Portugal president warns Europe's leaders to back off austerity demands

Picking up the baton from the leaders of Greece and Cypress, Portugal's president has come out and said that Europe's leaders need to back off their austerity demands as there are limits to what is economically and socially sustainable.

Austerity is a policy promoted by Germany that results from the choice of protecting bank book capital levels and banker bonuses under the Japanese Model for handling a bank solvency led financial crisis.

This choice puts the burden of the excess debt in the financial system on the real economy.  At best, this results in a never ending Japan-style economic slump.  At worst, this results in a depression and a rewriting of the social contract as the real economy is unable to generate enough capital to cover both the debt service burden and existing needs for reinvestment and social programs.

Regular readers know that there is an alternative to the Japanese Model that protects the real economy and does not require austerity or re-writing the social contract.  That choice is the Swedish Model under which the banks do what they are designed to do and recognize upfront the losses on the excess debt in the financial system.

Banks are able to do this because they can operate with low or negative book capital levels.  Their ongoing operations are supported by the combination of deposit insurance and access to central bank funding.  With deposit insurance, taxpayers become the silent equity partners while banks are rebuilding their book capital levels.

As reported by the Telegraph,

President Anibal Cavaco Silva called for urgent action to halt the “recessionary spiral”, warning Europe’s leaders that the current course had become “socially unsustainable”. 

In a speech to the nation, he said Portugal would “honour its international obligations”, but in the same breath called for a tough line with the European Union-International Monetary Fund Troika over the pace of fiscal tightening under Portugal’s €78bn (£63bn) loan package. “We have arguments, and we should use them firmly,” he said. 

“Fiscal austerity is leading to declining output and lower tax revenue. We must stop this vicious circle,” he said, cautioning the Troika that there would be no way out of the crisis until policy was set in the interests of the “Portuguese people” as well as foreign creditors.... 

Please re-read the highlighted text as Mr. Silva summarizes the argument that your humble blogger has been making.

Pursuing the Japanese Model, including fiscal austerity, does not work.

The Swedish Model balances the interests of the Portuguese people and foreign creditors.  Creditors take the losses they should take for extending too much credit.  The result of this write-down is the Portuguese people are left with debt that they can afford to repay.

Portugal’s jobless rate has risen from 13.7pc to 16.3pc over the past year, reaching 39pc for youth, even before the full impact of austerity hits....

Clearly, Portugal is in a severe recession that austerity would only make worse.  This in turn would decrease the ability of the Portuguese people to service any debt and increase the losses for the creditors.

The strategy with the best outcome for both the Portuguese people and the creditors is to forget about implementing austerity and rather write-down the debt.

“There are well-founded doubts over whether the distribution of sacrifice is just,” he said.... 

Popular anger is building over the over the Troika’s fiscal shock therapy, which will push up average income tax rates by 3.4 percentage points and bring in a plethora of surcharges and fees. It aims to cut the budget deficit to 4.5pc this year, largely through tax rises. 

Markets have so far brushed off worries that the country risks a Grecian vortex as austerity bites in earnest. ... 

“Investors are willing to give Portugal the benefit of the doubt right now, but the country still hangs in the balance,” said David Owen from Jefferies Fixed Income. 

“Our concern is that the fundamental economic situation is still getting worse. The European Central Bank’s policy is still too tight. They need to do quantitative easing and cut overnight rates below zero,” he said....

Adding austerity to a situation with deteriorating fundamentals in not a prescription for improvement.

Portugal has taken its medicine with stoicism until now, winning praise from the EU leaders for sticking to its bail-out terms. But Troika officials fear that “social cohesion” is fraying as the slump deepens. The country saw the biggest street protest this autumn since the end of the Salazar dictatorship.

As Ireland has shown, there is no benefit to stoicism as frankly Germany's leadership cares more about the book capital levels of its banks than the people of any debtor country.

Portugal to hold fire-sale of state assets

Under intense pressure from Germany and the Troika (IMF, ECB and European Commission), Portugal is about to engage in a fire-sale of its assets.

Regular readers know that this fire-sale will accomplish nothing positive for the citizens of Portugal.

