Tuesday, 22 November 2011

To whom does Portugal owe?

In a recent article, BBC News identified for major Eurozone (highly indebted) countries, the US, the UK and Japan how much money is owed by each country to banks in other nations. Focusing on the Portuguese case, whose foreign debt amounts to 251% of GDP (equivalent to about 38.000 euros per person), the country is, first and foremost, highly indebted to Spain (65.7 bn euros). To a lesser extent it is also indebted to Germany, France and the UK (26.6bn, 19.1bn and 18.9 bn euros, respectively). Moreover, Portuguese banks are owed 7.5bn euros by Greece.
There are, naturally, worse cases starting with Ireland with a foreign debt to GDP ratio above 1000%, followed by the UK (436%), Spain (284%) and Greece (252%). Greece seems to have a figure almost identical to Portugal's level but the two countries are quite different in terms of its composition, namely the level of public debt: 100% of GDP vs. 166% of GDP for Portugal and Greece, respectively.

In the figure below (retrieved from the above-mentioned article) we can have a graphical representation of the current external debt situation in Portugal. The arrows point from the debtor to the creditor and are proportional to the money owed as of the end of June 2011 (data sources: Bank for International Settlements, IMF, World Bank, UN Population Division)

Monday, 21 November 2011

The bank recapitalization law proposal: throwing good money after bad

I had forewarned, on this blog (here and here) and in a 2009 paper that the Portuguese banking system was on route to nationalization.

The current Government has submitted to the Parliament (Assembleia da República) a new law proposal (which revises a prior law) to promote the recapitalization of the banking system with €12bn of public funds. The law proposal has been unanimously approved by the Economics and Public Works Committee. It is to be discussed and voted this week (November 22) by the plenary, a mere 15 days after it was first submitted to the Parliament.

Sadly, the recapitalization option is far more costly than what international best practice would recommend (special resolution regime), and it is poorly implemented. As implied in an interview by its Governor, Carlos Costa, the Bank of Portugal seems to have had a leading role in crafting this law proposal. In various issues (see 1, 2 and 3), the Bank of Portugal sides with the banks, and against the public interest, in an appalling display of regulatory forbearance.

The costs the taxpayers will incur to support the bank recapitalization program are substantial. The Portuguese Government will likely pay an interest rate of 3.5%-4% on the €12bn of loans from the IMF and EFSF that are being used to recapitalize the banking sector.

To put it in context, the interest outlays will likely come to represent around €450 million per year or nearly 50% of the entire 2012 budget allocated to higher education (which in addition to the transfers to public universities and colleges includes financial support to students from low income families). It is as if the government had created an entirely new large entitlement program that does not appear separately in the budget (it will appear under interest expenditure).

In fact, the casual ease with which our policy leaders and legislators dispense with large sums of public funds does not cease to surprise me. It is really a case of cutting costs on the pennies in order splurge on bit item expenditures.

In return for this large outlay of capital, the government gets very little back.

Now, countries like the US, the UK, and Germany had somewhat similar bank recapitalization programs in 2008-2009 and banks received what can only be interpreted as the “glove” treatment. But that was then and those programs generally had far harsher conditions for the banks. Moreover, since then, these countries have put in place much stronger special resolution regime legislation which, for example, in the case of the US Dodd-Frank Act, obliges the government to use an orderly liquidation regime to manage the wind-down of failing large financial institutions (a regime that is much stronger than what I advocate).

In its October 26, 2011 meeting, the European Council agreed to increase bank capital requirements to 9%. But left to national governments significant leeway on how to achieve the capital increase, if additional private sector capital fails to materialize.

Instead, the law proposal under consideration by the Parliament has various deficiencies. Contrary to past international practice, the public interest is not adequately represented in the board, and banks want to reduce the already de minimis representation of the government. This is bound to result in incentives to act against the interest of the largest shareholder (the Government).

Moreover, bank management is not replaced, as occurred, for example, in the case of Sweden, and the UK, and is internationally accepted best practice.

The aim seems to be to avoid political nominations. But, for example, the UK government supported the hiring of a Portuguese (António Horta-Osório) to manage one of its largest (nationalized) banks, the Lloyds Banking Group. The Swedish equally hired foreigners to manage their nationalized banks in their banking crises in the 1990s. So why won’t the Portuguese government replace current managers with foreign managers, for example?

The banks are up in arms because they want to ensure that if share prices recover to earlier levels, the government will not keep the profits. In fact, a recent proposal by the banks, which was also supported by the Bank of Portugal, in essence means that the government gives away to the banks a free and highly valuable 5-year call option to buy the stock back (perhaps even at the original price paid by the government). Depending on the exercise price of the option, it may be worth several billions of euro.

Notwithstanding these details, which are highly detrimental to the public and national interest and much worse than comparable bank recapitalization programs elsewhere in Europe, it is far more likely that the government capital investment in the banks will have to be substantially written down by the Government in a couple of years, i.e., the Government (and the country) will likely suffer large losses on this investment.

In sum, the law proposal should be rejected (though I have little hope of seeing this happening). There are far better and less costly alternatives, namely one based on a special resolution regime. A special resolution regime would ensure a functioning and healthy banking system, at a fraction of the costs. This bank recapitalization law will do neither.

Finally, the IMF staff (together with the remainder of the troika) were in Portugal last week for the 2nd quarterly review of the adjustment program. One would have thought they would have had a hawk-like focus on the law proposal. After all, the €12bn foreseen in it represents in excess of 15% of the entire bailout package. No such luck, unfortunately. IMF staff focused on the trivia.

