by 2.8 percent; and Dax is 5.6 percent above the trough on May 25, 2010. Japan’s Nikkei Average is 3.3 percent below the trough on Aug 31, 2010 and 25.1 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 8536.46 on Fri Dec 9, which is 16.8 percent below 10,254.43 on Mar 11 on the date of the Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 12.2 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 12/09/2011” in Table ES1 shows sharp mixed performance of risk financial assets in the week of Dec 9. There are still high uncertainties on European sovereign risks, US and world growth recession and China’s growth and inflation tradeoff. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table ES1 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 12/09/11” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Dec 2, 2011. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 12/09/11” but also relative to the peak in column “∆% Peak to 12/09/11.” There are now only two US equity indexes above the peak in Table ES1: DJIA 8.7 percent and S&P 500 3.1 percent. There are several indexes well below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 24.1 percent, Nikkei Average by 23.1 percent, Shanghai Composite by 26.8 percent, STOXX 50 by 14.3 percent, Dow Global by 12.3 percent and Dow Asia Pacific by 10.0 percent. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. The situation of risk financial assets has worsened.
Table ES1, Stock Indexes, Commodities, Dollar and 10-Year Treasury
| Peak | Trough | ∆% to Trough | ∆% Peak to 12/09 /11 | ∆% Week 12/09/ 11 | ∆% Trough to 12/09 11 | |
| DJIA | 4/26/ | 7/2/10 | -13.6 | 8.7 | 1.4 | 25.8 |
| S&P 500 | 4/23/ | 7/20/ | -16.0 | 3.1 | 0.9 | 22.7 |
| NYSE Finance | 4/15/ | 7/2/10 | -20.3 | -23.1 | 1.2 | -3.5 |
| Dow Global | 4/15/ | 7/2/10 | -18.4 | -12.3 | -0.3 | 7.5 |
| Asia Pacific | 4/15/ | 7/2/10 | -12.5 | -10.0 | -2.0 | 2.8 |
| Japan Nikkei Aver. | 4/05/ | 8/31/ | -22.5 | -25.1 | -1.2 | -3.3 |
| China Shang. | 4/15/ | 7/02 | -24.7 | -26.8 | -1.9 | -2.8 |
| STOXX 50 | 4/15/10 | 7/2/10 | -15.3 | -14.3 | 0.6 | 1.2 |
| DAX | 4/26/ | 5/25/ | -10.5 | -5.5 | -1.5 | 5.6 |
| Dollar | 11/25 2009 | 6/7 | 21.2 | 11.6 | 0.0 | -12.2 |
| DJ UBS Comm. | 1/6/ | 7/2/10 | -14.5 | -1.4 | -2.3 | 15.3 |
| 10-Year T Note | 4/5/ | 4/6/10 | 3.986 | 2.065 |
T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)
Source: http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
Chart ES1 of the Board of Governors of the Federal Reserve System provides indexes of the dollar from 2010 to 2011. The dollar depreciates during episodes of risk appetite but appreciate during risk aversion as funds seek dollar-denominated assets in avoiding financial risk.
Chart ES1, Broad, Major Currency, and Other Important Trading Partners Indexes for the US Dollar
Source: Board of Governors of the Federal Reserve System
I International Financial Turbulence. Financial markets are being shocked by multiple factors including (1) world economic slowdown; (2) growth in China, Japan and world trade; (3) slow growth propelled by savings reduction in the US with high unemployment/underemployment; and (3) the outcome of the sovereign debt crisis in Europe. This section analyzes the events of the week culminating in the meeting of European leaders. Subsection IA Financial Risks provides analysis of the evolution of valuations of risk assets during the week. Subsection IB Fiscal Compact analysis the restructuring of the fiscal affairs of the European Union in the agreement of European leaders on Dec 9. Subsection IC European Central bank considers the policies of the European Central Bank. Subsection ID Euro Zone Survival Risk analyzes the threats to survival of the European Monetary Union. Subsection IE Appendix on Sovereign Bond Valuation provides more technical appendix.
IA Financial Risks. The past four months have been characterized by financial turbulence, attaining unusual magnitude in the past few weeks. Table 1, updated with every comment in this blog, provides beginning values on Fr Dec 2 and daily values throughout the week ending on Fri Dec 9 of several financial assets. Section IV Valuation of Risk Financial Assets provides a set of more complete values. All data are for New York time at 5 PM. The first column provides the value on Fri Dec 2 and the percentage change in that prior week below the label of the financial risk asset. The first five asset rows provide five key exchange rates versus the dollar and the percentage cumulative appreciation (positive change or no sign) or depreciation (negative change or negative sign). Positive changes constitute appreciation of the relevant exchange rate and negative changes depreciation. Financial turbulence has been dominated by reactions to the new program for Greece (see section IB in http://cmpassocregulationblog.blogspot.com/2011/07/debt-and-financial-risk-aversion-and.html), modifications and new approach adopted in the Euro Summit of Oct 26 (European Commission 2011Oct26SS, 2011Oct26MRES), doubts on the larger countries in the euro zone with sovereign risks such as Spain and Italy but expanding into possibly France and Germany, the growth standstill recession and long-term unsustainable government debt in the US, worldwide deceleration of economic growth and continuing inflation. The most important current shock is that resulting from the agreement by European leaders at their meeting on Dec 9, which is analyzed in the following subsection IB Fiscal Compact. The dollar/euro rate is quoted as number of US dollars USD per one euro EUR, USD 1.339/EUR in the first row, first column in the block for currencies in Table 1 for Fri Dec 2, depreciating to USD 1.3402/EUR on Mon Dec 5, or by 0.1 percent. The dollar depreciated because more dollars, $1.3402, were required on Dec 5 to buy one euro than $1.339 on Dec 2. Table 1 defines a country’s exchange rate as number of units of domestic currency per unit of foreign currency. USD/EUR would be the definition of the exchange rate of the US and the inverse [1/(USD/EUR)] is the definition in this convention of the rate of exchange of the euro zone, EUR/USD. A convention is required to maintain consistency in characterizing movements of the exchange rate in Table 1 as appreciation and depreciation. The first row for each of the currencies shows the exchange rate at 5 PM New York time, such as USD 1.3402/EUR on Dec 5; the second row provides the cumulative percentage appreciation or depreciation of the exchange rate from the rate on the last business day of the prior week, in this case Fri Dec 2, to the last business day of the current week, in this case Fri Dec 9, such as virtually no change to USD 1.338/EUR by Dec 9; and the third row provides the percentage change from the prior business day to the current business day. For example, the USD appreciated (positive sign) by 0.3 percent from the rate of USD 1.339/EUR on Fri Dec 2 to the rate of USD 1.3344/EUR on Thu Dec 8 {[(1.3344/1.339) – 1]100 = -0.3%} and depreciated by 0.3 percent from the rate of USD 1.3444 on Thu Dec 8 to USD 1.3378/EUR on Fri Dec 9 {[(1.3378/1.3444) -1]100 = 0.3%}. The cumulative appreciation of the USD of 0.3 percent by Thu Dec 8 was reversed by the depreciation of 0.3 percent from Thu Dec 8 to Fri Dec 9, such that the USD/EUR rate virtually did not change from Fri Dec 2 to Fri Dec 9: virtually the same amount of dollars, USD 1.339/EUR, were required to buy one euro on Fri Dec 2 as USD 1.3378 required to buy one euro on Fri Dec 9. Other factors constant, depreciation of the dollar relative to the euro is caused by decreasing risk aversion, largely resulting with declining uncertainty on European sovereign risks, with purchases of risk financial investments by reduction of dollar-denominated assets. Funds move away from the safety of dollar investments to higher yield risk financial assets. When risk aversion declines, funds have been moving away from safe assets in dollars to risk financial assets.
