Currency War & Exchange Rates Tension!

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Tension over exchange rates

WHAT ARE WE TO DO By TAN SRI LIN SEE-YAN

Amid heightened fears over eurozone sovereign debt risks and increasing concerns about the health of the United States and eurozone economies, worried investors have flocked to the safety of haven currencies, especially the Swiss franc, and gold.

While investors and speculators have since moved aggressively to buy gold, the switch from being large sellers to buying by a number of emerging nation's central banks (Mexico, Russia, South Korea and Thailand) has helped propel the price of gold more than 25% higher this year, hitting a record US$1,920 a troy ounce earlier this month. At a time of high uncertainty in the face of the International Monetary Fund's (IMF) latest gloomy forecast on global growth, few central banks relish the prospect of a flood of international cash pushing their currencies higher.

Massive over-valuation of their currencies poses an acute threat to their economic well-being, and carries the risk of deflation.

The Swiss franc

Switzerland's national currency, the CHF, should be used to speculative attacks by now. So much so in the 1970s, the Swiss National Bank (SNB) was forced to impose negative interest rates on foreign investors (who have to pay banks to accept their CHF deposits).

And, it has been true in recent years, with the CHF rising by 43% against the euro since the start of 2010 until mid-August this year. There does not seem to be an alternative to the CHF as a safe haven at the moment.

With what's going on in the United States, eurozone and Japan, investors have lost faith in the world's two other haven currencies: US dollar (USD) and the yen.

This reflects the Federal Reserves' ultra-loose policy stance and the political fiscal impasse in the United States which have scared away investments from the dollar. The prospect that Tokyo might once again intervene to limit the yen's strength has deterred speculators from betting on further gains from it. To be fair, the CHF has also benefitted from recent signs that the Swiss economy, thanks in large part to its close ties to a resurgent Germany, is thriving.

But enough is enough. SNB made a surprising announcement on Sept 6 that it would buy foreign currencies in “unlimited quantities” to combat a huge over-valuation of the CHF, and keep the franc-euro exchange rate above 1.20 with the “utmost determination.”

On Aug 9, the CHF reached a new record, touching near parity against the euro from 1.25 at the start of the year, while the USD sank to almost CHF 0.70 (from 0.93). The impact so far has been positive: the euro rose 8% on that day and the 1.20 franc level had since stabilised. It was a gamble.

Of course, SNB had intervened before in 2009 and 2010, but in a limited way at a time when the euro was far stronger. But this time, with the nation's economy buckling under the currency's massive over-valuation, the risks of doing nothing were far greater. In July last year, following a chequered history of frustrated attempts, SNB vowed it would not intervene again. By then, the central bank was already awash with foreign currency reserves. Worse, the CHF value of these reserves plunged as the currency strengthened. In 2010, SNB recorded a loss of CHF20 billion, and a further CHF10 billion in 1H'11. As a result, SNB came under severe political pressure for not paying the expected dividend. But exporters also demanded further intervention to stop the continuing appreciation.

This time, SNB is up against a stubborn euro-debt crisis which just won't go away. True, recent efforts have been credible. Indeed, the 1.20 francs looks defensible, even though the CHF remains over-valued. Fair value appears to be closer to 1.30-1.40. But inflation is low; still, the risk of asset-price bubbles remains. What's worrisome is SNB acted alone. For the European Central Bank (ECB), the danger lies in SNB's eventual purchases of higher quality German and French eurozone government bonds with the intervention receipts, countering the ECB's own intervention in the bond market to help weaker members of Europe's monetary union, including Italy and Spain.



This causes the spread between the yields of these bonds to widen, and pile on further pressure on peripheral economies. Furthermore, unlimited Swiss buying of euro would push up its value, adding to deflationary pressures in the region.

The devil's trade-off

As I see it, the Swiss really has no other options. SNB has been attempting to drive down the CHF by intervening in the money markets but with little lasting effect. “The current massive over-valuation of the CHF poses an acute threat to the Swiss economy,” where exports accounted for 35% of its gross domestic product. The new policy would help exports and help job security. As of now, there is no support from Europe to drive the euro higher.

SNB is caught in the “devil's trade-off,” having to choose risking its balance sheet rather than risk “mounting unemployment, deflation and economic damage.” The move is bound to cause distortions and tension over exchange rates globally.

New haven: the Nokkie'

SNB's new policy stance has sent ripples through currency markets. In Europe, it drove the Norwegian krone (Nokkie) to an eight-year high against the euro as investors sought out alternative safe havens. Since money funds must have a minimum exposure in Europe and, with most European currencies discredited and quality bonds yielding next to nothing, the Nokkie became a principal beneficiary. It offers 3% return for three-month money-market holdings.

Elsewhere, the Swedish krona also gained ground, rising to its strongest level against the euro since June after its central bank left its key interest rates unchanged, while signalling that the rate will only creep up. What's worrisome is that if there is continuing upward pressure on the Nokkie or the krona, their central banks would act, if needed with taxes and exchange controls. With interest rates at or near zero and fiscal policy exhausted or ruled out politically in the most advanced nations, currencies remain one of the only policy tools left.

At a time of high uncertainty, investors are looking for havens. Apart from gold and some real assets, few countries would welcome fresh inflows which can stir to over-value currencies. Like it or not, speculative capital will still find China and Indonesia particularly attractive.

Yen resists the pressure 

SNB's placement of a “cap” to weaken the CHF has encouraged risk-adverse investors who sought comfort in the franc to turn to the yen instead. So far, the yen has stayed below its record high reached in mid-August. But it remains well above the exporters' comfort level.

