Contagion Turns East

by Edward Hugh: Barcelona

Well, I don't know how many other people have noticed, but the Hungarian forint has been having rather a hard time of it over the past few days. The currency was down by as much 1.3 percent against the euro at one point today, today making the two-day intraday loss 3.6 percent, and this according to Bloomberg, was the biggest such fall since March last year. The Polish zloty also has weakend slightly, and fell by 0.1 percent to 3.9333 against the euro today while the Czech koruna gained 0.1 percent to 25.582 against the euro. At the same time the cost of credit default swaps on Hungarian debt rose 23.5 basis points to 240. Now virtually all currencies associated with the euro have been having a hard time of it in recent days, but what matters is the magnitude of the pressure being felt in each case, and Hungary here has been unlucky enough to have entered a period of political uncertainty at just the time when the level of market nervousness is higher than normal. There is another problem too. Over 85% of Hungarian home mortgages are not in forints, they are not even in euros, they are in Swiss francs, and the CHF has risen sharply against the euro since the start of the year. So unfortunately Hungarians don't even benefit from the euros woes.



Really, and unfortunately, this is the one I had been waiting for, and expecting. And precisely why did has the forint tanked in this way? What is so special about Hungary? After all, aren't many of Europe's economies seeing the cost of financing their government debt rising sharply over recent days. Basically one of the key reasons the forint has taken such a sharp knock is that Viktor Orban, Hungary’s new premier-in-waiting, just said in public what everyone following Hungary has been thinking (and saying) for weeks now: Hungary's fiscal deficit is going to be higher (possibly significantly higher) than the target agreed with the IMF. Other factors have also added to the level of concern about the country. What exactly will the core orientation of the incoming government economic policy be, and how much political interference might there be in the financial and monetary institutional structure? Certainly things haven't been helped by the way Hungary's incoming Prime Minister has publicly criticised the financial markets regulator (PSZÁF) and even gone so far as to give the impression he would like to replace central bank (National Bank of Hungary - NBH) governor Andras Simor (see Portfolio Hungary account here). In a world like the one we live in right now, what you ask for is what you get, and so get it they did.

The Comeback of a Political Survivor

Guest Post by Mark Pittaway


The outright victory of Viktor Orbán’s FIDESZ party in the first round of Hungary’s parliamentary elections on 11 April, and the likeliehood that they will win a two-thirds majority in parliament after the second round on 25 April marks a new stage in the unfolding of Hungary’s entangled political and economic crises – crises that have been in process since the summer of 2006. Most discussion of the election outside Hungary has focussed on the 16.67 percent won by the neo-fascist Jobbik party, with its explicit racist rhetoric towards Hungary’s Roma, its open anti-Semitism and its uniformed paramilitary wing, the Hungarian Guard. Within the country attention has focussed, especially among FIDESZ’s defeated left-liberal opponents, on the probability that FIDESZ will use its new found power and influence to purge the public sector and the media of its opponents, waging an intensified version of the “culture war” it conducted against the liberal left when it was last in power between 1998 and 2002.

Viktor Orbán himself ranks among Europe’s most persistent political survivors. In 2002 he was narrowly defeated by a coalition of Socialists and the liberal Alliance of Free Democrats in an election he was widely expected to win that took place in a benign economic climate. This defeat was largely self-inflicted and a product of FIDESZ’s authoritarian and confrontational policies towards its opponents. A further, and larger defeat in 2006 seemed to confirm the outcome of 2002 – that Orbán’s divisive style and widespread suspicion of his authoritarianism and use of right-wing populism would keep FIDESZ out of power for a long period. In the light of this, Orbán’s political survival and return to power are worthy of explanation. In the morrow of his defeat in 2002, Orbán began to transform FIDESZ from a traditional political party into an alliance of disparate movements originally integrating elements on the far right into a broad political coalition. A politics of using the deep-seated left-right polarization within Hungary to integrate the far right into his coalition was combined with a reach for the political centre by seeking to present FIDESZ as a party that stood for an expansion of welfare protection for the population – a kind of social democracy in national colours. Re-launched as FIDESZ-the Hungarian Civic Alliance in 2004, the party promised an expanded welfare state and lower taxes, while it began using the provision in the Hungarian constitution to initiate referenda as a campaigning strategy. Between 2004 and 2006 this strategy failed, yet it has been used to considerable effect since 2006 – though this effect has been less the result of trust in Orbán than a consequence of the political failures of his opponents and the unwinding of Hungary’s post-socialist economic model.

After the deep recession that followed the collapse of state socialism during the early 1990s, Hungary produced growth of 4-5% per annum during the latter half of the decade as a consequence of favourable economic circumstances, the apparent stabilization of the country’s external debt as a consequence of receipts from the privatization process, and an influx of FDI, largely of German and Austrian origin, in the expectation of speedy Hungarian membership of the European Union. Growth peaked in 2000 and after this date the circumstances that underpinned it began to unwind. Hungary’s competitiveness vis-a-vis its German and Austrian neighbours declined progressively, exacerbated by the strength of the Forint, while the EU’s decision in 2000 to support a large eastern enlargement, rather than one in which a select number of countries in Central Europe would gain EU membership intensified competition for FDI. While growth averaged 3-4% per annum until 2006, this was only maintained by running larger fiscal deficits and as a consequence of the demand created by increased consumer indebtedness fuelled by the de-regulation of financial markets that occurred in the wake of the consolidation of the banking sector and with EU membership.

As predominantly Austrian-owned entrants into the personal lending markets sought to increase market share they used the strong Forint, and high Forint interest rates to offer loans to households denominated in foreign currency, predominantly in Swiss Francs, but also in Euros, and even in Japanese Yen.

In 2004 the Socialist-Free Democrat government, believing they faced defeat in subsequent elections, ditched Prime Minister, Péter Medgyessy, and replaced him with Ferenc Gyurcsány. Faced with a large opinion poll deficit and attacks from FIDESZ that called for an expansion of welfare spending, Gyurcsány sought to gain re-election through maintaining large public deficits. As a consequence of pre-election spending both the European Union, and international credit rating agencies became increasingly nervous at Budapest’s poor control over public spending, and its attempts to move some public expenditure – notably on motorway construction projects – off the balance sheet.

The patience of financial markets was stretched up to the elections in April 2006, which Gyurcsány won, aided by a cut in the rate of VAT on luxury goods from 25% to 20%, and unfunded promises of tax reduction over the coming parliamentary term. Austerity followed the election as taxes were hiked, spending was cut, while co-payments in health and higher education were introduced. The government became severely unpopular by the beginning of summer, a situation compounded by a series of communication errors that culminated in the leaking to the press of a recording of a speech by Gyurcsány in which he admitted “we lied morning, noon, and night” to win the elections in September, and several months of disturbances on Hungary’s streets.

