Monday, February 9, 2015

Greece – The Moment of Truth Is Approaching Fast

by Pater Tenebrarum

Game of Chicken Continues, EU Ratchets Up Pressure on Greece

After the ECB has made Greek debt no longer eligible for repos (note that this mainly concerns government bonds however, bank bonds that have been “guaranteed” by the government will however no longer be eligible after February 28 2015 either – these amount to a quite large € 25 billion), fears of an intensifying bank run in Greece are growing. At the end of December, Greek banks owed about € 56 billion to the euro system. This is estimated to have jumped to about € 70 billion since then.

These debts to the system have grown concurrently with a sharp decline in deposit liabilities since November last year, when it dawned on people that there might be an election. Unfortunately more up-to-date data aren’t available as of yet, but we will try to post them as soon as the Bank of Greece makes them available. However, there exist estimates regarding the extent of the decline in deposits since the end of December as well – very likely an additional € 15 billion has fled from the Greek banking system since then.

Below are two charts showing assorted liabilities of the Greek banking system, with deposit liabilities shown separately in the second one:

1-Liablities of Greek banking system

Assorted liabilities of Greek banks – the boom and bust are nicely illustrated by this (assets have of course taken a similar course). “Liabilities to Bank of Greece” designate central bank credit to the banking system. This is estimated to have grown to around € 70 billion, replacing the approx. € 15 billion in deposit money that has likely been withdrawn since the end of December – click to enlarge.

2-Deposit liablities, Greek banks

Deposit liabilities of Greek banks – total and domestic until the end of December 2014. A further € 15 bn. decline is estimated to have occurred since the end of December; this has been replaced with central bank funding. Some of this will take the form of “ELA” from February 11 onward, when the eligibility of Greek debt as collateral for ECB funding is withdrawn – click to enlarge.

In the meantime, the Greek government has warned that it will soon run out money, as the EU has refused to accept further treasury bill issuance for bridge funding purposes (which would have bought the Greek government some more time). The government’s tax revenues have collapsed, as Greece’s citizens largely stopped paying taxes when it became clear that Syriza was likely to win the election; this is a case of election promises coming to haunt the government, as it promised to rescind numerous taxes. In the wake of all this, S&P has downgraded Greece’s debt. According to the WSJ:

“Greece warned it was on course to run out of money within weeks if it doesn’t gain access to additional funds, effectively daring Germany and its other European creditors to let it fail and stumble out of the euro.

Greek Economy Minister George Stathakis said in an interview with The Wall Street Journal that a recent drop in tax revenue and other government income had pushed the country’s finances to the brink of collapse.

“We will have liquidity problems in March if taxes don’t improve,” Mr. Stathakis said. “Then we’ll see how harsh Europe is.”

Government revenue has declined sharply in recent weeks, as Greeks with unpaid tax bills hold back from settling arrears, hoping the new leftist government will cut them a better deal. Many also aren’t paying an unpopular property tax that their new leaders campaigned against. Tax revenue dropped 7%, or about €1.5 billion ($1.7 billion), in December from November and likely fell by a similar percentage in January, the minister said.

Other senior Greek officials said the country would have trouble paying pensions and other charges beyond February.

Greece has made no secret of its precarious financial position, but the minister’s comments suggest the country has even less time than many policy makers thought to resolve its standoff with Europe.

Eurozone officials have asked Greece to come up with a specific funding plan by Wednesday, when finance ministers have called a special meeting to discuss the country’s financial situation.

The country needs €4 billion to €5 billion to tide it over until June, by which time it hopes to negotiate a broader deal with creditors, Mr. Stathakis said, adding that he believes “logic will prevail.” If it doesn’t, he warned, Greece “will be the first country to go bankrupt over €5 billion.”

If the Greek government runs out of cash, the country would be forced to default on its debts and reintroduce its own currency, thus abandoning the euro. Most of the €240 billion in aid that Europe and the International Monetary Fund have pumped into the country would be lost.

Mr. Stathakis said Athens has asked for €1.9 billion in profits from Greek bonds held by other eurozone governments. In addition, the government wants the eurozone to allow Greece to raise an additional €2 billion by issuing treasury bills, he said.

Both proposals clash with the rules governing Greece’s bailout and eurozone officials have dismissed them.


Bloomberg reports that Jeroen Dijsselbloom let it be known that “we don’t do bridge loans”, which seems to have been one of the triggers provoking the S&P downgrade of Greece’s debt:

“The new government’s request for a debt writedown has already been rejected, and Eurogroup chief Jeroen Dijsselbloem on Friday rejected a request for a short-term financing agreement to keep the country afloat while it renegotiates the terms of its bailout program.

“We don’t do” bridge loans, Dijsselbloem told reporters in The Hague, when asked about Greece’s request. “A simple extension is possible as long as they fully take over the program.”

The European Union’s latest rebuff raises the stakes for Greece’s new government. The next showdown is scheduled for Feb. 11 in Brussels, when Greek Finance Minister Yanis Varoufakis faces his 18 euro-area counterparts in an emergency meeting after Tsipras delivers his major policy address to lawmakers.

Standard & Poor’s lowered Greece’s long-term credit rating one level to B- and kept the ratings on CreditWatch negative.

“Liquidity constraints have narrowed the timeframe during which Greece’s new government can reach an agreement with its official creditors on a financing program, in our view,” S&P said in a statement on Friday.

Greek stocks and bonds rebounded at the start of the past week after the government dropped its debt writedown demand. The trend reversed on Feb. 5, and the yield on 10-year bonds jumped 42 basis points to 10.11 percent on Friday, with the Athens Stock Exchange index falling 2 percent, after Dijsselbloem rejected the bridge financing.


Note the last sentence highlighted above: Greece’s financial markets got whacked once again after what transpired on Friday. Importantly though, the effect remained largely confined to Greece.

Who Has the Better Cards?

We have read a number of theories about the back and forth between the EU and the Syriza-led government last week. Some people are saying that Mr. Varoufakis (who is considered an expert on game theory) is deliberately using Greece’s weakness as a negotiating weapon, even going so far as to making the Greek government look weaker than it actually is.

Others have pointed out that it has actually become far easier for the EU to adopt an extremely tough stance. Note in this context that Italy’s finance minister was not amused at all when Mr. Varoufakis remarked on Sunday that Italy’s debt is just as unsustainable as that of Greece, and that it would likely become a victim of contagion if Greece were to default:

Italy’s minister of finance Pier Carlo Padoan was evidently not amused by Varoufakis’ comments on Italy’s € 2 trillion+ debtberg

It seems to have dawned on Varoufakis that one of the reasons why the EU is prepared to yield to any of Syriza’s demands is probably that Greece’s stock and bond markets are the only financial markets that are really getting hit badly so far. Contrary to 2010-2012, Greece’s troubles are no longer rattling markets across Europe, presumably because the European commercial banking system’s exposure to Greece has declined sharply.