Table 1, Weekly Financial Risk Assets Dec 5 to Dec 9, 2011
| Fri Dec 2, 2011 | M 5 | Tu 6 | W 7 | Th 8 | Fr 9 |
| USD/ 1.339 -1.1% | 1.3402 -0.1% -0.1% | 1.3400 -0.1% 0.0% | 1.3410 -0.1% -0.1% | 1.3344 0.3% 0.5% | 1.3378 0.0% -0.3% |
| JPY/ 77.96 -0.3% | 77.7535 0.3% 0.3% | 77.7405 0.3% 0.3% | 77.6620 0.4% 0.1% | 77.6925 0.3% 0.0% | 77.62 0.4% 0.1% |
| CHF/ 0.919 1.5% | 0.9203 -0.1% -0.1% | 0.9262 -0.8% -0.6% | 0.9236 -0.5% 0.3% | 0.9259 -0.7% -0.2% | 0.9240 -0.5% 0.2% |
| CHF/EUR 1.2343 -0.2% | 1.2335 0.1% 0.1% | 1.2412 -0.5% -0.6% | 1.2386 -0.3% 0.2% | 1.2356 -0.1% 0.2% | 1.2362 -0.1% 0.0% |
| USD/ 1.021 0.9794 4.9% | 1.0275 0.9732 0.6% 0.6% | 1.0245 0.9761 0.3% -0.3% | 1.0286 0.9722 0.7% 0.4% | 1.0169 0.9834 -0.4% -1.2% | 1.021 0.9794 0.0% 0.4% |
| 10 Year 2.042 | 2.03 | 2.08 | 2.03 | 1.97 | 2.065 |
| 2 Year T Note 0.252 | 0.26 | 0.25 | 0.23 | 0.22 | 0.226 |
| Germany Bond 2Y 0.31 10Y 2.13 | 2Y 0.34 10Y 2.20 | 2Y 0.34 10Y 2.19 | 2Y 0.31 10Y 2.10 | 2Y .29 10Y 2.02 | 2Y 0.32 10Y 2.15 |
| DJIA 12019.42 7.0% | 12097.83 0.7% 0.7% | 12150.13 1.1% 0.4% | 12196.37 1.5% 0.4% | 11997.70 -0.2% -1.63 | 12184.26 1.4% 1.6% |
| DJ Global 1837.15 8.8% | 1855.55 1.0% 0.9% | 1846.27 0.5% -0.6% | 1851.99 0.8% 0.4% | 1813.28 -1.3% -2.0% | 1830.78 -0.3% 1.0% |
| DJ Asia Pacific 1200.79 7.4% | 1206.84 0.5% 0.5% | 1190.26 -0.9% -1.4% | 1205.50 0.4% 1.3% | 1197.09 -0.3% -0.7% | 1176.56 -2.0 -1.7% |
| Nikkei 8643.75 5.9% | 8695.98 0.6% 0.6% | 8575.16 -0.8% -1.4% | 8722.17 0.9% 1.7% | 8664.58 0.2% -0.7% | 8536.46 -1.3% -1.5% |
| Shanghai 2360.66 -0.8% | 2333.23 -1.2% -1.2% | 2325.90 -1.5% -0.3% | 2332.73 -1.2% 0.3% | 2329.82 -1.3% -0.1% | 2315.27 -1.9% -0.6% |
| DAX 6080.68 10.7% | 6106.09 0.4% 0.4% | 6028.82 -0.9% -1.3% | 5994.73 -1.4% -0.6% | 5874.44 -3.4% -2.0% | 5986.71 -1.5% 1.9% |
| DJ UBS Commodities 146.29 3.2% | 145.51 -0.5% -0.6% | 145.84 -0.3% 0.2% | 144.61 -1.1% -0.8% | 143.48 -1.9% -0.8% | 142.98 -2.3% -0.3% |
| WTI $ B 100.99 4.4% | 100.78 -0.2% -0.2% | 101.00 0.0% 0.2% | 100.65 -0.3% -0.3% | 98.00 -2.9% -2.6% | 99.73 -1.2% 1.8% |
| Brent $/B 110.17 3.5% | 109.50 -0.6% -0.6% | 110.61 0.4% 1.0% | 109.54 -0.6% -1.0% | 107.53 -2.4% -1.8% | 108.8 -1.2% 1.2% |
| Gold $/OZ 1748.7 3.6% | 1726.4 -1.3% -1.3% | 1731.5 -1.0% -0.3% | 1745.9 -0.2% 0.8% | 1712.3 -2.1% -1.9% | 1715.2 -1.9% 0.2% |
Note: USD: US dollar; JPY: Japanese Yen; CHF: Swiss
Franc; AUD: Australian dollar; Comm.: commodities; OZ: ounce
Sources: http://www.bloomberg.com/markets/
http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata
The flow of cash from safe havens to risk financial assets is processed by carry trades from zero interest rates that are frustrated by episodes of risk aversion or encouraged with return of risk appetite. Factors of risk appetite and risk aversion during the week of Dec 2 are important in understanding the financial environment before the meeting of European leaders on Dec 9.
· Bank Fears. European sovereign risk crises are closely linked to the exposures of regional banks to government debt. An important form of financial repression consists of changing the proportions of debt held by financial institutions toward higher shares in government debt. The financial history of Latin America, for example, is rich in such policies. Bailouts in the euro zone have sanctioned “bailing in” the private sector, which means that creditors such as banks will participate by “voluntary” reduction of the principal in government debt (see Pelaez and Pelaez, International Financial Architecture (2005), 163-202). David Enrich, Sara Schaeffer Muñoz and Patricia Knowsmann, writing on “European nations pressure own banks for loans,” on Nov 29, 2011, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204753404577066431341281676.html?mod=WSJPRO_hpp_MIDDLETopStories), provide important data and analysis on the role of banks in the European sovereign risk crisis. They assemble data from various sources showing that domestic banks hold 16.2 percent of Italy’s total government securities outstanding of €1,617.4 billion, 22.9 percent of Portugal’s total government securities of €103.9 billion and 12.3 percent of Spain’s total government securities of €535.3 billion. Capital requirements force banks to hold government securities to reduce overall risk exposure in balance sheets. Enrich, Schaeffer Muñoz and Knowsmann find information that governments are setting pressures on banks to acquire more government debt or at least to stop selling their holdings of government debt.
