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Can Greece Shrink Out Of Trouble?

William De Vijlder, CIO, strategy and partners, BNP Paribas says that the length of the negative economic environment in Greece could be longer…

In the European Union, the problem is not one of total savings, since the EU has a current account surplus. The problem is more of allocation of savings. If a lender of last resort could be found, then the problem could be solved, and that too without incurring a very significant cost, says William De Vijlder, chief investment officer, strategy and partners, BNP Paribas Investment Partners, in an interview with our editor, Dhirendra Kumar.

Until three to four weeks earlier, the dominant opinion about the euro zone crisis was that one way or the other it would be contained. The Economist magazine in its October 15 issue quoted, “This newspaper persists in believing that European politicians cannot be stupid enough to allow the euro to collapse.” But today there are at least some people saying that it may not be so, they can be really stupid. Which camp do you belong to?
I am a firm believer in Europe and in my view it will be solved. Why? Because it has to be solved, otherwise the cost would be way too disruptive.
One point of view among people is that when things get tough, go for the easy way out. Just drop this and go for the quick solution, however disruptive it may be. The other consideration is the difference between willing and being able. You can say that there is a willingness, but will we get there? And the discussions that are now going on centre on this. For instance, the example that I gave of ECB and IMF quoting yesterday’s Financial Times. Would that be the way? It’s how we get there while being compliant with the treaties — that is the answer.

But who will pay the bill?
It’s a good question. I think that people over estimate the bill. Why am I saying that? There is no shortage of available savings in the euro zone because it runs a slight current account surplus. By definition that means that the domestic savings pool is sufficiently large to finance both the capital expenditure of corporates, plus any budget deficits that you have at the level of the monetary union. The issue you have is one of allocation of the available pool of savings. Until recently that allocation happened fairly smoothly, but now it has become disruptive. So there’s an issue about the allocation of savings and not about the total amount of savings.
In the US the issue is about the total amount of savings. They have a current account deficit and they don’t have the money. Europe has the money. Then you have to say: wait a second, an issue in the allocation of savings is that certain countries have abnormally low levels of bond yields, like Germany, which is a safe haven. Other countries have abnormally high levels of bond yields. So then when you introduce a buyer of last resort, you are saying to the private sector: well you don’t want to invest in what are perceived as levered countries. Fine, we will do that. And we will draw a line in the sand. As a consequence, the riskiness of the weak assets changes completely. The risk disappears to a fairly large extent because the line in the sand has been drawn. As a consequence, the rationale underpinning the investment in the safe haven disappears as well.

But somebody has to underwrite that.
There is a difference between underwriting and paying the cost. That is what I am coming to.
Imagine that you would issue a euro bond of a sufficient size. Then the cost would be that a country which has a top quality rating going forward would have a slightly less top quality rating. That would be reflected in the spread on interest rates and that would imply a structural cost. But countries are saying we don’t want to do that, so let’s forget about it.
Then you say you will find somebody to be the lender of last resort. What you can then say from an asset-liability perspective is that you will actually make money on it.
The way it could work is that you would first find out the gross financing requirement: there is a debt that you procured that needs to be rolled over, plus there is a net borrowing requirement. We will fund that at a level of interest rate that is x basis points above the German yield rate.
If you look at it from a leveraged EFSF perspective and imagine that it would have been technically possible and they would have the willingness to leverage it, the EFSF would fund itself money at one rate and would lend at another rate and look at the spread. Besides, you have full control of the situation. Why? Because you have commitments, peer group monitoring and pressure, and you have drawn a line in the sand. So actually you control everything. It means that you are making a spread between your funding cost and what you get on your investments. So frankly I don’t see any cost here.
Importantly, because you draw the line in sand, you are running a position with fairly little risk and there is no cost to it.

In brief, what you are saying is that it’s a not a big bill; it’s just a matter of managing it.
It’s a huge position at a small spread. Because you control the entire structure you also control the risk. People make analogies with CDOs and other structures. In these types of structures you would not control the risks because you are subject to shocks coming from anywhere. In this case, you have all the details on the public sector accounts via the troika. You have the commitment and you can really enforce the commitment.
Then you can say: well, isn’t this a bit easy? What can happen is that because of recession or the global slowdown the time it takes to bring the deficit under control would be longer. But you still have the line in the sand drawn. That’s why I am saying that I don’t see an eventual cost. But you would have to carry the position for a long time. But actually you would make money on it.

