Forget Apple, Slovenia was the real deal

All that matters for the US media is the stock market. Just take a look at the TOP category in Bloomberg or tune into CNBC for… well… as long as you can bear it. And of course many put the “=” sign between the US equities and Apple. Therefore, last week’s premier issue of Apple bonds grabbed all the headlines. Granted, it was a bond, not a stock but it’s Apple so it can still rule the global economic reports. But honestly, in the greater scheme of things this issue had really zero relevance for anything. Yeah, probably the PIMCOs of the world decided to park some cash there expecting that high outstanding value would boost liquidity in the secondary market. Plus, there were some comments about Apple’s tax bill but that’s about it.

I think something considerably more important happened in the small European country of Slovenia.

slovenia_apple

After several days of roadshowing, the troubled Slovenia decided to open books for 5 and 10y bonds on Tuesday (30 April). Given that in the previous weeks peripheral bond markets rallied like mad, it wasn’t too heroic to assume that the book-building would be quite quick. Indeed, in the early afternoon books exceeded USD10bn (I guess Slovenia wanted to sell something around 2-3bn) and then reached a quarter of what Apple managed to get in its book building. If I were to take a cheap shot I would say that Slovenia’s GDP is almost 10 times smaller than Apple’s market capitalisation* but I won’t.

And then the lightning struck. Moody’s informed the government of an impending downgrade, which has led to a subsequent suspension of the whole issuance process. I honesty can’t recall the last time a rating agency would do such a thing after the roadshow and during book-building but that’s beside the point. That evening, Moody’s (which already was the most bearish agency on Slovenia) downgraded the country by two notches to junk AND maintained the negative outlook. This created a whopping four-notch difference between them and both Fitch and S&P (A-). The justification of the decision was appalling. Particularly the point about “uncertain funding prospects”. I actually do understand why Moody’s did what it did – they must have assumed that the Dijsselbloem Rule (a.k.a. The Template) means that Slovenia will fall down at the first stumbling point. But they weren’t brave enough to put that in writing and instead chose a set of phony arguments.

Anyway, May 1st followed and the book reopened for bids only on Thursday. In the meantime, it was interesting to see what happened in the secondary market: the existing Sloven22 USD bonds got given on Tuesday at 99.00, they were sold just below 98.00 on Wednesday and by the time the books restarted they were firmly on their way towards par. I know markets don’t care about ratings these days but this was a pretty extreme vote of no-confidence for Moody’s.

I took advantage of the fact that May 1st is a holiday across Europe and had a few meetings with fund managers here in London. All of them were telling me the same thing, i.e. that they hope that the downgrade would cheapen the deal by at least 10bp. They “hoped” but didn’t really think that would happen. This sharply contrasts with some analysts’ comments who said that the downgrade could cost Slovenia around 100bp (i.e. from 6 to 7% in yield). Imagine that – some people seriously thought Slovenia would have to pay more than Rwanda (no disrespect, of course).

Then the big day came – books reopened, bids were even stronger than during the first attempt and Slovenia sold 3.5bn worth of 5 and 10y bonds. On Friday, the new Sloven23s traded up by more than 4 points, which means yield fell by more than 50bp from the 6% the government paid. A fairy tale ending.

So why do I think this event was so important? Because it shows how different the perception of European sovereign risk is. I wrote a few times about it (see here and here) partly making fun of people who thought that Slovenia would be the next Cyprus. Now, don’t get me wrong, I don’t think that Slovenia is out of the woods yet. In fact, the 3.5bn cash injection could make the government less eager to push for necessary reforms (for details, do check an excellent summary of a great paper by @GoodRichWatts which can be found here). But the emotional reaction to the Cyprus debacle was ridiculed by the market. In other words, just because something happened in one part of the Eurozone, it doesn’t mean that there will be an impending domino effect, or an outright tsunami.

Perhaps issues from both Apple and Slovenia have only proved that investors will buy anything that yields. But I strongly believe that in the case of Slovenia we got something much more important in terms of where the crisis in the Eurozone is headed. If you want to be short Europe, feel free to do that but better check whether your story holds first and don’t count on panic spreading quickly.

