Valuation of Business

1. Capitalized Earning Approach

Capitalization refers to the return on investment that is expected by an investor. The logic is readily understandable to any business person-- it's as simple as evaluating return on investment based on the risk involved. As simple as it is, it provides a good understanding of how a buyer may initially approach valuaing your business.

To demonstrate the capitalization method of valuation, let's look at a mythical and highly oversimplified business. Imagine the business is simply a post office box to which people send money. The magic post office box has been collecting money at the rate of about $10,100 per year steadily for ten years with very little variation. It is likely to continue to collect money at this rate indefinitely. The only expense for this business is $100 per year rent charged by the post office. So the business earns $10,000 per year ($10,100-$100). Because the PO box will continue to collect money indefinitely at the same rate, it retains its full value. The buyer should be able to sell it at any time and get his initial investment back.

A buyer would look at this "minimum risk" business earning $10,000 and compare it to other ways of investing his or her money to earn $10,000 per year. Let's assume a near no risk investment like a savings account or government treasury bills currently pays about 4% a year. At the 4% rate, for someone to earn the same $10,000 per year that the magic PO box earns, an investment of $250,000 (250,000 times 4%= $10,000) would be required. Therefore, the PO box value is in the area of $250,000. It is an equivalent investment in terms of risk and return to the savings account or T-bill.

Now the real world of business has no magic PO boxes and no "no risk" situations. Business owners take risks and have expenses, and business equipment can and usually does depreciate in value. The higher the perceived risk, the higher the capitalization rate (percentage) that the buyer will use to estimate value. Rates of 20% to 25% are common for small business capitalization calculations. That is, buyers will look for a return on their investment of 20% to 25% in buying a small business. However, as we'll see below, some businesses have value to some buyers for reasons that have little to do with the amount of money they are earning.


2. Excess Earning Method



This method is similar to the capitalization method described above. The difference is that it splits off return on assets from other earning (the excess earnings). For example, let's suppose Mr. Owner runs a business that manufactures novelty products. His company has Tangible Assets of $900,000. Further let's suppose that Mr. Owner pays himself a very reasonable market value salary-- the same amount that he would have to pay a competent manager to do his job. After paying the salary Mr. Owner's business has earnings of $360,000.

The financially rational reason for owning business assets is to produce a financial return. Let's say that a reasonable return on Mr. Owner's Tangible Assets is 15% per year. A reasonable number here should be based on industry averages for return on assets adjusted to current economic conditions.

So $135,000 of Mr. Owner's profits are derived from the tangible assets of the business ($900,000 x 15%= $135,000) The remaining $225,000 ($360,000 - $135,000 = $225,000) in earnings are the excess earnings.

This $225,000 excess earning number is typically multiplied by a factor of 2 to 5 based on such considerations as the level of risk involved in the business, the attractiveness of the business and the industry, competitiveness, and growth potential. The higher the factor used, the higher the estimate of the business will be. A typical multiplier number is 3 for a solid, but not spectacular small business that is judged to be average in terms of the level of risk involved, the attractiveness of the business, the industry, competitiveness, and growth potential. The actual factor used is a mix of opinion, comparison to others in the industry, and industry outlook.

Let's suppose that Mr. Owner's business is a bit better than average in these factors and assign a multiplier of 3.6. Therefore, the value of this business can be determined as follows:

A. Fair market value of tangible equipment $900,000
B. Total Earnings $360,000
C. Earnings attributed to Tangible Assets
($900,000 x 15%=$135,000) $135,000

D. Excess Earnings
($360,000 - $135,000=$225,000) $225,000
E. Value of excess earnings
($225,000 x 3.6=$810,000) $810,000


F. Estimated Total Value (A+E) $1,710,000


The capitalization methods work best for medium size businesses that have substantial assets such as recievables, inventory, and/or fixed assets.


3. Cash Flow Method




Buyers often look at a business and evaluate it by determining how much of a loan the cash flow will support. That is, they will look at the profits and add back to profits any expense for depreciation and amortization but also subtract from cash flow an estimated annual amount for equipment replacement. They will also adjust owner's salary to a fair salary or at least an acceptable salary for the new owner.

The adjusted cash flow number is used as a benchmark to measure the firm's ability to service debt. If the adjusted cash flow is, for example, $300,000, and prevailing interest rates for business loans are 8%, and the buyer wants to amortize the loan over 5 years, the maximum this buyer would be willing to pay for the firm would be about $1.2mm. This is the amount that $300,000 per year would support over 5 years.

Therefore, when using this method, the value of a company changes with interest rate conditions. It also changes with the terms a buyer can obtain on a business loan. From a buyer's perspective this may make sense, but from a seller's perspective it introduces a sort of arbitrariness into the process.



4. Tangible Assets
(Balance Sheet) Method


In some instances, a business is worth no more than the value of its tangible assets. This would be the case for some (not all) businesses that are losing money or paying the owner(s) less in total than a fair market compensation. Selling such a business is often a matter of getting the best possible price for the equipment, inventory, and other assets of the business. It is generally best to approach other firms in the same business that would have direct use for such assets. Also, a company in the same business might be interested in taking over your facility. This would mean your leasehold improvements (modifications to space, etc.) would have value and the equipment would have value as "in place" plant and equipment. In place value is higher than the value on a piece by piece basis such as at a sale by auction.


5. Cost To Create Approach
(Leap Frog Start-Up)


Sometimes companies or individuals will purchase a company just to avoid the difficulties of starting from scratch. The buyer will calculate his or her start up needs in terms of dollars and time. Next he or she will look at your business and analyze what it has and what it may be missing relative to the buyer's start up plan. The buyer will calculate value based on his or her projected costs to organize personnel, obtain leases, obtain fixed assets, and cost to develop intangibles such as licenses, copyrights, contracts, etc.).
A reasonable premium of above the sum of projected start up costs may be offered because of the effort and time being saved by the buyer. The more difficult, expensive, and/or time consuming startup is likely to be, the higher the value would be based upon this method.



6. Rule of Thumb Methods


One of the most common approaches to small business valuation is the use of industry rules of thumb. While most financial analysts cringe at the use of these approaches, they do have their place, which we believe to be as adjuncts to other methods.
One industry rule of thumb says a payroll service customer is worth 1.5 to 2 times its annual service fees. Another says that small weekly newspapers are worth 100% of one year's gross income.

The problem with these and all rule of thumb formulas is that they are statistically derived from the sale of many businesses of each type. That is, an organization might compile statistics on perhaps 100 small weekly newspapers that were sold over a two year period. They will then average all the selling prices and calculate that the average paper sold for 100% of one year's gross income. The rule of thumb is thus created. However, some newspapers may have sold for twice one year's gross while other may have sold for half of one year's gross.

The rule of thumb averages may be accurate for those businesses whose performances are right about at the average. The business with expenses and profits that are right on target with industry averages may well sell for a price in line with the rule of thumb formula. Others will vary. To apply the rule of thumb to a business that varies significantly from the average is not appropriate.



7. EBITDA Method


Some buyers value a company by simply multiplying the Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA ) by a factor, typically in the 3 to 6 range. This straightforward approach tends to be used for companies with sales over $5,000,000 that have a management infrastructure in place

The advantages are:

It avoids the issue of depreciation and amortization, since most companies use a depreciation and amortization schedule that is intended to take best advantage of the prevailing tax laws.

It avoids the issue of taxes, which usually vary according to the ownership structure

It is uncomplicated, and most useful for companies that are well established and earnings are consistent and predictable going forward

It lends itself to comparisons with similar sales

It is most suitable for companies larger than $5MM in revenue, especially companies where variations in tangible assets do not significantly effect the value of the company

The disadvantages are:

It makes no distinction between companies that have a large working capital requirements (current assets, less current liabilities), versus small working capital requirements

It makes no distinction between companies that have large fixed asset needs, vs small fixed assets

It makes no provision for companies that have very substantial real depreciation (e.g. trucking companies, where the trucks rapidly decrease in value) as opposed to companies where actual decrease in asset value is less than the IRS depreciation allowance. In some cases EBIT is used instead of EBITDA when there are large, recurring depreciation expenses.

Even when the EBITDA method is appropriate for valuation, certain adjustments and allowances need to be made before the simple formula can be applied. And of course, the actual multiplier used (whether 3 or 4 or 5 or some other number) is likely to be vigorously negotiated between buyer and seller.

If you would like to know if the EBITDA method may be appropriate for your company, please contact us.



8. Valuation based on Synergies


In some instances, a buyer will pay a somewhat higher price than any of the above methods would justify.

This could be the case when a buyer sees clear and immediate synergies: if the buyer can make 2 + 2= 5. A strategic buyer may pay a premium if for example, he can gain immediate and sizable economies of scale, gain a new distribution channel for his existing products, or a new product that can take immediate advantage of his existing distribution channels. A buyer may consider this method of valuation when a very high proportion of the seller's gross revenue will, after the acquisition, fall to the buyer's bottom line.