You are talking about it very authoritatively as if it has almost happened. Do you see it happening along these lines?
What I see is that the BRICS countries have said, sorry, we are not interested. The IMF does not directly have the means. The ECB is not willing. It says it cannot do it. That is what the new president has said. But then I also see that now another route is being explored, quoting Financial Times which got the information from Reuters. Well, ECB could lend money to IMF which is allowed in its by-laws — that it can lend money to financial organisations.
From an investment perspective that would be interesting. Because we are in such an extreme environment, it can change all of a sudden. If the markets start to believe that there may be something that could work out eventually, that in itself would stabilise the situation. It will not solve it but it will at least stabilise it.
I have no clue when they will come up with something but I continue to expect something.

One of the most prescribed economic medicines has been austerity. Do you think Greece can shrink its way out of trouble?
It is clear when you look at the literature on fiscal consolidation, the experience that we have had over the past 30-40 years, that one can have a negative short-term effect. Typically an economy goes into a recession and faces slow growth. But then the economy turns around quite rapidly. Why? Before going into fiscal consolidation interest rates have reached high levels. As you start to consolidate, interest rates come down because people see that you are doing the right thing, so the risk premium goes down. The second reason why the economy turns around is that typically the currency has been under pressure beforehand. The central bank may have to defend the currency to a certain extent. As the economy goes into a recession, that allows the central bank to ease policy. So what you have is at the short end of the curve policy is being eased and at the long end of the curve the risk premium shrinks. So the entire yield curve comes down, which gives a boost to the interest-rate sensitive demand components — consumption, housing, and capital expenditure. Also typically what you see is that the currency weakens.
When you use this as a framework to do your analysis in the European situation, for a country like Greece the risk premium will go down. However, short-term interest rates cannot go down. And the currency can’t go down either because they are in the euro zone. That means that the length of the negative economic environment, which comes from fiscal consolidation, would be longer than would otherwise be the case.

What kind of an opportunity would it create for investors? Where do you suggest people should invest now?
How do you define an opportunity? For me an opportunity has two components: one, valuation must be attractive, and second, you must have a catalyst. At the moment the valuation condition is met. European equities are really cheap. The majority of the European bond markets are also cheap. A big exception is Germany which is very expensive. Corporate bond markets have also suffered, so they are also cheap. Now you need a catalyst. And that can only come from what we have discussed until now.

If it happens there could be a significant rebound.
Perhaps at some point you might want to visit my blog. I wrote a piece two or three weeks ago. I was looking at the possible outcomes of the European Union summit. My conclusion was that if the outcome is positive, it would create a flash rally. I used the word flash rally as the kind reminiscent of the flash crash that we saw last year — the flash rally being the one-day fireworks. This is exactly what you have seen recently. There was the one-day rally and the next day people started to say: oh my god, this is not the solution, so they started selling again.

I think what you would have here is that it will last longer. And the reason is that people have, to a certain extent, cleared up their risk positions. As always you would have a kind of all-clear signal in the market, a really positive development. The market starts to understand that we are getting close to the end of recession. The initial rise of the markets is fairly steep and then it continues to rise at a slower speed. We would have something like that. Because there will be enough sceptics around to say: well, is it going to work? How much recession are we going to have? But the markets would still continue to rise. It would not be a flash rally but longer lasting because of the fundamental change that the line in the sand has been drawn.

What you saw in 2008 in America and what you now see in Europe, has it in any way fundamentally changed your understanding of risk-free and riskiness. Have you made any significant changes in how you analyse markets?
Of course the world has become far more difficult for a number of reasons. I think you can say that 2008 was the start of a, let’s say, two-decade, or minimum one-decade long process of deleveraging.
I don’t whether you have read the paper of Vincent R. Reinhart and Carmen M. Reinhart which they presented at Jackson Hole last year. It’s called after “After the fall”. When I read that paper, I said, wow, it cannot be that bad. They looked at all the experiences of deleveraging and what it does to employment and growth rates. Everything we have seen since confirms whatever they were saying back then. So that is already one new element. The second new element is: what is the risk-free rate now? And that’s a real issue. That is something which will have structural or lasting consequences. Why? You own a pension fund and you want to hedge your liabilities. Typically the way these pension funds are run is: I have my liabilities stream and I am going to hedge it, and hopefully on a net present value basis I am over funded. So it means that I hedge my liabilities and I still have some money left and that I am going to generate extra return. Well, in the hedging of your liabilities stream you must have the RFR (risk-free rate). So where is it now?
And the issue that you have is that the US needs to deleverage on the household side. There is also an issue of what will be the impact on growth. The public sector needs to deleverage, and it is not clear how that’s going to happen. So now we have this lingering worry that there may be another downgrade of US rating. If there is another US downgrade, there will be nervousness because there are a host of consequences in terms of acceptable collateral and repo transactions. So that is one element.
In the EU you will have a reassessment of what is genuinely risk-free. And that will have an implication on when spreads will come back to the levels we had before the crisis.