· Bond Auctions. An important inflexion occurred on Nov 29. Jack Farchy, writing on “Italian bond sale boosts stock rally,” on Nov 29, 2011, published in the Financial Times (http://www.ft.com/intl/cms/s/0/2168664e-196b-11e1-92d8-00144feabdc0.html#axzz1f5gvxb00), informs on the boost to stock markets from the placement by Italy of the auction of €7.5 billion of bonds. Although the yields of 7.89 percent for three-year bonds and 7.56 percent for ten-year bonds were above the fear level of 7.0 percent, the euro gained 0.7 percent and stock markets rose.
· China Lowers Reserve Requirements. Yajun Zhang and Prudence Ho, writing on “China cuts reserve requirement ratio,” on Nov 30, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204012004577069804232647954.html?mod=WSJ_hp_LEFTWhatsNewsCollection), inform that the People’s Bank of China (PBOC), or Chinese central bank, announced the reduction of the reserve requirement of banks by 0.50 percentage points effective Dec 5. This is the first such reduction since Dec 2008. The PBOC increased the reserve requirement six times in 2011 and increased deposit rates five times since Oct 2010. Market participants are more hopeful that China will attain the elusive soft landing to lower inflation but with economic growth.
· Central Bank Dollar Swaps. The biggest boost to financial markets was provided by the return of central bank dollar swaps that were used during the financial crisis. The objective of the measure is to prevent deterioration of financial markets that could worsen the European sovereign debt crisis. The statement by the Federal Reserve is as follows (http://www.federalreserve.gov/newsevents/press/monetary/20111130a.htm):
“The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank are today announcing coordinated actions to enhance their capacity to provide liquidity support to the global financial system. The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.
These central banks have agreed to lower the pricing on the existing temporary U.S. dollar liquidity swap arrangements by 50 basis points so that the new rate will be the U.S. dollar overnight index swap (OIS) rate plus 50 basis points. This pricing will be applied to all operations conducted from December 5, 2011. The authorization of these swap arrangements has been extended to February 1, 2013. In addition, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank will continue to offer three-month tenders until further notice.
As a contingency measure, these central banks have also agreed to establish temporary bilateral liquidity swap arrangements so that liquidity can be provided in each jurisdiction in any of their currencies should market conditions so warrant. At present, there is no need to offer liquidity in non-domestic currencies other than the U.S. dollar, but the central banks judge it prudent to make the necessary arrangements so that liquidity support operations could be put into place quickly should the need arise. These swap lines are authorized through February 1, 2013.
Federal Reserve Actions
The Federal Open Market Committee has authorized an extension of the existing temporary U.S. dollar liquidity swap arrangements with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank through February 1, 2013. The rate on these swap arrangements has been reduced from the U.S. dollar OIS rate plus 100 basis points to the OIS rate plus 50 basis points. In addition, as a contingency measure, the Federal Open Market Committee has agreed to establish similar temporary swap arrangements with these five central banks to provide liquidity in any of their currencies if necessary. Further details on the revised arrangements will be available shortly.
U.S. financial institutions currently do not face difficulty obtaining liquidity in short-term funding markets. However, were conditions to deteriorate, the Federal Reserve has a range of tools available to provide an effective liquidity backstop for such institutions and is prepared to use these tools as needed to support financial stability and to promote the extension of credit to U.S. households and businesses.“
· European Central Bank. The European Central Bank (ECB) has been pressured to assist in the bailouts by acquiring sovereign debts. The ECB has been providing liquidity lines to banks under pressure and has acquired sovereign debts but not in the scale desired by authorities. In an important statement to the European Parliament, the President of the ECB Mario Draghi (2011Dec1) opened the possibility of further ECB actions but after a decisive “fiscal compact:”
“What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.
Just as we effectively have a compact that describes the essence of monetary policy – an independent central bank with a single objective of maintaining price stability – so a fiscal compact would enshrine the essence of fiscal rules and the government commitments taken so far, and ensure that the latter become fully credible, individually and collectively.
We might be asked whether a new fiscal compact would be enough to stabilise markets and how a credible longer-term vision can be helpful in the short term. Our answer is that it is definitely the most important element to start restoring credibility.
Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right. Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term. After all, investors are themselves often taking decisions with a long time horizon, especially with regard to government bonds.
A new fiscal compact would be the most important signal from euro area governments for embarking on a path of comprehensive deepening of economic integration. It would also present a clear trajectory for the future evolution of the euro area, thus framing expectations.”
· French and Spanish Bond Auctions. Jack Farchy, writing on “French and Spanish auctions calm nerves,” on Dec 1, 2011, published in the Financial Times (http://www.ft.com/intl/cms/s/0/2168664e-196b-11e1-92d8-00144feabdc0.html#axzz1fIVz4kv1), analyzes the significant improvement in bond markets. Yields of government bonds of “peripheral countries” fell significantly and the yields of Italian government bonds fell below 7 percent. Spain placed the auction of €3.75 billion of government bonds and France placed €4.35 billion of government bonds.
· Brazilian Interest Rate Cut. The Banco Central do Brasil, Brazil’s central bank, lowered its policy rate SELIC for the third consecutive meeting of its monetary policy committee, COPOM (http://www.bcb.gov.br/textonoticia.asp?codigo=3268&IDPAI=NEWS):
“Copom reduces the Selic rate to 11.00 percent · 30/11/2011 7:47:00 PM
Brasília - Continuing the process of adjustment of monetary conditions, the Copom unanimously decided to reduce the Selic rate to 11.00 percent, without bias.
The Copom understands that, by promptly mitigating the effects stemming from a more restrictive global environment, a moderate adjustment in the basic rate level is consistent with the scenario of inflation convergence to the target in 2012.”
A worldwide easing movement by central banks contributed to the boom in valuation of risk financial assets. Much depends on the insistence of strong fiscal measures that were announced in the meeting of European leaders on Dec 9.
The combination of these policies explains the surge of valuations of risk financial assets in the week of Dec 2. Table 1 shows mixed valuations of risk financial assets in the week of Dec 9. Risk aversion returned in the earlier three weeks because of the uncertainties on rapidly moving political development in Greece, Italy, Spain and perhaps even in France and Germany. Most currency movements in Table 1 reflect stability of risk aversion because of the policies of central banks worldwide. The dollar depreciated was stable in the week of Dec 9 after depreciating 1.1 percent in the prior week. Safe-haven currencies, such as the Swiss franc (CHF) and the Japanese yen (JPY) have been under threat of appreciation. A characteristic of the global recession would be struggle for maintaining competitiveness by policies of regulation, trade and devaluation (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation War (2008c)). Appreciation of the exchange rate causes two major effects on Japan.