Some 80% of Greece’s outstanding public debt are in the hands of the EFSF, the ECB and the IMF now. While quite a bit of interbank lending has been extended to Greek banks (some €19 bn.), this is mainly collateralized with EFSF bonds, so European banks are considered safe.

Nevertheless, a Greek default would affect some €240 bn. in European and IMF aid to Greece, not an inconsiderable amount. If these funds have to be written off, the EFSF guarantees of other euro area members would be called in. As a result, debt-to-GDP ratios in the rest of the euro zone would jump noticeably. Apparently though, the other EU members are willing to take that risk – they are betting that Greece would be hit much harder by a default and an exit from the euro area. In short, they believe they will prevail in the game of chicken.


The Athens General Index has once again turned down – click to enlarge.

4-Greece 10-Year Bond Yield(Weekly)

10 year Greek government bond yields, weekly – almost at a new high for move. 3 year paper currently yields about 18.15%.

Greek bank stocks have not surprisingly taken the biggest hit. For instance, NYSE listed National Bank of Greece (NGB) is now down 99.83% from its 2007 high. This is presumably some kind of record (only one Cypriot bank and several of Iceland’s banks have suffered even more in the wake of the debt crisis, by going out of business altogether):


NBG, weekly: down 99.83% from the peak in 2007 – click to enlarge.

As the data below show, it was widely expected that Greece would finally pull out of its economic slump this year – however, this has now obviously become somewhat less certain.


Greek GDP and public debt – 2.9% GDP growth was hitherto expected in 2015. Given that this wouldn’t have involved an increase in government spending, it would have represented actual private sector type GDP growth, which contrary to the former is actually a sign of wealth creation – click to enlarge.

So the EU is at best willing to offer some face-saving cosmetic changes to the Greek bailout deal, but resolutely refuses to countenance any delays or substantive changes to the agreement. On the other hand, the Syriza government finds it impossible not to present something substantive to its voters and is therefore digging its heels in as well. One thing is certain though, the “contagion gambit” has not worked this time around – at least not yet.

Our guess is that the EU could probably be persuaded to “do bridge financing” after all, if the Greek government were to relent with respect to some, or rather most, of its demands. Markets probably won’t remain as unruffled as they currently are if no solution is found and Greece indeed ends up defaulting and abandoning the euro. The current relative calm is likely predicated on the idea that Greece’s government will ultimately have to give in. This could of course turn out to be a miscalculation.

The losses due to a Greek default would presumably not be impossible for the EU to absorb. However, they would increase the pressure on other governments to impose more austerity type measures as well, once they cough up for the guarantees they have given to the EFSF. In short, the Greek government is not completely without leverage. It just doesn’t have as much leverage as it would have had at the height of the crisis three years ago. Back then, a Greek default could have sent several other much larger countries over the brink.


The moment of truth is approaching fast for Greece.

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Greek Contagion? Spanish/Italian Bond Risk Surge Most In 4 Months

by Tyler Durden


Germany could top here, impacting S&P 500

by Chris Kimble



When it comes to discussing hot stock markets in 2015, Germany's DAX index would be part of a conversation. So far the year the DAX index is up around 11%, making it one of the best performing stock index's in the world.

The rally in the DAX index now has it facing the top of a multi-year resistance channel and up against a Fibonacci 161% extension level based upon its 2007 highs and 2009 lows.

Despite the strong rally in the DAX, momentum has been creating a series of lower highs over the past year, similar to what it did in 2007 and 2011.

A DAX breakout here could be a plus for the S&P 500 and a top here could be a negative influence. Investors might want to keep a close eye on this white hot index because what it does from here could send a clue to what the S&P 500 could do going forward. 

See the original article >>

Greece is Playing to Lose

by Project Syndicate

LONDON – The future of Europe now depends on something apparently impossible: Greece and Germany must strike a deal. What makes such a deal seem impossible is not the principled opposition of the two governments – Greece has demanded a debt reduction, while Germany has insisted that not a euro of debt can be written off – but something more fundamental: while Greece is obviously the weaker party in this conflict, it has far more at stake.

Game theory suggests that some of the most unpredictable conflicts are between a weak, but determined, combatant and a strong opponent with much less commitment. In these scenarios, the most stable outcome tends to be a draw in which both sides are partly satisfied.

In the Greek-German confrontation, it is easy, at least in theory, to design such a positive-sum game. All we must do is ignore political rhetoric and focus on the economic outcomes that the protagonists really want.

Germany is determined to resist any debt write-offs. For German voters, this objective matters much more than the details of Greek structural reforms. Greece, for its part, is determined to gain relief from the punitive and counter-productive austerity imposed on it, at Germany’s insistence, by the “troika” (the European Commission, the European Central Bank, and the International Monetary Fund). For Greek voters, this objective matters much more than detailed calculations about the net present value of national debt in 30 years.

A deal should be easily negotiable if both sides concentrate on their top priorities, while compromising on their secondary aims. Unfortunately, human fallibility seems to be working against such a rational solution.

Yanis Varoufakis, Greece’s new finance minister, is a professor of mathematical economics who specializes in game theory. But his negotiating technique – unpredictable oscillations between aggressiveness and weakness – is the opposite of what game theory would dictate. Varoufakis’s idea of strategy is to hold a gun to his own head, then demand a ransom for not pulling the trigger.

German and European Union policymakers are calling his bluff. As a result, the two sides have become stuck in a passive-aggressive standoff that has made serious negotiation impossible.

There was nothing inevitable about this outcome. Just last month, ECB President Mario Draghi provided a textbook example of how these negotiations could, and should, have progressed, when he outmaneuvered German opposition to the monetary stimulus that Europe clearly needed.

Draghi spent months before the ECB’s January 22 announcement that it would launch quantitative easing (QE) in intense public debate with the Germans over which point of principle they chose as a “red line” – the point beyond which no deal would be possible. Germany’s red line was debt mutualization: there must be no sharing of losses if any eurozone country should default.

Draghi let Germany win on this issue, which he viewed as economically irrelevant. But, crucially, he was careful not to back down until the last possible moment. By focusing the QE debate on risk-sharing, Draghi managed to distract Germany from an infinitely more important issue: the enormous size of the QE program, which completely defied the German taboo against monetary financing of government debts. By conceding at the right time on an issue of no importance, Draghi achieved an enormous breakthrough that really mattered to the ECB.

