By Claus Vistesen, on January 18th, 2012
Edward Hugh has a brilliant analysis of recent events in the eurozone and especially how banks are leveraging the liquidity provided by the ECB to “cleanse” their balance sheet of bad assets and essentially exchanging these for freshly minted euro deposits at the ECB. I think we should be very clear what is going on here; this is essentially a covert recapitalisation of the European banking system and the ECB is in every sense of the word acting as a lender of last resort.
Here is the relevant part;
Another area where the transfer of liquidity doesn’t show up as a change in aggregate excess liquidity is when banks offload their wholesale liabilities to other EuroArea banks and refund via the ECB. Here again, if they do it smartly, they can even earn a bit of “quasi carry” in the process, by buying back their debt at well below face value from those who are anxious to exit the periphery, and then refinancing at the ECB without writing down the underlying asset. This could be termed a liability “write down”, and again the procedure earns the bank a nice bit of income which can subsequently be used to help the recapitalisation process.
Take the Portuguese Bank BPI (the country’s fourth largest), which is making public tender offers to buy back its debt. If all concerned tender their bonds to BPI, BPI will pay something short of €1.5bn cash to investors. Mortgages which were previously sitting in one of their SPVs will return to their balance sheet, and ECB money will now be on the other side financing them allowing significant profits (and capital) to be reported. In this particular tender the smallest discount is 35% and the largest is 65%. Investors may initially balk at the offer, since they will nurse a heavy loss (equal, naturally, to BPI´s profit) but ultimately they will probably be only too happy to be able to walk away from Portugal, and with some cash in their pocket to boot.
Iberian banks were already aware of the benefits of this kind of restructuring during the 2009-2010 liquidity wave, and went about quietly repurchasing their bonds (bank capital, securitizations, senior bonds) on a selective and private basis at a discount. Much of their reported profits in those years in fact came from either the ECB carry trade or this kind of transaction. So when we read that another Portuguese bank – Banco Espirito Santo – has just had €1 billion of debt guaranteed by the Portuguese state (a sovereign which can’t itself go to the markets) it isn’t hard to imagine that the process going on in the background is something similar to that seen in the BPI case, and that the debt is being guaranteed so it can go over to the ECB to be posted as collateral.
The National Bank of Greece has been doing something similar. They recently offered to buy back some €1.5 billion in covered bonds and preferred securities,offering 70% of face value for the covered bonds and 45% for the preferred hybrids. As the bank itself says, “The purpose of the offers is to generate core Tier 1 capital for the group and to strengthen the quality of its capital base….The offers would generate a gain for the group.”
And Italian banks would seem to be doing something similar, since they issued around €40 billion in government backed bonds specifically to take to the ECB. The bonds are held by the banks themselves and stay on their books to maturity, their only purpose being to provide collateral for use at the ECB. In fact Italian banks took something like €116 billion from the LTRO, or almost 25% of the total. Perhaps this is why Unicredit CEO Federico Ghizzoni and other European top bankers met ECB officials in Frankfurt back in November, to discuss new rules for collateral.
In Spain securitised mortgages sitting on the balance sheets of the bank-ownedFondos de Titulizacion de Activos could also be recycled in this way (here’s a complete list, although note that these Funds are regulated by Spain’s CNMV and not the Bank of Spain, which is why their presence is relatively unknown and people are able to accurately say that the central bank has been very strict on SIVs, since they weren’t their responsibility).
That something like this may be happening, with the ECB “buying into” public and private Euro Periphery debt while investors are discretely getting out is suggested by this report in Bloomberg:
The euro is losing the relationship with riskier assets that underpinned the currency in 2011 as the deepening sovereign debt crisis reduces the creditworthiness of even the biggest economies in the region. The 17-nation currency has fallen 8.7 percent against the dollar since October, while the Standard & Poor’s 500 Index has gained 3.4 percent, and the correlation between the two dropped to 58 percent from a record 91 percent in November, according to data compiled by Bloomberg. The euro had moved almost in lockstep with investments linked to growth, including stocks and the Australian dollar, since January 2011.
This decoupling is taking place as European Central Bank President Mario Draghi cuts interest rates and promises banks unlimited cash for three years to rein in soaring borrowing costs for governments… Strategists also anticipate more losses as the US economy improves while the euro zone shrinks, driving international investors away from the region’s assets.
So if the first two objectives were to help the struggling sovereigns, and enable the commercial banks to refinance their debt, then to some extent these objectives have been met. But what about the third objective, moving credit on the periphery to get the real economy moving again? Well, here the ECB’s measures are likely to have far less effect, and indeed what effect they do have may be in some way a mixed blessing, since the banks seem far more worried about demonstrating they have an adequate level of core capital than they are about participating in solutions to real economy problems.
While I would, in general, be hesitant in taking anything from Zero Hedge at full face value I think the following story on Unicredit adds flavor to this by providing further evidence on the points Edward mentions above.
The story is clearly speculative but gets backing from Edward’s accout above. The following seems to be a part of the general process which in itself is, in my view, absolutely mad.
Banks in weak countries have been issuing debt, getting a government guarantee, and then posting them as collateral at the ECB. There are examples of this for Greek banks for sure, but my understanding is it has also been occurring in Portugal and Ireland. It is the only way banks in Greece (and the other countries) can raise money.
The article then goes on to make this more alarming point (but really does not have evidence to back it up) that it appears that about €40 billion of the first LTRO was done by Italian banks (Unicredit?) that issued bonds to themselves and got a government guarantee, and then posted this asset as collateral for liquidity through the LTRO.
So, here is how I understand it.