1. Trade. Consider an example with actual data (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars (2008c), 70-72). The yen traded at JPY 117.69/USD on Apr 2, 2007 and at JPY 102.77/USD on Apr 2, 2008, or appreciation of 12.7 percent. This meant that an export of JPY 10,000 to the US sold at USD 84.97 on Apr 2, 2007 [(JPY 10,000)/(USD 117.69/USD)], rising to USD 97.30 on Apr 2, 2008 [(JPY 10,000)/(JPY 102.77)]. If the goods sold by Japan were invoiced worldwide in dollars, Japanese’s companies would suffer a reduction in profit margins of 12.7 percent required to maintain the same dollar price. An export at cost of JPY 10,000 would only bring JPY 8,732 when converted at JPY 102.77 to maintain the price of USD 84.97 (USD 84.97 x JPY 102.77/USD). If profit margins were already tight, Japan would be uncompetitive and lose revenue and market share. The pain of Japan from dollar devaluation is illustrated by Table 58 in the Nov 6 comment of this blog (http://cmpassocregulationblog.blogspot.com/2011/10/slow-growth-driven-by-reducing-savings.html): The yen traded at JPY 110.19/USD on Aug 18, 2008 and at JPY 75.812/USD on Oct 28, 2011, for cumulative appreciation of 31.2 percent. Cumulative appreciation from Sep 15, 2010 (JPY 83.07/USD) to Oct 28, 2011 (JPY 75.812) was 8.7 percent.
2. Foreign Earnings and Investment. Consider the case of a Japanese company receiving earnings from investment overseas. Accounting the earnings and investment in the books in Japan would also result in a loss of 12.7 percent. Accounting would show fewer yen for investment and earnings overseas.
There is a point of explosion of patience with dollar devaluation and domestic currency appreciation. Andrew Monahan, writing on “Japan intervenes on yen to cap sharp rise,” on Oct 31, 2011, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204528204577009152325076454.html?mod=WSJPRO_hpp_MIDDLETopStories), analyzes the intervention of the Bank of Japan, at request of the Ministry of Finance, on Oct 31, 2011. Traders consulted by Monahan estimate that the Bank of Japan sold JPY 7 trillion, about $92.31 billion, against the dollar, exceeding the JPY 4.5 trillion on Aug 4, 2011. The intervention caused an increase of the yen rate to JPY 79.55/USD relative to earlier trading at a low of JPY 75.31/USD. The JPY appreciated to JPY76.88/USD by Fri Nov 18 for cumulative appreciation of 3.4 percent from JPY 79.55 just after the intervention. The JPY appreciated another 0.3 percent in the week of Nov 18 but depreciated 1.1 percent in the week of Nov 25. There was mild depreciation of 0.3 percent in the week of Dec 2 that was followed by appreciation of 0.4 percent in the week of Dec 9. Historically, interventions in yen currency markets have been unsuccessful (Pelaez and Pelaez, The Global Recession Risk (2007), 107-109). Interventions are even more difficult currently with daily trading of some $4 trillion in world currency markets. Risk aversion with zero interest rates in the US diverts hot capital movements toward safe-haven currencies such as Japan, causing appreciation of the yen. Mitsuru Obe, writing on Nov 25, on “Japanese government bonds tumble,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204452104577060231493070676.html?mod=WSJ_hp_LEFTWhatsNewsCollection), analyzes the increase in yields of the Japanese government bond with 10 year maturity to a high for one month of 1.025 percent at the close of market on Nov 25. Thin markets in after-hours trading may have played an important role in this increase in yield but there may have been an effect of a dreaded reduction in positions of bonds by banks under pressure of reducing assets. The report on Japan sustainability by the IMF (2011JSRNov23, 2), analyzes how rising yields could threaten Japan:
· “As evident from recent developments, market sentiment toward sovereigns with unsustainably large fiscal imbalances can shift abruptly, with adverse effects on debt dynamics. Should JGB yields increase, they could initiate an adverse feedback loop from rising yields to deteriorating confidence, diminishing policy space, and a contracting real economy.
· Higher yields could result in a withdrawal of liquidity from global capital markets, disrupt external positions and, through contagion, put upward pressure on sovereign bond yields elsewhere.”
Exchange rate controls by the Swiss National Bank (SNB) fixing the rate at a minimum of CHF 1.20/EUR (http://www.snb.ch/en/mmr/reference/pre_20110906/source/pre_20110906.en.pdf) has prevented flight of capital into the Swiss franc. The Swiss franc depreciated 0.5 percent relative to the USD in the week of Dec 9 and depreciated 0.1 percent relative to the euro, as shown in Table 1. Risk courage is evident in the appreciation of the Australian dollar by cumulative 4.9 percent in the week of Fr Dec 2 after depreciation by 3.1 percent in the week of Nov 25 but the Australian dollar remained unchanged in the week of Dec 9. Risk appetite would be revealed by carry trades from zero interest rates in the US and Japan into high yielding currencies such as in Australia with appreciation of the Australian dollar (see Pelaez and Pelaez, Globalization and the State, Vol. II (2008b), 202-4, Pelaez and Pelaez, Government Intervention in Globalization (2008c), 70-4).
Risk aversion is captured by flight of investors from risk financial assets to the government securities of the US and Germany. Increasing risk aversion is captured by decrease of the yield of the 10-year Treasury note from 2.326 percent on Oct 28 to 1.964 percent on Fri Nov 25 and 2.065 on Dec 9. The 10-year Treasury yield is still at a level well below consumer price inflation of 3.5 percent in the 12 months ending in Oct (http://www.bls.gov/cpi/). Treasury securities continue to be safe haven for investors fearing risk but with concentration in shorter maturities such as the two-year Treasury with declining yield of 0.226 percent on Dec 9. Investors are willing to sacrifice yield relative to inflation in defensive actions to avoid turbulence in valuations of risk financial assets but may be managing duration more carefully. During the financial panic of Sep 2008, funds moved away from risk exposures to government securities.