Indeed, the Bank of Japan (BoJ) has signalled its readiness to ease policy to help as global growth falters. But so far, the authorities are happy just monitoring and indications are they will resist pressure to be as bold as the Swiss, for three main reasons: (i) unlike to CHF, the yen is not deemed to be particularly strong at this time it's roughly in line with its 30-year average; (ii) unlike SNB, Japan is expected to respect the G-7's commitment to market determined exchange rates; and (iii) Japan's economy is five times the size of Switzerland and the yen trading volume makes defending a pre-set rate in the global markets well-nigh impractical.

Still, they have done so on three occasions over the past 12 months: a record 4.51 trillion yen sell-off on Aug 9 (surpassing the previous daily record of 2.13 trillion yen from Sept 2010).

The operation briefly pushed the USD to 80.25 yen (from 77.1 yen) but the effects quickly waned and the dollar fell back to a record low of 75.9 yen on Aug 19. But, I gather the Finance Ministry needs to meet three conditions for intervention: (a) the yen/USD rate has to be volatile; (b) a simultaneous easing by BoJ; and (c) intervention restricted to one day only.

Given these constraints, it is no wonder MOF has failed to arrest the yen's underlying trend. In the end, I think the Japanese has learnt to live with it unlike the Swiss who has the motivation and means to resist a strong currency.

Reprieve for the yuan 

I sense one of the first casualties of the failing global economic expansion is renewed pressure to further appreciate the yuan. For China, August was a good month to adjust strong exports, high inflation and intense international pressure. As a result, the yuan appreciated against the USD by more than 11%, up from an average of about 5% in the first seven months of the year. However, the surge had begun to fade in the first half of September.

But with the United States and eurozone economic outlook teetering in gloom, China's latest manufacturing performance had also weakened, reflecting falling overseas demand.

This makes imposing additional currency pressure on exporters a no-go. Meanwhile, inflation has stabilised. Crude oil and imported food prices have declined, reducing inflationary pressure and the incentive to further appreciate the yuan. Looks like September provided a period of some relief. But, make no mistake, the pressure is still there. The fading global recovery may have papered over the cracks. Pressure won't grind to a halt.

Central banks instinctively try to ward-off massive capital flows appreciating their currencies. There are similarities between what's happening today, highlighted by the recent defensive move by SNB, and the tension over exchange rates at last year-end. It's an exercise in pushing the problem next door.

This can be viewed as a consequence of recent Japanese action (Tokyo's repeated intervention to sell yen). It threatens to start a chain of responses where every central bank tries to weaken its currency in the face of poor global economic prospects and growing uncertainty. So far, the tension has not risen to anything like last year's level. But with rising political pressure provoking resistance to currency appreciation, the potential for a fresh outbreak remains real. The Brazilian Finance Minister just repeated his warning last year that continuing loose US monetary policies could stoke a currency war.

Growing stress

With the euro under growing stress from sovereign debt problems, the market's focus is turning back to Japan (prompting a new plan to deal with a strong yen), to non-eurozone nations (Norway, Denmark, Sweden and possibly the United Kingdom) and on to Asia (already the ringgit, rupiah, baht and won are coming under pressure on concerns over uncertainty and capital flight). Similarly, Brazil's recent actions to limit currency appreciation highlights the dilemma faced by fast growing economies (Turkey, Chile and Russia) since allowing currency appreciation limits domestic overheating but also undermines competitiveness.

This low level currency war between emerging and advanced economies had further unsettled financial markets.

Given the weak economic outlook, most governments would prefer to see their currencies weaken to help exports. The risk, as in the 1930s, is not just “beggar-thy-neighbour” devaluations but resort to a wide range of trade barriers as well. Globally co-ordinated policies under G-20 are preferred. But that's easier said than done.

So, it is timely for the IMF's September “World Economic Outlook” to warn of “severe repercussions” to the global economy as the United States and eurozone could face recession and a “lost decade” of growth (a replay of Japan in the 90s) unless nations revamped economic policies. For the United States, this means less reliance on debt and putting its fiscal house in order.

For the eurozone, firm resolution of the debt crisis, including strengthening its banking system. For China, increased reliance on domestic demand. And, for Brazil, cooling an over-heating economy. This weekend, the G-20 is expected to take-up global efforts to rebalance the world overwhelmed by heightened risks to growth and the deepening debt crisis. Focus is expected on the role of exchange rates in rebalancing growth, piling more pressure on China's yuan.

Frankly, IMF meetings and G-20 gatherings don't have a track record of getting things done. I don't expect anything different this time. The outlook just doesn't look good.

Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time writing, teaching and promoting public interest. Feedback is most welcome; email: starbizweek@thestar.com.my.

Europe puts its head in sand over growth crisis

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LONDON | Mon Sep 5, 2011 By Alan Wheatley, Global Economics Correspondent

(Reuters) - Japanization is shorthand for slouching toward that country's noxious mix of low growth and high debt. Euro zone governments will find it tough to keep the ugly new word out of their lexicon.

Concern is mounting over a deterioration in Europe's long-term growth prospects that, unaddressed, will make it even harder to tackle the banking and debt problems underlying the current life-or-death struggle over the euro.

The financial crisis that has been rocking the global economy since 2008 has permanently reduced trend growth across the industrial world. The Organization for Economic Cooperation and Development in Paris reckons the potential output of its 34 member countries has dropped by about 2.5 percent.

"A lot of countries are going to take a permanent hit to their trend rate of growth. This is not an ordinary recession and so we're not going to see countries bouncing back to pre-crisis rates of growth," said Philip Whyte, a senior research fellow at the Center for European Reform, a London think-tank.

As firms have gone bust, capacity has been lost for good. With demand subdued, profitable companies are not replacing old plants.

