Why is Portugal in trouble?

Solving the problem should undoubtedly be the priority now, but looking at how Portugal got into this mess might help to formulate a solution.

Clearly there were many factors which helped to precipitate the current crisis, including numerous domestic political and policy mistakes. However, being a member of the single currency definitely seems to have played a part.

According to an interesting paper published by European Commission officials, joining the euro had the following consequences:

"The Portuguese economy went from a boom led by in the second half of the nineties to a marked slowdown in this decade (Chart 1). A major impulse for the expansion was the considerable fall in interest rates when the prospect of accession to EMU became increasingly self-validating. Nominal short-term interest rates fully converged to those at the common low level set by the ECB (Chart 2)."

The paper suggests that the "substantial fall in interest rates, [was] the main trigger for the boom", which later resulted in a bust. The interesting difference with Portugal, compared to Spain, Ireland and Greece, is that it experienced the infamous boom - bust dynamics before it entered the eurozone, but still because of the "prospect of accession to EMU", as the officials put it.

The eurozone's "sleeping pill" dynamics (as Herman Van Rompuy puts it) have prevented investors from forcing the country into unpopular, but necessary, reforms to boost competitiveness, resulting in Portugal becoming 21% less competitive relative to Germany over the past decade (this looks to be true of the past and current crisis).

So when Portugal experienced its bust, long before Spain and Ireland experienced theirs, there wasn't a currency which could come under strain and thereby discipline the politicians. This was surely one of the reasons for the consistently sluggish growth in Portugal following its bust.

There is, obviously, more to it though. Thanks to the ECB's artificially low interest rates, which were designed for a slow growing Germany, the country started accumulating very high levels of private debt, up to more than 200 percent of GDP (just like in Spain and Ireland, however, they managed to grow at the same time ).

On top of all of this, the Portuguese government hasn't exactly been a shining example of sound budgetary management. It has run large budget deficits for many years and has accumulated a significant level of debt for an economy the size of Portugal's (both the debt and deficit figures for last year were recently revised upwards as well).

Fundamentally however, an overvalued currency which prevented growth (the Escudo would have decreased in value following the original bust), combined with interest rates which were an ongoing stimulus to take on new debt, left Portugal with a decade of low growth. The resulting fall in relative living standards, compared to the rest of the EU, and the fall in tax receipts further fuelled the build up of both private and pubic debt.

Interestingly, Portugal's problems can provide some hint at what the future may hold for Greece, Ireland and possibly Spain. Even loose monetary policy and boosts in liquidity (admittedly in debt form) didn't solve Portugal's underlying competitiveness and currency problems, in fact they may have made things worse.

These lessons from Portugal's past should be heeded by those in charge. Tackling the root causes of this crisis - eurozone imbalances, competitiveness problems and the banking crisis - is of paramount importance, as is providing for all eventualities, including a restructuring and possibly even a change in eurozone membership.

Is the ECB becoming a bad bank?

Its common knowledge that the ECB has been providing massive amounts of liquidity to eurozone governments both directly (through the purchase of government bonds) and indirectly (by taking on large amount of government debt as collateral for lending to banks). The extent of this – and therefore also the implications – are less clear, mostly thanks to the ECB’s reluctance to publish any data on its holdings of collateral or government debt.

FT Alphaville highlights a note from JP Morgan, which suggests that the indirect exposure of the ECB to the Greek state is massive - and then we mean massive. JPM estimates that Greek banks have posted almost €140bn in state related collateral with the ECB (€85bn of state guaranteed bank paper, €45bn of Greek government bonds owned by Greek banks and €8bn of zero-coupon bonds which the Greek government had lent to Greek banks in 2008). Combining this with the direct holdings of government debt (thought to be around €60bn, as we noted in our paper on Greece) you get total exposure of the ECB to the Greek state of around €200bn.

That is a phenomenal amount.

