Satyajit Das: European Death Spiral – Communicable Diseases

By Satyajit Das, the author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives”

Communicable Diseases

European politicians and central bankers have provided useful geographical clarifications. Prior to succumbing to the inevitable, the Ireland told everyone that they were not Greece. Portugal is now telling everyone that it is not Greece or Ireland. Spain insists that it is not Greece, Ireland or Portugal. Italy says it is not in the “PIGS”. Belgium insists it was no “B” in “PIGS” or “PIIGS”.

EU pressure on Ireland to accept external “help” was to safeguard financial stability in the Euro area, as much as rescue Ireland. However, contagion is proving difficult to prevent.

Russian writer Leo Tolstoy wrote that: “All happy families resemble one another, every unhappy family is unhappy in its own way.” The same applies to beleaguered European countries.

Greece had a bloated public sector and an uncompetitive economy sustained by low Euro interest rates. Ireland suffered from excessive dependence on the financial sector, poor lending, a property bubble and an increasingly generous welfare state. Portugal has slow growth, anaemic productivity, large budget deficits and poor domestic savings. Spain has low productivity, high unemployment, an inflexible labour market and a banking system with large exposures to property and European sovereigns. Italy has low growth, poor productivity and a close association with the other peripheral European economies. Italy has recently started to rein in its budget deficit. The Italian banking system is relatively healthy but exposed to European sovereign debt. Belgium is really two ethnic groups that share a king and high levels of debt (about Euro 470 billion, 100% of GDP).

Portugal, Ireland, Greece and Belgium are also small, narrowly based economies which increases investor’s risks. The countries have in common, very high and potentially unsustainable debt levels. They also have in common a reliance on foreign investors to purchase their debt.

Contagion is transmitted through different channels. The rising cost of borrowing increasingly makes high levels of debt unsustainable because of the cost of meeting interest payments. Eventually, countries lose access to commercial funding sources, which is what happened to Greece and Ireland. By the end of 2010, the cost of funds for the relevant countries had risen, in some cases to punitive levels. Greek debt is trading around 12%. Ireland trades at around 9.50%. Portugal trades around 6.60%. Spanish debt now trades at 5.50-6.00%, while Italy is trading close to 5.00%.

Rising rates result in unrealised losses on investor holdings of the debt. If EU/ IMF support is not available and the debt is restructured or defaults when it falls due, then this loss is realised. This affects the profitability and potentially the solvency of investors or banks depending on the quantum of exposure or size of the losses.

In total, banks have lent over $2.2 trillion to the PIGS. French and German banks have lent around $510 billion and $410 billion respectively. British banks have lent $324 billion to Ireland and Spain. The problem is compounded by complex cross funding arrangements. Spain, which may need financial support, has $98.3 billion exposure to Portugal as well as a $17.7 billion exposure to Ireland.

The final channel of transmission is less obvious. Where stronger countries move to support the weaker countries, financing the bailouts affects their own credit quality and ability to raise funds. As concerns about the peripheral countries increased, interest rates for Germany and France, which would have to bear the burden of supporting others, rose. Europe increasingly resembles a group of mountaineers roped together. As the members fall one by one, the survival of the stronger ones is increasingly threatened.

European leaders see markets as the cause of the problems. George Papandreou, Greece’s Prime Minister, spoke of “psychological terror” that traders were inflicting. EU Commissioner Michel Barnier complained that traders were “making money on the back of the unhappiness of the people”. Others variously blamed “wolf-pack markets”, hedge funds and credit ratings agencies. But unsustainable levels of debt remain the heart of the problem.

Unpalatable Dishes

The EU and IMF are hoping that the bailouts of Greece and Ireland will restore market confidence. In combination with stronger growth, greater fiscal discipline and domestic structural reforms, they hope that the fear of default or restructuring will recede. Eventually, the troubled countries will regain access to markets. The emergency facilities and support mechanisms will be gradually unwound. While not impossible, the chances of this script playing out are minimal.