When dealing with a bank solvency led financial crisis, the critical first step is to require the banks to absorb upfront all of the losses on the excess debt in the financial system.

By taking the first step under the Swedish Model, the link between bank book capital levels and sovereign debt is severed.  

At the same time, the sovereign can continue to guarantee bank deposits.  This allows the banks that are capable of generating earnings before banker bonuses to continue in business and rebuild their book capital levels.  Banks that cannot generate earnings must be resolved or merged into banks that can.

Without taking this first step, countries are tempted to bailout their banks.  This links bank book capital levels.

Even worse, it places the debt service burden of this excess debt on the real economy.  This creates a drag in the real economy since capital that is needed for growth and reinvestment is now being used for debt payments.

Your humble blogger observed that a fire-sale of the state's assets would accomplish nothing positive because it is simply generating capital that will be consumed by the debt service burden of the excess debt.

As reported by the Guardian,

Portugal is to embark on a sweeping fire-sale of state companies over the coming months, possibly even privatising state broadcaster RTP, as it bends to the will of the troika of lenders that bailed it out 20 months ago. 

With the government of prime minister Pedro Passos Coelho hoping to persuade the troika of the European commission, the European Central Bank and the International Monetary Fund to treat it more leniently in 2013 by lowering interest rates on loans, the sell-off of national companies is seen as one way of winning support....

The lesson from Ireland is not to expect more lenient treatment.

The bailout exercise is all about extracting as much from the country and its taxpayers as possible so as to minimize bank losses and preserve banker bonuses.

The troika has told Portugal to sell €5bn of state companies as part of the deal which saw it receive a €78bn bailout in May 2011. But it looks set to beat that target thanks mainly to sell-offs in the electricity sector and in airports.... 

Under the bailout plans, Portugal is due to return to bond markets in 2013. Its borrowing costs have tumbled in recent months, with 10-year bond yields finally falling back to pre-bailout levels of below 7% shortly before Christmas. A successful return to the markets would be seen as a sign that the euro crisis was finally being solved.

The euro crisis is far from being solved.

For example, Portugal is mired in a deep recession.  Who would buy its debt when both the tax base and asset base is shrinking?

Passos Coelho's government hopes that the troika, which recently eased lending conditions to Greece, might do the same with Portugal – lowering interest payments and making it easier to cut the budget deficit. Portugal's debt is expected to reach 120% of GDP this year and it currently pays 3.6% interest on troika loans. 

Germany has already said it opposes a softening of the bailout loan terms, with its finance minister, Wolfgang Schäuble, saying that would look as though Portugal was unable to meet targets. "It would be a devastating signal and I would really advise them not to pursue this point any further," he said. 

The government should take this to heart and stop bailing out its banks and selling its state assets.

Instead, the government should require its banks to take the first step towards ending the financial crisis and recognize their losses.

Portugal's economy shrank by 3% this year and the country has lost almost 6% of GDP since the credit crunch of 2007.

Portugal bailout on track except for collapsing economy

Reuters reports that according to the EU and IMF everything is on track with the Portugal bailout with the exception of its collapsing economy.

To anyone who isn't an adherent to pursuing the Japanese Model for handling a bank solvency led financial crisis and protecting bank book capital levels and banker bonuses at all costs, an economy that is shrinking uncontrollably would be a problem.

Fortunately, both the EU and IMF officials are adherents to pursuing the Japanese Model and therefore they don't see it as a problem.

For the rest of us, the collapse of Portugal's economy is a problem (but then again, so is the collapse of the Greek economy).

This economic collapse was also completely predictable as under the Japanese Model the economy of Portugal is not large enough to support the burden of the excess debt in the financial system that has been placed on it.

Your humble blogger is left to wonder if we are going to have to watch the collapse of both the Spanish and French economies under the Japanese Model before the EU and IMF stops pursuing the Japanese Model and adopts the Swedish Model.

Under the Swedish Model, banks are required to recognize upfront their losses on the excess debt in the financial system.  This preserves the real economy in places like Greece, Portugal, Spain and France as well as the social contract that exists in these countries.

