The Mediterranean Rim in Turmoil: Observations from Cyprus, Greece, Spain, and Portugal

I spent the last fortnight trying to get a better understanding of what is happening in Greece, Cyprus, Spain and Portugal. I arranged for meetings with central banks, ministries of finance, very top government leaders, unions, political parties in both government and opposition, academics, journalists, the local IMF and EU teams, businesses, aid organizations, and in Greece and Spain also with local governments.

The crisis in its form, its dynamic, and in its details is particular to each country. What struck me was the number of common among the four.

I have tried to summarize two weeks of meetings and observations into these 12 points.

 

1. Unemployment and under-employment: crushing is not a strong enough word. It is one thing to see the numbers, it is another to see the reality on the street.

For youth unemployment, the numbers are acute – 34% and rising quickly in Cyprus, 43% in Portugal, 57% in Spain, 63% in Greece; in comparison, it is 40% for Italy, 31% for Ireland, 26% for France, 21% for the UK, 9% for Austria, 8% for Germany. So in raw data terms, Spain and Greece are running youth unemployment seven to eight times that of Germany, and Cyprus and Portugal at five times.

Importantly, note that the official unemployment statistics only include those who have been looking for a job in the last four weeks, so the reality is surely even more extreme than these numbers.

Across the four countries, the average of youth unemployment is 49%, and the average unemployment rate of the 25-35 age cohort is 39% and still rising. Again the statistics under-count the reality: Among the unemployed in 25-35 age cohort, some 45% have tertiary education degrees (technical college or university)! An example of the labor market imbalance is that while I was in Spain 18,500 people applied for 11 summer jobs at the Prado!

Among the unemployed over 45, there appears to be virtually no hope that most will ever be employed.

This employment situation is simply staggering, and has to be the number one issue.

 

2. A credit shock which is virtually total for small and mid-sized companies and extreme for larger firms.

Can there be recovery without credit? In theory, there could be a recovery driven by investment from abroad (foreign direct investment (FDI) – private equity, international companies establishing local operations or acquiring assets – or official sector investment from, say, the European Bank for Reconstruction and Development (EBRD)), corporate loan guarantees or credit insurance from the EU, and eventually access to capital markets of the strongest local companies at prices which allow them to invest profitably.

With rare exception (e.g. the long-term lease of half of the port of Piraeus by COSCO), and a handful of very expensive bond issues of some international companies (e.g. Greek cement company Titan has managed to issue 5 year paper at 8.5%), there is no flow yet of investment into these countries in any way that could make a difference.

One thing is for sure: there is a vast output gap, such that any new investment would have an immediate multiplier effect.

 

3. Non-Performing Loans (NPLs) continue to surge in all four countries, and the fall in prices of labour, real estate, and company assets continues.

As NPLs climb, the day when the banking system starts to function effectively becomes still more distant. That in turn means that foreign investment becomes still more important. Yet foreign firms on a net basis are still withdrawing capital from all four countries. The banking crisis is in my view far from over.

 

4. Six years into the crisis, official forecasts – IMF, ECB, EU, national governments – continue to under-estimate virtually everything!

They continue to under-estimate the drop in demand, the scale of non-performing loans, unemployment, and government deficits, and to over-estimate government revenues in all forms (taxes, fees, duties, privatizations, etc), foreign inflows (investment, tourism, remittances), credit creation, the pace of recovery of the banking system, as well as the overall trend for the economy – everything on which 'sustainable programmes' are based is inadequate.

I discussed this ad nauseum with everyone, and I still do not understand why this is the case. Surely much of the analysis is 'political', but even in private, the people who are at the center of things, even now, seem to be living in a land of hopes rather than in a world of realities.

 

5. Much discussed privatizations have been to date but a modicum of expectations.

Why? There are multiple reasons – incompetence, unrealistic price expectations, inability to resolve related finance issues (e.g. governments incapable, unwilling, or forbidden by the Troika to provide guarantees for payments in arrears due to assets to be privatized), intractable legal entanglements, unclear regulatory regimes, and meddling from the EU and other countries (e.g. the failed sale of Greek gas co DEPA in which apparently both Germany and the US intervened to block Russian and Chinese bidders).