A more likely scenario is that the support measures do not work and increasingly Portugal and Spain, initially, find themselves under siege. As market access closes, they too will need bailouts straining existing arrangements, necessitating new measures. If Portugal (debt around Euro 180 billion) was to require assistance, then it will reduce the available funds in the existing EU’s bail-out mechanism. Spain (with debt of over Euro 950 billion) is simply too big to bail out using the present facilities.

Under such a scenario, available options include greater economic integration of the EU, expansion of existing arrangements or a decision to allow indebted countries to fail.

Greater economic integration would entail adoption of a common fiscal policy, encompassing strict controls on fiscal policy including tax and spending. It could also include the issue of Euro zone bonds (“E-Bonds”) to finance member countries, lowering borrowing costs for peripheral economies and facilitate access to markets.

Fiscal union would prevent default of over-indebted borrowers without necessarily addressing the fundamental problems of individual economies. The likelihood of greater fiscal union in the near term is limited, as it is unlikely that nations will surrender the required economic powers and autonomy.

The E-Bond proposal, for up to 50% of a State’s funding requirement, is unworkable given large differences in credit quality and interest rates between Euro Zone members of around 10%. The E-Bond credit support structure would resurrect the ill-fated EFSF on a larger scale.

In any case, Germany takes the view that national governments should bear responsibility for their own decisions. Germany also opposes E-Bonds, as they would increase its borrowing costs. France’s early enthusiasm for E-Bonds seems to have diminished.

The cost of full fiscal union is prohibitive, entailing between Euro 340 billion and Euro 800 billion, depending on the degree of fiscal imbalances. Much of this cost would have to be borne by Germany and other richer economies.

If Portugal and Spain experience problems, then in absence of a full fiscal union, the only available actions are further EU support or default.

There have been proposals to expand the EFSF/ ESM as needed. While Germany currently has opposed any expansion, it remains an option. Perversely, increasing the funding available to support troubled countries may signal that problems were imminent, with a resulting loss of confidence necessitating a bailout.

The ECB can increase support for the relevant countries, in the form of purchases of bonds or financing Euro Zone banks to purchase them. Interestingly, the ECB will increase its capital base, from Euro 5.76 billion to Euro 10.76 billion by end 2012, the first such increase in its 12-year history. The increase in capital allows greater support from the ECB, whilst providing reserves against potential losses.

In an extreme scenario, the ECB could simply print money, following the US Fed’s lead, to support its members, known technically as “unsterlised purchases”. Such action may not be permissible under its existing rules, requiring amendments to EU treaties. It would severely damage the ECB’s already tenuous credibility and be resisted by Germany and other conservative EU countries.

“Extend and pretend” measures would allow orderly default or debt restructuring by some countries over time. It minimises losses, controlling the timing and form of restructuring. It would also minimise disruption to financial markets and solvency issues for investors and banks with large exposures.

If the EU does not agree to fiscal union or continuing support, then pressure on Portugal, Spain, Italy and Belgium may reach a tipping point, making default or restructuring the likely end game. Presumably, existing programs, such as those for Greece and Ireland, would be suspended. Governments would announce debt moratoriums, defaulting on at least some debts and forcing write downs. This would be followed by a domino effect of defaulting countries within Europe.

The defaults would affect the balance sheets of banks, potentially forcing governments, especially in Germany, France and UK to inject capital and liquidity into their banks to ensure solvency. The richer nations would still have to pay, but for the recapitalisation of their banks rather than foreign countries.

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  1. Jim Haygood

    ‘The ECB will increase its capital base, from Euro 5.76 billion to Euro 10.76 billion by end 2012, the first such increase in its 12-year history. The increase in capital allows greater support from the ECB, whilst providing reserves against potential losses.’

    Meanwhile, the ECB’s latest balance sheet shows Euro 2.006 trillion in assets:

    So even after doubling its capital, the ECB would still be employing 200:1 gearing [leverage].