Unicredit issues a 3m bill and gets a government guarantee so that whoever chooses to buy this bill knows that it will be backed by the sovereign (after all, this is still better than the bank even if the two are joined by the hip). The only problem is that it is being issued to itself with a permanent guarantee from the government.
From an accounting perspective this must be close to illegal in any meaningfully lawful jurisdiction, but I defer to experts here of course. The issue here is not then that the sovereign is guaranteeing a liability of a bank, we have seen this plenty of times and it is indeed the only way that some financials can issue debt, but rather that the bond never gets marketed to third party buyers.
It is absolutely astonishing that this 3m bill is then being posted as collateral at the ECB. But you must understand that it has to be posted as such as far as I can see since you can’t hold your own liabilities. So, the banks posts a bond issued to itself and posts it at the ECB and get freshly minted fresh euros credited to its bank account at the ECB. After the process, Unicredit still has the bond as a liability but instead of the same bond on the asset side (which is impossible) it has a deposit asset with the ECB.
If this is true, and the ECB is agreeing to this I must admit that it amounts to a serious bout of banking follies in the European banking industry.
By Claus Vistesen, on January 5th, 2012
One point that I have been shouting from the proverbial roof tops in my research, to partners and colleagues is that 2012 may well be the year when all major central banks will be conducting both conventional and unconventional monetary easing at the same time. I think this is a very strong testament not only to the severity of the ongoing debt crisis in the developed world, but also to the propensity of central banks to choose inflation as the desired route to recovery. We need not initially discuss whether they are deploying the proper set of policies or even whether such policies represent moral hazard or a ponzi scheme on government debt.
The main thing is to realise that this is an unprecedented global monetary experiment.
My message to investors in 2012 would then be not to underestimate this inflation bias by part of global central banks. Inflating your way out of too much debt won’t work in the long run without considerable defaults and/or economic stress (hyper inflation). Events since 2008 are ample evidence of this, but the simultaneous inclination to create inflation and debase your currency (to generate more inflation and exports) by all major central banks will continue to exert a profound effect on asset prices and the global economy.
In so far as goes the idea that an investors’ interest in asset prices is conditioned on return and volatility we can say that central bank policy will affect both. Financial assets will certainly benefit from excess liquidity, but the unravelling of too much debt through inevitable defaults and the central bank policies themselves will generate volatility. Whether the combination of such volatility and return means that you should stay out of the market entirely is a question for the individual investor. I believe that
From a macroeconomic point of view, the downbeat assessment remains however that it is difficult if not impossible to paint a picture of where sufficient growth is going to come from and on the investment side of things, the higher level of volatility will tend to shake the foundation of investors even if money is to be made for short periods of time.
Most attention has been centered on the ECB, whether the 3y LTRO represent QE and whether the continuing rejection to buy government bonds outright means that the ECB is a laggard among global central banks (see this excellent report by Hinde Capital for additional analysis relative to the points below).
750 Billion USD, and counting …
Europe remains the center of the global debt crisis, a role the continent has now decisively taken over from the US which stood at the forefront in the initial phases of the crisis in 2008. Apart from the almost endless summits and meetings among government officials the significant measures continue to be the ones coming from the ECB.
In my view, the European interbank market is virtually dead and dusted, and the ECB and the Fed are now effectively the only thing between Europe’s banks and large scale failures. Since early September 750 billion USD worth of liquidity has been provided to the European banking system of which 100 billion sits on the Fed balance sheet through USD swap lines.
Who will bet against the final 3y LTRO auction to take this beyond one trillion USD?
Spanish and Italian curves are now nicely steep again after a brush with inversion which obviously was one of the main objectives even if it was always debatable whether banks would buy government bonds with the liquidity taken up at the ECB.
The question is; how do you unwind all this? 750 billion USD to roll short term liabilities with the ECB and the Fed seems to me to be one of the biggest gamble in monetary history.
While the BOE and the Fed have been transparent in their QE efforts and the BOJ never really having left the zero bound the ECB has been more covert. However, it is my contention that with the expansion of the securities market programme (SMP) in 2011 to buy considerable amounts of government bonds (1) as well as the 3y LTRO the ECB is now fully engaged in quantitative easing.
I base this on two points.
- The ECB has acted as a sovereign debt buyer of last resort in times of crisis. It is common knowledge in the market that the ECB has been Italian and Spanish bonds in times of particular stress on the notion that these two economies in particular could not be allowed to fatally succumb to the debt snowball dynamics.
- ECB support for the banking system in the form of collateralised liquidity and wholesale funding is not temporary but structural and permanent in nature. The interbank market in Europe is not working and has not been working since the crisis started in 2008.
The ECB will of course vehemently deny this but investors should understand that such denial is mainly out of political reasons. When Draghi unveiled the ECB’s attempt to backstop the crisis in Europe by offering full allotment liquidity on a 3y basis, the market was disappointed because the central bank president also reiterated that the ECB would not step up its purchases of government bonds.
I think that the ECB will be forced into a much more direct and active role where unsterilized purchases in the primary market (monetisation) will be needed, but I fully appreciate the political issues. We are currently in a delicate situation where new governments in most of the involved countries are saddled with forced mandates to impose austerity. It is very difficult for all parties involved to push this agenda if the ECB had stepped up a full backstop. Moral hazard risks are consequently paramount here.
As such, investors must content with the ECB’s attempt to shore up the European banking system which is no little feat given the bank rollover schedule in 2012 as well as new Basel II regulation which will further impair already shaken balance sheets. The ECB’s initiatives then follows the steady deterioration of conditions in the European (indeed global) banking system which initially culminated in the coordinated action by global central banks to supply dollars through Fed swap lines and which found its European answer in the ECB’s decision to provide unlimited liquidity yet again.
