16/08/2011: Euro area and German growth Q2 2011

Two quick updates on some economic data released today.

Germany posted virtually zero rate of growth with GDP in Q2 2011 adjusted for seasonal effects up just 0.1 percent on Q1 2011. Q1 2011 quarterly growth rate was revised to 1.3 percent. German GDP growth was 2.6% yoy in Q2 2011, down from 4.6% in Q1 2011.

France data released last week showed economy stagnated in the three months through June with zero growth rate qoq and 1.6% growth rate yoy in Q2 2011, down from 2.1% expansion in Q1 2011. Italy reported data on August 5th showing its GDP growing 0.3% qoq in Q2 2011, 0.8% yoy, down from 1.0% yoy growth in Q1 2011. Spain’s economy expanded by just 0.2 percent in Q2 2011 (qoq) and 0.7% yoy, against 0.8% expansion in Q1.

And so on... until eurostat posted euro area-wide growth rate of 0.2% qoq in Q2 2011, down from 0.8% qoq in Q1 2011. Year on year growth rate fell to 1.7% in Q2 2011 from 2.5% in Q1 2011. Exactly the same growth rates were recorded in EU27, showing that the ongoing slowdown is now spreading across non-euro area member states as well. The EU27 and the euro area growth rates are now below those in the US (+0.3% qoq).

Summary table courtesy of the eurostat:

The overall disappointing growth in the euro area was entirely predictable, given that the leading indicators were pointing to it for some time now (see here), the industrial output data (here), etc.

However, here's an interesting chart suggesting that months ahead are not going to be easy for German economy:
Pay especially close attention to the yellow line showing business expectations for economic activity in months ahead. The data above is through July 2011, the latest we have and it firmly shows that business expectations have now dropped to the lowest level since January 2010, marking as fifth month of consecutive declines. The index stood at 105.0 in July 2011, down from the Q1 2011 average of 110.1 and Q2 2011 average of 107.1.

Euroarea leading economic indicator is now slipping since the beginning of July and this confirms continued weakness in the growth series.

07/08/2011: Emergency G7 Summit - Policy Dilemma

My latest column in the Globe & Mail on the topic of G7 emergency summit: link here.

25/07/2011: Comprative analysis of Euro Area and Euro Big 4

There’s a lively debate going on in parts of Europe about the longer-term fall out from last week’s ‘Deal for Greece +”. Most notably – in Germany (see here). In light of this, it is worth looking into some facts about economic performance of the Euro area Big 4 economies: is Germany right about protecting its fiscal conservativism from collectivization of risks envisioned by the ‘Deal’?

Let us plough through some data and IMF forecasts for the following set of countries & country-groups: France, Germany, Italy and Spain (the Big 4) against the Euro area as a whole, plus Advanced Economies and Major Advanced Economies (G7). Please note that the IMF forecasts are not exactly in agreement with my view of where some of these economies are heading, but for the reasons of comparative simplicity and transparency, I will rely on IMF data here.

In the end, what I am after here is some (crude – so be warned) metric of risks – disaggregated across countries and groups.

Starting from the top: chart below shows annual growth rates in GDP expressed in constant prices.

Economies, 2000-2007 growth rates averaged 2.61%, while the crisis years growth fell on average 0.06% annually. The projected growth for post-crisis period 2011-2016 IMF forecasts growth of 2.46%. In all of these periods, Advanced Economies group leads the league table of our sample countries/regions.

Area managed to achieve average annual growth of 2.16% in pre-crisis period, but suffered 0.63% annual average contraction during the crisis. Post-crisis, Euro area economies are expected to grow 1.76% which is the third slowest rate of growth in our sample.

G7 economies grew 2.27% on average annually in pre-crisis period and faced a relatively mild average crisis-period contraction of output of 0.36%. These economies are expected to grow at 2.29% per annum on average in 2011-2016.

France recorded average annual growth of 2.12% in 2000-2007 and subsequently posted relatively mild contraction of 0.32% (annual average) in 2008-2010. The country is expected to grow its economy at an average annual rate of 1.94%.

German economy grew on average at an annual rate of 1.58% during the pre-crisis years – posting second slowest growth in the sample. During the crisis, the economy contracted 0.15% per annum on average (second best performance in the sample), while it is expected to grow at 1.84% average rate in 2011-2016 – not a blistering growth forecast, but above Euro area as a whole.

Italy posted slowest average annual growth in the sample during the pre-crisis period (1.46%), the deepest average annual contraction in the sample during the crisis (-1.75%) and is expected to continue slowest growth performance with 1.32% average annual growth rate in 2011-2016.

Spain recorded the fastest real growth in the sample for the pre-crisis period (3.62% average annual rate), followed by the second magnitude of contraction (-1.0% per annum on average) in the crisis period. Spanish economy is expected to grow at 1.62% on average in 2011-2016 – second slowest in the sample.