And as high unemployment persists, skills atrophy. This weakens productivity and shuts people out of the job market for longer and longer periods -- a danger stressed by Federal Reserve Chairman Ben Bernanke at the U.S. central bank's Jackson Hole symposium last month.

Apart from sapping animal spirits and forcing governments to raise taxes or cut spending, diminished growth closes off one route for lowering the high sovereign debt to gross domestic product ratios that have locked Greece, Ireland and Portugal out of the bond markets and are unnerving investors in Italian and Spanish debt.

Against this background, and with the scope for fiscal and monetary stimulus all but exhausted, politicians might be expected to grasp the nettle and push through reforms to improve the supply side of the economy -- policies such as making it easier to hire and fire, promoting greater competition and investing more in training.

Far from it. Pier Carlo Padoan, the OECD's chief economist, says he is less optimistic about the prospects for deep-seated change than he was at the start of the year.



"I see that measures are being announced. I would like to see them being implemented," Padoan said.

With policy ammunition running desperately short, he said it was time for governments to overcome their squeamishness about confronting vested interests opposed to change. "This is a luxury that many countries cannot afford any more. The situation does not allow it."

SOUTHERN DISCOMFORT

The vicious circle of rising debt and falling growth is made worse by the fact that those countries drowning in debt on the periphery of the euro zone are also the ones that have dragged their feet on freeing up their product and labor markets or modernizing their education systems.

"They're going through some truly horrible times. I'm very worried about the whole southern European fringe, not just on an 18-month to 2-year view but looking out a decade or longer," said Whyte with the Center for European Reform.

Germany, by contrast, derided a decade ago as the sick man of Europe, is being held up as a model, at least when it comes to jobs.

"The remarkable resilience of the German labor market in the last few years, where wage moderation and flexible time accounting shielded the economy from excessive job destruction, illustrates admirably the promise of well-structured reforms," Jean-Claude Trichet, president of the European Central Bank, said approvingly in Jackson Hole.

How much are countries missing out by not pressing the reform button?

Padoan says Europe's trend growth has fallen in recent years to an average of just 1.5 percent a year, but he says some members of the 17-nation euro zone could almost double that rate with a supply-side jolt.
Italy needs to liberalize its service sector, open up professions to new entrants and improve energy efficiency, Padoan said. Greece needs to do all that and overhaul its labor market and competition policy at the same time.

POOR ADVERT FOR FREE MARKETS

Germany, too, could grow faster still if it liberalized services, which would trigger increased investment.

These policy prescriptions are well worn. Leaders of the European Union enshrined them and a host of other reform goals in the 2000 Lisbon Agenda, which they promptly ignored. The pledges have since been repackaged as the Europe 2020 Strategy, but Whyte says the havoc wrought by the near-collapse of the international financial system will make politicians more wary than ever of the social disruption that reforms entail.

"The Great Financial Crisis hasn't been a great advert for free-market capitalism," said Whyte. His research outfit publishes a booklet this week exploring how Europe could take off by embracing innovation. But in this area, too, Whyte fears the political climate means policy is likely to be increasingly hijacked by incumbent firms hostile to competition from start-ups.

Europe is not doomed to go down Japan's path of economic stagnation. Its potential growth rate is low but stronger than Japan's -- estimated by the Bank of Japan at just 0.5 percent a year because of a fast-shrinking working-age population.

But the specter of a renewed recession is a reminder for governments that, even if they can spirit away the euro zone's currency and debt woes, they have still to find the elixir for growth.

"I'm not saying politicians will implement reform, but they should," Padoan said. "Some politicians resist reform because they are captive to interest groups. Well, the price for those governments in terms of sustainable growth will be very high."

(Reporting by Alan Wheatley; Editing by Ruth Pitchford)
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Dark clouds over US and Europe !

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WHAT ARE WE TO DO By TAN SRI LIN SEE-YAN

Within the past couple of weeks, the world has changed. From a world so used to the United States playing a key leadership role in shaping global economic affairs to one going through a multi-speed recovery, with the emerging nations providing the source of growth and opportunity. This is a very rapid change indeed in historical time. What happened? First, the convergence of a series of events in Europe (contagion of the open ended debt crisis jolted France and spread to Italy and Spain, forcing the European Central Bank or ECB to buy their bonds) and in the US (last minute lifting of the debt ceiling exposed the dysfunctional US political system, and the Standard & Poor's downgrade of the US credit rating) have led to a loss of confidence by markets across the Atlantic in the effectiveness of the political leadership in resolving key problems confronting the developed world. Second, these events combined with the coming together of poor economic outcomes involving the fragilities of recovery have pushed the world into what the president of the World Bank called “a new danger zone,” with no fresh solutions in sight. Growth in leading world economies slowed for the fourth consecutive quarter, gaining just 0.2% in 2Q'11 (0.3% in 1Q'11) according to the Organisation for Economic Cooperation and Development. The slowdown was marked in the euro area. Germany slackened to 0.3% in 2Q'11 (1.3% in 1Q'1) and France stalled at zero after 0.9% in 1Q'11. The US picked up to 0.3% (0.1% in 1Q'11), while Japan contracted 0.3% in 2Q'11 (-0.9% in 1Q'11).

A construction worker guides a beam into place in Philadelphia. Picture: AFP Source: AFP

IT’S not always sunny in Philadelphia. The Federal Reserve Bank of Philadelphia has reported severe dark clouds over the area’s factory sector. 

