Ed Note: Satyajit Das correctly called the credit crisis before it hit financial markets in 2008. He is a keynote speaker at “After America”: the first investing symposium from Port Phillip Publishing. He has a lot to share with attendees, including a question and answer session at the conference. To learn more, click here.
Financially futile, economically erroneous, politically puzzling and socially irresponsible, the December 2011 European summit was a failure. Only the attending leaders and their acolytes believe otherwise. German Chancellor Angela Merkel’s post-summit homilies about the “long run”, “running a marathon” and “more Europe” rang hollow.
The proposed plan is fundamentally flawed. It made no attempt to tackle the real issues – the level of debt, how to reduce it, how to meet funding requirements or how to restore growth. Most importantly there were no new funds committed to the exercise.
The centrepiece of the new plan was a commitment to a new legally enforceable “fiscal compact” requiring government budgets to be balanced or in surplus, with the annual structural deficit not to exceed 0.5% of nominal Gross Domestic Product (“GDP”).
The language was Orwellian and incomprehensible in equal measure: “Member States shall converge towards their specific reference level, according to a calendar proposed by the Commission.” The European Commission is to approve national budgets with, curiously, the European Court of Justice designated as final arbiter.
Whatever the long-term merit of greater budget discipline, the compact recycles previous treaties, which have been honoured in the breach rather than observance. Since 1999 or from the time of their entry, eurozone member countries have recorded nearly 70 breaches of the existing Stability and Growth Pact, including nearly 30 occasions when budget deficits exceeding 3% of GDP were allowed because of recessions. Germany and France have been in breach on at least 6 occasions each.
Just as Margaret Thatcher favoured “sado monetarism” (a term coined by Denis Healey), the German plan for Europe is “fiscal B&D” (bondage and discipline).
The plan may result in a further slowdown in growth in Europe, worsening public finances and increasing pressure on credit ratings. This is precisely the experience of Greece, Ireland, Portugal and Britain as they have tried to reduce budget deficits through austerity programs. This would make the existing debt burden even harder to sustain. The rigidity of the rules also limits government policy flexibility, risking making economic downturns worse.
Fiscal controls may not prevent future problems. Until 2008, Ireland, Spain and Italy boasted a better fiscal position and lower debt than Germany and France. The weak economic fundamentals of these countries were exposed by the global financial crisis, leading to a rapid deterioration in public finances.
Irrespective of the treaty’s provisions, enforcement will be difficult. The Excessive Deficit Procedure call for “automatic consequences unless a qualified majority of euro area Member States is opposed”. The provision defines how any breach and automatic sanction can be waived rather than the consequences of failure to comply. It is difficult to see France and Germany voting to levy sanctions on each other. In 2003, there was an ignominious episode where France and Germany each breached the deficit ceiling but voted against condemning each other.
Recalling John Maynard Keynes’ observation about the Treaty of Versailles, if actually implemented and strictly followed, the compact will skin Europe, especially those in the weaker economies, alive year by year.
The fiscal compact did not countenance any writedowns in existing debt. It also did not commit any new funding to support the beleaguered European periphery. Germany specifically ruled out the prospect of jointly and severally guaranteed eurozone bonds. Instead, there were vague platitudes about working towards further fiscal integration.
Instead of dealing with the financial problems of the central bailout mechanism (the EFSF – European Financial Stability Fund), European leaders chose the re-branding option.
The EFSF will remain active until mid-2013 and then subsumed into the permanent European Stability Mechanism (“ESM”). The ESM will be implemented by July 2012 once 90% of member countries have ratified it – “rapid deployment” in European terms.
Crucially, the overall ceiling of the EFSF/ESM remains at Euro 500 billion, but will be reviewed in March 2012.
To increase available funds, the EFSF leveraging rules will be implemented more quickly, using the European Central Bank (“ECB”) as an agent in transactions. Given the indifference towards various leveraging proposals, especially from emerging nations like China, the ability to reach the target of at least Euro 1 billion in capacity remains in doubt.
Long-standing problems of the original EFSF structure remain unaddressed. The creditworthiness of Italy and Spain (which make up around 30% of the EFSF’s supporting guarantees) remains questionable. Pressure on the ratings of stronger guarantors (Germany, France, Netherlands, Finland and Luxembourg) complicates the ability of the EFSF to raise funds. Rating agencies have already warned of the risk of a rating downgrade.
Currently, the EFSF is only issuing short-term bills to finance its commitments (under the bailout packages agreed for Greece, Ireland and Portugal). Its long term funding costs are nearing the rate it is permitted to charge borrowers. The EFSF was even forced to deny reports that it would need to include a health warning about the risk of a rating downgrade and also break-up of the Euro in documentation for any new fund raising.
