Thursday, March 4, 2010

How do you say Deja Vu in Greek?

For those of us with a little experience in Emerging Markets, the crisis that ended in the Argentine default and devaluation in 2002 will undoubtedly stand forever in our minds as a top market event. Judging by the superficially naive analysis of the Greek situation, this memory has been lost to most Americans who hardly remember The slowest train wreck in History.

As most people know, much like Greece, Argentina is a country of contradictions. Endowed with beautiful land and sellable natural resources it was in the early 20th century one of the richest countries in the world. In addition, whether because of immigration, government policies, or other reasons, Argentina enjoyed one of the highest educational levels in Latin America, favorably comparable to many in Europe.

Somehow, they managed to screw enough things up to end up in chaos, default, and hyperinflation during the 80's (aka. The lost decade). Having lost all confidence in their currency through a recurring mix of chronic public deficits, future promises to unionized government workers and pensioners (their equivalent of Social Security went bankrupt), and quantitative easing, they resorted to an old-new idea: Convertibility, which was a US Dollar standard instead of a Gold standard. (I have attached a timeline at the end of this article).

Under convertibility Argentina thrived. The economy grew, long-term mortgage financing became available for the first time in decades, tax collections soared, etc. Debt to GDP went to a low of about 35%. There was one problem, inflation, although much lower than in pre-convertibility times, was high in dollar terms. Thus, Argentina gradually became expensive. Then, the usual happened. President Menem, trying to gain favor for a second term, opened the fiscal spigot and began to accumulate fiscal deficits which they now needed to finance in hard-currency. By the end of his second term, Debt to GDP was North of 50%, which is still low by today's standards. At the time, the argument was that Argentina's numbers were good enough to meet the Maastricht Treaty requirements to join the Eurozone, which they were.

Except Argentina is in South America. After the financial crises of 1997-1998 markets became increasingly reluctant to finance Argentine (and Brazilian) deficits.

Here is the Greek Tragedy (pun intended), even though the Argentine government tried to lower the deficit from 3-4% to zero, as opposed to from 13% to 3% as the Greeks are currently trying to do, the market never regained its appetite for, in Wall Street parlance, the story. Naturally, with every austerity package the Argentine voters rejected the situation grew worse. The economy slowed down more bringing down tax-collections and increasing the deficit.

Indeed, the IMF, which I would argue had more leeway than Germany since its directors were not subjected to the vagaries of democracy, did not want to see Argentina fail. Nor was the problem too large for the IMF which, in addition, had several allies in the Argentine government. Did I mention the Argentine debt was held by institutions and citizens in countries that controlled the IMF? (Anything rimes yet?)

Why then did they fail? Because regular people, the ones who vote and pay taxes, HATE deflation and austerity programs. Cutting some else's salary and/or pension may sound very logical in Berlin, but it is a hard sell to the average Greek just as it was to the average Argentine who, as the historical norm would have predicted, eventually accepted a biggest cut through devaluation. By the way, Germans do not vote in Greece.

Clearly, I have no idea what will happen in Greece, Spain, Portugal, or Germany. What I do know is that I have seen the cycle of promises and good intentions before. I also do not know of any country that has cut their fiscal deficit by 10% in two years without a devaluation. In any case, the similarities are worth mentioning given the level of analysis (or lack thereof) I see in the financial press. The differences I find are mostly favorable to Argentina as Greece doesn't have access to a super-abundant commodity sector or even a medium-size domestic market to fall back on.

By the way, the Argentine default took three years to develop and the market had several rallies (there were no CDS' in 1998 so I used their stock index in US$ as a proxy), so be careful what conclusions you draw from the announcements and trade carefully.Argentina