In terms of GDP per capita (chart below):

Germany was the first in our sample to reach pre-crisis peak level of GDP per capita between 2009 and 2010, followed by the Advanced Economies and the Euro area. G7 group of countries recovered from the crisis in terms of GDP per capita by the end of 2010, while France’s recovery will take it into 2011. Spain is expected to recover from the declines in GDP per capita around 2011-2012, while Italy will take the longest to reach pre-crisis peak – some time between 2012 and 2013.

In terms of investment as a share of GDP (chart below):

Advanced economies investment averaged 21.05% in the period prior to the crisis, falling to 19.08% during the crisis before recovering somewhat to 20.08% in the period 2011-2016. No data is available for the Euro area and G7 countries.

France invested 20.2% of its GDP on average during 2000-2007 period, recording a marginal decline to 20.11% in the crisis years and is expected to recover to 20.60% of GDP in 2011-2016.

Germany was the weakest country in the sample in terms of investment with investment ratio to GDP of 18.24% in the pre-crisis years, followed by 17.50% during the crisis and by expected 17.81% in the post-crisis period.

Italian economy investment as a share of GDP was 21.01% in pre-2008 period, followed by 20.11% during the crisis. IMF expects Italian investment to rise to 20.54% of GDP in the post-crisis period.

Spain’s investment to GDP ratio was 28.30% in 2000-2007 period, followed by 25.5% in 2008-2010 and 22.98% projected for 2011-2016.

So in terms of investment as a share of GDP, Germany is clearly a laggard here, which is of course explained by two core factors: (1) aging population and (2) already extensive stock of capital.

Unemployment rates are shown in the chart below:

During pre-crisis period, Spain psoted the highest rate of unemployment, averaging 10.54%, followed by Germany (8.93%) and France (same as Germany). Euro area as a whole averaged 8.45% unemployment rate during the pre-crisis period, followed by Italy at 8.11%. This poor performance by European part of out sample is contrasted by the pre-crisis unemployment of 6.11% for the group of Advanced Economies and 6.05% for G7 group.

During the crisis, Spanish unemployment rose to 16.47%, followed by France (9.02%) and Euro area (9.0%). G7 economies posted 7.35% average rate of unemployment while Advanced economies came in at 7.34%. Germany shows the best unemployment rate for the period at 7.22%.

Post-crisis, IMF forecasts for Spain to remain worst performing country in our sample with 16.91% average unemployment rate, followed by Euro area at 9.03% and France at 8.57%. In contrast, Italy’s unemployment is projected to settle at 7.87% average, with Advanced economies coming in at 6.77% and G7 economies at 6.54%.

So what about employment – in other words, jobs creation:

The chart clearly shows that Germany, G7 group and France are the weaker performers in the sample in terms of longer-term trends in jobs creation. Now, see the following chart on population changes. Of course the problem here is that while German population is shrinking (so jobs creation is not exactly high on their agenda, especially with low unemployment), for France (with expanding population) slow jobs creation is a major draw back (hence high unemployment as well).

By 2015, based on IMF projections, German population will shrink by 1.284 million relative to 2000, while Italian population will grow by 4.638 million, French by 5.352 million and Spanish population will expand by 6.304 million.

In terms of fiscal performance, consider the following two charts plotting general government revenue as % of GDP and the general government expenditure as % of GDP:

The following chart shows general government deficits:

Based on three charts above, consider the fiscal adjustments required to deliver on the deficit targets to 2016:

Of all countries in the sample, France represents the steepest required fiscal adjustment in terms of deficit reductions, totaling 4.475% of GDP between 2011 and 2016, followed by the G7 group of countries with 4.063% and Advanced economies at 3.567%. Euro area projected adjustments are 2.519%, while German projected adjustment is 2.326%. The weakest – fiscally – performing countries – Italy and Spain – have the lowest fiscal adjustments planned at 1.439% and 1.679% respectively.

Mapping these adjustments alongside the absolute measure of fiscal performance (Gross Debt) and taking into account the economies growth potential, chart below shows two groups of countries. The first group (no shading) is the group of economies facing the moderate adjustment on deficits side, against stronger targets on debt reductions. This group includes Germany, Italy and Euro area. The second group of countries represents a group facing steeper adjustments on fiscal deficits side and/or significant deterioration in debt positions. This group covers Spain, Advanced economies, G7 and France. It is worth noting that this group of countries faces stronger growth prospects, but Spain and France represent two weaker economies in this group.

Chart below provides an illustration of the debt challenges faced by the sample economies. General Government debt rose 48% in Spain form an average of 47.62% of GDP in 2000-2007 to 70.5% of GDP projected average for 2011-2016. In France, the same increase was 43.6% from 61.83% of GDP pre-crisis to 88.76% average in post-crisis period. At the same time in Germany, gross government debt to GDP ratio rose from 63.64% of GDP pre-crisis to 76.48% of GDP in post-crisis period – the second slowest rate of increase in the sample after Italy.

Overall, for the period of 2011-2016, average gross government debt levels are expected to range from 121.93% of GDP for the G7 economies, to 119.32% of GDP for Italy, 105.33% of GDP for Advanced economies, 88.76% of GDP in France, 87.55% of GDP for the Euro area, 76.48% of GDP in Germany and 70.49% of GDP in Spain.