A few examples where we have been able to sell companies based on synergies include:

Example 1:

We have sold several payroll service companies. Payroll service companies (such as Paychex or ADP) often acquire smaller companies in their industry. When they do so, they are more concerned with top line income than bottom line profit. More accurately, they are concerned with what the bottom line income would be if they were to transfer the selling company's customer base to their own system where they have excess capacity. They can add incremental payrolls without a corresponding increase in expenses. A payroll service company that has gross receipt of say, $500,000 and is breaking even, could represent a profit of several hundred thousand dollars to an acquirer already in the business that can process more efficiently and can eliminate much of the smaller firms overhead.

To the buying payroll service company, a more important calculation than the selling company's earnings is a comparison between the cost of gaining customers through acquisition vs. the cost of gaining equivalent customers by traditional methods like hiring salesmen, advertising, etc. Because payroll service firms can accurately estimate their processing expenses based on gross revenues, these companies tend to sell for a multiple of their annual gross sales with only minor regard for their profit or loss.

Example 2:

Some time ago, an outdoor furniture company approached us looking to acquire a complimentary company. They had great distribution of their porch and patio furniture and specifically wanted to acquire a company that made or imported a product that could be sold through the channels they had built. We were able to find an importer of wicker planters that matched its distribution channel perfectly. They agreed to pay a premium based on the synergies they knew they could achieve.

Example 3:

A few years ago we represented a mail order seller of knitting supplies for sale. We found a buyer, a large mail order company of quilting supplies, and showed them how they would gain economies of scale, synergies, and customers that could be cross-sold (knitting customers would buy quilting supplies and vice-versa). They buyer paid a premium justified by the excellent synergies.

Warning

There are companies that overplay this synergy concept by claiming to be in touch with buyers who will pay far more for your business than any valuation method would justify. They may be foreign buyers who are anxious to get a foothold in the US or other synergistic buyers who will pay for hidden assets. Their arguments are quite seductive; who doesn't want to sell their business for twice its value?

However, the rest of the sales pitch is that you need to pay them a large amount of money upfront,typically $50,000, or the names of these overly generous buyers won't be revealed. They make their money primarily based on the upfront fees. After you pay the upfront fee, you'll get a very nice write-up of your company with fancy charts and printed on the finest cloth weave paper, but you won't get a buyer to overpay for your company.

When buyers buy based on synergies, they typically pay a reasonable premium over the financial methods described previously, or based on some logical method that reflects the buying companies likely earnings (such as with payroll service companies, above). For example, instead of using a multiple of 3.5 times EBITDA, they may use 5.5 times EBITDA. Now the difference between a multiple of 3.5 vs. 5.5 is significant to be sure, but it is not the double or triple valuation that you were promised, before you paid the hefty upfront fee.


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THE ORIGIN OF MEXICO'S 1994 FINANCIAL CRISIS

Author : Francisco Gil-Diaz

Francisco Gil-Diaz is General Director of Avantel, S.A., and former Vice Governor of the Bank of Mexico.

After nearly a decade of stagnant economic activity and high inflation in Mexico, the Mexican government liberalized the trade sector in 1985, adopted an economic stabilization plan at the end of 1987, and gradually introduced market-oriented institutions. Those reforms led to the resumption of economic growth, which averaged 3.1 percent per year between 1989 and 1994. In 1993 inflation was brought down to single-digit levels for the first time in more than two decades. As its economic reforms advanced, Mexico began to attract more foreign investment, a development helped by the absence of major restrictions on capital inflows, especially in the context of low U.S. interest rates. Indeed, large capital inflows began in 1990, when a successful foreign- debt renegotiation was formalized. The devaluation of the peso in December 1994 put an abrupt end to these capital inflows and precipitated the financial crisis.

Regulatory Failures, Credit Growth, and the Onset of the Crisis

The financial sector also underwent a substantial liberalization, which, when combined with other factors, encouraged an increase in the supply of credit of such magnitude and speed that it overwhelmed weak supervisors, the scant capital of some banks, and even borrowers.[1]

Several factors contributed to facilitate the abundance of credit:
(1) improved economic expectations;
(2) a substantial reduction in the public debt;[2]
(3) a phenomenal international availability of securitized debt (see Hale 1995);
(4) a boom in real estate and in the stock market; and
(5) a strong private-investment response.

Poor borrower screening, credit-volume excesses, and the slowdown of economic growth in 1993 turned the debt of many into an excessive burden. Nonperforming loans started to increase rapidly. A process of adjustment of the balance-sheet position of the private sector, underway by the second half of 1993, and the late adoption by some commercial banks of prudent policies were signs that nonperforming loans had exceeded reasonable dimensions before 1994.[3]

The substantive causes of the debt increase were:[4]

1. The financial sector was liberalized: lending and borrowing rates were freed, the forced channeling of credit was abolished, and bank reserve requirements were eliminated.

2. Banks were hastily privatized, in some instances with no due respect to ``fit and proper'' criteria, either in the selection of new shareholders or top officers (see Honohan 1997: 13, and Ort z 1997). It must be noted, however, that on average the banks remained in government hands for half of the expansionary period.

3. Several banks were purchased without their owners proceeding to their proper capitalization. Shareholders often leveraged their stock acquisitions, sometimes with loans provided by the very banks bought out or from other reciprocally collaborating institutions.

4. The expropriation of the commercial banks in 1982 contributed to their loss of a substantial amount of human capital during the years in which they were under the government. With these officials institutional memory migrated as well.

5. Moral hazard was increased by the unlimited backing of bank liabilities.

6. There were no capitalization rules based on market risk. This encouraged asset-liability mismatches that in turn led to a highly liquid liability structure.

7. Banking supervision capacity was weak to begin with, and it became overwhelmed by the great increase in the portfolios of banks. Part of this weakness originated in the political stature of government-appointed CEOs when banks were still government owned.

8. There was a substantial expansion of credit from the development banks.

9. From December 1990 on, foreigners were allowed to purchase "domestic" (short-term) government debt. Since domestic public debt decreased during this period, the purchases of Cetes by foreigners enhanced the purchasing power of their domestic sellers.

10. Short-term, dollar-indexed, peso-denominated Mexican government securities, Tesobonos, were issued at the end of 1991, although not in large amounts except during certain periods.

These experiences are not unique to Mexico. As Lindgren et al. (1996: 100) point out, ``Formerly regulated banks may lack the necessary credit evaluation skills to use newly available resources effectively.''[5] And they concluded: ``Unless properly overseen, liberalization can result in too rapid growth of bank assets, over-indebtedness and price-asset bubbles'' (p. 107).

The factors listed above combined with a greatly improved perception of the country's short- and long-term prospects to generate the conditions that would result in the Mexican crash.[6] This combination of forces constitutes another example[7] of how financial liberalization[8] can go astray, despite important economic achievements. Thin or no capitalization of some banks was a key ingredient that combined with the other elements to induce imprudent credit growth.[9] But, as Lindgren et al. (1996: 77-8) show, fast credit growth and its aftermath is not an exclusive feature of Mexico's crisis: ``Kaminsky and Reinhart (1996) reviewed the experiences of 20 countries that experienced banking and balance-of-payments crises and found that in about half, the banking crisis preceded the balance-of-payments crisis. The causal pattern reversed in only a few instances. Thus, there is support for the notion that bank soundness exerts negative effects on the external balance and the exchange rate.'' Also, ``All the sampled countries except Venezuela experienced a sharp expansion of credit to the private sector prior to the crisis'' (Lindgren et al. 1996: 84). The experiences of the Czech Republic, Malaysia, Thailand, South Korea, and others in 1997 should be added to the list above, as well as the similar episodes of Sweden and other developed countries in 1992.

The Macroeconomic Feedback of the Credit Expansion

Mexico's credit expansion churned out impressive numbers. From December 1988 to November 1994, credit from local commercial banks to the private sector rose in real terms by 277 percent, or 25 percent per year.[10]

Some items provide a better understanding of the underlying trends: credit card liabilities rose at a rate of 31 percent per year, direct credit for consumer durables rose at a yearly rate of 67 percent, and mortgage loans at an annual rate of 47 percent, all in real terms.

External credit flows to the private sector went from -$193 million in 1988 to $23.2 billion in 1993. The figure fell to $8.9 billion in 1994, but that decrease was more than compensated by the fall in the international reserves of the Banco de M‚xico, which decreased by $18.9 billion.[11] Therefore, the total use of external resources in 1994 was $27.8 billion. The total external financial flows to the private sector were also substantial: $97 billion over the 1989-94 period.

Those rates of growth are portentous. As Honohan (1996: 1A) warns, ``There are general indicators which apply whether or not there is a macroeconomic boom and bust cycle.'' He lists, among others, the following tell-tale signs: ``One measuring balance sheet change, namely the growth in aggregate lending (in real terms). This is the classic indicator of individual bank failure and may also serve for systems.'' And, ``two drawn from the structure of the balance sheet, namely the loan-deposit-ratio and reliance on foreign borrowing.''

