Greece and the Middle East - The Economics of it All
Global Economics Weekly Brief
Economic conditions in Greece were the big news last week and will continue to be so in the future until they sort their issues! Even if the Greek government manages to get its austerity plan through parliament and qualify for bailout funds, there is still a long way to go. If it defaults the repercussions will flow well beyond its borders (this is a global issue for governments, banks and other lenders. Contagion to the peripheral Eurozone countries is part of the story but, as the Governor of the Bank of England made clear, direct and indirect bank exposures to Greek debt mean there will be consequences even in the stronger economies. Elsewhere sentiment about the pace of global recovery has weakened. In the UK more quantitative easing has been discussed, while in the US growth forecasts have been revised down and measures to cool China’s economy are beginning to take effect. Here we go again!
The Greek drama continues. Despite the Greek government winning a crucial confidence vote, worries about a Greek sovereign default persist. The provision of an additional €12bn in bailout funds from the European Central Bank and the IMF depends on passing legislation to implement €28bn in austerity measures by 29 June. Without the funds Greece will default on sovereign bond redemptions due on 15 July. But there is public unrest and the opposition parties may prevent the package going through. Even if these immediate hurdles are overcome, the feeling is that bailouts just delay the inevitable. Greece simply cannot afford to finance a debt burden of almost 160% of national output. Greece is financial dead!
The new MPC member tilts the balance further away from an early UK rate rise. The MPC minutes showed a 7-2 voting split at June’s meeting, as new member Ben Broadbent sided with the doves after the departure of the hawkish Andrew Sentance. The tone of the minutes was gloomier too. The weakness of recent UK data coupled with the potential for problems in the Eurozone to spread, led to discussions at the meeting about the possibility of more quantitative easing. Market expectations of the first rate hike moved back to Q2 2012 as a result, but with inflation at 4.5% and set to rise further, can they hold on for that long? Sir Mervyn King , Governor of the Bank of England - what was the knight-hood for? The strategy and forecasting for the UK has been so wrong for so long and still it is not correct!
Bank of England in firing line for soaring inflation. The Bank of England has suffered a dressing down at the hands of International financial regulators over its failure to keep inflation in check. The Swiss-based International Settlements - the central bank for central banks took a swipe at Threadneedle Street as it called for rapid rises in interest rates across the globe. While `Sir` Mervyn King receives his knight - hood for `not` controlling inflation he then receives the `swipe` from the Swiss `big` guns to get the UK into control rapidly! Watch this space!
Rising receipts support UK public finances in May. The UK budget deficit narrowed slightly over the past 12 months, helped by higher indirect tax receipts. Public sector net borrowing excluding financial interventions (the Government’s favoured measure of public finances) came in at £17.4bn in May, down from £18.5bn a year ago. While this is good news we shouldn’t get carried away. The bottom line is that there is still little room for manoeuvre on the Government’s spending plans if the structural budget deficit is to be eliminated over the course of the current parliament. Why are so many government employees still employed?
Eurozone economic performance is losing momentum, but inflation may be easing. The composite Purchasing Managers’ Index (PMI) for the Eurozone dropped to a 20-month low of 53.6 in June from 55.8 in March. A number above 50 signals expansion, but manufacturing and services output growth are both softening. Germany is holding things together. Its service sector reading rose to a three month high of 58.3 in June, reflected in improved business confidence, despite concerns about sovereign debt and slowing global growth. Without France and Germany’s contribution Eurozone output would have contracted for the first time since November 2009. On a positive note, input and output price inflation slowed, indicating that headline inflation may ease in coming months. Keep your fingers crossed!
US Fed keeps policy stable but downgrades growth prospects. The MPC isn’t alone in acknowledging the deterioration in economic conditions. The Federal Open Markets Committee (FOMC) kept rates below 0.25% at its June meeting and accepted that the recovery's strength had deteriorated. It backed this up with a gloomier set of forecasts. The Fed now expects growth in 2011 to be 2.8%, down from 3.2% just two months ago. Unlike the MPC, there was no mention of additional QE. The existing asset purchasing programme, known as QE2, will draw to a close by the end of this month, but don't expect it to be sold down just yet. Indeed the Fed will continue to reinvest the proceeds it receives from maturing securities for some time to come. The US debt is climbing rapidly daily!