The austerity programme effectively removed demand from the economy, while the strong Forint policy was maintained by the central bank, and foreign currency lending continued apace. The economy stagnated, entering its first recession since 1993 in early 2007. Enormous discontent with austerity measures focussed on the figure of Gyurcsány, who many believed had shamelessly lied to win the election. Street demonstrations radicalized sections of right-wing opinion, which laid the basis for the future rise of Jobbik, and FIDESZ attacked directly the austerity programme with a series of several citizen-initiated referenda, three of which – on two sets of co-payment in health, and one in higher education- made it onto the ballot.

When these referenda succeeded in March 2008 by large margins, they weakened Gyurcsány fatally, but also strengthened FIDESZ’s credibility with a Hungarian electorate tired of market-based reform and frustrated at cuts in living standards as a party that offered social democracy in national colours. Thus, even before Hungary was forced to call in the IMF in October 2008 at the height of the global financial crisis the stage was already set for FIDESZ’s return. Events since – the fall of Gyurcsány in March 2009 and his replacement with Gordon Bajnai along with continued IMF-sponsored austerity; the electoral collapse of the Socialist Party; the rise of an explicitly neo-fascist party with mass support, especially in ex-Socialist voting industrial areas; and the victory of FIDESZ stems from the intensification of the impact of factors already visible in 2002.

The FIDESZ led list with its 52.73% of the first round list votes has become the first party to win an absolute majority of the popular vote since 1990. Its success reflects the considerable support among large sections of Hungarian society for a government that offers social democracy in national colours, and a desire for a period of respite from continued falls in living standards. This is revealed by opinion poll data and the broad geographical distribution of its support in the first round, where it was able to lead its opponents even in many of the formerly Socialist-voting strongholds in the working-class eastern suburbs of Budapest. Its electoral success was aided by its failure to offer any kind of concrete programme to the electorate, which allowed potential supporters to project their desires onto the party.

Yet this strength is now clearly a weakness moving forward. The latest figures suggest that Hungary’s GDP declined by 6.3 percent in 2009, and will continue to decline at a slower pace in 2010 – though the precise extent is uncertain due to the country’s dependence on exports to the Eurozone. Independent experts believe that Hungary will have severe difficulties in keeping its budget deficit below 4% in 2010 without urgent remedial action to raise revenues and cut spending. Furthermore, these figures do not include the deficits and the lending undertaken by local authorities, many of which are on the edge of bankruptcy, as are Hungarian State Railways and the Budapest Public Transportation Company. Consolidating these entities will place further pressure on the budget. There remain question marks over the long-term financial health of the Hungarian financial sector.

At the same time, given the high value of the Forint against the Euro, the consequent persistence of the problem of Hungarian competitiveness, and the continuing burden of financing debts in both the public and household sectors, Hungary’s economy seems to be condemned to either stagnation or sluggish growth for the foreseeable future. FIDESZ’s approach to these problems is almost completely unknown. It is difficult, however, to imagine that the measures they will have to undertake to deal with this situation, in all probability underpinned by an IMF loan, will be anything other than extremely painful.

Hungarian households are under severe pressure from declining real incomes, unemployment and the fear of unemployment, and the burden of servicing loans denominated in foreign currency. Furthermore, Hungary is now entering its fifth year of austerity and consequently the climate in the country is very tense, as the patience of the population with this situation is thin. Orbán has never been a universally popular leader and his divisive style seems to make him deeply unsuited to leading Hungary through the crisis. Furthermore, he will face considerable opposition both from his left, and from a militant, insurgent neo-fascist right. At the same time in a clientelist political system he will face enormous pressure to reward his supporters, and failure to do will meet with negative consequences. For these reasons, despite the size of his victory, it is difficult to see his position as being very secure. Hungary’s road out of the crisis will be, at the very best, a bumpy one.

The Greek Tragedy Continues

by Edward Hugh: Barcelona

The future of the Eurozone is decidedly hanging in the balance at the moment. As I said earlier in the week, the problem isn’t a simple question economics anymore: everything now is all about credibility, about who does what, and when, and how everyone else reacts. As the crisis trundles on and on, news that Greek bond spreads have hit ever higher post European Monetary Union records has become such a regular event that the process now seems almost a monotonous one. However, what happened on what we could now call this week’s Greek “Black Thursday” certainly marked a new, and more worrying milestone in the ever evolving crisis. The news this morning that Greece has demanded the activation of the EU-IMF loan - news which apparently took even the EU Commission itself by surprise it seems - only adds to the general sense of confusion that abounds.

The problem we are presented with is not only that Greek 10-year bond yields reached 8.83 per cent, their highest levels since 1998, or that the cost of insuring Greek government debt against default hit a record high of 616 basis points. The really disturbing development was that spreads on government bonds all around Europe’s periphery – including countries like Hungary and Bulgaria - widened sharply, raising heightened concerns that Greek contagion may move from being a mere possibility to becoming a reality. And the cost of protecting peripheral eurozone borrowers against default also hit record levels, with Spain and Portugal touching record highs for their Credit Default Swap prices.

The surge in Greek bonds followed news that Eurostat, the European Union’s statistical service, had revised its estimate of the country’s 2009 deficit to 13.6 per cent of gross domestic product from 12.7 per cent, and the announcement that Moody’s Ratings Agency had downgraded Greek sovereging debt to A3 from A2.

Markets are obviously nervous at the moment, and understandably so, with two issues in the forefront of their minds. In the first place the real level of commitment of core Europe, and especially Germany, to supporting the periphery through several years of difficult and painful structural adjustment is far from clear. On the other, the ability of political leaders in Greece and other affected countries to carry their citizens with them through the sacrifices which will be required to maintain the monetary system intact continues to remain in doubt.

German voters are notably uneasy about lending money to Greece, and a sizeable majority of them are against any form of aid. Reticence on the part of Angela Merkel’s coalition partner also makes obtaining parliamentary backing for the loan difficult, and the FDP senior spokesman on financial questions, Frank Schaeffler, stated bluntly this week that either Greece needed to intensify its austerity plan or it should leave the Euro.

Most observers, however, consider a Greek withdrawal to be only a remote possibility, given that any return to the Drachma would make the country’s debts even less payable. In fact the threat to the integrity of the currency union comes from an altogether different quarter. What is in now increasingly in doubt is the ability of Germany’s political leadership to carry voters with them should either Greece decide to default while continuing with Euro membership, or should other member countries be forced to apply for loans.

At the same time, some sort of Greek default is now no longer simply a theoretical possibility among many others, indeed talk of the inevitability of some form of debt restructuring (albeit voluntary) grows with every passing day. Erik Nielsen European Economist with Goldman Sachs said this week he is expecting Greece to offer some sort of “voluntary debt-restructuring” to creditors over coming months, while JP Morgan issued a research note saying that while such restructuring may not be imminent, the move would make sense given that Greece could be seen as “the sovereign analogue of a ‘bad’ company with a bad capital structure”.