Had Varoufakis adopted an equivalent strategy for Greece, he would have stuck doggedly to his demand for debt cancellation until the last moment, then backed down on this “principle” in exchange for major concessions on austerity and structural reforms. Or he could have adopted a less aggressive strategy: Concede from the start the German principle that debts are sacrosanct and then show that austerity could be eased without any reduction in the face value of Greek debt. But, instead of consistently pursuing either strategy, Varoufakis veered between defiance and conciliation, losing credibility both ways.

Greece started the negotiation by insisting on debt reduction as its red line. But, instead of sticking to this position and turning a debate over debt forgiveness into a Draghi-style diversionary tactic, Greece abandoned this demand within days. Then came the pointless provocation of refusing talks with the troika, despite the fact that the three institutions are all much more sympathetic to Greek demands than the German government.

Finally, Varoufakis rejected any extension of the troika program. This created an unnecessary new deadline of February 28 for the withdrawal of ECB funding and consequent collapse of the Greek banking system.

Greece’s idealistic new leaders seem to believe that they can overpower bureaucratic opposition without the usual compromises and obfuscations, simply by brandishing their democratic mandate. But the primacy of bureaucracy over democracy is a core principle that EU institutions will never compromise.

The upshot is that Greece is back where it started in the poker contest with Germany and Europe. The new government has shown its best cards too early and has no credibility left if it wants to try bluffing.

So what will happen next? The most likely outcome is that Syriza will soon admit defeat, like every other eurozone government supposedly elected on a reform mandate, and revert to a troika-style program, sweetened only by dropping the name “troika.” Another possibility, while Greek banks are still open for business, might be for the government to unilaterally implement some of its radical plans on wages and public spending, defying protests from Brussels, Frankfurt, and Berlin.

If Greece tries such unilateral defiance, the ECB will almost certainly vote to stop its emergency funding to the Greek banking system after the troika program expires on February 28. As this self-inflicted deadline approaches, the Greek government will probably back down, just as Ireland and Cyprus capitulated when faced with similar threats.

Such last-minute capitulation could mean resignation for the new Greek government and its replacement by EU-approved technocrats, as in the constitutional putsch against Italy’s Silvio Berlusconi in 2012. In a less extreme scenario, Varoufakis might be replaced as finance minister, while the rest of the government survives. The only other possibility, if and when Greek banks start collapsing, would be an exit from the euro.

Whatever form the surrender takes, Greece will not be the only loser. Proponents of democracy and economic expansion have missed their best chance to outmaneuver Germany and end the self-destructive austerity that Germany has imposed on Europe.

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The Eurozone: Collateral Damage

By John Mauldin

Greece in a Nutshell
A Game of Chicken, European-Style
European Deflation
The 2015 Strategic Investment Conference
The Cayman Islands, Dallas, Florida, Switzerland, and New York

Collateral damage. Unintended consequences. Friendly fire. Certainly no one intended to have a global banking meltdown when they let Lehman Bros. go under.

Now we’re watching another Greek drama that could have significant unintended consequences – far beyond anything the market has priced in today. Then again, maybe not. Maybe the market is right this time. When we enter unknown territory, who knows what we will find? Fertile valleys and treasure, or deserts and devastation? Today we look at the situation in Europe and ponder what we don’t know. Greece provides a wonderful learning opportunity.

At the end of this letter I’ll mention our Strategic Investment Conference, which will be in San Diego, April 30–May 2. This week we have confirmations from George Friedman of Stratfor and Bill White, former chief economist at the Bank for International Settlements. The conference is shaping up to be the best ever. You can see the rest of the speakers at the end of the letter.

Greece in a Nutshell

Let’s see if we can briefly summarize the situation in Greece. When Greece plunged into crisis three to four years ago, its debt-to-GDP ratio was about 120%. Greek interest rates rose precipitously as investors began to be concerned as to whether they would actually get their money back. The interest rate on the Greek 10-year bond went to 48.6%.

Everybody agreed that Greece couldn’t actually pay that debt; and since so much of it was owed to French and German banks (with not an insubstantial amount owed to Italian banks and those in other countries), the Eurozone decided to bail out Greece, which was a backdoor way of bailing out their own banks. (Seriously, you can go to the IMF minutes, in which they admit that the bailout was about saving the banks and the rest of Europe, not about Greece. Cyprus was cut loose when it would have been a rounding error for the EU to save it – but there were no European banks involved. (The lesson every politician should learn from this is that if you think you’re going to need a bailout someday, make sure your banks owe everybody else a lot of money.)

Everyone breathed a sigh of relief, and Greek interest rates fell to even lower levels than before the crisis, as you can see on the chart above. Meanwhile, because the solution forced Greece into a depression that reduced GDP by 25%, saw unemployment rise to 25% (nearly 60% among youth), forced Greeks (at least some of them) pay their taxes, and obliged the Greek government to try to balance its budget (kind of, sort of), the debt simply got worse. Now debt-to-GDP is 175%. If the Greeks couldn’t pay their debt at 120%, they have zero chance of paying it at 175%.

Eventually, Greek voters noticed that the agreement with the Troika (the ECB, the IMF, and the European Commission) didn’t seem to be working for them, so last month they voted in a new government that promised to change the agreement. The party that won the election, Syriza, had made lots and lots of promises about how they would make those mean old Germans back down and fork over the money. If we threaten to not pay the debt, the new government assured its citizens, the Europeans will give us more money, and we can even make them change the agreement. Of course, if the Greeks don’t get more money their system will be completely bankrupt, and their economy will collapse even further. (The technical economics term is that their economy will be screwed.)

This threat is somewhat like holding a gun to your own head and threatening to commit suicide if you don’t get your way. This is generally not a workable strategy when you are asking the politicians of other countries to pay a lot of money to keep you alive, especially when you are not very popular with the voters who elected those politicians. However, the new Greek government seems to think this is a perfectly reasonable bargaining tactic. Their new finance minister has written five books on game theory. It seems he has negotiating theory down pat, but in practice things are not working out according to his theory.

Because the Greeks agreed as a condition of their bailout to do something that is impossible – to pay off their debt – the rest of the Eurozone (led by Germany) actually wants them to continue to commit to doing the impossible in order that they might be given even more money, so that their debt, which they can’t possibly pay, can rise even further. (Yes, I know you may have to read that sentence three or four times to make sense out of it. That’s because the Eurozone’s position doesn’t make any sense.) The rest of Europe seems to be just fine with Greece’s going further into debt that it can’t pay, as long as they at least promise to pay it. The fact that their doing so will mean a permanent depression in Greece doesn’t really rank very high on their list of concerns.

