Friday, November 27, 2009

Money for nothing

Central bank money is available in huge quantities for almost 0%. However, while this has helped to propel risk asset prices higher/credit spreads lower, it has only masked but it clearly did not solve the deeper problem of undercapitalisation. The latest events in Greece as well as in Dubai should are testimony to this assessment.
While I do not have any special insight into the Dubai situation, to me it has some similarities to the Greek developments. In Greece, we have an undercapitalised banking sector in a structurally weak and uncompetitive economy. The undercapitalisation of the banking sector was only masked by the ECB's liquidity provision measures but just as you cannot extinguish a Greek fire with the help of water alone you can not heal an undercapitalised banking sector with the sole help of liquidity. Furthermore, the Greek problems are not confined to Greece as a host of Eurozone countries face a very similar structural situation while the undercapitalisation of the banking sectors in a large number of countries across the globe are being masked by a massive amount of central bank liquidity.
In the case of Dubai we have had a debt-fuelled housing bubble which left housing markets overvalued and the corporate sector massively overindebted. Again, this sounds rather familiar and is not an issue solely confined to Dubai. A debt-fuelled housing bubble was also a global phenomenon and has left corporates and/or households over-indebted in a host of countries. While the non-financial corporate sector seems to be in an unsustainably large financial deficit for example in Spain, France and Italy, household finances seem unsustainable especially in the US and the UK. Again, a massive dose of central bank provided liquidity for banks will not solve the problem of over-indebtedness of corporates and households. It is the same as with the banking sector, corporates and households need to recapitalise. For corporates this can either be done via increasing equity (hurting share prices) or paying down debt (from internal cash-flows/selling of assets) which in an economy growing only at limited speed largely means cost-cutting. Households on their side can only 'recapitalise' via higher incomes (from wages, capital or the government) and/or lower spending which would result in a higher savings ratio. However, this process is made even more difficult by the increasing unemployment rates.
In turn, we live in an environment where money/liquidity is available for nothing but capital is scarce. Given the challenges to recapitalise in a world of low nominal GDP growth, we should brace ourselves for more defaults within the banking, the corporate as well as the household sector over the next few years.


  1. What evidence do you have to support your thesis of under capitalised Greek banks?

  2. This statement is not based on 'hard' data but rather indirectly via a more qualitative assessment:
    a) their behaviour: excess liquidity reserves relative to Eurozone average (high), change in government bond holdings (up), lending behaviour (down) etc.
    b) my believe about the quality of their assets. Greek banks have been spared by the subprime crisis as they are not active in these market segments and rather hold not marked-to-market assets. However, they are very much dependent on the domestic economy (as well as Southern Eastern Europe). The quality of those loans should have been deteriorating drastically over the past quarters. They have been based on high nominal growth (amid relatively high inflation and real growth), however, Greek nominal growth does not promise to return to the heights of the past years soon. In turn, loan delinquencies should be rising. Coupled with the assumed lower level of marked-to-market assets but higher levels of non-marketable securities (loans etc.), one would expect that losses do not show up in real time on the balance sheet.
    c) what I wonder most about is why do the Greek banks hold so much excess liquidity reserves especially given that they have a large deposit base? From the market structure you would expect that Greek banks would be hoarding less liquidity than the Eurozone average as their deposit base relative to total assets is around 70% vs. 50% for the Eurozone average (if one uses aggregate balance sheet data for monetary financial institutions according to the ECB).