* Comparing a country’s GDP with a company’s market capitalisation is ridiculous, though because one is flow and the other one is stock. But this sort of comparison is what would get me quoted on Bloomberg so I couldn’t resist. For the record, if you wanted to compare a country’s GDP to anything from the corporate finance world it should rather be sales, in which case Slovenia is a third of Apple.

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Abolish deposit insurance, please

This crises has taken its toll on livelihoods of many people. But it’s also making otherwise reasonable and balanced investors lose the plot and move from investing to preaching.

I have found myself in a surprising situation lately – I inadvertently became the only person on my twitter feed who does not condemn Jeroen Dijsselbloem. Now, I like being controversial like the next man (anyone who ever tried to talk to me about Hungary can testify that) but this time around I have had to endure more abuses than normally.

I am sure many of you still have in mind “the Cyprus debacle”. If not, please start with an excellent piece from Joseph Cotterill entitled “A stupid idea whose time had to come” and work your way through links. The title of Joe’s piece has stuck in my mind ever since and I finally have a few moments to explain why.

To be sure, I do not contest the fact that the EU outdid itself and managed to make their communication even muddier than usual. But this is now behind us and we should focus on the essence rather than on the way the package was announced. I may have mentioned that in the old days I was quite involved in Iceland’s banking crisis of 2008. And I have always claimed that – despite a few minor hiccups on the way – letting the big banks default and closing the capital account was the right thing to do. I think there are many similarities between Iceland and Cyprus and that’s why I believe that bailing-in the (foreign to a large extent) depositors was the correct course of action. I mean of course the final solution, not the initial idea of not sparing smaller deposits, which was plain ridiculous. Yet, ever since the announcement I had to argue with people who were throwing all sort of populist arguments and who went into great length in finding ways to insult Jeroen Dijsselbloem. Jeroen Dijsselbloem who is a politician trying – like all of them – to get reelected and who understands that top priority in a support package for any country must include ways to prevent citizens of core European nations from revolting.

But instead of spending time explaining why I think the Cyprus solution was a correct one*, I thought I would touch on a somewhat more medium term issue, which is deposit insurance. This is because I think the debate in Europe whether to centralise the deposit insurance scheme or keep it on the national level is a wrong kind of discussion. I think that we should begin to discuss whether one of the lessons from the crisis shouldn’t be to cancel deposit insurance altogether.

Please bear with me before you click the unsubscribe/unfollow button.

Deposit insurance was introduced in the US in 1933 (earlier it was created in Czechoslovakia). The idea was to restore faith in the financial system and get banks to lend more. This was the idea whose time had to come. And it wasn’t stupid at the time but rather necessary. Since then a lot of things have changed, though. For starters, the world has seen a remarkable ascent of investment banks, which have benefited quite a bit from deposit insurance. This was at times coupled by quite a bit of recklessness in the way banks’ balance sheets were used and this is now widely recognised. Perhaps all-too widely.

Think about it – we just witnessed a full-blown bank holiday in a country which is relatively small but which was in the spotlight for at least a fortnight. During that time I even recall one of the macro tourists hedge fund guys who said that the best thing to do at the moment was to put live cameras in front of banks in Milan and Madrid because “the end is nigh”. Of course none of that happened and we probably need to entertain the idea that people in the street are not completely dumb, as difficult as it may sound…

But why didn’t we have a run on other European banks? I think most of the Europeans understood that the bail-in in Cyprus was due to the fact that there was a lot of foreign and most probably dirty money there. Heck, even the average person in Cyprus seems to have comprehended that problems at Laiki were pretty specific to Laiki. True, the capital account remains shut and it will probably stay like that for a while but it’s really not a big deal in the greater scheme of things.