Greek Finance Minister Yanis Varoufakis (until recently a professor at the University of Texas and as fine, or maybe more to the point, as typical a socialist as you will find at a US university) went on a tour of Europe to drum up support for the idea that, far from wanting more bailout money, Greece just wanted to buy time, via a “bridge agreement,” to work out a better plan. He came back home with a big fat nothing. He did elicit a little sympathy here and there, but no one offered any money or promises. And after he met with ECB President Mario Draghi, in what was at first thought to have been a cordial meeting, Draghi simply cut Greece off at the knees. From the Financial Times:

The French president said he supported the newly elected Syriza government in its efforts to secure a better deal from its international bailout creditors – possibly through an extension of debt maturities – as long as Greece committed to remaining in the euro, reforming its economy and honouring its debts.

Mr. Hollande also backed the European Central Bank’s surprise decision on Wednesday night to ban Greek lenders from using their country’s debt as collateral to access cheap liquidity. The move has been widely interpreted as a warning from the ECB to dissuade Athens from following through with a promise to abandon its EU bailout when it expires on February 28.

“The European Central Bank’s decision forces Greece and Europeans to sit at the same table to outline a new programme,” the French president said. “It’s legitimate.”

As the saying goes, with friends like this, who needs enemies? Greece is essentially isolated. As I understand it, the offer on the table is to extend the term of the debt, reduce the interest payments, and lighten up a little on austerity measures.

There is considerable debate as to whether the ECB actually had the authority to take the (highly political) action of declaring that Greek government debt is no longer acceptable collateral. The entire Greek finance program expires on February 28. Until that time, Greek banks can get Emergency Liquidity Assistance (ELA), which will cost them a great deal more. But ELA is available only to solvent banks with acceptable collateral. Further, the ECB has kept ELA for Greece limited to €60 billion. Ambrose Evans-Pritchard estimates that an amount closer to €100 billion will be needed, and very quickly. It is highly questionable whether the board of the ECB will grant any increase in the ELA program to Greece, absent an agreement. (You can find out more about Greece and the ELA here.)

Not only can Greek banks use only certain types of debt to access the ELA, that debt has to be free and unencumbered; and it’s not clear how much unencumbered collateral Greek banks actually have. Their consolidated balance sheet suggests they held close to €293 billion in loans and bonds as of the end of the December. Only €12.4 billion was actually Greek government debt. But €42 billion was in government-guaranteed bonds, which are not eligible to serve as collateral. Greek banks are already using €50 billion of ECB funding. Further, Greek banks had almost €40 billion in funding from non-Greek banks in the interbank market. It is highly likely that some of their assets, probably of the highest quality available, are pledged against that commercial paper. Further, 35% of Greek bank loans are nonperforming loans that are not eligible for ELA, and the rest would be subject to a severe haircut for collateral purposes (Davies).

The problem is compounded by the fact that money is beginning to leave Greek banks. “Flying out the door” might be a more accurate way to put it. Honestly, I can’t imagine leaving any significant assets in a Greek bank beyond what I would need for basic business transactions. Almost €14 billion were withdrawn from Greek banks in January, which was equivalent to the peak monthly outflow during the crisis of the last few years. You can bet the outflow did not turn around when Varoufakis came back empty-handed from his trip.

Essentially, Draghi told both the Greeks and the rest of the Eurozone that they needed to come to an agreement and do it fast. ECB collateral rules are arbitrary, and Draghi has arbitrarily put a time limit on the decision process. The total amount of time left is under three weeks, but there are interim deadlines that are even more important. The Greeks are to submit their financing proposals to the Eurozone finance ministers at their meeting on February 11 (next Wednesday).

Greece can probably fund itself into March by stretching out payments and engaging in a few bits of financial chicanery. But if the ECB does not extend their financing past February 28, the Greek banks are finished as solvent institutions. The ECB is basically saying that unless Greece agrees to continue to honor its agreements, funding will not be renewed or extended. At that point, Varoufakis would essentially have to issue Greek “scrip” in order to allow the banks to continue to function, but who would want that paper?

Things may come to a head even sooner than February 28:

Jeroen Dijsselbloem, who chairs the Eurogroup of eurozone finance ministers, told Reuters that Greece had to apply for an extension of its reform-for-loans plan by February 16 to ensure the eurozone keeps backing it financially. He stressed that the meeting on this date would be Greece's last chance to apply for the bailout extension, because some eurozone countries will need any agreement approved by their parliaments. The EFSF eurozone bailout fund, which is in charge of lending to Greece, will need time to complete its formalities, too.

But extending the bailout program, even temporarily, would mean agreeing to its terms that are hotly contested by Greece, leaving little common ground between Athens and the eurozone. (The Telegraph)

The clock is ticking. The 16th is just a week away. Not a lot of time for negotiations, and the rest of Europe doesn’t appear to be willing to give Greece more time. This seems to be a take-it-or-leave-it offer.

I’ve been talking with a number of people who have insights into the Greek issue. One trader/analyst at a major hedge fund, whose job it is to know these things, says that it’s very difficult to get a handle on how much interbank debt there is and who owes what to whom. Some of the big banks are telling us things are okay, but he worries about whether we can trust them.

How much of that €40 billion in interbank debt to Greek banks is subject to haircuts or defaults? How do you ring-fence that debt? If you don’t, it could be massively deflationary in an already deflation-prone system. We simply have no idea of the repercussions. Maybe the ECB steps in and makes the various banks whole if Greece leaves. Then again, maybe it decides that moral hazard must not be encouraged. It is certainly taking a hard line already with Greece.

On Friday after the close of US markets, Standard & Poor’s downgraded Greece to B- from B, just one level above default range. It kept its outlook negative, which means that Greece’s rating is likely to be cut further. “S&P said the downgrade ‘reflects our view that the liquidity constraints weighing on Greece’s banks and its economy have narrowed the timeframe during which the new government can reach an agreement on a financing programme with its official creditors” (The Telegraph).

It is not clear what the Greeks will do. A significant majority of the population wants to stay in the euro. But if Tsipras and Syriza back down, it is unlikely their government will last the year.

The problem is compounded by the fact that Greeks have already started not paying certain of their taxes that Syriza has indicated it wants to cut or eliminate. That drying up of revenue worsens the funding crisis the Greek government will face in early March.

Even if Greece were to leave the Eurozone and go back to the drachma, the promises the new government has made cannot be kept without further harming the country. They want to expand the government bureaucracy, raise the minimum wage, and increase taxes on businesses. None of these measures will spur economic growth and create jobs, which is what the country needs. Unit labor and productivity cost in Greece since the creation of the euro in 2000 has been roughly three times that in Germany. Even with the cost of labor dropping significantly, Greece is still not competitive on a productivity-per-worker basis with Germany and much of rest of Northern Europe.

