Greece aims to shoot itself in the foot

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Last week’s EU agreement was just about holding together until last night, when Greece threw in the curve-ball of announcing a referendum on the deal.  Many Greeks feel that the option of full default, letting the bond-holders take the full hit is better than the restructuring currently being negotiated and the years of austerity currently planned. 

But this puts the troika in a difficult position.  Having just agreed the latest EUR 5.8bn loan instalment, it is now faced with the position of lending further money to a country that could potentially renege on the conditions of all the outstanding lending.  Greece has EUR 8.2bn of maturing debt in December and EUR 15.1bn in Q1 next year. It would be totally irresponsible for the EU and IMF to disburse any more money to Greece whilst the potential for a rejection of the new EU/IMF deal is possible.

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Furthermore, the current administration has called a confidence vote for this week.  In sum, despite its seriousness, the current situation is bordering on a farce of epic proportions and the reaction in financial markets (dollar firmer, stocks down) reflects this.

Commentary

RBA rate cut knocks the Aussie.  The Australian central bank delivered a 25bp rate cut, putting the cash rate at 4.50% and sending the Aussie back below 1.04, from its 1.0550 level ahead of the announcement. The market was partially, but not fully, positioned for the move, which reflects a sharp turnaround in the fortunes of the Australian economy.  Earlier this year the market was still positioned for further rate increases.  The move further undermines carry and ‘risk-on’ strategies, of which the Aussie has been one of the primary beneficiaries in the past couple of years.

SNB less focused on the euro.  Is it a central bank or is it a hedge fund? From some angles, the boundaries are fairly blurred, not least because the quarterly statement on its balance sheet notes that: “The SNB result depends largely on developments in the gold, foreign exchange and capital markets”. The key difference though is that the SNB can effectively manipulate the main market in which it is present, namely that of Swiss francs. Its balance sheet was pummelled last year and the first half of this year (2010 loss of CHF 26.5bn), September’s announcement of a cap to the CHF at EUR/CHF 1.20 saw a substantial turn-around in fortunes. On that day alone, we calculate that the SNB could have made as much as nearly CHF 18bn on the resultant FX moves (using just published Q3 weights on FX holdings). Gold movements have also served to bolster the SNB’s balance sheet, the gold price some 15% higher this year when valued in Swiss francs. The other interesting point to note is that euro holdings, as a proportion of total FX holdings, have fallen to 50.7%, from 55.3%. When the SNB was last intervening to counteract CHF strength, euro holdings rose to as much as 70% of total FX reserves (middle of 2010). Meanwhile, the dollar is now 34% of reserves, from 25% in Q2-2011. This is the highest proportion for five years and suggests that the SNB is more focused on maintaining a more diversified portfolio of FX reserves than was the case before. This is a wise move, as it avoids boxing itself into a corner with an ever-increasing proportion of euro holdings.

Trichet’s failure to learn.  There was generally gushing praise from the political elite for the outgoing ECB President Trichet on his last day in office. Much of this is likely through gritted teeth, given his ongoing lambasting of governments’ fiscal behaviour and the ECB’s reluctance to jump head-first into the water and rescue the eurozone project, rather than standing pool-side shouting instructions on how to swim.  There were two major failings of Trichet’s presidency, the blame for which lies somewhere between the man and the institutional arrangements under which he was operating. The first was to set policy too loose for too long in the middle of the last decade. Of course, the Fed has faced the same criticism. For the ECB, whilst a simple Taylor rule (modelling policy as function of inflation and output gaps) worked well in the early years, it broke down in 2002-03, with the rule showing that policy should have been tightened at a time when rates were being held steady at 2%. Furthermore, the rule showed the ECB very slow to act in 2008, when it put rates up in the middle of the year. The observation is that greater emphasis was given to the core, beyond what its GDP-weighting would warrant.  The tightening of rates in 2008 was the manifestation of Trichet’s failure to realise that the rules of central banking had been changed by the financial crisis. Many were questioning the wisdom of inflation-targeting at a time of heightened financial stress and risks. Whilst the ECB could not change its mandate, it should have realised the increased significance of financial imbalances on the outlook for price stability. This is not to say that the ECB should have been able to predict the collapse of Lehman Brothers three months later, but it should have factored into its thinking the inherent financial risks that were being widely talked about at that time.  The same holds true for this year, with respect to the ECB’s tightening of policy in both April and July. For the July move especially, there were obvious stresses in both money markets and bond markets which had a direct bearing on the outlook for the economy and prices. Trichet assumed that the economy was largely immune from the sovereign crisis and somehow managed to carry the ECB Governing Council along with him. In effect, Trichet repeated the same mistake of mid-2008 and his failure to learn will blight his record as a central banker, all the more so when the sovereign crisis has run its course.

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