Macro and Markets

It should be no surprise that eurozone finance ministers failed to agree to disburse €2 billion in bailout money to the Greek government today or to release bank recapitalization funds. Despite optimism following the recent announcement of a relatively benign program for recapitalizing Greek banks, it is hard to escape the conclusion that the Greek program again is headed off track.  The government has fallen behind its reform commitments, and a substantial number of additional end-year measures look unlikely to be met. Even with substantial forbearance from Greece’s European partners, it now looks likely that conclusion of the first review of its program will be delayed and that the promised debt relief negotiation will come only in 2016. Further, an eventual International Monetary Fund (IMF) program is likely to be small and leave a large unfilled financing gap that will further strain Greece’s relations with its European neighbors.  It is hard to predict how long Greek voters will continue to support a government that cannot deliver on its economic pledges of low debt and sustainable growth. The European Union (EU) bank audit results revealed a capital need of €14.4 billion in an adverse scenario (€4.4 billion in the baseline), which conveniently looks to be consistent with previously approved bank recapitalization funding from the Hellenic Financial Stability Fund (HFSF). While the downside scenario is not an exit scenario—the capital needs would likely be far greater if Greece were to exit the eurozone (and Greek bank capital still relies on deferred tax assets to an excessive and credibility-destroying extent), it does cover a substantial renewed recession that would result from a protracted standoff with the IMF and its European creditors. The push is now on to complete the recapitalization by year end, raising private capital to the extent possible before state aid is drawn on, before new EU rules go into effect that would require a greater haircut on bank creditors as a condition of state support (there is a certain irony in hearing policymakers celebrate the evasion of these new rules once seen as critical to the credibility of EU banking union). The next step in Greece’s reform effort is the first review of the August European Stability Mechanism (ESM) program, which is a condition for further disbursements under the package and, more significantly, required for starting the negotiation of debt relief. Reports today suggest disputes remain on a new foreclosure law, the VAT on private education, and pricing of non-generic medications, as well as on the timing and pace of pension reform.  Individually, each of these problems would appear solvable if the government has the will to move forward, but the growing list of unmet commitments has raised concerns among creditors as has the request by the Greek government for a "political decision" on the review. Much was made over the summer on the dispute between the IMF and Europe on debt relief for Greece, The United States now is also pressuring the eurozone on debt relief for Greece. While the announcement of debt relief could maintain domestic support within Greece, the ultimate success of the program is still uncertain. Whether Greece receives haircuts (what the IMF and the United States would like to see) or further deferral of interest payments (the German proposal) will only affect what Greece has to pay after 2022.  In any event, the extended window of very low debt payments to official creditors creates temporary space for private issuance, but this type of seniority-driven market access is not durable and will require repeated official debt service extensions. Despite this issuance, in the near term there would appear to be substantial funding needs for the Greek government.  The fiscal position has returned to deficit (taking into account accumulated arrears) and growth is likely to remain muted at best.  The current IMF forecast is for growth (year-over year) to turn positive only in 2017. It is easy to be critical of a reform program that contains so many reform measures, and arguably a lack of institutional capacity within the Greek government limits their capacity to move forward. But at the same time, there cannot be a return to durable growth within the eurozone without a major transformation and opening of the Greek economy, and creditors are increasingly frustrated with the slow pace of the Greek government in meeting its commitments.  Ultimately, “Grexit” will become an option again when Greek voters lose patience with the current path being charted by the government.  It is hard to predict when it will happen, but hard to imagine another result.