A Game of Chicken, European-Style

We have two implacable forces moving toward each other at rather high speed. Let’s turn now to my friend Kiron Sarkar, who summarized the thinking on the European side of the table this morning in an email to me:

In addition to the issues I have already reported on, (basically, it's politically impossible for the EZ to accept an overt debt haircut on Greece's outstanding debt to the EZ at this stage), a number of other issues have popped up which will harden the EZ's/ECB's resolve and, in effect, make them get tougher with Greece. They include:

  • Spain wants the EZ to get tough with Greece, as the government does not want to provide further ammunition to Podemos, the anti-austerity party (basically the Spanish Syriza), to gain further support. The crushing of Syriza will stem support for Podemos and other fledgling anti-austerity/EU parties, which have been gaining support in the EU. Spain is a far greater potential problem for the EZ than Greece;
  • The upcoming French bi-election could result in Marine Le Pen's National Front winning – Hollande/French support for Tsipras will hurt him/the current regime further;
  • Finland and Holland are getting tougher with Greece, to appease their own electorates, who are opposed to a debt haircut for Greece;
  • German resolve is stiffening. The German's have had enough of references to the Nazis by Tsipras/Mr V/the Greeks. There has been a huge domestic political backlash, following Tsipras’/Mr V's comments;
  • Mr. V. [Varoufakis] had disastrous meetings with Mr. Dijesselbloem and Mr. Schaeuble, the German finance minister. That is not going to do the Greeks any favours;
  • France will not cross Germany; and better Italian data, together with Mr. Renzi's win over Berlusconi over the election of the President, has emboldened Renzi – forget the public comments; 
  • PM Mr. Orban in Hungary has his own domestic problems and is not liked in the EU, in any event. It is felt that Slovakia and Austria can be contained. Ireland will shut up and hope that Greece accepts the better deal (which they will get, either way) in due course;
  • Furthermore, the recent Greek habit of not paying their taxes has emboldened the hawks in Berlin. They have told Merkel that it is yet another sign of Greek unreliability; 
  • German domestic public opinion (which Merkel follows closely) is turning sharply against Syriza/Tsipras/Mr. V. There is a growing opinion in Mrs. Merkel’s CDU and their sister party, the CSU, that the contagion risks of Grexit can be contained!!! The SPD do not want to alienate voters by supporting Greece. Finally, further aid to Greece requires the approval of the German Parliament – the Bundestag – no done deal;
  • Initial US support for Greece is softening (turning?);
  • Cyprus is starting to play up again – a “victory” for Syriza will encourage them to play act again;
  • The threat (oh yeah) that Greece will turn to China/Russia for financial support is unrealistic, long-term. China does not want to cross Germany and, in any event, will move cautiously. Russia is a wilder card, but they have enough financial and other problems of their own;
  • Syriza's coalition partners (the Independent Greeks) have the defense ministry portfolio and are pro-NATO. Unfortunately, the Defense Minister is an unsavory character and is also seriously anti-Semitic. The current coalition agrees only on its opposition to the bailout programme – expect violent disagreements (a bust-up?) once that has been settled, either way; 
  • Finally, Germany (and a number of other important EZ countries) are fed up with Greece/Cyprus's attitude towards issues such as Macedonia/Cyprus itself/EU sanctions on Russia re Ukraine, etc.

Greece’s position was not helped by a Varoufakis press conference in Germany during which he talked about Nazis. Yes, I know he was referring to the Nazi party in his own country, but he reminded the Germans that they were once run by Nazis, and it didn’t work out very well for them, so they should understand and give Greece a lot of money. I’m not sure why he thought that would be a helpful analogy, but it just further poisoned the well.

Then Tsipras gave his first major speech to the Greek Parliament on Sunday, in which he said again that Greece wants no more bailout money, that he still plans to renegotiate its debt deal, and that he still seeks a “bridge agreement” to tide the country over until a new pact is sealed. He apparently believes that Draghi and the Eurozone finance ministers in Europe don’t really mean it when they say there will be no bridge agreement without an agreement to maintain previous commitments.

As Kiron noted above, there seems to be a growing consensus that Europe can contain the problems from a Greek exit of the Eurozone. What are the chances of Greece’s leaving, either willingly or unwillingly? After the speech Tsipras gave today, I think it’s a 50-50 thing. Tspiras and Varoufakis seem to believe that the risk of a major Eurozone crisis if Greece leaves is a big enough threat to force Europe to fund them in order to avoid it.

European Deflation

The European Commission has put out its projections for 2015. Buried in the tables is its projection for inflation for Europe: -0.1%. They have Greece at -3.3% year-over-year and Spain at -1.5%. Italy is expected to experience mild deflation.

Japan is fighting deflation with a level of quantitative easing that is 15% of its GDP, and it is not clear that it’s winning. The European Central Bank wants to fight deflation with half that level of QE, spread out over a longer period. Rates are already so low that it is essentially meaningless to try to drive them down. How much can 20 basis points actually do for you? Ask Japan.

QE may indeed help spur European stock markets, and banks will benefit, but what does that do for Main Street Europe?

A Greek exit from the Eurozone will only make deflation pressures worse. The chart below shows where Greece owes its €323 billion. I assume that the vast majority of this debt will go “poof” at the moment of exit. The ECB can paper over a lot of it, or at least I think they can, but the question is, how much of the private debt will they cover?

And how will the interbank debt be dealt with? What about the remaining debt that is held by foreign banks, as well as Greek bonds in all sorts of funds?

Does Greece remain in NATO? Do we really want an anti-NATO country in the Balkans? That would be rather a nuisance. Can Greece stay in the free trade zone created by the European Union even if it leaves the European Monetary Union (the Eurozone)? Can the Greeks run a dual-currency system somewhat the way Argentina does, one where the official currency is the drachma but real transactions are done in euros? If the current Greek government gains the power of the printing press, it is quite likely that we will see very high inflation in short order, at least in terms of the drachma.

Could it be that Tsipras really wants to leave the euro but feels it will be better for him politically if it appears that Greece is forced out of the euro because the ECB has taken away the ELA? If you go back to his early speeches, he was all for leaving the euro unless Greece got total debt forgiveness.

Exactly what could the ECB and the rest of the EU do if Greece leaves? It’s not as if they can repossess a few Greek islands. Can you go after private Greek assets outside of the country? That approach would seem to be highly problematical. The lawyers could be fighting over this for years.

There are no clear answers for any of these questions. We have an inexperienced government trying to bluff in a poker game full of professional card sharks. The good news is that the situation is unlikely to remain unresolved for months or years. We are talking days and weeks.