The unseemly attraction of foreign resources, the liquidation of large amounts of government debt, and moral hazard nurtured an increase in private aggregate demand that contributed to the rapidly rising current-account deficit. Furthermore, the deficit was financed in large proportion by short-term capital. The growing external deficit was combined with the commitment, a pledge consecrated in the so-called Pacts, to contain the exchange rate within a widening but relatively tight band.

For most of the period, the exchange rate stuck to the most appreciated level within the band, as domestic interest rates attracted short-term capital, banks and private firms borrowed abroad, and foreign money flowed into the stock market. The central bank accommodated the demand for currency and in that endeavor partially sterilized inflows or outflows of foreign exchange, allowing international reserves to increase or decrease as required. Because of the excess supply of dollars, the amount of reserves persistently increased, up to the uncertain period prior to the vote of the U.S. Congress on NAFTA, when reserves temporarily fell. The increase in reserves resumed after NAFTA was approved and continued to increase until the start of the political wobbles of 1994.

The deficit in the balance of trade rose 5.83 percentage points as a proportion of GDP over the period, explainable up to 81 percent (4.74%/5.83%) by the rise in private investment. But a substantial portion of the increase in private investment went into unprofitable ventures, thus contributing to the unsustainability of the current-account deficit. Some of those undertakings were highly leveraged tollroads, or unrecoverable home mortgages, or credit unions that invested with low or negative returns financed through the development banks. Some of the credit, in turn, went to finance nonexistent enterprises or the hugely levered acquisition of bank shares, or went to non-collateralized loans.

Thus, a classic overindulgence in credit, a frenzy of spending, a substantial short-term debt,[12] and the sitting-duck features of a fixed exchange rate combined to set the stage for the 1995 economic crisis. The emphasis should be placed on the potential destabilizing effects of short-term debt, since foreign direct investment, portfolio investment, foreign-currency securities issued by commercial banks and their credits, and foreign deposits at commercial banks exhibited remarkable stability, even after the onset of the crisis (Trigueros 1997: 3-4). This piece of information is useful to pinpoint the vulnerabilities associated with a fixed exchange rate, especially when it does not coexist with the automatic stabilizers of a currency board.

Even though the virtually fixed exchange rate exhibited its virtues by steadily stabilizing prices, in hindsight one can conclude that it also became increasingly untenable within the environment created: an ever greater fragility of the economy to a speculative attack.

Sharply higher real interest rates in the United States in the second quarter of 1994,[13] a considerable but still orderly depreciation of the peso prior to the December 1994 debacle, and the aftermath of the assassination of a presidential candidate and other unfortunate political events poured gasoline onto already burning coal.

Just as many European currencies collapsed in 1992 after unrelenting speculative attacks on their narrow exchange bands, the political events of 1994 triggered what for one economist was a death foretold but a surprise nonetheless: a drain in international reserves until the exchange-rate limits had to be abandoned in December 1994 (see Calvo 1995).

The devaluation prompted several damaging effects as inflation and interest rates skyrocketed, economic activity collapsed, the burden of servicing debts denominated in domestic and foreign currency increased, and banks' capitalization ratios fell.

The crisis had little or nothing to do with a low savings rate, but a lot to do with credit expansion, as McKinnon and Pill (1995), Calvo and Mendoza (1995), Hale (1995), and Trigueros (1997) have pointed out. It was also unrelated to an overvaluation of the exchange rate as Gil-D z and Carstens (1997) painstakingly document. Trigueros (1997) provides some additional clarification on this issue: ``Most of the increase in the share of non-tradable productive activities on GDP is explained by the growth of the financial services industry.''

A Financial Interpretation of the Crisis

Are the European financial crises of 1992, the Mexican crisis of 1994-95, and the recent Asian currency crises of 1997-98 the result of unsustainable policies given unexpected shocks, or a reflection of multiple equilibria not closely related to measured fundamentals? (See Bordo and Schwartz 1996.)

The classic position, which relates crises to misaligned fundamentals, can be traced back to Harry Johnson (1972), where an excess credit expansion is translated into a loss of international reserves. A balance-of-payments crisis is the outcome of the depletion of international reserves. This position can also be found in Sargent and Wallace (1981), who provide a closed-economy model in which a persistent deficit and real interest rates above the rate of economic growth eventually lead to debt saturation. At that point, private agents refuse to continue purchasing debt, the deficit is monetized, and inflation ensues--not very different from the open-economy model. Finally, Krugman (1979), in a model reminiscent of Mundell (1968), follows on this tradition in a futile attempt to time the speculative attack that will force an abandonment of the exchange rate and thereby propitiate a rise in inflation.

In all those classic approaches, an excessive expansion of credit leads the public, national and foreign, into a refusal to continue purchasing debt, and in all of them a day of reckoning is finally forced upon the government and society.

Michael D. Bordo and Anna J. Schwartz (1996) scroll the experiences of currency crises dating from the 18th century to Mexico's recent episode and find reassuring evidence to support the classical contention: currency crises stem from fundamental causes or impending wars. They conclude: ``The theory of self-fulfilling speculative attack may have intellectual merit but contributes nothing to our understanding of real-world events. In every crisis examined here, the fundamentals are more than adequate to account for the actions of speculators'' (pp. 47-48). Honohan (1997: 2-3) reaches a similar conclusion.

This brings us back to the Mexican crisis. What were its fundamental causes? All the factors listed above made some contribution, but those with the greatest significance were the combination of the exchange-rate regime with a rapid expansion of credit (Bordo and Schwartz 1996), a substantial part of which was of poor quality.[14] The surge of bad credits is in turn explained by flimsy bank capitalization and the failure to ensure that some bankers met the ``fit and proper'' criteria to own or manage the institutions.

It would be incorrect to isolate a factor, despite the key role it played, like the proportion of short-term government debt held by foreigners whose holdings have been shown to be particularly volatile (see Calvo 1996). Such volatility is probably derived from the ease with which, under a fixed or quasi-fixed exchange rate, peso demand fluctuations have to be and are expected to be readily accommodated.[15] Volatility and risk stem in part from the exchange-rate regime. A floating rate presents speculators with currency uncertainty compounded by other risks, notably market-value risks.

The lower risk speculators confront under a fixed exchange rate is borne by the government (i.e., by society at large). The insurance premium paid by society to cover exchange-rate risks is proportional to the size of the international reserves needed to reassure investors that potential claims will be satisfied. Mexico's reserves were insufficient even before December 1994 because of the size of the country's financial sector. Some authors puzzled by the depth and virulence of the Mexican financial crisis have tried to explain it, at least partly, by pointing out the financial vulnerabilities of the country (see Calvo 1996: 208).

That line of reasoning is insightful, but it does not go far enough.[16] All domestic and foreign liabilities, peso and foreign currency denominated, have to be honored if there is a run on a country committed to a fixed exchange rate. One must also take into account that about 70 percent of all bank liabilities were payable overnight and that the rest were very short term.

But this situation of extreme liquidity was not new to Mexico nor to most other countries. What was new was the coexistence of a formidable growth in the volume and speed of international capital movements with the persistence, in some countries, of a fixed exchange rate (see Hale 1995). In this regard Mexico's currency collapse was not much different from that of several European countries in 1992 or the recent Asian crises.

Another often-invoked contributor to the Mexican crisis is the expansion of central bank credit in 1994. This vision ignores the fact that fractional reserve banking requires a lender of last resort, even under a currency board. Banks cannot liquidate loans when there is a run. Because of this simple but inescapable fact, all the lines that have been written about the so-called excessive expansion of the central bank's internal credit during 1994 are nonsensical. The logic of a fixed exchange rate is implacable. When there is a run, banks are all of a sudden left with more loans than deposits. Hence, when the central bank lends to commercial banks to balance their positions, it is simply fulfilling its unavoidable obligation as lender of last resort. This task is either performed by foreign creditors, which is unlikely when there is a run, or by the central bank. Under these circumstances, even a currency board needs a lender of last resort, as attested by the (appropriate) 1995 reaction by Argentinean authorities to stem the run they were facing.

To sum up: the correct sequence of events, which has been amply described and documented elsewhere (Mancera 1997, and Gil-D z and Carstens 1997), was initiated by a fall in the demand for peso assets equivalent to a loss in international reserves equal to the loss in bank deposits. This fall in demand was followed by an almost simultaneous credit increase from the central bank.

Conclusion

The original sin that led to the Mexican crisis is to be found in the expropriation of commercial banks that weakened them and rendered them a fragile conduit for privatization and credit expansion.

