The Denial on Housing in Spain

I am sure many of my readers will have caught this Bloomberg piece earlier this week, but if you haven't it is a brillian piece of journalism by Bloomberg reporters Sharon Smyth, Neil Callanan and Dara Doyle. The story takes us to Spain and Ireland and the former's denial with regards its housing market. 

Quote Bloomberg

In the stages of death of a real estate boom, Spain is still in denial. In Ireland, they’re moving toward acceptance. The first auction of one of 2,000 unfinished housing estates takes place tomorrow at the Shelbourne Hotel in central Dublin, with sales expected to fetch cents on the euro, showing the Irish may be closer to the end than the beginning.

“Ireland faced up to its problems faster than others and we expect growth there rather soon,” said Cinzia Alcidi, an analyst at the Centre for European Policy Studies in Brussels. “In Spain, there was kind of a denial of the scale of the problem and it may be faced with many years of significant challenges before full recovery takes place.”

Spain, Europe’s fifth-largest economy, is the current focus of attempts to contain the region’s sovereign debt crisis, as Prime Minister Mariano Rajoy struggles to quell speculation it will need a bailout. Developers are showing similar optimism. They continue to build even with 2 million homes vacant around the country, new airports that never saw a single flight being mothballed, and property appraisers and banks reporting values have fallen only about 22 percent, said Encinar, who estimates the real decline is probably at least twice that.

Another passage that was staggering to my mind was the comments by Miguel Angel Garcia Nieto, mayor of Avila (a town showcased in the article) that this is just an interim soft spot as a result of the crisis and that oversupply and overcapacity will eventually be absorbed. 

Quote Bloomberg

“When we approved the first urban plan back in 1998 there was an unprecedented demand for homes,” Nieto said in a telephone interview on April 19. “Yes, there is oversupply at the moment because of the financial crisis and everyone’s gone back home to live with their parents, but it’s not because there is lack of demand. When the economy gets back on track I am confident the supply will be absorbed.”

Hope as they say, springs eternal.

The Curious Case of Liquidity Traps and Missing Collateral - Part 1

The debate is on! Are we in a liquidity trap and if so what should we do? Why is the financial system depleted of collateral and what does this mean? Should policy makers and central banks be even more "irresponsible" [1] and conduct more monitised deficit spending? What does a lack of triple A rated/safe haven securities mean and is it real? 

All these questions and more have recently gotten a fascinating treatment in the economics debate courtesy, mainly, of this piece by Credit Suisse.  FT Alphaville has been given the question extensive and brilliant coverage and now even the IMF has pitched in. I think the issues raised are not only important, but likely to form a substantial part of the framework for the next decade's research on macroeconomics, monetary policy and financial markets.

So yes my dear reader. This is no time to shy back. Dig in, and dig in hard! In this first post of a series of 3-5 posts, I try to present the building blocks of the argument as I see them and answer the question of why the traditional view on the liquidity trap does not apply in the current situation. 

Let me begin with the following key premises for my argument and the state of the global economy and financial system post 2008/09. I will try to develop each of these statements in the posts that follows. 

• The crisis of 2008/09 has ushered in what is likely to be a period of severe stress in global sovereign fixed income markets. Sovereign debt distress and defaults are messy and costly affairs and take a long time to deal with. We have now entered a period where the next 10-20 years will see several developed economies default on their sovereign debt. Ageing populations, too low growth and insufficient future income/consumption to push forward mean that the OECD is now at an inflection point. For global financial markets this means that an unprecedented and systemic share of the global fixed income market is likely to be in distress at any given point in time over the next 10-20 years. 

• There is an accute shortage of liquid triple A rated government securities. This shortage is structural and capital deepening in emerging economies is too slow and insufficient in size to take up the slack. Pension funds, insurance companies and big real money managagers are now essentially unable to construct their portfolios in such a way to match their future liabilities with a satisfactory (or perhaps even promised) yield. In addition, this leads to mispricings in remaining assets considered the last safe havens. US government bonds, UK Gilts, German Bunds, Danish Mortage Backed Securities etc. 

