Celtic Thoughts - March 28th, 2011
The London Brief
March 28th, 2011
In February 1929, a German delegation led by Hjalmar Schacht, attempted to renegotiate Germany's reparations to stem an immediate crisis. His offer was $250 million spread over 37 years. The French demanded $600 million spread over 62 years with a potential revision to $1 billion. Although Schacht almost walked out, German politicians did not want to face the prospect of outright default. They relented and signed a deal where they would pay $500 million for the next 36 years and $375 million for 22 years after that to cover the Allies debt to the United States. Schacht said, "The crisis may have been postponed for another two years, but it will arrive with the same certainty and with even greater severity. Germany will be cut off from all foreign capital for a long time, maybe two to three years. For all segments of the German people this will mean managing without, longer working hours, lower wages".
It's a shame Angela Merkel doesn't learn from Germany's own history when negotiating with Ireland. Germany never paid its reparations debt.
The anecdotes from my friends and contacts in Ireland are troubling. There are some people pulling deposits out of their banks and burying euros in their back yard. The Irish tax rate for most income earners is now 60%. As a result, there is an exodus of people trying to find jobs outside the country. In Irish bars and homes the debate is about when Ireland will either be kicked out of the euro or forced to leave the euro. Many people are stuck on variable rate mortgages worried about when the ECB will raise interest rates. This will further depress the housing market and increase the number of bad loans at the banks. JP Morgan notes that the periphery output gap between capacity utilization and output has never been higher in 40 years. Irish GDP shrunk 1.6% last quarter. It's a deflationary spiral.
The latest issue is that Germany and France want Ireland to raise its corporate tax rate from 12.5% in return for a 1% interest rate cut in the EU/IMF loan facilities. “We’re not asking Ireland to put up their corporate taxes to the European average, but to make some effort. But you can’t ask others to contribute for you, when you won’t make an effort on your tax receipts,” French President Sarkozy said. However, there would soon be an exodus of corporations leaving, most likely reducing tax revenues. Germany and France don't seem to care, most probably to hurt their national competitors, many of whom are American using Ireland as a tax base for Europe. “It is a fundamental issue for our country,” said Enda Kenny. Raising the rate “would represent a major breach of trust.” Logic suggests that Germany and France will relent, but it represents a failure of intent on the part of the EU.
There is a joke running around the streets of Dublin that the British conquered Ireland and made them slaves by boat whereas EU bureaucrats conquered Ireland through Ryanair flights. The intent from Brussels should not be to subjugate a member state to fiscal torture, but to allow Ireland to recover. Germany and Japan received better treatment after World War II. A recovery is better for everybody, particularly Germany.
Let's imagine an alternative: debt restructuring. Instead of bailing out the banks and increasing government debt to GDP, the debt is forgiven to get Ireland to a sustainable debt burden. Instead of a 60% tax rate, Ireland reduces it a rate that encourages GDP growth. Rather than hurting corporations, Ireland provides a stable environment to attract them. The property market is allowed to clear. Instead of bail-out facilities to keep Ireland paying its debt to European banks, direct aid is given to European banks to help them work through their capital losses.
To avoid moral hazard issues in the future, statutory debt limits could be imposed on Ireland and its banks. If exceeded, Ireland would have to pay back debt that was forgiven first before being allowed to leverage back up again. (There are other ways to control moral hazard post restructuring).
Besides obvious political reasons, there are several elements holding the EU back from considering an Irish debt restructuring: (1) lack of fiscal sustainability; (2) contagion effects; (3) the inter-bank market effect; and (4) ECB losses.
Defaults only work if the debtor nation has a fiscal surplus. A nation which defaults can no longer tap credit markets for a few years. After a period of time, the bond market forgets and debt can be issued (if Pakistan can do that, certainly Ireland can). During the lean years though you need to be in surplus. Even excluding the capital account and interest, Ireland is at a 5% budget deficit. However, if any nation has the intestinal fortitude to cut social security and health care spending (about 57% of the budget), it is the Irish.
Contagion is another important issue. In an Irish default, Greece and Portuguese bonds would be sold indiscriminately because their plight is similar to Ireland. Although Spain and Italy are in a more theoretically manageable situation without debt restructuring, the market will not buy that risk and sell their bonds too. If the default issue was dealt with systematically where Greece, Portugal and Ireland were all restructured and the European Financial Stability Fund (EFSF) were dedicated to purchases of Italian and Spanish debt, the EU could solve the crisis. However, Greece is no where near getting its fiscal house in order and Portugal's president had to resign when he tried. Thus there is a timing problem with a comprehensive debt restructuring. That said, the European facility is large enough to absorb the panic selling in Spain and Italy, so if the Irish debt restructuring is ad hoc and singular, the scale of the EFSF should stem the panic. China also continues to support periphery bonds and are buying bonds issued by the EFSF. China says that 25% of their reserve allocation to euros will go to periphery countries. This accentuates the possibility contagion risk can be contained.