Lastly, let’s take a look at the current account positions.

As chart above shows, cumulative 2011-2016 expected current account positions as the share of GDP are: Germany +25.9% of GDP, Euro area +0.67% of GDP, Advanced Economies -1.92% of GDP, G7 economies -7.13% of GDP, France -14.6% of GDP, Italy -17.4% and Spain -24.5% of GDP.


Now, let us pool the information contained in the above data to derive the overall riskiness of each economy/group in the sample. To do this, I assign to each country/group a score out of 1-14 based on their performance relative to the top performing economy. So top performer in each category of score below gets 14, the with the next performer getting 12 or less, with distribution of scores within each category/heading following the underlying data. The higher raw scores reflect stronger economic performance and / or lower risk. So the final risk scores are based on inverting the raw scores. Summing these up across categories/criteria produces the total risk score reported in the penultimate column of the table. These are ranked in the last column with 1=highest risk country.


The results are consistent with statistical distribution and are robust to several checks, namely:
1) Removal of the GDP per capita recovery statistics
2) Removal of the Employment index
3) Removal of the Government Expenditure metric

The core results are:

1. Germany clearly represents the most sustainable country in the sample of all Big 4. In fact, its fiscal and macroeconomic position would be significantly undermined if it were to move to Euro area harmonized position
2. Spain and Italy are the two weakest economies in the sample with very high risk rating
3. France is statistically closer to Spain and Italy than to Euro area harmonized economy and is clearly the least sustainable economy in the sample after Spain and Italy.
   

Economics 12/12/10: Europe's crisis won't be solved by the ideas advanced to-date

The most revealing feature of the EU response to the current crisis is the nation states' and Brussels/Frankfurt total denial of the real problem. We are witnessing a debt crisis stemming from unsustainable levels of liabilities piled onto weak economies in order to finance various forms of social welfare state.

This fact is clearly revealed in the 'solutions' being discussed by the EU leaders:

• Tax and fiscal policies harmonization - Harmonizing PIIGS, German, French and other fiscal systems will not achieve more transparency or discipline than the already existent SGP criteria for deficits and debt allowances delivers on the paper. Nor will it provide for better enforcement of these rules. More importantly, it will not reduce the unsustainable levels of debt accumulated by the citizens and sovereigns of Europe. Instead, the divergence between fiscal objectives of the younger and/or less developed states and those with older population and capital and consumption bases will be amplified.
• The idea that centralized bond issuing mechanism will solve the current crisis is basically equivalent to believing in self-healing properties of the disease that's killing you. Bond markets are shorting European sovereign debt not because it is issued by decentralized authorities, but because EU sovereigns have borrowed too much already and/or assumed too much of the private banking sector debt. To issue even more debt, underwritten by the very same sovereigns is like combating a hangover by drinking more whiskey in the morning. Common EU bond issuance will be repeating the fallacy of securitization that has resulted in the markets saturated with AAA-rated mortgages packages blending AAA and subprime loans.
• Increasing EFSF funding will not solve the problem, for it assumes that EU states are facing a cash flow problem, not a structural debt overhang. As I said before in the Irish and Greek cases - issuing more debt to pay down old debt is simply not going to be a long-term solution to our difficulties.
• Finally, the idea of national currencies or two-tier Euro is even more denialist in its nature than all of the above proposals combined. The argument against it is provided in my article in today's Sunday Independent here.

The core problem is that the EU and the national governments remain blind to the main issue at the center of the current crisis: European social welfare states have accumulated too much debt to sustain status quo. These debts were accumulated via various channels:

• The sovereign channels operated in Italy, Portugal, Belgium and Greece;
• The depressed consumption transferred private incomes into public in Germany, Austria, Hungary, Slovenia and the Nordics;
• Banking debts socialization and obligations transfers from public spending to private liabilities has led to the debt explosion in Ireland
  

But across the entire Europe, either Governments or private sector or both simply live well beyond their means. The only resolution that can restore health to our economies rests with a two-step structural change:

1. Restructuring debts to reduce debt burdens on the real economy, followed by
2. Restructuring economies to make them leaner, fitter and capable of sustaining growth

Both require re-thinking of the European social welfare state system with a view of making it's core principles sustainable in the environment of economic growth we can deliver. Nothing else will do the job.

Economics 26/11/10: Contagion is spreading to Spain & Italy

Another day, another spike of contagion from Ireland's Sovereign bonds to other Eurozone countries:
Yesterday's closing bell marked another day in which markets have completely disagreed with the EU officials and Irish Government view of the reality of our and PIIGS' ability to weather out the current crisis.

Economics 3/10/10: The real stress in Euro area banks

"A picture's worth a 1,000 words" an old proverb goes. So here's a couple of pictures from the latest GFSR analytical papers issued by the IMF last week:

Remember the favourite EU leadership myth: "The Americans caused this crisis". Ok, if so, one would assume that EU banks are in a better position through the crisis than their US counterparts.
If the assertion above was correct, why would the demand for CB financing be so much greater in the EU both in terms of banks demand for liquidity prior to the crisis and after the crisis?