In addition, the following factors reveal the true measure of Mexico's financial vulnerability at the end of 1994:
(1) A semifixed exchange rate;
(2) a sizable current-account deficit resulting to a large extent from a huge credit expansion, not from the overvaluation of the exchange rate, as often claimed;
(3) a substantial rise in U.S. interest rates; and
(4) a trigger, consisting of the political tensions accumulated during 1994, a fact seldom incorporated by most analysts.

In hindsight, I now believe we have a clear idea of the origins of Mexico's financial crisis. Its symptoms and causes, as those of other countries, provide us with valuable lessons, the most important of which is perhaps the need to observe the behavior of credit aggregates, to follow the path of real estate prices, and to achieve transparency in the disclosure of financial information. Although many of these symptoms are by now almost self evident, and although the relevant information was available at the time to the international financial community, the consensus was that Mexico was doing everything right.

References
Bordo, M.D., and Schwartz, A.J. (1996) ``Why Clashes between Internal and External Stability Goals End in Currency Crises, 1797-1994.'' Cambridge, Mass.: National Bureau of Economic Research.

Calvo, G.A. (1996) ``Capital Flows and Macroeconomic Management: Tequila Lessons.'' International Journal of Finance and Economics 1(3): 207-23.

Calvo, G.A.; Leiderman, L.; and Reinhart C.M. (1993) ``Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors.'' Staff Papers 40. Washington, D.C.: International Monetary Fund.

Calvo, G.A., and Mendoza, E.G. (1995) ``Reflections on Mexico's Balance of Payments Crisis. A Chronicle of a Death Foretold.'' Preliminary manuscript. College Park and Washington, D.C.: University of Maryland and Federal Reserve System.

Gavin, M., and Hausman R. (1995) ``The Roots of Banking Crises: The Macroeconomic Context.'' Paper presented at the Conference on Banking Crises in Latin America. Washington, D.C.

Gil-D z, F., and Carstens, A. (1997) ``Pride and Prejudice: The Economics Profession and Mexico's Financial Crisis, 1994-95.'' Mexico City: Banco de M‚xico.

Hale, D. (1995) Lessons from the Mexican Peso Crisis of 1995 for International Economic Policy. Preliminary manuscript. Vienna: Oesterreichische Nationalbank.

Honohan, P. (1996) ``Financial System Failures in Developing and Transition Countries: Diagnosis and Prediction.'' Paper prepared for the International Monetary Fund/Bank for International Settlements/Basle Committee Conference on ``Strengthening the Financial Systems in Developing Countries.''

Honohan, P. (1997) ``Banking System Failures in Developing and Transition Countries: Diagnosis and Prediction.'' Basle: Bank for International Settlements.

Johnson, H.G. (1972) ``The Monetary Approach to the Balance of Payments.'' Journal of Financial and Quantitative Analysis 7: 1555-72.

Kaminsky, G.L., and Reinhart, C.M. (1996) ``The Twin Crises: The Causes of Banking and Balance-of-Payments Problems.'' International Finance Discussion Papers No. 544. Washington, D.C.: Board of Governors of the Federal Reserve System.

Krugman, P.R. (1979) ``A Model of Balance of Payments Crisis.'' Journal of Money, Credit and Banking 11 (August): 311-24.

Lindgren, C.J.; Garc a, G.; and Saal, M.I. (1996) Bank Soundness and Macroeconomic Policy. Washington, D.C.: International Monetary Fund.

Mancera, M. (1997) ``Problems of Bank Soundness: Mexico's Recent Experience.'' Banking Soundness and Monetary Policy: Issues and Experiences in the Global Economy. Papers presented at the 7th Seminar on Central Banking, Washington, D.C., 27-31 January. IMF and Monetary and Exchange Affairs Department.

McKinnon, R.I., and Pill, H. (1995) ``Credible Liberalizations & International Capital Flows: The Overborrowing Syndrome.'' Unpublished manuscript. Palo Alto, Calif.: Stanford University.

Mundell, R.A. (1968) International Economics. New York: Macmillan.

Ort z, G. (1997) As reported in the Mexican newspaper El Economista, 22 September: 11.

Sargent, T.J., and Wallace, N. (1981) ``Some Unpleasant Monetarist Arithmetic.'' Federal Reserve Bank of Minneapolis Quarterly Review (Fall): 1-17.

Trigueros, I. (1997) ``Capital Inflows and Investment Performance: Mexico.'' Mexico City: Centro de An lisis e Investigaci¢n Econ¢mica-Instituto Tecnol¢ico Aut¢mo de M‚xico.

Velasco, A. (1987) ``Financial Crises and Balance of Payments Crises.'' Journal of Development Economics 27: 263-83.

Werner, A. (1997) ``Un Estudio Estad stico sobre el Comportamiento de la Cotizaci¢n del Peso Mexicano frente al D¢lar y de su Volatilidad.'' Documento de Investigaci¢n 9701. Mexico City: Banco de M‚xico.

[1] Lindgren et al. (1996: 18) show there is abundant evidence of similar phenomena: ``Excessive credit growth relative to GDP and rapid rises in asset prices have been associated with a weakening of the quality of bank portfolios and an increase in risk exposure.'' Furthermore, they add that ``Banks that have lost most of their capital face a different incentive structure from sound banks, and competition from insolvent banks can pose threats to the financial soundness of their competitors. As owners and managers try to recoup their losses, moral hazard increases, particularly when managers or owners do not have their own funds at stake. An unsound bank may offer higher interest rates than competitors to draw in deposits to pay operating expenses, may resort to outright gambling by choosing high-risk transactions, or may incur higher risk through adverse selection. In many cases unsound banks become captive to insolvent debtors or carry a portfolio of loans to related borrowers, who have no intention of repaying their debts. Unable to declare loans in default lest they acknowledge their own insolvency, such banks may continue to lend to unperforming borrowers or to capitalize interest on those borrowers' loans'' (pp. 57-58).

[2] As Trigueros (1997: 9) shows, ``Domestic public debt went from 19.5 percent of GDP at the end of 1989 to just 5.4 percent of GDP at the end of 1994.|.|.|. This latter aspect played an important role in the expansion of bank credit during the period 1989-94.''

[3] As Miguel Mancera (1997) has observed, ``Wide insufficiency of capital was becoming perceptible, a phenomenon explained by the relatively high level of past due loans that had not been adequately provisioned. Moreover, some commercial banks were operating with serious problems which were not readily noticeable to the financial authorities. In some instances, bank administrators acted with disregard to existing regulations and proper banking standards.''

[4] 4Other factors are: (1) To calculate nonperforming loans, banks applied a ``due payments criteria''--the amount of payments due after 90 days were recorded as delinquent loans, instead of the value of the loans themselves. (2) Taxes on international capital flows (dividends, interest, etc.) were drastically reduced or eliminated. (3) Some commercial banks were able to have access to disproportionate amounts of money-market funds because of their confidence that, on any particular day, they could rely on an unlimited supply of daylight overdraft facilities at the central bank. (4) The banking sector did not have a consumer-loan credit bureau, nor did it actively utilize the bureau available on business loans. (5) There was a deep structural transformation in the economy that radically altered many relative prices, which canceled opportunities in traditional sectors, turned good projects into bad ones, and altered the relative ability to service the debt of many sectors and enterprises.

[5] Also see Honohan (1996): ``Often hailed as the panacea for banking weaknesses of one sort or another, privatization has all too often been the regime change which incubated more serious problems. This has been the case both in transition economies and in developing countries that had operated with state-owned banks. The problem has generally lain in the lack of suitability or experience of the new owners, in the inadequate capitalization of the privatized banks or both.''

[6] Lindgren et al. (1996: 12) describe well what went on in Mexico from 1994 to 1996: ``After many years of nationalized banking [from 1982 to mid-1992], commercial banks lacked the experience and organizational and information systems to adequately assess credit and other market risks and to monitor and collect loans. Accounting practices did not follow international standards. Concentration of loans and loans to related parties was a problem in those banks that were subsequently subject to intervention.'' They also find that ``banks that are, or were recently, state-owned were a factor in most of the instances of unsoundness in the sample'' (p. 107), and ``it becomes more difficult to distinguish good from bad borrowers when bank loans are growing rapidly'' (p. 110).

[7] Chile's 1982-83 crisis has many parallels with Mexico's. See, for instance, Gil-D z (1995) and Velasco (1987).

[8] Mancera (1997) discusses the causes of the increase in private debt and provides a full presentation of the diverse financial salvage operations performed in the aftermath of the crisis to protect depositors, to provide relief to low-income debtors, and to encourage shareholders to capitalize commercial banks.

[9] According to Honohan (1996: 13), ``Unusual asset price movements, rapid growth of lending, especially for property transactions and for financing of stock market positions, [and] capital inflows.|.|.|.are some of the tell-tale signals of a credit financed asset-price boom which may prove to be unsustainable.''

[10] All the figures quoted in this section were provided directly by the Economic Research Department of Banco de M‚xico.

[11] Gil-D z and Carstens (1997) provide a detailed explanation of why these losses were deemed recuperable at the time.

