Friday, June 29, 2012

Welcome to the Banking Union

Just a short not on today's news:
I think that the statement with respect to secondary market support for Spanish and Italian government bonds is not the most important point from last night (it is not that far away from what the EFSF/ESM could do already). The most important point for me is that the EU summit effectively established a Eurozone banking union with a central banking supervisor who has access to a fund (ESM) for direct banking recapitalisation and who can itself provide unlimited amounts of liquidity. As stated, the bailout for Spanish banks will ultimately end up in this  new bank recap facility. As a result, it should then not count anymore towards the Spanish sovereign debt. This is clearly a game changer with respect to the negative feedback loop prevailing between banks and the sovereigns in the periphery where weak banks weigh on the sovereign and weak sovereigns weigh on banks. (On the downside, such a super-ECB can also commit super mistakes)

Additionally to quote from the statement: "The Eurogroup will examine. the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme. Similar cases will be treated equally. " If similar cases will be treated similarly, Ireland and Greece could also see parts of their bailout money (the money which went to the banks) being shifted off their balance sheets and hence leading to a sharp reduction in their indebtdedness (and with that also lower interest expenses).
As such it helps to solve parts of the overindebtdedness problem of several countries.

To be sure, this summit has done nothing to promote near-term or long-term growth (the growth pact is not really much new money and in total amounts only to 1% of GDP). For the long-run developments of the Eurozone it is important that the peripheral countries continue on their path of structural reforms to improve trend growth (without higher growth over the longer-term, debt-GDP ratios will not come down except via inflation or default). Furthermore, it seems clear that the EFSF/ESM capacity will most likely not be enough. However, that is not an acute problem but one to be solved at a later stage (in another emergency situation) and where last night gives confidence that it can be solved either via increasing the capacity or giving the ESM a banking licence and hence access to the ECB to leverage the paid-in capital.

The summit has certainly reduced the systemic risks prevailing in the banking sector. As a result, the elevated risk premia priced into Eurozone assets can fall again (and on the other side, the safety premia priced into Bunds should fall as well). I personally see bond markets of the semi-core countries (AT, NL, BE, FR, FI) as the ones which are best placed in terms of risk-reward and expect spreads of this group of countries to converge and to trade much closer to Bunds.

A last word for the ECB: I continue to expect an ECB rate cut (with a lower repo-depo spread). Furthermore, I do not see a reactivation of the SMP programme (this is no clearly in the EFSF/ESM court). However, the ECB will continue to do everything to keep solvent banks liquid as it has done vigourously since last December (and soon it will also have access to the money to keep the banks solvent).

Tuesday, June 19, 2012

Four Weddings and a Funeral

This blog post is dealing with some longer-term, i.e. multi-year issues, concerning the Eurozone.
First a quick comment regarding the short term view: Markets can stabilise into the EU-summit at the end of the month, as they have always done in the past two years. It is rational to partially close shorts/underweight positions in for example the Euro or overweights in Bunds ahead of the summit, irrespective of what one thinks might be the result, and potentially increase them again after the summit. Hence, we see some stabilisation in markets but that should not be confused with a stabilisation in the underlying fundamental dynamics. In this respect I am more worried than ever.

To me, the European integration project of the last decades secured four freedoms: the free flow of people, capital, goods & services between the member countries (the four weddings). Economic integration promoted economic development and political stability. The creation of the single currency (the funeral) was meant to move even closer together in economic and political terms, however, this time the integration was neither necessary nor well-thought through threatening the whole project. A common currency is not really necessary given that corporates & households nowadays have many tools available to diversify/hedge/reduce the currency risks which were not available a few decades ago/much costlier to set up. Global capital markets offer hedging instruments and render a global portfolio allocation easy. For corporates it has also become easier to implement a global supply chain or geographically diversify their production capacities. The result is that the economic benefits of a currency union are lower now than a few decades ago. On the other side, the structure of the Eurozone has not been set in accordance with its needs (it is not a fiscal/political union).
With the birth of the Euro, yields in the Eurozone countries converged down to the German level (markets wrongly priced Eurobonds), fuelling a debt-financed boom in the periphery. This led to higher inflation in these countries which over time eroded their competitiveness. As a result, a growing number of Eurozone countries is facing a simultaneous competitiveness and overindebtedness problem (however, the two are interlinked. If the countries' corporate sectors would be competitive, their growth would be better and hence debtloads would be easier to manage). While in the case of Greece, the debtload stems from the sovereign, in the case of Spain/Ireland it originates in the banking/household sector (via the construction boom/housing bubble), whereas Italy has always had a high government debt load but amid ever lower trend growth and rising yields faces increasing long-term challenges.

There are a few things that can be done to tackle overindebtedness:
a) higher real growth
b) higher inflation
c) default
d) shift the debt to someone else

Higher real growth helps to lower debt/GDP ratios (as GDP increases which directly lowers the ratio and given higher GDP, there is more money for debt service). Peripheral countries would like to promote cyclical growth via stimulus measures (easier monetary policy, easier fiscal policy) whereas Germany would like to promote trend growth via structural measures (which though work only in the longer term). 
Higher inflation also directly increases nominal GDP and works the same way, however, in real terms, no one is better off than under a) whereas bondholders are worse off.
Default directly reduces debt but has enormous negative consequences on capital markets and the economy in the short term.
Finally, shifting debt to someone else can be done in several ways. One way is Eurobonds (where the debt is shared among a larger group of countries) but this can also be done via forcing certain types of investors to buy bonds or force artificially low yields on investors (for example this can be done via regulation for banks or pension funds/life insurers).

The drive by the  periphery to implement structural reforms is clearly waning (and in the case of France, seems to have moved the opposite way) which worsens the longer-term growth outlook. Furthermore, the ECB seems not willing to tolerate higher inflation. Finally, Germany is still against Eurobonds (even thought they might shift in favour of the so-called European Redemption Fund which would be a partial mutualisation of debts) given that Germany fears that it will have to pay for the social security net in the periphery.

Hence, out of the bad options, it seems that only the worst ones are left. Hence, the dominos will continue to fall. If no meaningful support measures for the peripheral countries are enacted, then these countries remain mired in recession while capital flight is rising sharply. Capital flight is increasing also in Spain which further weakens the banking system and leads to tighter credit availability and hence a weaker economy. With no further strong support measures, the pressures to introduce a parallel/new currency and/or default rises, not only in Greece but increasingly in other countries too. As a result, the scenario of a break-up of the Eurozone can not be dismissed.
However, should strong support measures be enacted which have the potential to stop capital flight in the periphery, then this might cause fears of sharply rising taxation and/or inflation in the northern countries (which undermines their economic capabilities) and promote capital flight there.
Overall, therefore, the risk that over the next years the Eurozone is breaking into several pieces or has to re-introduce capital controls (around single countries and/or around the Eurozone) to prevent capital flight increases. Thereby, the Euro is threatening the four freedoms of European integration.  

Personally, I would favour a combination of the above: much more measures to increase trend growth across the Eurozone (also in Germany), a substantially easier monetary policy stance (rate cut, buying of government bonds via the ECB without rendering them senior to outstanding govies) coupled with a move to nominal GDP targeting. Furthermore, this policy mix should be accompanied by a mild form of financial repression to secure demand for government debt and a move towards an ERF.
As a second best solution, the northern European countries (Germany, Netherlands, Luxembourg, France, Austria, Finland, Slovakia) could together leave the Eurozone and form a Northern Eurozone, essentially splitting the currency area into two.