A similar risk aversion phenomenon occurred in Germany. The estimate of euro zone CPI inflation is at 3.0 percent for the 12 months ending in Oct (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-16112011-AP/EN/2-16112011-AP-EN.PDF) and the flash estimate for Nov is also 3.0 percent (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-30112011-AP/EN/2-30112011-AP-EN.PDF) but the yield of the two-year German government bond remained virtually unchanged at 0.31 percent by Dec 9. The yield of the 10-year German government bond was also almost unchanged at 2.15 percent on Dec 9. Safety overrides inflation-adjusted yield but there could be duration aversion. Turbulence also affected the market for German sovereign bonds. Emese Bartha, Art Patnaude and Nick Cawley, writing on “German bond auction falls flat,” on Nov 23, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204630904577055590007145230.html?mod=WSJPRO_hpp_LEFTTopStories), find decrease in risk appetite even for the highest quality financial assets in the euro zone. The auction of €6 billion of 10-year bunds on Nov 23 placed only €3.664 billion, or 60.7 percent. Although inflation of consumer prices in the UK at 5.0 percent exceeds euro zone inflation at 3.0 percent, David Oakley, Tracy Alloway, Alex Barker and Gerrit Wiesmann, writing on “UK borrowing costs drop below Germany,” on Nov 24, published in the Financial Times (http://www.ft.com/intl/cms/s/0/78994200-15c2-11e1-8db8-00144feabdc0.html#axzz1eWzvlRSp), inform that on Thu Nov 24 the UK 10-year gilt traded at 2.20 percent, which was lower than the yield of 2.23 percent of the German 10-year bond. Richard Milne, writing on “Italian bond yields rise above 8%,” on Nov 25, published in the Financial Times (http://www.ft.com/intl/cms/s/0/07079856-1754-11e1-b20e-00144feabdc0.html#axzz1eoXVrMVL), provides a quote of 8.13 percent for two-year Italian government bonds registered by Reuters’ data. Emese Bartha, writing on “Italy leads busy week of euro-zone bond sales,” on Nov 25, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204452104577060002367158964.html?mod=WSJPRO_hpp_LEFTTopStories), informs that Italy, Belgium, Spain and France are auctioning bonds in the week of Nov 28. Stacy Meichtry and Jonathan Cheng, writing on Nov 26, on “New strains hit euro, global markets,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970204452104577060660416404298.html?mod=WSJPRO_hpp_LEFTTopStories), inform that the planned auction of bonds by five euro zone governments is for €19 billion. European sovereign risk successfully navigated turbulence in the week of Dec 2 but these earlier eruptions of yields illustrate the troubled road ahead.
All the equity indexes in Table 1 with the exception of the US DJIA fell during the week of Dec 9. Germany’s Dax jumped 1.9 percent on Fri Dec 9 but still ended down by 1.5 percent. Dow Global rose 1.0 percent on Dec 9 but was still down 0.3 percent in the week. DJIA gained 1.4 percent.
Financial risk assets increase during moderation of risk aversion in carry trades from zero interest rates and fall during increasing risk aversion. Commodities fell together with most equity indexes. The DJ-UBS commodities index lost 2.3 percent in the week of Dec 9, Brent fell 1.2 percent and WTI also fell 1.2 percent. Gold also declined 1.9 percent in the week of Dec 9.
IB Fiscal Compact. There are three types of actions in Europe to steer the euro zone away from the threats of fiscal and banking crises: (1) fiscal compact; (2) enhancement of stabilization tools and resources; and (3) bank capital requirements. The first two consist of agreements by the Euro Area Heads of State and government while the third one consists of measurements and recommendations by the European Banking Authority.
4. Fiscal Compact. The “fiscal compact” consists of (1) conciliation of fiscal policies and budgets within a “fiscal rule”; and (2) establishment of mechanisms of governance, monitoring and enforcement of the fiscal rule.
iii. Fiscal Rule. The essence of the fiscal rule is that “general government budgets shall be balanced or in surplus” by compliance of members countries that “the annual structural deficit does not exceed 0.5% of nominal GDP” (European Council 2011Dec9, 3). Individual member states will create “an automatic correction mechanism that shall be triggered in the event of deviation” (European Council 2011Dec9, 3). Member states will define their automatic correction mechanisms following principles proposed by the European Commission. Those member states falling into an “excessive deficit procedure” will provide a detailed plan of structural reforms to correct excessive deficits. The European Council and European Commission will monitor yearly budget plans for consistency with correction of excessive deficits. Member states will report in anticipation their debt issuance plans. Deficits in excess of 3 percent of GDP and/or debt in excess of 60 percent of GDP will trigger automatic consequences.
iv. Policy Coordination and Governance. The euro area is committed to following common economic policy. In accordance, “a procedure will be established to ensure that all major economic policy reforms planned by euro area member states will be discussed and coordinated at the level of the euro area, with a view to benchmarking best practices” (European Council 2011Dec9, 5). Governance of the euro area will be strengthened with regular euro summits at least twice yearly.
5. Stabilization Tools and Resources. There are several enhancements to the bailouts of member states.
iii. Facilities. The European Financial Stability Facility (EFSF) will use leverage and the European Central Bank as agent of its market operations. The European Stability Mechanism (ESM) or permanent bailout facility will be operational as soon as 90 percent of the capital commitments are ratified by member states. The ESM is planned to begin in Jul 2012.
iv. Financial Resources. The overall ceiling of the EFSF/ESM of €500 billion (USD 670 billion) will be reassessed in mar 2012. Measures will be taken to maintain “the combined effective lending capacity of EUR 500 billion” (European Council 2011Dec9, 6). Member states will “consider, and confirm within 10 days, the provision of additional resources for the IMF of up to EUR 200 billion (USD 270 billion), in the form of bilateral loans, to ensure that the IMF has adequate resources to deal with the crisis. We are looking forward to parallel contributions from the international community” (European Council 2011Dec9, 6). Bailouts “will strictly adhere to the well established IMF principles and practices.” There is a specific statement on private sector involvement and its relation to recent experience: “We clearly reaffirm that the decisions taken on 21 July and 26/27 October concerning Greek debt are unique and exceptional; standardized and identical Collective Action clauses will be included, in such a way as to preserve market liquidity, in the terms and conditions of all new euro government bonds” (European Council 2011Dec9, 6). Will there be again “unique and exceptional” conditions? The ESM is authorized to take emergency decisions with “a qualified majority of 85% in case the Commission and the ECB conclude that an urgent decision related to financial assistance is needed when the financial and economic sustainability of the euro area is threatened” (European Council 2011Dec9, 6).
6. Bank Capital. The European Banking Authority (EBA) finds that European banks have a capital shortfall of €114.7 billion (http://stress-test.eba.europa.eu/capitalexercise/Press%20release%20FINAL.pdf). To avoid credit difficulties, the EBA recommends “that the credit institutions build a temporary capital buffer to reach a 9% Core Tier 1 ratio by 30 June 2012” (http://stress-test.eba.europa.eu/capitalexercise/EBA%20BS%202011%20173%20Recommendation%20FINAL.pdf 6). Patrick Jenkins, Martin Stabe and Stanley Pignal, writing on Dec 9, 2011, on “EU banks slash sovereign holdings,” published in the Financial Times (http://www.ft.com/intl/cms/s/0/a6d2fd4e-228f-11e1-acdc-00144feabdc0.html#axzz1gAlaswcW), analyze the balance sheets of European banks released by the European Banking Authority. They conclude that European banks have reduced their holdings of riskier sovereign debt of countries in Europe by €65 billion from the end of 2010 to Sep 2011. Bankers informed that the European Central Bank and hedge funds acquired those exposures that represent 13 percent of their holdings of debt to Greece, Ireland, Italy, Portugal and Spain, which are down to €513 billion by the end of IIIQ2011.