After the last bailout, I said that Greece would end up defaulting again. The bailout agreement was not unlike the one imposed upon Germany at the end of World War I. It was simply mathematically impossible for it to work. I have sympathies for both sides.

Many of us have had the uncomfortable experience of watching a marriage of close friends come apart. Sometimes, a divorce really is the best thing, but it is nearly always painful and very expensive. The old joke goes something like this: Why is divorce so expensive? Because it’s worth it.

In the end, I think Greece will be better off leaving the euro and negotiating as hard as possible to stay within the European Union. Europe, after absorbing the cost, will be able to move on and begin to deal with the sovereign debt problems of the other troubled countries, including France. In a way, Greece is just a distraction from the very real crisis brewing in the rest of Europe. Stay tuned.

The 2015 Strategic Investment Conference

As I said at the beginning of the letter, George Friedman of Stratfor and Bill White, the former chief economist at the Bank for International Settlements have just agreed to speak at my conference. They will be joined by (in no particular order) Peter Briger of the $66 billion Fortress Investment Group, who will talk on the state of credit in the world; David Rosenberg; Dr. Lacy Hunt; Grant Williams; Raoul Pal; Paul McCulley; David Harding (of the $25 billion Winton fund family); Louis Gave; Jim Bianco; Larry Meyer (former Fed Governor); the irrepressible Jeff Gundlach; the wickedly brilliant Stephanie Pomboy; Ian Bremmer; David Zervos; Michael Pettis (flying in from China); and Kyle Bass, along with Jack Rivkin of Altegris and your humble analyst. There will still be a few more to add to the list, but it’s already shaping up to be our best conference ever.

The conference is in San Diego, April 30–May 2, and will once again be at the Hyatt Manchester. For the first time this year, our conference is open to everyone, not just accredited investors. You want to register now so that you can get the early-bird discount.

Since the first year of the Strategic Investment Conference, my one rule has been to create a conference that I want to attend. Unlike many conferences, this one has no sponsors who pay to speak. Normal conferences have a few headliners to attract a crowd and then a lot of fill-ins. Every speaker at my conference is an A-list speaker I want to hear, who would headline anywhere else. And because all the speakers know the quality of the lineup, they bring their A games.

Attendees routinely tell me that this is the best conference anywhere, every year. And most of the speakers hang around to hear what is being said, which means you get to meet them at breaks and dinners. Plus, this year I am arranging for quite a number of writers and analysts to show up, just to be there to talk with you. And I must say that the best part of the conference is mingling with fellow attendees. You will make new friends and be able to share ideas with other investors just like yourself. I really hope you can make it.

Registration is simple. Use this link. While the conference is not cheap, the largest cost is your time, and I try to make it worth every minute. There are also two private breakfasts where hedge funds will be presenting. Altegris will contact you to let you know the details.

The Cayman Islands, Dallas, Florida, Switzerland, and New York

I will be somewhere close to a beach as you read this, either on Little Cayman with my friend Raoul Pal or at a conference on the large island later in the week. I will be presenting with my friend Nouriel Roubini at the Cayman Alternative Investment Summit, one of the premier alternative investment conferences of the year. They always attract very interesting speakers and entertainment. I see a few days of R&R on the beach (as well as in the gym) before and after the conference. Maybe I can catch up on some of my reading, too.

Then I will be back in Dallas to speak at an open forum for financial advisors, sponsored by S&P and called “Managing Risk and the Future of Factor-Based Strategies.” If you are an investment professional, you can register at this link.

At the beginning of March I will be in Orlando to do a keynote presentation for the American Banking Association and share a dinner with my old friend Greg Weldon. A few weeks after that, I fly to Geneva and Zürich, where I have a very packed schedule. In addition to speaking, I’m particularly looking forward to being with Dylan Grice and meeting Bill White for the first time, plus lots of other friends. I’m sure I will be staggered by the cost of everything in Switzerland, but the train ride from Geneva to Zürich is worth every penny. On a side note, Bill White was smart enough to negotiate his speaking fee in Swiss francs while I’m getting dollars for mine. That should probably tell you all you need to know about whose advice you should listen to.

I have some other speeches in Dallas and will then head to New York at the end of March.

The twins are in town to see their new nephew (Henry Junior), and it appears that I’m going to get all my kids together for brunch. I’m pretty excited about that. I’ll write next week about what I learned in the Caymans. Have a great week in the meantime.

Your wondering how cheap a Greek vacation will get analyst,

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China's imports drop 20% explaining PBoC action; China watchers clueless

by Sober Look

China's trade report this weekend was dismal. Exports dropped 3.3% vs. economists' consensus of a 6.3% increase from last year. That is a 10% miss, demonstrating that the global community of professional China watchers do not have a clue about the nation's trade dynamics. This is quite unsettling given the importance of China to global growth.

A great deal of this weakness in exports was due to softer demand from the Eurozone and especially from Asia.

Reuters: - ... the data showed that while exports to the United States rose by 4.8 percent year-on-year to $35 billion, exports to the European Union slid 4.6 percent to $33 billion in the same period.
Exports to Hong Kong, South Korea and Japan were also down, with exports to Japan slumping over 20 percent.
But the real shocker came from the nation's import figures. Imports dropped by 20% from last year as the nation bought less (or paid less for) coal, oil and other commodities. Economists missed this measure by a whopping 17%!

As a result of the huge decrease in imports, China's monthly trade surplus spiked to a record of $60bn.

China's industrial demand has clearly suffered a decline in recent months - which explains the reason the PBoC chose to cut reserve requirements for banks (RRR - see chart/quote). However it is far from certain that this action will end up having the desired effect.

Fitch: - ... uncertainty remains as to whether the recent easing measures by the PBOC (including the earlier rate cuts in November 2014) will actually result in increasing credit to targeted sectors, such as small and micro enterprises. If banks utilise the monetary loosening to continue expanding credit in sectors which are already highly leveraged, it would exacerbate vulnerabilities in the system and be credit negative.

The question remains however if China watchers, both domestic and international, can develop a better insight into the nation's economic trajectory or if the projected figures continue to wildly deviate from reality.

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If Greece Exits, Here Is What Happens

by Tyler Durden

Now that the possibility of a Greek exit from the euro is back to being topic #1 of discussion, just as it was back in the summer of 2012 and the fall of 2011, and investors are propagandized by groundless speculation posited by journalists who have never used excel in their lives and are merely paid mouthpieces of bigger bank interests, it is time to rewind to a step by step analysis of precisely what will happen in the moments before Greece announces the EMU exit, how the transition from pre- to post- occurs, and the aftermath of what said transition would entail, courtesy of one of the smarter minds out there at the time (before his transition to a more status quo supportive tone), Citi's Willem Buiter, who pontificated precisely on this topic previously. Three words: "not unequivocally good."

