Yves here. Das’ understated comment on the latest Eurorescue scheme, “Implementation of the plan faces significant risks,” has been proven true by the events of the day, namely, the proposal by Greek prime minister George Papandreou for a referendum on the proposed rescue plan. Even though he secured unanimous approval of his cabinet, two members of his coalition, which has a thin hold on government, defected, and he faces a vote of no confidence on Friday. Mr. Market was not happy with this news. While the fall in equity markets was what got the headline, the enthusiasm there had been considerably overdone. Far more serious was the action in the debt markets. The spread between German bunds and Italian government debt hit 450 basis points. That put Italian borrowing rates at over 6%, which is an intolerable level relative to the country’s growth prospects.
We discuss what the Greek gambit means in a related post.
By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
Without Wings, Sans Prayers…
The initial market response to the EU proposal was positive, with major stock markets and bank shares rising sharply. Unlike equity markets, debt traders were cautious. On Friday 29 October, an Italian debt auction met with lack lustre demand falling short of the full amount offered for sale. The debt markets registered their doubts by pushing up 10 year interest rates on the bonds of both Italy (up 0.14% per annum to 6.01% per annum) and Spain (up 0.18% per cent to 5.49%). Greek rates remained high at 22.35% for 10 years while comparable Portuguese rates were 11.48% and Irish rates were 7.98%.
Implementation of the plan faces significant risks. Many elements of the plan are works in progress and are yet to be agreed with affected parties.
The players also seemed to have left the summit with different song sheets. ECB council member and head of the German Bundesbank Jens Weidmann expressed doubt about proposals to increase the capacity of the EFSF through leverage: “The leverage instruments that have been tabled are similar in their design to those that helped to cause the crisis.” He also observed that: “it [is] very important that all aid extended to member states under threat should only be in the form of loans.” Portugal asked Mexico to tell fellow G20 members at an upcoming meeting that the United States should offer “financial help”.
Germany’s Finance Minister Wolfgang Schäuble and retiring ECB President Jean-Claude Trichet pointedly cautioned that the crisis was far from over.
At best, the plan provides funds to tide over the immediate funding problems of weaker Euro-Zone members. It does little to deal with the Euro-Zone’s structural problems. There is still the risk that Europe enters a prolonged period of low growth or recession. The plan does not address the economic divergences that exist within the Euro-Zone or ease the painful adjustment processes that weaker members will still have to undergo within the constraints of the single currency. These problems are far more difficult to fix than the task of finding buyers for the required amount of government debt.
A crucial element of the plan is the ability of Spain and Italy to take action to improve their finances and maintain access to funding at reasonable cost. The EU communique specifically refers to the need for action by these two members at some length. There is considerable doubt as to whether this will occur.
Spain’s economy is weak, with low growth, low productivity and high reliance on debt. As the country has sought to bring its finances under control, Spain’s growth has slowed with an increase in the unemployment rate to 21% and youth unemployment above 40%.
Spain is seeking to reduce its budget deficit, enacting a balanced budget amendment to the constitution. But Spanish debt levels are still rising. Regional finances are even worse.
Spain’s banking sector is heavily exposed to construction, which was affected when the real estate bubble burst. The building sector alone owes Spanish banks around Euro 300 billion. The banks own more than 1.5 million dwellings, which are probably worth less than the price paid. There are substantial levels of uncompleted buildings. The Bank of Spain asked lenders to write down the value of their property related assets by 20% but further write-offs may be necessary. Spanish banks are also exposed to European sovereign debt, especially neighbouring Portugal. Given the high unemployment rates, the risk of further mortgage related losses are present.
Banks could have to write down property related loans by around Euro 100 billion. The need for Spain to provide capital for the banks would place a strain on public finances. Any recapitalisation is also difficult because of the structure of Spanish banking. Around 50% of mortgages are owned by local savings institutions called Cajas, essentially semi-public institutions with no shareholders which reinvest around half of their annual profits in local social projects. Local politicians control how these funds are used as mechanism for political influence making reform difficult.