Portugal's EU and IMF lenders gave Portugal thumbs up for the next tranche of their bailout funds on Monday, but warned of significant risks at home and abroad to the recession-hit, debt-laden country. 

"The program is broadly on track, despite stronger headwinds," the European Commission, European Central Bank and International Monetary Fund said in a joint statement. 

"Rising unemployment, lower incomes, and uncertainty are weighing on confidence, while the recession in the euro area is beginning to bear on export dynamics,"... 

"While downside risks to growth are significant, the program's macroeconomic framework remains appropriate." 

EU Economic and Monetary Affairs Commissioner Olli Rehn also said that "confidence in Portugal's prospects continues to grow, both among its institutional partners and market participants. This bodes well for Portugal's full return to market financing."

Maybe I missed something, but who would lend money to a country that cannot repay the loan because its economy is shrinking?

Bank of Portugal wants banks to securitize their real estate loans

Bloomberg reports that the Bank of Portugal wants to increase the availability of credit by having the country's banks securitize their troubled real estate loans.

While I understand why the Bank of Portugal wants to increase the availability of credit, this is going to be extraordinarily hard to achieve if the banks try to sell 'sub-prime' mortgage-backed securities without observable event based reporting.

Who would buy a portfolio of distressed real estate loans if they did not have current information on how the loans were performing?

However, with observable event based reporting, where all activities like a payment or default involving the underlying loans are reported before the beginning of the next business day, investors would have the current information they need to know what they own.

With the ability to know what they currently own comes the ability to assess the underlying loans and value the security.

The Bank of Portugal wants the country's banks to set up a fund where their shaky real estate loans would be securitised and sold in order to provide more financing to the recession-hit economy, the financial authority said on Tuesday. 

It said it had met representatives of the Portuguese Banking Association to present its initiative which had already been coordinated with the country's European and IMF lenders. 

Such a fund would increase the banking sector's "capacity to finance the economy, boost the prospects of longer-term profitability in the sector and reduce the levels of borrowing by the banking sector with the European Central Bank".

Your humble blogger has frequently made the point that restarting the securitization market would reduce the need for accessing a central bank for funds.

In fact, the ECB is desperate to restart the structured finance market.

Portuguese banks have long been frozen out of the interbank funding market due to the country's debt crisis and relied heavily on ECB liquidity....

The reason the banks are frozen out of the interbank funding market has to do with the lack of transparency.  Their disclosures leave them resembling 'black boxes'.

When banks with money to lend cannot assess the risk of banks looking to borrow, the banks with money to lend don't lend.  This is what is happening to the Portuguese banks.

Fixing this problem is simple.  The banks should provide ultra transparency and report on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, banks with money to lend could assess the Portuguese banks and the interbank lending market would reopen.

The property market in Portugal has not been as hard-hit by the crisis as in Spain or Ireland, but the volume of overdue loans held by Portuguese firms has been rising, hitting record highs in June, as credit conditions tightened. 

Bank of Portugal data show construction and real estate companies accounting for nearly 17 percent of all non-performing loans to businesses in the first half of the year. The share of bad loans to businesses in general increased to 8.8 percent of all loans in June from 5.6 percent a year ago. 

Housing loans to private individuals still have a fairly modest 2.2 percent share of overdue loans. 

Trends like these make it even more important that banks provide ultra transparency and structured finance securities provide observable event based reporting.

Portugal caves on hiking workers social security taxes

Portugal highlights just how pervasive the Pension Fund Death Spiral is in the global economy.  In the case of Portugal, the pension fund spiraling down is social security.

The reason that social security is spiraling down is a combination of lack of investment return in an artificially low interest rate environment and money that could be used to support social security is instead being used to support excess debt in the financial system.

Please recall that in the private sector, the lack of earnings on pension fund assets causes the private sector to deprive the real economy of growth by diverting money that could be used by firms for investment in growth into covering the shortfall in pension earnings.

Since the firms aren't investing, they are not hiring.

Without hiring, payments into social security are less than they would be if the economy was growing.