[12] Trigueros (1997: 5) concludes, ``From the beginning of 1990 to the third quarter of 1994 accumulated short-term inflows amounted to at least $40 billion while, over that same period, the increase in international reserves was close to $10 billion.''

[13] The demand for peso assets is highly sensitive to changes in the price of the 30-year U.S. Treasury bond (see Calvo et al. 1993: 108-51).

[14] A further discussion of the effect rapid growth in bank lending has on bank failure can be found in Gavin and Hausman (1995) and Honohan (1997: 3-6).

[15] Evidence of how different institutional arrangements condition market behavior can be found in the comparison of the 1988-89 adjustment period with the 1995-96 period. Alejandro Werner (1997) found that the volatility of interest rates and the average value of the real interest rate were much lower in the latter period. Both intervals have several similarities, the most important one being that both were phases of adjustment to a crisis, but also a major difference: in the 1995-96 adjustment program a flexible exchange rate was adopted versus a predetermined rate in the 1988-89 program.

[16] One could even counterargue that the lowest convertibility risk comes from holding the local currency (M0 or M1) which is totally liquid and, conversely, that the highest convertibility risk comes from those bank and government obligations not included in M2.


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Greece debt crisis FAQ

Why is Greece still in crisis, wasn't there a bailout?

After months of uncertainty, the EU and IMF had finally offered a €45bn rescue package (€30bn from Europe and €15bn from the IMF), which might have seen Greece through its short-term borrowing needs. But political opposition in Germany led investors to lose confidence and drove up Greek borrowing costs to the point where a far bigger rescue package now looks necessary.


What happens if a bigger bailout can't be agreed?

With short-term borrowing rates hitting 38% on Wednesday, investors fear Greece will have no choice but to default on some of its existing debt obligations, or at the very least negotiate a partial debt restructuring. In short, refuse to pay. The latest crisis was sparked on Tuesday when credit rating agency Standard & Poors downgraded Greek sovereign bonds to junk status.


Why is this so bad? Don't the bankers deserve it?

It is bad for Greece because it will make it almost impossible to borrow its way out of trouble in future, making it difficult to pay all its public sector employees and deepening its recession. It is bad for everyone because most fund managers invest in these bonds on behalf of international pensioners and savers. Though Goldman Sachs has been criticised for helping Greece hide its problems and hedge funds are blamed for exacerbating the market reaction, the banking industry is far less culpable in this crisis than it was last year.


Will Greece leave the euro?

If its domestic economic crisis gets bad enough, Athens may decide a currency devaluation is the only way to restore international competitiveness. It is hard to imagine it would restore the drachma with so many corporate and household debts still denominated in euros.


How might the contagion spread?

Rating agencies have downgraded government debt issued by Spain and Portugal, suggesting greater fears of default and higher borrowing costs across much of southern Europe. The cost of insuring against default in Poland and Ireland has also jumped as the so-called "sovereign" credit market suffers a widespread loss of confidence. Confidence could quickly return if European governments agree a more convincing rescue plan when they meet on 10 May.


Could the UK be next?

A wider collapse in investor confidence could make it more expensive for the UK to continue its heavy borrowing programme too. Lying outside the single currency means this would probably express itself first in a sharp fall in sterling rather than an outright "gilts strike" (when investors refuse to buy UK government bonds). Interest rates would also have to rise, potentially pushing the economy back into recession.

Debt crisis: UK banks sitting on £100bn exposure to Greece, Spain and Portugal

Debt crisis: UK banks sitting on £100bn exposure to Greece, Spain and PortugalShares in UK lenders slide amid fears of renewed credit crunch but French, German and Swiss most at risk from Greek default

Fears of a fresh banking crisis stalked the markets today as the risk of Greece defaulting on its debt repayments raised concerns about the exposure of major banks to indebted countries in Europe.

As analysts estimated that Britain's banks have a combined exposure of £100bn to Greece, Portugal and Spain – the three countries causing most concern on the financial markets – the Financial Services Authority was closely watching the markets and assessing exposures to the vulnerable countries.

After the ratings agency Standard & Poor's had downgraded Greek debt to "junk" yesterday, bank shares were knocked today but spared further falls as the downgrade of Spain's crucial credit rating came just as the stock market was closing. With UK banks standing to lose more in Spain than in Greece and Portugal, analysts said there might have been a more severe reaction if London had remained open longer today.

Analysts at Credit Suisse calculated that UK banks had £25bn of exposure to Greece and Portugal but £75bn to Spain, where the collapse in the property market has already forced banks such as Barclays to admit to bad debt problems and left Royal Bank of Scotland facing questions about its exposure.

"Lloyds' exposure to the three regions is likely to be negligible, we estimate that Barclays has £40bn exposure (predominantly loans in Spain and Portugal, excluding daily positions in Barclays Capital), and RBS has around £30bn–£35bn (again predominantly Spain, although we estimate £3bn to £4bn in Portugal and Greece as well)," the Credit Suisse analysts said.

Money markets, in which major banks lend to each other, also reflected the tension caused by the Greek downgrade with eurozone interbank lending rates enduring their biggest rise in nearly a year.

Much of the anxiety was targeted at French, German and Swiss banks. Howard Wheeldon, of BGC Partners, said: "If Greece defaults that means the pressure will then be felt and exerted on national banks that hold the Greek debt. That includes very many German, French and Swiss banks and it just may be that with so many banks involved one of these might just go down."

At today's annual meeting, RBS's chairman, Sir Philip Hampton, played down any exposure to Greece, while Lloyds' finance director, Tim Tookey, said on Tuesday that the bank had no "material [significant] exposure". Barclays publishes a trading update on Friday and will face questions about its exposure to the countries being downgraded.

In early trading today banks were the biggest fallers, with RBS tumbling 7%, Lloyds down by 6.5% and Barclays off 4%, though they recovered much of their losses by the time market closed.

Among continental European banks, analysts at Evolution calculated that Fortis, Dexia, CASA and Société Générale were most affected because of the value of their Greek debt holdings relative to their size.

According to Barclays Capital, UK banks account for only 3% of the exposure to Greek bonds, while data from the Bank for International Settlements shows that, at the end of 2009, Greece owed about $240bn (£160bn) overseas. Of this, France and Germany have the biggest exposures of $75bn and $45bn respectively.

Analysts expressed concern about the problems spreading. Daragh Quinn, banks analyst at Nomura, said: "Given the scale of the debt problem facing Greece, the prospect of some kind of debt rescheduling or even default are being considered as possibilities by the market. Sovereign risk concerns are also spreading to Portugal and Spain."

Only last week the International Monetary Fund, which has been called in to help fund the Greece deficit, warned about the impact of a sovereign risk crisis. "Concerns about sovereign risks could undermine stability gains and take the credit crisis into a new phase, as nations begin to reach the limits of public-sector support for the financial system and the real economy," the IMF said.

Credit Suisse analysts pointed out that not all the problems facing the markets were negative for the banking sector. "The increase in volatility should assist revenues at the investment banks, particularly for primary dealers like Barclays," the Credit Suisse analysts said.

"But there are clearly a number of important potential negatives. These include the potential for increased capital and liquidity trapping in affected sovereigns, or increased micro prudential requirements for local subsidiaries. Our bigger concern, however, is increased nervousness towards the UK," they added.

But while the timing of the downgrade of the Greek sovereign rate surprised the markets, there had been expectations for some time that the ratings agencies would eventually lose patience with the situation and take the decision to downgrade. This might have helped to cushion the markets' reaction to the situation, analysts said, and was likely to ensure that the major banks and other investors had already assessed their exposure to the Greece market before the downgrade took place.

The impact of a downgrade
The cost of borrowing for the Greek government briefly hit 38% in a stark illustration of the impact that a downgrade can have on the health of a nation's finances. Greece has been graded BB+ by the credit rating agency Standard & Poor's, official "junk" territory. It is now on a par with Azerbaijan, Colombia, Panama and Romania.

Britain is one of 11 countries with a prized 'triple A' rating, along with Australia, Denmark, Germany, France, the United States and Luxembourg. But it is the only one of the elite to have been put on "negative watch", a warning that it might face a future downgrade.

The cost of Greece borrowing on a two-year bond was as little as 1.3% in November, but has risen sharply amid fears of bankruptcy. By the end of tradingtoday, the cost had fallen back to 19%. In contrast, Britain is able to borrow on two-year bonds at a rate of 1.2%. S&P's lowest rating, CCC+, is assigned to Ecuador, which defaulted on $3.2bn of bonds last year.

Ben Chu: Greek default could have same impact as Lehman collapse

Why does Greece's debt crisis matter to the rest of us? The answer, in a word: contagion.


If Greece defaults or crashes out of the euro it will send an almighty shockwave through the global capital markets. First of all, French and German banks, which are estimated to hold up to 70 per cent of Greece's debt, will register writedowns. If their exposure is great enough, they could even go bust.