When I first tweeted about the idea of abolishing deposit insurance, the replies I received pointed out that it could topple the whole financial system. There is some truth in it. After all, if the deposit insurance was to be abolished as of tomorrow, many people would probably go to ATMs “just in case”. But let’s try and work out the logistics of the issue. First of all, most European countries guarantee deposits up to €100k in full. This seems to be working even though there are quite a few governments who could not possibly meet this obligation if required, just like Cyprus. So it’s one of those barrier-type option hedging products that stops working precisely when you need it. Another question is why 100k? It’s a round number and nothing else, because the average deposit is way below that level. And if that’s the case then would it change much if we reduced the limit to 99,999.99€? With the exception of the holier-than-thou folk in the media who would immolate over the concept, probably not much.

Let’s take it a step further. What if Europe announced the following:

  1. As of January 1, 2014, all the countries within the Eurozone will be jointly responsible for insuring any deposit up to 100,000€.
  2. Starting from January 1, 2015 the limit will go down by 10,000€ every year until it goes down to zero on January 1, 2024, after which no deposit will be guaranteed by any Member State.
  3. (repetition) Governments and national central banks of Member States will irrevocably guarantee the insurance with their full faith and credit until January 1, 2024.

I would argue that the average person in the street would probably be interested to browse through front pages of various newspapers which would be “shocked and dismayed” but since they don’t have anything close to 100,000€, they would probably only calculate when their savings could potentially become vulnerable. What would be far more interesting is the reaction of banks. After all, even in core countries like Germany, the Netherlands or France “some banks are better than others”. There’s no need to point them out – they are perfectly aware of their own situation. After such a change in the system they would know they have several years to build up the sufficient capital buffer and to improve their books or else… In other words, Europe wouldn’t place those institutions under an imminent threat of a rapid deposit withdrawal but would send a strong signal that the clock is (slowly) ticking. Sure, there would probably be some turbulence in the cost of bank funding but I don’t believe that would be fatal. Simultaneously, the banks would have to voluntarily cut their riskiest and most balance sheet consuming operations in trading. No need for financial transaction tax, bonus caps or short-sale bans.

I know that what I described may sound a bit like science fiction but we have just gone through something that was seemingly unthinkable only a few months ago, i.e. haircutting desposits and shutting the capital account within the Eurozone. And guess what – not much has happened. So instead of throwing calumnies at Jeroen Dijsselbloem consider that if we stop here then it will mean that we (Europe) have just sent a signal to people that they can keep money in however crappy bank they want as long as it’s less than 100,000€. Alternatively, we could give the banks’ customers and the banks themselves a friendly nudge with a not-too-close deadline and let the market forces work their magic. Remember, systemic ain’t what it used to be. Let’s take advantage of that.

* By the way, don’t even try to assume that I think every single country in trouble should be dealt with in the same way as Cyprus.

Eddie Vedder and the Japanese carry

Just like everyone else in the financial markets over the last week or so I have become the world-famous specialist on Japanese flows (!)*. I have heard a lot of more or less plausible stories and when I was trying to digest all the noise, I couldn’t help but think about “Nothing As It Seems” by Pearl Jam:

Occupations overthrown, a whisper through a megaphone
It’s nothing as it seems, the little that he needs, it’s home
The little that he sees, is nothing he concedes, it’s home
And all that he frees, a little bittersweet, it’s home
It’s nothing as it seems, the little that you see, it’s home…

Jeff Ament, Pearl Jam

I am not certain what is going to happen with the wall of money that is seemingly coming from Japan, but I know that there’s a remarkable amount of superficial analysis, which I would like to comment on.