This problem is exacerbated by the simple fact that the Portuguese government is using its limited access to funds to support excess debt in the financial system.  Since the money is being used to support excess debt, it is not available to cover the shortfall in social security taxes.

I know it sounds simplistic, but there really is an easy way out of this problem.  The solution, also known as the Swedish model for handling a bank solvency led financial crisis, is to require the banks to recognize all the losses on the excess debt in the financial system.

As shown by Iceland, making the banks recognize losses today equivalent to what they will recognize if they go through the long process of default, bankruptcy, and foreclosure saves the real economy.  In the case of Iceland, not only is their economy growing, but they were able to expand social benefits.

Please note, with the losses out of the financial system, there is no need for the artificially low interest rates.  This ends the Pension Fund Death Spiral.

As reported by the Guardian,

It's official, Portugal has caved in on its plans to hit workers with a hike in their social security payments. 

As expected (see 8.23am), the Lisbon government has pulled a U-turn on the austerity measures. 

Speaking a little while ago, the prime minister, Pedro Passos Coelho, said new tax measures would be proposed. The original plan to raise employee social security payments from 11% of their salary to 18% is abandoned. 

The decision is a victory for the hundreds of thousands of people who took to the streets nine days ago in massive protests against the plan. 

Passos Coelho warned that Portugal needs to find the money from another source, otherwise its €78bn bailout could be at risk. 

He added that he will continue negotiating with unions and business confederations over news ways to raise the funds, which could include separate income tax rises or changes to "capital tax measures".

This raises the question of why is Portugal taking the bailout.

Its banking system is designed not to need to be bailed out and to be able to function even after absorbing all of the losses on the excess debt in the financial system.

EFSF head says Eurozone crisis over in two years

The Telegraph reports that the head of the European Financial Stability Fund (EFSF), Klaus Regling, said the eurozone crisis could be over in "one to two years" if member states stick to their pledges.

Now there is a big 'if'.

How exactly can member states stick to their pledges given the negative economic feedback loop embedded in the pledges?

For example, Spain is already in a recession/depression.  Cutting government spending per the pledge demand by the EU as part of a bailout would reduce economic activity further.  With a more depressed economy, naturally Spain will generate less tax revenue.  With less tax revenue, how will Spain meet its pledge to balance its budget?

"If all countries in the currency zone strictly fulfil their budgetary consolidation targets and continue to improve their competitiveness then the crisis can be over in one or two years," he told German news weekly Der Spiegel in an interview to be published on Monday. 

Regling, who is German, described his European Financial Stability Facility (EFSF) rescue fund as successful in heading off the worst potential consequences of the crisis, now in its third year. 

"If it weren't for us, Portugal and Ireland would probably no longer be in the eurozone."

Actually, Portugal and Ireland could still be in the eurozone if the EFSF didn't exist.

Rather than receive a bailout that is crushing their economies, they would have followed Iceland and adopted the Swedish model.  Under this model, the banks would have absorbed the losses on the excess debt in the financial system.

Like Iceland, by making the banks absorb the losses their real economy would have been protected.  Like Iceland, they would now have an investment grade rating on their debt and their economies would be growing.

Compare this to the tremendous burden placed on the real economies of Ireland and Portugal by the mountain of excess debt including the bailout.

Which countries position is better - Iceland's, Ireland's or Portugal's?

The EFSF, which was established with a total lending capacity of €440bn (£348bn), is due to be replaced by a permanent bailout fund called the European Stability Mechanism, with €500bn of firepower.

EU official: Portugal may need bailout within one year

Apparently rumors of the end of the Eurozone's financial crisis were premature.  According to a Telegraph article, a well known EU official thinks Portugal may need bailout within one year.

Political leaders should be ready to provide a further bail-out for Portugal within the next year, Europe's economic and financial affairs commissioner Olli Rehn has warned. 

Mr Rehn said Lisbon, which has received a €78bn (£64.5bn) rescue package, is likely to need more public support before it can return to the bond markets next year. "From the European Union side, it would be wise to be prepared. Some kind of bridge needs to be built when Portugal returns to the markets," he said. 

