The General Theorist

MATTHEW KLEIN at the FT has a nice post in Alphaville recalling the egregious adjustment in the peripheral euro area current account balances since the Great Financial Crisis (GFC)—from deficit to surplus. Indeed, “the change in the 19-member group’s current account balance can be almost entirely attributed to the crisis countries.” As he points out, similar to the experience of those hit hardest during the Asia Crisis, current account surpluses and deleveraging are forcing global adjustment elsewhere.

While true, of course, this Crisis-reaction narrative somewhat understates the contribution of flawed euro area policies—in an incomplete and disjointed monetary union—forcing adjustment entirely on domestic demand in the periphery, and therefore a compression in imports there, with little offsetting expansion in demand in the Core. This allowed the area-wide surplus to expand at the expense of the rest of the world.

Indeed, the trick for Germany at that time, in order to ride-out lower intra-euro demand, was to switch goods exports towards the rest of the world—China, the UK and US amongst others. This is shown in Figure 1 where Germany’s surplus against non-euro area rest of the world (ROW) expands throughout 2011 and 2012 (measured as percent of EA19 GDP). Meanwhile, the rest of the euro area (ROEA) balance against ROW went from deficit to surplus against ROW, as Klein points out.

Another way of seeing this is witness—and decompose—domestic demand growth in the euro area into contributions from Germany and the remaining countries. This is shown in Figure 2. Germany made a smaller contribution to overall domestic demand through 2007, after which followed a coordinated drop in domestic demand in 2008-09. After a brief recovery, led by Germany, the Crisis hit Europe and domestic demand fall sharply across the euro area once more. But rather than offset peripheral compression, German domestic demand also slowed at this crucial time—meaning there was no counter-cyclical force. Perhaps best seen in terms of the levels of domestic demand in the lower chart, this pro-cyclical intra-union policy reaction was a result of huge mistakes in monetary and fiscal policy at that time.

But this is all backwards looking. What I’d like to celebrate today is how Germany is perhaps contributing—for the first time in over a decade—to global rebalancing. This can be seen in Figure 2 by the fact that German domestic demand growth has contributed more to aggregate euro area domestic demand that the rest of the currency union members put together in the past two quarters. Moreover, the level of German domestic demand has broken the 2 percent trend time for the first time since 2000 (lower chart.)

Furthermore, seen in terms of the 12 month change in euro area aggregate current account balance, which is now compressing, most of the adjustment in the euro area current account is due to Germany. See Figure 3. Indeed, Germany’s contribution to the lower current account over the 12 months through June this year is the largest (in percent of GDP) since 2000 (consistent with domestic demand above). What we cannot be sure of is how much is due mainly to higher oil prices.

But the fact this is coincident with domestic demand picking up in Germany and a global upswing suggests this is more than simply the terms of trade. It’s also worth recalling how  many in 2010 and 2011  argued German expansion then would not help peripheral adjustment because this would not directly impact exports there. Well, so what? This missed the fact that by spurring growth outside the euro area  would spillback to support the rest of the euro area—exactly as is the case today. A rising tide really does lift all boats.

Yet we have only just begun! It is frightening to hear of Germany’s Council of Economic Experts warning about the risk of overheating. Since 2000, the German share in euro area total GDP has diverged sharply from the share in domestic demand. This gap, shown in Figure 4, is another measure of imbalances in the euro area. With continued domestic demand growth in Germany, in particular offsetting the global challenge of deleveraging in China, and continued current account compression, there is hope that the global recovery will continue. This will allow further peripheral export-led growth, the flipside of the overall rebalancing.

So let’s not cut short the encouraging recovery in German domestic demand. Indeed, fiscal expansion would do very nicely right now. And as Neil Young put it many years ago, perhaps thinking of Germany’s domestic demand expansion within the euro area today: “We’ve been through some things together, with trunks of memories still to come. We found things to do in stormy weather. Long may you run.” [END]

 

 

THE PERCEPTIVE Simon Tilford of the Centre for European Reform has noticed a curious feature of Germany’s external accounts: her net international investment position (NIIP) reveals net “foreign assets have risen much less rapidly than the accumulated current account surpluses, leading to … losses: around €580 billion since 1999.”

That is, the value of Germany’s stock of external financial assets minus liabilities measured at market prices is worth substantially less than implied by cumulated flow of current account surpluses. This “loss” of roughly 18 percent of GDP—a decent chunk of change—deserves attention. Why save so much abroad if it is being spilled onto the ground?

To explain this gap, Tilford suggests—contrary to the narrative of an ageing society attaining higher yields abroad—Germany’s external returns fall short of expectations. Given these losses, it would be in her interest to rein in her surplus and invest more at home.

Meanwhile, Martin Sandbu of the Financial Times’ Free Lunch column picks up on this discrepancy, arguing that since surpluses are being “diffused” by “poor … lossmaking … investments,” German savings are not the concern some suggest—if she insists on investing abroad then Germany’s steady loss represents others’ gains.

Against this, Sandbu references in passing another interpretation, due to Matthias Busse and Daniel Gros of the Centre for European Policy Studies in Brussels. They argue current account data to be more reliable; in contrast, measurement errors likely creep into Germany’s net IIP—being the difference between two large and “imperfectly measured” stocks. They therefore propose to focus on the yield on German investments abroad, observing “returns … have remained above most domestic returns” and therefore “German savers have fared quite well over the last decade in their foreign investments.” Thus, net IIP figures can be misleading; surpluses are perfectly rational given relative returns.

What’s going on?

Figure 1 uses the latest external accounts data— consistent with the IMF’s Balance of Payments Manual 6 (BPM6) methodology—for Germany, plotting from end-2003 the cumulative current account balance, financial account, and the change in net IIP. The former two series being cumulative flows, the latter a change in (net) stocks. This illuminates the gap under consideration. Germany’s current account surplus sums to about €2,310bn over the period, the change in net IIP is €1,790; sure enough, the gap is roughly €530bn.