Restructuring is simply a polite word for default, with the difference that it is normally carried out by agreement. The most likely form of restructuring in the present context would be debt rescheduling, whereby short and medium-term debt is converted into a long-term version, as happened with the so-called “Brady bonds” devised by the US Treasury to resolve the debt difficulties of a number of Latin American countries in the late 1980s.

One indication that the ground may be being prepared for some kind of restructuring can be found in the decision reported by German Deputy Finance Minister Joerg that any aid to Greece would come in the form of pooled loans from the euro-zone countries and not through the purchase of Greek bonds. Plans to purchase bonds are “off the table,” he said. This procedure implies that government loans would be strongly guaranteed, while private bond holders would really pay the price for the Greek “rescue”.

At the same time voices are now being raised asking whether it would not be a better idea for Germany, rather than financing more and more loans, simply to put its losses down to experience and go back to the Deutsche mark? According to Joaquin Fels, Chief Global Economist at Morgan Stanley, the Greek rescue measures could “set a bad precedent for other euro- area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time,” in this case “countries with a high preference for price stability, such as Germany, might conclude that they would be better off with a harder but smaller currency union.”


Evidently such statements can be read as bargaining postures, attempts to get politicians and voters in the South of Europe to focus their minds on the problem in hand, but they can also be read as warnings of what could happen if they do not. At the present time the situation is extraordinarily confused. Greek Prime Minister George Papandreou's formal request for financial financial support seems to have taken almost everyone completely by surprise although it shouldn't have, since as I reported in my earlier post the Greek Finance Minister George Papaconstantinou had previously warned that his country could call on loan backup from the EU and the IMF even while talks with the 20 strong EU, ECB and IMF mission were continuing. Actual details of the level of financial support which will be offered remain scant at this point. According to G20 sources who spoke to Reuters, the Greek government have only asked at this point for a first tranche downpayment, to give them working capital to keep going while the talks continue (think of the JP Morgan distressed company talks with the receiver analogy). What is quite striking, however, is how the government let things come to this pass before striking the decisive agreement - evidently they could not hold out till after the German regional elections, and that is another worrying sign. When all is said and done, one thing is obvious, the forthcoming loan will clearly have some kind of super-senior status (which means it would be payable before ALL other creditors - German voters would settle for nothing less), and this implies that it is likely to be existing bondholders, and not EU national governments, who are going to be invited invited to pay for the Greek bailout. How they will react to this realisation is what remains to be seen in the days and weeks to come.

Do I See Movement In The Greek Trenches?

by Edward Hugh: Barcelona

This isn't about economics anymore, this is now about who does what, and when, and how everyone else reacts.

Certainly the news that Greek bonds hit another post-EMU record high yesterday can hardly be said to have come as a surprise. 10-year bond yields reached 7.76 per cent at one point and closed up 26 basis points on the day. This morning Greece comfortably sold 1.5 billion euros worth of 3 month Treasury Bills - in the end they sold 1.95 billion euros of them - but the yield on the bonds more than doubled to 3.65 percent, from 1.67 percent for a sale of similar debt on January 19. And the the extra yield investors demand to hold Greek 10-year bonds instead of German bunds, the euro-region’s benchmark government securities, rose again today - to as much as 472 basis points - the most since Bloomberg records began in 1998. The average spread over the past 10 years has been 61 basis points. Greek two-year notes also fell, pushing the yield 23 basis points higher to 7.51 percent.

On the other hand, Bundesbank President Axel Weber was out there yesterday telling a group of German lawmakers that Greece was going to need more, not less money.

Greece may require financial assistance of as much as €80 billion ($107.92 billion) to escape its debt crisis and avoid default, Bundesbank President Axel Weber told a group of German lawmakers Monday, according to a person familiar with the matter.

The estimate, considerably more than the €45 billion that European countries and the International Monetary Fund are currently prepared to extend Greece this year if it needs a bailout, suggests that a rescue of the country may come in several stages and reach beyond 2010.

Why, I ask myself, is a conservative, and normally discreet, figure like Axel Weber out there stressing precisely this point at this moment in time, when German voters are notably nervous about any sort of aid to Greece, reticence on the part of Angela Merkel's coalition partner makes a parliamentary debate on a loan difficult, and voices are even being raised about whether it would not be a better idea for Germany simply to put the losses down to experience and go back to the Deutsche mark?

Germany might consider exiting Europe’s current monetary union to create a smaller bloc as the Greek crisis threatens to turn the euro area into a region of “fiscal profligacy,” Morgan Stanley said.

Greek rescue measures “set a bad precedent for other euro- area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time,” said Joachim Fels, co-chief global economist at Morgan Stanley in London, in an April 14 note. “If so, countries with a high preference for price stability, such as Germany, might conclude that they would be better off with a harder but smaller currency union.”

All these statements can be read as bargaining postures, attempts to get people in the South of Europe to focus their minds on the problem in hand, but they can also be read as warnings of what could happen if they do not.

Certainly, nothing at this point is very clear. Especially, as the FT reminds us this morning, when we live in a world where the unthinkable has finally become thinkable. So we could now ask ourselves whether the financial markets are not in fact, and before our very eyes, gearing themselves up for an event which many had not previously been factored into the realms of the possible: Greek debt restructuring.

Even as Greek bail-out discussions continue – talks between representatives of the European Commission, European Central Bank and IMF were delayed on Monday by the volcanic ash cloud – market watchers are starting to question whether, in the long term, Greece can avoid a restructuring of its debts or even an outright default.

“Investors and analysts are now running the numbers to see what a haircut to Greek bonds would be,” says Steven Major, global head of fixed income research at HSBC. “One way to do this is to compare restructurings for emerging market sovereigns. Based on the defaults over the last 12 years the average long-term recovery rate is close to 70 per cent. Ultra-long Greek bonds currently trade at a price below this.”

The Financial Times also reports that the IMF is likely to raise the question of debt restructuring at their forcoming meetings with the Greek finance ministry - you know, the ones that have been delayed by the symbolic intervention of all that volcanic ash. According to the FT source it is not likely to be a detailed discussion “just a pointed reminder of the debt forecast”.

The IMF has already told the finance ministry informally that Greece’s debt will reach 150 per cent of GDP by 2014, according to this person. Greece’s debt to GDP level – 113 per cent in 2009 – is already the highest in the eurozone. The IMF calculates that Greece will need to find €120bn ($162bn) over the next three years.

Of course, the term "debt restructuring" does sound a lot better than default, and the expression does cover a wide range of possible outcomes, running from unilaterally changing the terms of the bonds one the one hand, to voluntary renegotiation to ease refinancing pressure at the other.

One proposal which has been advanced (most recently by Wolfgang Munchau) is for recourse to some form of Brady bond:

Restructuring is a form of default, except that it is by agreement. It could imply a haircut – an agreed reduction in the value of the outstanding cashflows for bond holders. The Brady bonds of the late 1980s, named after Nicholas Brady, a former US Treasury secretary, worked on a similar principle. An alternative to restructuring would be a debt rescheduling, whereby short and medium-term debt is converted into long-term debt. This would push the significant debt rollover costs to well beyond the adjustment period.