The warning came amid rising fears over the stability of Spain and Italy. Mario Draghi, president of the European Central Bank (ECB), said "sinner states" must execute their austerity reforms to reassure the rattled markets....

"Markets are asking these governments to deliver," he said....

For those who don't remember, the ECB's long term refinancing operation was designed to address the issue of bank funding liquidity.

It was not designed to handle the issue of bank solvency.

It is the solvency problem that has re-emerged as Eurozone governments do not have the ability to access enough capital to both pursue both expansionary economic policies and to recapitalize their banks.

Proponents of austerity would like the scarce funds to go into the banks.

Proponents of expansionary economic policies would like the scarce funds to go into the real economy to, among other uses, create jobs.

[For new readers, your humble blogger supports the use of scarce funds for expansionary economic policies.

By design, banks are there to protect main street from the losses on the excesses in the financial system.  Because of government deposit guarantees and access to central bank liquidity, banks can operate for years with negative book capital.  As a result, banks can absorb these losses and do not need to be recapitalized.]

Although politicians and central bankers have praised Madrid for passing tough austerity measures, global traders are concerned that the targets may be out of the government's reach.... 

The Spanish finance minister, Luis de Guindos, acknowledged that clinging on to market confidence was the most important factor for Madrid. He told Reuters: "The main negative effect, the main risk for the Spanish economy, is the perception that public accounts are not sustainable...

Market confidence is a function of disclosure of all the useful, relevant information in an appropriate, timely manner.

Confidence occurs when market participants use this information to independently assess the risk of and value each security.  Confidence reflects the simple fact that participants trust their own analysis.

Confidence is lost when market participants perceive that they are not getting all of the useful, relevant information.

In Spain's case, this information is directly related to what the true condition of the Spanish banking system is.

If Spain wants to retain market confidence, it will require its banks to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off balance sheet exposure details.  With this data, market participants can assess the true condition of the Spanish banking system.

More importantly, with disclosure of this data, there is no longer a need to prop up zombie borrowers.  As a result, Spanish banks can clear out their troubled exposures while at the same time Spain maintains market confidence.

Meanwhile, the precarious state of Europe's banks last year was laid bare by the European Banking Authority, which said they would have had to have raised €242bn to achieve the capital ratios demanded by the new Basel III rules. 

The regulator said had the incoming rules been in place last June, Europe's top 48 banks would have fallen woefully short of 7pc assets required.

PIMCO chief expects Portugese debt write downs similar to Greece

According to a Telegraph article, PIMCO chief Mohamed El-Erian expects Portugal to need a debt reduction package similar to what Greece received.

What was interesting about this was the discussion of just how far the private sector debt holding had to be written down as a result of not including the public sector debt holdings in the restructuring.

Regular readers know that by adopting the Japanese model for how to handle a bank solvency led financial crisis, policy makers and financial regulators have allowed the private sector to socialize their losses by selling their Portugese bonds to the public sector.

Mohamed El-Erian, PIMCO’s chief executive, said Portugal will need a second rescue as the original package of €78bn (£65bn) falls short, setting off a political storm over EU rescue costs....

German finance minister Wolfgang Schäuble insists that Greece is a “completely unique case” and that there will be no further haircuts for banks, insurers and pension funds holding eurozone sovereign bonds. 

However, the EU authorities broke their pledges so many times during the Greek saga that market faith has been shattered. 

Even Norway’s sovereign wealth fund has expressed disgust, signalling that it will give Club Med debt a wide birth from now on. It has already sold half its Spanish bonds. 

The fund, under Norway’s finance ministry, voted against the Greek debt deal on the grounds that European institutions were exempted from losses and given “special” treatment. “It's very important to create trust in the markets. To create trust you have to stick to the rules,” said director Yngve Slyngstad. 

If they have sold half of their Spanish bond exposure, how much of their Italian bond exposure have they sold?

If the Greek haircut formula is ultimately extended to Portugal, private creditors can expect to lose everything. The EU and the International Monetary Fund already own most of the debt, reducing everybody else to cannon fodder status.