1. The Japanese carry trade will continue as the BoJ prints more.

According to estimates by Daiwa net issuance of JGBs after stripping BoJ purchases will be -26trn yen. This is around 5% of GDP, which is a pretty monstrous amount. This naturally makes people’s imagination go into overdrive, particularly as we’re talking about the country with decent carry-trading history. But there is one problem with such an approach. Carry trade was Japan’s response to the lack of returns in the local market. Bond yields have been ridiculously low and the stock exchange was still suffering as zombie-banks kept dragging it (and the economy) lower. Now, do you think this situation has not changed even a bit? We may be agreeing or disagreeing with what the BoJ is doing but investors (particularly retail) could be excused for e.g. thinking that the Nikkei will double this year. This is particularly the case as what the BoJ seems to have orchestrated is a fantastic opportunity for the Japanese banks to cash in on their available-for-sale JGB portfolios. So answer yourself this question – is it so entirely obvious that Mrs Watanabe continues buying AUDJPY (annual yield of 3.2%), ZARJPY (annual yield 5.4%) or MXNJPY (annual yield 4%)? Granted, these and many other currencies will continue to constitute a very important part of the Japanese investment portfolio but pretending that the investment backdrop in Japan has not changed is naive in my opinion.

2. The big yen move has only just begun.

Currently various forecasters are trying to come up with the most bearish view for the yen. I have already seen 120/USD but admittedly I do not pay much attention to that stuff. But try to think who has so far made money on the yen debasement? If you don’t know then try to get a hold of the HSBC hedge fund report to see that the vast majority of macro funds have caught at least a part of this move. And because selling the yen is seemingly such a no-brainer**, not being in the trade is a big career-risk for many. In some sense, macro hedge funds cannot afford to miss another leg in the yen move (if there is one). But in the greater scheme of things this is just noise. Don’t forget that the Japanese economy has just become at least 30% cheaper. And we are talking about a bunch of historically deadly innovative companies who have managed to keep their place in the global market place against all odds.

Goldman has recently produced a study showing that the country with the most similar exports composition to Japan’s is… Germany. It is already very much visible it the underperformance of the DAX, in my opinion. Personally I prefer Mercedes over Toyota but at a 25% discount I know I would change my mind.

My thinking is as follows: if this yen depreciation and the crowding out of the Japanese banks from the JGB market is persistent then Japan has every chance to become the champion of the global trade again. And if so, why on earth would I be buying GBPJPY or AUDJPY?

Let me give you another example: If you have been selling the yen and buying the South African rand consistently in the last five years then only last week did you break even on your average spot level. Sure, you got some coupons in between but it cannot be ruled out that investors who have been buying the ZAR against the JPY will just take this as an opportunity to close the position after being bailed out by the BoJ.

3. Banks will invest abroad.

This bit I find preposterous. I have mentioned above that banks may have just been given a lifeline by the BoJ and they will be able to off-load their available for-sale portfolios at a significant profit. What they do with the cash next is anyone’s guess but banks are not really in the business of punting on currency markets with their balance sheets. Believe it or not but even when GS recommends buying EURUSD, it’s not like Goldman’s treasury shifts all its money to Europe. Banks operate in the “LIBOR+” world. They are happy to take exposure to foreign bonds but it is usually done on an asset swap basis. Below are a few bonds that I just looked up on Bloomberg and how they compare when swapped to JPY.

  • T 2 02/15/23                                     78bp
  • SAGB6.75 03/31/21 #R208       68bp
  • MBONO6.5 06/09/22                    68bp
  • POLGB 4 10/25/23                          10bp
  • TURKGB8.5 09/14/22                   36bp

As you can see those differences are not huge and definitely not big enough to make emerging markets irresistible. Additionally, there’s a perverse effect of what’s been going on in the JGB market lately. The chart below shows a crude calculation of VaR for 10y JGB futures since 2000.

JGBVaR

A chart of the yield volatility is looking even scarier, which – paradoxically – could bring the Japanese banks into a risk-reduction mode as no one can bear such wild swings of the profit and loss account. And adding Brazilian assets to the portfolio doesn’t help much.

4. Asset managers, insurance companies and pension funds will invest abroad.

Yes they will. The same way as they have in the past. Well, maybe with a bit bigger size but it’s far from being certain at the moment. If it’s the yen weakness they’re after then I suppose buying the USD will do (without adding an extra layer of volatility between the USD and some other currency). And if they don’t think the yen weakens much from here then why would they accelerate foreign buying in the first place?