The problems look ominous for European banks and the global financial system in general. No matter what, European financial institutions will have to delever significantly which will spread its tentacles wide and far due to the high penetration by European banks in emerging markets (Eastern Europe in particular).
Behind the scenes however, significant ink has been spilled to debate and speculate on to the exact significance of the ECB’s liquidity operations.
John Hempton for example suggests that the ECB’s policy move is an open invitation to play the carry trade game using almost free liquidity to buy higher yielding government bonds.
Well the Euro fix is in. Whether it works – that is another question. But the fix is this: European banks can borrow unlimited amounts for three years to buy Euro government debt. The debt often yields 5 percent. The money costs 1 percent.
I agree that the incentives are certainly there for the banks to play this game especially in the context of government bonds as zero risk weighted assets. The problem is that many European banks have spent more than a year and two stress tests to get rid of substantial amount of peripheral government debt (which do not count as zero risk weighted assets according to Basel III) and as such weak governments are unlikely to benefit from this.
The flip side of this is that most of the liquidity taken up by banks go straight back to the ECB at the deposit facility which is now standing higher than at any time between 2008 and 2010.
Quote Reuters
The euro zone banking system starts the new year awash with record levels of liquidity but few signs that institutions are prepared to lend to each other, leaving money markets frozen.Most of the near half trillion euros of three-year funds borrowed from the European Central Bank in the last week of 2011 have made their way back to the ECB’s overnight deposit account.
The Reuters piece goes on to argue that most of the liquidity will probably go to aid the large refinancing need banks face in 2012 and thus effectively as a replacement for a non-functioning interbank market that would normally be able to roll this financing. If this does nothing to solve the problem of sovereign insolvency and illiquidity it will work wonders through the fact that banks won’t act as a drag on their respective sovereign’s balance sheet as long as the ECB is involved.
I would note though that even though the liquidity is mainly reflected in reserves held at the ECB, it still represents excess liquidity as noted by Danske Bank.
Some market commentators have argued that the first 36 months long-term refinancing operation (LTRO), in which banks took EUR490bn in total, has so far not worked as planned because the extra liquidity has simply been placed on the deposit facility at the ECB. However, this argument is false.The sharp increase in outstanding open market operations (MRO+LTRO) increases excess liquidity (defined as open market operations plus recourse to the marginal lending facility minus autonomous liquidity factors minus reserve requirements) and this excess liquidity shows up as deposits at the ECB in just the same way as it did in 2008-10.
However, nothing is easy and despite the fact that collateral can be posted for liquidity the sovereign is still on the hook as my friend Edward Hugh points out.
Banks are being encouraged to keep rolling over what are basically NPLs by financing them at 1% at the ECB (foreclosing on them in Spain and keeping the property on the books may cost something like 8% in comparison). But the ECB isn’t assuming the risk here, the national sovereign implicitly is, and is getting in deeper by the day.
This is certainly true by the letter of the law but one has to wonder whether the ECB will ever get paid back here. I mean 3 years is an awful lot of time. The ECB can roll these loans as long as need be (it has already effectively been rolling bank funding since 2008) while maintaining the figue leaf that it is not funding sovereigns. This may be true, but it is effectively funding the sovereign’s banks and postponing the day of reckoning which is bank failures or nationalisation or both.
If the ECB is then forced take a hit on the collateral or the loans themselves, it will need to create the money to pay for these loans by printing euros. This sounds as a plan to me except that it does not solve the funding risks of governments which may or may not be able to ask their banks for help. The likely answer is that they won’t be unless the ECB and EU decide to wield the ultimate weapon of financial oppression which would be to penalise reserves over a given level with negative interest rates at the same time as banks would be forced, through regulation, to hold government bonds.
But Edward makes another interesting point;
Looking at the Greek PSI, what they would try and do (if all this gets that far, I mean if the Euro holds together long enough in this Byzantine world) ) is load up the private sector share of the haircut, and keep the ECB as untouchable official sector. At the limit they can use ELA to keep the banks afloat while the sovereign restructures and then recapitalises.
(…)
Why would any ex Eurozone third party want to be counterparty to anything which might end up being subordinated to ECB exposure later on down the line. The more I think about it the more it seems to me that the 3 yr LTROs might end up choking the European banking system to death.
It is difficult to disagree on the gist of this point, namely that the ECB is digging itself a very big hole. If banks can exchange under water assets at the ECB for a deposit asset at the ECB (albeit with a negative carry) the ECB is running the risk that it becomes the sole counterparty of bad assets in the euro zone in which case seniority will mean very little.
The Greek situation is a good example. Private creditors face an almost certain 100% wipeout exactly because they represent such a small tranche of the total stock of debt. In such a situation the asymmetric relationship between subordinate and senior debt holders mean that the latter essentially become equity holders. But once subordinate creditors are wiped out the turn comes to the senior debt tranches and the further the ECB goes along the road of providing full allotment liquidity the higher will be its implicit direct claim on assets of all sorts of qualities.
In conclusion, it is my view that the ECB is now the only thing between the economy and widespread bank failures, but I also concur that the consequence of this is a permanent outsourcing of the interbank market in Europe to the ECB’s balance sheet and, quite possibly, Fed’s USD swap lines.
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(1) – Even if such purchases have been fully sterilised.
By Claus Vistesen, on October 24th, 2011
As I read the latest round-up of comments by Fed officials that they are certainly not ruling out another round of asset purchases I am wondering whether this signals another round of actual quantitative easing by the Fed or whether investors should change their mindset back to before the crisis where it wasn’t the USD that acted as the global carry trade funder but rather the JPY (or maybe the GBP here?).