    That’s ludicrous. It’s preposterous. It makes pre-crash Fannie Mae look like a paragon of conservative capitalization.

    Of course, as the IMF pointed out in a paper analyzing the Reserve Bank of Zimbabwe, nothing precludes central banks from operating with negative net worth, since their liabilities (predominantly currency) aren’t redeemable. It just looks bad. And the speculator wolf-pack can always punish them by selling off the confetti currency, even if they can’t redeem it.

    Restructure now, or restructure later and larger. Escudo me for being so peseta-mistic!

  2. Hugh

    I know it is easy to slip into talking about Spain and Germany or even the banks or markets as if they were actors on a stage, but what we are really talking about here as so often elsewhere are failed kleptocratic elites who are trying to dump their failures and bad bets on whoever is dumb enough or weak enough to let them.

    What is needed in Europe as here is a restructuring of both the financial and political systems. But as this would entail loss of power and wealth to the elites, it won’t happen unless the people force it to happen. As it is, all the elites have is extend and pretend not to fix anything but to keep the casino open and the looting going as long as possible.

  3. stearm

    Timing is decisive.

    1) Wait until economic growth will bring Germany close to potential output;
    2) Start a well-organized debt restructuring of all European countries -no exception-which punish big investors and protect small investors -and not the other way around;
    3) ECB embarks on massive unsterilised purchases to all banks of the Eurozone to cover their losses.

    What will happen?

    Interest rates will go up because of debt restructuring but the fall will be partially offset by expansionary monetary policy. Euro will fall at first 20-30% helping the export sector.

    Things can eventually get worse, but it’s unlikely. Markets like to be treated badly. After a while -two or three months- they will buy government bonds again, but the supply of government being reduced and long-term expectations about the euro raising again will make European government bonds a quite safe and profitable investment.

    It sounds like a social experiment, but what will happen if governments goes on doing what they are actually doing, that is, moving taxpayers money to the banks’ balance sheets?

  4. SH

    I guess this is the fight between solvency and liquidity. It makes zero sense that lowering the cost of money makes it more likely that more money will come in. Aside from the money that exists, there are two sources of new money. Central bank printing or new savings. As an American with not a lot of money, do I want my new savings going to Greece because the EUSF lowered their cost of borrowing? No, I do what I can with my measly 401(k) withdrawals and give it to Bill Gross who decides that Greece is not credit worthy. Only when he gets a sweet deal will he make that bet. Even if they figure out a way to rollover all the debt, then that means that they are crowding out new investment at the cost of securing the old debt. New money will not come in unless the price is right. This is stupid.

  5. GermanQR

    Mr Das (and everyone else who still does, really) needs to stop using that “PIGS” word. It’s offensive and gratuitous.

  6. Ottovbvs

    These theoretical IF and MAYBE doom scenarios get more hilarious by the day. It’s total fantasy wrapped up in a load of market speak to give it a veneer of cred. There’s not going to be any fiscal union (not in the immediate future anyway) and Portugal, Spain, Greece and Ireland are not going to default. These places are going have a bumpy few years no question, don’t look for much growth, but deathwatches? I think not. It’s all a very entertaining intellectual game guys but has nothing to do with reality.

  7. Truthful James

    Time now to devise some financing instruments. Perhaps the GIPS should determine the market for Consols, the perpetual notes that Britain sold after 1814 to refinance the costs of the Napoleonic Wars.

    These Notes could be bought back only in the marketplace but also could be traded there. They would be paid off either from surpluses or from refinancings by the nation state issuing them.

  8. Emanuel

    @ GermanQR

    I’m portuguese and I don’t mind reading my country included in an acronym that reads as such a delicious animal.
    I do hope, though, that the negative implication of that reading will soon change, through the removal of the letter “P”, even if the future might add a “B” in its place. “Bigs countries” still reads much nicer then “Pigs”.

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