Charts above are confirmed by the even more dramatically divergent case of the banking sectors exposure to the repo operations:
The magnitude of European banks internal sickness in structuring funding - from their chronic dependence on CB funding even at the times of plentiful liquidity, to their massive exposures to repo operations in general is stunning.

If you want to see the really frightening summary of this analysis, here it is, courtesy of the GFSR:
Notice the disproportional over-reliance of Euro area banks on short-term funding (the infamous maturity mismatch) and non-deposits-based long-term funding (the infamous liquidity and counterparty risk-linked bit). Now, check out the healthy US side of deposits finance - you'd think that the picture should be inverted, given Europe's demographics, but no - heading into the massive explosion of retirement age population in EU, our savings play so much smaller of a role in funding our banks, one must wonder: What happens when German consumers start drawing down their deposits to finance their retirement consumption? Will there be anything else left for the future of the continent other than sales of Mercs and BMWs to China?

Economics 24/9/10: EU-wide slowdown confirmed

Eurocoin for August 2010 has confirmed that composite leading indicators for the Euro area growth are pointing to continued deterioration in growth in Q3 2010. Eurocoin has declined to 0.37 i n August from 0.4 in July, marking a 5th consecutive monthly drop.

Here's the chart:
My forecast for next Eurocoin to reach 0.34 in September and Q3 2010 growth to slide to 0.2-0.25%. My previous forecast for Eurocoin for August-September (issued in June and confirmed in July) was 0.34.

Economics 30/8/10: Euro area growth indicator slows in August

Eurozone's leading growth indicator, Eurocoin has fallen once again to 0.37 in August from July already anemic reading of 0.4. This means that my updated forecasts for Euro area growth remain in the range of 0% - 0.26%, with mid-range forecast of 0.20% for Q3 2010.

Chart below illustrates:In the mean time, continued pressures on Euro area economies and unbalanced nature of recovery (with Germany powering ahead, while the rest of Europe stagnates or continues to decline) are taking their toll on public confidence in European institutions.

Overall voters confidence in EU has dropped to record lows in most countries according to the Eurobarometer published on August 26th. Just 49% Europeans think that their country's membership of the EU is a "good thing" – lowest in 7 years. Trust in EU institutions has dropped to 42% from 48% recorded in Autumn 2009. Latest survey results are most likely impacted by the survey timing - carried out in May 2010 - at the peak of sovereign debt crisis worries. But it is unlikely that August events would have done much to repair this. PIIGS, plus Cyprus, Lux and Romania lead in terms of declines. Confidence in all PIIGS countries declined 10-18% yoy.


The latest Eurocoin leading indicator reading clearly suggests that unemployment and economic performance will remain leading causes of concerns across the EU (Eurobarometer recorded 48% of EU citizens being primarily concerned with rising unemployment, while economic crisis in general is a cause for concern for 40%). For the first time Eurobarometer also included Iceland, now a candidate for EU accession. Only 19% believe accession will be a good thing for their country and only 29 percent believe their country will benefit from EU membership.

Another interesting result was that when asked what they associate the EU with – most of the respondents said free travel and the euro, followed by peace and, amazingly, "waste of money" (23%). The latter category was led by Austrians (52%), Germans (45%) and Swedes (36%). Just 19% of respondents said the EU stands for democracy, a drop of seven points yoy. Just 10% of respondents in Finland, UK and Latvia identified "democracy" as a principle that is linked to the EU objectives. Romania (33%), Bulgaria (32%) and Cyprus (30%) were the countries with most positive view of the link between democracy and the EU. Overall, in no country did 'democracy' figure as the EU core objective for more than 1/3 of the population.

Support for EU acting as a policeman of financial markets was much stronger. 75% of the respondents said more coordination of economic and financial policies among member states would be effective in fighting economic crisis. 72% back a stronger supervision by the EU of international financial groups (though this majority increased just 4 points since 2009).


Perhaps encouraged by the public support for greater coordination, French and German authorities continue to move in the direction of enhanced harmonization of their tax systems. French budget minister Francois Baroin visited his German counterpart Wolfgang Schaeuble, making an announcement that "Germany is a model which should be a source of inspiration for [France]." Baroin also stated that France "intends to accelerate the harmonisation of both fiscal systems, on corporate as well as personal income taxes". President Sarkozy has requested the French court of auditors to issue a report (due for early findings release at the end of September) looking at areas of fiscal convergence with the German system. The report is due by the end of the year, but a pre-report will be published at the end of September. It is likely that France might move to abolish wealth tax as Germany did back in 1997. Per reports: "in the longer term, Paris is also looking at harmonising Vat, which is higher in France – 19.6% compared to the German 19%" and "capping the EU budget" to give national Governments more opportunities to slash domestic deficits. Mr Schaeuble indicated that Berlin wants consensus on European harmonisation on bank profits taxation - a subject for the next ministerial meeting between the French and German finance ministers in September.

Economics 30/7/10: No double dip for the euro area, yet...

