Greece’s failed privatization, Europe’s potential recovery and Abenomics
In the links today, the biggest threads outside of the NSA scandal were on Greece and Europe. I believe the economy there is bottoming and I want to discuss some of the news flow. There was also a rate decision by the Japanese central bank that was met with disappointment. Let’s put this into context regarding the viability of Abenomics.
First on Greece, the beginning of Greece’s privatization program failed as the state-owned natural gas company DEPA did not attract the kinds of bids that the government was hoping for. This is a medium-term problem but not a short-term one. Let me explain my view here.
First, the principal considerations is the path of tax revenue versus fiscal outlays. And a number of variables impinge on this, making it a tricky task to predict debt sustainability. The revenue side of the coin is affected by the size/growth of the economy, tax rates, and the efficacy of tax collection while outlays are also affected by economic strength, but inversely due to the rise in automatic stabilzer expenditures in a downturn, as well as by budgeting decisions. This fact alone makes austerity a tricky devil in a private debt crisis. With the private sector already in distress, austerity sucks more money out of the private sector, increasing debt stress and fuelling an accelerated private deleveraging. The toxic mix of pre-existing private debt stress and public sector austerity, therefore, makes each unit cut in expenditure translate into much more than one unit loss in overall economic output.
Second, just like in private restructurings, this fiscal path can be leavened by asset sales. Clearly you want to sell assets when bidding will be high and without having the assets deteriorate in value in order to maximize revenue to reduce debt. Selling straight away during a crisis means getting firesale prices that reflect a lack of best alternatives to a negotiated agreement. But, if the country waits too long, the asset value could deteriorate. Striking that balance is hard as we saw with the attempted sale of DEPA
If we think about Greece as being akin to a company turnaround, events that we often see highly indebted companies in the high yield market go through, then the key features to a sustainable economic recovery I highlighted above are similar. I think this analogy is apt because Greece is a currency-using nation without monetary sovereignty, making it vulnerable to market concerns about solvency. If the company/country in question is highly indebted, it has to undergo a major restructuring program that might include debt default and investor haircuts. Greece has already started this path. However, the sustainability of the sovereign debt load is questionable even after the initial restructuring. The potential need for official sector involvement (OSI), requiring the ECB, EU and IMF to take losses, at some point down the line is large. To minimize the likelihood of this outcome, we need Greece to hit targets on other facets of the restructuring including the privatization.
I have some experience with indebted companies from my previous work in the leveraged finance business and Greece looks like a good comparison to the companies that go through this process. One key note in the process is that people in restructurings always look at both the absolute debt to income or EBITDA (earnings before interest depreciation and amortization) levels as well as the interest coverage ratios to gauge short and medium term sustainability. These are the two metrics most commonly used when I was in the business. So when you look at sovereign restructurings, the same logic applies.
I wrote a post on the sovereign debt crisis and the debt servicing cost mentality highlighting the need for the dual constraints because a lot of macro pundits are talking about the sovereign debt crisis as if the only key consideration is the debt service number. That’s not a good way to look at it because these countries have considerable debt rollover and new deficit financing risk that makes them vulnerable to spikes in interest rates. And it is always an unexpected spike in interest rates that kills their debt service ratios and triggers default.
From the company side, what often happens in distressed situations is that companies go into survival mode to avoid liquidation. They fire staff, cut capital investment to the bone, shed assets like crazy and try to get their lenders to roll over loans at favourable interest rates aka extend and pretend. If the companies are successful, they essentially re-start as a going concern from a lower revenue and income base. And so the questions are: how much lower is that base going to be? how many losses are they going to pile on before they get there? And how much interest can they pay without default at that level? Those are all medium term issues, meaning that it’s clear that the company will be put through the wringer and come out weaker from a revenue perspective, the question is whether it can sustain its debt load over the medium-term without default given this.
With Greece, the questions are the same. My sense is that the 175% debt load the country carries is totally unsustainable without significant asset sales, decent economic growth and low interest rates. The asset sales are a bust so far, so that’s worrying. But Greece does seem to be bottoming and interest rates are low. Will rates stay low? We don’t know. But, at a minimum, if Greece cannot meet targets, rates could spike before Greece can qualify for the OMT, in which case, it’s game over: default and OSI. In the short-to- medium-term Greec is just fine. But the country needs growth. If they don’t get it, you have a big problem. Expect to see growth by the end of the year if this is going to work.
Elsewhere in Europe, I think recovery will take hold. The latest news out of Spain is that house prices are down a massive 37% since the 2007 peak. Judging from the Irish experience, we still have at least another 20% to lose to get us down to the 50% loss range that seems reasonable. But the year-on-year price declines are already moderating. They were 10% his past month versus 11%, three months prior and even higher before that. So the debt deflation is receding. Spain is somewhat like Greece in terms of debt deflation and deleveraging but earlier in the cycle.
I am hopeful that they will actually make it through because their initial sovereign debt levels were low and because the Europeans see Spain as a key fault line which they will defend. If we see further house price falls that compromise bank balance sheets, likely we will see Spain go back to the well for EU bailout money. But this time it will be a combination of bank creditor bail-in a-la Cyprus and EU gifts without larding up the sovereign balance sheet like last time. I believe the EU has learned from the first Spanish crisis that it made a mistake in not fully decoupling bank and sovereign risk by directly recapitalizing Spanish banks via a EuroTARP. Look at October as a reasonable time frame for this to occur in. It might see Spain going OMT as I have been predicting since early this year.
Contrast all this to Japan, where debt levels are extraordinarily high at the federal government level and you see how a sovereign currency gives you a lot more leeway. The big and regional banks have 3.15 trillion yen of credit available from the Bank of Japan at the 0.1% policy rate if they make more loans in the private sector. To date, banks have made more by buying JGBs than by lending as net interest margins are ridiculously low given the extended period of zero rates. Today the Bank of Japan disappointed markets by not extending its rate lending facility for medium-sized and large banks from 1 to 2 years. Nikkei futures fell on this news.
What this is telling me is that the monetary policy side of Abenomics is running out of steam. Growth in Q1 was big, the best in the G7 by far at 4%. But will it last? Yes, we have huge deficit spending which is goosing the private sector’s income. But we need to see serious structural reform and immigration into Japan if we are going to see any sustainable medium-term impact here. It is very early days for Japan, but the demographics are working against the country because it makes high nominal GDP growth exceedingly difficult as the population simply is not expanding enough to get them there. For me, this is a big impediment to the sustainability of Japan’s reform policy.
In my view, the Japanese stock market rally has ended until we get signs that the third pillar of Japan’s new economic policy works.