The storm before the calm
By Tim Condon
Turbulence rules in global financial markets. Our title “The Storm Before the Calm” reverses the idiom to convey our view that the turbulence will be transitory and will be followed by a prolonged lull.
We ascribe the turbulence to increased uncertainty. The path out of the eurozone debt crisis is uncertain and the uncertainty increases with doubts about the U.S. growth outlook. European Union leaders thought they had solved the debt crisis on July 21 when they announced the second bailout of Greece. It featured debt relief in the form of voluntary participation in a Greek debt exchange where new credit-enhanced bonds were priced to produce a 21 percent net present value loss.
As long as Greece adhered to the conditions of the assistance program it agreed with the “Troika” comprised of the IMF, the EU and the ECB, it would not need to return to the public capital markets until 2013. The July 21 package also upsized the bailout facility, the European Financial and Stability Facility (EFSF), authorized it to buy government bonds in the secondary market and recapitalize banks.
Under the Troika program, Greece would narrow its fiscal deficit to 3 percent of GDP by 2013 ― all EU members undertook to do the same when the bailout was announced. Italy and Spain would also demonstrate to investors that they were financially viable, Italy by balancing its government budget by 2013 and Spain by demonstrating that its banks could handle the property market crash.
Eurozone banking systems would be strengthened by banks reducing their exposure to Greece by not rolling it over and by selling Greek bonds to the EFSF.
Ireland’s “resolute implementation” of its Troika program has produced a significant narrowing in its sovereign credit spread, a hopeful sign for Greece. However, if by 2013 Greece’s debt was still deemed too large it could be restructured without causing dangerous contagion.
It was obvious in July that EU member governments would need time for their parliaments to vote on the agreement. This would not have been a problem had the deterioration of the U.S. economic outlook not created doubts that the July 21 bailout was enough. The greater likelihood of a U.S. double-dip recession increased the degree of difficulty for Greece to adhere to the conditions of the July 21 bailout.
A low point was reached in late September after the U.S. central bank, the Fed, announced Operation Twist. Stock markets across the world sold off sharply, indicating that investors downgraded their assessment of U.S. growth prospects. And again, investors re-assessed the sustainability of Greece’s public finances. Financial market turbulence intensified as a disorderly Greek default loomed.
Instead of a disorderly default, a consensus emerged that Greece needs an orderly 50 percent haircut on its government debt. And the failure of the turbulence to crystallize into a Lehman Brothers panic moment has led to “turbulence fatigue.” Financial assets are re-pricing in the calm after the storm.
We think the re-pricing will prove durable. First, EU member governments have accepted the market solution, a 50 percent haircut for Greek debt. They are now working out the financing details. While not an edifying process to watch, financing is a second-order problem. It carries little risk of triggering a disorderly default by Greece, which is the most likely trigger of another Lehman panic.
We’re entering the calm ― a long period of slow growth in the U.S., the eurozone and, of course, Japan, where slow growth is nothing new. Apart from the slow growth, there will be other parallels between the first two and Japan, most prominently ultra-low bond yields and the need to reform public finances.
Emerging economies obviously would do better if the advanced economies were growing strongly but the slow-growth scenario is not bad for them. Asia benefits from its proximity to China, which the World Bank classifies as an upper middle income country — it has per capita GDP at constant 2005 purchasing power parity prices of $6,810 in 2010.
Real per capita income has grown by a steady 7.7 percent since Deng Xiaoping launched the Open Door reforms in 1979. In view of the still-low level, per capita incomes can double by 2020 provided the authorities maintain macroeconomic stability.
The last decade was exceptional in Asia. Booming growth in China accelerated regional economic integration, contributing mightily to improved economic performance. The coming decade will be exceptional in a different way, namely the speed at which Asia’s emerging economies narrow the per capita income gap with the world’s advanced economies.