Monday, June 7, 2010

Economics 07/06/2010: Moving to the next stage in Euro crisis

Last Friday, speaking at the CPA annual conference (will be posting the highlights of the speech here later) I referred to a new 'beast' of the sickly-prickly Eurostates: the BAN-PIIGS. The new bit - 'BAN' - referred to Belgium, Austria and the Netherlands.

Fast forward two days, getting off the trans-Atlantic flight in hot and humid New York guess what hits my news feed? Belgium and France taking in water on the back of Hungary's woes (see earlier post here) and Ukraine is putting some new pressures on Euro area banks. French and Belgian CDS are moving up, while Austria is also back in the spotlight.

Brian Lenihan's announcement that Irish banks will be rolling over €74.2bn of guaranteed loans, bonds, and other systemic support papers before October 1 guarantee is scheduled to run out is not helping the markets either. As Morgan Kelly, Karl Whelan and couple other analysts estimated - once again well ahead of our gallant DofF 'forecasters' - everyone dependent on the Irish government guarantees will be pushing their re-scheduling/roll-overs before October hits.

Surprised? You see - we used to have one main crisis back in 2008-2009: insolvency of banks balancesheets. It should have been resolved directly through recapitalization of the banks via equity take overs by the taxpayers and restructuring of the banks debts. Foolishly, we chose a different path:
  • We facilitated banks rolling over debt - as if changing maturity date on the bonds that cannot be serviced changes the level of debt impacting the banks;
  • We then proceeded to allow banks to name their capital requirements by allowing them to spread their losses over longer time horizon, as if changing the date of repayments start on a defaulting loan can make the loan perform;
  • Following this, we pumped the banks with steroids of ECB facilitated lending - as if swapping few private bonds for ECB loans resolves the problem of balance sheet overhang;
  • We created Nama to take bad loans off the banks balancesheets, but, realising the futility of the undertaking, went on to impose unrealistically low haircuts that simply sped up some of the very process of losses recognition in the second bullet point above. Given the levels of real impairments on the loans, Nama only bought banks more time to spread their losses, thus avoiding recognizing the problem of weak balance sheets and amplifying the problem of insolvency;
  • Amidst all of this, banks became liquidity traps - sucking up vast amounts of funding. This was not fully satisfied by the ECB, so the banks engaged in predatory re-pricing of performing loans (mortgages etc) in a futile effort to get some more cash flowing;
  • The insolvency crisis blew up into a liquidity crisis.

So now we have both. And no real way of resolving either or both.

We could have sustained this game, teetering on the brink between full insolvency and a credit crunch, if and only if the euro bonds markets were at the very least stable and the ECB was capable of parking collateral garbage it collected in exchange for banks loans for a long time. Alas, two things are currently under way.

First, the French bonds have slid off their 'safe heaven' pedestal over the last couple of weeks, with spreads over the German bund going up eight-fold since the end of 2009. French bonds are now posing massive liquidity risk to institutionals holding them. French Prime Minister declared last week that: “I only see good news in parity between euro and dollar”. In effect, the French are now openly inviting massive devaluation of the euro - something that is bound to disappoint Germany.

Second, there is no room for more Quantitative Easing, as the ECB has been exposed as an institution that has run out of reserves cover for its own operations. Last week, ECB balancesheet had more than 150% ratio of immediate liabilities to assets held. And that was only for liabilities vis-a-vis Greek rescue package.

Something will have to give, folks. Just as Ireland has precipitated its own implosion by pushing the liquidity crisis on top of our already formidable insolvency crisis, so the ECB and the entire euro zone is now working hard to achieve the same. We are now well behind that point of no return in monetary policy where promises to act with support for the sovereign bonds will be sufficient to stave off a run on the bond yields. Instead, the ECB's rhetoric will be tested, leaving it only one option - start running printing presses.

Now, those of you who followed my writings on the issue will say 'Good, we need a massive - €3-5 trillion - issuance of cash, don't we?' The problem is that while the answer is 'yes, we do', this emission cannot simply involve purchasing of more Government bonds. We need a direct, un-levered injection of new money into the system and it must be broadly based - going not just to the public coffers, but to private economies of the Euro area as well. ECB printing cash to buy Government debt will not reduce the debt levels for the Eurozone sovereigns (which means insolvency problem will remain and will actually increase), nor will it resolve the problem of liquidity crunch in the block (giving money to the Governments to finance roll over of existent debt is about as liquidity-enhancing as burning this cash in a fireplace).

The end game, in my view, can be only across three major disruptions in the euro assets:
  • Collapse of the euro below parity of the US dollar; followed by
  • Debt restructuring through offers to the bondholders to take a haircut (possible ranges: 35-50% for Greece and Portugal, 25-30% for Spain, 20% for Ireland and Italy, 15-20% for Austria, Belgium... and so on). These will be attempted first privately - via larger institutional consortia, with both sticks (threat of default) and carrots (some sort of delayed tax incentives?) being deployed to get larger institutional holders to accepts a drastic shave off; and once this is underway, the inevitable conclusion to the crisis will be:
  • Imposing haircuts on banks bondholders, with the ECB standing by to hose the banks with cash, should liquidity dry up during the haircut imposition.
Finale: euro's credibility gone, euro/usd rate below parity persists, inflation will be running ahead of economic recovery and Europe will slide into a Japan-styled long-term depression.