This brings us to the last point I would like to make. As much as in previous years the Japanese investments abroad were driven by expectations of superior returns outside of the country, we are now talking about the expected yen weakness. In my opinion this changes the structure of investors taking advantage of the move and I believe that it will be the foreigners shorting the yen, rather than the locals. This, at least in the near term, makes it a tactical, rather than a structural trade.

So these were my views on the whole situation. I don’t have any concrete recommendations this time but I just don’t like how one-sided the discussion has become. And if I’m wrong then… well… listening to Eddie Vedder while writing this post definitely made it worth my while.

* not sure how to stress that I am being ironic, but I have noticed that subtitled movies on Sky have (!) at the end of sarcastic sentences.

** I have always thought that no-brainers are for people without brains but somehow this definition hasn’t become mainstream.

Baron Münchhausen and spreads in Europe

Hieronymus Carl Friedrich von Münchhausen is known for telling the story that he pulled himself (and the horse he was sitting on) out of the swamp by his own hair.

This reference was the first thing that came to my mind after seeing this and this post on Paul Krugman’s blog. After the whole bunch of swearwords, that is.

In the first one he argues that France has finally joined the club of ultra-sovereign countries, i.e. countries who can do whatever they please and yet get away with it because bond yields remain remarkably low. The second one uses “research” material from VoxEU entitled Panic-driven austerity in the Eurozone and its implications. There are five charts in it which I would like to discuss before circling back to Krugman’s thesis about French bonds.

Chart 1. Austerity measures and spreads in 2011.

 

degrauwe_fig1

 

In this chart the author argues that the higher the spread, the bigger the austerity that was subsequently applied. Well if it isn’t remarkable – so they’re telling us the higher the increase in credit spread in 2011, the bigger the adjustment had to be? Brilliant. But let’s say it’s an introductory statement just to warm us up.

Chart 2. Change in spreads vs. initial spreads

degrauwe_fig2

Now this is epic. The Baron Münchhausen argument. It basically says that the the higher the initial spread, the bigger the subsequent decline. A few things about that. Firstly, absent of a total collapse of the eurozone, how else should this chart look like? Secondly, using the same weight for the spread on tiny Portugal and Greece as Spain or Italy is just skewing the results. Thirdly, I don’t think that using the decline in percentage points as dependent variable is kosher because spreads can’t go negative and so 50bp for France is something completely different to 50bp for Portugal. Finally, I seriously wonder if the fit would be so bombastic if they removed Portugal and Greece – those dots at the beginning seem close to the best-fit line but I have a sneaky feeling that this is mostly because of the scale.

Chart 3. Change in debt-to-GDP ratio vs. spreads since 2012Q2

degrauwe_fig3

 

First of all, this is just plain wrong from the econometric point of view. What is this -0.6747 factor in the equation? It means that if there is no change in debt/GDP then spread will fall on average by 67bp. So 10 years of unchanged debt and spread falls by almost 700bp? No, friends, such results should be deemed “inconclusive” and there shouldn’t be any downward sloping line here. But if you want the line then have a look what it would imply if debt levels fell. Spreads would increase… Brilliant. Finally, assuming no lags or anything is just ridiculous.

Figure 4. Austerity and GDP growth 2011-2012  <– this one I actually have no problems with. Stating the obvious, but so be it.

Figure 5. Austerity and increases in debt-to-GDP ratios

degrauwe_fig5

 

This one says that austerity increases debt to GDP. A lot has been said on the subject and in the short run it is very difficult to argue with that. One could make an argument that without austerity debt/GDP would’ve increased even more because of super-high borrowing costs but let’s not go there here.

Wait a second though. So if austerity increases debt to GDP and we “know” from (ridiculous) Chart 3 that higher debt to GDP is associated with a decline in credit spread then isn’t austerity leading to lower spreads? Alternatively, if we interpret Chart 3 as the lack of relationship then shouldn’t we also conclude that austerity has no impact on credit spreads?

If the author’s only intention was to show that the ECB was instrumental in narrowing the spreads then fair enough. But the analysis provided is weak to say the least.

