European leaders are interpreting stabilisation of economic activity and stable borrowing costs as evidence that the debt crisis is over.
The reality is that since mid-2012, the European financial crisis has been in remission, with the symptoms of the underlying disease temporarily suppressed. As treatment is discontinued and drugs lose efficacy, there is a high probability of a relapse.
Taking the Waters…
A combination of austerity programs, debt write-downs, the European Central Bank’s (ECB) commitment to ‘do whatever it takes’ to preserve the Euro, the proposed banking union and the finalisation of the primary bailout fund the European Stability Mechanism (ESM) helped restore relative financial stability. There were falls in the interest rates of peripheral countries and a rally in stock markets, although no meaningful recovery in the real economy.
The cost of Spanish 10-year debt fell from more than 7.5% to 4.04%; Italy from 6.7% to 3.76%: Greece from 30% to about 10%; Portugal from 12% to 6.4%. The Spanish and Italian stock markets recorded a 1 year gain of 31% and 24% respectively.
The French and German stock markets rose by over 24%. In contrast, Euro-Zone gross domestic product (GDP) fell 0.1% during Q3 2012, 0.6% during Q4 and 0.3% during Q1 2013, with sharper falls in the weaker economies. Modest growth was registered in Q2 2013 but it is unclear whether that will continue.
Falling off the Austerity Wagon…
Austerity has failed to bring public finances and debt under control. Increases in taxes and cuts in government spending have led to sharp contractions in economic activity, reducing government revenues and increasing welfare and support payments as unemployment rates increase. Budget deficits, while smaller, persist and debt levels continue to rise.
Euro-Zone GDP is now 3% below the level in 2007/2008. It is also some 135 below trend levels. Individual economies have fared even worse: the Greek economy has decreased by 23%; Ireland by 8%, Portugal by 8%, Spain by 8% and Italy by 9%.
Euro-zone unemployment is 12%. Despite emigration of skilled workers, some weaker nations have higher unemployment: Greece 28%, Ireland 14%, Portugal 17%, Spain 26% and Italy 14%. Youth unemployment is significantly higher with 25-50% in some countries.
In the antiseptic language of economists, the fiscal multipliers (the proportionate impact of austerity) have proved higher than expected, resulting in deeper recessions than forecast.
The Euro-zone used large current account surpluses, which have increased to a surplus of 2.3% of GDP, to reduce the need for internal adjustment.
Falling Greek wages and improvement in Italian and Spanish exports are cited as evidence that imbalances are correcting and peripheral countries are regaining competitiveness.
Unfortunately, this improvement may be dependent on the value of the Euro. If the Euro continues to increase, due to the US continuing its Quantitative Easing program for longer than expected, then improvements in economic activity may slow. Fundamentally, all countries cannot achieve an increase in net exports.
The IMF recently concluded that Euro-zone internal adjustments were cyclical, that is, due to slower growth and weaker currency, rather than sustainable structural policy changes. Internal cost adjustments within the Euro-zone itself have been slow, driven in part by the reluctance of stronger countries led by Germany to reflate and switch from their export driven models. The prospects of such changes occurring in the near term are poor.
Reduced dependence on foreign capital also stabilised borrowing costs. Leading into the crisis, Greece, Ireland, Portugal, Spain and Italy were running current account deficits which were financed by imported capital.
Most countries are now funding their needs domestically. Around 70% and 60% of all Spanish and Italian government bonds respectively are now held domestically. Almost 100% of net issuance of Spanish and Italian government is now purchased by domestic investors, reducing vulnerability.
The ECB provided low cost funding to domestic banks to buy government bonds issued by the sovereign, which are then lodged as collateral for the loan. Withdrawing from foreign markers and reducing exposure to riskier investments, Euro-zone banks have been ‘encouraged’ to purchase government bonds, which generate attractive profits.
The policy does not address the problems of debt levels. It concentrates exposure to government bonds and creates problems if the debt has to be restructured. It also increases the vulnerability of the banking system.
Stabilisation has reduced the pressure on reluctant governments to continue austerity programs in the face of weak economic activity and high levels of unemployment. Pleading exceptional circumstances and extraordinary conditions, many nations have sought and received exemptions. Deficit and debt reduction targets have been deferred, although even these new reduced or deferred thresholds are unlikely to be met.
In September 2012, Spanish Prime Minister Mariano Rajoy stated that ‘reality prevented‘ him from keeping to his electoral promises. He argued later that pension cuts were ‘imposed by reality‘. Now, it seems that in Spain and throughout Europe ‘reality’ is ‘imposing’ slower fiscal consolidation and slippage in debt reduction programs.
Overall, economic improvement will, at best, be slow. Growth will not strong enough to reduce unemployment, public finances or improve solvency of banks, corporations or households.
Write Me Down, Write Me Up….
