Archive for February, 2012

BNN Appearance: Banks & Housing

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Source:  BNN

Category: Media

10 Tuesday PM Reads

My afternoon train reads: • MF Global: Crime, Comedy and the Cover-Up (Huff Post) • Main Street’s $100 Billion Stock-Market Blunder (Smart Money) • Stock valuations now versus last April (Market Watch) • For the Costliest Homes, Foreclosure Comes Slowly (WSJ) see also JPMorgan, BofA Strain for Qualified Staff to Clear Foreclosures (Bloomberg) • Our…Read More

Category: Financial Press

A Primer on the Euro Breakup

A Primer on the Euro Breakup
John Mauldin
February 27, 2012

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It’s one thing to say that peripheral eurozone countries are better off leaving the euro, but how, exactly? And how severe can we expect the consequences to be, not only for those nations but also for the entire eurozone – and for the rest of us, worldwide? To minimize fallout from the event(s), it would be helpful to have a solid foundation, based on an historical understanding of similar events, on which we could build a reasonable set of expectations.

In the following piece, Jonathan Tepper, my Endgame coauthor, gives us the cornerstone of just such a foundation. With his London firm, Variant Perception, he has prepared a 53-page report with the very confident title “A Primer on the Euro Breakup: Default, Exit and Devaluation as the Optimal Solution.”

He reminds us that “during the past century sixty-nine countries have exited currency areas with little downward economic volatility.” He makes the case that “The mechanics of currency breakups are complicated but feasible, and historical examples provide a roadmap for exit.”

The real problem in Europe, he says, is that “EU peripheral countries face severe, unsustainable imbalances in real effective exchange rates and external debt levels that are higher than in most previous emerging market crises.”

The way through? “Orderly defaults and debt rescheduling coupled with devaluations are inevitable and even desirable. Exiting from the euro and devaluation would accelerate insolvencies, but would provide a powerful policy tool via flexible exchange rates. The European periphery could then grow again quickly with deleveraged balance sheets and more competitive exchange rates, much like many emerging markets after recent defaults and devaluations (Asia 1997, Russia 1998, and Argentina 2002).”

We’ll need this sort of robust thinking and a willingness to meet the challenge head-on if we’re going to get through not just this eurozone crisis but the Endgame in which the whole world finds itself, in the final throes of the Debt Supercycle.

You can see the entire report on the Variant Perception blog – http://blog.variantperception.com/2012/02/16/a-primer-on-the-euro-breakup/ – or download it as a PDF.

Your confident that we will master the Endgame analyst,

John Mauldin, Editor
Outside the Box

JohnMauldin@2000wave.com

A Primer on the Euro Breakup: Default, Exit and Devaluation as the Optimal Solution

This is an abbreviated version of a longer report which can be accessed at Variant Perception’s blog at http://blog.variantperception.com, or as a PDF document. Contact us here to learn more about receiving Variant Perception research as a client.

Summary

Many economists expect catastrophic consequences if any country exits the euro. However, during the past century sixty-nine countries have exited currency areas with little downward economic volatility. The mechanics of currency breakups are complicated but feasible, and historical examples provide a roadmap for exit. The real problem in Europe is that EU peripheral countries face severe, unsustainable imbalances in real effective exchange rates and external debt levels that are higher than most previous emerging market crises. Orderly defaults and debt rescheduling coupled with devaluations are inevitable and even desirable. Exiting from the euro and devaluation would accelerate insolvencies, but would provide a powerful policy tool via flexible exchange rates. The European periphery could then grow again quickly with deleveraged balance sheets and more competitive exchange rates, much like many emerging markets after recent defaults and devaluations (Asia 1997, Russia 1998, and Argentina 2002).

Key Conclusions

The breakup of the euro would be an historic event, but it would not be the first currency breakup ever – Within the past 100 years, there have been sixty-nine currency breakups. Almost all of the exits from a currency union have been associated with low macroeconomic volatility. Previous examples include the Austro-Hungarian Empire in 1919, India and Pakistan 1947, Pakistan and Bangladesh 1971, Czechoslovakia in 1992-93, and USSR in 1992.

Previous currency breakups and currency exits provide a roadmap for exiting the euro – While the euro is historically unique, the problems presented by a currency exit are not. There is no need for theorizing about how the euro breakup would happen. Previous historical examples provide crucial answers to: the timing and announcement of exits, the introduction of new coins and notes, the denomination or re-denomination of private and public liabilities, and the division of central bank assets and liabilities. This paper will examine historical examples and provide recommendations for the exit of the Eurozone.