 

6. Large scale migration among the most dynamic, entrepreneurial, best educated young people, and among the most experienced and best trained people between 25 and 40.

Much of this emigration is benefiting Germanic Europe (Switzerland, Austria, Denmark, Germany...), and an increasing portion is headed to North and South America.

 

7. Social welfare systems are contracting dramatically, and this is the case even for the medical and hospital systems.

The result is everywhere a very real and deep social crisis.

 

8. Coalition governments in each of the four countries have an increasingly precarious hold on power.

None would survive elections. It is not clear, however, if the Opposition is anywhere, including Greece, prepared to govern, nor even that they want elections. So I expect governments to continue stumbling from one crisis to another, as we have seen in recent sessions.

Governments in the four countries have Troika-imposed budget plans, fiscal targets, government debt to GDP targets, revenue targets, and deregulation targets all based on assumptions which frequently make little sense. At the same time there is permanent improvisation.

A case in point is the sudden closing of the national Greek TV network. For 2013, the Athens government has committed to reducing the civil service by a further 6,000 people a quarter. By early June, they had only cut 4,000 for Q2. In negotiations to prepare for late June meetings in Athens with the Troika, when it would be decided to release a new tranche of financing, the Greek government was told that one categorical condition for the release of the funds was meeting the job cut target. Coalition negotiations were stalled.

So at the last moment, the prime minister's office issued a late night decree mandating the closing of the national TV network, which conveniently had just over 2,000 employees, largely members of left wing unions, which had been a thorn in the side of the government. The Troika had their 6,000 public servant scalps. The government had an additional one billion Euros released by Troika, and thought it had killed off an important center of opposition. The imbroglio in turn led to one political party leaving the coalition, so in the end the government is today even more fragile than before the TV network was 'closed.' But the TV network has refused to die; most of the network is today occupied, and operates on a wildcat basis. The courts have mandated that the employees be paid until it can decide on the legality of the closing of the TV network. Not surprisingly, the television programming today is even more in opposition to the government than previously.

 

9. In all four countries a parallel, informal, cash based economy and a parallel barter economy have emerged.

Cyprus is a special case in this regard, where people not only are doing everything possible to keep cash, but also to make their daily maximum withdrawal from the local banks.

In all four countries, most daily transactions are discounted for cash – restaurants, hotel rooms, clothing, food, etc. Cheques are suspect. Letters of credits issued by local banks are virtually nonexistent. Credit cards are accepted with much reluctance. People try to keep as much cash as they can out of the banking system, and to do transactions in cash. Barter markets are common.

Interestingly in all four countries Chinese merchants are active in the barter markets. The Chinese traders import cheap goods – garments, everyday household goods, do-it-yourself tools – and they are everywhere trying to create business. The work on a basis of clans, and so can operate very effectively in these conditions. After all, as one of Chinese traders told me, "We survived in China, so this is easy!"

 

10. Despite how the crisis of the last six years has been handled, everywhere there is still a sense that staying in the Euro makes more sense than anything else.

There are lots of reasons for that, but importantly, the case for Euro exit has not been made in ways that are convincing to people who are crushed by fear and extreme economic crisis. I was surprised about this, as I had anticipated much more hostility to the EU, for what these countries are living today is equivalent to the depression of the 1930s. There is hostility but it is directed toward local governments and toward Germany to some extent. But the frustration has not yet been political organized in any clear way, and so tends to be dispersed in many directions. It may not remain that way.

The initial priorities of the EU, its biggest countries, the ECB, and the IMF were to stop the real prospect in 2009-2012 that the northern European banking system would fail, that the Euro could fail, and being able to selling what was done to domestic voters in Germanic Europe. The immediate consequences for the countries on the Mediterranean Rim was a secondary consideration.

At the same time, forecasts for growth, deficits, debt, unemployment, investment, and hence of stabilization have been systematically and wildly optimistic. The result is that the IMF and others committed to and continue to commit to targets which in reality only made sense with collective "suspension of disbelief." This continues.

 

11. Cyprus is being forced into a contraction which will later be seen to be the equivalent of that of Iceland, if not worse.