Further write downs in debt, as in Greece and Cyprus, to reduce debt to sustainable levels is difficult. Official lenders now directly or indirectly now own large amounts of the relevant debt.
The ESM, the ECB and the International Monetary Fund (IMF) have direct loans to or have purchased bonds issued by Greece, Ireland, Portugal, Cyprus, Spain and Italy. The ECB and national central banks have substantial loans to Euro-Zone central banks and banks secured over the bonds of beleaguered countries. For example, the ESM, ECB, IMF and European central banks now hold more than 90% of Greece’s outstanding debt.
Further debt write downs, providing relief for the borrowing nations, would result in immediate losses to these official bodies, ultimately flowing through to the taxpayers in stronger countries such as Germany.
On a visit to Greece which necessitated a large and expensive security operation, German Finance Minister Wolfgang advised Greeks ‘not to continue at this time this discussion on a new haircut‘ (European code for no further write downs of existing loans).
Wolfgang Schäuble argued that it was not in Greece’s interests to ask for debt relief. In reality, it is in Germany’s interest that Greece does not seek further write downs. Further debt restructuring may result in actual cash losses to Germany, contradicting assurances to German voters that they were not at risk in the bailouts.
The Invisible Measure…
The ECB Outright Monetary Transactions (OMT), which allows purchase of unlimited amounts of the debt of Euro-Zone nations, has been hailed a success. President Mario Draghi has, self-effacingly, referred to it as the ‘most successful monetary policy measure undertaken in recent times‘.
Details of the yet to be used program remain opaque, especially on key issues such as whether the ECB’s status as a preferred creditor on such purchases in the event of default or restructuring. The OMT program is conditional, requiring the relevant government to formally request assistance and agree to comply with strict.
It will be politically difficult for countries like Italy and Spain to ask for assistance if required, knowing that if a future debt restructuring is necessary then domestic taxpayers face a loss on their bank deposits as in Cyprus. If they are forced to seek assistance, then it will be under such extreme conditions and market pressures, meaning that ECB intervention may be too late.
Germany and other Euro-Zone members remain opposed to unlimited purchase of sovereign bonds under the OMT. Its legal basis remains uncertain. The result of a challenges being heard by the German constitutional court is unknown.
Diluting the Break…
The banking union was intended to ‘to break the vicious circle between banks and sovereigns‘.
However, in the period since the announcement of the banking union, bank exposure to sovereign debt has increased, as national banks have purchased the sovereign’s debt which is used as collateral to obtain financing from the national central bank or ECB.
As at August 2013, more than 10% of Italian banks’ total assets were sovereign bonds, an increase from 6.8% at the start of 2012. Spanish banks’ holding of sovereign bonds is 9.5%, an increase from 6.3% in the same period.
Portuguese banks’ holding of sovereign bonds is 7.6%, an increase from 4.6%. As part of a global trend to re-nationalisation of banking systems, the majority of the sovereign bonds held are that of the banks’ own governments.
These holdings are complicated by the fact that banks hold no or minimal capital against these investments. The securities are frequently not marked to market, being held at historical purchase value.
Euro-Zone bank claims on the public sector range between 10-40% of national GDP. European banks own around Euro 700 billion of Spanish government bonds and Euro 800 billion of Italian government bonds. They also have significant exposure to Greece, Ireland and Portugal.
The key elements of any banking union are deposit insurance and a centralised recapitalisation fund. German opposition forced the ECB President to personally assure the Bundestag that a Euro-Zone wide deposit insurance scheme would not be part of the arrangements.
There are no specific additional financial resources for recapitalisation, which remains reliant on the inadequate ESM. Germany insists that the banking union cannot be responsible for ‘legacy’ risk, that is, problems originating from events before the finalisation of the banking union.
Claudia Buch, a member of the German Council of Economic Advisers, speaking in an interview with the Frankfurter Allgemeine noted that bank recapitalisation would be carried out under ‘international control and national liability‘. It highlighted the fact peripheral nations do not have the capacity to support their banks.
The banking union has become an inadequate single supervisory mechanism for a small number of Euro-Zone banks, maintaining pretence of action and progress allowing all governments to save face. The European Union has clarified that the goal is now to only ‘dilute’ the link.
The scope of the Euro 500 billion ESM is also limited. Following assistance to Greece, Ireland, Portugal, Cyprus and Spain (for the recapitalisation of banks), there is only maximum capacity of around Euro 200 billion, well below potential requirements, especially if Spain or Italy should require assistance.
The ESM’s position is weak as it needs to issue debt, backed primarily by capital contributions of four countries: Germany (27.1%), France (20.4%), Italy (17.9%) and Spain (11.9%). If Spain or Italy needs assistance, then the contingent commitment of the remaining countries, especially France and Germany, would presumably have to be increased to maintain the viability of the ESM.