Timeline of Argentina's Crisis

1989: Carlos Menem becomes Argentina's president.
1991: Finance minister Domingo Cavallo introduces the "Convertibility Law" which pledges
to keep at least US$1 for each peso in circulation. The law is quickly approved by Congress
1993-98: Save for a brief panic during the Mexican crisis(1995), Argentina's economy soars as inflation subsides.
1995: Fiscal restraint is gradually abandoned as Carlos Menem seeks a constitutional reform and a
consecutive second term as president.
1996-98: Argentina's debt continues to grow in the midst of persistent fiscal deficits
1997-98: The Asian, Russian, and LTCM crises reduce investor appetite for EM bonds
1999: Brazil devalues its currency in January. Recession hits Argentina.
12/10/2000: F. De la Rua becomes Argentina's president. Promises to end corruption
5/29/2000: Spending cuts announced to reduce fiscal deficit. 20,000 protest.
8/24/2000: Finance minister (JL Machinea) announces more spending cuts, cites lower than expected tax-collection.
12/18/2000: Government announces IMF funded rescue package. Markets rally strongly on optimistic view that the crisis is over.
3/2/2001: Finance minister Machinea, unable to turn the situation around, resigns
3/19/2001: Government officials resign in protest at the cuts announced by new finance minister(R. Lopez Murphy)
3/20/2001: New Finance minister (R. Lopez Murphy) resigns. D. Cavallo is appointed finance minister.
6/3/2001: Argentina swaps U$40B in debt extending maturities and lowering current coupons
7/30/2001: Government approves "zero deficit" law. The package cuts state salaries and pensions by 13%
8/3/2001: IMF to accelerate $1.2B loan
8/21/2001: IMF Managing Director, Horst Koehler, agrees to recommend an $8B increase in Argentina's $20B stand-by loan agreement
11/1/2001: Mr. De La Rua and Mr. Cavallo announce a new economic plan which includes a very large debt swap to lower current payments.
12/3/2001: Government limits cash withdrawals
12/5/2001: IMF announces it will NOT disburse $1.2B loan
12/17/2001: Government presents 2002 budget which includes spending cuts of 20%
12/19/2001: Finance Minister (D. Cavallo) resigns
12/20/2001: President (F. De La Rua) resigns
12/22/2001: New president (A. Rodriguez Saa), backed by the unions, promises jobs and austerity
12/23/2001: Debt payments suspended (Total debt about US$130B, about 55% of GDP, unemployment at 18%,
Public Deficit/GDP about -3.5%)
1/2/2002: New-new president (E. Duhalde) decides to abandon the dollar peg. Intends to devalue the peso by "just" 30%
1/31/2002: Argentine peso closes at 1.40 per US$1.40
3/29/2002: Argentine peso closes at 2.935 per US$2.935
6/28/2002: Argentine peso closes at 3.81 per US$3.81
3/31/2003: Partly help by Agricultural exports, Argentine GDP grows for the first time since 1998.
Argentine peso closes at 2.9725 per US$
2003-2007: Argentina's real GDP grew by almost 9% in 2003, 2004, 2005, 2006 and 2007.
The federal government had surpluses of 1-2% of GDP. Source: CEPR).
2007: Unemployment at 9.6% first time below 10% in close to a decade.


Let's hope Bernanke pulled a Casablanca moment in Congress

Ben Bernanke is supposed to be a smart guy. A respected academic with enough political skill to be appointed (and reappointed) to head the Federal Reserve. In addition, he is supposed to understand basic financial products as well as banks. Having this in mind, I am still unsure of whether he was pulling a page of Casablanca ("I am shocked! shocked...") or he really didn't know that swaps are routinely used to change the look of one's balance sheet.

On the one hand he seems to be surprised that Greece would enter a transaction to get cash upfront in exchange for future cash receipts (NY Times story). After all, politicians live in the now and this is routinely done in Washington as well as in all 50 states and other public entities. In essence, you can argue that the Fed entered into such an arrangement by taking illiquid assets (Maiden Lane, for example) in exchange for cash. California is currently issuing IOUs in order to "defer cash payments into the next fiscal year" (a forced bond issuance or swap of sorts).

Then again, Bernanke was genuinely surprised by the sup-prime problem which according to him was "...small and contained..." (the quote is now too famous to require a source). So it strikes me that it is possible that the people at the Fed don't really know that convertible bonds are routinely pitched to "fixed income only" funds/entities. Maybe the also do not know that "access products" (a very lucrative area in Wall Street) involves nothing more sophisticated than packaging options, foreign currencies, and/or futures contracts into "principal protected notes" for sale to investors who are not legally allowed to buy the products directly.

In fact, CDOs were designed for investors who wanted to "own a leveraged portfolio without risking a margin call" (which of course meant the principal could go to zero). What are the odds that Greenspan, Bernanke or Chris Dodd knew this?

I'd bet if I stopped our esteemed Chairman somewhere in Washington DC and asked him what is the size of Citibank (one of our largest and most bailed out banks) he would reply: "about $2Trillion". Yet, as shown at the bottom of page 129 on their 10-Q report as of Sep2009, they held almost another Trillion in off-balance sheet liabilities.

Maybe that is why Bernanke and Geithner (and Greenspan) are so friendly with Wall Street. They know they are way over the heads when it comes to understanding the complexity of these institutions and the risks they take.