In the mean time, before the end game, expect more bans on trading in various instruments (the French have finally agreed to the German-style ban on naked shorts) and more fiery rhetoric about speculators, destabilizing market forces and other gibberish from the dear leaders of Europe.

PS: All of this reminds me of a conversation I had with one very senior stocks analyst/strategist back in the middle of 2008 meltdown in the markets. I was concerned that the ways in which fiscal and monetary authorities were throwing cash at the banks were going to lead to both running out of policy space to continue accelerated supports for the sector and economy at large. "Charged by the bear, make sure you don't run out of all bullets early on. You might miss," I insisted. In response I was given a complete assurance that resolute actions on large scale (equivalent to unloading the entire magazine of ammunition at the shadow of the problem before actually having an idea as to what the problem really is) will mean that the 'Bear won't be charging for long'. I wish I was wrong... He still writes daily, weekly and monthly missives about the investment strategy for clients.


Anonymous said...

The germans most certainly don't want QE, printing off money like that will devalue the Euro. If there is a run on the euro, could we get hyperinflation, something the Germans have experienced in the past.

Anonymous said...

Do you see a timeline for the start of the endgame,such as in a moths time or three months time?

And how would one recognise it was starting? would it for example be when the euro crashes through trade wighted parity with the Dollar which I understand to be 1.17 or will it be a collective rise in all sovereign bond spreads aginst the bund?

Do you have any thoughts on what Ireland will be like in the first six months after the endgame?


Anonymous said...

Hi Dr. Constantin Gurdgiev,

Do you think Swiss frank is better investment ? To keep your savings...

TrueEconomics said...

With a delay - thanks for comments.

Can hyperinflation take place in the current euro environment? Well, not hyperinflation in the old 1930s sense, but a high inflation - yes. It will take time to build, but if you think of the pre-crisis build up of commodities and asset market-driven inflation, take on board the expected robust growth in the emerging markets, plus inflationary dynamics in North America, we can see euro zone languishing in stagflationary momentum, with real growth of 0-0.7% pa and inflation at 5% plus.

More importantly, however, will be the geographic and sectoral distributions of growth and inflation. Inflation will evenly impact all countries, while growth will be concentrated in Germany and possibly the UK and France.

Timeline for the endgame: the whole mess depends on the willingness of the EU leadership to pump cash into supporting the euro. Once euro starts significant - 20% monthly decline, the whole process will no longer be feasible. 1.17 euro to USD rate is a significant fundamental level, but it is not a psychological level, as the average punter has no understanding of the issue of trade weighted valuations of the currency. I would aim for a panic to start setting in at closer to 1.15-1.10 markers. And yes, the simultaneous rise in all sovereign spreads will be a sign. We are already seeing it. The last stage will be a rise in German yields. After that, the whole game will be blown wide open.

Swiss franc - so far since January 1, CHF/USD is down 10.9% while CHF/€ is up 6.9%, so Swiss are offering some downside control on the Euro/USD pair. Will it hold? I think it might - the Swiss are sane(r) when it comes to their economic management than the BAN-PIIGS and are more globally diversified/integrated. However, Swiss economy is still heavily interlinked with the Euro area, implying possible shallow contagion from the mess around it. Remember, in the past Switzerland gained during markets turmoils in Europe because it was seen as a safe heaven of Europe. It still remains that, but with the advent of internationalization of investment portfolios, we now have many European investors diversified globally, which means that Switzerland has to compete with other jurisdictions (some with higher growth rates) than before. Incidentally, internationalized portfolios imply that the impact of the whole European macroeconomic mismanagement mess is itself amplified both in speed and severity, as investors have options to 'run away' from Europe on a much vaster scale. Our (European) policymakers' arrogance and naive belief that as a mature economy Euro zone is a stable attractor for investors will cost us dearly in the end...

Anonymous said...

"After that, the whole game will be blown wide open."

can you please elaborate?

Anonymous said...

Hi Dr. Constantin Gurdgiev,

Thank you for your reply. I think your blog is very informative, based on facts and logic. Difficult to find where to invest your money. it seems that China is blown real estate bubble. Precious metals gold and silver hit a record could be a correction soon in the future. Interest rates kept low for banks so there is now point to keep money in so called high interest accounts (2.5% up to 15000eur and 1.5% over 15000eur) :) But you blog gives a few ideas what can we expect in the future... Thanks

TrueEconomics said...

As I said in the post, if the pressure rises across the board, Germany and possibly France will face a tough call. Following up with more cash/guarantees for sovereign debt issuers from BANPIIGS will become untenable and non-productive. Something will have to give. As monetary policy can be cornered into a scenario where further cash emissions/QE will do nothing to the yields, there will be an acute need for downsizing debt exposures via a hair cut on bond holders...

If that happens, it will blow the entire sovereign debt market wide open. Think of implications: from yields, to actual cash flow management on fiscal balancesheets to China and other BRICs either having to absorb their own balance sheet deterioration pressures or dump sovereign debt in an effort to undercut losses...

Another issue that will arise should the above transpire is the collapse of balance sheets of pensions funds and insurance companies - anyone with a statutory allocations to A-rated paper... Think of the potential fallout here.

Anything becomes feasible.

TrueEconomics said...

A caveat - please, do keep in mind that I am looking at economic issues. There are, of course, political dimensions. In the long run, I believe the above scenarios to be plausible. In the short run, there can be other possibilities, informed/shaped by political economy.

Alan said...

You mentioned that ECB ratio of immediate liabilities to assets held reached 150% last week.

How do you arrive at this number?