Greece and Fed Balance Sheet Updates
(June 16, 2011)
Dear Subscribers and Readers,
Yesterday, Moody's threatened to downgrade France's three largest banks, citing their exposure to Greek sovereign debt. In a “it would be funny if it wasn't so sad” moment, France defended its banks by pointing out that the exposure of German banks to Greek debt were even higher! Surely, the tension in the Euro Zone over what to do with Greece—and consequently, Ireland, Portugal, and Spain—has risen significantly. Because of Greece's record high yields (its ten-year bond yield is almost at 18%), getting access to the market sometime next year (the original intent of last year's bailout, when Greek ten-year yields were under 10%) is out of the question. The EU is now working on a new plan to fund Greece's fiscal needs over the next three years—which may reach nearly 100 billion Euros. A substantial portion will come from the EFSF and the IMF—meaning that Greek debt will increasingly be monetized by public institutions over the next several years. As of Q1 2011, “only” about 42% of Greece's 300 billion-Euro debt is held by the “official sector,” as shown in the following table courtesy of Goldman Sachs:
Of course, the above numbers do not take into account that the ECB is directly funding the Greek banks' purchases of its own government debt. Should there be any kind of official “haircut” of Greek debt because of default; the balance sheets of Greek banks would be decimated. As of today, the EU plans to fund Greece's 100 billion-Euro needs over the next there years through a combination of funds from the EFSF and the IMF, debt rollovers by Greek banks, and Greek government privatizations (projected to reach 15 billion Euros over the next couple of years). Because of Greece's increasing reliance on EU aid, “official sector” funding of Greek debt would likely reach 60% by the end of 2013, as illustrated by the following figure (again courtesy of Goldman Sachs):
Assuming the IMF's Greek economic projections are met (which in the past have been overly optimistic), Greek debt outstanding would continue to increase over the next two-and-a-half years—easily reaching over 350 billion Euros. If current economic projections are not met, then Greek debt outstanding could easily reach 400 billion Euros. What the EU's three-year plan only does is “kick the can down the road,” so to speak. It is not a long-term solution and the market is quickly losing patience—not just with Greece, but with the financial situation of all “peripheral countries” and banks that are holding their debts.
Let's now shift to a discussion on the size of the Federal Reserve's balance sheet. Despite plentiful evidence of an economic slowdown, the Federal Reserve will no doubt discontinue its “QE2” policy of purchasing an additional net $600 billion of Treasuries as discussed in its November 3, 2010 press release once it expires at the end of this month. A “QE3” policy would do more damage than help, as the rally in commodity prices will reignite—causing further deterioration in the current account and the balance sheets of lower-income U.S. households. From late June to mid-November last year, the size of the Fed's balance sheet (the amount of securities outstanding) remained steady in the $2.04 to $2.07 trillion range. Since the implementation of the Fed's “QE2” easing policy in mid-November, securities outstanding on the Fed's balance sheet has rocketed higher by $533 billion as of June 8, 2011—a record high. As shown on the following charts, the Fed had been purchasing more Treasuries as its agency debt and agency MBS holdings matured over the last 12 months:
Note that any further asset purchases by the Fed will likely do more damage, as U.S. monetary policy is already highly misaligned—i.e. there's no need for further quantitative easing as the U.S. financial system is no longer in “crisis mode.” As mentioned, any further purchases will likely cause further erosion in the US$, resulting in further deterioration in the current account and commodity inflation. Just as important, a “zero interest-rate” policy, combined with quantitative easing, will result in a gross misallocation of capital in the long-run (it not only “short circuits” Joseph Schumpeter's “creative destruction” forces; but also allows the U.S. government to spend even more money that it doesn't have). Make no mistake: The Fed will not implement a “QE3” policy.
Let's now look at the Fed's weekly purchases up to June 8, 2011:
Since mid-November, the Fed has purchased a net $17.5 billion of securities every week. While the amount of agency securities (which includes debt + MBS) outstanding has declined by $164 billion, this has been more than offset by $697 billion in Treasuries purchases over the same period. More important, the size of the Fed's balance sheet has rocketed higher by nearly $533 billion in the last seven months—to a whopping $2.58 trillion. At this point, QE2 will add little to global liquidity, although this may not be a bad thing if commodity prices follow to the downside. Subscribers please stay tuned.
Henry To, CFA, CAIA