Friday, 8 June 2012

The Methodical Approach to Apocalypse

We often make fun in these pages over the inability of the eurocrats to get anywhere and the incredible emergency summit inflation they have given birth to, with none of the summits ever producing anything of consequence. We are always amused by their pompous pronouncements, which alternate between blue—eyed naivete (Olli Rehn, mid 2011: 'Europe has effectively contained the crisis') and darkly pessimistic predictions of imminent doom (Olli Rehn, late 2011: 'Europe has ten days to find a solution'). But things may soon take a turn for  the worse and then some of the fun will go out of the situation. 
Given that the ECB's supranational status keeps it from monetizing government debt directly, there is a kind of dialogue going on between the financial markets and the euro-group governments. The markets are frequently saying: 'You and your banks are bankrupt, or at least, some of you are and most of your banks are. Here and now. Show us why we should believe that you are still solvent.'
Whenever these questions are forwarded with some vehemence (e.g. when Spain's long term government bond yields approach 7%), an emergency summit ensues, which usually ends with a follow-up summit being announced. The follow-up summit then is supposed to deliver what the emergency summit couldn't.
As the follow-up summit approaches, rumors begin to circulate about what might get done. Most of the rumors center on Germany and the degree to which it is going to shift its position. In this context, not the following picture, which decorates the Economist magazine's cover this week:

Apparently the world economy has already sunk – and yet, the Economist magazine still seems to think it is up to Angela Merkel to 'start the engines'.
(Image credit: Jon Berkeley)

This image reflects how a great part of the mainstream views the situation, especially in the English-speaking world, but also in parts of the euro area: Mrs. Merkel and her government are held to obstruct the way to recovery by obstinately refusing to guarantee everyone's debt.
That is an utterly absurd view. Germany can not be expected to simply underwrite the debts of profligate spenders. Moreover, it would not be a solution anyway – it would merely cement an unsustainable situation and make it even worse in the long run (regardless of the fact that financial markets would likely throw a party in the short term). In the end, Germany would crash with everybody else.
And yet, the whole world is busy trying to second-guess the next German inconsistency – the moment where the markets are held to force Germany to give in on one or another point of principle. Certainly Germany's government has given  ground here and there when occasion seemed to demand it, such as e.g. on the size of the EFSF/ESM 'firewall',  but never on the truly important issues – and rightly so.
It forced through the PSI as a condition for the second Greek bailout; it remains staunchly opposed to euro-bonds; it remains opposed to 'QE' or anything that smacks of the ECB eschewing its statutory limitations. It also forced through the 'fiscal compact', even though said compact remains a deeply flawed construct.
Another feature of the 'follow-on' summits is that Germany eventually gets busy with deflating expectations. Whenever a new rumor bursts forth ('Germany agrees to a banking union!') the denials follow within hours, sometimes within minutes, of the rumor surfacing. Then, as the summit comes closer and closer, there comes the moment when someone finally says: 'don't expect anything substantial to emerge'. And they are correct: nothing ever does.  The latest example is provided in this report in the German magazine 'Der Spiegel':

Both Britain and the US want to see Europe move quickly toward a solution to the euro crisis. But Chancellor Merkel prefers a more methodical approach. In comments on Thursday morning, she sought to lower expectations ahead of the European Union summit in late June.
Merkel's day includes talks with British Prime Minister David Cameron as well as a joint afternoon appearance before university students in Berlin together with Cameron and Norwegian Prime Minister Jens Stoltenberg — just two days after Cameron joined US President Barack Obama in demanding immediate action to resolve the euro-zone crisis.
During a Wednesday evening visit to Oslo, Cameron repeated the message. "Speed is of the essence," he said. "Clearly the euro-zone crisis is the biggest threat to the world economy today." Merkel, for her part, laid out her talking points early on Thursday in an interview on German public television station ARD. Ahead of a crucial European Union summit at the end of the month, Merkel once again emphasized the need for "more Europe," saying "we don't just need a currency union, but we also need a so-called fiscal union — meaning more joint budgetary policies."
Most of all, though, she said that a political union was necessary. "That means that we must, step by step through the process, give up more powers to Europe as well and allow Europe oversight possibilities," she said.
Yet even as Cameron and US President Obama are clamoring for a quick solution, Merkel has already begun trying to lower expectations ahead of the late-June summit. While she has lent her support for the idea of a banking union — which would increase European oversight of systemically important banks as a step on the path toward providing direct EU aid to banks — Merkel said on Thursday morning that expectations of a complete plan to emerge at the late June summit are likely to be disappointed.
"I don't think that there is a single summit at which the big design will appear," she said on ARD. "But what we have been doing for some time and where a working plan will certainly be presented … is that we say we need more Europe."

