Hungary First To Offer Real Solution To Debt Crisis; Sets Stage for Gold's Re-Monetization

Hungary is considering allowing its citizens with mortgages denominated in a foreign currency -- typically the Swiss Franc -- to pay back their mortgages at an exchange rate that is lower than the current Forint/Franc exchange rate. Hungarian banks would be responsible for picking up the difference between the fixed exchange rate mandated by the government on these mortgages and the Forint/Franc market rate.

This plan has some problems -- in that Hungarian banks may not be able to afford picking up the tab on the exchange rate difference, and that the Swiss National Bank (SNB) may find an influx of capital, even in the form of loan repayments, to strengthen their currency (something the SNB has vowed to prevent) -- but I think it has some key features that may help us understand how the global sovereign debt crisis will be resolved, and what this means for the global economy. Specifically:

By letting those with mortgages pay back their debts denominated in foreign currencies at a lower exchange rate, Hungary is basically making banks pay for part of the loan -- not just the debtor with the mortgage. This type of debt cancellation is exactly what is needed and is the first step to a real solution. Until global debt levels are significantly reduced, there will not be sufficient capital available for investment or consumption. It's that simple.

By proposing a lower exchange rate for foreign-denominated loans, Hungary is pursuing an indirect form of currency appreciation; at least for Hungarians with mortgages denominated in foreign currencies, the Forint will be able to buy them a greater piece of their debt repayment. I still think the Forint has many problems and is not worth owning as a store of value, but a central bank pursuing a stronger currency in some way, while also helping advance the cause of debt cancellation, may be a policy we may see more of as this is at the heart of the solution to the global sovereign debt crisis.

As other central banks realize the need to strengthen their currency, they will naturally turn to where history has always turned to find strength in the midst of public debt crises: gold. This puts us on the trajectory toward some type of re-monetization of gold, which is what sends gold and gold mining shares both much, much higher.

Hungary's proposal here is also unlocking a new era in monetary policy, suggesting a reversal to fixed exchange rates and the end of the floating exchange rate system born when US President Richard Nixon terminated the link between US dollars and gold in 1971. We've already seen the SNB announce that they are basically pegging the Franc to the Euro, and now we are seeing talks of the Forint being pegged in certain situations at a rate different than what the market is pricing the Forint at. I don't think monetary authorities around the world have the trust of their constituents to pull this off, and think various forms of revolution and political re-organization are likely.

So, at the very least, developments in this story will be worth watching. If the right type of debt cancellation deal can be worked out, we may be on our way out of the global debt crisis and ready for the next secular bull market in equities.

Source: http://seekingalpha.com/article/293104-hungary-first-to-offer-real-solution-to-debt-crisis-sets-stage-for-gold-s-re-monetization

The euro: Beware of falling masonry

FIRST Greece; then Ireland and Portugal; then Italy and Spain. Month by month, the crisis in the euro area has crept from the vulnerable periphery of the currency zone towards its core, helped by denial, misdiagnosis and procrastination by the euro-zone’s policymakers. Recently Belgian and French government bonds have been in the financial markets’ bad books. Investors are even sniffy about German bonds: an auction of ten-year Bunds on November 23rd shifted only €3.6 billion-worth ($4.8 billion) of the €6 billion-worth on offer.

Worse, there are signs that the euro zone’s economy is heading for recession, if it is not there already. Industrial orders in the euro zone fell by 6.4% in September, the steepest decline since the dark days of December 2008. A closely watched index of euro-zone sentiment, based on surveys of purchasing managers in manufacturing and services, is also signalling contraction, with a reading of 47.2: anything below 50 suggests activity is shrinking. The European Commission’s index of consumer confidence fell in November for the fifth month in a row.

Now an even bigger calamity is looking likelier. The intensifying financial pressure raises the chances of a disorderly default by a government, a run of retail deposits on banks short of cash, or a revolt against austerity that would mark the start of the break-up of the euro zone.