Brady bonds were initially issued to ease the debt difficulties of a number of Latin American countries in the late 1980s (and they are modeled on the earlier Japanese par bonds - you can read more about them in wikipedia here). The essential idea in the Greek case would be that current debt instruments would need to be swapped for some longer term bond with a lower than market rate coupon (or implied interest rate).

Of course, as Munchau points out, in order to get the existing bondholders to trade their debt on a voluntary basis, they would have to be put under some sort of pressure:

One way to force the debate would be to attach super-senior status to the EU loan to Greece. I understand this is still an unresolved issue. Super-senior means this loan would be repaid before existing debt. Should Greece ever get into a liquidity squeeze, bondholders would be put in a back seat. In such a situation, they might prefer rescheduling.

Which makes this little detail about the form of the EU loan rather more interesting than it might seem at first sight:

Any aid to Greece would come in the form of pooled loans from the euro-zone countries and not the purchase of Greek bonds, German Deputy Finance Minister Joerg Asmussen said Tuesday.

He also said that Greece will be an issue at the meetings of finance ministers and central bankers from the Group of Seven leading industrial nations and the Group of 20 industrial and developing nations this weekend in Washington.

"Of course, Greece will be an issue," Asmussen told reporters Wednesday. He also said that "if financial aid for Greece will be given, then the pursued path will be to provide pooled loans." Germany would provide its share of such loans through the state-owned KfW Banking Group and the loans would be guaranteed by the government.

Plans to purchase bonds "is off the table," he said. The advantage of providing pooled loans is that there can be stricter conditions to paying out such loans, such as demanding the implementation of fiscal reforms.

So we could imagine that the forthcoming loan would have super-senior status (German voters would settle for nothing less), and, if this interpretation is correct, it will be existing bondholders, and not the EU governments, who will be being invited to "bail Greece out". Well, maybe we won't have to wait too much longer to find out, since the Greek Finance Minister George Papaconstantinou stated today that the country could call on loan backup from the EU and the IMF by as early as next month depending on loan conditions and the progress of talks with the EU, ECB and IMF joint mission, which is composed of around 20 people according to reports. Plenty to talk about, and plenty of people to do the talking. Too many, perhaps?

Liquidity Giveth, Liquidity Taketh - The IMF on International Capital Flows

By Claus Vistesen: Copenhagen

To be an economist these days is a rare privilege and especially; it is a privilege to be a blogging economist since there is just so much good material to write about at the moment. On the one hand, there is the unfolding unravelling of Goldman Sachs (loads of material out there already, but just read Felix and you will be fine) and on the other there is the increasingly ominous signs that the Eurozone as we know it is about to become a thing of the past [1].

I hope that I will get to deal with these specific topics at a later time, but for now I would like to point, in the most obscure of all directions, to chapter 4 [2]of the IMF's part released Global Financial Stability Report which deals with the transmission of global monetary supply to international capital flows and global asset prices as well as inflation (hat tip: Tracy Alloway at FT Alphaville). Essentially the IMF report takes up the baton of some fundamental issues of global capital markets and issues which I have discussed on numerous occasions. The issue can be summarize through the two following questions;

1 - Can increasing nominal interest rates to quell domestic inflationary pressures be counterproductive and actually lead to overheating?

2 - What is the global effect of near ZIRP policies in a number of big developed economies and what will the effect be if this persists?

My own answer to the questions above is yes to the first with the qualifying remark that this implies a relative loss over the domestic monetary transmission mechanism both from the point of view of receiving (high interest rate) as well as sending (low interest rate) economies. And as for the second question I tend to see it as an externality to the global economy and crucially so, an externality which adds considerable volatility to global asset prices [3] since implied risk aversion in the market will determine whether the open taps by the G4 are used (or not) to build carry trade positions [4].

In their recent analysis on global capital flows (see link above), the IMF produces quantitative results and a well tailored methodology to boot to support these claims:

The global liquidity cycle started in 2003 and accelerated from the second half of 2007 when country authorities began to undertake unprecedented liquidity-easing measures to mitigate the effects of the crisis (Figure 4.1). While helping stabilize the financial system and support the return to growth, current easy global liquidity conditions and the accompanying surge in capital flows pose policy challenges to a number of countries where the crisis did not originate, with the primary challenge being an upside risk of inflation expectations in goods and asset markets. Such “liquidity-receiving” countries have had to ease domestic monetary conditions in response to both the slowdown in global demand and the acceleration in global liquidity, adding further pressure to asset prices. The policy challenge posed by easy monetary conditions is greater in economies—primarily emerging markets—that, in addition to strong growth prospects, have fixed or managed exchange rate regimes.1 The associated surges in capital inflows also raise early concerns about vulnerabilities to sudden stops once the global liquidity is unwound, with implications for financial stability.

Thus, what the IMF coins as liquidity receives are those economies subject to carry trade inflows (e.g. Brazil, Australia, New Zealand, South Africa etc) and liquidity senders on the other are developed economies with low interest rates. Recently, these were confined to Switzerland and Japan, but in the context of the financial crisis the UK, Europe (to some extent), and the US have also move short term interest rates to the floor and flooded their banking systems with cheap money for the wholesale market. This has even led some to dub it as the mother of all carry trades.

Now, I am tinkering at the moment with a model of international capital flows and global liquidity transmission which exactly seeks to incorporate this effect. In this sense, I think IMF's results are very welcome. I am of course including demographics which I see as the missing link here since while I suspect the US (and the UK) may ultimately succeed in creating inflation which would force them to pull back liquidity provision others will not. Japan is the famous example here, but as the world ages there will be more and more.

In the jargon of the IMF; old age makes economies structurally prone to being a liquidity sender [5] and as the world ages we will have relatively more liquidity senders than receivers. This poses an externality to the global system and also adds to volatility of asset returns and growth over time.

---

[1] - Please note that I am in no way favor of this as I am personally a big believer in the European project but Germany has neither the capacity nor willingness to keep paying for others regardless of the fact that Germany's economy is also, itself, an integral part of the problem.

[2] - See a web cast of the conclusions here

[3] - Which, by the way, is why I see great risks from the policy advice that central banks should target asset prices since there is a hidden volatility multiplier in the works here from tinkering too much with short term nominal interest rates.

[4] - I have even made my own humble contribution to a growing body of literature on this.

[5] - C.f. My master's thesis I think this can be explained through intertemporal preference, but I am open to other interpretations.

China's Recent Trade Deficit: Is What You Yuan What You're Gonna Get?

by Edward Hugh: Barcelona

China is self-evidently both a minefield and a potential graveyard for would-be global economists, the sort of place where reputations are made and lost in the twinkle of a dragon's eye, so I think had better tread rather carefully here. However, having duly noted that only fools rush in, here I go...