Quote Bloomberg
Fed Vice Chairman Janet Yellen said yesterday that a third round of large-scale asset purchases “might become appropriate if evolving economic conditions called for significantly greater monetary accommodation.” A day before, Governor Daniel Tarullo said buying mortgage-backed securities “should move back up toward the top of the list of options.”
They join Charles Evans, president of the Chicago Fed, and Boston’s Eric Rosengren in calling for consideration of further stimulus to boost growth and bring down a jobless rate stuck around 9 percent or higher for 30 months. A stock-market rally and gains in manufacturing and retail sales may convince the Federal Open Market Committee, which meets Nov. 1-2, to decide that it’s too soon for a third round of bond purchases.
You see, the recent initiative of the Fed in the form of Operation Twist is not quantitative easing since it does not involve an expansion of the balance sheet. In stead, it is what we refer to as qualitative easing as the bonds the Fed intends to buy on the long end (to move long rates down to help the mortgage market) will be paid for by proceeds of selling bonds on the short end.
The biggest problem for the Fed here is not necessarily that Operation Twist is a bad idea. Indeed, to the extent that it fixes the effort squarely on halting the slide in the housing market and supporting volume and price in the primary and second market for mortgage securities I think it is an excellent idea.
But we are forgetting the auxiliary objective of QE by the Fed; to weaken the USD. Make no mistake that this is an important objective for the Fed even if they have never declared this formally. And herein lies the rub. Quite simply, with the recent announcement by the BOE of another round of QE worth £75 billion, with the ECB now willingly or unwillingly being forced into increased support of peripheral debt markets and with the BOJ also pledging more stimulus, the Fed is starting to look like the conservative central bank in the G4. [1].
In my opinion, this is very significant and also one of the reasons why Fed officials are busy ensuring markets that they have plenty of ammunition left should economic conditions merit it. But investors should not take anything at face value I think. Before the Fed actually starts to buy those MBS and/or moves to lower interest rates on excess reserves there is a real chance that especially the JPY will start to act more like the JPY of old, a.k.a global carry trade anchor of choice. Of course, this requires the BOJ to back up all the pledges with real action. For now though, the only thing we can say is that the Fed looks set to be outgunned by its peers in the G4.
EMU Outflanked
Is Europe now finally getting down to serious business or is it just another round of fudge from the fudge factory that investors have learned to respect for its ability to produce relief rallies out of nothing. Looking at the evidence I thoroughly inclined to go for the latter even if each failed attempt to shore up market confidence brings Europe closer to full fiscal union.
Even if Merkel and Sarkozy, and rightly so, appear most concerned with putting pressure on Italy, the most significant issue remains Greece which is now in default a fact that was un-sanctimoniously confirmed by the leaked bailout document which has the Troika admitting that the medicine they were mandated to administer would only make the patient worse and not better.
Quote FT
Greece’s economy has deteriorated so severely in the last three months that international lenders would have to find €252bn in bail-out loans through the end of the decade unless Greek bondholders are forced to accept severe cuts in their debt repayments.The dire analysis, contained in a “strictly confidential” report by international lenders and obtained by the Financial Times, is more than double the €109bn in European Union and International Monetary Fund aid agreed just three months ago.
The most recent estimate of haircut has now risen to 60% and this, mind you, would only reduce the debt to GDP to 110% and this without any consideration on how Greece is supposed to grow itself out of this level of debt while simultaneously dealing with the default. In addition and only adding to my disdain for the ECB, Reuters reports that the central bank opposed a 60% haircut on account that it the private sector would refuse likely refuse this leading to a “fullscale” Greek default.
I am continuingly amazed by the denial here. Ever since the first Private Sector Proposal (PSI) was put on the table, Greek has been in default and figuring out who would pay for recapitalising banks as a function of how large the final haircut ends up are merely steps in the actual default process.
The second issue on the table is what to do with the increasingly freakishly looking EFSF. There has been no shortage of suggestions on how to increase the scope of the fund using the same guarantee by the same countries for the same amount of money (currently €440 in effective capital). The suggestion that might actually work came from France which has aired the suggestion that the EFSF be turned into a bank which would then allow it to access liquidity from the ECB. Both Germany and the ECB however have vehemently denied this which indicates that there is still notable reluctance to allow the ECB to wield the full arsenal of quantitative easing.
The proposal which currently seems to have most traction is to turn the EFSF into a monoline insurer which would essentially use its capital to insure anything from 10% to 30% on any new issuance of sovereign debt by Italy and Spain. Crucially, the idea is that this “leverage” would bring calm to markets as this insurance could cover as much as 2 trillion worth of debt.
I really struggle to find adequate words here. I think this is madness and if any Eurozone politician were afraid that an equivalent of AIG would certainly enter the scene, they now seem content on creating one. The first and most widely flagged issue is this would obviously create a two tier bond market.
Quote Reuters
This would create a division between insured and non-insured debt, that could split a country’s investor base and suck liquidity out of the market unless new bonds were carefully constructed to allow them to trade on a par with existing debt.”The issuer would have to create a new curve of insured debt, limiting the liquidity in both curves with risks that investors would dump the old non-insured bonds,” said Commerzbank rate strategist Christoph Rieger.
Based on a 20 percent insurance model, JPMorgan estimates that insured bonds issued by Italy would trade at a yield around 100 basis points below existing debt with new, insured Spanish debt likely to be priced 80 bps lower than existing bonds.
I think this is significant, but we are missing the main point here. If this is set ut Spain and Italy will likely never be able to issue un-insured debt again and the contingent liability here is not only complex but will lock in future capital commitments to this aim of providing first loss insurance. For me, this is a horrible way to spend already scarce capital.