The chart immediately points to one source of discrepancy. Germany’s financial account flows only cumulate to €2,180bn, the gap with the current account being inevitable “errors and omissions” in collection of balance of payments (BOP) data. Indeed, these sum to €130bn—per year perhaps €10bn (say ½ percent of GDP). Either the current account surplus is overstated or financial account flows understated. We cannot say which. But we have captured one-quarter of the missing €530bn already.

But what of the remaining €400bn?

Recall how net IIP data record the change in asset and liability stocks due to flows, recorded in BOP, plus valuation adjustments—due to exchange rate, price, or other adjustments impacting stocks. We can therefore decompose the IIP gap by contrasting the cumulative financial flows with the change in IIP stocks for each investment category—as in the table below.

The accumulation of assets since end-2003, for example, according to BOP was €4,070bn. But the change in the outstanding stock of financial assets over this time was €4,530bn—meaning assets have increased in value by roughly €460bn more than flows. The same is true of liabilities, however—for example, non-resident holders of Bunds, recorded as part of portfolio liabilities, have experienced large capital gains as yields approached zero.

Overall, the positive asset valuation adjustment (+€460bn) is more than offset by that due to liabilities (-€530bn) in net IIP; the total contribution to the IIP shortfall is exactly €66bn. This accounts for an additional 12 percent of the €530bn IIP gap. Together with errors and omissions, we have filled 37 percent of the shortfall.

What next? Only one item in the external accounts remains in “financial derivatives (excluding reserve assets) and employee stock options”—FDs for short.[i]

Since, per BPM6, flows due to FDs are only recorded on a net basis—not gross—it is impossible to deconstruct the stock-flow contributions exactly as in the table above. However, we can decompose Germany’s FD transactions in BOP—a measure of external gains or losses on derivatives positions—in three different ways, by: product, sector, and country, shown in the three figures that follow.

Typically, through time, Germany registers “losses” on FDs—positive flows. The total since 2003 is €305bn. But to think of these as losses is somewhat misleading. If these represent hedges—say on foreign exchange value of foreign denominated securities—then “losses” may simply offset by gains elsewhere in the net IIP, so should not be viewed in isolation.

Nevertheless, since 2010, positive FDs flows mostly reflect forward contracts. However, during GFC large losses on options were recorded. In 2007 and 2008, for example, positive options flows of €110bn (of €163bn in total options over the 14-year period) were recorded, only partially offset by gains in following years.

Employee stock options are immaterial.

In terms of sector, FD flows over the period mainly accrue to monetary financial intermediaries excluding the Bundesbank (€190bn) and other financial intermediaries (€92bn). Direct losses due to non-financial corporates and households are minimal (€22bn).

In 2007 and 2008, when noted losses on options positions were largest, banks (€60bn) and other financial intermediaries (€54bn) were hit roughly equally.

Finally, we can trace the country-counterpart to these FD flows, using the Bundesbank’s bilateral financial account flows data. Historically, Germany’s FD flows were largely recorded against the United Kingdom. For example, the correlation coefficient between total FD flows and that against the UK was more than 0.9 in the decade through 2000, while that recorded against France was less than 0.2. From the millennium—perhaps related to the inception of the euro?—the flow of FDs in Germany’s financial account has pivoted towards France. Indeed, since 2003, €138bn flows have accrued against France and only €116bn against the UK. Moreover, most of this was recorded during GFC, when FD flows against France equalled €94bn—when options losses were at a peak.

The bilateral losses against France are particularly interesting. The growing importance of derivatives trading by German banks in the period prior to GFC has been noted, as well as greater losses of Germany relative to France during GFC (see here). The BOP data appear to suggest that one reason for the high relative German losses is that French banks benefited from their derivatives positions against Germany. In other words, Germany provided the hedge for French banks during GFC, helping mitigate losses at that time. But this, like the financial positions then, is mainly speculation.

In any case, we have now precisely accounted for Germany’s missing €500bn, summarized in the chart below as cumulative flows since 2003. As the chart reiterates, most “losses” were incurred during two stress periods.

First, in 2007/08, during the onset and crescendo of GFC, a cumulative gap of about €200bn developed. A substantial part of this (over €100bn) reflected losses on options positions against France, noted above. But there were other valuation losses during this period on net other investment and net FDI positions.

Second, in 2010/11, during the euro area crisis, valuation on net portfolio investment assets created a further dent. Between early- and end-2011, losses on net portfolio investment asset of about €130bn were recorded. This will reflect both losses on German holdings of peripheral bonds during peak stress, but also the bund’s status as haven pushing down German yields.

            Errors and omissions, meanwhile, fill much of the remaining gap.

It is also noteworthy how, since 2011, the €500bn gap has levelled off. Continued flows relating to FD positions are offset by valuation adjustments elsewhere; net IIP has moved in line with the current account.

To summarize, the German data on external asset and liability stocks and flows is complete. It is not true that errors in recording IIP stocks require instead focus on the current account. While Germans make terrible macroeconomists, they make formidable accountants. There is nothing much wrong with the data. All we lack is interpretation.

But this narrative also unveils flaws in Sandbu’s sanguine interpretation of this gap. In fact, Germany’s losses occur largely during period of financial stress—revealing dangers of unchecked capital flows and external imbalances. Germany’s net IIP losses are not, therefore, a harmless means of dissipating her growing external claims. Rather external losses reflect the destabilizing influence of surplus savings and large gross capital flows across borders—leaving financial crises in their wake.

And this also refutes Tilford’s claim that Germany’s external returns have failed to deliver. Indeed, absent destabilizing financial crises, Germany’s net IIP gap would not have materialized. And it has now settled down. The gap need not grow further—and rate normalization and pull to par of bonds could see it close.

But what about the relative returns on German investments abroad? These are shown in the chart below. As Busse and Gros note, Germany has indeed generated a higher yield on external assets than non-residents have achieved from investment in Germany. But it is noteworthy that the yield gap on portfolio investments has closed in recent years, while other investment returns are more-or-less identical through time. As such, the only advantage Germany currently gains is the yield on direct investment abroad, which has generated about 1.7 percentage points more than investments in Germany on average since 2007. But this is also closing.