From Willem Buiter (2012)

What happens when Greece exits from the euro area?

Were Greece to be forced out of the euro area (say by the ECB refusing to continue lending to Greek banks through the regular channels at the Eurosystem and stopping Greece’s access to enhanced credit support (ELA) at the Greek central bank), there would be no reason for Greece not to repudiate completely all sovereign debt held by the private sector and by the ECB. Domestic political pressures might even drive the government of the day to repudiate the loans it had received from the Greek Loan Facility and from the EFSF, despite it having been issued under English law. Only the IMF would be likely to continue to be exempt from a default on its exposure, because a newly ex-euro area Greece would need all the friends it could get – outside the EU. In the case of a confrontation-driven Greek exit from the euro area, we would therefore expect to see around a 90 percent NPV cut in its sovereign debt, with 100 percent NPV losses on all debt issued under Greek law, including the debt held, directly or directly, by the ECB/Eurosystem. We would also expect 100 percent NPV losses on the loans by the Greek Loan Facility and the EFSF to the Greek sovereign.

Consequences for Greece

Costs of EA exit for Greece are very high, most notably the damage done to balance sheets of Greek banks and nonfinancial corporates in anticipation of EA exit.

We have recently discussed at length what we think would happen should Greece leave the euro area (Buiter and Rahbari (2011)), so we shall be brief here. Note that we assume that Greece exits the euro area and does not engage in the technical fudge discussed in Buiter and Rahbari (2011), under which it technically stays in the euro area but introduces a second, parallel or complementary currency.

The instant before Greece exits it (somehow) introduces a new currency (the New Drachma or ND, say). Assume for simplicity that at the moment of its introduction the exchange rate between the ND and the euro is 1 for 1. This currency then immediately depreciates sharply vis-à-vis the euro (by 40 percent seems a reasonable point estimate). All pre-existing financial instruments and contracts under Greek law are redenominated into ND at the 1 for 1 exchange rate.

What this means is that, as soon as the possibility of a Greek exit becomes known, there will be a bank run in Greece and denial of further funding to any and all entities, private or public, through instruments and contracts under Greek law. Holders of existing euro-denominated contracts under Greek law want to avoid their conversion into ND and the subsequent sharp depreciation of the ND. The Greek banking system would be destroyed even before Greece had left the euro area.

There would remain many contracts and financial instruments involving Greek private and public entities denominated in euro (or other currencies, like the US dollar) that are not under Greek law. These would not get redenominated into ND. With part of their balance sheet redenominated into ND which would depreciate sharply and the rest remaining denominated in euro and other currencies, any portfolio mismatch would cause disruptive capital gains and losses for what’s left of the Greek banking system, Greek non-bank financial institutions and any private or public entity with a (now) mismatched balance sheet. Widespread defaults seem certain.

As discussed in Buiter and Rahbari (2011), we believe that the improvement in Greek competitiveness that would result from the introduction of the ND and its sharp depreciation vis-à-vis the euro would be short-lived in the absence of meaningful further structural reform of labour markets, product markets and the public sector. Higher domestic Greek ND-denominated wage inflation and other domestic cost inflation would swiftly restore the old uncompetitive real equilibrium or a worse one, given the diminution of pressures for structural reform resulting from euro area exit.

In our view, the bottom line for Greece from an exit is therefore a financial collapse and an even deeper recession than the country is already experiencing - probably a depression.

Monetising the deficit

A key difference between the ‘Greece stays in’ and the ‘Greece exits’ scenarios is that we believe/assume that if Greece remains a member of the euro area, there would be official funding for the Greek sovereign (from the Greek Loan Facility, the EFSF and the IMF), even after the inevitable deep coercive Greek sovereign debt restructuring, and even if NPV losses were imposed on the official creditors – the Greek Loan Facility, the EFSF and the ECB. The ECB probably would no longer engage in outright purchases of Greek sovereign debt through the SMP, but the EFSF would be able to take over that role following the enhancement and enlargement of the EFSF later in 2011.4 If Greece remains a member of the euro area, the ECB would likewise, in our view, continue to fund Greek banks (which would have to be recapitalised following the Greek sovereign debt restructuring), both through the regular liquidity facilities of the Eurosystem and through the ELA.

In the case of a (confrontational and bitter) departure of Greece from the euro area, it is likely that all official funding would vanish, at least for a while, even from the IMF (which would, under our most likely scenario, not have suffered any losses on its loans to the Greek sovereign). The ECB/Eurosystem would, of course, following a Greek exit, cease funding the Greek banks.

This means that the Greek sovereign would either have to close its budget gap through additional fiscal austerity, following its departure from the euro area, or find other means to finance it. The gap would be the primary (non-interest) general government deficit plus the interest due on the debt the Greek sovereign would continue to serve (the debt issued under foreign law other than the loans from the Greek Loan Facility and the EFSF, and the debt to the IMF), plus any refinancing of this remaining sovereign debt as it matured. We expect the Greek General Government deficit, including interest, to come out at around 10 percent of GDP for 2011, while the programme target is 7.6 percent. General government interest as a share of GDP is likely to be around 7.2 percent of GDP in 2011, which means that we expect the primary General Government deficit to be around 2.8 percent of GDP. We don’t know the interest bill in 2011 for the IMF loan and for the outstanding privately held debt issued under foreign law. If we assume that these account for 10 percent of the total interest bill on the general government debt – probably an overestimate as interest rates on the IMF loan are lower than on the rest of Troika funding – then we would have to add 0.72 percent to the primary deficit as a percentage of GDP to obtain an estimate of the budget deficit that would have to be funded by the Greek government, say 3.5 percent of GDP. We would have to add to that any maturing IMF loans and any maturing privately held sovereign debt not under Greek law. This is on the assumption that even those creditors under international law that continue to get serviced in full, would prefer not to renew their exposure to the Greek sovereign once they have been repaid. In addition, future disbursements by the IMF under the first Greek programme would be at risk following a Greek exit. This would create a further funding gap.

Assume the Greek authorities end up (very optimistically) having to find a further 5 percent of GDP worth of financing. This could be done by borrowing or by monetary financing. Borrowing in ND-denominated debt would likely be very costly. Nominal interest rates would be high because of high anticipated inflation – inflation that would indeed be likely to materialise. Real interest rates would also be high.

