Sunday, May 9, 2010

Economics 09/05/2010: What sort of EU leadership?.. Part 1

Prepare to be afraid, ye the financial markets – those always-on-time and forever-effective super leaders of the Eurozone have concocted a Plan. A Plan to deal once and for all with the frightening levels of their own governments’ insolvency. A Plan code-named Bondzkrieg!

The troops of illiquid and insolvent PIIGS will be backed by the armies of the liquid, but pretty much nearly as insolvent the rest of EU. The attack, commencing possibly as early as on Monday next will be a two-pronged strategy: a pincers manoeuvre.

Part 1 will, per latest reports from the EU16 summit, require an issuance of Euro Commission Bonds. These will be backed by the EU16 states’ guarantees and something that is called ‘an implicit ECB guarantee’. Sounds terrifying, folks:
  1. What is exactly an ‘implicit ECB guarantee’? A sort of ‘we might print mucho Euro notes, should Brussels default’ stuff? What kind of nonsense is this? The best the ECB can do is promise to monetize the EU Common bond in the same way it monetizes Greek junk bonds. Yet, the latter has not stopped contagion, only accelerated it by undermining the ECB credibility.
  2. What will back these Common bonds? The solvency of the EU nations guaranteeing them? But wait – isn’t the problem the EU is facing is precisely the very lack of solvency? How is it going to work then? A severely indebted and deficit ridden pack of nations issues new debt to cover up the old debt problems? Well, that did work for the Russian Government a miracle back in 1998. Without actually resolving the problem of excessive and long-running deficits, and without either restructuring (default) or deflating (devaluation which is a de facto default) the existent pile of debt, the new EU-wide bond issue will simply transfer Greek-style problems of the PIIGS to the rest of EU. Given that we are talking about roughly a €1 trillion worth of junk, the entire pyramid scheme concocted by the EU is going to collapse unless Germany is good for underwriting the entire EU16 with its economic might. Trouble is – Germany can’t. It has little prospect of growth and its’ current economy simply cannot carry the burden of the rest of EU16 obligations.
  3. What will be the seniority of these bonds? If the new bond is subordinated to the existent state bonds (as implied by a ‘guarantee’ proviso), these bonds will have no meaning. If it will be senior to existent member states’ debt, then issuing them to pay down sovereign debt will be equal to deflating seniority of sovereign issues already outstanding. Which, in common English, is called defaulting on existent debt.
  4. How can these bonds be priced? Normally a bond is priced by a combination of factors. Some are exogenous – such as global liquidity and portfolio driven demand. Some are endogenous – such as analysis of what the sovereign deficit is for the issuer, what debt burden the issuer is paying and what prospects for economic growth (and other components of future default probability) does a sovereign face. Finally, expected Forex positions for sovereign currency in which the bond is denominated are taken into account. Care to guess what any of these endogenous variables might be for the EU16? Right – they are totally meaningless. Will EU bond be written against EU own debt (which is nil) or against guarantors’ debt (sovereigns already overloaded with debt)? Will the Forex rates relate to the ECB rate which the ‘sovereign’ issuing the bonds (the EU Commission) cannot control (due to ECB independence)? Will EU ability to repay these bonds rest on Euroarea economic growth? If so, what does this mean, since the EU Commission collects revenue from EU27, of which 11 member states are not a party to issuance of the bond! Will, for example, UK government assume liability to the Eurozone-issued bonds by committing its own economy to the risk of a call on the bond should, say, Belgium decide to default?

The second prong of the EU attack on the markets is the incessant blabber about the need to set up an EU-own rating agency. Here, the promised might is clearly unmatched by any sort of internal capability:
  1. The EU itself cannot certify own annual accounts, despite having only in-house own auditors. Even these are refusing to sign off on EU accounts for over a decade now. How can the same institution produce a credible rating agency that will be entrusted with providing assessment of the EU credit worthiness?
  2. Can the EU-imposed metrics be seriously treated as fundamental benchmarks for solvency? Give it a thought – the EU oversees a union of member states bound by own sovereign treaty to uphold the Maastricht Criteria targets. The EU has failed to enforce these in the case of Greeks, Portuguese, Spaniards, French, Italians, Belgians and so on. In other words, the EU cannot enforce its own rules, let alone police economic and fiscal performance parameters required to issue any sort of risk assessments. In fact, this year Euroarea deficit is expected to reach 6.6% of GDP and in 2011 -6.1% - way above the 3% the block set as its own rule. Debt to GDP is heading for double digits, before we add banks supports. Letting the EU run a rating agency is equivalent to letting an alcoholic run a bar!
  3. The entire idea of an EU rating agency traces back to Merkel’s and Sarkozy’s desire to shift blame for the Greek (and indeed PIIGS) debacle off the shoulders of the European governments and Brussels and onto the shoulders of ‘speculators’ and the Big-3 rating agencies. Of course, the logical inconsistency of the EU attacks on the Big-3 is painfully obvious. The Big 3 are accused for failing to properly recognize and publicize risks to the systemic solvency of financial institutions in the case of ABS/MBS and so on. Yet, the minute the rating agencies actually do their jobs – as in the case of PIIGS in recent months – they are standing accused of… well… doing the jobs only to well? Can anyone have any trust in a ‘rating agency’ set up by the very people who are simply and evidently incapable of a simple logical argument?

Mrs Merkel have stated this Friday: "Those who created the excesses on the markets will be asked to pay up -- those are in part the banks, those are the hedge funds that must be regulated ... those are the short-sellers and we agreed yesterday to implement this more quickly in Europe." Obviously, over a decade of fiscal recklessness across the PIIGS was never a problem for Mrs Merkel. And she is supposed to be the reasonable one?

All I can say, folks, forget any hope for growth in Europe with this sort of leadership.
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