The fear that commercial banks were on the verge of failure was responsible for the last credit crunch as financial firms grew wary of lending money to each other at anything other than penal interest rates. If that fear of failure returns, we might witness another savage contraction in lending. And another credit crunch would open the way for the long-feared "double dip" recession.

But an even greater economic danger could lie in the effect that a Greek default would have on investors' perception of the credit risk of holding sovereign eurozone bonds, which for much of the past decade they have treated as equally safe investments. The interest rate on Spanish, Portuguese and Irish bonds has been creeping up in recent days as investors have begun to wonder who might follow Greece down the road to default.

Yesterday's downgrading of Spain's sovereign debt by a notch to AA status by the credit rating agency Standard and Poor's was an ominous sign. If investors in Greek bonds end up losing money, those rates are likely to shoot up still further. Spain, Portugal and Ireland could yet find themselves in their own Greek-style debt tragedy. And while European banks stand to make losses on Greek debt, they are even more exposed to the debts of the rest of the so-called "PIGS".

The clean-up bill would be vast. One analyst has estimated that Greece could need £90bn, Portugal £40bn and Spain £350bn in loan guarantees if the worst came to the worst. It is unclear whether the eurozone could afford a bailout on such a scale, even if the economically stronger nations of the zone, primarily Germany, were prepared to sanction it.

This makes the case for early action. A Greek default could have the same effect on global financial and economic confidence as the 2008 bankruptcy of Lehman Brothers. If policymakers in Berlin think that the costs of bailing Athens out are high, they should consider the potential costs of letting it go under.

Euro debt crisis deepens as 'contagion' spreads from Greece to Spain

Angela Merkel moved to halt the deepening crisis in the euro yesterday by pledging German support for a controversial Greek bailout package.


Despite her actions, fears that the shockwaves from Greece's debt crisis were spreading to the continent's other ailing economies grew after the credit rating agency Standard and Poor's downgraded Spain's rating. The risk of a wholesale collapse in the value of government bonds issued by the weaker eurozone nations is now becoming more real, and threatening the fragile recovery across the EU.

The German Chancellor promised support for Athens after an urgent crisis summit in Berlin with the heads of the International Monetary Fund and the European Central Bank – the two key architects needed for any Greek rescue deal – as markets tried to recover from a dramatic slide sparked by the Greek debt.

"It is a question of the euro's stability," Ms Merkel told reporters. "We cannot avoid this responsibility. Trust in Greece must be restored. Germany will play its part but Greece must make its contribution as well," she added.

The German Chancellor hosted the Berlin summit with the International Monetary Fund's Dominique Strauss-Kahn and the European Central Bank's chief, Jean-Claude Trichet, less than 12 hours after Standard & Poor's downgraded the Greek debt to the status of "junk", causing panic on the markets. But even as efforts were under way to calm market reactions to the Greek crisis, the agency then downgraded Spain's rating from AA+ to AA.

The government downplayed the setback. José Manuel Campa, Secretary of State for the Economy, said he was "surprised", adding that the agency's projections for Spain's growth were "very low, outside of the range of analysis we are now looking at". He said he considered it "unlikely" that other ratings agencies such as Fitch and Moody's would adjust their ratings as well.

In Germany Ms Merkel was placed under intense pressure to agree to a quick solution that would lead to a rapid bailout for Athens. "Trust in the Eurozone is at stake," warned Mr Strauss-Kahn, "Every day of delay makes the situation worse," he added.

By yesterday afternoon the situation appeared to have stabilised following major falls on the European markets. Stocks in Paris and Frankfurt fell by 2 per cent yesterday morning, while Spain's leading index dropped by 3.3 per cent. "The market is now looking at every country with a lot of curiosity," said Gilles Moec, a senior economist with Deutsche Bank.

The decision on Spain reflects concern that is potentially far more significant than the warnings about Greece and Portugal, both comparatively small Eurozone economies. Spain, by contrast, is the fourth-largest zone's economy behind Germany, France and Italy.

As the euro fell to a new one-year low against the US dollar, it emerged in Berlin that the scale of the Greek debt problem had increased dramatically because several of the poorer EU members states were too indebted to be able to contribute. Both the ECB and IMF heads revealed to German MPs that they needed to increase spending on the rescue package to a figure ranging from between €120bn-€135bn over the next two to three years.

"The plan envisages removing Greece from the financial markets for three years," said the German Green party leader Jürgen Trittin, one of the MPs at the meeting. The previous figure cited in Germany as needed for the Greek bailout had been €45bn, with Berlin providing €8.4bn for 2010. But the new figure for Germany's contribution was put at €25bn yesterday.

Wolfgang Schäble, the German Finance minister, said that his government would make every effort to hold a parliamentary vote on German funding for the Greek rescue package by Friday of next week after negotiations had been held with the European Commission, the IMF and the ECB.

But the prospect of a payout for Greece three times higher than the amount previously discussed was certain to inflame public opinion in Germany, which was already hostile. An opinion poll conducted by Germany's Ntv news channel yesterday showed that 92 per cent of respondents were opposed to a Greek bailout. The country's mass circulation Bild newspaper ran a banner headline exclaiming "Greek debt is junk" alongside a photograph of striking Greek workers and the words, "We don't want to save!"

The constantly changing picture of the euro crisis saw European stock markets endure a roller-coaster ride yesterday. Share prices fell to a seven-week low in the early hours of trading. They recovered with the show of support in Berlin only to fall again on news of Spain's lower credit rating.

On the debt markets, the interest rate paid by two-year Greek government bonds ballooned to an unheard-of 38 per cent in the morning.

In the UK, the FTSE 100 index of blue chips, which slumped by 2.6 per cent on Tuesday, fell by another 1.2 per cent in early trading. Banking shares suffered as investors began to fret about the sector's exposure to Greece.

UK shares later moved into positive territory and Greek bond yields began to retreat. But hopes of a positive ending were dashed after the ratings agency Standard & Poor's made its move two minutes before the end of business.

The Greek debt crisis could hardly have come at a worse time for the German leader. She faces a key regional election in just over a week's time. The worsening Greek-driven euro crisis is forcing her to take domestically unpopular steps to shore up the currency. A loss on 9 May could seriously destabilise her coalition government.

Yuan Forwards Fall on Concern Greek Woes to Delay Currency Gain

By Patricia Lui

April 28 (Bloomberg) -- Yuan forwards fell on concern the euro zone’s deepening debt crisis may derail a global economic recovery and prompt China to delay appreciation of its currency.

Standard & Poor’s Ratings Services yesterday cut Greece’s credit rating by three notches to junk, the first time a euro member has lost its investment grade since the currency’s debut. The firm also slashed Portugal’s ratings by two steps to A-. Global stock markets slumped, and the Chicago Board Options Exchange Volatility Index, popularly known as the fear gauge, jumped the most since October 2008.

“The magnitude of declines in U.S. and European stocks has substantially reduced investors’ appetite for risk,” said Dariusz Kowalczyk, chief investment strategist for SJS Markets Ltd. in Hong Kong. “Any emerging-market asset will fall under the current circumstances, and this specially applies to Chinese forwards as the likelihood of a yuan appreciation declines.”

Twelve-month non-deliverable forwards fell 0.2 percent to 6.6270 per dollar as of 8:47 a.m. in Beijing, according to data compiled by Bloomberg. It was the lowest level for the contracts since April 20 and reflects bets the currency will strengthen 3 percent from the spot rate of 6.8258. The yuan has been pegged at about 6.83 per dollar since July 2008.

--Editors: Ven Ram, Sandy Hendry

%CNY

To contact the reporters on this story: Patricia Lui at plui4@bloomberg.net

To contact the editor responsible for this story: Sandy Hendry at shendry@bloomberg.net.

Markets fall amid Greek downgrade

World stock markets have fallen sharply after Greece's credit rating was downgraded to junk status by rating agency Standard & Poor's.

Greek shares were down nearly seven per cent and US stocks suffered their biggest loss in almost three months on Tuesday after Greece became the first member of the eurozone to have its debt lowered to such a level.

The downgrade means certain categories of investors, such as pension funds and insurance companies, may no longer be allowed to buy the country's debt.

Portugal's debt was also downgraded on Tuesday, leading to fears the crisis could spread beyond the two countries and further undermine the euro currency.

Greece has requested $52bn from eurozone governments and the IMF to shore up its finances but the reluctance of Germany, the largest country using the euro, to move quickly in providing assistance has sent shudders through markets.

Brussels summit

Investors fear the money may not reach Greece to enable it to avoid default by May 19, when $12bn in bond payments becomes due.

With the clock ticking, leaders of Greece's 15 euro currency partners are planning a summit on May 10 in a bid to agree on the rescue loan, a source close to the Spanish EU presidency told the AFP news agency.

"Intensive dialogue is under way between heads of state and government to call a summit of euro countries at the level of leaders on May 10," for only the second time in the euro's history, the source said.

