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)
Over the next few months, the Euro-Zone faces a number of challenges including: the implementation of the new arrangements, possible further downgrading of a number of nations, refinancing maturing debt and meeting required economic targets. There will also be complex political and social pressures.
Implementation of the new fiscal compact may not be a fait accompli. The lack of agreement by Britain makes the change more complex. A number of treaties and protocols need to be amended. There are also doubts as to whether the “work around” will be legally effective.
At least four governments have indicated that agreement to the changes is contingent on the precise legal text. One key area of concern is the precise form and extent of powers granted to the EU to police national budgets. Another relates to the structure of the ESM, where a qualified majority of 85% will have the power to make emergency decisions. Finland is currently opposed to the ESM act by super majority instead of unanimity. Others are also reluctant to pay in capital, which can be placed at risk without the right to a veto.
Given issues of national sovereignty, it is possible that there will delays in implementation. Changes cannot also be ruled out.
In the background, negotiations on the Greek package of July 2011 have also stalled. There is a risk that a significant number of banks will refuse to participate in the complex debt restructuring, entailing a writedown of 50% of private debt.
Following a review, S&P have downgraded France and Austria from AAA to AA+. The rating agencies may follow. The risk of further downgrades exists. The European bailout fund is under threat of being downgraded As the number of AAA rate guarantors backing it has fallen from Euro 451 billion to Euro 271 billion (a fall on 40%). This weakens its already compromised ability to raise funds to meet existing commitments to Greece, Ireland and Portugal and to support the funding of other countries.
Wall of Debt…
A crucial issue is the ability of European sovereigns to meet maturing debt commitments and to keep borrowing costs at a sustainable level.
European sovereigns and banks need to find Euro 1.9 trillion to refinance maturing debt in 2012, equivalent to around Euro 7.5 billion each business day.
Italy requires Euro 113 billion in the first quarter and around Euro 300 billion over the full year, equivalent to around Euro 1.5 billion per business day. Italy, Spain, France, and Germany together will need to issue in excess of Euro 4.5 billion every working day of 2012.
European banks, whose fates are intertwined with the sovereigns, need Euro 500 billion in the first half of 2012 and Euro 275 billion in the second half. They need to raise Euro 230 billion per quarter in 2012 compared to Euro 132 billion per quarter in 2011. Since June 2011, European banks have been only able to raise Euro 17 billion compared to Euro 120 billion for the same period in 2010.
Given that banks and investors have been steadily reducing their exposures to European countries and banks, the ability to finance this wall of debt is uncertain. The bailout fund and the IMF with around Euro 200-250 billion each cannot absorb this issuance. Europe will be forced to resort to “Sarko-nomics” to finance itself.
The ECB has reduced Euro interest rates and lengthened the term of emergency funding of banks to three years with easier collateral rules (a lottery ticket is now acceptable as surety for borrowing). The French President suggested that banks should buy government bonds, which could then be pledged as collateral to borrow unlimited funds from the ECB or national central banks.
Nicolas Sarkozy was unusually direct: “each state can turn to its banks, which will have liquidity at their disposal.” He pointed out that earning 6% on Italian bonds that could then be financed at 1% from central banks was a “no brainer”. At the same, ECB President Mario Draghi is urging banks to reduce holdings of government securities and to use the funding provided to meet debt maturities.
Sarko-nomics perpetuates the circular flow of funds with governments supporting banks that are in turn supposed to bail out the government. It does not address the unsustainable high cost of funds for countries like Italy. If its cost of debt stays around current market rates, then Italy’s interest costs will rise by about Euro 30 billion over the next two years, from 4.2% of GDP currently to 5.1% next year and 5.6% in 2013.
In many countries, Sarko-nomics will be supplemented by “financial oppression” as government increasing coerce their citizens and institutions to purchase sovereign bonds. Regulatory changes will require a proportion of individual retirement savings to be invested in government securities. Banks and financial institutions will be required to hold increased amounts of government bonds to meet liquidity and other requirements. There may be restrictions on foreign investments and capital transfers out of the country.