New data from eurocoin is out - time to update euro area forecasts. Aptly in line with the US Q2 growth now coming at a slower 2.4% annualized rate, both the leading eurocoin indicator of activity (down to 0.4 in July from 0.46 in June) and my forecast for Q2 and Q3 2010 growth for the euro area are also moderated. Chart below illustrates:
GDP forecast range is for quarterly growth of -0.1% to +0.05% in Q3 2009.

So no double dip for the euro area yet, but things continue to head that way...

Economics 25/7/10: What lending markets tell us about EU policies

So the markets are not that enthused about the stress tests. After the initial bounce on the back of 'pass' grades, there are rising concerns about some 19 banks, including AIB, which were given 'all clear' with some serious stretch of assumptions.

But to see what is really going on behind the scenes, look no further than the actual interbank lending rates. In fact, the interbank lending markets provide a good reflection on the combined euroz one policies enacted since the beginning of the Greek debt crisis. Both euribor (the rate for uncollateralized lending across euro zone's prime banks) and eurepo (lending rates for collateralized loans between euro zone's prime banks) are significantly elevated on twin concerns about:

1. The quality of the borrowing banks (recall - these are prime banks); and
2. The quality of the collateral (with sovereign bonds being top tier quality, deterioration in sovereign debt ratings is hitting interbank markets hard).

Here are the usual, updated charts:

Chart 1Long maturities have been signalling extremely adverse effect of the Euro rescue package since its inception.

Medium-term maturities show severe deterioration since the euro rescue package. Steepest, and uninterrupted rise in 3 months euribor signals that the rescue package is faltering in delivering anything more than a buy-time for the euro… In other words, we have an expensive (€750 billion-sized) buy-in of short time.

The ECB claw back on longer term lending window did not help this process either. But the stress tests are doing nothing to stop the negative sentiment dynamics.

Chart 2Per chart 2 above, short-term maturities are showing that despite supplying underwriting to about a half of the full year worth of euro area bonds refinancing, the rescue package has achieved no moderation in the short-term risk perceptions of the market. In fact, the rise in euribor is more pronounced in the short term than in longer maturities, suggesting that short term risks of sovereign default remain unaddressed by the rescue package and are exerting a continuous pressure on interbank lending.

Introduction of the stress tests also did nothing to reduce overall cost of borrowing amongst the prime banks which were fully expected to pass the test even before the EU got on with setting test parameters.

In turn, all of this spells much higher costs of funding for the banks which have shorter term financing needs, such as the Irish banks. The implicit cost of taxpayers’ guarantee for Irish banks debt is therefore rising.

And panicked markets are not about to surrender their fears to the EU PR machine. With all the increases in the euribor, the volatility of the interbank lending rates also increased, across all maturities, as shown in charts 3 and 4 below.

Chart 3Chart 4As evident, in particular, from chart 4, in the longer term, credit markets are absolutely not buying the combination of the EU rescue package, ECB liquidity measures and the stress tests. Euribor trajectory for maturities of 6 months and higher firmly re-established and vastly exceeded volatility that preceded the pre-rescue panic. We are now worse off in terms of the cost of banks financing than we were before the Greek crisis blew up.


To remind you - eurepo is the rate at which one prime bank lends funds in euro to another prime bank if in exchange the former receives from the latter the best collateral in terms of rating and liquidity within the Eurepo basket. Eurepo rates have posted dramatic increases since mid-June 2010. The original effect of the June 2010 closure of the longer maturity (12 months) ECB discount lending was a temporary reduction in the rates, followed by a stratospheric rise two week later that has been sustained through the end of this week. This is especially true for shorter term maturities, suggesting that part of the adverse effect was due to the heightened uncertainty around the EU stress tests. Chart 5 below illustrates.

Chart 5Chart 6The u-shaped response in the interbank lending rates to ECB lending changes and to stress tests is even better reflected in the longer maturity eurepo rates, as highlighted in chart 6 above.

3-months and 12-months eurepo rates are now at the levels consistent with the height of the sovereign default crisis. There are significant differences in the rates by maturity group and vis-à-vis euribor due to the fact that the quality of collateral offered in the markets is now itself uncertain as sovereign credit quality continues to deteriorate both in terms of increasing probabilities of default and thus associated risk premia, but also due to the regulatory treatment of collateral that is being signalled by the stress tests.

As with euribor, eurepo rates are showing remarkable increases in volatility, for both shorter and longer term maturities.


Let us finally put the two rates side by side to compare evolution of euribor against eurepo, setting index for all at 100=January 4, 2010

Chart 7Chart 8
Some pretty dramatic stuff. To round off, recall that since the beginning of April 2010, the eurozone has undertaken the following measures to shore up its financial markets:

1. Set up a sovereign rescue fund worth more than €750 billion to underpin roughly 50% of the total borrowing requirement in the euro zone (which could have been expected to yeild an improvement in banks collateral and thus a reduction in overall systemic risks in the interbank markets as well);
2. Reduce maturity profile of ECB lending window (which was from the get-go equivalent to dumping more petrol on the forest fire);
3. Deploy aggressive quantitative easing by the ECB (again, this should have reduced uncertainty in the interbank markets as in theory improved pricing for sovereign bonds should have increased the quality of interbank collateral and improve banks own books);
4. Conduct an absolutely discredited stress test of the banks (designed to provide positive newsflow for the banks, especially for prime banks which should have seen their risk profiles reduced by a mere setting up of the test).