The German government, which is the largest single contributor to the bailout package with an $11.2bn loan, is reluctant to vote on the deal until after May 9 elections in the country's most populous state - North Rhine-Westphalia.

As a result, the meeting in Brussels will take place the day after the election.

A governmental source in Berlin told Dow Jones Newswires that IMF-EU negotiations in Athens would conclude on May 2, with the proposals to be debated in the Greek parliament ahead of the May 10 talks in the Belgian capital.

Shares hit

On Wall Street, the Dow Jones industrial average fell 213 points, or 1.9 per cent, to 10,991.99 on Tuesday, its biggest drop since it fell 268.37 points on February 4, also amid concerns about European debt problems.

The Standard & Poor's 500 index fell 28.34, or 2.3 per cent, to 1,183.71, while the Nasdaq composite index dropped 51.48, or 2 per cent, to 2,471.47.

The FTSE 100 index of leading British shares closed down 2.6 per cent on Tuesday, while Germany's DAX slid 2.7 per cent and the French CAC-40 ended 3.8 per cent lower.

Greek and Portuguese shares were worst hit, down 6.7 per cent and 5.4 per cent respectively.

Both governments have imposed budget cutbacks against political resistance from unions at home.

But markets have been sceptical that they can push through the measures given the widespread opposition.

The ratings downgrades also sent the US dollar up more than 1.1 per cent against the euro, hitting its highest level in about a year.

At the same time, gold and treasury prices also rose as investors sought safer investments.

Brian Peardon, a wealth adviser at Harrison Financial Group, said the markets' response was "a knee-jerk reaction". The small size of Greece's and Portugal's economies means their debt struggles are not yet a major problem, he said.

But if they were to default on their debt, other countries that hold their bonds would also suffer, and debt-strapped countries would also likely find it harder to spend more to stimulate their economies and help feed the global economic recovery.

'Decisive moment'

Speaking to the AP news agency following the downgrade, Giorgos Petalotis, a Greek government spokesman, said: "This shows that the problem is broader, and concerns all the other countries and not just Greece.

"As a country, we are doing everything necessary to overcome this difficult situation, we are taking the measures and decisions that have been asked of us for sometime now."

Asked if the downgrade news means bailout negotiations need to be speeded up, Petalotis answered: "I think the need to them speed up, is something everyone can assess."

Portugal's finance minister said the downgrade would only make things worse.

"This is a decisive moment," Fernando Teixeira dos Santos said in a statement, urging political parties in opposition to his minority Socialist government to help swiftly enact debt-reduction measures he has outlined in his austerity plan.

"Regardless of the opinion we have in relation to the fairness and update of the rating, the fact is that this decision will not help markets to calm down, but will, on the contrary, contribute for their turbulence," he said.

Source: Agencies

Greece downgraded as Europe's debt crisis worsens

By NICHOLAS PAPHITIS and PAN PYLAS – 12 hours ago


ATHENS — Europe's government debt crisis worsened ominously Tuesday when Greece's credit rating was downgraded to junk status and Portugal's debt was lowered on fears the trouble could spread. Stocks slid on the news.

The Portuguese downgrade was a sign the European Union's fears of that the debt crisis would spread beyond Greece — and further undermine the euro currency — might be coming true.

For its part, Greece has already admitted it can't pay debts coming due shortly and reached for a bailout. But the reluctance of the largest country using the euro — Germany — to fund the largest share of the euro45 billion rescue by European government and the International Monetary Fund is sending shudders through markets.

Investors fear the money may not reach Greece to enable it to avoid default by May 19, when euro8.5 billion in bond payments come due.

The FTSE 100 index of leading British shares closed down 2.6 percent, Germany's DAX slid 2.7 percent and the French CAC-40 in France ended 3.8 percent lower. On Wall Street, the Dow Jones industrial average was down 132.25 points, or 1.2 percent, at 11,072.78 around midday New York time while the broader Standard & Poor's 500 index tumbled 18.17 points, or 1.5 percent, at 1,193.34.

Greek and Portuguese share were pounded, down 6.7 percent and 5.4 percent. The interest rate gap, or spread, between Portuguese and benchmark German 10-year bonds trading on financial markets — a key indicator of market skepticism — rose 57 basis points, or more than half a percentage point, to hit 5.86 percentage points. The higher the gap, the less confidence in Portugal — and it was the widest gap since the shared euro currency, which Portugal and 15 other nations use, came into circulation.

Both governments have imposed budget cutbacks against political resistance from unions at home. Markets have been skeptical that they can push through enough cuts, given political resistance, to put their finances in order.





Greek government spokesman Giorgos Petalotis, speaking to AP after news of downgrade, said, "This shows that the problem is broader, and concerns all the other countries and not just Greece. As a country, we are doing everything necessary to overcome this difficult situation — we are taking the measures and decisions that have been asked of us for sometime now."

Asked if the downgrade news means bailout negotiations need to be speeded up, Petalotis answered, "I think the need to them speed up, is something everyone can assess."

Portugal's finance minister said the downgrade would only make things worse.

"This is a decisive moment," Finance Minister Fernando Teixeira dos Santos said in a statement, urging political parties in opposition to his minority Socialist government to help swiftly enact debt-reduction measures he has outlined in his austerity plan.

"Regardless of the opinion we have in relation to the fairness and update of the rating, the fact is that this decision will not help markets to calm down, but will, on the contrary, contribute for their turbulence," Teixeira dos Santos said.

The spreading trouble threaten more woes for the shared euro currency, and raise the possibility of trouble spreading even further to Spain, whose economy is far larger than that of Greece or Portugal. Eurozone governments, themselves facing higher debt levels from the global recession, would be hard pressed to find enough money to bail out Spain if it comes to that.

The crisis has highlighted the inability of the rules set up to support the euro to keep governments from undermining the currency by running up big debts. Those rules limited deficits to 3 percent of grosse domestic product but have been widely flouted, and EU officials are talking about ways to strengthen them.

Nicholas Skourias, chief investment officer at Pegasus Securities, said that markets were already pricing in a Greek default or restructuring, while rising spreads on Portuguese bonds showed that "the more important and main risk is the contagion effect. And I think that the Germans do not realize this risk."

Germany wants to see a commitment to deep, long-term cutbacks in Greek government services and benefits before it agrees to provide its euro8.4 billion euro of the bailout cash. But investors remain highly skeptical that Greek voters used to generous benefits and worker protections will accept a drop in living standards. They also worry that the proposed bailout will not cure Greece's long-term imbalance between its soaring debt and tepid prospects of economic growth.

"The downgrade results from our updated assessment of the political, economic, and budgetary challenges that the Greek government faces in its efforts to put the public debt burden onto a sustained downward trajectory," said Standard & Poor's credit analyst Marko Mrsnik.

The move deprives Greece of an investment-grade rating on its bonds, meaning it would pay higher costs to borrow if it taps debt markets again. The agency said Greece's weak long-term growth prospects made it less credit-worthy.

"The Greek bond market is now in full scale meltdown," said Jeremy Batstone-Carr, head of private client research at stockbrokers Charles Stanley. "The nightmare scenario from an investor stand point is that either Greece defaults, forcing investors to take a severe 'haircut' on their investments-loans, or the Greek authorities could honor the country's debts and simply shut down all nonessential operations, markedly escalating the strife for the nation's people."

Default would hurt the shared euro currency and could lead to the debt crisis spreading to other countries with shaky finances such as Portugal and Spain, threatening them with the same vicious spiral of default fears leading to higher rates.

A debt downgrade immediately preceded Greece's call for the bailout last week. While Portugal has less debt, economists have focused on it as the next possible victim if concerns over high levels of government debt in Europe spread. Standard & Poor's downgraded its credit rating on Portugal amid mounting concerns about the country's ability to get a handle on its debt load, saying that the two-notch downgrade to A- reflects its view of "the amplified risks Portugal faces."

Greek company shares plunged for a fifth straight session Tuesday, with the benchmark Athens stock index shedding 6.75 percent to reach 1,683.08 points in late afternoon trading. The message from the markets is clear — there are real doubts that Athens will be able to service its debts.

"The market is pricing in the realistic prospect that Greece may not be in a position to meet all its debt obligations," said Jane Foley, research director at Forex.com.

Athens now faces a long, nail-biting wait with far from guaranteed results before its mid-May payment date.

"Until that day, everything must be concluded," Finance Minister George Papaconstantinou said. "I have absolutely no doubt that we will get there."

Prime Minister George Papandreou said his country stood "naked before international market storms."

"We are going through Greece's hardest time in recent decades," Papandreou told his Socialist party lawmakers. "The challenges our country faces are unprecedented, not only for Greece, but also for Europe and even the world economy. ... And what I say is no exaggeration."