China ran its first monthly trade deficit in six years in March, a development which encouraged the country's Commerce Ministry to up the volume a bit on the argument that the need to revalue China's currency was being greatly exaggerated. The debate surrounding renminbi revaluation has also given us one more reason - beyond the recent accusations of the US SEC - to cast a watchful eye over how things are done at Goldman Sachs: the outrageous suggestion from their Chief Economist Jim O’Neill (in this Financial Times article) that if things carry on as they are, China will soon overtake France as the principal destination for German exports (see in depth analysis below).

The problem is, that with the argument having become so politicised, and with so many different interested parties at work, it is fast becoming hard to see wood from the trees, or even the sandals and tee shirts from the high speed trains.

A One-off Deficit?

Looking through the data, it would appear that while China's March performance was undoubtedly a one-off, import growth has been outpacing export growth for some months now. And with imports of commodities surging, and with them commodity prices, it was not really that surprising to find that China swung into a trade deficit of $7.24 billion in March, from a surplus of $7.61 billion in February, according to figures issued by China's Customs agency. Overall imports were up 66% from a year earlier in the moth, with purchases of crude oil and copper at near-record levels in volume terms.



In fact Chinese officials had been signalling for some weeks that March could produce a rather exceptional trade deficit, a development they highlighted to show how China's strong growth has been boosting its purchases from other countries. But beyond the March reading, China's trade surpluses have been shrinking as the government stimulus plan, and extensive bank lending, have boosted domestic demand, and indeed the cumulative trade surplus for the first quarter of 2010 fell 77% from a year earlier to hit $14.49 billion.

On the other hand, according to the Chinese customs department, the March deficit mainly comes from trade with Taiwan, Japan and South Korea, while large surpluses continued with the U.S. and the European Union.



Evidently one month's data is unlikely to convince anybody, and especially when there is so much doubt surrounding the sustainability of China's domestic consumption growth, so the March data is surely unlikely to silence the deafening roar of international criticism of China's trade policies, and indeed European voices are now increasingly being added to US ones.



Evidently March's exports may well have lower than normal as factories took their time reopening after the February Lunar New Year holiday. Exports were up in March, but the rate of increase fell to 24.3% from a year earlier, as compared to the 31.4% annual growth registered in the first two months of the year, although it is hard to tell how much of this weakening was a Lunar New Year effect, and how much the development reflected domestic demand weaknesses among China's main customers.

Looking at the trade balance chart (above), it is clear there is normally a dip in February/March, and this year we may have simply seen an exaggerated version of what is really an annual phenomenon. Certainly, till we see a bit more data it will be hard to separate a stimulus-based surge from the trend.

China: The New Import Powerhouse?

Separating surge from trend however does seem to have turned into something of a problem for Goldman Sachs Chief Economist Jim O’Neill, since he argued recently (in a widely quoted piece) that:

"As far as China’s involvement with the rest of the world goes, the real story since the worst of the crisis is not China’s recovering exports but China’s strong imports. The forthcoming trade release – interestingly due a few days before the Treasury report – is likely to demonstrate enormous import growth again, absolutely and relative to exports. This is seen not just in Chinese data, but in those from many other important trading nations. Indeed, quite remarkably, Germany’s trade with China is showing such strong growth that by spring next year, on current trends, it might exceed that with France".

This is quote a claim, and evidently impressed both Tyler Cowan at Marginal Revolution, and the Economist Free Exchange Blog, since they quote precisely this extract in support of their argument that the threat to global economic stability represented by China's trade surplus is being rather overdone (which may or may not be the case), and they obviously take his China overtaking France claim as good.

As a student of German export performance, I however did not. The most important point to bear in mind is that Germany basically missed out on the first wave of China import growth (with the market being largely dominated by Japan). To give an indication, in 2008 German exports to the Czech Republic and to China were of about the same order of magnitude, a data point which is reasonably suggestive of the extent to which German export growth 2005 - 2008 was dependent on growth in Central and Eastern Europe (both inside and outside the EU). Growth in this market has, of course, now come screeching to a halt, hence the renewed German interest in China, and in general terms, non-European export destinations - which is one reason why, at the end of the day, the sharp drop in the value of the Euro has been as much to Germany's advantage as it has to that of any other Eurogroup country.

So the key point to note is that German exports to China started from a comparatively low base, and hence even a sudden sharp surge does not make that much of a dent in the rankings list.

So just what are the facts? Well, according to the most recent release from the German Federal Statistical Office, German exports to China were worth 36.5 billion euros in 2009. Which means that, compared to 2008, exports to China were up around 7%, while total German exports declined 18.4% during the same period. So evidently the importance of German exports to China has been growing, but nothing like as much as O'Neil claims. Really!

Given that German exports to China have been running at something like 40% of exports to France, I thought I would take a look at the actual data. There are two available sources for such information: the German Statistics Office, and the OECD. Here is will use the OECD data. As can be seen in the first chart, there can be no doubt that German exports to China have been growing steadily and impressively over the last 3 years, but it is equally evident that they are still well, well short of those to France, and by no stretch of the imagination could it be thought feasible that China will overtake France as an export destination in the near future.




The second chart puts things in a longer term perspective, and what stands out is the fact that while German exports to China have followed a steady path, while those to France slumped significantly in 2008 as a result of the global economic crisis. So what this means is that exports to France are unusually low (and thus it is impossible to talk of trend), while those to China are unusually (and possibly unsustainably) high, given the impact of the stimulus programme. So to extract his "trend" (which is in no case valid) Goldman Sachs' Chief Economist seems to be assuming a worst case scenario for France and a best case one for China: hardly a balanced methodology. Or does Jim O'Neil really want to tell us he is discounting the possibility of a sustained recovery in demand in the OECD economies? Even without the benefits of our own "proprietary indicators", simple testimony of the naked eye should tell us he is wrong here.



Which is a pity, since stripped of its exaggerated claims, his substantive argument may not have been entirely false. Also we should not forget that Germany imports Chinese products (55.4 billion euros worth in 2009, as compared to the 36.5 billion euros worth of exports), and ran a trade deficit of 18.9 billion euros last year (or roughly 50% of the total value of exports) while Germany ran a trade surplus of some 27 billion euros with France.

Whatever You Yuan

In fact the impact of a revaluation in the renminbi may be much more complex than many seem to be assuming, and one good example of the kind of perverse consequences we may see is offered us in a really interesting research note from Alexandre Schwartsman (Bank Santander, Brazil) entitled "What Do You Yuan?"

There is an ongoing debate about how China should handle its currency in face of both political pressures and signs that inflation may be accelerating. Such challenges raise the possibility of the resumption of yuan appreciation trend that prevailed between 2005 and 2008. Of course, we claim no special knowledge on whether or when Chinese authorities will decide on the issue, but in our opinion, eventual decisions on that could have considerable implications for Brazil.

We do not think, however, that the direct effects through the trade channel are the most important part of the story. While it is true that China has become the largest market for Brazilian exports, we rush to note that it still represents only 13% of Brazilian exports (which, in turn, are equivalent to about 12% of Brazilian GDP). Moreover, even its current status as the main customer for Brazilian exports is threatened at the margin by the recovery of exports to the U.S. and Argentina.