Although the Greek sovereign’s ability to service newly issued debt would be greatly enhanced following its repudiation of most of its outstanding debt, the default would raise doubts about its future willingness to service its debt. Default risk premia and liquidity premia (the market for ND-denominated Greek debt would be thin) would raise the cost of borrowing in ND-denominated debt. Even if the Greek authorities were to borrow under foreign law by issuing debt denominated in US dollars or euro, default risk premia and liquidity premia would likely be prohibitive for at least the first few quarters following the kind of confrontational or non-consensual debt default we would expect if Greece were pushed out of the euro area.

So the authorities might have to finance at least 5 percent worth of GDP through issuance of ND base money, under circumstances where the markets would inevitably expect a high rate of inflation. The demand for real ND base money would be very limited. The country would likely remain de-facto euroised to a significant extent, with euro notes constituting an attractive store of value and means of payment even for domestic transactions relative to New Drachma notes. We have few observations on post-currency union exit base money demand to tell us whether a 5 percent of GDP expected inflation tax could be extracted at all by the issuance of ND – that is, at any rate of inflation. If it is feasible at all, it would probably involve a very high rate of inflation. It is possible that we would end up with hyperinflation.

The obvious alternative to monetisation is a further tightening in the primary deficit through additional fiscal austerity (of something under 5 percent of GDP), allowing for some non-inflationary issuance of base money. Because Greek exit would be in part the result of austerity fatigue in Greece, this outcome does not seem likely.

A collapsed banking system, widespread default throughout the economy, a continuing non-competitive economy and high inflation with a material risk of hyperinflation would make for a deep and enduring recession/depression in Greece. Social and political dislocation would be certain. There would, in our view, be a material risk of a downward spiral of dysfunctional politics and economics.

Consequences for the remaining euro area and EU member states of a Greek exit

For the world outside Greece, and especially for the remaining euro area member states following a Greek exit, the key insight would be that a taboo was broken with a euro area exit by Greece. The irrevocably fixed conversion rates at which the old Drachma was joined to the euro in 2001 would, de facto, have been revoked. The permanent currency union would have been revealed to be a snowball on a hot stove.

Not only would Greek official credibility be shot, the same thing would happen for the rest of the EA member states in our view. First, monetary union is a two-sided binding commitment. Both sides renege if the accord is broken. Second, Greece would only exit from the euro area if it was driven out by the rest of the euro area member states, with the active cooperation of the ECB. Even though it would be Greece that cuts the umbilical cord, it would be clear for all the world to see that it was the remaining euro area member states and the ECB that forced them to wield the scalpel.

It does not help to say that Greece ought never to have been admitted to the euro area because the authorities during the years leading up to Greek membership in 2001, knowingly falsified the fiscal data to meet the Maastricht criteria for EMU admission, and continued doing so for long afterwards.6 After all, what Greece did was just an exaggerated version of the deliberate data manipulation, distortion and misrepresentation that allowed the vast majority of the euro area member states to join the EMU, including quite a few from what is now called the core euro area7. The preventive arm of the euro area, the Stability and Growth Pact (SGP) which, if it had been enforced would have prevented the Greek situation from arising, was emasculated by Germany and France in 2004, when these two countries were about to be at the receiving end of its enforcement.

Euro area membership is a two-sided commitment. If Greece fails to keep that commitment and exits, the remaining members also and equally fail to keep their commitment. This is not just a morality tale. It has highly practical implications. When Greece can exit, any country can exit. If we look at the austerity fatigue and resistance to structural reform in the rest of the periphery and in quite a few core euro area countries, it is not plausible to argue that the Greek case is completely unique and that its exit creates no precedent. Despite the fact that both Greece’s fiscal situation and its structural, supply-side economic problems are by some margin the most severe in the euro area, Greece’s exit would create a powerful and highly visible precedent.

As soon as Greece has exited, we expect the markets will focus on the country or countries most likely to exit next from the euro area. Any non-captive/financially sophisticated owner of a deposit account in that country (or in those countries) will withdraw his deposits from banks in countries deemed at risk - even a small risk - of exit. Any non-captive depositor who fears a non-zero risk of the future introduction of a New Escudo, a New Punt, a New Peseta or a New Lira (to name but the most obvious candidates) would withdraw his deposits from the countries involved at the drop of a hat and deposit them in the handful of countries likely to remain in the euro area no matter what - Germany, Luxembourg, the Netherlands, Austria and Finland. The ‘broad periphery’ and ‘soft core’ countries deemed at any risk of exit could of course start issuing deposits under English or New York law in an attempt to stop a deposit run, but even that might not be sufficient. Who wants to have their deposit tied up in litigation for months or years?

Apart from bank runs in every country deemed, by markets and investors, to be even remotely at risk of exit from the euro area, there would be de facto funding strikes by external investors and lenders for borrowers from these countries. Again, putting under foreign law (most likely English or New York) all cross-border (or perhaps even all domestic) financial contracts and instruments could at most mitigate this but would not cure it.

The funding strike and deposit run out of the periphery euro area member states (defined very broadly), would create financial havoc and mostly like cause a financial crisis followed by a deep recession in the euro area broad periphery. The counterparty inflow of deposits and diversion of funding to the ‘hard core’ euro area and the removal (or at least substantial reduction) of the risk of ECB monetisation of EA sovereign and bank debt would drive up the euro exchange rate. So the remaining euro area members would suffer (at least temporarily) from an uncompetitive exchange rate as well from the spillovers of the financial and economic crises in the broad periphery.

As noted by the new IMF Managing Director, Christine Lagarde (Lagarde (2011) and confirmed by Josef Ackerman (Ackermann (2011, p.14)), the European banking sector is seriously undercapitalised. It would not be well-positioned, in our view, to cope with the spillovers and contagion caused by a Greek exit and the fear of further exits. Ms Lagarde was arm-twisted by the EU political leadership, the ECB and the European regulators into a partial retraction of her EU banking sector capital inadequacy alarm call.10 However, this only served to draw attention to the obvious truth that despite the three bank stress tests in the EU since October 2009 and despite the capital raising that has gone on since then both to address any weaknesses revealed by these tests and to anticipate the Basel III capital requirements, the EU banking sector as a whole remains significantly undercapitalised even if sovereign debt is carried at face value. In addition, the warning by Ackermann that “… many European banks would not be able to handle writing down the sovereign bonds they hold on their banking books to market levels…” (Ackermann (2011), see also IMF (2011, pp. 12 -20)) serves as a reminder of the fact that Europe is faced with a combined sovereign debt crisis in the euro area periphery and a potential banking sector insolvency crisis throughout the EU.

A banking crisis in the euro area and in the EU would most likely result from an exit by Greece from the euro area. The fundamental financial and real economy linkages from the rest of the world to the euro area and the rest of the EU are strong enough to make this a global concern.

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