Source : The Associated Press

Euro Trades Near One-Year Low on Concerns Over Greek Crisis

April 28 (Bloomberg) -- The euro traded near a one-year low versus the dollar on concern debt problems will spread across Europe after Standard & Poor’s lowered Greece’s debt to junk and cut Portugal’s rating by two steps.

The common currency, which tumbled the most in a year against the dollar yesterday, neared a five-week low versus the yen as European Central Bank President Jean-Claude Trichet prepares to meet German policy makers after they showed reluctance to bail out Greece. The pound was near a one-week low against the yen on concern next week’s election will create a U.K. government without the parliamentary support needed to trim the biggest budget deficit in the Group of Seven nations.

“With sovereign problems showing signs of contagion, the euro is losing its allure as an alternative currency to the dollar,” said Akio Yoshino, chief economist in Tokyo at Societe Generale Asset Management (Japan) Inc. “The currency may test the $1.30 mark sooner rather than later.”

The euro traded at $1.3192 as of 10:51 a.m. in Tokyo, after earlier dropping to $1.3145, the least since April 29, 2009, from $1.3175 in New York yesterday. The 16-nation currency was at 122.90 yen from 122.88 yen, after touching 122.37 yen, the weakest since March 25.

The pound was at 142.18 yen from 142.37 yen yesterday, when it reached 141.61, the weakest since April 20.

Trichet and International Monetary Fund Managing Director Dominique Strauss-Kahn will brief German parliamentary leaders in Berlin around noon today about the $60 billion aid package for Greece, which has met with opposition in Europe’s biggest economy. The joint European Union-IMF package would require Germany to stump up the biggest individual loan to Greece.

Rating Actions

“Why do we have to pay for Greece’s luxury pensions?” Germany’s biggest-selling tabloid newspaper, Bild Zeitung, asked on its front page yesterday. Almost 60 percent of Germans don’t want to help Greece, Die Welt newspaper reported, citing a survey of 1,009 people.

German Finance Minister Wolfgang Schaeuble asked Trichet and Strauss-Kahn to speak with lawmakers to “facilitate direct insight into the actions as they stand.” In Greece, Prime Minister George Papandreou will speak around 8 p.m. local time at a conference about the nation’s financial crisis.

Rating Downgrade

S&P lowered yesterday its long- and short-term sovereign credit ratings on Greece to BB+ and B, respectively, from BBB+ and A-2. Portugal’s long-term local and foreign currency sovereign issuer credit ratings were cut yesterday to A- from A+ at S&P, which cited “fiscal and economic structural” weakness. The outlooks on both were negative.

“The source of this bout of risk aversion is escalation in European sovereign debt concerns,” said John Kyriakopoulos, head of currency strategy at National Australia Bank Ltd. in Sydney. “Traders will be watching for a break below support around $1.3000 with sentiment toward the euro taking another leg down.”

Credit-default swaps on Greece’s government bonds climbed 114 basis points to 824.5, according to CMA DataVision. Those on Portugal’s debt rose 67 basis points to 383. Yields on Greece’s two-year notes surged above 18 percent, the highest level since at least 1998.

The pound fell after the Times of London newspaper said, citing a Populus poll, that the May 6 election would produce a hung Parliament. The prospect of political deadlock following the election has contributed to more than 5 percent decline in the pound versus the dollar this year.

“Given the huge budget deficit and unstable politics, it would not be a surprise if the pound became the next victim of sovereign woes following Greece,” said Norihiro Tsuruta, chief strategist in Tokyo at Shinko Research Institute Ltd., a unit of Japan’s second-largest banking group Mizuho Financial Group Inc.

Source : Bloombers
Authors : Yasuhiko Seki and Ron Harui

Debt default by Greece would undermine credibility of the euro

"Theoretical alternatives aren't pretty."

By JAY BRYAN, The GazetteApril 27, 2010 2:05 AM

At first blush, it's a little hard to understand why financial markets in Europe and North America are paying so much attention to a debt problem in a little country like Greece.

Greece has only a modest stature among the 16 countries that share the euro. Its economy is one-eighth the size of France's, for example.

But in this case, it's not really the Greek problem itself that scares investors so much. It's more the fact that the Greek government's debt crisis acts something like a canary in a coal mine.

If Greece should keel over financially, investors are very worried that this will be just the beginning, with Portugal, Ireland and even bigger countries like Spain and Italy quite possibly swooning under their own huge debt loads.

With a Greek debt default, for instance, these weaker economies would be "hammered" by skyrocketing interest rates on their government lending, predicts Mo Chaudhury, a finance specialist at McGill University's Desautels Faculty of Management.

Beyond this, any debt default by Greece would undermine the credibility of the euro, a serious problem for all of Europe. Investors would become wary of the euro zone, pushing interest rates up and stock markets down.

As well, big banks in the region, still struggling to recover from the financial crisis that hit in 2008, would be further damaged.

They hold billions of dollars worth of Greek government bonds, putting them in line for huge losses that could hamper their ability to support the area's economic recovery, since losses diminish a bank's ability to lend.

Financial specialists like Aron Gampel, an economist and vice-president at the Bank of Nova Scotia, still express a degree of confidence that Greece will pull through its present crisis, but this is largely based on the lack of any credible alternative.

"It's almost hard to believe that you could possibly cut enough to relieve such a horrendous burden" of government indebtedness, Gampel said yesterday.

Nevertheless, he added, with the world economy recovering - which will help Greece's export earnings - and its partners in the euro currency zone left with little choice but to keep Greece afloat, "I think it will be contained."

Chaudhury seems to lean toward the same conclusion, and for the same reason.

There are theoretical alternatives to the current rescue plan, which would see about $60 billion in affordable loans pumped into Greece by the euro member countries and the International Monetary Fund, but they aren't pretty.

One would be for Greece to simply default in some fashion, perhaps paying a fraction of its bonds' face value. Argentina did this in 2002.

But the likely consequence would be to get shut out of any further borrowing on foreign markets, which is what happened to Argentina for several years.

A second alternative would be for Greece to leave the euro zone, once again issuing its own national currency, which could be devalued. That would make Greece more competitive on world markets, boosting its economic growth.

But beyond the difficulty of making this transition, imagine the immediate impact of a Greek currency worth, say, half as much as the euro. It would simply make debts in euros or U.S. dollars twice as onerous for Greece to support, notes Chaudhury. So the theoretical gain could be trumped by immediate insolvency.

That leaves the bailout, which should give Greece some breathing space while it slashes government benefits and salaries to help balance a budget that has far outrun the country's means.

"There is misery ahead for the Greek people," said Chaudhury, but the cushioning effect of a bailout could at least minimize this.

And in the longer run, it's even possible that the agony of Greece will bring benefits for all of europe.

Greece isn't the only country that has let its spending spiral out of control, Chaudhury pointed out, and the mess in Greece might have been just the example that other members of the euro zone needed. Today all can see that unpopular as it is, voluntary cost-cutting is less painful than forced cost-cutting in the middle of a crisis.

"In the end," said Chaudhury, ''this could turn out to be a good thing, not only for Greece, but for the rest of europe, too."



Source and © Copyright (c) The Montreal Gazette

Read more: http://www.montrealgazette.com/business/Debt+default+Greece+would+undermine+credibility+euro/2954618/story.html#ixzz0mIEi30U1

Causes of The Greek Financial Crisis

What is wrong with Greece?

Its Government failed to reform the economy and reduce public spending, including the huge military budget, when it joined the eurozone. Greece entered the recession ill equipped to cope. Government debt was bigger than the economy last year and is forecast to exceed 120 per cent of GDP this year.


Why is Greece troubling the financial markets?

It needs to borrow €50 billion this year to pay its bills but its credit rating has been cut to just above “junk” level so it must pay much higher interest on its borrowings than other eurozone states. On April 20 it has to pay back €8 billion to bondholders.


Why is that a problem for the euro?

Greece is heavily in breach of eurozone rules, the Stability and Growth Pact, requiring members to keep their deficit below 3 per cent of GDP. Greece’s deficit is 12.7 per cent and the Government lied about the true state of its finances. Drastic cuts in public spending and tax rises are now necessary to bring the deficit down by 2012.


So that’s OK, then . . . ?

Not necessarily. The financial markets are betting that Greece won’t make it and investors have turned their attention to other states on the eurozone periphery such as Spain, Portugal and Ireland, which are also burdened by big deficits. A rescue by the European Central Bank, the European Union, the International Monetary Fund or all three would constitute a big loss of credibility and cause the euro to fall against major currencies.


Does that mean the eurozone might fall apart?

That is highly improbable. There is no legal mechanism for ejecting a state that has joined the euro.


So no chance of a week in Crete on cheap drachmas?

Unlikely. If Greece quit the euro it would be courting disaster.


Will Greece get a bailout?

The markets reckon so. The country may be forced to swallow some loss of sovereignty over financial affairs.


Will we have to pay for this?

Britain is not part of the eurozone. In theory, we are not involved — but British taxpayers already pay for Greece through EU structural funds.