The German government can probably shrug off a failed auction: it likes to price its bonds as richly as it can, and occasionally cannot sell all it would like, even in untroubled times. Still, the timing is awful, and other governments are not so lucky: the contrast between Germany’s borrowing costs and those of other euro-zone sovereigns is stark (see chart 1). European banks are dumping the bonds of the least creditworthy, and other assets, in an attempt to conserve capital and improve cashflow as a full-blown funding crisis looms. Governments are promising ever more severe budget cuts in the hope of pacifying bond markets. The direct result of these scrambles is a credit crunch and a squeeze on aggregate demand that is forcing Europe into recession. Add the indirect effects on the confidence of consumers and businesses, and the downturn will be deep.

A recipe for recession

Consider the three ingredients for recession: a credit crunch, tighter fiscal policy and a dearth of confidence. In aggregate, European banks’ loans exceed their deposits, so they rely on wholesale funds—short-term bills, longer-term bonds or loans from other banks—to bridge the gap. But investors are becoming warier of lending to banks that have euro-zone bonds on their books and that can no longer rely on the backing of governments with borrowing troubles of their own. Long-term bond issues have become scarce and American money-market funds, hitherto buyers of short-term bank bills, are running scared.

Banks are frantically shedding assets both to raise cash and to ration their capital in order to meet European Union minimum capital-adequacy targets by next June. The early victims of this deleveraging are borrowers in emerging markets. The euro zone’s eastern neighbours may be hit particularly hard: the Turkish lira, for instance, has come under pressure in the past week, a hint that money is flowing out. The repatriation of funds by euro-zone banks might explain why the euro has been remarkably stable against the dollar in recent weeks, despite the zone’s internal convulsions. But businesses and householders at home will also soon be hurt by scarcer credit and rising interest rates, as the banks’ higher funding costs are passed on.

Governments are cutting back too. The precise impact of next year’s belt-tightening is tricky to gauge. France’s budget plans are close to being agreed on; further cuts are likely but will be delayed until after the elections in spring. Italy has yet to vote through a much-revised package of cuts. Spain’s incoming government has promised further spending cuts, especially in regional outlays, in order to meet deficit targets agreed with Brussels.

Even so, it seems plain that fiscal tightening will weaken growth. Take the plans that countries presented to the European Commission and add what has been advertised since, and the squeeze across the euro area comes to around 1.25% of GDP next year, reckons Laurence Boone, chief European economist at Bank of America. That alone is enough, says Ms Boone, to chop around a percentage point off GDP growth in 2012. Germany will be the least affected of the zone’s four biggest economies, followed by France. Spain and Italy will be hurt most.

The euro zone’s businesses and consumers will be drawn into the downward spiral of confidence. In the autumn of 2008 companies learned that credit lines could not be relied on when banks were fighting for survival. When banks are short of liquidity, firms have to watch their own cashflow closely. That implies leaner stocks and reductions in discretionary spending, such as capital projects or advertising campaigns.

September’s sharp decline in industrial orders is an early sign that companies are cutting back. Andreas Willi, head of capital-goods research at JPMorgan, notes that SKF, a Swedish firm that is the world’s largest maker of ball bearings and a bellwether of industrial demand, gave analysts a cautious assessment of its future revenues in mid-October. That guidance suggests a further softening of investment demand. Consumers are also likely to defer big purchases as long as the crisis is unresolved and credit is scarce.

A drop in demand for capital equipment, durable consumer goods and cars will strike at the euro zone’s industrial heartland, including Germany. Ms Boone reckons GDP will fall by around 0.5% in Germany next year and by the same amount in the whole zone. In September the IMF forecast that the zone’s GDP would grow by 1.1% in 2012 but estimated that if European banks were deleveraging quickly (as they are now), the economy could shrink by around 2%.

Breaking point

A downturn of such severity will hugely increase the pressures within the zone. Investors will be even less willing to finance banks, as more garden-variety loans to businesses and householders turn bad. As unemployment rises, tax receipts will go down and welfare payments up, making it harder for governments to rein in their deficits and hit the targets they have set, and causing bond markets to question their solvency more pointedly still.

In such circumstances, the chances of a policy error or broader panic increase sharply. The calculations of bond investors, bank depositors and politicians are prone to sudden change. Hopes that the fracture of the euro zone might be averted by far-sighted policymakers could give way to a belief that it is inevitable. Such beliefs, once they take hold, are likely to be self-fulfilling.