The US slides

Recent data disclosures and revisions showed that the 2008 recession was deeper than first thought, and the subsequent recovery flatter. The outcome: Gross domestic product (GDP) has yet to regain its pre-recession peak. Worse, the feeble recovery appears to be petering out. Over the past year, output has grown a mere 1.6%, well below what most economists consider to be the US's underlying growth rate, a pace that has been in the past almost always followed by a recession. Over the past six-months, the US has managed to eke out an annualised growth of only 0.8%. This was completely unexpected. For months, the Federal Reserve had dismissed the economy's poor performance as a transitory reaction to Japan's natural disaster and oil price increases driven by turmoil in the Middle East. They now admit much stiffer headwinds are restraining the recovery, enough to keep growth painfully slow. Recent sentiment surveys and business activity indicators are consistent with expectations of a marked slowdown in US growth. Fiscal austerity will now prove to be a drag on growth for years. Housing isn't coming back quickly. Households are still trying to rid themselves of debt in the face of eroding wealth. Old relationships that used to drive recoveries seem unlikely to have the pull they used to have. Historically, consumers' confidence had tended to rebound after unemployment peaked. This time, it didn't happen. Unemployment peaked in Oct 2009 at 10.1% but confidence kept on sinking. The University of Michigan's index fell in early August to its lowest level since 1980. Thrown in is concern about the impact of the wild stock market on consumer spending. Indeed, equity volatility is having a negative impact on consumer psychology at a time of already weakening spending.

Traders in the oil options pit of the New York Mercantile Exchange – the oil price slipped as US growth was revised down in the second quarter. Photo: AP

Three main reasons underlie why the Fed made the recent commitment to keep short-term interest rates near zero through mid-2013: (i) cuts all round to US growth forecasts for 2H11 and 2012; (ii) drop in oil and commodity prices plus lower expectations on the pace of recovery led to growing confidence inflation will stabilise; and (iii) rise in downside risks to growth in the face of deep concern about Europe's ability to resolve its sovereign debt problems. The Fed's intention is at least to keep financial conditions easy for the next 18 months. Also, it helps to ensure the slowly growing economy would not lapse into recession, even though it's already too close to the line; any shock could knock it into negative territory.

The critical key

Productivity in the US has been weakening. In 2Q11, non-farm business labour productivity fell 0.3%, the second straight quarterly drop. It rose only 0.8% from 2Q10. Over the past year, hourly wages have risen faster than productivity. This keeps the labour market sluggish and threatens potential recovery. It also means an erosion of living standards over the long haul. But, these numbers overstate productivity growth because of four factors: (a) upward bias in the data - eg the US spends the most on health care per capita in the world, yet without superior outcomes; (b) government spending on military and domestic security have risen sharply, yet they don't deliver useful goods and services that raise living standards; (c) labour force participation has fallen for years. Taking lower-paying jobs out of the mix raises productivity but does not create higher value-added jobs; and (d) off-shoring by US companies to China for example, but they don't enhance American productivity. Overall, they just overstate productivity. So, the US, like Europe, needs to actually raise productivity at the ground level if they are to really grow and reduce debt over the long-term. The next wave of innovation will probably rely on the world's current pool of scientific leaders - most of whom is still US-based.



US deficit is too large

The US budget deficit is now 9.1% of GDP. That's high by any standard. According to the impartial US Congressional Budget Office (CBO), even after returning to full employment, the deficit will remain so large its debt to GDP will rise to 190% by 2035! What happened? This deficit was 3.2% in 2008; rose to 8.9% in 2010, pushing the debt/GDP ratio from 40% to 62% in 2010. This “5.7% of GDP” rise in the deficit came about because of (i) a fall of “2.6% of GDP” in revenue (from 17.5% to 14.9% of GDP), and (ii) a rise of “3.1% of GDP” in spending (from 20.7% to 23.8% of GDP). According to the CBO, less than one-half of the rise in deficit was caused by the downturn of 2008-2010. Because of this cyclical decline, revenue collections were lower and outlays, higher (due to higher unemployment benefits and transfers to help those adversely affected). They in turn raise total demand and thus, help to stabilise the economy. These are called “automatic stabilisers.” In addition, the budget deficit also worsened because, even at full-employment, revenues would still fall and spending rise. So, the great recession did its damage.

Looking ahead, the Obama administration's budget proposals would add (according to CBO) US$3.8 trillion to the national debt between 2010 and 2020. This would raise the debt/GDP ratio to 90% reflecting limited higher spending, weaker revenues from middle and lower income taxpayers, offset in part by higher taxes on the rich. Even so, these are based on conservative assumptions regarding military spending, no new programmes and lower discretionary spending in “real” terms. No doubt, actual fiscal consolidation would imply much more spending cuts and higher revenues. According to Harvard's Prof M. Feldstein, increased revenues can only come about, without raising marginal tax rates, through what he calls cuts in “tax expenditures,” that is, reforming tax deductions (eg cutting farm subsidies, eliminating deductions for ethanol production, etc). Such a “balanced approach” to resolve the growing fiscal deficit will be hard to come-by given the political paralysis in Washington. Worse, the poisonous politics of the past two months have created a new sort of uncertainty. The tea partiers' refusal to compromise can, at worse, kill off the recovery. The only institution with power to avert danger is the Fed. But printing money can be counter-productive. Fiscal measures are the preferred way to go at this time. Even so, the US fiscal problems will mount beyond 2020 because of the rising cost of social security and medicare benefits. No doubt, fundamental reform is still needed for the long-term health of the US economy.

Eurozone stumbles

Looming large as a risk factor is Europe's long running sovereign debt saga, which is pummelling US and European financial markets and business confidence. So far, Europe's woes and the market turmoil it stirred are worrisome. The S&P 500 fell close to 5% last week extending losses of 15.4% over the previous three weeks, its worse streak of that length in 2 years, and down 17.6% from its 2011 high. The situation in Europe has been dictating much of the global markets' recent movements. The eurozone's dominant service sector was effectively stagnant in August after two years of growth, while manufacturing activity, which drove much of the recovery in the bloc shrank for the first time since September 2009. Latest indicators add to signs the slowdown is spreading beyond the periphery and taking root in its core members, including Germany. The Flash Markit Eurozone Services Purchasing Managers' Index (PMI) fell to 51.5 in August (51.6 in July), its lowest level since September 2009. The PMI, which measures activity ranging from restaurants to banks, is still above “50”, the mark dividing growth from contraction. However, PMI for manufacturing slid to 49.7 the first sub-50 reading since September 2009. Both services and manufacturing are struggling.