This summer’s market turmoil was a serious jolt to emerging markets, particularly commodity exporters and those countries with strong trade and financial ties to China. Fortunately, there are good reasons for comfort that the tail risks facing these countries do not rise to the level of the Asia financial crisis or the Great Recession. After early missteps, China’s policymakers have been more assured in recent weeks in signaling their commitment to near term stability and support for growth. Financial distress in emerging markets, the most serious channel for contagion, has yet to materialize. Moreover, bolstered by high reserve levels, more flexible and competitive exchange rates (see chart) and in some cases better policies, emerging market buffers against contagion have been strengthened. In my monthly, released yesterday, I ask whether, in the event of crisis, policymakers are up to the task of an aggressive and coordinated response. I have several concerns: The scale of financial imbalances is large. Corporate emerging-market debt now stands at $18 trillion, or close to 75 percent of gross domestic product (GDP), and leverage has soared. The Great Recession reminded us that interconnectedness—even more than the size of financial institutions—can be a recipe for crisis. The lack of transparency regarding China’s economic policies and relationships matters as well. China’s importance for financial markets and supply chains is not well understood, and a hard landing in China, renewed crisis in Europe, or even the anticipated normalization of U.S. monetary policy could cause real distress in countries as diverse as Brazil, Turkey, and Korea. Weak global growth environment limits the scope for policymakers to respond to a demand shortfall. A few years ago, the judgment that emerging markets had come out of the Great Recession with strong fiscal and monetary positions—“policy space”—provided optimism that these markets could outgrow the industrial world and would be able to adopt expansionary cyclical policies in the face of a global shock. That optimism is now dashed, as many countries’ strong fiscal positions have been wasted and market reforms rejected. The global fire station is poorly equipped to deal with future blazes. Over the past two decades, official resources to address crises have not kept pace with the rapid growth of financial markets. The IMF has seen its resources bolstered, but a recent reform package that would have strengthened its governance and ensured broad support for its crisis resolution efforts remains stuck in the U.S. Congress. A vote by the International Monetary Fund (IMF) Board later this month to include the Chinese currency in its currency basket (the SDR) may make passage of the bill more difficult, suggesting that there is a narrow window of a few weeks for the reform package to catch a ride on must-pass legislation. Growing fiscal constraints in the major creditor countries mean that coming up with the necessary official sector finance will pose an increasing challenge when facing protracted, large-scale financial crises. In Greece in 2012 and Ukraine this year, it was the inadequacy of official funding and the resultant financing gaps, as much as anything else, that dictated the timing and extent of private debt restructurings. Political pressures on governments are also limiting their ability to respond actively with financing and the other tools at their disposal—including regulatory measures and through the bully pulpit—to address market crises. In Europe, rising populism on both the left and the right, and bailout fatigue after years of crisis in the periphery, has weakened governments and reduced support for bailouts. In the United States, the Dodd-Frank Act and other postcrisis legislation and regulation limit the capacity of the Federal Reserve and Treasury to provide emergency support. In contrast, during the 1994 Mexican bailout and the 1997 Asian financial crisis, the creative use of U.S. economic power—including moral suasion on banks to participate in restructurings—played a central role in stabilizing markets. In recent years, the Group of Twenty (G20) has been the focus of policy coordination, but whether that group could find common cause as it did in 2008 remains a question. Although a severe global financial crisis remains a tail risk and not the base case, governments should be prepared to respond. A strengthened and reenergized G20, an IMF with adequate resources and improved governance, and governments willing to act aggressively to deal with potential contagion are all needed to ensure that the downside scenario, if it occurs, does not become a major crisis. FIGURE 1. EMERGING MARKET CURRENCY VALUATION Source: Goldman Sachs, Investment Strategy Group, Investment Management Division © 2015

This is what governing looks like. When outgoing speaker John Boehner promised to “clean the barn up a little bit” before leaving, there was understandable skepticism that a large number of must-pass pieces of legislation could be sheparded through a sharply divided congress.  From that perspective, last night’s agreement on a budget framework—if it holds—looks to be an important step forward. While far from ideal budgetary policy, it removes substantial tail risk from U.S. economic policymaking between now and the election. The agreement reached last night would suspend the debt limit until March 2017, ease the sequester caps for fiscal year 2016-17 (allowing a roughly $80 billion increase in spending over two years split evenly between defense and non-defense spending), and provide fixes for a substantial array of items for 2016, including temporary relief from Medicare premium and Social Security disability rate hikes.   Two other pieces of legislation—a temporary extension of the highway bill and the reopening of the Export-Import Bank (Ex-Im), were not included in the deal but look to be moving forward on separate tracks, with the House likely to vote for Ex-Im reauthorization today.  The roughly $1.5 trillion debt limit increase is the centerpiece of this agreement and clearly most important to markets. The package does not extend funding for the government, and the current spending bill expires on December 11. The hope here is that, by setting the top line numbers and easing the sequester, it makes the ultimate agreement on a full-year spending bill (omnibus) much easier and reduces (but doesn’t eliminate) the risk of a government shutdown. I tend to agree, though as Chris Krueger of Guggenheim Securities emphasizes, Republicans are likely to push for a number of policy riders (e.g., Planned Parenthood defunding) around that December 11 cliff, marking a difficult first test for Paul Ryan as speaker. The debate over temporary tax measures ("extenders") also will be tough, and potentially meaningful for the budget.  Further, there is still “deal risk”—a stumble that prevents passage before the November 3 debt limit deadline. Still, we have managed through these type of spending showdowns in the past without a material disruption to the U.S economy, and the odds of going off the cliff in December now look reduced. In terms of spending, the measures are “paid-for” in a budgetary sense through promised longer-term savings including reform to Obamacare, revenue measures and changes to the strategic petroleum reserve. In fact, the package may be budget positive over a ten year horizon. Still, the net effect on current spending is stimulative.  Alec Phillips of Goldman Sachs estimates that the package will increase fiscal spending and raise GDP growth by 0.1 percent to 0.2 percent in 2016 and 2017. If the deal reduces market volatility from what it would have been in a debt showdown, the benefits could be even larger. Assuming this package passes, the deficit is likely to be around 3 percent of GDP in FY16 (which started on October 1), and slightly lower in subsequent years, which is consistent with a stable debt ratio in the near term (See Goldman Sachs and CBO forecast below). Forecasts for the longer term are more art than science but there is near uniform agreement that we face a worrisome deterioration in the deficit and debt levels as the population ages and interest rates normalize, with the rapidity of the deterioration dependent on the pace of increase in health care costs.  This deal does not address those concerns.  But at a minimum, we appear to have taken a destructive and unnecessary debt-limit showdown off the table. Further, we can hope for a temporary end to destructive fiscal cliffs and economic policy standoffs that we have weathered over the last three years, despite a political campaign driven by populist calls for confrontation. And that is worth noting. Chart: A Stable but Slightly Larger Deficit for the Next Few Years Source: Congressional Budget Office, Goldman Sachs Global Investment Research