• Central banks are now acting as international clearing houses for the banking system. This is mainly seen in Europe where the ECB has been forced into taking up slack for an interbank market which has essentially been broken. Lowering of collateral standards, ever higher portions of liquidity and extension of maturities of its open market operations are all signs that the ECB is now effectively not only acting as the lender of last resort, it is de-facto the vehicle through which European banks can access liquidity across all maturities. However, whether the central banks buys government bonds outright or funnels demand through the banking system amounts to the same thing. 

• The demand for credit is as much a propblem as is the supply. Sifting through the references below, you will find that at least one solution to the problem is that governments must issue even more impaired debt instruments which essentially become assets backed by liabilities created by the central bank. We must understand however that the core of the problem is that there is now a structural lack of solvent sovereign and private credit demand. The argument goes that the higher demand for safe haven triple A rated assets must be met with supply by sovereign debt issuers, but the ability of governments to issue such securities is structurally impaired. 

• Central bank monetisation of government liabilities either outright or through open market operations providing liquidity to banks are not costless, even in a liquidity trap. Macroeconomic theory is currently informed by the notion that creating unlimited amount of excess bank reserves in the presence of a liquidity trap (zero velocity environment) has no malicious inflationary side effects. I think the evidence from more than three years of monetary experiment among the major central banks forces us to re-visit this conclusion. 

The Liquidity Trap Revisited

In order to start somewhere, I will begin with Izabella's exposé on this paper by Paul McCulley and Zoltan Pozsar. The main points from Monsieurs McCulley and Pozsar's paper, with some slicing and dicing of quotes, are as follows. 

At the macro level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction and re-lever by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.

(...)

... the operational mandate of a central bank operating in a liquidity trap environment should be changed materially.Rather than “policing the government to keep it from borrowing too much” the central bank should help it “to borrow and invest by targeting to keep long-term interest rates low by monetizing debt, with the aim of killing the fat tail risks of deflation and depression. ”The interests of the fiscal authority and the monetary authority rightfully become entwined. What’s more, the loss of the central bank’s independence should not be seen as a concern.

(...)

Critics invoke the orthodoxy that printing money is inflationary. But in a liquidity trap it is not. Money is as money does, and judging from the trillions in excess reserves on banks’ balance sheets, money isn’t doing anything. Printed money is unlikely to become inflationary until after the private sector has finished deleveraging and is bidding for funds again.

Generally, I find it difficult to see what new McCulley and Pozsar brings to the table here. This is liquidity trap and deleveraging economics 1.0, but I feel that we need a version 2.0 to understand what is really going on. The liquidity trap argument of old rightly emphasize that government should weigh against a necessary private deleveraging by running large and perhaps even, on the face of it, irresponsible deficits. This line of argument was, in part, inspired by the Japanese experience and the widely held perception that the BOJ was too timid in the initial phases of the Japanese bust.

I largely agree with this line of argumentation, but if the sovereign is an intrinsic part of the problem the argument breaks down. The problem today consequently runs a step deeper than the original liquidity trap argument.

While the initial symptoms of the financial crisis were rightly identified as too much private debt and reckless credit expansion in a key sector (housing and construction) the subsequent crisis in the euro zone has exposed two additional and critical aspects of the crisis.

Firstly, we have seen how governments will ultimately end up assuming private liabilities onto their balance sheet. Secondly, issues of fiscal sustainability in the OECD have been known for ages, but now time has run out. In my opinion, the crisis has provided a catalyst for the unravelling of the obvious mismatch between governments' pension and health care promises to their populations and the inability to meet such promises due to ageing population and low growth environments. 

If you accept my premise that sovereign debt sustainability is now a systemic part of global financial markets, you will also see that they role they are supposed to fulfill according to the original views on the liquidity trap becomes very difficult. 

Arguing that sovereigns should ramp up the supply of government debt and that central banks should add to the demand for such debt by creating money represents a misinterpretation of the problem. While it may surely mask the underlying issues for a while it cannot hide the fact that we are now at a crucial inflection point in the developed world. OECD governments' business model is broken due to population ageing and future liabilities which they will not be able to pay off. 