Though these amounts are slightly speculative at the moment, there are some interesting and possibly disturbing implications here, particularly for those of us who believe that Greece will need to restructure its debt at some point soon (not that we’re alone, this group includes nearly all investors and apparently the IMF). This exposure to the Greek state is in the direct firing line if a restructuring occurs. First, there are likely to be large write downs on the direct holdings of Greek government bonds (at least 35% to have any significant impact on the debt burden) and secondly, the state backed paper could become close to worthless. Potential losses are still hard to quantify but would easily be upwards of €40bn.

Comparing this loss to the capital and reserves which the ECB holds, around €79bn, shows the potentially difficult situation which the ECB could find itself in following a Greek restructuring. Essentially the ECB would either have to ask eurozone governments for an injection of capital or or try to print their way back to an acceptable level of capital and reserves.

Therefore, following a Greek restructuring the ECB may have may face a difficult choice: completely ignore its primary mission (i.e. price stability) and print money or go hand in cap to governments - like the bad banks in the financial crisis - and ask for cash (almost like a bail-out).

Two questions: how in the world did the ECB allow itself to get so deep into this mess? And do German politicans/economists/opinion formers understand how incredibly exposed the ECB - once dubbed the world's strongest central bank - actually is?

Kicking the euro while it’s down

Eurozone leaders seem intent on making their crisis resolution as messy as possible. According to draft summit conclusions, seen by Reuters, the decision on how the EFSF will increase its lending effective lending capacity to €440bn will be delayed until June.

Clearly the months of pitching this week’s EU summit as the defining moment in solving the eurozone crisis were not well thought through or just wishful thinking. The markets' reaction to what is now destined to be a seriously underwhelming agreement is likely to be painful for the peripheral eurozone economies.

Discussions will now focus on the ESM, which is not due to come into force until 2013. Crisis management 101 (for the EU officials out there) – handle the problems on your plate first, then deal with the ones coming down the line. Not that an agreement has been finalised on the ESM either, with German Chancellor Angela Merkel looking to score a more gradual timeline for Germany’s contributions to the fund, probably given the increasing pressures her party is facing in this year's local elections.

Not one to be topped, Portuguese Prime Minister, Jose Socrates walked out of Parliament in the middle of possibly the most important vote in the country's recent history. According to Portuguese press reports, he left without saying a word and no-one knows if or when he will be coming back.

Well, at least its shaping up to be an eventful summit…

Saying 'Nein' To Angie

Last week's EU summit, saw the Franco-German "pact for competitiveness" - a raft of proposed rules on wages, pensions, spending and taxation to strenghten discipline in the eurozone - run into some serious opposition. Not surprising given that the plan effectively demanded that permanent, cast-iron rules, rather than votes in democratically elected national parliaments, determine key policies on spending, taxation and pensions across the eurozone.

Mariano Rajoy, leader of the Spanish opposition Partido Popular, summarised the underlying problem: “As a Spaniard, I don’t like to be told what I have to do by outsiders”.

Both the content (such as breaking the link between wages and inflation) and the process (France and Germany hammering out a deal behind closed doors with little input from anyone else) caused plenty of mutters from the other EU leaders.

The Merkel-dominated plan would lay down the new economic rules in exchange for injecting more money into the eurozone's rescue fund, but is now unlikely to be adopted in full.

Here is a round-up of what the press in the so-called 'peripheral' eurozone countries - the politically correct epithet for PIIGS - said last week about Iron Angie's ultimatim.

An article in Greek left-liberal newspaper To Ethnos argued,

The way in which decisions are being forced through in the states of the Eurozone and EU nowadays is nothing short of a coup d' état. One may or may not agree with Merkel's proposals [...] But what is absolutely unacceptable is this method of foisting these measures on the states.

In Spain, an editorial in El País criticised plans to keep salary increases below the level of inflation and argued,

The Spanish economy needs to change its growth pattern; save more and increase productivity. To achieve this, many changes are needed, and one can also discuss what Merkel proposes. But in the end, each country must choose its own formula to boost productivity.