But this is not the end of the story. First, low relative returns in Germany could simply reflect the lack of domestic demand there. Any attempt to generate domestic-led growth could change this calculus. Second, in any case, inwards foreign direct investment in Germany experienced substantially larger valuation gains over the past decade (see table above). A measure of total return–that is, yield plus valuation gain or loss–on FDI (not shown) generates very similar returns on inward- as outward-FDI. In other words, the case for Germany achieving a greater return abroad is not clear-cut.

The case for continued net external asset accumulation by Germany is not clear cut.

***

[i] Now…   a technical note: BPM6 introduced FDs as a separate functional category in BOP reporting for the first time (see here). FDs, such as forwards and options, are used for “risk management, hedging, speculation, and arbitrage” with prices linked to some underlying financial instrument. And since employee stock options, while not derivatives, take a similar form—say, the right to purchase equity as remuneration—these are folded into this category. And it turns out that a large part of Germany’s “missing” €500bn can be traced to FDs.

BPM6 manual gives the helpful example of an exporter hedging currency risk with a forward contract (see page 163). This helps intuition. In short: at inception of the hedge, no entries in external accounts are needed—the initial forward position is zero; not true of options. As asset prices change, the value of the forward contract changes, reflected in IIP (asset or liability). Only when the contract is finally settled is the FD transaction recorded in both the BOP as financial account (flow) and net IIP (stock) as a transaction within the period and final valuation adjustment. And the FD transaction equals total net IIP valuation adjustment (but with opposite sign) returning the IIP stock position to zero.

And so, gains or losses due to FDs positions can distort changes in net IIP when compared to the cumulative current and financial account flows. Concretely, in the forward contract example, losses due to hedged exchange rate risk for an exporter imply a $1,200 goods surplus is met with an increase in “currency and deposits” on financial account of only $1,000 alongside a negative $200 FD liability flow (positive $1,200 total) because of losses on the forward contract. Net IIP only increases $1,000—and thanks to FDs, the change in net IIP deviates from the current/financial account flows. Such is the cost of hedging exchange rate risk—with the benefit that local currency value of goods is assured in advance. Technical aside over.

Consolidated Parts I to III in pdf. Fixing Greece_FINAL

 

What happens next?

OF LATE, Greece’s current account has come close to registering, but has not yet equalled, surpluses achieved by her comparators at the time their crises abated. Against this, Greek public external debt remains much larger.

What next? Four things are worth noting:

First, Greece experienced the largest current account adjustment since 2008Q4—nearly 14 percent of GDP (see table). And this adjustment challenge was exacerbated by the lowest initial ratio of goods and service exports-to-GDP as well as the weakest export performance since (text chart). While export recovery was already lagging in Greece compared to other peripheral countries, the mid-2015 creditor showdown provided a further set-back such that nominal exports today are scarcely higher than in 2009. The largest burden of adjustment has, to date, fallen on domestic demand and import compression. Fortunately, there is scope for catch-up through export recovery as financial conditions ease.

Second, while Greece’s current account today (-0.8 percent of GDP, 4QMA 2017Q1) remains below that registered by Portugal (+0.8 percent) and Ireland (+2.1 percent) at the time of their clean program exits, in cash terms Greece’s external position is a stronger than the headline figure implies. This is due to the fact Greece benefits from interest deferral of €1-1½ billion (½-1 percent of GDP, see Table 2 and Table 7) over the forecast horizon, meaning in cash flow terms her current account is near balance. Greece therefore generates roughly all the foreign exchange cash flow needed at the moment to service external debt. There is a decent case that, with export recovery, program exit is near.

Third, more important, Greece is currently experiencing her largest foreign direct investment (FDI) inflow—that is, net non-debt creating investment from abroad—since joining the euro (Figure 6, right chart). This is reflected in both resident FDI repatriation and large non-resident investment inflows totally 2½ percent of GDP. Together with the current account (ex. interest) surplus, Greece now creates 4¼ percent of GDP foreign exchange—without taking on any more external debt—with which to service external debt at 2 percent of GDP—of which about ½ percent is deferred (Figure 6, left chart). In this respect, for perhaps the first time since the Crisis, the Greek Transfer Problem has been solved.

Fourth, there remains the possibility of inclusion in the ECB’s Asset Purchase Program (APP). This would not necessarily generate foreign exchange inside Greece to recycle towards servicing external debt since many Greek bonds are held by non-residents. However, APP inclusion would cause bond yields to compress further—as elsewhere in the periphery—and catalyse other capital inflows to Greece. Further easing the external constraint, this would allow for domestic demand pick-up and the sustained recovery as witnessed elsewhere. That said, APP inclusion seems unlikely until mid-2018—by which time bond buying could be near an end.

Overall, the improvement in Greece’s external position—with or without APP inclusion—implies a period of recovery ahead. But this was also the case in 2014, when the Samaras government was expecting debt relief from the Europeans—having generated a primary fiscal surplus as agreed end-2012 (Figure 5, left chart). When this promise was reneged upon—eying elections ahead—Samaras turned populist, causing a stand-off with creditors. The rest is history. With the next Greek election due on or before October 2019, will this turmoil be repeated?

Near-term, problems will only re-emerge for Greece if: (i) fiscal slippage requires additional unpalatable fiscal measures causing renewed recession—as already legislated in the IMF’s program, against which the authorities hope to push; or (ii) regardless of the fiscal outcome, the Europeans try and prevent clean program exit—sparking further political turmoil in Greece. Such developments would re-awaken once more those calling for Grexit. But with some forbearance and political will, Europe can quite reasonably support Greece in some form of program exit—if not entirely clean, then with a precautionary ESM backstop. As such, absent negative political intervention, the Greece success story has some way to run.