Manufacturing growth in the world's second biggest economy slowed in June. The June flash reading of China's manufacturing PMI was the lowest in 11 months, falling from 51.6 in May to 50.1. The lower reading confirms monetary tightening measures are cooling growth, which should reduce inflationary pressures. But how quickly? A hard-landing in China is still unlikely, but like a Greek default, if it happened it could have tragic consequences. Watch this space!
Oil. That is what the modern Middle Eastern geopolitics have usually been about. Given the vast energy resources that form the backbone of western economies, influence and involvement in the Middle East has been of paramount importance for the former and current imperial and super powers, including France, Britain, USA and the former Soviet Union.
Source: World Atlas
Prior to the discovery of oil, the region had been a hotbed for religious conflict and wars over other rich resources and land. The declining Ottoman Empire paved way for the rising European imperial and colonial powers interested in securing various territories and controlling access to Asia. In more recent times, interest in the region has been due to the energy resources there.
As a result, for centuries, western populations have been acclimatized to a type of propaganda and vilification of the Arab and other people of the Middle East, and of Islam in general. This was especially so during the European colonial times, as so vividly examined by Edward Said, in his well-respected book, Orientalism. This negative stereotyping has served to provide justifications for involvement and to ensure “stability” for the “national interests” of the powers that want to be involved in the region.
This cultural stereotyping and racism has occurred in the modern times too. Often, especially in the 1980s, war films depicting an Arab or Islamic group as the bad guys were common place, sometimes reflecting prevailing turmoils at the time. Even in the 1990s, those ideas continued, where the bad guy was often a despotic Arab from one of the “rogue states” and as a result of the terrorist attacks against the US in September 11, 2001 and the resulting “War on terror”, such imagery is likely to continue. Over such a long time then, such boundaries of discourse about the Middle East have already been framed. To overstep those boundaries is to be labeled anti-Semitic, neo-Nazi, anti-West or some other equally negative label. For most journalists in the mainstream then, self-censorship is often the course, sometimes unknowingly.
To maintain superiority, control and influence over the region, the West has placed corrupt Arab leaders into positions of power and supported the overthrow of those that are not seen as favorable. This has also served to keep their populations at bay, in return for militarization, power and personal wealth of the elite. Sometimes this has been done in the name of fighting communism. The common theme underlying it though has been the struggle to control access to important resources such as oil.
The Middle East is the most militarized region in the world and most arms sales head there. A suppressed people that sees US influence as a major root cause of the current problems in the Middle East has led to a rise in Islamic militancy, acts of terrorism and anti-west sentiment, anti-US in particular. When looking at some of the actions of the US, it can often be seen why this is unfortunately so.
Global Financial Stability Report
GFSR Market Update
Since the publication of the April 2011 Global Financial Stability Report (GFSR), financial risks have risen for three reasons. First, while a multi-speed global recovery remains the base case, downside risks to this baseline have increased. Second, concern about debt sustainability and support for adjustment efforts in Europe’s periphery is leading to market pressures and worries about potential contagion. Political risks are also raising questions about medium term fiscal adjustment in a few advanced countries, notably, the United States and Japan. Third, notwithstanding some recent pullback in risk appetite, the prolonged period of low interest rates may push investors into riskier assets in a “search for yield.” This trend has the potential to build financial imbalances for the future, particularly in some emerging markets. Against these tensions, deep-seated challenges remain. Although there has been progress, improvements in financial system robustness have been insufficient so far. Markets may lose patience and become disorderly if political developments derail momentum on fiscal consolidation and financial repair and reform. Given these risks, policymakers need to accelerate actions to address long-standing financial vulnerabilities as outlined in the GFSR, before the window of opportunity to do so closes.
Markets Pricing a Mid-Cycle Slowdown
The base case of a multi-speed economic recovery remains intact, as outlined in the WEO Update. A key contributing factor to the improved financial stability outlook of the April GFSR has been the global economic recovery, which has helped strengthen private and banking sector balance sheets. However, negative surprises in recent economic data are causing investors to rethink the pace and strength of the recovery (Figure 1).