How? The drying-up of funding for sovereigns and for banks is a threat to the integrity of the euro, because of the stark divide between debtor and creditor countries within the zone. As late as March 2010, Jean-Claude Trichet, then head of the ECB, boasted that simply belonging to the euro area automatically ensured balance-of-payments financing. It doesn’t look that way now.

During the credit boom, cheap capital flowed into Greece, Ireland, Portugal and Spain to finance trade deficits and housing booms. As a result, the net foreign liabilities—what businesses, householders and government owe to foreigners, less the foreign assets they own—of all four are close to 100% of GDP. (By comparison, America’s net foreign liabilities are 17% of GDP.) Much of their debt is being financed by local bank borrowing or bonds sold to investors in creditor countries, such as Germany. Ireland is unusual in that a large chunk of what it owes is in the form of equity (all those American-owned factories and offices) and so does not need to be refinanced.

With a few exceptions, the benchmark cost of credit in each euro-zone country is related to the balance of its international debts. Germany, which is owed more than it owes, still has low bond yields; Greece, which is heavily in debt to foreigners, has a high cost of borrowing (see chart 2). Portugal, Greece and (to a lesser extent) Spain still have big current-account deficits, and so are still adding to their already high foreign liabilities. Refinancing these is becoming harder and putting strain on local banks and credit availability.

The higher the cost of funding becomes, the more money flows out to foreigners to service these debts. This is why the issue of national solvency goes beyond what governments owe. The euro zone is showing the symptoms of an internal balance-of-payments crisis, with self-fulfilling runs on countries, because at bottom that is the nature of its troubles. And such crises put extraordinary pressure on exchange-rate pegs, no matter how permanent policymakers claim them to be.

One of the initial attractions of euro membership for peripheral countries—access to cheap funds—no longer applies. If a messy default is forced upon a euro-zone country, it might be tempted to reinvent its own currency. Indeed, it may have little option. That way, at least, it could write down the value of its private and public debts, as well as cutting its wages and prices relative to those abroad, improving its competitiveness. The switch would be hugely costly for debtors and creditors alike. But the alternative is scarcely more appealing. Austerity, high unemployment, social unrest, high borrowing costs and banking chaos seem likely either way.

The prospect that one country might break its ties to the euro, voluntarily or not, would cause widespread bank runs in other weak economies. Depositors would rush to get their savings out of the country to pre-empt a forced conversion to a new, weaker currency. Governments would have to impose limits on bank withdrawals or close banks temporarily. Capital controls and even travel restrictions would be needed to stanch the bleeding of money from the economy. Such restrictions would slow the circulation of money around the economy, deepening the recession.

External sources of credit would dry up because foreign investors, banks and companies would fear that their money would be trapped. A government cut off from capital-market funding would need to find other ways of bridging the gap between tax receipts and public spending. It might meet part of its obligations, including public-sector wages, by issuing small-denomination IOUs that could in turn be used to buy goods and pay bills.

When cash is scarce, such scrip is readily accepted by tradesmen. In August 2001 the Argentine province of Buenos Aires issued $90m of small bills, known as patacones, to employees as part of their pay. The bills were soon circulating freely: McDonalds even offered a “Patacombo” menu in exchange for a $5 pata c ón. Argentina broke its supposedly irrevocable currency peg to the dollar a few months later.

Scrip of this kind becomes, in effect, a proto-currency. In a stricken euro-zone country, it would change hands at a discount to the remaining euros in circulation, foreshadowing the devaluation to come. To pre-empt further capital outflows, a government would have to pass a law swiftly to say all financial dealings would henceforth be carried out in a new currency, at a one-for-one exchange rate with the euro. The new currency would then “float” (ie, sink) to a lower level against the abandoned euro. The size of that devaluation would be the extent of the country’s effective default against its creditors.