If this proves to be the case, the main risks will only re-emerge once external debt service fully kicks in. And with scope for decent out-performance in Greek GDP, European institutions might feel emboldened into thoughtlessly implementing a “growth adjustment mechanism” based on their currently DSA framework. Consider how the EU Commission fails to distinguish external from domestic demand, does not project the current account or financial flows for Greece.

Why does this matter? This leads us once again back to the German experience in the 1920s. A caricature: facing reparation payments, following the Dawes Plan, Germany engaged in large-scale external borrowing to sustain demand and avoid the balance of payments constraint. This largesse was exacerbated by a mechanism whereby Germany’s private creditors had first claim on her foreign exchange surplus. As a result, rather than running a trade balance surplus as the logical counterpart to reparation payments, Germany’s current account deficit widened into the late-1920s. When official creditors eventually tried to call in reparations and reassert a claim on Germany’s foreign exchange earnings, this triggered private capital flight and a sharp current account compression (See, e.g., Albrecht or Tooze). Having experienced one extraordinarily painful sudden stop, it is incumbent on the international community that this should not happen again to Greece.

The EU institutions, in their design of the post-Crisis framework for Greece, ought therefore be able to fully account for future drivers of nominal GDP growth.

Suppose nominal GDP growth is driven by export growth and/or net FDI inflows, thus generating foreign exchange needed to service external debt without creating new external debt. This would be a favourable means of helping Greece recover.

However, as in 1920s Germany, if growth is instead driven by the accumulation of net private external debt—and government external debt simply replaced by opportunistic private external debt—then the prospect of a renewed widening of the current account deficit and danger of a sudden stop cannot be ruled out. And the period until 2022 where external interest payments and amortization remain contained is an opportunity for private capital inflows once more (Figure 7).

Clearly, this is a difficult line to walk. But any “growth adjustment mechanism” for Greece ought provide for sustainable recovery.

More generally, there is a case for the primary surplus to move counter-cyclically to net external debt creation—in Greece and elsewhere. That is, absent a central bank policy—through reserve creation—to offset booms and busts created by the ebb and flow of external capital flows, the primary fiscal balance provides the only tool for this purpose. For Greece, this would imply a fiscal rule that offsets net private debt creating inflows in the period ahead rather than the current mechanical fiscal requirements.

This could also create an automatic mechanism for expansion in surplus countries—creating a symmetry in adjustment that has been sadly lacking to date.  But this is a topic for another occasion.

The Greek transfer problem

THE MACROECONOMIC challenge facing Greece in 2010 was side-stepped from the start—driving, in turn, policy missteps.

Figure 3 highlights the truly extraordinary non-resident purchases of Greek government debt—capital inflows—during the decade from 1999. The left chart uses the Bank of Greece’s excellent flow of funds data—recorded at market value of transactions—to track the 4-quarter sum of non-resident and resident purchases of Greek debt. It also shows the fiscal balance throughout.

Between 1999 and 2009 the cumulative fiscal deficit was about €150 billion; meanwhile, total flows of Greek liabilities at market prices was €180 billion (left chart), of which about €160 were purchases by non-residents—meaning, roughly, the entire deficit was funded by non-residents—although this does not imply primary market purchases.

As a result, in terms of the face value of debt outstanding, by 2009 about 80 percent was held by non-residents (right chart)—up from 60 percent in 2003 and, by flow of funds market value data (not shown), from 25 percent in 1998.

Crowded out of their own sovereign’s debt, Greek banks sought, and found, alternative means of generating income—intermediating savings domestically, lowering lending standards, contributing pro-cyclically to demand.

Meanwhile, whereas under a traditional fixed exchange rate arrangement the Bank of Greece might have absorbed part of this immense capital inflow through reserve accumulation, the fledgling currency union made this not only impossible but apparently unnecessary.

In addition, note how as the Crisis hit—with the price of Greek bonded debt in freefall—domestic financial institutions began purchasing from non-residents GGBs at discounted prices. In 2010-11 Greek intermediaries bought about EUR25 billions of government bonds at prevailing market prices—equating to roughly 30 percent of the total face value outstanding!

Thus, temporarily, the non-resident share in the face value of Greek debt fell below 50 percent in December 2011 (right chart). But the debt exchange of March 2012 upset hopes of capital gains; substantial losses were recorded instead, requiring recapitalization via additional program funds—as well as eventually triggering the Cyprus bailout.

In this way, non-resident ebullience and over-exposure to Greece was eased not simply through the flawed 2010 bailout—and ECB purchases under their SMP program—but also through the miscalculation of domestic financial institutions. And the so-called domestic bank-sovereign doom loop is misleading. There would have been no such “doom loop” for Greece had the euro area the institutional frameworks in place along with analytical foresight to trigger restructuring in 2010.

And so, Greek external debt remains about 85 percent of the total outstanding stock—itself about 170 percent of GDP.

And this burden of external government debt has always set Greece apart from other euro area peripheral countries. Figure 4 shows the evolution of the face value of government external debt against the current account in percent of GDP (left chart) and in percent of exports of goods and services (right). The chart shows data for Greece, Ireland, Italy, Portugal and Spain between 2008Q4 and 2017Q1—the earliest point is the left-hand dot in each case.

 

Greece entered the Crisis with not just with high public debt, but much higher share held externally (90 percent of GDP, 480 percent of exports). Moreover, Greece was running a substantial current account deficit at the time (15 percent of GDP)—again larger than comparators.

 

This challenge was nearly identical to the Transfer Problem facing Germany in the 1920s. Of German reparations, Keynes noted the “Budgetary Problem” of “extracting the necessary sums of money out of the pockets of the German people”—and the “Transfer Problem”—of “converting the German money so received into foreign currency” in order to repay this external debt are two distinct challenges. And Keynes objected to the “view … widely expressed that the Transfer Problem is of quite secondary importance and that, so long as the Budget Problem is solved, the Transfer Problem will, in the main, solve itself.”