(emphasis added)
Of course Mrs. Merkel is right – it is not possible for this upcoming summit to solve what umpteen summits before it have not been able to solve. However, the more often this happens, the less likely it appears that there will be any solution at all, or that there indeed ever was one.
Considering the far-reaching changes Germany believes to be necessary, it is clear that it will take a long time to go from the drawing board to negotiations to implementation. After all, 17 different governments must be brought on board. However, the crisis-tinkering has now been going on for more than two years and yet it feels as though the euro area is still where it was at its very beginning, with the main difference that three nations are officially bankrupt and another is on the verge of getting there.
And therein lies the problem – time for the methodical approach to the crisis is running out. Spain has just been downgraded again by Fitch – to BBB, 'outlook negative'. The markets seemed to ignore this development, but we would advise not to ignore it. The effect may arrive with a slight lag, but it will arrive. Clearly the rating agencies are still behind the curve, as the markets have long ago 'downgraded' Spain on their own – but official downgrades often result in more selling of the downgraded entity's debt, as various fund managers are forced by their mandates and statutes to sell bonds that fall below certain ratings thresholds. The IMF announced that Spain's banks will need €40 billion – more than Spain can afford, but in the opinion of most observers still far off the mark, given that the true size of the losses is not yet known. A bank recapitalization that aims to preemptively head off the need for another round of bank bailouts at a later stage will probably have to be a great deal bigger (always assuming that no bank will be allowed to go under).
Speaking of European banks, a chart recently published by CLSA shows that their combined assets currently amount to about 350% of the euro area's GDP – right back at the all time high. No wonder there is a banking crisis – it doesn't take much to bring down a banking system that sports such extreme leverage.

Assets held by euro area banks relative to the region's GDP. The combined market cap of the banks in the Euro-Stoxx bank index meanwhile has fallen to a mere €210 billion – click chart for better resolution.

The danger is ever greater that the markets won't give the eurocrats the time that is evidently required to make the kind of changes everybody can live with.
Meanwhile, the fact that the ECB's LTRO exercises have already turned into a damp squib of sorts, while concurrently creating even more problems for Spain's and Italy's banks, makes it unlikely that the ECB can pull yet another comparable rabbit out of its hat (that doesn't mean it won't try – but it may not work this time).
The risk that the recent gale will turn into a hurricane seems great – and as understandable as Mrs. Merkel's position is, the financial markets and depositors are not likely to wait around to see whether Spain or its banks can be rescued in the nick of time. We don't know how big the capital outflows from Spain have been since the end of March, but presumably they have continued to accelerate. There are also the Greek elections on June 17 and the elections for France's parliament at the same date to look forward to. Both events have the potential to sour market sentiment even further.
Ben Bernanke and Mario Draghi both seemed unwilling to commit to new easing measures 'unless things get worse', which of course means that they very likely will get worse.
And these are the conditions under which we are now serenely sailing toward another euro-group summit of which we are already told that it once again won't produce anything of consequence.
Instead, 'a working plan will certainly be presented'. Oh, and by the way, forget about the ESM being ready at the most recently appointed date – that seems no longer doable. Furthermore, in case SYRIZA wins the Greek election and Greece ends up leaving the euro, Fitch already threatens more downgrades for other euro area member nations.
We continue to hold that the problem has not been correctly diagnosed and that therefore all the 'solutions' bandied about are doomed to failure in the long run anyway. The crisis did not drop out of the sky like an asteroid strike from nowhere. It is the end result of a willy-nilly credit expansion instigated by the fractionally reserved banking system and aided and abetted by the central bank. This fundamental problem has continually received the silent treatment – and it still seems not deemed to be fit for debate. Similarly, the urgent need for economic liberalization has not received the urgent attention it deserves.
In conclusion, it seems to us that things could get rather dicey in the very near future. Batten down the hatches.

Euro-Stoxx bank index: a feeble bounce in recent days has lifted it off its lows, but this index has now lost about 80% from its former highs - click chart for better resolution.

Via Goldman Sachs: various 5 year CDS on financials – European banks, US banks, and the I-Traxx Senior Financials index, compared to I-Traxx Main and CDX - click chart for better resolution.

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