Outstanding debt of Spanish banks is around 45% of the country’s GDP. In addition, Spain’s total private debt stands at 178% of GDP.
Implementation of structural reforms of product and labour markets has been slow. Unions and the population at large are highly resistant to the austerity measures planned.
Italy also faces difficulty in reforming its economy. Italy has a relatively low annual budget deficit but its total debt to GDP is the second highest in the Euro-Zone after Greece. In an emotional letter to the EU, Italian Prime Minister Silvio Berlusconi described hoped-for measures to improve the economy. A commitment to increase the retirement age in Italy from 65 to 67 by the year 2026 highlighted the lack of urgency and intent of the reforms.
The Northern League, a coalition partner of the government, is resisting many of the reforms. In a letter to the newspaper Il Foglio, Prime Minister Berlusconi supported growth and development but rejected austerity measures declaring that the word “isn’t in my vocabulary”. This conflicts with Italian commitments to the EU for large cuts in government spending.
It is difficult to see Italy, weakened by internal political strife, making rapid progress to making required structural changes to its economy and cutting public debt.
The EU refuses to deal with fundamental problems. The austerity and balanced budget measures, reinforced and reiterated in the plan, cannot deal with the primary problem – the deflation of the debt-fuelled bubble.
The EU is seeking to enforce the rarely adhered to rules for membership of the Euro, the Stability and Growth Pact requires a deficit no larger than 3% in any one year and a Debt to GDP ratio no larger than 60%. Based on 2010 figures, Austria, Belgium, Cyprus, France, Ireland, Italy, Portugal, Spain and Greece do not meet one or both of these tests on current measures. Only Germany, Finland and the Netherlands are in compliance and would pass in 2013 on current projections.
Strict enforcement of this rule about deficits would prevent counter cyclical spending by Governments undermining economic recovery and lock the Euro-Zone into a death spiral of budget deficits, further budget cuts and low growth.
The problem is compounded by the competitiveness gap between Northern and Southern countries, estimated at 30% difference in costs. The EU’s refusal to contemplate a break-up or restructuring of the Euro makes dealing with this problem difficult.
For many of the weaker countries, the best option would be to devalue their currency in the same way that the US and Britain are debasing dollars and sterling respectively. Unable to devalue or control interest rates, these weaker countries are trapped in a vicious and ultimately self-defeating cycle of cost reduction.
An additional problem is the internal imbalances exemplified by Germany’s large intra-Euro-Zone trade surplus at the expense of deficit states, especially the Club Med countries like Greece, Portugal, Spain and Italy. German reluctance to boosting spending and imports makes any chance of resolving the crisis even more remote.
German hypocrisy, in this regard, is problematic. German banks lent money to many countries to finance exports, which benefited Germany. Germany also gained export competitiveness from a weaker Euro – an exchange rate of Euro 1 = US$ 2.00 would be a realistic exchange rate if the Euro were to be a purely German currency. Reluctance to confront these problems makes a comprehensive resolution of the crisis difficult.
In chess, endgames require utilising the few pieces left on the board to achieve a result. Strategic concerns in endgames are different to those earlier in the game. The King becomes an attacking piece. Pawns become more important because of the potential to promote it to a queen. Endgames are more limited and finite than say openings.
The plan has bought time, though far less than generally assumed. As the details are analysed, weaknesses, unless remedied, will be quickly exposed.
The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies); debt monetisation (the ECB prints money); or sovereign defaults.
The key element of the 27 October Plan was the unwillingness or inability of Germany and France to increase the size of their commitments. The communique explicitly states: “[the increase in the EFSF’s capacity will be] without extending the guarantees underpinning the facility [Paragraph 18].” In other words, any further increase in the bailout facility will be difficult.