Indeed, we believe the main channel of transmission to Brazil is likely to be through commodity prices. We argue, with the help of a small theoretical model, that a stronger yuan should imply higher commodity prices in dollar terms. In fact, it is possible to show that, if dollar commodity prices do not change in response to a stronger yuan, there would be excess demand for commodities, which would eventually drive their dollar prices up.

The economic intuition which lies behind Schwartsman's argument is really very simple, but the logic is also quite compelling. Basically, it depends on two points:

i) China domestic demand growth is more energy intensive than the OECD average
ii) China is large enough to be (to some extent) a price setter, and not simply a price taker.

Put another way, the income elasticity of energy consumption in China is greater than it is in the developed part of the Rest Of the World. This also applies to the energy component of agricultural produce, with important positive consequences for countries like Brazil. That is to say, China consumes energy directly, and indirectly, via the energy input which goes into the food production (fertilizers for soya beans in Brazil, for example) that it outsources. So there is a direct, and an indirect impact.

The net consequence of this, is that the Santander analyst expects the dollar price of commodities like oil to rise sharply on the back of any significant yuan revaluation, making China richer (in relative terms), and logically the developed world poorer. Again, and put in other words, the terms of trade are about to change against Europe, the US and Japan, and possibly bigtime, as the Yuan and other emerging market currencies rise. On the other hand, Brazil and other resource rich emerging economies stand to benefit, equally bigtime, in what will be one of the largest rebalancings of the global economy seen in many a long year. The main losers, it seems to me, will be the long-term structurally unemployed we now have in the developed world, and those living in poor countries with few natural resources.

Where Do We Go From Here?

Where we go from here on the China trade front is now very hard to tell. Evidently, on the one hand, evidence continues to mount that more flexibility in yuan parities in in the pipeline. But will the much sought after revaluation really do all that heavy lifting that is being expected of it? After all, Germany's currency was effectively revalued upwards on joining the Euro, and the country then spent several years putting downward pressure on cost elements, with the result that the German trade surplus was even larger (as a % of GDP) in 2008 than it was in 1998. And China's almost unique demographic trajectory also suggests that promoting internal consumption as a growth driver may be up against significant constraints. Life Cycle Theory Nobel Franco Modigliani, in what was his final published paper (2005) - The Chinese Saving Puzzle and the Life-Cycle Hypothesis - drew attention to this oft neglected dimension which evidently forms part of the problem. At the very least, some simple economic theory suggests that all may not be as simple here as it seems at first sight.

On the other hand Chinese officials, far from showing signs of alarm at March's deficit, generally seem to have welcomed the development. According to Zheng Yuesheng, director of Statistics at China's customs office, "This kind of deficit is healthy as it happened while both imports and exports experienced rapid growth," and in any event, as he also points out, China will undoubtedly continue to run (smaller) trade surpluses over the long term. This, at least, has the benefit of being a realistic, and pragmatic assessment of the situation. All we need now is for a bit of this realism and pragmatism to work its way steadily westwards.

Is Estonia's Euro Membership A Done Deal?

by Edward Hugh: Barcelona

Well, if you read this report from Euractiv, citing unnamed EU Commission officials, it is:

"If nothing extraordinary happens, the Commission will give its positive opinion for the accession of Estonia to the euro zone on 12 May," an EU official said, clearing the way for Baltic country to join the euro in 2011.

There just one little snag here: that extraordinary, "fat tail" event seems to have just happened. For the Commission to be able to move forward on Estonia's Euro Membership, the ECB have to agree. And it is here that Estonian journalist Mikk Salu steps in (in Estonian in the newspaper Eesti Päevaleht, summarised in English here) and says "not so fast". Salu reports on a closed-door meeting of the Economic and Monetary Affairs Committee of the European Parliament held last Tuesday (April 13). The meeting had a single-item agenda: Estonia's membership of the Eurozone, and the meeting was attended by ECB Executive Board member Jüergen Stark. According to MEPs who attended the meeting (but did not wish to be identified), Stark was "stark": Estonia is not going to be admitted. The reason given was that in the wake of the recent crisis affecting the Eurozone, new criteria will be introduced - including per capita GDP and competitiveness sustainability - and on these counts Estonia will not qualify.

Salu also spoke to Estonian MEP Ivari Padar, who attended the meeting and confirmed the substance of the discussion, although Padar did try to mediate the situation slightly, saying, "you know, he is a central banker, and central bankers are a conservative lot", etc etc. On phoning the ECB itself and the Commission the only reply he got to a straight question seems to have been "no comment".

Basically, as I said, maybe the ECB are a conservative crowd, but I think it is very hard to see Estonia being admitted to the Euro without ECB backing, and indeed looking at what is happening over in Greece at the moment, and in the German Constitutional Court, I think it is very hard to see any new members at all in the immediate future. Consensus thinking right now seems to be more towards small(er) is more beautiful.

None of this surprises me, indeed when I wrote my last post on Estonia, back in February, it seemed to be an increasingly likely outcome.

But as Fitch pointed out when they raised their Estonia outlook, while eurozone membership looks increasingly possible it is not yet certain. Fitch warned in their report that even if Estonia meat all the formal Maastricht reference criteria for euro entry there is still a risk that the European authorities' interpretation of these same criteria could lead them to reject Estonia's application. According to Fitch, in Estonia's case uncertainty surrounded whether the idea of "sustainable price performance" was going to be consistent with the deflation which is to be expected from such a severe recession, after inflation had so recently been in the double digit range. The agency also added that one-off measures taken by the government to reduce the budget deficit in 2009 could also count against it in the EU authorities' judgment of whether the medium-term budget plans are credible.

The first point is an important one I think, and is reiterated by the ECB's own Jürgen Stark in an interview given to the German magazine Der Spiegel for this weekend: "But when taking on board new members, we will need to take an even closer look, concerning the data and the sustainability of convergence," he is quoted as saying.

Indeed if we go back to the 172 page EU Commission document leaked to the German magazine Der Spiegel last month, the EU Stability and Growth Pact is increasingly going to focus on issues surrounding competitiveness as well as on fiscal deficit ones. That is what the whole deabate over the Greek and Spanish economies which EU leaders are engaging in this week is all about. And any country which is not considered to be in completely good health under the SGP criteria is hardly likely to get the green light from the ECB and Ecofin.

It is obvious that the Estonian economy is still suffering from earlier structural distortions which have not yet been corrected. If we come to the consumer price index, this was only down about 2% in 2009, far short of the deflationary adjustment which will be needed to restore growth and competitiveness.