Going forward, poor data show neither Germany nor France (together making- up one-half the bloc's GDP) is going to be the locomotive. Indeed, the risks of “pushing” the region over the edge are significant. Germany faces an obvious slowdown and a possible lengthy stagnation.

European financial markets just came off a turbulent two weeks, with investors fearing the debt crisis could spread further if Europe's policy makers fail to implement institutional change and new structural supports for the currency bloc's finances. In the interim, the ECB has been picking up Italian and Spanish bonds to keep borrowing costs from soaring. The action has worked so far, but the ECB is only buying time and can't support markets indefinitely. So far, the rescue bill included 365 billion euros in official loans to Greece, Portugal and Ireland; the creation of a 440 billion euros rescue fund; and 96 billion euros in bond buying by the ECB. Despite this, market volatility and uncertainty prevail. Europe is being forced into an end-game with three possible outcomes: (a) disorderly break-up - possible if the peripherals fail in their fiscal reform or can no longer withstand stagnation arising from austerity; (b) greater fiscal union in return for strict national fiscal discipline; and (c) creation of a more compact and more economically coherent eurozone against contagion; this implies some weaker members will take “sabbatical” from the euro. My own sense is that the end-game will be neither simple nor orderly. Politicians will likely opt for a weak variant of fiscal union. After more pain, a smaller and more robust euro could emerge and avoid the euro's demise. Nobel Laureate Paul Krugman gives a “50% chance Greece would leave and a 10% odds of Italy following.”

Leaderless world

The crisis we now face is one of confidence. Starting with the markets across both sides of the Atlantic and in Japan. This lack of confidence reflected an accumulation of discouraging news, including feeble economic data in the US and Europe, and signs European banks are not so stable. The global rout seems to have its roots in free-floating anxiety about US dysfunctional politics and about euroland's economic and financial stability. Confidence is indeed shaky, already spreading to businesses and consumers, raising risks any fresh shock could be enough to push the US and European economies into recession. Business optimism, at best, is “softish.” Consumers are still deleveraging. Unfortunately, this general lack of confidence in global economic prospects could become a self-fulfilling prophecy. In the end, it's all about politics. The French philosopher Blaise Pascal contends politics have incentives that economics cannot understand. To act, politicians need consensus, which often does not emerge until the costs of inaction become highly visible. By then, it is often too late to avoid a much worse outcome. So, the demand for global leadership has never been greater. But, none is forthcoming not for the US, not from Europe; certainly not from Germany and France, or Britain.

The world is adrift. Unfortunately, it will continue to drift in the coming months, even years. Voters on both sides of the Atlantic need to demand more from their leaders than “continued austerity on autopilot.” After all, in politics, leadership is the art of making the impossible possible.

Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time writing, teaching and promoting the public interest. Feedback is most welcome; email: starbizweek@thestar.com.my.

Stupid central banker tricks

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By Paul R. La Monica

The euro has rallied against the dollar despite worries about Greece as investors bet on ECB rate hikes. Click chart for more on currencies.

NEW YORK (CNNMoney) -- Greek debt crisis? What Greek debt crisis?

The European Central Bank is meeting this Thursday and is widely expected to raise interest rates by a quarter of a percentage point to 1.5%. That would be the second rate hike by the ECB this year.

Sure, the austerity vote in Greece is good news since it could mean the worst-case scenario fears about a euro meltdown may not be realized.

But this isn't the end to the difficulties in Greece. Doesn't it seem just a bit odd that the ECB is contemplating more tightening at a time when there are still legitimate worries about the problems spreading to Portugal, Ireland, Italy and Spain? Moody's downgraded Portugal's debt to junk status on Tuesday.

The sovereign debt woes could be disastrous news for banks in France and Germany -- the two big euro zone nations that actually have somewhat healthy economies.

But the ECB, unlike the Federal Reserve in the U.S., only has one mandate: inflation. (The Fed is charged with watching prices as well as employment.)

And even though commodity prices have come back from their peaks earlier this year, they are still somewhat alarmingly high. Crude oil, for example, has crept back above $95 a barrel. So that may be all that ECB president Jean-Claude Trichet needs to justify bumping rates up a bit.

Still, will the move backfire?

Another ECB rate hike would further widen the gap between interest rates in the euro zone and here in the United States. (They've been near zero since December 2008.) The general rule of thumb in the land of paper money is that the higher the interest rates are, the stronger the currency.

Europe cited as scariest risk to economy

But that's a problem from an inflation standpoint. With oil and many other commodities denominated in dollars, the weaker the greenback gets, the more likely it is for commodity prices to go higher.

"An ECB rate hike means a higher euro going forward," said Brian Gendreau, market strategist with Financial Network Investment Corp., a Segunda, Calif.-based advisory firm.

"It seems paradoxical that Europe, with its very serious problems, has a currency that's strong and rising but that's a reality. That means the trading bias is in favor of a lower dollar and higher oil prices," Gendreau added.

It makes you wonder if David Letterman needs to expand his stupid tricks franchise and create one specifically for central bankers.

Other currency experts wondered if the ECB should just leave well enough alone since crude prices have pulled back in the past few months after surging due to Arab Spring-inspired supply disruption fears.