Instead, the problem was in achieving fiscal adjustment while simultaneously transferring resources from non-traded production towards exports. Yet this has been overlooked in Troika analysis throughout the Greek Crisis—the tacit assumption being that austerity could be treated orthogonal to external adjustment. The balance of payments was simply assumed to passively adjust to meet growth assumptions—disconnecting macroeconomic projections from fiscal adjustment. This resulted in a succession of flawed GDP projections (Figure 5, left chart) which now begin to resemble an outstretched hand begging for food.

Thus, absent symmetric expansion in Core Europe—and offsetting export growth—Greece followed the same pattern, though more severe, of contracting domestic demand and imports as revealed across the periphery (Figure 4). In each case, the current account swung from large deficit to small surplus after which the Crisis would abate, domestic demand stabilize, yields moderate. Indeed, in the case of Portugal and Ireland, “clean” program exits were achieved only once their current accounts registered surpluses. For Italy and Spain, yield compression accelerated at this point.

Having recently passed the 5-year anniversary of Draghi’s “Whatever it Takes” speech of July 2012 it is worth reflecting how—important as it was—this speech only really bought time for the completion of peripheral current account compression. Indeed, consider how the same pattern of current account adjustment-cum-stabilization played out identically in the Baltic states in 2008 and 2009 (not shown). They could not benefit from Draghi’s intervention, but their stabilization followed external adjustment. In other words, Draghi didn’t save the euro area in 2012, but Depression did!

Why does this happen? The current account, as a debit item, records interest on all external debt as part of primary income. Once a surplus obtains there is enough foreign exchange generated—roughly a surplus of exports over depressed imports—to service external debt without resort to additional borrowing from abroad.

Alternatively, seen in terms of saving-investment balances, a surplus on current account means the domestic private sector is saving enough to fully finance both private investment and the fiscal deficit—with some foreign exchange to spare. Foreign financing is no longer necessary.

A current account surplus sends a strong signal that the crisis will, at last, abate. With this background, can we now contemplate how the Crisis might be resolved from here? This is in Part III.

WITNESS, IF YOU WILL, the resurrection of the Greeks. Disbursement of €7.7 billion on 7^th July by the European Stability Mechanism (ESM), with another €0.8 billion soon to follow, and an “Agreement in Principle” International Monetary Fund (IMF) precautionary arrangement, has brought Greece to life once more—and deservedly so.

The Greek government bond (GGB) 10-year yield at roughly 5½ percent sits close to post-crisis lows. The Tsipras government has returned to markets with a five-year bond with 4.635 percent coupon, below that attained by the previous administration in 2014. SYRIZA can be forgiven for eyeing program exit.

But the Greek situation raises a substantial analytical challenge still—especially with public debt to GDP hovering above 170 percent. The IMF claims Greek debt to be unsustainable—pressuring EU creditors to offer more substantive debt relief—and insist on both more fiscal adjustment near-term yet lower primary surplus targets beyond 2022. The Europeans (EU) and Greeks take a more sanguine view. International investors seem unperturbed.

How can Greece be fixed? And what prospects from here?

Debt sustainability wars

           THE LATEST Greek program documents (EU Commission and IMF) make no effort to conceal divergent views between Brussels and Athens—the “Europeans”—and Washington, DC. Differences mainly relate to fiscal policy and public debt sustainability.

Three points of contention stand out: near-term austerity; the medium-term primary surplus; and long-term growth.

First, near-term austerity. A quick recap. Following the aborted effort of the SYRIZA government to reverse austerity mid-2015, the Greek government committed to a primary surplus of 3½ percent of GDP by 2018—on threat of extinction. This required 4½ percent of GDP additional—quickly legislated—consolidation despite ongoing depression. Meanwhile, 2016’s primary surplus success (+4.2 percent of GDP), though largely due to “temporary factors,” offers hope that the worst is at last behind the Greeks.

In assessing progress towards these 2015 commitments, European institutions recently saw a small fiscal shortfall (0.3 percent GDP) promptly addressed by the Greeks.

But the IMF were not convinced. Relative to the European assessment, the Fund remains circumspect as to tax revenue yields and likely future
pension spending; in addition, they remain cautious regarding future growth and capacity for fiscal restraint.

Overall, the IMF see a shortfall relative to the Europeans’ 3½ percent primary surplus objective. And so, to secure continued IMF involvement additional fiscal measures have been legislated: average pensions will be cut 12 percent and the personal income tax credit reduced 40 percent in 2019 to yield an additional 2 percent of GDP fiscal adjustment—on top of the 4½ percent of GDP plus 0.3 percent additional action, as assessed by the Europeans and agreed since 2015, itself on top of the roughly 10 percent primary balance adjustment since 2009.

The primary surplus will therefore, in the IMF’s baseline, increase from 1¾ surplus this year to 2.2 percent in 2018 and 3½ percent in 2019.

Given their disagreement with the IMF on the impact of 2015 measures, the Europeans have additionally agreed—and the Greeks legislated—an offsetting 2 percent of GDP in expansionary measures for the Greek economy “contingent” on fiscal performance. If the 3½ percent primary surplus is assessed as durably achieved in 2018—as the Europeans currently expect—then an expansionary tax and spend package of 2 percent of GDP will be triggered to offset that legislated for 2019 to keep the IMF involved in the program.

If this seems messy, that’s because it is.

Second, medium-term primary surpluses. Based on historical experience, the IMF argue that primary surpluses of 3½ percent of GDP into the (almost) indefinite future beyond 2022 are unlikely to obtain.

The IMF therefore envisage expansionary measures noted above will be enacted after 2022, and the primary surplus settle down at 1½ percent from 2023 onwards. The Europeans, on the other hand—while softening their previous position aiming for a 3½ percent primary surplus into the foreseeable future—expect the primary surplus to fall to 2.2 percent in 2025, holding thereafter. This 2.2 percent target conveniently means, despite rising interest costs, the total (primary and interest) fiscal deficit approaches, but never exceeds, the Europeans’ 3 percent deficit limit—whereas in the IMF’s baseline this redline is crossed.

Third, long-term growth. To assess sustainability, a view is needed on long-term growth and inflation. Greece is a rapidly ageing society, with working-age population expected to contract roughly 1 percent a year from 2020—hence rising pension costs.

