Here’s an interpretation of the euro zone I have been meaning to discuss. I touched on it in the update to my post on how austerity in Europe works. In a fixed exchange rate environment like the euro area, you don’t have currency fluctuation issues. So persistent current account imbalances as we see within the euro zone are really a form of vendor financing. I am familiar with the perils of vendor financing having witnessed the Telecom bubble of the late 1990s go bust, wiping out the major source of revenue in the European high yield market in which I worked. Here’s an article from right around the bust that gives you a positive spin on how how vendor financing worked in telecoms.
Aerie is just one of the 45 vendor financing deals Nortel has on its books. As such, it offers a glimpse into a battle the big telecommunications equipment makers — notably Nortel, Lucent (LU) and Cisco (CSCO) — are rushing to join: picking up more of the financing slack for the very companies that buy their equipment.
Islands in the Stream
While Nortel is certainly knee-deep in the lending business, rival Lucent is the true champion of vendor financing. Lucent has been saying "yes" ever since it hit the ground four years ago, to the tune of $7 billion in financing commitments, more than double Nortel’s $3.1 billion. (Nortel has $1.4 billion in actual loans outstanding to buyers of its equipment; Lucent, $1.6 billion.)
Cisco, in order to compete with the incumbent telecom equipment makers, says it has beenincreasing its vendor financing activities through its banking arm, Cisco Capital. Cisco has so far promised $2.4 billion in loans to its customers. (Cisco’s loans outstanding amount to $600 million.)
Equipment makers derive several advantages from so-called vendor financing arrangements, the terms of which often remain under wraps. Namely, they gain relationships with potentially lucrative customers and revenue that will look good on the next financial statement.
Vendor financing works successfully as long as the lender makes sure the customer can pay back the loans. In the telecoms arena, the whole sector cratered and these loans were an albatross around the necks of the likes of Nortel and Lucent. Not only did firms like Nortel lose huge revenue streams, they also had to write off massive amounts of capital from dud loans they had made to customers during the bubble. It’s as if most of the revenue Nortel and Cisco were booking in 1998 or 1999 was phantom revenue, maintained artificially by their channel stuffing and vendor financing of customers. Eventually Nortel went bankrupt.
And so it is in Europe as well. The lurid Telegraph story about German-made Porsches bought in Greece shows you an extreme example of how this works. The reality is you can’t have Germany and Spain both running current account surpluses with each other at the same time. Unless the euro zone as a whole runs a current account surplus as large as Germany and the Netherlands, then you are automatically going to have a sort of vendor financing relationship going.
The euro area did have a good-sized trade surplus through 2005 – not as large as the one that Germany and the Netherlands had, but sizable. This all unravelled starting in 2005 (chart below via tradingeconomics.com). That would have been the time for German banks and companies to pull in their horns and restrict credit to the periphery.
So, if Germany or the Netherlands wanted to be the export juggernaut and run a massive current account surplus, this had intra-EU ramifications. The most important is that Germany’s or the Netherlands’ current account surplus matched current account deficits in Spain, Portugal, and Greece. That’s how it works. You sell more to me than I do to you and I get more cash than you do. There are always two sides to every transaction (chart from the FT below).
The large euro-area internal current account imbalances should be seen as a form of vendor financing, whereby the creditors, principally Germany, forward their customers, the debtors, trade finance in order to sell their wares. Germany’s aging society meant slow growth. So German companies have looked abroad for growth, just as the Japanese have done in their aging society. Taken in aggregate, this means persistent current account surpluses which are a fancy way of saying vendor financing at the national level.
German banks were at it too, by the way. German retail banking is a low margin business and credit growth is weak. So the German banks loaded up on foreign assets, making loans abroad. German banks were very active in Ireland and Spain during the housing bubbles there, for example.
So, one way to look at the sovereign debt crisis is a complicated form of vendor financing. German banks have been particularly aggressive in seeking returns abroad and now the chickens are coming home to roost.