Another issue is obviously that it assumes that it will make the Spanish and Italian problem go away which it clearly won’t. However, much more fundamentally; while the idea is to ring fence Italy and Spain it almost guarantees painful haircuts in the case of Ireland, Portugal and Greece and once again, who will pay for those I might ask.
The only silver lining I have seen in the latest reports is that it seems to me that while the imminent objective is to fiddle with the EFSF, there has also been serious talk about bringing forward the ESM which would have a much stronger mandate and essentially constitute a first step towards socialising of sovereign risk in the euro zone. Until that happens, the EMU and her politicians will be continuously outflanked by economic realities.
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[1] – I repeat that with the ECB not formally in ZIRP mode, the Fed still has the yield disadvantage here but do we really expect the ECB not to lower going forward?
By Doug Gentry, on October 12th, 2011
So, who cares about the Greek debt crisis? It’s a small country, a long ways away.
Answers:
Greece as a Country: “We care!”
The Euro currency countries: “We care!”
Europe Generally: “We care!”
U.S. and International Financial Community: “We care!”
Stock Investors: “We care!”
All right, already. Here’s why they care.
The background
Through a series of missteps over the last 10 years the Greece government amassed a large government (or sovereign) debt, and then disguised it from its citizens, lending institutions, its Euro partners, and international financial organizations. The recession exacerbated the problem, threatening to push the Greece government into bankruptcy. Annual deficits as a percent of GDP or total national debt as a percent of GDP are higher but not that different from the United States, but in contrast to the U.S. the global investment community has very little confidence in Greek bonds and the ability of the government to repay them. That means Greece has to pay much higher interest rates on its debt, if it can borrow money at all.
What Can Greece Do?
When faced with larger government deficits, policy makers typically turn to two economic “levers” – fiscal policy and monetary policy. On the fiscal side the government can cut spending and/or raise taxes. Both of these actions have met strong resistance in a country used to heavy subsidies of middle class citizens and notoriously poor tax collection records.
Monetary policy can be an effective tool – often because it does not require the approval of the legislature or the voters. Normally a central bank can inject funds into the economy (electronically “printing” money) and use that to pay debts. This injection of money can also lead to the devaluation of the local currency. While devaluing doesn’t sound appetizing it can be very effective, since it encourages more exports and more tax revenues, and because it makes it easier to pay off debts denominated in the local currency.
BUT, Greece can’t execute its own monetary policy. It is a member of the Eurozone – using the Euro as its currency rather than the drachma. As a result Greece cannot unilaterally change the supply of its currency. It does not have control over monetary policy. To make matters worse for Greece, the Euro has held a fairly high value against other world currencies – just opposite of the direction Greece needs to help with its problems.
 Euro
How Does the Crisis Affect the Euro?
The Euro is a common currency, currently used by 22 European countries. Decisions on the supply of the Euro are made by a representative body at the European Central Bank.
When a member country, like Greece, threatens to default on its loans, global investors pull funds out of Greece and the Eurozone. This reduces the demand for euros, and causes the value of the euro to fall. This is a mixed blessing. Countries often prefer a strong currency, but a weaker one can encourage exports. Europe is an export driven continent.
Joining the Eurozone initially, countries have to prove that their economies and government budgets are healthy. It is like welcoming someone new onto a lifeboat. You prefer the new person to be healthy. It appears that Greece hid or obscured its economic reports when applying for membership and now its fellow lifeboat members are not happy.
Commentators, such as Paul Krugman, have argued that Greece should never have been allowed in the Eurozone. They also argue that the Euro common currency is flawed if monetary policy is directed centrally, but fiscal policy remains with individual countries. Macroeconomic theory suggests that both need to work in concert, and the slow, deliberative and political style of the European Central Bank is not well suited to crisis management. Here’s one of many Krugman posts on the crisis.
Why the Large Bailouts by European Governments?
Other European countries, particularly those who share the use of the euro currency, want to stabilize the currency in their own self-interest. In additional many of the large banks and financial institutions in Europe hold Greek debt. If Greece defaults on that debt, those institutions are in trouble. France and Germany have been two of the largest contributors. French voters have been relatively quiet about the bailout, but German politics are much more sensitive to the issue. Chancellor Merkel of Germany has to balance the need to preserve the Eurozone economy against the indignation of German taxpayers who feel little affection for Greece.
European policymakers also worry about other members of the Eurozone – including Spain and Ireland. These two countries have stressed economies for reasons different than Greece. Neither of them had profligate government spending, but both have been hit particularly hard by the recession. Additional stresses on Europe could tip these countries further into trouble.
Why the International Community and Stock Investors Worry
The source of concern in the stock markets and among international investors is mostly fear of default. Large financial institutions and other holders of Greek debt would be seriously hurt. If a Greek default pushed other European countries like Spain and Ireland over, the impact grows significantly.
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By Claus Vistesen, on August 4th, 2011
Starting a new job and settling in a new city/flat has proved a little more unsettling for my blogging efforts than I had expected. Anyway, what better time to return to the fray when the SP500 completes its worst run in a long time returning to levels not last seen since March where we thought we had to write off the entire Japanese economy as a nuclear wasteland. So, is it all back to square one for the already weak recovery?
Arguably though the catalyst this time is more sinister in that it cannot really be pinned on any single event. Surely, the debt ceiling charade and the prospects of Spain and Italy spiralling further into the arms of what ever bailout that might be on offer are catalysts in themselves, but the underlying economic data is getting increasingly sour.
All the leading data we are looking at, both in terms of the global breadth of economic momentum and specifically on the US economy have rolled over in a dangerous fashion and a recession in the US cannot be entirely ruled out. Indeed, on some measures we would even be calling one. Elsewhere, the slump in the July Australian PMI also suggests that one of the hitherto strongest economies in the global recovery may be about to embark on its own homegrown downturn.