The move from an old currency to a new one can be accomplished quickly and efficiently – While every exit from a currency area is unique, exits share a few elements in common. Typically, before old notes and coins can be withdrawn, they are stamped in ink or a physical stamp is placed on them, and old unstamped notes are no longer legal tender. In the meantime, new notes are quickly printed. Capital controls are imposed at borders in order to prevent unstamped notes from leaving the country. Despite capital controls, old notes will inevitably escape the country and be deposited elsewhere as citizens pursue an economic advantage. Once new notes are available, old stamped notes are de-monetized and are no longer legal tender. This entire process has typically been accomplished in a few months.

The mechanics of a currency breakup are surprisingly straightforward; the real problem for Europe is overvalued real effective exchange rates and extremely high debt – Historically, moving from one currency to another has not led to severe economic or legal problems. In almost all cases, the transition was smooth and relatively straightforward. This strengthens the view that Europe’s problems are not the mechanics of the breakup, but the existing real effective exchange rate and external debt imbalances. European countries could default without leaving the euro, but only exiting the euro can restore competitiveness. As such, exiting itself is the most powerful policy tool to re-balance Europe and create growth.

Peripheral European countries are suffering from solvency and liquidity problems making defaults inevitable and exits likely – Greece, Portugal, Ireland, Italy and Spain have built up very large unsustainable net external debts in a currency they cannot print or devalue. Peripheral levels of net external debt exceed almost all cases of emerging market debt crises that led to default and devaluation. This was fuelled by large debt bubbles due to inappropriate monetary policy. Each peripheral country is different, but they all have too much debt. Greece and Italy have a high government debt level. Spain and Ireland have very large private sector debt levels. Portugal has a very high public and private debt level. Greece and Portugal are arguably insolvent, while Spain and Italy are likely illiquid. Defaults are a partial solution. Even if the countries default, they’ll still have overvalued exchange rates if they do not exit the euro.

The euro is like a modern day gold standard where the burden of adjustment falls on the weaker countries – Like the gold standard, the euro forces adjustment in real prices and wages instead of exchange rates. And much like the gold standard, it has a recessionary bias, where the burden of adjustment is always placed on the weak-currency country, not on the strong countries. The solution from European politicians has been to call for more austerity, but public and private sectors can only deleverage through large current account surpluses, which is not feasible given high external debt and low exports in the periphery. So long as periphery countries stay in the euro, they will bear the burdens of adjustment and be condemned to contraction or low growth.

Withdrawing from the euro would merely unwind existing imbalances and crystallize losses that are already present – Markets have moved quickly to discount the deteriorating situation in Europe. Exiting the euro would accelerate the recognition of eventual losses given the inability of the periphery to grow its way out of its debt problems or successfully devalue. Policymakers then should focus as much on the mechanics of cross-border bankruptcies and sovereign debt restructuring as much as on the mechanics of a euro exit.

Defaults and debt restructuring should be achieved by exiting the euro, re-denominating sovereign debt in local currencies and forcing a haircut on bondholders – Almost all sovereign borrowing in Europe is done under local law. This would allow for a re-denomination of debt into local currency, which would not legally be a default, but would likely be considered a technical default by ratings agencies and international bodies such as ISDA. Devaluing and paying debt back in drachmas, liras or pesetas would reduce the real debt burden by allowing peripheral countries to earn euros via exports, while allowing local inflation to reduce the real value of the debt.

All local private debts could be re-denominated in local currency, but foreign private debts would be subject to whatever jurisdiction governed bonds or bank loans – Most local mortgage and credit card borrowing was taken from local banks, so a re-denomination of local debt would help cure domestic private balance sheets. The main problem is for firms that operate locally but have borrowed abroad. Exiting the euro would likely lead towards a high level of insolvencies of firms and people who have borrowed abroad in another currency. This would not be new or unique. The Asian crisis in 1997 in particular was marked by very high levels of domestic private defaults. However, the positive outcome going forward was that companies started with fresh balance sheets.

The experience of emerging market countries shows that the pain of devaluation would be brief and rapid growth and recovery would follow – Countries that have defaulted and devalued have experienced short, sharp contractions followed by very steep, protracted periods of growth. Orderly defaults and debt rescheduling, coupled with devaluations are inevitable and should be embraced. The European periphery would emerge with de-levered balance sheets. The European periphery could then grow again quickly, much like many emerging markets after defaults and devaluations (Asia 1997, Russia 1998, Argentina 2002, etc). In almost all cases, real GDP declined for only two to four quarters. Furthermore, real GDP levels rebounded to pre-crisis levels within two to three years and most countries were able to access international debt markets quickly.