The risk to the inter-bank market directly is low because no one risks lending to an Irish bank. Greece and Portugal are also on the "do not touch" list of most banks. The real risk is that inter-bank lending to Spanish and Italian institutions gets lower, which in turn, makes banks reduce inter-bank lending outside of their home country. Again the EFSF should help in this regard by maintaining a stable market for the banks.
The ECB issue is a big problem. With Irish depositors consistently withdrawing and doing such things as burying their money, the ECB is having to take more and more Irish risk. They are in effect substituting for the Irish depositor through the Bank of Ireland and Irish sovereign debt. If Ireland turned around and said, "right, let's restructure all the debt" the ECB would take real losses to capital. The European Stability Mechanism (ESM) is supposed to help relieve the ECB. But as of today, the ECB is on the hook. They have been the most vocal against debt restructuring for obvious reasons.
For Ireland, the key issue is what happens to the depositor? Under a default scenario, Ireland could go back to the pound and re-denominate all the euro deposits. The people who did not bury their euros in their backyard will be very upset. But while deposit losses would probably kill what little remains of consumer spending, the weakened currency, post-crisis balance sheet, the pro business mentality and the high quality labour force should make Ireland an appealing choice for industry. It's very painful, but it does not have to be the apocalypse.
Another solution is to implement debt restructuring but do it later. To this end the EFSF will be replaced by the ESM in 2013. The ESM will have 500 million euros of lending capacity and can buy bonds in the primary market. From now until that date bank buffers can be built, the EU can continue working with periphery countries to get their fiscal balances into surplus and then they can agree on a managed debt restructuring. It's an open question whether the Irish people can wait for debt restructuring. But perhaps this is the most probable outcome.
Today the EU is imposing nonsense macro-economic policy on Ireland. The EU has to change its intent from punishment to problem solving. Otherwise eventually the Irish people will go the way of Hjalmar Schacht's Germany and default on the debt.
In last week's note, I stated losses may be $175 billion. Goldman is higher and calculates the total damage at Y16 trillion or $200 billion. Bloomberg cites estimates of $300 billion of damages. That said, a distinction with the Kobe earthquake is that there was no lasting effect to the energy system.
By the summer-time, TEPCO will probably be short 40% of its generating capacity. Total demand rises from 41 million kilowatts to 55 to 60 million kilowatts by summer in TEPCO's area. Under the best case assumptions, they will be short 5 million kilowatts. TEPCO will probably supply manufacturers fully in order to keep Kanto-area GDP up, so it may be a hot summer for many Tokyoites.
Additionally, Japan exports food equivalent to 0.7% of its GDP. There is world-wide fear on consuming such products now. Most countries have instituted bans from the four areas with evidence of high radiation readings, but many are banning any agricultural produce from Japan.
While Japan will recover, the nuclear reactor problem is going to stretch normalization out a bit and probably make this worse than the Kobe earthquake. So the Japan recovery trade may take a few quarters to play out.
A reader from Shanghai forwarded me an article on China National Nuclear Corporation, the largest operator of nuclear power plants in China. The president was dismissed last year for taking $1 million of bribes. A foreign company paid the bribes wanting to build nuclear power plants in China. He was jailed for life. Safety considerations clearly did not have the most importance in reactor design.
In Taipei's 101 tower, Japanese executives have the option to check out their sashimi with a Geiger counter. "We didn't want to put the Geiger counter out originally because we were afraid of losing it, but customers kept asking us to scan their food for them and compare the reading with their friends' dishes". Far from keeping clients away, the Peony restaurant and its Geiger counter were featured on TV and they are jammed pack. So note to Japan sushi chefs: a Geiger counter costs about 100 pounds and can be purchased on-line.
Another reader also sent me this link to his blog on Hong Kong air pollution.
After reading it, I would prefer somewhat higher radiation in Tokyo. (Of course my wife tells me in London we don't have to worry about radiation or smog because permanent wetness is not a health hazard).
I'll leave you with an entertaining video from the Columbia Business School on Ben Bernanke. The person in the video looks like the assistant dean of the business school who was one of the contenders for Mr. Bernanke's job.
London, March 28th, 2011