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Daily Commentary 18/02/15

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Greece offers half a compromise The Greek newspaper Kathimerini reported that Greece will request a six-month extension to its loan agreement with its creditors. This is half of what the Eurogroup wanted. However, Greece still refuses to accept the reform program that the Eurogroup insists is an essential precondition of the loan. On the contrary, PM Tsipras announced that his government would begin submitting legislation to overturn some parts of the program, such as reversing some labor market deregulation and protecting homeowners from foreclosure. Greece’s proposal is similar to the one that was floated on Monday by EC economic chief Pierre Moscovici but quickly rejected by the Eurogroup of Eurozone finance ministers, although the new legislation contravenes the Moscovici plan as well.

The plan is due to be sent to Eurogroup chief Jeroen Dijsselbloem this morning and the Dutch finance minister will decide if it merits calling an extraordinary Eurogroup meeting Friday. So far, the Eurogroup has remained adamant that Greece has to continue with the terms of the loan that the previous administration agreed to, but the new Greek government argues that it was elected with a pledge to renegotiate those terms and so it can’t. Greece’s refusal may create problems in getting some countries’ parliaments to approve the extension.

Greece’s move is seen in the market as somewhat of an advance, and the euro has strengthened this morning while the safe havens CHF and JPY are the worst performing G10 currencies. Personally though I don’t see any compromise here – the fact that Greece is submitting legislation to overturn the conditions of the program seems to me to be making irreversible their refusal to compromise, which is EUR-negative. I await Dijsselbleom’s response, however. It may be that he decides to compromise rather than push the situation to the brink.

Why Greece leaving the Eurozone – a “Grexit” – would be a disaster The Eurozone is a common currency shared by several countries. If it is found that countries can leave, however, it will be seen just as a fixed exchange rate agreement, like EMU was previously. In that case, the inevitable question will be “who’s next?” Once that happens, then we are back to the old days of speculative attacks against currencies and the whole structure is at risk of breaking down.

How might that happen? Imagine that you live in Spain and you have your money in the local bank. You’re worried that your country might be next to pull out of the Eurozone. (Remember that the point of pulling out of the Eurozone is so that you can reinstate your own currency, which then falls in value vs the euro and makes your country more competitive internationally.) So it makes a lot of sense for you to take your money out of the local bank and put it in a bank in Germany. If your country does pull out, then you are still holding euros while your mortgage is redenominated in a newly depreciating currency – you win! If your country doesn’t pull out…you are no worse off than you would have been otherwise. Heads you win, tails you don’t lose. A no-cost hedge.

Speculators outside the country could do the same sort of thing by borrowing money in a country that they think might leave and depositing it in a bank in Germany. This could even become a self-fulfilling prophecy as it would drive up interest rates in the troubled countries and make it more difficult for them to stay in the euro.

As a result of this kind of thinking, once Greece pulls out, we are likely to see the greatest bank run in history. With the experience of Greece (and Cyprus) in mind, savers will be quick to act. The banking systems of Ireland, Portugal and Spain, perhaps even Italy, are likely collapse in short order.

There are only two ways that this could be avoided. The first would be if the ECB and other EU institutions could make a promise that would be convincing enough to persuade people not to move their money. This would involve Europe-wide bank insurance and probably some measure of fiscal transfer – changes that the core countries have strongly resisted up to now. The other way, which some observers are starting to suggest for Greece, would be to institute capital controls to prevent people from moving their savings out. But in that case the euro really no longer exists – there would in effect be a Portuguese euro, a Spanish euro, an Irish euro, etc. as markets sprang up to allow investors to offset or take on country risk as they saw fit. In other words, that would precipitate the break-up of the euro in fact if not in name.

BoJ keeps steady, a bit more upbeat The Bank of Japan ended its two-day policy meeting and kept policy steady, as everyone expected. The commentary accompanying the decision was somewhat more upbeat than before, as it said that exports and industrial production were “picking up.” Curiously, it also said that “Inflation expectations appear to be rising on the whole from a somewhat longer-term perspective.” I don’t know what they’re talking about, as both breakeven inflation rates and the 5yr/5yr inflation swap are trending lower. At their last meeting, Bank of Japan cut its inflation forecast for the coming fiscal year beginning in April to 1% from around 2%, an admission that they are not going to hit the 2% target that they were supposed to achieve by then, and today it estimated that inflation is actually running about 0.5%. Gov. Kuroda added little to our knowledge at his press conference. He made no comments to clarify the news story that ran last week reporting that some Bank policy makers view further monetary easing to shore up inflation as a counterproductive step for now. He said only that the BoJ’s QQE policy is having the intended effects and there’s no need for further easing now, but he wouldn’t hesitate to act again in the future if needed. This confirms my view that more easing is still possible in the future. Indeed, I’d say it’s likely.

Indonesia unexpectedly cuts rates for the first time in three years. Bank Indonesia lowered its reference rate by 25 bps to 7.5% as output shrinks and imports fall. The country thus joins the parade of countries cutting rates.

Today’s highlights: During the European day, from the UK, we get unemployment rate for December and Bank of England February meeting minutes. The minutes are likely to show a similar outlook to Thursday’s inflation report. Thus, the market may choose to overlook the meeting minutes and focus mainly on the employment report. A decline in the unemployment rate and acceleration in average weekly earnings could bring forward estimates of the first rate hike and thereby strengthen GBP.

The ECB will hold a non-monetary policy meeting to decide whether or not to continue providing emergency liquidity assistance (ELA) to Greek banks. If the ECB take away ELA, the Greek government may have to impose capital controls to avoid mass withdrawals and the collapse of the country’s financial system.

In the US, the Fed releases the meeting minutes of its Jan. 27-28 meeting. The statement was slightly more confident on the economy, with “solid job gains” upgraded to “strong job gains.” Any reference to when they may start normalization or even remove the line about being “patient” could boost USD. US housing starts and building permits for January are also coming out. Both figures are expected to rise, keeping the overall trend consistent with an improving housing market. Industrial production for January is expected to rise, a turnaround from the previous month.

Besides Gov. Kuroda, we have one speaker on Wednesday’s agenda: Riksbank Deputy Governor Cecilia Skingsley speaks.

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