Historical Currency Exits: Case Studies for the Euro

The Mechanics of a Euro Area Breakup: Lessons from Previous Currency Breakups

The dissolution of the euro would be an historic event, but it would not be the first currency breakup. Some noted economists have called the euro sui generis, or one of a kind. In fact, currency breakups and exits are a common occurrence. Within the past 100 years, there have been over 100 breakups and exits from currency unions.

Andrew K. Rose, a Professor of International Business at the University of California, Berkeley, has done a study of over 130 countries from 1946 to 2005. The following table taken from his research gives each exit during the period. In some cases, these were small colonies exiting currency areas and in other cases, these were large countries and currency unions breaking up:


Source: Checking Out: Exits from Currency Unions Andrew K. Rose, 2007 www.mas.gov.sg/resource/publications/staff_papers/StaffPaper44Rose.pdf

The conclusions Andrew Rose draws from the study of all the currency exits are remarkable:

“I find that countries leaving currency unions tend to be larger, richer, and more democratic; they also tend to experience somewhat higher inflation. Most strikingly, there is remarkably little macroeconomic volatility around the time of currency union dissolutions, [emphasis added] and only a poor linkage between monetary and political independence. Indeed, aggregate macroeconomic features of the economy do a poor job in predicting currency union exits.”

Source: Checking Out: Exits from Currency Unions Andrew K. Rose, 2007 www.mas.gov.sg/resource/publications/staff_papers/StaffPaper44Rose.pdf

The conclusion – that most exits from a currency union have been associated with low macroeconomic volatility and that currency breakups are common and can be achieved quickly – flies in the face of conventional wisdom.

Any exit from the euro would inevitably re-introduce devalued drachmas, pesetas, escudos, punts or lire, because of extremely overvalued real effective exchange rates and very high net external debt levels. In this context, then, the exit from the euro should be looked at as an emerging market crisis, where countries defaulted on private and/or public debts, abandoned pegs or managed exchange rates, and devalued. The euro merely overlays currency exit to what is a classic emerging market crisis.

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Category: Think Tank

Differing views of LTRO results

As we await the results of LTRO2 at about 5am tomorrow morning, the total amount borrowed can be interpreted in different ways. If its well above 500b euros, we can say that a)European banks really needed the money or, b)we can say banks are of course taking advantage of cheap 1% funds where they in…Read More

Category: MacroNotes

Greek Haircuts

> The chart above, courtesy of Bianco Research, is presented without comment

Category: Bailouts, Credit

The Future Delivery of Active Management

Josh went to AdvisorShares – the company that turns active strategies into ETFs – to discuss how active ETFs are gradually taking share from actively managed mutual funds.

AdvisorShares Alpha Call – At 4pm ET/1pm PT today, our alpha call presentation, “The Future Delivery of Active Management,”will feature:

  • Scott Burns, Director of ETF, Closed-End Fund and Alternative Research for Morningstar
  • Josh Brown, Vice President of Investments for Fusion Analytics Investment Partners and author of the popular financial blog, “The Reformed Broker”
  • Noah Hamman, CEO of AdvisorShares

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Category: Investing, Video

Consumer confidence jumps but gasoline .20 higher since

The Feb Conference Board Consumer Confidence figure at 70.8 was well above expectations of 63, up from 61.5 in Jan and the best in a year. The gain was led by the Expectations component which rose by 11.3 pts. The Present Situation rose by 6.2 pts. The answers to the labor market questions were the…Read More

Category: MacroNotes

Case Shiller: What Housing Bottom?

December 2011 Case-Shiller Home Price Indices showed that 2011 ended at new index lows.

The National Composite Index fell by 3.8% during Q4;  year over year changes were down 4.0%. The 10- and 20-City Composites also fell by similar amounts, falling -3.9% and -4.0% versus December 2010, respectively.

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more charts after the jump

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Category: Data Analysis, Real Estate

10 Tuesday AM Reads

Some lively reads to start your morning: • The Warren Buffett Haters Club (Businessweek) see also Buffett’s shareholder letter dangles clues (MarketPlace) • Research: Wealthy More Likely to Lie, Cheat (Bloomberg) • World Bank warns: China is a ticking time bomb (Market Watch) • Is This Stock Market Rally for Real? (Time) • Robosigning 2.0:…Read More

Category: Financial Press

Golden Boy

Warren Buffett deserves the public’s respect. His great success and apparent modesty, kindness and reason in a field replete with promoters and chest thumpers have allowed him to stand out in our society. He is to most an honest broker among charlatans, uniquely capable of separating truth from fiction, the way it is and will…Read More

Category: Gold & Precious Metals, Think Tank