The limitations of the ESM were highlighted by recent rating agency actions. If the ESM injects capital into Euro-Zone banks (up to a maximum of Euro 60 billion), then it will have to post collateral of Euro 120 billion (i.e. on a 2:1 basis) to maintain its credit rating, required to raise debt.
Significantly the Latin American representative did not approve release of the most recent tranche of IMF funding for Greece, on the basis that forecasts for Greece’s debt and economic growth are delusional and there is significant risk of loss.
The token abstention (the voting levels would have been insufficient to block the disbursement), which was puzzlingly repudiated by Brazil subsequently, highlights increasing divisions within the IMF about further assistance to Europe. In August 2013, Brazil asked for an overhaul of IMF assistance to European countries to make them more realistic.
The identified weaknesses of key policies will increasingly be exposed. History suggests that European governments and the ECB will be tested.
Firstly, the weakness of the real economy will increase financial pressure on European countries. During the second quarter 2013, European economies recorded slow growth, technically ending the recession.
However, the levels of economic activity excluding Germany and France remained low. The turnaround may prove fragile, given deteriorating conditions in emerging markets which have been major buyers of European exports.
European governments and policy makers now proclaim a stabilisation or lower rate of decline as an indication of the success of their policies. Early in 2013, European Union Economic Affairs Commissioner Olli Rehn provided an interesting summary: ‘The current situation can be summarised like this: we have disappointing hard data from the end of last year, some more encouraging soft data in the recent past and growing investor confidence in the future.‘ But European forecasts of recovery may prove over-optimistic.
Secondly, banking sector problems will continue. European banks may have as much as Euro 1 trillion in non-performing loans. Italian banks may have as much as Euro 250 billion of these.
Increasingly, European governments are resorting to tricks to resolve problems of the banking system including inadequate stress tests, overly optimistic growth and asset price forecasts and accounting stratagems. For example, Spain plans to convert Euro 51 billion in deferred tax assets (resulting from loan losses) into ‘core’ capital to meet minimum requirements. If successful then these would represent around 30% of Spanish bank core capital.
Without urgent and resolute action, bad debts and weak capital positions will create zombie banks, unable or unwilling to supply credit to the economy restricting any recovery.
Thirdly, crucial structural reform of labour markets and entitlements will be slow, reflecting weak economic activity and also the unpopularity of many measures. In addition, the relative stability of the last twelve months has lulled governments into a false sense of security, reducing the urgency of pursuing economic restructuring.
Fourthly, political tensions, both national and within the Euro-Zone, are likely to increase.
Many countries also have domestic issues that contribute to political instability. In Spain, the bribery scandal involving the ruling PP remains problematic. In Italy, continued political volatility centred on a fragile coalition government and the legal difficulties of former Italian Prime Minister Silvio Berlusconi remain.
Debate on crucial policy measures is hostage to these political dramas. Italy is living up to former dictator Benito Mussolini’s observation: ‘Governing the Italians is not impossible, it is merely useless‘.
Across the Euro-Zone, Germany’s repeated rejection of any steps amounting to a mutualisation of debt or hidden transfer payments as well a reluctance to increase German commitments, increasingly supported by Northern European nations, will complicate crisis management. Little is expected to change under the new German government.
The slow, rancorous process of Euro-zone negotiation will not help. French Prime Minister Francois Hollande provided a candid diagnosis: ‘The problem with Europe is that there are others involved.‘
Economic and political pressures will manifest themselves in a number of ways.
Weaker countries may require extensions of existing loans, additional assistance or debt write downs. While it is likely to exit the bailout arrangements in the near future, poster child Ireland’s economy and access to capital markets remains fragile. It must also repay a high level of borrowings that it has incurred.
Credit ratings are likely to be under pressure. Spain (BBB) and Italy’s current credit rating (BBB with a negative outlook) is perilously close to non-investment grade. Stronger countries also face rating pressure from larger financial burdens off supporting peripheral countries and European and global economic weakness.
Banking system problems will continue to simmer.
Borrowing costs of weak European countries have begun to increase, reflecting different factors including: economic weakness of the borrowers, political stresses and also the potential reduction of the US quantitative easing program.
Doubts about the OMT program and decreasing flexibility to use national banks and state pension funds to purchase government debt will accelerate the pressure on rates.
For Europe, it is now a case of NWO (no way out), as without strong growth (which is unlikely) its debt problems may prove intractable. The ECB has repeatedly stated that its ability to respond to pressures is ‘adequate‘. Unlike in July 2012, it is not clear whether it response will be ‘enough’ this time around.
The best summation of the situation was provided by Spanish Prime Minster Rajoy when responding to a question of his country’s economic status, he stated that: the recession is over, but the crisis continues.
for Markets and Money
© 2013 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money
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