Demographics imply a negative long-run real growth rate given past productivity trends. And so, assuming total factor productivity (TFP) growth at triple the historical rate thanks to “structural reforms” allows the IMF to, reluctantly, justify 1 percent real growth from 2025 for forecasting purposes. The Europeans also acknowledge the impact of ageing, but see real GDP growth at 1¼ percent beyond 2030.

As for the GDP deflator, despite saggy global inflation and a huge output gap in Greece, with unemployment expected to remain in double digits until 2040 (IMF ¶11), both institutions see inflation returning to close to, but below, 2 percent from the mid-2020s—with the EU long-run assumption roughly 0.1 percentage points above the IMF.

Together the EU’s growth and inflation assumptions compound to deliver Greek 2060 nominal GDP (€740 billion, 2016’s being €176 billion) roughly 20 percent above the IMF’s projection (€625 billion)—2060 being the current horizon for the EU’s debt sustainability analysis; the IMF now carry theirs to 2080!

This background allows us to recreate and contrast the debt sustainability analyses of EU Commission and the IMF. Some additional differences should be noted, however. The Europeans expect larger privatization proceeds through time (€17 billion versus the IMF’s €2 billion). In addition, IMF are more concerned about bank solvency given high non-performing loans. And so, while the Europeans now expect €27½ billion less ESM funding than envisaged in 2015, when the total envelope was agreed at €86 billion, the IMF set aside an additional €10 billion buffer for bank recapitalization needs and larger draw on ESM funds.

In addition, each have their own interest rate assumptions—for official borrowing and the interest rate at which private borrowing can be sourced. Roughly, the EU Commission sees the official interest rate increasing to close to 2 percent by mid-2020s, and 3.3 percent in the long run; the private interest rate at about 5½ percent to being with, falling through time. The IMF is on average slight more pessimistic.

Together, these fiscal, growth and interest assumptions compound to large differences in the prospects for Greek debt “sustainability”—and necessary debt relief.

Figure 1 recreates the EU Commission baseline forecast for Greece public debt-to-GDP (left) and Gross Financing Needs (right). It shows debt-to-GDP dipping below 100 percent in 2060. Onto this baseline we fold the impact of various IMF assumptions. With IMF growth, the EU baseline would increase to 120 percent debt-to-GDP in 2060; together the IMF’s primary balance and growth takes this to 160 percent and so on.

Figure 2 decomposes the cumulative drivers of the EU Commission’s baseline. Debt-to-GDP falls about 80 percentage points by 2060, mainly driven by nominal GDP growth—the denominator effect—which reduces debt-to-GDP by about 170 percentage points. The primary surplus meanwhile subtracts about 100 percentage points, with the cumulative impact of interest payments adding about 190 percentage points through 2060. Together, the primary surplus and growth assumptions are enough to drag down the debt-to-GDP below 100 percent despite the heavy interest bill.

Fully, Greece will pay about €800 billion in interest through 2060 which, with a 4 percent discount rate, is slightly more than €300 billion in net present value terms—or about 170 percent of GDP!

The EU Commission’s baseline illustrates the importance of global interest rates and the premium Greece must pay. Yet any interest rate forecast over the next 45 years is no more than guesswork. Indeed, scenarios where the interest rate remains low for a protracted period—think Japan on a global scale—seem reasonable. Against this, the growth assumptions appear optimistic.

The right chart in Figure 2 therefore recreates the EU Commission and IMF baselines assuming fixed 2 percent official and 4 percent private interest throughout. In this case, Greek debt dynamics look much more favourable—in the Commission baseline falling below 60 percent by 2060. With nominal growth at ¾ the EU Commission baseline, however, debt-to-GDP returns close to 100 percent in 2060.

In any case, this all serves to highlight how, as the Greece fiasco approaches its final stages, the institutions are now engaged in a game of Debt Sustainability Wars:

The Eurogroup has agreed to implement a “second set of [debt relief] measures” for Greece whereby some re-profiling of debt could occur “according to an operational growth-adjustment mechanism” on the basis of an “updated DSA in cooperation with the European institutions.”

For the IMF, their Approval in Principle arrangement means IMF resources will only be released “conditional upon Greece’s European creditors providing commitments for debt relief sufficient to secure debt sustainability.” But the IMF’s judgment as to debt sustainability will “be guided solely by the IMF’s own debt sustainability analysis.”

Meanwhile, not to be outdone, Governor Draghi has insisted, in the context of possible inclusion in the Asset Purchase Program, the ECB will conduct its own assessment of debt sustainability. Even the fledgling ESM is in on the act.

DSAs are all the rage!

Curiously, whereas the IMF’s “expertise” was insisted upon in 2010, the EU now sees outside support as a hindrance and not a help.

And lament we might! The Troika’s marriage is loveless. Seven years have passed and in different beds they sleep. Worse, given past failings it seems unlikely “European institutions,” with or without IMF oversight, will concoct a sensible “growth adjustment mechanism” for Greece—not least they are yet to recognise why the original Greek program went awry.

To this we now turn, in Part II, with a view to prospects thereafter.

IT’S PERHAPS the greatest irony of all: just as euro area crisis appears consigned to history, should the European Central Bank (ECB) meet its 2 percent inflation target peripheral stress could return!

How so? In short: rapid unwinding of the ECB’s Asset Purchase Program (APP) due to building inflation pressure would rekindle balance of payments pressures in TARGET2 (T2) debit countries—triggering a rise in yields, slowdown in growth, and fears once more for debt sustainability.

Here we briefly explore this scenario by highlighting the exceptional risks associated with unwinding the ECB’s balance sheet—a challenge not faced by other major central banks.

To be sure, it remains too soon for the ECB to “taper” the APP. But the ongoing euro area recovery suggests Eurosystem balance sheet growth—mainly through purchase of mainly government securities—could slow or stop in 2018. At that point, absent a negative turn in the macroeconomic conjuncture, attention will turn to the timing and modalities of balance sheet reduction. How will this happen in the euro area given the uneven distribution of high-powered money?