And this brings us back to Paul Krugman. Because if he believes in what De Grauwe wrote, i.e. that the reduction in spreads was the function of how high the spreads went in the first place then why has France rallied so much? Similarly, why would it rally if austerity worsens things so much?

Oh, I know why. Blame the markets (both ways).

First De Grauwe:

Since the start of the debt crisis financial markets have provided wrong signals; led by fear and panic, they pushed the spreads to artificially high levels and forced cash-strapped nations into intense austerity that produced great suffering.

Then Krugman:

Markets have concluded that the ECB will not, cannot, let France run out of money; without France there is no euro left. So for France the ECB is unambiguously willing to play a proper lender of last resort function, providing

If one wants to make an argument that OMT has led to significant tightening of credit spreads in the eurozone, we really don’t need working papers – a tweet will do. But for crying out loud do not mix austerity with that. Especially as austerity and OMT were completely coincidental. And if you do have to mix austerity into all this then make a little bit of effort to make a consistent and mathematically correct set of arguments. And make up your mind, Mr. Krugman. Either austerity is bad and ultimately keeps debt to GDP high and thus credit risk elevated in which case you need to rethink France. Or austerity sometimes makes sense in which case… well… you need to rethink a hell of a lot of things.

Otherwise your story is not far from what Baron Münchhausen – amusing and entertaining but ultimately ridiculous.

 

Systemic ain’t what it used to be

I remember that in the first days after the bankruptcy of Lehman Brothers, many believed that the collateral damage would not be terrible. I distinctly recall asset managers who were still eager to discuss idiosyncratic factors in some emerging markets. Not that I was so much smarter back then – after all, I did not send an email entitled “SELL EVERYTHING”. Of course shortly afterwards came an avalanche and dominoes started falling. All of a sudden everything appeared systemic, even things you wouldn’t normally care about.

Just to give you a few examples from my turf:

  • Iceland was relevant because of huge assets of local banks outside of the country (aka Icesaave);
  • Hungary (and CEE in general) was key for survival of Austrian and Italian banks;
  • Latvia threatened the stability of the banking system in Sweden;
  • Ukraine was a big risk for French banks;
  • The Middle East… well, it’s always considered to be a tail risk anyway.

One could extend this list quite a bit.

Considering the fragility of the financial system back then, any of those factors could’ve spiralled out of control. Therefore we had various programmes, such as the Vienna Initiative which were aimed at ring fencing potential fallout. When that initial phase of panic ended (with the London Summit) we had a brief period of calmness followed by the mighty Eurocrisis.

This one has been very similar to the initial “Lehman” stage. First came Greece, which initially was considered to be not that relevant. That was the case until roundabout the PSI Summit of 2011, which – perhaps inadvertently – wreaked havoc in the system. There was also Ireland with its “bad bank” ideas and the Iberia with all sorts of problems. And then, again, everything became systemic and potentially fatal. The culmination of it all was in my opinion when a) the market went after Italy and b) people wanted the Bund to start trading with a credit premium (search Bloomberg headlines towards the end of 2011 if you want to see that actually was the case).

Like with the Lehman, many people missed the Eurocrisis trade and began making up for that by creating more or less far-fetched implications. I described this mechanism in one of my previous posts about Slovenia. But does anyone really care about Greece or Ireland anymore? I know there’s punting going through in GGBs and some when-in-trouble-double funds made a killing buying Irish bonds but in terms of global significance this is barely relevant. Similarly, we shouldn’t really care about Cyprus, although some people are trying to persuade us it’s yet another reason to buy gold bitcoins and hide.

In this vein, I was actually pretty impressed with recent comments from Jeroen Dijsselbloem. He is right and he knows he can take a bit of a gamble by speaking his mind: not everything is systemic. And if something is then, well, we have the Draghi Doctrine.