"I don't think the ECB would be doing the right thing with a rate hike. Oil prices are high but inflation pressures have abated quite a bit," said Kathy Lien, director of currency research for foreign exchange brokerage GFT in Jersey City.

Lien said the ECB needs to pay more attention to slow growth in Europe -- even if it's not officially one of that central bank's particular mandates.

"Price stability is the top priority but the more important question is should the ECB be doing this during a fragile point of negotiations with Greece?" she said. "Raising rates makes financing more difficult for people in Europe."

What makes matters more vexing is the fact that it's not as if the ECB won't have other opportunities to raise rates soon if inflation does in fact pick up.

The ECB will meet again on August 4 and has another meeting scheduled for September 8. Wouldn't it be more judicious to wait for at least another month or two to see how the situation in Greece plays out before rushing to raise rates again?



"I am a little puzzled by why the ECB seems so intent on raising interest rates right now. It's not going to ease any of the problems in the peripheral euro countries," Gendreau said.

Still, some think that the ECB rate hike may be a non-event. That's because the euro has already rallied against the dollar this year despite all the negative headlines about Greece, Portugal, Ireland, etc.

"The speculation about a rate hike has been in the cards for a couple of months," said Ian Naismith, co-manager of The Currency Strategies Fund (FOREX), a Sarasota-Fla. Based mutual fund specializing in foreign exchange investments.

Naismith pointed out that just because the ECB is likely to raise rates on Thursday does not mean that this is the beginning of a long cycle of rate hikes. The key is going to be whether Trichet signals that he's still worried about inflation and that more rate increases are on the way.

"Nothing is etched in stone," Naismith said.

Let's hope so. The ECB does seem strangely hell bent on rate hikes even though Europe is still in the midst of major financial upheaval.

But the last thing Greece, other troubled European nations and the rest of the world for that matter, need is for the ECB to make matters worse with ill-timed policy decisions.

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The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, and Abbott Laboratories, La Monica does not own positions in any individual stocks. 

Greece is bankrupt !

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WHAT ARE WE TO DO By TAN SRI LIN SEE-YAN

A rose by any other name would smell as sweet. In the case of Greece, default by any other name just stinks! The plain truth: Greece is bankrupt. Greece's sovereign debt crisis deepens daily as the gap in reality widens between politically driven “in denial” views of European Union (EU) leadership and market-place views as reflected in 5-year Greek bonds trading at a yield close to 20%; Standard & Poor cutting Greece's rating to triple-C (the lowest credit rating ever); and highest premiums payable on CDS (credit default swaps, used as insurance to protect investors against defaults) on Greek debt. Probability of default by Greece over the next 5 years has jumped to 86%.

Today, a CDS will cost US$2mil annually to insure US$10mil debt over 5 years. Markets have indicated for some time Greece suffers from a condition of bankruptcy rather than a crisis of liquidity (i.e. cash-short).

This simply means Greece cannot survive without significant debt relief and restructuring, combined with an overhaul of the ways its government collects revenue and expends. In essence, Greece has 2 major problems: it has too much debt and it cannot grow. I am afraid more and more of EU will get contaminated.

Trouble in Greece: A Greek flag at the Akropolis in Athens. Millions of Greeks participated in a strike to oppose new heavy austerity measures. — EPA
 

The Greek illusion

Greece should not have been into the euro in the first place. It failed to join in 1999 because it did not meet fiscal criteria. When it did so in 2001, it was through phony budget numbers. As Twitter R. Cohen wrote: “Europe's bold monetary union required an Athenian imprimatur to be fully European. So everyone turned a blind eye.” But Greece has had an awful history. The 1912-13 war wrested northern Greece from Ottoman control. Then came the massive exchange of 1923 where 400,000 Muslims were forced from Greece to Turkey and 1.2 million Greek Orthodox Christians, from Turkey to Greece.

A military dictatorship followed in the 1930s; brutal German occupation in 1941-44; and a civil war in late 1940s. There was the rightist dictatorship of 1967-74, not to mention the on-going conflict with Turkey over Cyprus. In “Twice a Stranger”, B. Clark wrote of Greece as a society “where blood ties are far more important than loyalty to the state or to business partners.”

It would appear EU membership provided some balm to Greek wounds. It detoxifies history. So Greece took to the EU as a passport to live on the never-never. The bottom line: a monetary union among divergent economies without fiscal or political union support has no convincing historical precedent. For a while, the easy-money, easy-lifestyle allowed everyone to overlook peripheraleconomies like Greece from becoming uncompetitive with the euro (with no drachma to devalue) and not showing any signs of “converging” (closing the gulf between strong and weak nations within EU), but amassing unsustainable deficits and debt. Greece remains a nation suspicious of outsiders and a place where state structures command scant loyalty.

This does not abode well. We now see a Greece resentful of deep spending cuts, and of the sale of state assets meted out by technocrats from outside. They feel the poor and unemployed are paying for the errors of politicians, and a globalised system that punishes those left behind. Strikes and violence are a measure of a EU that now leaves most Greeks unmoved by the achievements of European integration.

Greece is insolvent

It is true a sovereign state, unlike a firm, has the power to tax. In theory, it can tax itself out of trouble. But there is a limit on how far it can tax before it becomes politically and socially unsustainable. Already, Greece has a debt/GDP ratio of 143% in 2010, rising to 150% this year. It is too high to convince creditors to continue lending.

In practice, the market expects Greece to reduce its debt ratio considerably before it can borrow again. This means it has to create a primary budget surplus (revenue less non-interest expenditure) in excess of 8% of GDP to be credit worthy again. Among advanced nations, none (except oil-rich Norway) has managed to attain a durable primary surplus exceeding 6% of GDP. Greece is insolvent.