In any case, Governor Mario Draghi’s term ends October 2019—and a replacement will be sought next year. Seldom has one person been so crucial to a region’s monetary-macro-financial stability. When institutions are frail, personalities matter.

Draghi’s heir-apparent, the Bundesbank’s Jens Weidmann, will not only have some considerable boots to fill, but will also carry the weight German expectations—including the narrative that low interest rates are an unnecessary drag on savers, while T2 credits represent the risk of impending inflation.

During any balance sheet normalization in the euro area, policy missteps or a misreading of the financial super-structure could prove disastrous.

A T2 snapshot

Figure 1 shows the distribution of T2 balances, credits and debits, as of end-May 2017—in billions of euro (left scale) and percent of GDP (right). Figure 2 shows the distribution through time of total T2 credit and debits of major countries.

The three largest creditors in absolute terms—Germany, €857bn; Luxembourg, €188bn; and the Netherlands, €98bn—total €1143bn or 93 percent of €1228bn total TARGET2 credits in May. Against this, the largest three debtors to the Eurosystem expressed through TARGET2 represent €995bn or 81% of the total—being Italy, €422bn; Spain, €375bn; and the ECB, €198bn.

Curiously, total T2 credit/debit position now exceeds that recorded at the height of the euro area crisis.

The previous local peak, of €1,093, was August 2012—just one month after Draghi’s “whatever it takes” speech. At that time, Germany’s T2 credit reached €751 billion. Since December 2016 the total T2 credits has exceeded the 2012 peak, and is currently 12 percent larger than at that time (Germany’s 14 percent larger). In addition, Italy’s imbalance is now larger than Spain’s.

Moreover, on current trends, Germany’s T2 credit will likely reach €940 billion by end-2017 and, depending on the details of APP tapering, could touch €1 trillion by end-2018. As a rule-of-thumb, for every €1 created by the Bundesbank in the purchase of government securities, Germany’s T2 credit increases by €0.9—meaning Germany’s base money—roughly the sum of the two—is increasing at about double the pace of local APP purchases.

Finally, since the euro area crisis began, the Netherlands, Luxembourg, and Germany have continually accounted for roughly 90 percent of all T2 credits. Early in the decade, Greece, Ireland, and Portugal were the major T2 debit countries; today Italy, Spain, and the ECB dominate.

The official narrative

The National Central Banks (NCBs) of the Eurosystem, alongside the ECB, have undertaken to explain their expanding TARGET2 balances since the inception of APP. (See, for example, ECB, Banka d’Italia, Bundesbank, and De Nederlandsche Bank as well as Draghi’s recent letter to MEPs.)

In general, these narratives correctly note that the recent build of “imbalances” should be distinguished from that which occurred during the euro area crisis—then it was banks’ access to ECB liquidity when faced with funding stress that pulled money from the periphery; now it is the push of the APP driving funds abroad (more below).

Moreover, today’s imbalances represent technical factors. Since T2 is a settlement system for the Eurosystem, and since “settlement services are concentrated in some financial centres” this has contributed to the build-up of T2 credits at some NCBs. For example, Draghi’s letter emphasizes how:

Almost 80% of bonds purchased by national central banks under the APP were sold by counterparties that are not resident in the same country as the purchasing national central bank, and roughly half of the purchases were from counterparties located outside the euro area, most of which mainly access the TARGET2 payments system via the Deutsche Bundesbank.

Draghi also notes how some sellers of government bonds to NCBs then

…rebalance their portfolios. [And] As the sellers also make other forms of investment or purchase other securities, including non-domestic securities, additional liquidity flows occur, which contribute to keeping TARGET2 balances elevated.

Or, to put less prosaically, in Germany many APP purchases are from non-euro area holders of Bunds who happen to access T2 system through the Bundesbank—and so, as with Vegas, base money created in Germany stays in Germany. And these are added to by resident sellers of claims on government bonds in the periphery, who then use these funds to purchase securities abroad. Overall, APP proceeds therefore tend to coagulate in Frankfurt, Luxembourg, and the Netherlands.

Even liquidity created by the ECB’s own bond purchases need not travel far, as the Bundesbank emphasizes:

The ECB counterparties’ accounts to which the liquidity is credited are maintained by NCBs. Hence, each purchase of a security by the ECB automatically results in a “cross-border” [comment inserted: or “cross-town”] transaction, thus increasing the ECB’s TARGET2 liabilities.

Notwithstanding the common understanding of the functioning of the T2 system, there remains a difference in tone.

For example, Banka d’Italia (a debtor) emphasizes resident rebalancing of portfolios but claims T2 “developments do not seem to be attributable to a preference for financial assets perceived as safer given the uncertainty surrounding the Italian economy.”

But for De Nederlandsche Bank (a creditor), while T2 “imbalances are no longer an indicator for rising market tensions… they do signal that risk perceptions within the euro area have not normalized either.”

 

What’s really happening?

It’s easiest to visualize T2 flows through the balance of payments of the major T2 counter-parties—Germany, Italy, and Spain (Figure 3.)

T2 flows are recorded in the balance of payments as other investment assets (credits) or liabilities (debits) in the financial account of each country. We can therefore strip these out and decompose T2 flows as being due to three factors: (i) the current account (plus capital account net of errors and omissions, which are small); as well as private flows of (ii) resident net claims on non-residents; and (iii) liabilities to nonresidents. Three observations:

First, glance back to 2011-12. At the height of the euro area crisis, the increase in T2 liabilities in Italy and Spain was driven by reduced non-resident claims on these economies. It had very little to do with the funding current account deficits, as some scaremongers claimed at the time. If anything, it allowed non-residents to convert a risky claim on the periphery into a less-risky claim on the T2 system—making it more like a form of insurance for the periphery’s creditors.