The financial system's ability to create highly liquid and safe fixed income securities depends on current and future income to service such liabilities and traditional suppliers of such safe assets are simply out of time. Asking governments to act as counterweights against private deleveraging by creating even larger quantities of unserviceable debt cannot work. We see this most forcefully in Europe where sovereigns are being brutally cut out of the market, but there is, in principal, not much difference across the entire OECD spectrum.

It is my view then that for such highly liquid and risk free securities to survive and be continuingly issued, in the current environment, central banks must become permanent supporters of their issuance. We may certainly come to the conclusion that this is a warranted use of central banks' power, but we should be under no illusion that their involvement on this will be, on any plausible definition, temporary. I think this part of the equation has been given far too little credence in the debate so far.

In conclusion, while I agree that LTROs and central bank bank monitisation of sovereign debt liabilities may certainly be warranted from the point of view of battling a severe crisis the way out of this one cannot be mapped exclusively through the lense of ongoing central bank liquidity provision and reserve creation. 

Once you accept this part of the argument, we are ready to move on to the issue of what such substantial central bank involvement in our economy means and and also why the collateral crunch is likely to continue and what it means.

Stay tuned ...  

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[1] - My readers who are well versed in the research on deleveraging, liquidity traps etc will understand the reference here. In the original literature and thinking about zero nominal interest rate bounds and liquidity traps, the central bank's ability to act irresponsibly is seen as a key prerequisite for turning the corner on debt deflation.  

Time Unlikely to be a Healer for Portugal's Economy

Despite comparisons with Greece, Portugal is not in entirely the same situation, at least not yet it isn't. Crucially, Portugal is currently under no obligation to deal with international or national creditors to increasing government debt issuance courtesy of joint aid programme administered by the EU and the IMF. 

The aid programme which aims to allow Portugal to return to normal market funding in mid 2013 stands at 78 billion euros of which 56 billion euros is provided by the EU and the remaining 26 billion euros by the IMF under the Extended Fund Facility. The recent mission statement concluded at the end of February found little to protest against and it appears the next installment of aid financing for Portugal (14 billion euros in total) will be delievered in April according to plan. 

So far so good. 

On the time scale currently employed by the market to assess the progress on the eurozone debt crisis mid 2013 is far away in the distant future. In other words, Portugal has time and while I am as certain as an economist can be that the country will need debt restructuring, the time between here and there may still prove crucial. 

Recent comments by European Central Bank’s Vice President Vitor Constancio suggest that while the headlines from the ongoing mission reiterate that progress is ongoing and according to plan the actual ability of Portugal to re-enter the market in 2013 is still not clear cut. 

Quote Bloomberg

The question of whether Portugal can sell debt or needs additional aid from international creditors “only poses itself in September next year,” Constancio, who is Portuguese, told reporters in Copenhagen today after a meeting of European finance ministers. “Until then, we have to see if this progress consolidates, allowing the return to the markets without a new program.” Meanwhile, “fortunately” market conditions have improved for the country, he said.

Portugal’s aid plan assumes the country will regain access to medium and long-term sovereign debt markets in 2013, with the program’s last disbursement to be made in June 2014, the International Monetary Fund said in December. European leaders declared then that Greece’s situation is “exceptional and unique” and said they don’t foresee bondholder losses in other nations that seek assistance.

No country that has been subjected to debt relief/aid programmes by the IMF and EU has so far been able to access debt markets on normal market conditions. Indeed, it appears that the only thing we can say for certain is the prospect of returning to normal declines proportionally with the time spent under IMF/EU custody.  

In the 3-4 years since the crisis broke out the bold statement by any country that it was now fully funded until a given date has, in all cases, been the coup de grace (remember Ireland?). Either the end result has been more debt aid by the IMF and EU through the effective rollover of existing aid arrangements or, in the case of Greece, a debt restructuring. 

The problem is that the time frame politicians and EU/IMF economists consider to be reasonable for recovery and a return to normal have persistently been proven too optimistic. The obvious effect of this is that aid and bailout programmes have so far been extended. Kicking the can down the road can be a powerful remedy, but the condition is that the time is well spent and that the structural mechanisms for a recovery are there in the first place. In most cases, both has so far been missing.  