This is a dire situation. Government bonds serve as a reference asset by setting the “riskless” rate of interest. So any doubts about its value can cause turmoil. Indeed, solvency of the Greek financial system is at risk. So are other European financial institutions. Equally vital is contagion with its sights set firmly on other debt-distressed nations notably Ireland, Portugal, Spain and Italy.

But it doesn't stop there. Top Europeans have warned contagion to EU members could spark off a crisis bigger than the Lehman Brothers collapse in Sept 2008. So, it is not difficult to understand the hard line taken by the European Central Bank (ECB) aimed primarily to protect European banks which need time to strengthen their capital base. For obvious reasons, it has rejected any sort of restructuring of debt raising the spectre of a chain reaction, and threatening to punish any restructuring (re-negotiation of the terms of maturing debt) by cutting banks' access to liquidity.

Moreover, credit rating agencies would deem any such action as a default (i.e. non-payment of due debt). With Greece insolvent, the EU has taken the narrow road of beefing up the financing for Greece (which can't refinance itself in the market), while using moral suasion to persuade private creditors to roll-over their bonds. It is buying breathing space.



More denial doesn't work just prolongs the agony. What's happening to Greece is distressful. Over the past 12 months: the number of unemployed rose by close to 40%; unemployment is above 16% among youths, it's a devastating 42%. IMF estimates showed its GDP contracted by 2% in 2009 and 4.5% in 2010 and will shrink by 3-4% this year.

Despite severe fiscal austerity, its budget deficit will improve only slowly: from -15.4% of GDP in 2009 to -9% in 2010 and -7% this year (and estimated at -6.2% in 2012). That's a long way to surplus! Greece has become so uncompetitive its current balance of payments deficit was -11% of GDP in 2009, -10% in 2010 and optimistically estimated at -8.2% this year (and at -7.2% in 2012). Truly, Greece is in “intensive-care” a solvency crisis, not just caught in a short-term cash crunch (yes, it also does not have cash to meet its next debt payment before July 15).

Even at today's low interest rates, Greece's government interest payments alone amounted to 6.7% of GDP, against 4.8% for Italy and considerably higher than all other major European nations and the United States (2.9%). Even Portugal's ratio is lower at 4.2%.

Political solution: slash and burn won't work

What Greece needs is deep economic reforms or fiscal transfers from the EU which help address deepening market concerns about sustainability of its huge debts. Without these, the crisis will simply be deferred.

The message is clear: Greece's debt load at Eureo 350 billion or 150% of its expected economic output this year, is simply too large for the EU troika's (plus ECB and IMF) strategy to succeed. Athens had accepted a package of Euro 110 billion of EU/IMF loans in May 2010. But it now needs a 2nd bailout of a similar size to meet financial obligations until end 2014 when it hopes to move seamlessly into the new ESM (European Stability Mechanism) bailout fund (which takes effect in 2013) to prop up fiscal miscreants.

Latest draw-down involves release of a vital Euro 12 billion very soon but carries a proviso that parliament passes on June 29 (which it did with a slim majority) Euro 28.6 billion in spending cuts and tax increases as well as Euro 50 billion from privatisation of state assets, in addition to continuing existing austerity policies.

That's not all. The new plan calls for private creditor's participation on a voluntary basis (meeting ECB's insistence to avoid even a hint of default) or “Vienna Plus”, a reference to the 2009 Vienna initiative where banks agreed to maintain their exposure to Eastern Europe.

For Greece, the brutal austerity plans call for enormous sacrifices; indeed, no end to their agonies. Today, the situation at Syntagma Square and in front of parliament is getting more strained, angry and confused, surrounded by riot police and clouds of teargas. The people are becoming frustrated at being always at the receiving end.

On the German side, however, voters are aghast at the prospect of a 2nd bail-out, which they regard as pouring good money after bad. Germans consider the Greek government as corrupt; its tax system operates on voluntarism; state railroad's payroll is 4 times larger than its ticket sales; many workers retire with full state pension at age 45; etc.

Be that as it may, the IMF in particular needs to learn from lessons of the Asian currency crisis, where it has since acknowledged its prescriptions at the time made matters worse in Indonesia, Thailand and the Philippines, in the name of unleashing market forces to force adjustment and ignoring the adverse social and political impact of their policies.

I see them repeating the same mistakes again in Greece, paying too little heed to human suffering and adverse social impact to protect private sector creditors and pushing the end-game at breakneck pace. Germany's insistence to get private creditors share in the burden is a good soft step forward. Even so, the IMF seems too harsh.

Few options left

The fact remains Greece was outstandingly egregious in its fiscal profligacy and its lack of prudent economic governance. But Greece was not the only European economy that was living beyond its means and being pumped withill-conceived loans mainly from German and French banks. Greece is today insolvent. The EU's solution addresses only immediate funding needs, without offering a credible long-term resolution. It's just a stopgap. Frankly, Greece'spolicy options are limited: either a default, partial haircut (creditors taking losses on their investments), or a guarantee on Greek debt. Bear in mind Germany remains the biggest beneficiary of the euro-zone experiment. In 2010,

Germany recorded a US$185bil balance of payments surplus or 5.6% of GDP. No doubt, the EU has since pledged to stabilise the euro-zone economy, vowing to starve off a Greek default, and the ECB has categorically ruled out debt restructuring. That leaves Greece with only deflation, a lot of it.

As I see it, this will not work. First, in a democratic Greece, people are clearly not in the mood for deeper spending cuts and more austerity. Policies can be adopted but they can fail. Second, deflation had already made Greece's debt problem worse the debt is too large and the economy won't grow with continuing deflation. It can't just deflate its way to solvency.