IIC European Central Bank. In the introductory statement to the press conference following the regularly-scheduled meeting of the European Central Bank (ECB), Draghi (2011Dec8) explains the decision to lower the policy rate:
“Based on its regular economic and monetary analyses, the Governing Council decided to lower the key ECB interest rates by 25 basis points, following the 25 basis point decrease on 3 November 2011. Inflation is likely to stay above 2% for several months to come, before declining to below 2%. The intensified financial market tensions are continuing to dampen economic activity in the euro area and the outlook remains subject to high uncertainty and substantial downside risks. In such an environment, cost, wage and price pressures in the euro area should remain modest over the policy-relevant horizon. At the same time, the underlying pace of monetary expansion remains moderate. Overall, it is essential for monetary policy to maintain price stability over the medium term, thereby ensuring a firm anchoring of inflation expectations in the euro area in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term. Such anchoring is a prerequisite for monetary policy to make its contribution towards supporting economic growth and job creation in the euro area.”
What markets awaited came in the weaker form of temporary liquidity measures instead of the expectation of more aggressive bond buying by the ECB (Draghi 2011Dec8). These measures are termed as “non-standard:” (1) longer-term refinancing transactions with maturity of 36 months with the option of repayment after a year; (2) extension of collateral to new asset-backed securities; (3) reduction of the reserve ratio from 2 to 1 percent; and (4) discontinuance of fine-tuning in the final day of the maintenance period. Draghi (2011Dec8) reaffirmed the need for strong fiscal measures or compact in the euro zone:
“Turning to fiscal policies, all euro area governments urgently need to do their utmost to support fiscal sustainability in the euro area as a whole. A new fiscal compact, comprising a fundamental restatement of the fiscal rules together with the fiscal commitments that euro area governments have made, is the most important precondition for restoring the normal functioning of financial markets. Policy-makers need to correct excessive deficits and move to balanced budgets in the coming years by specifying and implementing the necessary adjustment measures. This will support public confidence in the soundness of policy actions and thus strengthen overall economic sentiment.
To accompany fiscal consolidation, the Governing Council has repeatedly called for bold and ambitious structural reforms. Going hand in hand, fiscal consolidation and structural reforms would strengthen confidence, growth prospects and job creation. Key reforms should be immediately carried out to help the euro area countries to improve competitiveness, increase the flexibility of their economies and enhance their longer-term growth potential. Labour market reforms should focus on removing rigidities and enhancing wage flexibility. Product market reforms should focus on fully opening up markets to increased competition.”
ID Euro Zone Survival Risk. Charles Forelle and Stephen Fidler, writing on Dec 10, 2011, on “Questions place EU pact,” published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052970203413304577087562993283958.html?mod=WSJPRO_hpp_LEFTTopStories#project%3DEUSUMMIT121011%26articleTabs%3Darticle), provide data, information and analysis of the agreement of Dec 9. There are multiple issues centering on whether investors will be reassured that the measures have reduced the risks of European sovereign obligations. While the European Central Bank has welcomed the measures, it is not yet clear of its future role in preventing erosion of sovereign debt values.
Another complicating factor is whether there will be further actions on sovereign debt ratings. On Dec 5, 2011, four days before the conclusion of the meeting of European leaders, Standard & Poor’s (2011Dec5) placed the sovereign ratings of 15 members of the euro zone on “CreditWatch with negative implications.” S&P finds five conditions that trigger the action: (1) worsening credit conditions in the euro area; (2) differences among member states on how to manage the debt crisis in the short run and on measures to move toward enhanced fiscal convergence; (3) household and government debt at high levels throughout large parts of the euro area; (4) increasing risk spreads on euro area sovereigns, including those with AAA ratings; and (5) increasing risks of recession in the euro zone. S&P also placed the European Financial Stability Facility (EFSF) in CreditWatch with negative implications (http://www.standardandpoors.com/ratings/articles/en/us/?articleType=HTML&assetID=1245325307963). On Dec 9, 2011, Moody’s Investors Service downgraded the ratings of the three largest French banks (http://www.moodys.com/research/Moodys-downgrades-BNP-Paribass-long-term-ratings-to-Aa3-concluding--PR_232989 http://www.moodys.com/research/Moodys-downgrades-Credit-Agricole-SAs-long-term-ratings-to-Aa3--PR_233004 http://www.moodys.com/research/Moodys-downgrades-Socit-Gnrales-long-term-ratings-to-A1--PR_232986 ).
The euro zone faces a critical survival risk because several of its members may default on their sovereign obligations if not bailed out by the other members. The valuation equation of bonds is essential to understanding the stability of the euro area. An explanation is provided in this paragraph and readers interested in technical details are referred to the following Subsection ID Appendix on Sovereign Bond Valuation. Contrary to the Wriston doctrine, investing in sovereign obligations is a credit decision. The value of a bond today is equal to the discounted value of future obligations of interest and principal until maturity. On Dec 2 the yield of the 2-year bond of the government of Greece was quoted above 105 percent. In contrast, the 2-year US Treasury note traded at 0.226 percent and the 10-year at 2.065 percent while the comparable 2-year government bond of Germany traded at 0.32 percent and the 10-year government bond of Germany traded at 2.15 percent (see Table 1). There is no need for sovereign ratings: the perceptions of investors are of relatively higher probability of default by Greece, defying Wriston (1982), and nil probability of default of the US Treasury and the German government. The essence of the sovereign credit decision is whether the sovereign will be able to finance new debt and refinance existing debt without interrupting service of interest and principal. Prices of sovereign bonds incorporate multiple anticipations such as inflation and liquidity premiums of long-term relative to short-term debt but also risk premiums on whether the sovereign’s debt can be managed as it increases without bound. The austerity measures of Italy are designed to increase the primary surplus, or government revenues less expenditures excluding interest, to ensure investors that Italy will have the fiscal strength to manage its debt of 120 percent of GDP, which is the third largest in the world after the US and Japan. Appendix ID links the expectations on the primary surplus to the real current value of government monetary and fiscal obligations. As Blanchard (2011SepWEO) analyzes, fiscal consolidation to increase the primary surplus is facilitated by growth of the economy. Italy and the other indebted sovereigns in Europe face the dual challenge of increasing primary surpluses while maintaining growth of the economy.
Much of the analysis and concern over the euro zone centers on the lack of credibility of the debt of a few countries while there is credibility of the debt of the euro zone as a whole. In practice, there is convergence in valuations and concerns toward the fact that there may not be credibility of the euro zone as a whole. The fluctuations of financial risk assets of members of the euro zone move together with risk aversion toward the countries with lack of debt credibility. This movement raises the need to consider analytically sovereign debt valuation of the euro zone as a whole in the essential analysis of whether the single-currency will survive without major changes.