In short, none of the measures seem to be working, folks... May be, just may be, the real problem with EU banks is their unwillingness to come clean on loans losses and start honestly repairing their balancesheets?

Economics 15/7/10: European bailout fund - set up to fail?

I thought it is worth sharing few thoughts on a superb article by Satyajit Das"Debt shuffling will be a self-defeating exercise" in July 12 Financial Times (sorry - no link) concerning the European bailout fund. All quotes are from the article, with some of my additions/explanations etc.

European Financial Stability Facility (EFSF) “…structure echoes the ill-fated collateralised debt obligations (CDOs) and structured investment vehicles (SIVs). …In order to raise money to lend to finance member countries as needed, the EFSF will seek the highest possible credit rating – triple A. But the EFSF’s structure raises significant doubts about its creditworthiness and funding arrangements…”

The €440bn bailout fund created a SPV, “backed by individual guarantees provided by all 19 member countries. …The guarantees are not joint and several…”

This means that SPV – an insurance fund against sovereign defaults – is in the need of an additional insurance mechanism against the risk that one or more of the funders fail to pay up into the EFSF. This is achieved by “…a surplus ‘cushion’, requiring countries to guarantee an extra 20% above their ECB contributions.”

One point, not mentioned to Das is that this ‘cushion’ fund is itself subject to risk as a call on the ‘cushion’ will require some states near default to supply even more funding to the fund. In other words, to any of the PIIGS participating in supporting one of their fellow member states, the cost of the EFSF bears a 20% premium reflective of the ‘cushion’. Just how this is going to be feasible for severely financially stretched states remains to unknown. Take one example – for Ireland this would mean that our €5bn exposure to the EFSF is, in reality, a €6bn exposure.

Das focuses on the overall risk transfer within the EFSF arrangement, saying that the ‘cushion’ “is similar to the over-collateralisation used in CDOs to protect investors in higher quality triple A rated senior securities.”

Das puts some numbers on this: “If 16.7% of guarantors (20% divided by 120%) are unable to fund the EFSF, lenders to the structure will be exposed to losses. Coincidentally, Greece, Portugal, Spain and Ireland happened to represent around this proportion of the guaranteed amount. If a larger eurozone member, such as Italy, also encountered financial problems, then the viability of the EFSF would be in serious jeopardy.”

There are other problems with the EFSF. Das notes the issue of ratings migration – the situation where if one eurozone member state experiences problems, then the ‘cushion’ will suffer to the proportion of that member state contribution to EFSF, thus reducing overall insurance pool and adversely affecting overall EFSF ratings.

There is an added and much more severe problem here that no one dares to talk about. If one of the PIIGS experiences problems contributing to the EFSF, then other eurozone states with tight borrowing constraints might have an incentive to ‘run on the bank’, attempting to hover up EFSF funds before they are depleted while simultaneously withholding all contributions to IFSF. First mover advantage here will guarantee a payoff, while staying on the sidelines guarantees at least an up to 120% hit on the member state own funding.

As Das correctly points, “any ratings downgrade would result in mark-to-market losses to investors. …Given the precarious position of some guarantors and their negative ratings outlook, at a minimum, the risk of ratings volatility is significant. This means that investors may be cautious about investing in EFSF bonds and, at a minimum, may seek a significant yield premium. The ability of the EFSF to raise funds at the assumed low cost is not assured.”

So the problem then is that from a political standpoint, EFSF might be borrowing in the markets at 3.5-4%, while lending out to PIIGS at 5%. Should interest rates rise, or inflation tick up, or Euro devaluation continues, the net of costs safety band of 75-125bps can be exhausted very quickly. As the safety band is being eroded, the pressure on triple A ratings will rise, triggering the need for further insurance provisioning. Which can, in turn, put pressure on the troubled states to cut provisions for the EFSS. The EFSF will then turn into a loss-making subsidy generator to the PIIGS.

Germans won’t be too happy to see this. The noises from Germany – the main underwriter of the EFSF will put added pressure on the PIIGS to act fast, increasing a probability of a run on EFSF and triggering ratings pressures once again. Notice that to get to this point won’t require an actual run on the fund – a simple rise in the probability of a run will do the damage.

Das’ superb analysis comes at the end of his article (emphasis is mine):

“Major economies have over the last decades transferred debt from companies to consumers and finally onto public balance sheets. A huge amount of securities and risk now is held by central banks and governments, which are not designed for such long-term ownership of these assets. There are now no more balance sheets that can be leveraged to support the current levels of debt.

The effect of the EFSF is that stronger countries’ balance sheets are being contaminated by the bail-out. Like sharing dirty needles, the risk of infection for all has drastically increased.

The reality is that a problem of too much debt is being solved with even more debt.