It was also interesting to see the SNB finally cave in (yet again) to the relentless rise of the CHF despite the bank’s efforts both communicative and with hard money to starve off the beast. As I have remarked before, safe haven flows hurts and can be akin to holding Old Maid. Indeed, it may turn interest rate decisions on their head as rates will be lowered going into a melt up of economic activity to attempt to deter speculative inflows.
Generally, one of the most obvious consequences of the recent bout of weakness will be that more stimulus is in the pipeline, at least in the US economy whereas the ECB will probably need a little time before the reality dawns on them. However, the underlying inflection point between an economic recovery that is clearly turning out much weaker than expected and the reality of too much debt is starting to hurt. In that vein, it is difficult to see a viable way out of the obvious need to cut spending and reign in excessive public spending with the simple fact that what has largely driven GDP in the recovery has been government consumption and investment.
We can consequently expect that the Krugmans of the world to get another big chunk of the discourse as the call for further and bolder stimulus packages increases. In this respect, the Squid had nice note out on Monday on the possible avenues a new round of QE would take where the main message seems to be that the Fed will try to further cement its position of low rates for an extended period. But more interestingly is the widespread expectation that if the Fed engages in further asset purchases it will be on the long end of treasury curve and thus to flatten the curve on the long end. Surely, this makes sense in so far as goes the idea that the housing market remains in an extremely poor condition. Mortgage rates are thus likely to be driven more by long term rates than rates on the short end or at the middle. Coupled with outright targeted asset purchases of MBS using the proceeds from its securities portfolio the Fed would be signalling that the size of its balance sheet will remain inact.
Sufficient on to the day and all that but with the current sinister backdrop of market currents and poor economic data we can expect Bernanke to step up any time now.
It has occured to me here that what we might be facing in the developed world is a mirror image of the situation in the emerging world and that the combination is not the best of mixtures for the global economy.
Consider then the situation e.g. in India where the RBI is trying frantically to weigh against excessive government spending not to mention China where you get the distinct feeling that at least some part of the inflation problem comes from the central authorities’ credit policies (or lack of tight standards). Conversely, in the developed world austerity is the name of the game quite simply out of necessity and faced with extremely fragile economies it is largely up to the central banks to attempt giving the economy some tailwind. On a personal note, this is also why I consider the ECB’s recent hiking campaign as the biggest policy failure since, well, they raised just before a recession the last time. The very best we can hope for in Europe is then not a recovery but simply that we might end up back at square one.
By Trace Mayer, on July 14th, 2011
This has to be one of the most ironic and ignorant statement I have heard come out of Washington. The tail risk is with people like Bernanke running the Federal Reserve, Trichet running the ECB, the eurocrats trying to run the rating agencies and politicians trying to design everyone else’s lifestyle.
It appears that despite a fairly short consolidation that the next gold upleg has started. The gold 50dma is $1,522.03 and the 200dma is $1,423.69. The silver 50dma is $36.06 and the 200dma is $32.24.
During this upleg that will likely last until November before a correction or consolidation may see gold run to $1,800 and silver to the $55-60 range. It will be important to see the activity over the next week or so to determine whether the strength will stay. If the monetary metals pull back slightly and continue their usual summer consolidation then it will help the 200dma continue to rise which will lay a stronger base for the autumn and winter rally.
By Claus Vistesen, on April 11th, 2011
With (sincere!) apologies to La Roux;
Going in for the Hike
(lead singer JCT with refrain by Axel Weber)
We can fight our crises
But when we start seeing prices
We get ever so cross
And must show we’re the boss
They say we shouldn’t care about the headline
But we believe it’s just fine
One council with a common goal
To protect the PPP of European souls
We’re going in for the hike
We’re doing it to quell a spike
Oh I’m hoping you’ll understand
And not let go of my hand
(x2)
We hang the PIIGS out to dry
And we’ll see how hard they’ll try
We can help their banks no longer
They’ll have to be stronger
Full stops to monetisation
To be ahead of the curve
How far can we stretch the Euro?
We’ll see but we aren’t sure though
We’re going in for the hike
We’re doing it to quell a spike
Oh I’m hoping you’ll understand
And not let go of my hand
(x2)
Let’s raise the rate
to kill the headline
Let’s test our fate
with a Por2y at 8
We hope in darkness
The market can see
That we are trying to set them free
We’re going in for the hike
We’re doing it to quell a spike
Oh I’m hoping you’ll understand
And not let go of my hand
By Claus Vistesen, on February 4th, 2011
It seems that JCT showed that he and the ECB are not completely blind and deaf when it comes to the reality of a stronger currency in a world where everyone is scrambling to devalue.
As I have noted before, stranger things have happended than the ECB raising into a an impending downturn, but it seems that the ECB has lifted off a little bit in terms of the vigilance against inflation.
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By Claus Vistesen, on January 17th, 2011
It would have been hard to believe only a few weeks ago that the euro zone could be the source of any good news let alone news to help push the market forward. Yet, with last week’s successful bond auctions and the pledge of international superpowers such as Japan and China to buy Euro zone debt and the ECB’s sudden more hawkish tones, the obvious question is; are we out the woods yet?
Hardly, but it was interesting to observe the almost coy manner in which the ECB slowly but surely began the move towards contemplating to think about raising interest rates. We are not there yet of course, and I still think that any hike in the ECB’s refi rate are, for now, confined Weber’s dreams and a very distant playbook sitting around somewhere on the lower levels in the Frankfurt tower. But let us be honest, stranger things have happened than the ECB raising rates just before the next downturn. Indeed, you might even call this a leading indicator.