And to cap it all, for the first time since the start of the financial crisis, Moody's has chosen this, of all, moments to up its ratings outlooks for Lithuania, Latvia and Estonia. The decision was apparently based on the idea that the contraction has been stabilized (which it has), but as we are unfortunately about to see, stabilization and getting back to growth are not one and the same thing. In Estonia's case the more favourable rating was a reflection of the expectation that the country "will soon be able to join the eurozone":

Estonia’s “economy and banking sector are exhibiting signs of a gradual recovery,” Kenneth Orchard, a Moody’s analyst in London, said. “Equally important, the government’s impressive fiscal performance in 2009 means that Estonia is likely to be permitted to adopt the euro next year.”

And if I'm reading this report aright, Latvia just declared a 9% general government fiscal deficit for 2009, well above the 6.7% which was originally estimated. Cry victory if you will, but perhaps it would be prudent to wait till the war is actually over before you cry it too loudly.

Random Shots (Absolute Returns Partners Edition)

By Claus Vistesen: Copenhagen

With so much going on at the moment and so many themes fighting to claim the main market discourse, I am in the mood for some random shots. First of all and to my continuing regret I have never actually got to thank Niels C. Jensen from Absolute Return Partners for the nice coverage I got way back in October 09 when Mr. Jensen discussed my thoughts on demographics and the life cycle.

So, let me repay by pointing towards Jensen's recent two monthlies which form the basis for this round of random shots. Both are very much worth reading and in some sense they go together to form a common narrative, but especially the second one where Niels is blowing echo bubbles is mandatory reading I think. The themes taken up by Niels are well known and so is the underlying narrative, but this does not mean that it is not worth repeating; I will Niels set the scene;

In last month’s letter I looked at the challenges confronting the world’s baby boomers based on the assumption that we are in a structural equity bear market, which implies below average returns for equity investors for several more years to come. Central to this forecast is my expectation that household de-leveraging, which is now underway on both sides of the Atlantic, has much further to run. In other words, we are in a balance sheet recession. When that happens, debt reduction becomes the priority. Savings rise and consumption falls at the expense of economic growth.

Please note that this forecast is predicated on a 5-10 year time horizon. Within a structural bear market – which is characterised by falling P/E ratios – it is certainly possible to have cyclical bull markets, so it is by no means one-way traffic. As you can see from chart 1, since the 1982-2000 structural bull market came to and end, we have enjoyed two powerful cyclical bull markets; however, global equity prices remain at 2000-levels.

(...)

However, this is not the same as saying that it will always be a losing proposition to invest in equities. Equities can, in fact, do quite well for long periods of time despite the negative undercurrent. This is what the perma-bears do not understand. They assume that structural bear markets equal negative returns and that is not necessarily the case.

Thus and to clarify, what is referred to here as an echo bubble is the rally we have seen since March 2009 and thus evidence that while structurally, deleveraging and low trend growth will be the main driving force, that does not mean that equities cannot and will not perform extraordinarily well for long passages of time. I mean, who wouldn't wish that they bought with everything they got back in March (I know I myself feel a bit peeved over not piling in).The broader issue of course is that while smart money may very well learn to navigate such an environment the smart dumb money (i.e. those who buy and holds the market) may realize that the reward from such a strategy may turn out to be less than splendid. And since this is basically a proxy for the return on savings, it means that permanent income will fall which means that consumers will need to save relatively more to compensate, and then we get the problem of a lack of consumption and aggregate demand and ... on and on we go!

On this, I agree that deflationary v inflationary forces will feature a tug-of-war for many years to come and, like Niels, I tend to favor the former. However, when pointing to Japan as an example of how continuous attempts have failed to spur inflation (and is still failing) I do think it is important to qualify that this goes strictly for domestic inflation. In this sense, what has become known as the Yen carry trade (and recently USD carry trade perhaps?) is merely a proxy for much broader and structural tendency which signifies how central banks have lost control over where the liquidity they provide is applied. This goes in both direction. In Japan, the liquidity create slips through the back door and ends up e.g. in Brazil or New Zealand who, in order to combat domestic inflation, are busy increasing interest rates only to that it sucks in more liquidity (or, if you will, purchasing power).

Clearly, with US rates stuck at near zero this provides a huge push for global liquidity and even though I think that the US (and the UK) will eventually succeed in getting inflation (and quite possibly, a lot of it), the fact that these economies may withdraw liquidity slower rather than faster represents strong sheet anchor for excess global liquidity and thus although we may be in a structural bear market, it is also a market with a high level of volatility.

This leads me to the following three themes I am following at the moment inspired not only by Niels' thoughts but also by the recent themes laid out in Variant Perceptions monthly (which is sadly not available online).

1. I accept the idea of a structural beak market but interpret it as investment lingo I guess for broader macro reality that we are now in a situation where we need to delever and that will be deflationary in domestic OECD economies (i.e. this is German austerity writ large). This, I would assume, is tightly connected to lower trend growth. In this sense, demographics (which I tend to focus on) and the defacto excess leverage (regardless of underlying capacity) serve as a ball and chain and it represents a structural break both in terms of behaviour by part of economic agents but also in terms economic growth.

2. Higher volatility. Why? Because just as Japan may fail in creating domestic inflation and just as the US/UK may find it hard to create domestic inflation (although at some point they will, for sure!) they may all create inflation and bubbles elsewhere. Please do read this again if you did not have the chance. I guess it goes back to the premise that while we may in a situation where growth and equity returns (beta!) are sluggish, we will still see bull markets that lasts (well the current one is running on a year now no?) and more importantly; there will be economies who are able to suck up excess liquidity but they are outnumbered by economies with a desire of excess (external savings) and this is what leads to volatility in asset markets and the real economy.

3. Who is running the deficits? This is an old time hobby horse of mine, but still one which is extraordinarily important. In short; where will bubbles form and why? Emerging markets seem certain. But more importantly and using demographics as a yardstick the equilibrium is changing. Thus, we are all ageing, so we are all moving towards the same "preferences" for a high level of desired external savings as well as more and more economies will struggle with domestic deflation. How this ends is still an open question and it is also the straight line my theoretical work draws into the real world.

Lastly, and moving in with some truly random shots, I think Niels has some interesting points on investors and commodities and how these markets are not really suited for the kind of activity they are seeing. This is of course a direct effect of all those who really think that we are heading to hell in an express elevator and that the fiat system is collapsing etc. You all know the story I guess. Yet, after having looked recently at Chile and thus copper, I am sure that here is a metal which looks very, very bubble prone! Finally, Niels touches on China and the fact that as China moves into a trade deficit would this mean that the Yuan should really appreciate? Or would it in fact depreciate? Well, we will see soon enough I guess since it turns out that Niels was right here. Consequently, news has just come in off the wire that China posted its first trade deficit in six years in March as the trade print came in at a $7.24 billion deficit. Q1-10 is still a surplus but is this the first signs of true and real rebalancing? Well, color me (very) skeptical here that China will be pulling the global economy anywhere through a trade deficit that is not based e.g. on stockpiling of base metals and other commodities, but the ball is in my court as a skeptic with these latest numbers; I fully accept this

Angela Calling

by Edward Hugh: Barcelona

Angela Merkel is a Chemist. In her doctoral thesis - entitled "Untersuchung des Mechanismus von Zerfallsreaktionen mit einfachem Bindungsbruch und Berechnung ihrer Geschwindigkeitskonstanten auf der Grundlage quantenchemischer und statistischer Methoden" - she demonstrated herself to be a thoroughgoing expert when it comes to analysing the speed of disintegration of chemical compounds once the bonds which hold them together are weakened. Unfortunately she is now having to apply all this acquired expertise and know-how in a determined attempt to avoid the break up and falling apart, not of a highly complex chemical substance, but of an even more complex economic and political one, and the bonds which are the focus of all her attention right now are not chemical, but financial and social.