Granted, Europe is pretty screwed economically and this won’t change anytime soon but this is a completely different set of issues than forecasting the total annihilation of the financial system. The two most important measures of stress, i.e. the cross-currency basis between EUR and USD as well as the BOR-OIS spread are telling us that we should change the way of looking at European affairs. And maybe this is the answer to a tweet from Joe Weisenthal asking why on Earth is the euro so stable. The euro has plenty of reasons to fall and I have been suggesting short EUR/EM positions lately but systemic just ain’t what it used to be.

The truth about € in Poland, Mr. Krugman

As a big fan of IS/LM, I have always admired Paul Krugman. He obviously knows his stuff but more importantly he has held his stance throughout the crisis and has done it in a very convincing way. This will definitely be remembered.
However, I sometimes have issues with what he says and these issues are proportional to the distance between him and the subject in question. While his views on Iceland were pretty much in line with what I think, I’ve been under the impression that he oversimplified things by conveniently ignoring the fact that there is a lot of cash trapped there, which will remain a big problem for many years to come. But this is nothing compared to what in my view is a completely misguided and superficial analysis of the Baltics. The fundamental difference between what he says and what I think is that for me just because a country that used to run significant excesses before the crisis has not returned to the previous level of output is by no means a proof of a failure of local policies. I would argue that a lot of pre-crisis GDP was, in effect, phantom and should not be treated as a benchmark. Additionally, countries like Lithuania are an example that internal devaluation can work well, which you can see looking at a rapid growth in productivity in recent years. And no, I don’t care that a lot of that has happened through reductions in employment. Not because I’m a heartless liberal but because a lot of the pre-crisis employment should not have happened in the first place. The same situation could be observed in Latvia and yet prof. Krugman keeps waving the GDP chart saying how ridiculous the policies have been.
But I wasn’t going to write about the Baltics. Today I read Paul Krugman’s latest post entitled Poland Is Not Yet Lost. The mention of Latvia aside, there is nothing in this post that would be factually incorrect – Poland did have a “nice” global recession and the zloty was an efficient corrective mechanism in 2009 and after.
However, the problem with his post is that it discusses an absolutely irrelevant issue of Poland joining the EMU. Sure, the Polish authorities have been quite vocal mentioning that in recent months but in my strong opinion it has nothing to do with the actual intention.
What’s the reason then? Polish bonds. After a spectacular rally in 2012, yields on POLGBs reached record low levels and the curve flattened dramatically as the NBP stayed way behind the curve. At the same time, standard valuation metrices like eg asset swaps or carry have become extremely tight. To the point that without assuming a paradigm shift or without classifying Poland as a safe haven it was difficult to justify further strong purchases. “Expensive” was the word most commonly used at the turn of the year. The Finance Ministry, which by the way holds a Ph.D. in public relations, realised that too and was frantically looking for a way to portray POLGBs as “still attractive”. And they quickly found one, ie the spread to Bund, which is hovering above 200bp. But in order for people to start looking at this spread they had to give them a reason. Joining the EMU was one. And believe me, this has been quite successful judging by how many requests I get about this spread these days.
Talk is cheap and Poland knows about it so if saying that eventually the zloty will be converted into € can bring us some flows then why not? Especially that there hasn’t been any commitment regarding the date or no indication on how on Earth Poland will meet the Maastricht criteria. But I guess this is a much simpler strategy of communication than trying to explain how the budget will cope with the first drop in consumption in almost 20 years or what does it mean that the budget deficit is already at 60% of the full-year plan after only two months. I guess it’s good there’s Hungary (and now Slovenia) next door who will always attract eager sellers, eh?
But coming back to prof. Krugman, I realise that my credentials are nowhere near his. Heck, I’m not even writing this under my own name. Still, I think in cases like Latvia or Poland, he lets his ideology run before the analysis of what actually is going on.

But you start to follow the money…

Attention, there are three words generally considered to be offensive used in the following post.

You follow drugs, you get drug addicts and drug dealers. But you start to follow the money, and you don’t know where the fuck it’s gonna take you

– Det. Lester Freamon

This is a pretty famous quote from The Wire that’s been echoing in my head since last weekend, i.e. after the Cyprus crisis grabbed all the headlines. But unfortunately, unlike in the case of Detective Freamon, it wasn’t because I admired the meticulous and hard work people have been putting into trying to figure out the broad consequences.