Germany is increasingly unwilling to increase its commitments. It is restricted by the German Constitutional Court’s decision, which makes it difficult to increase support for bailouts without a new constitution. On 28 October 2011, the German Federal Constitutional Court issued a temporary injunction requiring the government to stop relying on a selected group of lawmakers (effectively the Bundenstag Finance Committee) to fast-track approval of Euro-Zone bailout funds. If the decision is upheld, then the German government’s flexibility to act quickly will be restricted as it will need full parliamentary approval for each decision.
For the moment, Germany cannot or will not go above Euro 211 billion in guarantees for the bailout funds already committed –about 7% of its GDP. Fiscal integration would have a higher cost than Germany is willing to pay or can sustain without affecting the country’s creditworthiness. Germany’s GDP is around US$3.2 trillion and its debt to GDP ratio is around 75%. Supporting the financial needs of weaker countries would stretch its financial abilities.
France is at the limit of its financial capacity. France’s GDP is around US$2 trillion and its debt to GDP around 82%. Following the assumption of the liabilities of the failed Franco-Belgium financier Dexia, the rating agencies have indicated that France faces a rating downgrade.
Netherlands, Finland and Luxembourg are too small to make much difference. Fragile coalition governments in Netherlands and Finland are increasingly reluctant to increase their commitments to the bailout process.
These constraints make fiscal union difficult.
The ECB is not allowed to print money. Theoretically, it would need a change in European Treaties although the ECB has stretched its operational limits. Under new President Mario Draghi they may be willing to monetise debt as a response to the special circumstances.
Germany’s Bundesbank opposes debt monetisation. There would be deep-seated unease about printing money in Germany, which is still haunted by the memory of hyperinflation in the Weimar period.
The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow the printing of money. This assumes that a cost-benefit analysis indicates that this would be less costly than a disorderly break-up of the Euro-Zone. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe that this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetisation.
Unless restructuring of the Euro, fiscal union and debt monetisation is removed from the verboten list, sovereign defaults may be the only option available.
Slip Sliding Away…
There is an increasingly social and political dimension to the debt problem. In Greece, Spain, Portugal and Italy, there is growing social unrest resulting from the hardships inflicted upon the general population under the mandated austerity program. There is also deep resentment at what is seen as external interference in sovereignty. Given European history, the fact that this intervention is seen to be driven by Germany and France is unhelpful.
In the “donor’ nations, there is increasing resentment at bailing out “lazy” Club Med members. The argument, whilst simplistic and incorrect, plays well electorally, appealing to nationalism, racism and xenophobia. In Europe generally there are deep differences between a political class (preserving political careers using taxpayers money and funds that simply don’t exist) and ordinary men and women (whose futures are being mortgaged in the process).
The atmospherics were not aided by the pre-summit discussions where German Chancellor Merkel, French President Nicolas Sarkozy read Italy’s Prime Minister Silvio Berlusconi the riot act. The discussion was framed by an earlier phone conversation recorded in a wiretap and widely disseminated on the Internet in which the Italian described Ms Merkel’s physical appearance in extremely vulgar terms. At a press conference following the meeting, there was derisive laughter when Ms. Merkel and Mr. Sarkozy both revealed sarcastic grins in response to a question about Italy’s commitment to implementing the necessary measure. Italians took this as an affront to the nation’s leader and a slur on the country’s character. Even opposition politicians rallied to Mr. Berlusconi’s defence.
The coming months will provide numerous tests to the new plan. Details will have to be provided and agreement reached with the relevant parties. Greece, Ireland and Portugal will need to meet test specified under their bailout plans to qualify for release of funds. Spain, Italy as well as other Euro-Zone members will need to issue debt. Economic releases will provide information on the state of Europe’s economies.
Any slippage on any of these fronts could quickly and fatally de-rail the process. Europe’s signature anthem to date has been Led Zeppelin’s “The Song Remains The Same”. But Robert Plant’s lusty wailing about “I have a dream” may soon have to give way to Carole’s King more plaintive voice. The song will be “It’s To Late”.
“And it’s too late, baby, now it’s too late though we really did try to make it something inside has died and I can’t hide And I just can’t fake it”.