In the meantime, the patchwork which is the Euro zone rescue/bail-out/backstopping mechanism is frantically being sown together. Barclay’s Capital collected the following from the market drums in terms of modifications to the hybrid (EFSF) already in place;
He [commissioner Oli Rehn] indicated that various options would be discussed among European policymakers but that it was too early to comment on this in more detail. However, Rehn mentioned that one modification could be related to the rate charged on EFSF loans, with a view to reduce those. Other media reports suggest this could also include the provision of short-term credits to euro area member countries requesting support, the purchase of government bonds through the EFSF, or a change of collateral rules to boost the fund’s effective lending ceiling.
A lot of things on the menu then it seems, but the most important question is really that no one has talked about yet; as Jack Barnes points out;
The system has reached the stage that a bankrupt sovereign state is issuing debt to buy bonds in a vehicle that is tasked with buying debt from a bankrupt Sovereign state that is no longer able to go to market. Folks this is reaching the level of a Monty Python skit.
This brings up a serious question not seen answered in the public yet.Who is ultimately responsible for the bonds that the rescue fund is going to be selling as AAA investments? Whose AAA balance sheet is guarantying these bonds that will be sold to investors like Japan?
So, apart from the obvious issue of issuing more debt to pay off the debt used to finance the debt of bankrupt sovereigns, there is a question of what exactly it is China and Japan will be buying. I am willing to give the EU some benefit of the doubt here especially since I have long been a strong advocate of issuing Euro bonds. But then, these are not Euro bonds as such, but rather instruments used to capitalise a fund which, as Jack Barnes succinctly notes, is in dire need of a capital injection even before it has deployed a single euro of capital. Obviously, the EFSF was created as an attempt to ring fence the problem in the periphery and thus to hedge against a future blow-up . But this always missed the point in the sense that we didn’t really need a bailout fund, but a rather a structural change in the way we perceive and organize the link between fiscal and monetary policy in the euro zone. As traders like to remind newcomers to the business, hedges are things you buy at a B&Q, not at your broker.
The EFSF could conceivably bailout a large part of the inflicted economies, but then there was always going to be Spain not to speak of Italy which it cannot deal with. On that note, it was eye-wateringly embarrassing to hear both the Spanish finance minister and the Portguese prime minister daftly using their respective “successful” bond auctions to note that neither of the their respective economies were going to need any form of bailout simply because they don’t need it!
This is then not to play down what was a long awaited successful event in the context of the European debt crisis which I unilaterally applaud (and hope for more to come) it is merely my attempt to put things a little into perspective. In this light, the gradually more hawkish tone by the ECB could be be seen as a little bit of stick to show economies that while we are here to help, we are also here to do our job which is to protect the purchasing power of all the euro zone citizenry. This may of course be waffle, but the ECB has long had a legitimate problem with simply playing the game in the form of providing liquidity and and even buying up peripheral bonds while playing into inability and flatfootedness of euro zone policy makers. Naturally, my bet is that we have only seen the nascent moves of what will become a full fledged measure of QE by the ECB and much more aggressive buying of sovereign bonds (simply because they have to), but this does not mean that policy makers can simply ignore the facts as they are presented by economic data and common sense.
But I might just be too harsh here and all it might be me who are behind the curve as those very same policy makers are now moving ahead of the curve in the form of, allegedly, a two-front attack on the situation with a bail-out of Portugal and a full euro zone backstop to whatever black hole the Spanish banking sector might turn out to be. Especially this last bit is interesting because it coincides with the news (albeit not fully confirmed and digested by the analysts) that Spain would stand ready to inject a hefty sum of money to shore up its banking system.
Here is Tracy Alloway from the FT Alphaville;
Just as the European Central Bank announced that Spanish bank borrowing resumed its upward trajectory last month (€70bn in December, up from €64.5bn in November) El Confidencial is reporting that Spain is preparing a massive capital injection of between €30 and €80bn to clean up the cajas, or local savings banks.
Having long been the twenty thousand pound elephant in the china shop this is indeed something worth noting more than in passing. Going into perma bear mode I am thinking about Ireland and the sudden reversal of a relatively good sovereign who was brought to its knees by its promise to see through the bailout of its financial sector. The point is that Spain is structurally similar with high private debt, and relatively low sovereign debt and while Ireland was probably going to hit the canvas in any case, its situation got worse by the ongoing quibble about what euro zone bailout funds could be used for. Specifically, the explicit refusal to allow the funds to bail out banks put the whole Irish situation in a tight spot although it was eventually an academic demarcation as the two got fused through the dreaded Irish government guarantee to backstop its largest banks.
So, I am carefully assuming that whatever Spain is brewing on here they have the potential firepower of the euro zone in the back. I have passed on this notion to a friend of mine much closer to the Spanish situation (guess who!) and here are the main points;
1) This is only the cajas, there will then need to be more for the banks (somehow). In fact, once the political argument is settled, the thing is much easier in the cajas case, since because they can’t go to the market with shares, the only thing to do is semi nationalise them, and then refloat later.
2) This then will be the first de facto step of Spain into the arms of the EFSF, since obviously the Spanish sovereign won’t be able to fund the injection (at least not at viable interest rates). Spain should be in completely between May and August.
As such, if it is part of a general euro zone backstop to the Spanish financial system it may be quite a move (and also as noted a sea change since all the quibble on Ireland concerning the use of bailouts would be presumably have been put in the past). I emphasize this since the clock is ticking and the same momumental structural challenges lie ahead even if one country’s successful bond auction may seem to have changed the situation for a while.
As such it might be worth having a look at those fundamentals of the euro zone again and what the proposed (and inevitable) correction mechanism presents in terms of challenges.