Market gurus and other students of misaligned stock, bond or home prices often say that although it is easy to spot an asset-price bubble, it is impossible to know the event that finally pricks it. In much the same way, the likeliest trigger for a disintegration of the euro is unknowable. But there are plenty of candidates. One is a failed bond auction that forces a country into default and sends a shock wave through the European banking system. Italy has €33 billion of debt coming due in the final week of January and a further €48 billion in the last week of February (see chart 3). Since bond investors are turning their noses up even at offerings from thrifty Germany, the odds against Italy’s being able to raise the money it needs early next year are uncomfortably short.

Another danger is a disagreement between Greece and its trio of rescuers (the EU, the IMF and the ECB) over the conditions of its bail-out. The risk of a mishap will be greater after the Greek elections in February if the country’s political mood sours yet further. Perhaps the spark will come from another source: the bankruptcy of a bank; fresh trouble in Portugal; or a chain of events that starts with France losing its AAA rating and ends with runs on banks across Europe. The exposure of French banks to Italy and to other countries that have been in bond traders’ sights for longer implies that contagion would quickly spread to the euro’s core (see chart 4). Widespread defaults in the periphery would wipe out a big chunk of Germany’s wealth and begin a chain of bank failures that could turn recession into depression.

The few left in the euro (Germany and perhaps a few other creditor countries) would be at a competitive disadvantage to the new cheaper currencies on their doorstep. As well as imposing capital controls, countries might retreat towards autarky, by raising retaliatory tariffs. The survival of the European single market and of the EU itself would then be under threat.

Such a disaster can still be averted. The ECB might launch a programme of bond-buying on the pretext that a deep recession in the euro area threatens deflation. If done on the scale that the Bank of England has undertaken, it could restore stability to Europe’s panicky bond markets. If bond purchases were made in proportion to the size of each euro member’s economy, that might go some way to overcoming German misgivings that the central bank was being used to provide favourable financing to profligate countries.

Such action by the ECB is an essential short-term palliative. But any lasting stability for the euro must lie with governments, particularly in the degree to which they are willing to give up fiscal sovereignty in return for pooling liabilities. Germany stands firmly at one extreme of this debate. Its chancellor, Angela Merkel, wants big changes to force probity (and wants the EU summit on December 9th to focus on such rule changes), but has opposed the idea of jointly guaranteed “Eurobonds”. German officials have argued that any open-ended commitment to joint liabilities would encourage errant governments to profligacy, violate Germany’s constitution and raise its borrowing costs. Even now, the head of the Bundesbank, Jens Weidmann, appears to believe that the imposition of fiscal rigour will be enough to restore calm to Europe’s bond markets.

Hanging together

Others think that circumstances demand speedier concentration on ways to pool liabilities. On November 23rd the European Commission laid out three approaches for issuing Eurobonds, two of which imply mutual guarantees.

Another new proposal is intriguing—thanks, in part, to its provenance. Germany’s Council of Economic Experts recently proposed a “European Redemption Pact”. This scheme would place the debt, in excess of 60% of GDP, of all euro-zone governments not already in IMF rescue plans into a jointly guaranteed fund that would be paid off over 25 years. Modelled in part on the federal government’s assumption of the debt of America’s states begun by Alexander Hamilton in 1790, the fund would provide joint liability for these debts under strict conditions. These would require euro-zone countries to introduce debt brakes into their constitutions, like the one Germany and Spain already have; give priority to paying off the mutualised bonds; set aside a specific tax revenue to do so; and pledge foreign-exchange reserves as collateral.

At its peak, the redemption pact would be huge: the joint liability would amount to €2.3 trillion. But it would technically be temporary. For all these safeguards, Germany’s government has so far poured cold water on the idea. But time is running out. And the scale of the impending catastrophe demands radical answers.

Source: http://www.economist.com/node/21540259

The euro crisis and emerging markets: Drought warning

AS THE rich world lurches from one crisis to the next, a consolation has been that emerging economies, which account for about half of world output, have been growing quickly. Even the wretched euro zone has a few racy emerging markets nearby. Turkey has on occasion rivalled China, with GDP growth of around 9% in 2010. Poland’s was the only economy in the 27-strong European Union to avoid recession in 2009. Sadly, euro misery seems to love company. A deep recession in the currency zone would leave few countries unscathed, even in fast-growing emerging Asia. For developing economies closer to home, the euro zone’s banks may be the main route by which the suffering spreads.