The problems we in Europe all now face together ("wir teilen ein gemeinsames schicksal" in M. Trichet's words) have not arrived just "suddenly one springtime" as it were, indeed they come from afar. Right from the very begining it has been no easy matter for German society to achieve the consensus necessary to accept the idea of participating in a common currency, the Bundesbank has long maintained its by now well-known reservations, while not a few have been the voices expressing the view that having so many diverse countries all sharing the same monetary unit would inevitably create a structure which was too unwieldy to be manageable, and too weak to hold together when the real storm weather came. What was needed, it was argued, was a two, not a one, speed Europe.

Unfortunately, all these simmering issues have once more resurfaced during the last week, over the tricky question of what to do about Greek financing needs, and Germany's economic and political leadership now seem to be locked in an intense debate about exactly which path to take. Meanwhile Greek bond spreads simply work their way onwards and upwards, while capital flight from Greek bank deposits has forced the banks themselves to go rushing to the government for a further 18.000 million euros in funding just to keep them alive.

The current issue came to a head last Monday afternoon, following a brief report on the Financial Times website stating that progress with the decision on any Greek rescue plan was effectively deadlocked due to the inability of the Germany to agree with her other European partners the precise rate of interest to be charged on any loan to be provided. Ironically it is this single issue which is currently bringing European decision making to a dead halt, and creating a level of uncertainty and debate of such intensity that, if it is not resolved decisively, could bring the very future of the Euro into question. And it is not a trivial matter, since the rate charged will become a precedent, which other, larger, countries can refer to later.

Essentially the problem is this. According to the US economists Carmen Reinhardt a Ken Rogoff (in a widely quoted paper Growth In A Time Of Debt) a potential tipping point exists once government debt breaches the 100% of GDP level in the aftermath of a financial crisis. After this point the impact of additional state spending is, paradoxically, to effectively reduce growth (given the weight of interest repayments, and the additional risk price charged for lending, and the impact of more government debt on investor confidence) and indeed far from helping a country to recover, further borrowing may mean the economy actually shrinks rather than grows.

Let's take an example. Imagine Greece has debt at the 100% of GDP level (in fact it is somewhat over 115%), and the price investors charge for buying the bonds is around 6% (or more or less 3% more than the German government has to pay to sell equivalemt debt). Now let's also imagine that Greece has zero inflation and zero growth (they are in the midst of a massive correction which will last some years, so these are reasonable, and indeed possibly even optimistic assumptions). Then Greece will need to produce what is know as a "primary surplus" (or difference between current spending and current income) of around 6% just to stand still, and not see its level of gross indebtedness increase. But Greece, in 2009, had a primary deficit of some 7% of GDP.That is to say, simply to not get more in debt Greece has to withdraw something like 13% of GDP in demand from the economy, and this is massive, which is why all the experts anticipate a sharp contraction in the Greek economy over the next 3 or 4 years, and why rather than looking to domestic demand the Greeks will need to look to exports for support (The US economist Charles Calomiris has an excellent detailed explanation of all this here, while Peter Boone and Simon Johnson dig even deeper here) .

Which is where the European Union comes in. Basically, if Greece has to pay such a high interest rate differential to support such a large debt there is every likelihood she will not be able to continue to finance herself, and default will become inevitable. You can only demand so much effort from the reformed alchoholic before they are driven back to drinking in frustration. On the other hand the EU could help by making the interest rates charged cheaper, but unfortunately there is a 1993 decision of the German constitutional court which makes it effectively illegal for the German government to participate in such a subsidised loan. The IMF can help, they are reportedly willing to make a loan of up to 10 billion euros at very favourable rates, but there are limits to how far they can go, since they cannot justify favouring comparatively rich Europeans when they deny such funding to poorer countries in the third world.

And the quantity Greece actually needs is massive. Initial reports spoke of a total loan of around 25 billion, but this is surely not enough. At least 50 billion will be needed, and some estimates put the number much higher (see Peter Boone and Simon Johnson again). And remember, we are not talking about fancy theories here, all of this is all simple arithmetic: either Greece gets a large, cheap loan, or she will default. They will have no alternative. So European decision making is gridlocked, while on Thursday Greece's 10 year bond interest rate differential hit record post-EMU highs of 4,63%, and the ineterest being charged was not 6% but near to 8% at one point.

Naturally, if Greece were to do the "honourable thing", and leave the Eurozone and default, "all would be light". But they won't, and there is no good reason why they should do so. Now, enter Professor Starbatty of Tübingen University. He has another proposal. Not Greece, but Germany should leave the Eurozone, and go back to the Mark. And before you start to laugh, you should bear in mind that he is very serious in his proposal, and many Germans agree with him. Indeed so seriously does Angela Merkel take the possibility that any cheap loan to Germany will encourage supporters of Professor Starbatty to go to the Constitutional Court and ask for a ruling that German participation in the common currency is illegal that she has frozen the whole Greek bailout process.

And it is not clear, at this stage what the view of the Bundesbank is. According to German press reports, accepted by the bank itself, the Bank is currently considering an internal report on the rescue loan proposal which states "This agreement of the heads of government, which according to our knowledge has been reached without any consultations from central banks, implies risks to stability that should not be underestimated," (my emphasis).

And before anyone complains that the Germans are too dependent on exports to the South of Europe to do anything which makes selling these more difficult, please consider that domestic demand growth in all four Southern European members of the Eurozone is expected to be extremely weak over the next decade, while growth in emerging markets like India, China, Brazil and Indonesia is predicted to be massive. The markets are moving, so why not move with them?

Of course, none of this means that the Eurozone, like one of those chemical compounds Angela used to study, is about to fly apart. But we should not underestimate the stresses the currency union faces at this point. As former IMF chief economist Ken Rogoff pointed out in the Financial Times this week, "if investors gather with enough sustained force, and if the central bank lacks sufficient resilience and resources, they can blow out a fixed exchange rate regime that might otherwise have lasted quite a while longer." What the countries in the South of Europe need to give the Germans right now are not arguments about how they would be foolish for them to leave, but arguments about what they themselves are prepared to do to make it more attractive for them to stay. The German giving machine is all done, and the Germans themselves are now more than tired of being continually told they need to pay, pay and pay again for events that now took place over half a century ago. Calling, Berlin, calling Berlin, hello, hello, is anybody there?