Financial oppression will complement traditional public finance strategies such as direct reduction in government spending, indirect reductions in the form of changing eligibility such as delaying retirement age, and higher taxes, including re-introduction of wealth and property taxes as well as estate or gift duties.
Debt reduction through restructuring remains off the agenda. The adverse market reaction to the announcement of the 50% Greek writedown forced the EU to assure investors that it was a one-off and did not constitute a precedent. Despite this, investors remain sceptical, limiting purchases of European sovereign debt.
Weaker Euro-Zone countries may meet their debt requirements through these measures but it will merely prolong the adjustment period. It will also increase the size of the problem, locking Europe into a period of low growth and increasing debt levels.
The prospects for the real economy in Europe are uncertain. European debt problems and slowing growth in emerging markets such as China, India and Brazil may lead to low or no growth.
For the nations that have received bailouts, the austerity measures imposed have not worked. Growth, budget deficit and debt level targets have been missed.
Greece has an Euro 14.4 billion bond maturing in March 2012. Prime Minister Lucas Papademos must meet existing targets and agree the second Greek bailout worth Euro 130 billion by end-January 2012 before scheduled elections to allow official funding to be available to re-finance this debt.
Even Ireland, the much lauded poster child of bailout austerity, has experienced problems. The country’s third quarter GDP fell 1.9% and its Gross National Product fell 2.2% (the later is a better measure of economic performance due to the country’s large export/ transhipment activity). Ireland must reduce its budget deficit from 32% of GDP in 2010 to 3% by 2015. Despite spending cuts and tax increases, Ireland is spending Euro 57 billion euros including Euro 10 billion to support its five nationalised banks, against Euro 34 billion in tax revenue.
Spain, which has voluntarily taken the austerity cure, is missing economic targets. Spain’s budget deficit is above forecast (at 8% of GDP, it is a full 2% above the target agreed with the EU) and the need for support of the Spanish banking system may strain public finances further. Unemployment increased to over 21% (nearly 5 million people). Spain’s economic outlook is poor and deteriorating.
Under Prime Minister Maria Monti, Italy has passed legislation and budget measures to stabilise debt. The actions focus on increasing taxes, especially the regressive value-added tax, rather than cutting expenditures. Structural reforms to promote growth are still under consideration and the content and timing is unknown. It is also not clear whether the plans will be fully implemented or work.
If the pattern elsewhere in Europe continues, it is unlikely that Italy will be able to stabilise its public finances. The sharp drop in demand from cuts in government spending and higher taxes will result in an economic slowdown, which will result in continuing deficits and increased debt.
In the third quarter of 2011, Italy’s economy contracted by 0.2%. The government forecast is for a further contraction of 0.4% in 2012. The government forecasts may be too optimistic. Confindustria, the Italian business federation forecasts the economy will contract by 1.6% in 2012.
Consumption is especially weak in many of the problem economies, with Greece experiencing falls of around 30% and Italy also experiencing large falls.
Stronger countries within the Euro-Zone are also affected. Lack of demand for exports within Europe and from emerging markets combined with tighter credit conditions may slow growth.
German export orders are slowing, reflecting the fact that the EU remains its largest export market, larger than demand from emerging countries. Germany exports to Italy and Spain total around 9-10 per cent in 2010), higher than to either the US (6-7%) or China (4-5%).
As what happens in Europe will not stay in Europe, being transmitted via trade and investment channels, negative feedback loops will complicate the economic outlook.
One complication will be the Euro itself. Following his American counterparts who insist that they favour a strong dollar inconsistent with the evidence, German Finance Minister Wolfgang Schaeuble stated that: “The Euro is a stable currency.” In fact, the Euro has fallen around 12 % against the dollar.
Should the European debt crisis cause currency volatility, as seems likely, the effects will be widespread. One unstated element of the calls for the ECB to engage in quantitative easing is to weaken the Euro, increasing the export competitiveness of weaker European nations boosting growth. Such action risks setting off currency wars as both developed nations (US, Japan, Britain, Switzerland) and emerging countries retaliate. The risk of capital controls, trade restrictions and currency intervention is high.