The EFSF …may be self defeating and unworkable. The resort to discredited financial engineering highlights the inability to learn from history and the paucity of ideas and willingness to deal with the real issues.”

Of course, much of this criticism is pretty close to heart for Nama - an SPV with even lesser transparency, accountability and capability of management. Irony has it, the SPV has no insurance 'cushion' provisions and instead becomes a direct liability of the Irish state as its guarantor. Then again, we already know this much...

Economics 23/06/2010: On Financial Services Tax

This is an unedited version of my article in the current issue of Business & Finance magazine.


Behind the headlines about the ongoing eurozone fiscal crisis, three significant events have taken place on both sides of the Atlantic in recent weeks.

First, in April, assets under management in hedge funds domiciled in North America reached above $1 trillion mark for the first time in 18 months. Currently, North American funds account for two thirds of the total global assets under management.

Second, both the US and Canadian governments, preparing for the upcoming G20 summit have signalled their unwillingness to join European leaders in their crusade against financial markets. In fact the US has taken a distinctly different approach to dealing with the aftermath of the financial crisis, focusing on banks stability and addressing balance sheet risks in the recent finance reform packages that cleared US Congress.

Third, bloodied and bruised by the bonds markets and the voters, European politicians, led by Angela Merkel, have been gearing up for an all-out fight with so-called financial speculators.

As unconnected as these events might appear today, make no mistake, should the EU continue down the path consistent with its recent rhetoric, Toronto, New York, Chicago and Boston, alongside other major financial services centres around the world will be boom towns courtesy of the investors fleeing populist and politicized EU.


German plans for an EU-wide revision of fiscal and financial architecture range from suspending voting rights of the member states to national bankruptcy proceedings, from regulating hedge funds to introducing a tax on financial transactions.

A global or at the very least an EU-wide financial services transaction tax has been an on-and-off topic of discussion amongst the member states and Brussels for some years. Back in 2006 I was asked to review one of such proposals for a senior European decision maker from one of the continental member states. Having systematically overtaxed and overspend their economies, European sovereigns have been seeking new means of getting their hands on taxpayers cash since at least 2002-2003. Like a junkie in a desperate search of the next hit, the EU states are now searching for a convenient and politically, if not economically, easy target to mug. A Tobin-styled transaction levy on financial instruments is just that.

Transactions tax has been proposed back in 1972 as a theoretical construct to reduce the volumes of high frequency trading in foreign exchange markets. The rationale for it was a naïve belief that currencies should only be traded internationally for the purpose of physical commerce – exporting and importing. Any other trading, such as using foreign exchange as either a hedge or a flight to safety instrument against inflation, low economic growth, excessive state graft on personal income, sovereign insolvency and other fundamentals was viewed as speculative. In reality, modern currency is cash and cash is more than a facilitator of physical transactions. It is an asset.

Fallacious in application to Forex markets, Tobin tax would be even more erroneous were it to be applied to a broader set of financial instruments.

Take Ireland: a gravely sick financial system with plenty of financial services taxes, including a stamp duty on transactions. Has the presence of the Tobin tax here helped to prevent or even moderate the crisis? No. Worse than that, over the last 5 years, Irish markets have shown remarkably high volatility, despite having one of the highest stamp duty rates in the developed world. If anything, our stamp duty can be blamed for artificially reducing liquidity in the Irish stock market and, as a result, for adversely (albeit extremely modestly) contributing to the collapse of Irish shares.

Sweden toyed with transactions tax on financial markets back in 1984, imposing moderate levels of a stamp duty on stocks and derivatives. Within one week of the new law coming into effect, Swedish bond market saw an 85% collapse in volumes traded, futures trades fell 98% and options trading ceased all together. Swedes finally abandoned this self-destructive tax in 1991. Finland faced exactly the same experience. Japan was forced to abandon Tobin-style tax in 1999. Switzerland – a global financial services hub – does charge, in theory, a transaction tax, set at a fraction of the one Germany is rumoured to favour. However, in a typical example of Swiss flexibility, authorities there have power to grant exemption from this tax for specific investors.

OECD has issued the following official position on Tobin-style taxes back in 2002: “A “Tobin tax” penalises high frequency trading without discriminating between trades which may be de-stabilising and those which help to anchor markets by providing liquidity and information. Indirect evidence from other financial markets where a securities transaction tax has been in place suggests a substantial effect on trading volume but either no effect, or a small one of uncertain direction, on price volatility.”

Tobin tax will not work for Europe:

The tax is avoidable by conducting trades and structuring portfolia outside the EU. The end game will be higher cost of capital raising for European companies, selection bias in favour of larger companies in access to the capital market, selection bias in favour of larger financial assets trading platforms, to the detriment of smaller exchanges, and lower after-tax returns to investors. Which part of this equation makes any economic sense?

The tax will not fund sufficient insurance cover for future crises. Given the magnitude of bailouts witnessed in the last two years, the levels of taxation would have to be so high – well in excess of benign rate of 0.1-0.2% currently levied in some countries – that there will be no European financial markets left.

This tax on financial transactions will retard economic development in Europe for decades to come.