In the United States, downward growth concerns, in part on the back of renewed weakness in housing markets, have pushed real U.S. Treasury yields lower and have started to exert pressure on risk assets. More broadly, with investors beginning to shift from equities to bonds, global stock markets have retreated since peaking at end-April. Commodity prices have fallen and remain highly volatile as net long positions in commodities futures markets have been pared.
Concerns about debt sustainability and support for adjustment efforts in the euro area periphery have intensified . . .
Market doubts about debt sustainability and support for adjustment programs in the smaller countries of the European periphery have resurfaced. Credit default swap spreads have risen to new highs in Greece amid concerns over the degree of political resolve that will be needed to implement adjustment and secure needed funding. This, in turn, has renewed the market’s focus on the potential for transmission of shocks from sovereigns to banks as banking systems in core European countries still have large exposures to peripheral countries (Figure 2). In a serious market event, a shock could be transmitted beyond the euro zone via both cross-border exposures and a general retraction of risk appetite.
. . . while the outlook for sovereign risk in some larger economies has worsened.
Negative sovereign ratings actions have spread beyond Greece, Ireland, and Portugal further into other euro area countries (Figure 3). This reflects concerns that it will be difficult to reach the political consensus necessary for fiscal consolidation and structural reforms. Market concerns are also rising about the fiscal path in the United States, given little evident progress in breaking the political stalemate over how to carry out needed fiscal consolidation. In the near term, markets have focused on a potential failure to raise the debt ceiling, which the U.S. authorities have estimated will become binding at the beginning of August, absent action. The risk of a temporary default has pushed U.S. short-term CDS spreads above those of some countries rated below the United States’s AAA rating. Even that rating has come under question following S&P’s issuance of a negative outlook in April. In Japan, ratings agencies have downgraded the sovereign outlook on concerns about the government’s ability to achieve deficit reduction.
Prolonged zero interest rates promote risk-taking, including a “search for yield”
Low interest rates in advanced economies are promoting pockets of re-leveraging by lowering the “all-in” cost of debt capital for corporate borrowers. This is encouraging investors to use financial leverage to generate sufficiently attractive returns on equity. Although credit spreads are still higher than before the crisis, ultra-low short-term interest rates mean that the cost of debt is now lower, both for floating-rate and fixed-rate debt. This lower cost of borrowing renders debt servicing ratios more favorable, even at higher debt loads, thereby enabling companies to operate with more financial leverage (Figure 4).
As leveraged loan prices recover (after the deep discounts of 2008–2009) and yields fall, investors are increasingly turning to financial engineering to achieve double-digit returns. Both new and refinanced private equity transactions suggest that related corporate balance sheets are quickly approaching pre-crisis leverage multiples. Though the aggregate amount of financial leverage provided remains far less than before the crisis, high-yield corporate bond and leveraged loan investors have recently been borrowing at higher earnings multiples, not much below 2007 levels.
Notwithstanding recent market jitters, the “search for yield” is also spurring flows into emerging markets, notably corporate debt markets. These inflows, although volatile, are often magnifying already ample domestic liquidity. These conditions, if they continue, risk stretching valuations and raising worries that some countries could be re-leveraging too quickly. Flows into mutual funds for emerging market debt have been strong (behind only high-yield and commodities funds as a percent of total outstanding amounts). Even record amounts of EM corporate bond issuance cannot keep up with demand, and investor due diligence is waning. At nearly $65 billion, external EM corporate debt issuance in the first quarter of 2011 was the highest in three years, and markets expect record issuance for the full year (Figure 5). Emerging market corporate bonds are increasingly seen as substitutes for U.S. corporate high-yield bonds—offering similar market capitalization, lower leverage, and higher returns for the same credit ratings, thus making such bonds attractive to a wider investor base. Although this may represent a healthy development to the extent that some previously credit-constrained companies now have access to capital, the risk is that if the trend continues, too much capital may be moving too quickly to emerging markets. This raises the risk of a mispricing of credit and/or a sudden reversal, if adverse events lead to a rapid retraction in risk appetite.