Welfare economics considers the desirability of alternative states, which in this case would be evaluating the “value” of Germany (1) within and (2) outside the euro zone. Is the sum of the wealth of euro zone countries outside of the euro zone higher than the wealth of these countries maintaining the euro zone? On the choice of indicator of welfare, Hicks (1975, 324) argues:
“Partly as a result of the Keynesian revolution, but more (perhaps) because of statistical labours that were initially quite independent of it, the Social Product has now come right back into its old place. Modern economics—especially modern applied economics—is centered upon the Social Product, the Wealth of Nations, as it was in the days of Smith and Ricardo, but as it was not in the time that came between. So if modern theory is to be effective, if it is to deal with the questions which we in our time want to have answered, the size and growth of the Social Product are among the chief things with which it must concern itself. It is of course the objective Social Product on which attention must be fixed. We have indexes of production; we do not have—it is clear we cannot have—an Index of Welfare.”
If the burden of the debt of the euro zone falls on Germany and France or only on Germany, is the wealth of Germany and France or only Germany higher after breakup of the euro zone or if maintaining the euro zone? In practice, political realities will determine the decision through elections.
The prospects of survival of the euro zone are dire. Table 2 is constructed with current IMF World Economic Outlook database for GDP in USD billions, primary net lending/borrowing as percent of GDP and general government debt as percent of GDP for selected regions and countries in 2010.
Table 2, World and Selected Regional and Country GDP and Fiscal Situation
| GDP 2010 | Primary Net Lending Borrowing | General Government Net Debt | |
| World | 62,911.2 | ||
| Euro Zone | 12,167.8 | -3.6 | 65.9 |
| Portugal | 229.2 | -6.3 | 88.7 |
| Ireland | 206.9 | -28.9 | 78.0 |
| Greece | 305.4 | -4.9 | 142.8 |
| Spain | 1,409.9 | -7.8 | 48.8 |
| Major Advanced Economies G7 | 31,716.9 | -6.5 | 76.5 |
| United States | 14,526.6 | -8.4 | 68.3 |
| UK | 2,250.2 | -7.7 | 67.7 |
| Germany | 3,286.5 | -1.2 | 57.6 |
| France | 2,562.7 | -4.9 | 76.5 |
| Japan | 5,458.8 | -8.1 | 117.2 |
| Canada | 1,577.0 | -4.9 | 32.2 |
| Italy | 2,055.1 | -0.3 | 99.4 |
| China | 5,878.3 | -2.3 | 33.8* |
| Cyprus | 23.2 | -5.3 | 61.6 |
*Gross Debt
Source: http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx
The data in Table 2 are used for some very simple calculations in Table 3. The column “Net Debt USD Billions” in Table 3 is generated by applying the percentage in Table 2 column “General Government Net Debt % GDP 2010” to the column “GDP USD Billions.” The total debt of France and Germany in 2010 is $3853.5 billion, as shown in row “B+C” in column “Net Debt USD Billions” The sum of the debt of Italy, Spain, Portugal, Greece and Ireland is $3531.6 billion. There is some simple “unpleasant bond arithmetic” in the two final columns of Table 3. Suppose the entire debt burdens of the five countries with probability of default were to be guaranteed by France and Germany, which de facto would be required by continuing the euro zone. The sum of the total debt of these five countries and the debt of France and Germany is shown in column “Debt as % of Germany plus France GDP” to reach $7385.1 billion, which would be equivalent to 126.3 percent of their combined GDP in 2010. Under this arrangement the entire debt of the euro zone including debt of France and Germany would not have nil probability of default. The final column provides “Debt as % of Germany GDP” that would exceed 224 percent if including debt of France and 165 percent of German GDP if excluding French debt. The unpleasant bond arithmetic illustrates that there is a limit as to how far Germany and France can go in bailing out the countries with unsustainable sovereign debt without incurring severe pains of their own such as downgrades of their sovereign credit ratings. A central bank is not typically engaged in direct credit because of remembrance of inflation and abuse in the past. There is also a limit to operations of the European Central Bank in doubtful credit obligations. Wriston (1982) would prove to be wrong again that countries do not bankrupt but would have a consolation prize that similar to LBOs the sum of the individual values of euro zone members outside the current agreement exceeds the value of the whole euro zone. Internal rescues of French and German banks may be less costly than bailing out other euro zone countries so that they do not default on French and German banks.
Table 3, Guarantees of Debt of Sovereigns in Euro Area as Percent of GDP of Germany and France, USD Billions and %
| Net Debt USD Billions | Debt as % of Germany Plus France GDP | Debt as % of Germany GDP | |
| A Euro Area | 8,018.6 | ||
| B Germany | 1,893.0 | $7385.1 as % of $3286.5 =224.7% $5424.6 as % of $3286.5 =165.1% | |
| C France | 1,960.5 | ||
| B+C | 3,853.5 | GDP $5849.2 Total Debt $7385.1 Debt/GDP: 126.3% | |
| D Italy | 2,042.8 | ||
| E Spain | 688.0 | ||
| F Portugal | 203.3 | ||
| G Greece | 436.1 | ||
| H Ireland | 161.4 | ||
| Subtotal D+E+F+G+H | 3,531.6 |
Source: calculation with IMF data http://www.imf.org/external/pubs/ft/weo/2011/01/weodata/index.aspx
There is extremely important information in Table 4 for the current sovereign risk crisis in the euro zone. Table 4 provides the structure of regional and country relations of Germany’s exports and imports with newly available data for Oct. German exports to other European Union members are 58.7 percent of total exports in Oct and 59.6 percent in Jan-Oct. Exports to the euro area are 39.0 percent in Oct and 40.0 percent in Jan-Oct. Exports to third countries are only 41.3 percent of the total in Oct and 40.4 percent in Jan-Oct. There is similar distribution for imports. Economic performance in Germany is closely related to its high competitiveness in world markets. Weakness in the euro zone and the European Union in general could affect the German economy. This may be the major reason for choosing the “fiscal abuse” of the European Central Bank considered by Buiter (2011Oct31) over the breakdown of the euro zone. There is a tough analytical, empirical and forecasting doubt of growth and trade in the euro zone and the world with or without maintenance of the European Monetary Union (EMU) or euro zone.