Given the problems of the EFSF, especially the ratings threat, the acceleration of the ESM initiative is an attempt to reduce the reliance on the member nation guarantees. The ESM will have paid-in capital (Euro 80 billion) which member countries can contribute.
Like its predecessor – the EFSF – is leveraged – Euro 80 billion supporting Euro 500 billion, equivalent to 6 times leverage. Continuing the circularity, nations like Italy and Spain will borrow to contribute capital to the ESM to allow the ESM to buy Italian and Spanish bonds. The ability of the ESM, like the EFSF, to raise the additional Euro 420 billion is also uncertain.
Eurozone nations and other EU members were asked to provide (up to) Euro 200 billion to the International Monetary Fund (“IMF”), to be lent, in turn, back to eurozone countries. As with the ESM, it is unclear how some countries will finance their contributions and the wisdom of countries de facto lending to themselves. The curious arrangement was necessary to avoid breaching existing European Treaties.
The arrangement, most likely, will be an IMF administered account, with the full risk being taken solely by the providers of funding. In the unlikely event that the IMF used its general resources, all members would have to bear the risk.
Full involvement of the IMF is difficult. A loan on the required scale represents a serious concentration risk for the fund. In addition, the funding would be released in tranches subject to meeting IMF conditions. IMF loans also have seniority over other obligations. So IMF involvement may reduce the relevant country’s access to commercial funding.
To date, European countries have only committed Euro 150 billion. Britain is a notable absentee, having rejected the Treaty changes, refusing the invitation to join the Europeans on the maiden voyage of the Titanic.
The summit communique looked “forward to parallel contributions from the international community”. The IMF (Influential Monied Friends) has proved reluctant, with the US and others unwilling to get involved. Only Russia has indicated a willingness to contribute (Euro 20 billion).
Bundesbank President Jens Weidmann observed that Germany would only release its contribution (Euro 45 billion) if: “there is a fair distribution of the burden amongst the IMF members. If these conditions are not fulfilled, then we can’t agree to a loan to the IMF.” He noted that: “If large members, for example the USA, were to say ‘we’re not taking part,’ then from our point of view it is problematic.”
Parallel to the Summit, The European Banking Authority (“EBA”) updated its stress tests, increasing the amount of capital that European banks need to raise to Euro 115 billion. The increase was necessary to cover a fall in the value of sovereign bonds held by the banks. As the data used was dated, further deterioration of the value of holdings may mean that more capital will ultimately be needed.
Italian, Spanish and Greek banks have the largest capital requirements. Italian banks need to raise Euro 15 billion. UniCredit, which holds around Euro 40 billion in Italian government bonds, needs to raise Euro 8 billion. Spanish banks need Euro 26 billion with Santander needing Euro 15 billion. German banks also need capital with Commerzbank, the country’s second largest bank, needing Euro 5.3 billion.
With share prices down significantly (40-60% for the year) and the likelihood of weak profits driven by write-offs and lack of balance sheet growth, European banks face difficulties in raising capital.
Unlike US banks in 2008/2009, European banks are reluctant to cut significant dividend payouts. Spanish bank Santander plans to pay shareholders euro 2 billion in cash and more in stock (over 15% of its stated capital requirements). They argue the need to preserve their brand, compensate investors for poor share price performance and a return to profitability. Curiously, the EBA or the Bank of Spain has not intervened to force a suspension of dividends to husband capital.
The most likely source is national governments providing the capital, adding to their debt problems. Germany has already reactivated its bank bailout fund for this purpose.
Banks can also lift their capital levels by reducing the size of their balance sheets. European banks could sell (up to) Euro 2 trillion in assets. In addition to capital concerns, such a move is driven by liquidity factors with European banks having trouble raising dollars at acceptable cost.
Credit Agricole, the third largest French bank, is planning to reduce assets by around euro 60 billion by the end of 2013. This will improve the bank’s capital position and also reduce its funding needs by euro 50 billion. If all banks undertake similar actions, selling foreign assets and shutting (mainly overseas) operations, then the effect on the broader economy will be significant. The tighter credit conditions and lower economic activity may increase normal credit losses setting off a negative feedback loop.
Asset sales by European banks to improve capital are acceptable to the EU as long as they “do not lead to a reduced flow of lending to the EU’s real economy”. Withdrawal from foreign markets is already having a noticeable impact in Eastern Europe and Asia. A slowdown in these economies will indirectly affect Europe, reducing demand for European exports.
Europe is now firmly on the road to nowhere, with doubts whether there is enough money or political will to retrieve the position.
© 2012 Satyajit Das All Rights Reserved. Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk. He is a keynote speaker at After America: the Port Phillip Publishing Investment Symposium, March 14th-16th at Sydney’s Intercontinental Hotel.
Ed Note: Next week, Satyajit Das completes his analysis of Europe and how this will impact Australia…
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