Although there is little evidence for generalized asset price overvaluation in emerging markets, one area of recent concern has been the real estate sector in fast-growing emerging Asian economies, and possibly a few countries in other EM regions. The pace of property price increases in Asia may be easing (with the possible exception of Hong Kong SAR) on the back of aggressive macroprudential and administrative measures, together with some moderation in economic growth. However, if there were to be a sharp slowdown in growth, this could trigger a large correction in property prices, given their still elevated levels in several markets.
Market concerns about property prices centre on China. In order to slow inflation, the central bank has tightened financial policies and hiked policy rates. Should such measures result in an unexpectedly sharp slowdown, the impact on property prices may be even higher. This is in part due to a recent history of strong investment in real estate, including by local authorities as part of the stimulus measures undertaken in response to the global crisis.
Policymakers Must Strive for Rapid Progress on Financial System Robustness
Deep-seated financial challenges remain, even if vulnerabilities are masked by highly accommodative monetary and liquidity conditions. The current window of opportunity to prepare the financial and economic system against potential systemic shocks, importantly by providing clarity on euro area-wide solutions to strains in the periphery, could close unexpectedly. It could be closed by market developments if a sudden pickup in risk aversion (caused, perhaps, by unrelated factors) leads market participants to narrow their tolerance for incomplete policy solutions. It could also be closed by political developments, either because adjustment programs lose political support in debtor countries, or because populaces in creditor countries lose patience in continuing to finance those programs.
Thus, a more robust financial system, notably in Europe, is needed to gird against shocks. This will require a coordinated and cross-border policy response. Though there has been progress on banking system repair, the pace is too slow. First, funding challenges for banks remain. Bank bond yields have risen and some banks in peripheral European countries remain heavily dependent on the European Central Bank (ECB) for liquidity support. In some countries, banks are vulnerable to a further tightening in funding conditions and will need to step up the pace at which they roll over maturing funding.
Second, some banks have not yet sufficiently de-risked their balance sheets, leaving a large measure of uncertainty about asset quality given holdings of legacy assets and significant real estate exposures. Third, the pace of recapitalization needs to be accelerated in order to provide cushions against asset losses or shocks to liquidity (Figure 6). The forthcoming stress tests from the European Banking Authority will represent an important opportunity for updating the assessment of risks in the European banking system and for addressing the weak tail of banks flagged in the April GFSR. It will be critical that, where potential capital gaps are found to exist, plans are seen to be in place to fill them expeditiously, together with the resolution of nonviable banks.
Emerging market policymakers need to guard against overheating and a build-up of financial imbalances amid strong credit growth and rising inflation, exacerbated by capital inflows in some countries. Corporate leverage is also rising and weaker firms are increasingly accessing capital markets. This could make corporate balance sheets more vulnerable to external shocks. With strong domestic demand pressures, especially in emerging Asia and Latin America, macroeconomic measures are needed to avoid overheating, an accumulation of financial risks, and an undermining of policy credibility. Macroprudential tools and, in some cases, a limited use of capital controls, can play a supportive role in managing capital flows and their effects. However, they cannot substitute for appropriate macroeconomic policies.
In sum, policymakers must act now to make the financial system more robust:
· Downside risks have again risen to the fore, including that the global economic recovery may be more fragile than had been thought, so time to address existing vulnerabilities may be running out.
· At the same time, the room for maneuver to counter shocks has been reduced, especially via traditional fiscal and monetary policy levers.
· Thus, it will be critical to make the financial system strong enough to withstand potential major shocks, thereby enabling it to support ongoing recovery. The key priorities are, first, to make the current financial system more robust, especially to clean up from the legacy of the crisis in advanced countries. Second, the financial reform agenda must be completed as expeditiously as possible.
Finally, policymakers must chart a path that supports recovery without allowing a build-up of excessive risks in the future. This is likely to prove particularly challenging in those emerging markets where policymakers face rising inflation pressures and a build-up of financial imbalances. This requires a tightening of macroeconomic policies and use of macroprudential measures.
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This was your report on Greece and the Middle East from the Global Economics Weekly Brief.