The risks of political and social instability remain elevated.
Greece faces elections in April 2011. The polls indicate a fractious outcome, with the major parties unlikely to gain majorities with significant representation of minor parties. An unstable government combined with a broad coalition against austerity may result in attempts to renegotiate the bailout package. Failure could result in a disorderly default and Greece leaving the Euro.
The French presidential elections, scheduled for May 2012, also create uncertain. The principal opponents to incumbent Nicolas Sarkozy either oppose the Euro and the bailout (the National Front led by Marine Le Pen) or want to renegotiate the plan with the introduction of jointly guaranteed Euro-Zone bonds (the Socialists led by Francios Holland).
The European debt crisis is also creating political problems in Germany, Netherlands and Finland, especially among governing coalitions. The risk of unexpected political instability is not insignificant.
In the weaker countries, austerity means high unemployment, reductions in social services, higher taxes and reduced living standards. Social benefits increasingly below subsistence are widening income inequality and creating a “new poor”. Protest movements are gaining ground, with growing social unrest.
In the stronger nations, increasing resentment at the burden of supporting weaker Euro-Zone members is evident. Despite the tabloid headline, Germans have been relatively sanguine about their current commitment of funds to the bailout, aided by limited disclosure of the extent of the commitment and a relatively strong economy.
It seems only a downgrade of Germany’s cherished AAA rating, actual losses or any steps to undermine the sanctity of a hard currency (by printing money or other monetary techniques) will force increasing focus on the costs to Germans of the bailouts. Germany’s commitment to date is Euro 211 billion in guarantees, Euro 45 billion in advances to the IMF and Euro 500 billion owed to the Bundesbank by other national central banks – around 25% of GDP. The increasing risk of losses may even divert attention away from the 2012 European Soccer Championship where Germany is drawn in the “Group of Death” with Netherlands, Portugal and Denmark.
Road to Nowhere…
In the short term, Europe needs to restructure the debt of number of countries, recapitalise its banks and re-finance maturing debt at acceptable financing costs. In the long term, it needs to bring public finances and debt under control. It also needs to work out a way to improve growth, probably by restructuring the Euro to increase the competitiveness of weaker nations other than through internal deflation.
Such a program is difficult and not assured of success, but would provide some confidence. At the moment, Europe does not have any credible policy or workable solution in place.
One persistent meme is that Europe has enough money to solve its problems. This is based on the Euro-Zone members’ aggregate debt to GDP ratio of around 75%. There are several problems with this analysis.
The debt is concentrated in countries where growth, productivity and cost competitiveness is low, which is what caused the problems in the first place. The relevant wealth is in the hands of a few countries like Germany that appear unwilling to bail out spendthrift and irresponsible neighbours. A substantial portion of the savings is also invested in European government debt directly or in vulnerable banks, which have invested in the same securities.
The total debt of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) plus Belgium is more than Euro 4 trillion. A writedown of around Euro 1 trillion in this debt is required to bring the debt levels down to sustainable levels (say 90% of GDP). In the absence of structural reforms and a return to growth, the writedowns required are significantly larger. This compares to the GDP of Germany and France respectively of Euro 3 trillion and Euro 2.2 trillion.
In addition, the stronger nations may have to bear the ongoing cost of financing the weaker countries budget and trade deficits. This does not appear economically or politically feasible.
Europe now resembles a chronically ill patient, receiving sufficient treatment to keep it alive. A full and complete recovery is unlikely on the present medical plan. Europe resembles a zombie economy, which functions in an impaired manner with periodic severe economic health crises. The risk of a sudden failure of vital organs is uncomfortably high.
In their song “Road to Nowhere”, David Byrne and the Talking Heads sang about “a ride to nowhere”. Byrne sang about “where time is on our side”. Europe’s time has just about run out. A failure to properly diagnose the problems and act decisively has put Europe firmly on the road to nowhere. It is journey that the global economy will be forced to share, at least in part.