The better option left is debt guarantee. Issuing guarantees (preferably partially backed by Greek assets) could help persuade creditors to exchange debt for new debt with longer maturities, effectively giving Athens more time to repay. As of now, only 27% of Greek debt is held by banks, 30% by ECB/EU/IMF, and 43% by other privates. Banks are already quietly resisting voluntary rolling-over unless offered incentives. EU has preferred to use moral suasion.

EU has also resisted haircuts. Mr Axel Weber, former Bundesbank governor, has since weighed in: “At some point you've got to cut your losses and restart the system,” drawing parallels between guarantee for Greek debt and steps taken by Germany and others during the financial crisis to backstop troubled banks.

The Greek problem “is a deep-rooted fiscal and structural problem that probably needs more than a 30-year time horizon to solve. The measures Europe need to adopt are much more profound than just short-term liquidity funds.” That, of course, raises the issue of “moral hazard”. EU has since pledged to stabilise the euro-zone, and starve off a Greek default in exchange for continuing Greek deflation and voluntary creditors' roll-over. Getting banks to share in the burden remains problematic. But, a narrow policy option is taken. It's another muddle-through created in response to politics. It offers no long-term way for Greece to resume growth.

I am told the political mood in Greece improves automatically in July and August as the urbans head en masse for family villages in the islands and mountains. Surely, for a little while, human woes will be eased by exposure to the beauty of the Agean.

Former banker, Dr Lin is a Harvard-educated economist and a British Chartered Scientist who now spends time writing, teaching and promoting the public interest. Feedback is most welcome at starbizweek@thestar.com.my

To Repay or Not to Repay Debts?

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Jean Pisani-Ferry

BRUSSELS – For months now, a fight over sovereign-debt restructuring has been raging between those who insist that Greece must continue to honor its signature and those for whom the country’s debt should be partly canceled.

As is often the case in Europe, the crossfire of contradictory official and non-official statements has been throwing markets into turmoil. Confusion abounds; clarity is needed.

The first question is whether Greece is still solvent. This is harder to judge than is the solvency of a firm, because a sovereign state possesses the power to tax. In theory, all that is needed in order to get out of debt is to increase taxes and cut spending.

But the power to tax is not limitless. A government determined to honor its debts at any cost often ends up imposing a tax burden that is disproportionate to the level of services that it supplies; at a certain point, this discrepancy becomes socially and politically unsustainable.

Even if the Greek government were to succeed shortly in stabilizing its debt ratio (soon to reach 150% of GDP), it would be at too high a level to convince creditors to continue lending. Greece will need to reduce its debt ratio considerably before it can return to the capital markets, which implies – even under an optimistic scenario – creating a primary surplus in excess of eight percentage points of GDP. Among advanced-country governments, none (except oil-rich Norway) has managed to achieve a durable primary budget surplus (revenue less non-interest expenditure) exceeding 6% of GDP.



This is too much for a democratic country, especially one where the tax burden is very unequally shared. Greece is, in fact, insolvent.

The second question is how serious a problem it is not to repay one’s debts.

One camp notes that, for decades, no advanced country has dared to do this, and that is why these countries still enjoy a positive reputation. If just one member of the eurozone embarked on the debt-default path, all the rest would immediately come under suspicion. In any case, according to this view, contracts simply must be respected, whatever the cost.

On the other side are those who call for the creditors who triggered the excessive debt to be punished for their imprudence. Lenders must suffer losses, so that they price sovereign risk more accurately in the future and make reckless governments pay higher interest rates.

Both lines of argument are valid, but the fact is that countries that have restructured their debt have not found themselves worse off as a result.

On the contrary, far from being banished from bond markets, they have generally bounced back quickly: investors like a sinner who returns to solvency better than a paragon of virtue on the verge of suffocation.

Twenty years ago, Poland negotiated a reduction in its debt and came off better than Hungary, which was keen to protect its reputation. Debt reduction is not fatal.

The third question is whether a Greek default would be a financial catastrophe – and when it should take place. Two channels are at work, one internal and one external.

First, government bonds are the reference asset for banks and insurers, because they are easily tradable and ensure liquidity. Obviously, any doubt about the value of such bonds could cause turmoil. The Greek banking system’s solvency and access to refinancing would be hit severely.

Externally, in turn, other European banks would be affected. But more importantly, other debt-distressed countries – at least Ireland, Portugal, and Spain – would be vulnerable to financial contagion.

So this is a dire situation. But it does not explain the European Central Bank’s attitude. The central bank has motives to be concerned. But instead of trying to find a way to cushion the possible impact of such a shock, the ECB is rejecting out of hand any sort of restructuring.

Indeed, it is raising the specter of a chain reaction by invoking the collapse of Lehman Brothers in September 2008, and threatening to punish any restructuring by cutting banks’ access to liquidity.

But if Greece is not solvent, either the EU must assume its debts or the risk will hang over it like a sword of Damocles. By refusing a planned and orderly restructuring, the eurozone is exposing itself to the risk of a messy default.

Europe, however, is not obliged to choose between catastrophe and mutualization of debt. The best route – admittedly a narrow road – is initially to beef up the financing program for Greece, which cannot finance itself on the market, while at the same time ensuring through moral suasion that private creditors do not withdraw too easily.

This is what is being attempted at the moment. But this breathing space must be used for more than simply buying time.

It should be used, first, to allow other distressed countries to regain or consolidate their financial credibility, and, second, to pave the way for an orderly restructuring of Greek debt, which requires preparation. Gaining time makes sense only if it helps to solve the problem, rather than prolonging the suffering.

Jean Pisani-Ferry is Director of Bruegel, an international economics think tank, Professor of Economics at Université Paris-Dauphine, and a member of the French Prime Minister’s Council of Economic Analysis.