Another Spanish daily, La Vanguardia, simply stated,

[A common] European economic policy is running. Angela Merkel is driving it.

An article in Italy's top financial newspaper Il Sole 24 Ore noted,

If all goes well, the Franco-German pact for growth and competitiveness will not make any mention of imbalance corrections for countries running excessive trade surpluses: no mention of the fact that Germany might be forced to boost its internal demand to favour growth in the rest of Europe. However, a blueprint will be provided for the gradual Germanisation of Europe [...] In other words, the European economic government always invoked by France, but all in German sauce [...] Will other eurozone countries follow? Bets are open, but if they want to stay in the euro area they will not have much choice.

In Le Figaro, Chief International Economy reporter Alexandrine Bouilhet described the Franco-German proposal as the “tree hiding the forest” , arguing,

The markets listen to it with only half an ear, not to say that they are indifferent. They are only waiting for one thing: fresh money on the table to avoid a Spanish collapse. The rest is nothing but political window-dressing made of promises that only bind those who made them…”

Chapeau!

Is EMU a new Rouble zone?

An interesting fact revealed by the Irish Independent has gone almost unnoticed.

The newspaper reported this less than two weeks ago:

The Irish Independent learnt last night that the Central Bank of Ireland is financing €51bn of an emergency loan programme by printing its own money... ...A spokesman for the ECB said the Irish Central Bank is itself creating the money it is lending to banks, not borrowing cash from the ECB to fund the payments. The ECB spokesman said the Irish Central Bank can create its own funds if it deems it appropriate, as long as the ECB is notified.

News that money is being created in Ireland will feed fears already voiced this week by ECB president Jean-Claude Trichet that inflation is a potential concern for the eurozone.

Jack Barnes, a retired professional trader comments:

This is a form of hyperinflation if you will, at least in context that a Central Bank, with no actual printing press, or a functioning bond market, has now electronically printed up new currency units for their banks without issuing debt behind these actions.

While this has happened before in history, it has not happened in the Euro currency project officially before today. This act is going to move the monetary policy of the union, to the individual capitals. The capacity to print electronic credits, with out the creation of cash currency or debt, is a new wrinkle in the economic landscape.

Citi chief economist Willem Buiter, who, as late as 2009, called for the UK to adopt the euro, has now published a paper looking at these operations. He makes a not so flattering comparison to another monetary union, which fell on hard times:

A monetary union with multiple independent centres of money creation will end up looking like the Rouble zone that survived the collapse of the Soviet Union at the end of 1991 for a bit, until it collapsed in a series of chaotic hyperinflations.

Meanwhile, Yale Phd Ed Dolan, who was a professor in Moscow from 1990 until 2001, provides some background in a new briefing, "The Breakup of the Ruble Area (1991-1993): Lessons for the Euro ":

The Central Bank of Russia claimed a monopoly on the issue of paper currency, but each of the 15 central banks of the ruble area could inflate the money supply through creation of bank credits. Each government was able to gain the full seigniorage benefit of financing its deficit through its own central bank, while spreading the resulting inflation among the whole group of 15.

(...) This gave rise to a free rider problem: Each country could use central bank credit to finance its budget deficit The resulting inflation was transmitted among all 15 member countries Each country had an incentive to act as a free rider, enjoying the benefits of credit expansion while shifting the inflationary costs to its neighbors.

Interestingly, as others before him, he sees Germany leaving the euro as the more preferable option:

It is hard for countries with weak economies to leave a stable currency area because doing so can trigger defaults and bank runs. These exit barriers do not apply to countries with strong economies that want to leave a weak, inflation-ridden currency area.

Similar inflation concerns are now forcing the ECB to choose: increase interest rates to promote a hard currency, satisfying Germany; or keep rates low to help out struggling economies on the eurozone's periphery.

Perhaps the first chapter of the eurozone crisis is over. Another one is about to begin.