There is a very significant probability of a hard default. The IMF is forecasting 18% unemployment as a peak this year. Yet it was already 16.8% at the end of Q1 2013, and has since headed sharply higher. The IMF is forecasting an 8.7% contraction of the Cypriot economy this year, and a return to growth by late 2014. People analyzing things on the ground are looking for a 15-18% contraction this year, and a possible return to growth in 2017. The IMF is forecasting public sector debt-to-GDP at 105% by 2020, which is an impossible number in the context. Think in terms of 150%. None of the IMF numbers, on which the Troika bail-in program is based, make any sense.

The haircut for depositors in the two main Greek banks are now likely to be in the order of 60-80% vs. the 30-40% forecast by the IMF at the time of the deal with the Troika. Government debt is no longer sustainable. The default of local bonds, which appears inevitable, will in turn bankrupt the Cooperative banks, the largest holders of these bonds. The Co-op banks reportedly hold deposits of four out of five families.

So Cyprus is an economic and financial calamity in the making. In effect, the Troika has adopted a scorched earth approach to the financial sector. All that is holding it together now is the Bank of Cyprus, which stamps its chop on virtually any paper as being 'acceptable' collateral. The ECB is keeping the BOC on a very short leash, and in this way continues to drive the process, reinforced by the IMF and the EU.

In these conditions it is impossible to lift the temporary capital controls. Yet the longer the controls stay in place, the greater the incentive to get money out as soon as possible and the higher the likelihood that the country will have to declare default, in one form or another. In the end, this will all come back to the balance sheet of the ECB.

The result is that depositors and bondholders will run instantly for the exit the next time any EU bank gets in to trouble.

Countries from Japan to Canada, and in much of Europe, have added bail-in resolutions to bank regulator legislation in the last few months. None of them should take Cyprus as a case for best practice.

Some are hoping that the blind luck of having recently made discoveries of what appear to be large quantities of natural gas in Cypriot territorial waters may be the piggy bank that saves the country from default. The problem is that the gas will not come on stream, at the earliest until late this decade, and Cyprus so far has refused offers from both Russia and German companies to take over the gas fields. The irony of this crisis would be that the country is forced to give up its best card for the future in order to finance a crisis which was largely imposed on it.

 

12. Where are the green shoots? It may be Greece which will see the upturn first, if only because it has been driven down so far, and the purge has been so brutal.

In Spain there is enormous reluctance to come clean about the banks. Real estate is still falling, NPLs are still increasing, and the small- and medium-size enterprises (SME) sector continues to be torn to shreds. There are zombie banks, zombie consumers, zombie regional governments, zombie companies, zombie co-ops, zombie everything, everywhere. It is hard to see how all of this works, but clearly there are vast efforts below the surface to provide support, to push the realization of losses to later. This is what we saw in Japan, and we know where that leads.

Spain and Portugal are now both generating current account surpluses, not because exports have increased, but because imports have crashed. Remittances are increasing for Greece, Spain and Portugal, as so many people have left to work abroad in the last three years.

Both the Greek government and the IMF are forecasting a primary surplus for 2014. Actually they were forecasting it for 2013, but given the obvious, a few weeks back they slipped it to 2014. Portugal claims it is headed to primary surplus for 2014 as well. Unlikely is my view, given how far they are already behind on their targets.

Portugal has recently adopted a series of laws to attract foreign investment – targeting Russians and the Chinese. In exchange for investing 500,000 euros or more in Portuguese real estate, or two million euros or more in Portuguese government bonds, and in spending but 12 days a year in the country, a foreign investor can acquire residency. After five years, the investor can apply for permanent residency. Spain is in the process of putting in place similar legislation. Over time this could make a big difference, because in effect it is a way for non-EU members to get permanent residency anywhere in the EU: for once a resident in one country, one can travel and reside anywhere in the Schengen area.

Portugal has recently adopted another law, which offers retirees from the private sector from anywhere in the EU a 10-year tax holiday if they settle in Portugal and buy a residence.

So green shoots, yes a few, but the spring is still far off.

My best conclusion for Spain, Portugal and Greece is that the pace of decline is slowing while for Cyprus the decline is just beginning. The very profound social crisis ripping these societies apart is nowhere near being over. Indeed so deep and damaging is the crisis that its consequences will last for decades.