Sure, the blogosphere’s reaction last weekend was marvelous and in my opinion helped to stabilise markets this week, but alas it’s not really an event in the eurozone if you can’t draw some explosive (and most of the time daft) parallels. Before we get to those I’d like to say a few words about origins of such a situation.

Haircut of depositors in Cyprus took the market by surprise. And by market I mean investors and traders but also the caste of research professionals whose job is to… well… try and forecast such events. Obviously, there is nothing wrong with being caught off guard from time to time and it’s the reaction to such a surprise that matters. The natural instinct of people who had not predicted what happened in Cyprus is to play it down and suggest to fade any adverse market reaction. The twisted logic here is “had it really been so important, I would’ve surely seen it coming and since I didn’t then it must be unimportant“. I’m sure there’s a name for such a behaviour in psychology but I can’t be bothered to search. In my opinion, this is the most common reaction.

If this first – let’s call it – line of defense fails and the person in question finally acknowledges that the surprising event could turn out to be quite important then another mechanism kicks in: they try and look for potential spillovers. The thinking is more or less that “ok, I may have dropped the ball here but have a look at those cascade effects that the market is missing“. I have been quite appalled to see that happening throughout the most of this week.

It usually starts with some pretty straightforward conclusions. In the case of Cyprus, people began assuming that we will inevitably have a run on the island’s banks and that it could lead to similar developments in Portugal, Spain, Italy or even Ireland. Right, because that’s what the Irish people do…

The next step in this “following the money” process was to figure out whose deposits will be cut in Cyprus. The answer to that seems to be “Russian” (although I would caution against making such a generalisation). This would look something like this…

You guys, let’s try and see how this affects Russia. Oh, here’s one: VTB is one of the most important Russian banks and it also has a subsidiary in Cyprus. Sell, Mortimer, sell! What? VTB bonds have sold off? Well then why don’t we sell bonds issued by VEB. It’s a big state-owned bank and while it has really nothing to do with Cyprus, there’s only a one letter difference to VTB so it’ll do. Oh, and did I just say it’s state owned? Mate, where’s your bid in 50m Russia30s?

Let’s move on. Cyprus is a small, country with problems in the banking system. Those problems partly stem from the immense inflow of dirty money in the past. After the Cypriot financial system reopens whatever is left of it will inevitably flee. What if it goes to Latvia, which is already a popular short-break destination for the Russians and which will soon enter the eurozone itself? (…unfortunately the person explaining to me what would happen next lost me completely and so I can’t follow this particular money trail to the end). By the way, the Latvian authorities had to start swearing that they wouldn’t end up like Cyprus. There’s no smoke without fire, anyone?

And finally, my very recent favourite…

There must be a small country in the eurozone, which has some problems with its banks and which we could sell. Hang on, what’s this little thing east of Italy that no one really knows about but occasionally makes some noises in the media? Slovenia! OMG, this is so exciting! Banks in Slovenia have NPLs reaching 20%? Some of them did not meet the ECB stress tests? The government recently collapsed and there’s a risk of an early election? I guess we’ve found a retirement trade. And don’t bother me with details that assets of the Slovenian banking system are only around 135% to GDP or that the total government financing needs for this year are projected by the IMF at 7.7% of GDP (slightly below Germany, Austria or Finland). Who cares that if the IMF’s forecasts are to be believed then Slovenia will meet both fiscal Maastricht criteria next year as it still has debt to GDP below 60%. And also, I’ve never believed in this cyclically-adjusted primary surplus mumbo jumbo…

Right, and when you’re done selling Slovenia, maybe we should look into Slovakia – there’s gotta be some connection!

I have started with a quote by Lester Freamon and I will end with one. Fifth series, episode three (entitled “Not for attribution”):

Shit like this actually goes through your fucking brain?