Table 4, Germany, Structure of Exports and Imports by Region, € Billions and ∆%
| Oct 2011 | 12 Months | Jan-Oct | Jan-Oct 2011/ | |
| Total | 89.2 | 3.8 | 881.1 | 12.5 |
| A. EU | 52.4 % 58.7 | 0.8 | 524.9 % 59.6 | 11.4 |
| Euro Area | 34.8 % 39.0 | -0.4 | 352.1 % 40.0 | 10.2 |
| Non-euro Area | 17.7 % 19.8 | 3.1 | 172.7 % 19.6 | 14.0 |
| B. Third Countries | 36.8 % 41.3 | 8.3 | 356.2 % 40.4 | 14.1 |
| Total Imports | 77.6 | 8.6 | 750.7 | 14.6 |
| C. EU Members | 49.2 % 63.4 | 7.3 | 475.9 % 63.4 | 15.1 |
| Euro Area | 33.8 % 43.6 | 6.1 | 334.2 % 44.5 | 14.3 |
| Non-euro Area | 15.4 % 19.9 | 10.2 | 141.6 % 18.9 | 17.1 |
| D. Third Countries | 28.5 % 36.7 | 10.9 | 274.9 % 36.6 | 13.8 |
Notes: Total Exports = A+B; Total Imports = C+D
IVA Appendix on Sovereign Bond Valuation. There are two approaches to government finance and their implications: (1) simple unepleasant monetarist arithmetic; and (2) simple unpleasant fiscal arithmetic. Both approaches illustrate how sovereign debt can be perceived riskier under profligacy.
First, Unpleasant Monetarist Arithmetic. Fiscal policy is described by Sargent and Wallace (1981, 3, equation 1) as a time sequence of D(t), t = 1, 2,…t, …, where D is real government expenditures, excluding interest on government debt, less real tax receipts. D(t) is the real deficit excluding real interest payments measured in real time t goods. Monetary policy is described by a time sequence of H(t), t=1,2,…t, …, with H(t) being the stock of base money at time t. In order to simplify analysis, all government debt is considered as being only for one time period, in the form of a one-period bond B(t), issued at time t-1 and maturing at time t. Denote by R(t-1) the real rate of interest on the one-period bond B(t) between t-1 and t. The measurement of B(t-1) is in terms of t-1 goods and [1+R(t-1)] “is measured in time t goods per unit of time t-1 goods” (Sargent and Wallace 1981, 3). Thus, B(t-1)[1+R(t-1)] brings B(t-1) to maturing time t. B(t) represents borrowing by the government from the private sector from t to t+1 in terms of time t goods. The price level at t is denoted by p(t). The budget constraint of Sargent and Wallace (1981, 3, equation 1) is:
D(t) = {[H(t) – H(t-1)]/p(t)} + {B(t) – B(t-1)[1 + R(t-1)]} (1)
Equation (1) states that the government finances its real deficits into two portions. The first portion, {[H(t) – H(t-1)]/p(t)}, is seigniorage, or “printing money.” The second part,
{B(t) – B(t-1)[1 + R(t-1)]}, is borrowing from the public by issue of interest-bearing securities. Denote population at time t by N(t) and growing by assumption at the constant rate of n, such that:
N(t+1) = (1+n)N(t), n>-1 (2)
The per capita form of the budget constraint is obtained by dividing (1) by N(t) and rearranging:
B(t)/N(t) = {[1+R(t-1)]/(1+n)}x[B(t-1)/N(t-1)]+[D(t)/N(t)] – {[H(t)-H(t-1)]/[N(t)p(t)]} (3)
On the basis of the assumptions of equal constant rate of growth of population and real income, n, constant real rate of return on government securities exceeding growth of economic activity and quantity theory equation of demand for base money, Sargent and Wallace (1981) find that “tighter current monetary policy implies higher future inflation” under fiscal policy dominance of monetary policy. That is, the monetary authority does not permanently influence inflation, lowering inflation now with tighter policy but experiencing higher inflation in the future.
Second, Unpleasant Fiscal Arithmetic. The tool of analysis of Cochrane (2011Jan, 27, equation (16)) is the government debt valuation equation:
(Mt + Bt)/Pt = Et∫(1/Rt, t+τ)st+τdτ (4)
Equation (4) expresses the monetary, Mt, and debt, Bt, liabilities of the government, divided by the price level, Pt, in terms of the expected value discounted by the ex-post rate on government debt, Rt, t+τ, of the future primary surpluses st+τ, which are equal to Tt+τ – Gt+τ or difference between taxes, T, and government expenditures, G. Cochrane (2010A) provides the link to a web appendix demonstrating that it is possible to discount by the ex post Rt, t+τ. The second equation of Cochrane (2011Jan, 5) is:
MtV(it, ·) = PtYt (5)
Conventional analysis of monetary policy contends that fiscal authorities simply adjust primary surpluses, s, to sanction the price level determined by the monetary authority through equation (5), which deprives the debt valuation equation (4) of any role in price level determination. The simple explanation is (Cochrane 2011Jan, 5):
“We are here to think about what happens when [4] exerts more force on the price level. This change may happen by force, when debt, deficits and distorting taxes become large so the Treasury is unable or refuses to follow. Then [4] determines the price level; monetary policy must follow the fiscal lead and ‘passively’ adjust M to satisfy [5]. This change may also happen by choice; monetary policies may be deliberately passive, in which case there is nothing for the Treasury to follow and [4] determines the price level.”
An intuitive interpretation by Cochrane (2011Jan 4) is that when the current real value of government debt exceeds expected future surpluses, economic agents unload government debt to purchase private assets and goods, resulting in inflation. If the risk premium on government debt declines, government debt becomes more valuable, causing a deflationary effect. If the risk premium on government debt increases, government debt becomes less valuable, causing an inflationary effect.
There are multiple conclusions by Cochrane (2011Jan) on the debt/dollar crisis and Global recession, among which the following three:
(1) The flight to quality that magnified the recession was not from goods into money but from private-sector securities into government debt because of the risk premium on private-sector securities; monetary policy consisted of providing liquidity in private-sector markets suffering stress
(2) Increases in liquidity by open-market operations with short-term securities have no impact; quantitative easing can affect the timing but not the rate of inflation; and purchase of private debt can reverse part of the flight to quality
(3) The debt valuation equation has a similar role as the expectation shifting the Phillips curve such that a fiscal inflation can generate stagflation effects similar to those occurring from a loss of anchoring expectations.
II Global Inflation. There is inflation everywhere in the world economy, with slow growth and persistently high unemployment in advanced economies. Table 5 updated with every post, provides the latest annual data for GDP, consumer price index (CPI) inflation, producer price index (PPI) inflation and unemployment (UNE) for the advanced economies, China and the highly-indebted European countries with sovereign risk issues. The table now includes the Netherlands and Finland that with Germany make up the set of northern countries in the euro zone that hold key votes in the enhancement of the mechanism for solution of the sovereign risk issues (Peter Spiegel and Quentin Peel, “Europe: Northern Exposures,” Financial Times, Mar 9, 2011 http://www.ft.com/intl/cms/s/0/55eaf350-4a8b-11e0-82ab-00144feab49a.html#axzz1gAlaswcW). Newly available data on inflation is considered below in this section. The data in Table 22 for the euro zone and its members is updated from information provided by Eurostat but individual country information is provided in this section as soon as available, following Table 5. Data for other countries in Table 5 are also updated with reports from their statistical agencies. Economic data for major regions and countries is considered in Section VI World Economic Slowdown following with individual country and regional data tables.
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