The IMF staff is making a disservice to clients and to their own institution by condoning this type of policy measure. The IMF staff is not following best practice recommendations (including IMF lessons learned from the Asian crisis and that described in various IMF working papers) and is violating its fiduciary duties towards IMF shareholders, by not being good stewards of the capital the IMF is lending to Portugal and to other European peripheral countries, in this and in other instances.

IMF staff should note that at some point more sensible leadership will arrive at positions of power, who will most certainly dispute the IMF credit so carelessly dispensed. Future leaders will have a fertile ground from which to pick evidence of policy mistakes and responsibility by IMF staff.

Looking further ahead, given this and other mishaps, it seems increasingly unlikely that the IMF will be able to survive the Eurozone sovereign debt crisis. In my view, it will, in a not so distant future, be replaced by some new multilateral institution based in Beijing.

Monday, 14 November 2011

the discussion on "fiscal disinflation" continues...

The discussion provided by Francesco Franco on fiscal disinflation / fiscal devaluation reached The Economist. You can follow it here

Saturday, 12 November 2011

Health sector and the adjustment due to the financial rescue plan

The financial rescue program of Portugal has a Memorandum of Understanding - MoU - detailing the policies to be applied in the public sector to achieve balance in the Government accounts.
One targeted sector is health care, with several measures aimed at reducing the public expenditure on health care goods and services.

Another review period of compliance with the MoU has started. I provide here an assessment of the degree of progress in the adoption of the policy measures contained in the MoU. In summary, some are done, some are ahead of schedule, some are still to fully develop and just started. Overall, the level of compliance is quite good. We can always ask for more, and more was achievable in my view, but current situation meets the demands.

Friday, 11 November 2011

ULC and trade deficits

If I focus on ULC in manufacturing (as opposed to total economy) and the trade balance in goods (as opposed to goods and services) I see a strong correlation. It is also interesting to observe that Germany stops to be the outlier in cost dynamics (again for the manufacturing sector).

(click to enlarge)

Wednesday, 9 November 2011

Fiscal devaluation, a PR failure?

The memorandum of understanding signed last May by the main Portuguese political parties contains a measure designed to improve competitiveness and accelerate the necessary improvement in the trade balance. The measure consists in a budget neutral tax swap: an increase in the effective VAT rate (by increasing the low and intermediate rates) and a reduction of the social security tax paid by employers (TSU). The measure has been compared by scholars, journalists, experts and others (myself) to a nominal devaluation. The idea was that to show that even if the euro has eliminated the exchange rate, euro members could implement policies with a similar outcome to realignments of the exchange rate.

This comparison might have been unproductive for two reasons.

The first is a public relations failure. The name of the suggested policy contains the word devaluation. I remember an influential journalist calling the fiscal devaluation a "new drug" to replace the old one (i.e. nominal devaluation).
While from a from a technical point of view this affirmation is incorrect, it reminds us that "devaluation" is considered a dirty word. In fact, southern euro countries have adopted the euro in part to tie their hands and avoid external adjustments through devaluations.

The second is that for practical (as opposed to academic) purposes we should have compared the fiscal devaluation with a competitive disinflation. The latter is the market based mechanism that takes place within a fixed exchange rate system to adjust to external imbalances (in the absence of fiscal transfers and with limited labor mobility). It can be described as follows: unemployment increases and pushes the growth rate of nominal wages down until the country’s competitiveness is restored. It is obviously a painful mechanism that relies on two key market transmission mechanisms:

1) the decrease in nominal wages in face of higher unemployment, and
2) the decrease in prices in face of a decrease in the wages.

Consider impediments to the first mechanism: when nominal wages are sticky and adjust slowly, the competitive disinflation requires a high unemployment rate. Are nominal wages (downward) flexible in Portugal? If I remember well it is very difficult (unconstitutional) to decrease private wages. The Portuguese government has recently cut the public sector wages. This should help alleviate the necessary increase in unemployment as it can signals to the private sector wage setters the necessity to accept a lower wage.

Now consider the alternative of a fiscal devaluation. The decrease in the social security contributions aims at reducing the cost of labor in substitution of a decrease in the nominal wages. It does not require unemployment and works when wages are sticky. Moreover it affects simultaneously both public and private sectors.

It appears that on the first key transmission mechanism, fiscal devaluation works better than competitive disinflation. For what regards the transmission from labor costs to prices, there are no differences between the fiscal devaluation and the competitive disinflation.

A critique to the decrease in the TSU is that it will lower revenues and jeopardize the financial stability of the social security system. The fiscal devaluation is designed to be budget neutral: the second element of the measure is an increase in consumption taxes that offsets the decrease in revenues. In reality, to increase consumption taxes in Portugal is objectively difficult as VAT has already been increased to diminish the budget deficit. Again the comparison with the competitive disinflation is useful. A decrease in nominal wages decreases social security contributions and requires a decrease in benefits to maintain financial sustainability. This suggests that the loss in revenues that follows the substantial decrease in the TSU can be financed through a combination of lower benefits and higher consumption taxes. To a first approximation if wages are expected to decrease by 25%, social security contributions will decrease by 25%. To maintain the solvency of the social security system benefits will have to decrease by 25%. The same reduction of benefits could be used to finance part of the decrease in TSU so that the increase in the consumption taxes can be lower.

Another advantage of the fiscal devaluation is that the real debt due by wage earners (debt deflated by wages) does not increase. This is not a secondary point in an environment of fragile banks balance sheets.

The fiscal devaluation and the competitive disinflation have also different distributional effects. The latter are important as they are likely to determine the political feasibility of the measure.

I am surely missing something, but as of today I see the fiscal devaluation as a superior policy than trying to manipulate the nominal wages in the private sector or to wait for unemployment to be sufficiently high to exert downward pressures on those same wages. So what explains the opposition to such a measure? Should we call the fiscal devaluation "fiscal disinflation"?