Remember the Catch 22
Structurally then we are still faced with the same seemingly irreconcilable issues in the form of imposing internal devaluations, fiscal austerity and returning to economic growth all at the same time from within a currency union. I have called this the catch 22 of euro zone imbalances not least in relation to the idea of a debt snowball;
[...] the forces which have lead to the build-up of imbalances are joined at the hip with the same forces which make it almost impossible to correct from within the Euro zone. Specifically the idea of a debt snowball effect is a good way to show why it will be almost impossible for some economies to correct their external imbalances without an explosive evolution in government debt and since they need to correct external competitiveness issues in order to achieve economic growth, the whole thing turns into a vice and essentially a catch 22.
It is consequently, the rapid deterioration in the private and public debt dyanmics which euro zone policy makers and the IMF are so concerned with and thus trying hard to backstop and reverse. But it might not be so easy as to focus entirely austerity since debt dynamics are also driven by your ability to grow.
At this point you may rightfully wonder then what the hell a debt snowball looks like? Well, why don’t I show you then (see this paper for the model).
Now, in any economic model we need assumptions and instead of feeding in any of the forecasts for the periphery (which are hugely uncertain) let me take the point of view in a model economy with somewhat better fundamentals than many of the peripheral economies. As you shall see, the initial condition matters less than the underlying dynamics for creating a debt snowball.
As such, I assume that my model economy starts with a debt/gdp at a humble 60% to GDP (say in 2010) and that it pays 5% on its entire sovereign debt portfolio. The point here is that while e.g Portugal might have paid 6.7% on its last issuance it does not pay this on its entire portfolio of liabilities. This is also why we have been talking so much as about roll over schedule since if you are so unfortunate that you need to roll over and refinance in times of trouble you are likely to incur a high cost that affects your entire liability side.
Finally, I crucially assume that you can’t have both austerity and growth at the same time. If you want growth it will cost a higher fiscal deficit and if you to run down the fiscal deficit you must endure deflation (negative nominal GDP growth in essence) and it is this latter which the ECB and EU are pushing. Especially this last assumption is absolutely crucial to understand since it is this situation the periphery faces with an internal devaluation in the euro zone (click on all pictures for better viewing).
The bar shows the average from the simulations shown by the line plots. As you can see the numbers are obviously fantasy numbers, but since this an average across many different scenarios where both the fiscal decifit (austerity measures) and growth are dynamic it might not be entirely irrelevant. The set up of these simulations are quite simple. I can change three things in my model; the growth rate, the interest rate, and the budget deficit (primary deficit) [1]. In all the simulations the interest rate is set at 5% and then I build a cross section where I dynamically change the growth rate and budget deficit building in the trade off that you cannot have a low budget deficit and “high growth” at the same time.
Obviously, the results are quite sensitive with respect to how strong you believe the trade-off is between growth and fiscal austerity. I have built in a pretty strong trade off in order to demonstrate what I believe are signficantly worse short term growth dynamics than the consensus. This is also why the model’s result becomes exponential at longer time horizons.
Consider then the debt/GDP dynamics of our model economy in the first 10 years;
Suddenly, the numbers look more realistic but not less scary since you need to remember that this is the average evolution of public debt across all policy mixes (i.e. in a continuum from high growth negative and large budget deficit and low negative growth and fiscal surplus). It is exactly because correcting from within the euro zone imposes this trade off that you end up in a catch 22. Take the example that our model economy manages to realize a constant budget deficit of 6% of GDP which results in a zero growth rate of GDP. In that situation the model predicts a debt/gdp ratio of 160% in 2020 (98% in 2015). It goes without saying that if your initial level of debt is higher, the corresponding level of debt will be corrected up.
I am not presenting this as truisms and prediction tools since evidently economic models are anything but. Instead, they should serve mainly as evidence that bailouts are going to be needed and also sadly that defaults of both the sovereign and private ones are coming and they will be costly.
Finally and just for the sake of argument I thought that I would demonstrate that this model is not simply about exponentially increasing debt/gdp ratios. Consequently, the “good economy” and “bad economy” below both pay 5% on interest on their government bond portfolio but the former has a budget surplus of 3% a year and grows at a rate of 3% a year as well. The latter on the other hand looks more like the periphery with a budget deficit of 5% and a negative growth rate of 1%.
Again, the point is not to extrapolate into the infinite unknown, but to observe that even in the very short run this creates unsustainable debt dynamicsfor the “bad economy”.
—
[1] – So I am being very nice here not even considering interest rate payments on existing debt.
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By Claus Vistesen, on December 3rd, 2010
Question: Which picture and caption best describes the outcome of yesterday’s ECB meeting?
“Read my lips, on n’achetera plus de dette”
“Show me to the trough”
Inquiring minds want to know. As far as I can we got the same basic New Speak as we are used to but on the other hand, as FT Alphaville points out the ECB used the occasion of the meeting to pick up a heavy portion of Irish and Portuguese bonds (since essentially, no one else wants to buy at anything near acceptable yields).
Of course, the above picture may be a bit unfair since Trichet did reiterate the “we are here to help” discourse in the sense that existing measures to provide liquidity will be kept in place. However, the expectation was that a heightened risky environment would also call for additional measures. Concretely, investors have been buzzing around the prospects of the ECB moving closer to the outrigt QE position of the BOE and Fed.
On this, Trichet and his colleagues so far stayed their course as the chairman reiterated that purchases on the Securities Market Program would remain to be fully sterilised. So far so good, but as Matteo Regesta from BNP Paribas SA in London points out (via Bloomberg);
“In the scenario where SMP eventually increases to a meaningful size, weekly full sterilization of the stock will become a non- trivial task. The only way to avoid such a jam is to keep the program at a low scale.”
So, there is an inflection point somewhere it seems and we may soon find out where it is.
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