These banks are under pressure to meet higher capital-ratio targets as part of a deal made last month to “save” the euro. Lenders may choose to cut loans rather than raise equity, which would dilute existing shareholders (including bank executives). Europe’s banks are owed $3.4 trillion by emerging economies, $1.3 trillion of which has been lent to eastern Europe, according to the Bank for International Settlements. Many have subsidiaries in the region. If banks choose to sacrifice foreign lending to concentrate on business at home, it could choke the supply of credit.

In a speech on November 8th, Mark Carney, the new head of the Financial Stability Board, a club of international regulators, gave warning about the damaging effects of European bank “deleveraging” on the world economy. Already Germany’s second-largest bank, Commerzbank, has said it will suspend new lending outside its home market—although it made Poland, where it has a subsidiary, an exception.

The current-account balance is a rough guide to which countries are most vulnerable. On that basis, Asia is generally a safer place than eastern Europe, where several countries run large current-account deficits, and so rely in part on fresh loans from big European lenders. Turkey looks at risk: the IMF puts its deficit at 10% of GDP this year. Poland has a biggish deficit, although Commerzbank’s pledge suggests its credit line to rich Europe may be more solid. Hungary is in surplus but it still has a financing hole to fill, says Gillian Edgeworth of UniCredit, because it has IMF loans to pay off and because foreign banks have been slowly withdrawing from it. Investors have been spooked by the government’s rows with its IMF rescuers and by a plan to cap repayments on Hungarians’ foreign-exchange mortgages. Greece’s banking troubles are a threat to economies in south-east Europe.

A drying up of foreign bank credit would also put downward pressure on the currencies of countries that rely on foreign capital, making it trickier for them to cut interest rates to stimulate their economies. Some emerging markets have already seen their currencies drop in recent months (see chart). A big sell-off in September, since partly reversed, was a warning of future trouble, says Stephen Jen of SLJ Macro Partners, a hedge fund.

There is an irony here. As the euro zone’s trouble spots, such as Italy, struggle against the constraints of a currency union, some developing countries (and a few rich ones, such as Japan and Switzerland) have long grappled with the problem of managing floating exchange rates. Brazil imposed a tax on the flightier sorts of foreign capital to stop the real from appreciating too much. In a similar vein Turkey initiated a range of unorthodox measures late last year to curb capital inflows and relieve the upward pressure on its currency, the lira. To cool a credit boom, the authorities forced banks to hold more cash reserves and put ceilings on property loan-to-value ratios as alternatives to raising interest rates (which might attract yet more footloose money). Turkey’s central bank also intervened in currency markets to hold down the lira.

Now a different set of problems looms. Fearful of inflation, which has risen to 7.7%, in part because of the weaker currency, the bank has recently reversed tack and sold some of its foreign-currency reserves to prop up the lira. Since its reserves are quite modest, Turkey may have to keep interest rates fairly high to defend its currency and maintain external financing, which would increase the chances of a hard landing. A cheaper currency should, in principle, boost exports and curb imports, narrow the current-account deficit and so reduce the amount of fresh borrowing needed from abroad. But the inflation that comes with higher import prices will temper the competitive gain from a cheaper lira; and euro-zone recession will hurt exports.

Europe’s banks are not the only source of foreign capital for Turkey, Poland and the rest. Purchases of bonds and stocks by foreign investors (“portfolio inflows”) are important, too, and have held up surprisingly well, says Ms Edgeworth. Rich-world investors have been keen on exposure to emerging markets because of low yields at home. But weakening currencies would mean losses on such investments, which could slow—or reverse—portfolio flows. That in turn would further depress currencies, reinforcing a vicious cycle.

A few policymakers are alive to the risks. Mr Carney suggested European banks should be required “to meet at least part of their requirements by raising private capital” rather than being able to do so entirely by deleveraging. The IMF is also sounding warnings. Erik Berglof of the European Bank for Reconstruction and Development has called for a second “Vienna Initiative”, a successful 2009 pact to keep bank loans flowing to eastern Europe. But the pressure on the euro-zone is now far greater than it was back then, so the near-abroad is less of a priority.

Source: http://www.economist.com/node/21538141