Moreover, the reduction in financial liabilities in Italy and Spain was met by an increase in financial liabilities in Germany. This is important. The simplistic narrative whereby German current account surpluses had directly funded the periphery in prior years would have presumably seen reductions in peripheral liabilities coincide with a symmetric decrease in German assets abroad. Instead, a decrease in peripheral liabilities translated almost one-for-one into an increase in German liabilities. In other words, third parties converted claims on the periphery into claims on Germany. At best Germany’s funding was indirect, via third parties.

Second, recent developments in the periphery confirm growing T2 liabilities now represent resident accumulation of assets abroad. In other words, purchases of bonds from locals under APP triggers a chain of financial transactions at the end of which residents take a claim on a financial asset abroad. There is a slight difference between Italy and Spain, however—Italy is seeing some non-resident outflows as the counterpart to APP, Spain’s flow of foreign liabilities remains largely unchanged.

Third, Germany’s T2 asset flows are now only partly driven by increasing foreign liabilities. Rather, Germany’s T2 asset accumulation reflects her large current account surplus. Put another way, holding financial flows constant, if Germany ran a smaller current account surplus her T2 asset accumulation would be more moderate.

How can we reconcile the above observations? Let’s first recognize that the bilateral current and financial flows between the countries under focus are relatively small. And all three run current account surpluses, so providing net financing to the rest of the world.

A caricature would run as follows: through APP residents of the periphery are being provided with euro area high powered money with a negative return (the ECB’s deposit rate is currently minus 40bps). They prefer to convert this negative-yielding claim into a higher-yielding (riskier) asset abroad. The euro thus created flows elsewhere to bring down global interest rates, allowing financing to be intermediated towards individuals, sectors, or countries content to spend more than they are currently earning—thus funding current account deficits at the level of other country units.

In turn, this new spending on currently produced goods and services eventually winds up as an export of goods from Germany to some other region of the world. And so, the continued growth of Germany’s T2 claims is a function of the global intermediation of APP funds and Germany’s saving surplus—or spending dearth.

But why should the chain of transactions end there? It need not. Indeed, in Figure 3 private residents of Germany could choose to further recycle this inflow and increase financial claims abroad—rather than through the T2 system. But the APP so alters asset prices and the constellation of interest rates globally that the marginal investor or intermediary—given their existing portfolio and regulatory constraints—no longer sees value in continuing the chain of transactions unleashed by the APP. They would rather sit on an asset yielding minus 40 basis points than take further risk given the constellation of yields they face.

Indeed, Figure 4 shows the 5- and 10-year Bund yield as well as the Italian and Spanish government bond spreads over the Bund at these maturities. Bund yields were pushed to near zero in early 2015 on interest rate reductions and in anticipation by investors of APP. At the same time, Spanish and Italian spreads to Bunds at these maturities were reduced from nearly 300 basis points in 2013 to as low as 100 basis points. Were German investors content to further increase their exposure to the periphery at these spreads, then the T2 balance would have remained contained. Instead, the chain of transactions stops once the relative risk-reward is exhausted.

What happens next?

The above only serves prologue, of course, to the ECB’s future TARGET2 dilemma. As developed-market central banks contemplate “tapering” or the proactive unwinding of post-Crisis balance sheet expansion, consider then the unique circumstances of the euro area.

Lack of risk sharing amongst euro area sovereigns alongside the balance of payments constraint in an incomplete monetary union means any balance sheet reduction takes on a geographical dimension.

Further witness the impact of APP in the periphery, as in Figure 5—the share of government debt held by non-residents and the national central banks of Germany, Italy, and Spain. The total in Germany in Spain is nearly 60 percent, in Italy just shy of 50 percent. For Italy and Spain, the impact of non-resident sales during the euro area crisis is evident. More recently, after inflows re-emerged, Spanish non-resident holding of government debt remains broadly unchanged, meaning APP crowded-out residents—facilitating their accumulation of foreign assets. Italian non-resident holdings have fallen somewhat, but total NCB and non-resident holdings have risen. German non-resident sales met APP purchases nearly one-for-one. These observations are consistent with the balance of payments flows in Figure 3.

Finally, another visualization, in Figure 6, is the consolidated public sector net International Investment Position data of Italy and Spain. The net IIP of the fiscal and monetary authorities combined shows the deteriorating official external balance. It is clear that both consolidated governments are experiencing a continued decline in their external position—despite their economies running current account surpluses. Of course, the resident private sectors in each case are increasing their net financial claims on the rest of the world. But they are at growing risk from external conditions.

What’s important here is that APP purchases in Italy and Spain have resulted in balance of payments outflows through the financial account; they are equivalent to non-resident holdings of government debt when the time comes to unwind APP. As a result, de facto, if and when APP is unwound, it will create a financing requirement in the balance of payments for Italy and Spain. The above compression of yields will be unwound in order to encourage non-residents to increase claims on the periphery and/or residents to repatriate funds.

To be sure, there remains a crucial difference to crisis period. Today, both Italy and Spain generate a current account surplus, so need not rely on net foreign financing to sustain domestic demand. But if domestic demand and inflation were to pick up in, say, Germany, and the ECB felt obliged to normalize rates and reduce its balance sheet, then the above-described financial flows and asset price impacts would go into reverse. Absent risk-sharing, should the 10-year Bund reach 150bps and Italian and Spanish spreads touch 250bps to attract capital inflows—given current primary surpluses in the periphery—a slowdown in growth and concerns about debt sustainability in the periphery could follow. In short, the ECB could provoke a return of the peripheral crisis in pursuit of its mandated price stability market if APP were too rapidly unwound.

It would be better for all if the ECB instead turned a blind eye to inflation for some time. Let Germany run hot, allow her current account surplus to adjust down, facilitating larger surpluses in the periphery (or smaller deficits elsewhere) and so easing the external constraint in southern Europe.

But this is an extremely delicate balancing act—an economic and political one. Whoever replaced Draghi better understand these constraints—otherwise the euro area could once again become a major object of concern for global investors.

Pdf version of this blog: The ECB_s TARGET2 challenge_FINAL

Chart pack: T2 challenge_chartpack