Whether Greece represents a roadmap for Portugal remains to be seen. I believe it is, but there is an alternative. All across Eastern Europe the IMF is in many cases nearings its third debt rollover deadline. Being under IMF stewardship is truly like Hotel California where you be able to enter but where leaving is difficult if not impossible. 

In this context, the 1 trillion firewall recently being served up is important. On the face of it, it appears inadequate not because of its size, but because the end effect may not be a viable way out for struggling European economies. However, it will give the EU and the IMF a drastically enhanced ability to continue rolling external debt/aid obligations. However, if the underlying mechanisms that should lead to economic recovery are not there even 1 trillion euros will eventually fall short of the task. This is especially the case if Italy and Spain were to enter the bailout equation. 

If Portugal represents the next eurozone country to face crunch time the problem with a debt restructuring are all too well known from the Greek case. As country after country spends longer under IMF/EU wardship (and perhaps even also sells bonds to the ECB) external liabilities become increasingly tilted towards official holdings. As we know, from the Greek case, this means a small pie for debt restructuring and thus a higher haircut for the private sector holding. Indeed, this process in itself is a critical determinant for why these economies will never be able to return to normal funding conditions.

No private entity will want, let alone be allowed to by its regulator, to buy debt from a non-domestic sovereign where you are essentially subordinate to 40-50 percent of the existing debt outstanding.

Nomura’s Dimitris Drakopoulos and Lefteris Farmakis have done the hard work on Portugal (courtesy of FT Alphaville) and their analysis is, in my opinion, crystal clear. The key is the following (my emphasis);

Total Portuguese state debt outstanding in 2011 of €174.8bn consisted of:

a) €104bn local law PGBs (the most easily restructurable portion of debt, if investors have taken lessons from Greece‟s local law restructuring techniques),

b) €4.7bn in foreign law bonds,

c) €17.4bn in Saving and Treasury certificates,

d) €12.6bn in T-bills, and

e) €35.9bn in official loans.

Note that this concept differs from the general government headline debt figure as reported to Eurostat, which was €183.bn in 2011 or 107% of GDP.Of those categories, only (a) and (b) are straightforwardly restructurable, making for a total of just under €110bn. Category (c) refers to securities held by retail investors, who are generally exempt from debt restructurings, while T-bills and official loans (especially IMF loans) would probably fall outside any PSI exercise. In effect, only 62% of total Portuguese debt is immediately restructurable as things stand (vs. 72% in Greece at the end of 2011). 

FT Alphaville's Joseph Cotterill furthermore adds; 

That’s a very useful list, by the way. It’s not

easy to extract debt stats about Portugal from the sources available…

But Nomura don’t break out ECB holdings of Portuguese bonds in the above! We all know now that these holdings are senior, so they get subtracted as well. It leaves just under half – 49 per cent – of Portuguese debt that can be restructured.

The math here is very clear. With only about 50 to 62 percent of the debt outstanding liable to restructuring the idea that Portugal may return to the market under "normal" conditions is ridiculous, especially if we assume that this includes the prospect of international creditors doing the bid.

However, there is an important difference between Portugal and Greece. Where Greece had a substantial part of its debt outstanding held by foreign creditors the restructurable debt in Portugal is mainly held by domestic corporates and banks. This is due to the increasing re-nationalisation of sovereign risk on the back of the crisis and specifically the ECB's LTROs which have incited banks to buy their respective sovereign's debt. This adds another layer to the Portuguese case in the sense that if the private sector gets hosed, it will mean domestic banking and corporate defaults. The ensuing re-capitalisation would be impossible for Portugal to deal with without EU/IMF help. 

This points towards kicking the can down the road as long as possible and thus the Eastern European outcome where the IMF/EU simply rolls liabilities. However, just as was the case with Greece, Portugal is likely to find it impossible to lower its debt level without a lump sum reduction in its debt level through restructuring. For now though, it appears that time, while not a healer, is still on the politicians' and IMF economists' side.