One of the reasons why European banks are so sick right now is European companies’ disproportionate, by international standards, over-reliance on debt financing. This contrasts the US corporates, which use more equity financing to raise capital. When the debt financing meets an asset bubble, banks balance sheets swell with bad loans. There is no equity cushion on European corporate balancesheets to underwrite the resulting losses. Instead, taxpayers get thrown to the wolves to rescue banks. Mrs Merkel & Co latest plans for ‘reforms’ will, therefore, mean even greater risks of bailouts in the future, and less growth and fewer jobs.


Next, of course, in Berlin’s line of fire were the hedge funds. Per populist rhetoric in European capitals, they had to be reined in because… well, no one actually knows, why. Hedge funds did not cause the current fiscal crisis (they had no control over the EU governments’ borrowing and spending excesses), nor did they cause the crash of our financial systems (hedgies did not pollute banks balance sheets and account for no more than 5% of the global financial assets). The hedge funds are not responsible for the property bubble or for exuberant stock markets overvaluations achieved in 2007-2008 worldwide.

The sole reason for this ‘reform’ is that for European leadership, ‘Doing right’ means ‘Doing politically easy’. Hedgies have no strong political lobby backing them, unlike banks, property developers, sovereign bondholders and issuers, or civil servants. So the EU prefers to attack a bystander in order to pretend that we are tackling the criminal. While taxpayers are being skinned alive to rescue reckless governments and banks, hedge funds are being presented as villain supremo. Farce? No – it’s politics.

After hedgies, came in even more sci-fi villains. Following Mrs Merkel’s ‘reforms’ talk, Germany banned naked short-selling and the trading of naked credit default swaps in euro zone debt. It turns out that European crisis was, after all, not about absurdly high levels of public debt carried by the PIIGS, nor by fraudulent (yes, fraudulent) deception by some countries of European authorities and investors about the true extent of national deficits. It was not exacerbated by the decade-long recessions turning into bubbles of exuberant lending and borrowing by companies and households, nor by a resultant severe depression that afflicted Euro area since 2008. The cause of these were the investors who were betting on all of these factors adding up to an unsustainable fiscal and economic situation in Europe. Farcical, really!

Worse than that, on top of the ridiculous financial services policies decisions Chancellor Merkel has also been working hard “on far-reaching changes to the treaty underpinning Europe's common currency”. German government would like to increase monitoring of member states' annual budgets, the introduction of stiff sanctions for those in violation of euro-zone debt rules and the suspension of voting rights in the European Council. Furthermore, Germany wants to establish “bankruptcy proceedings for insolvent euro-zone countries.”

The problem with the first part of Mrs Merkel’s fiscal policy proposal is that there are no independent organizations in Europe left that could oversee member states’ budgets. The ECB is a full hostage to Europe’s whims on monetary policy, engaging in the most reckless forms of monetary interventionism known to mankind – direct purchases of risky states’ debt. Outside the ECB ‘Yes, Minister’-styled ‘independent’ states-sponsored institutes populate the realm of European economic policymaking. By-and-large, they have no capability of delivering any independent analysis. Even the likes of the OECD – a very capable organization with some degree of independence – is subject to direct political and bureaucratic interference from its own members.

As far as German proposals for euro zone rules enforcement go, member states that do not conform to deficit reduction rules will be temporarily cut off from receiving structural funds. The galling dis-proportionality and lack of realism in this proposition does not even occur to the EU leaders supporting the idea.

Greece today is recipient of €110 billion bailout. Will suspending a few billion worth of discretionary structural funds commitment be a significant deterrent to a state like that?

This idea is potentially quite dangerous economically. Structural funds go to finance long term infrastructure investment programmes which often rely on co-funding from the Member States and/or private partners. All have private sub-contractors. Withholding EU funds will either destabilise these investments (if the measures to have any punitive powers), thus preventing economic growth necessary for fiscal stabilization or will do nothing. In short, Mrs Merkel’s proposal is a cure that threatens to make the disease incurable.

Earlier in May, German officials also mentioned the possibility of suspending member states' votes should they find themselves in violation of European debt rules. Of course, should this come to pass, Italy, Greece… no wait virtually the entire Eurozone, including Germany will have to be suspended from voting.


In short, in contrast to the US Congressional blueprints for financial sector reforms, European proposals to date can be described as a bizarre amalgamation of the impossible, the improbable, and the outright reckless. Their likeliest outcomes would be a large scale capital flight out of Europe and perpetuation of the status quo of continued sovereign and banks bailouts across the continent. Already struggling under the unsustainable burden of European taxation, the real economy – exportable and non-traded services and manufacturing – will be left holding the bag for these politically driven ‘reforms’. In addition to having an acute solvency problem, the EU will be saddled with a crippling lack of liquidity that only financial markets can provide.

Economics 04/06/2010: Bond markets are still jittery

For all the EU efforts:

• Throwing hundreds of billions into the markets in bonds supports;
• Banning 'speculative' transactions;
• Talking tough on reforms;
• Bashing rating agencies into a quasi-submission; and
  
• Proposing a 'markets calming' [more like 'markets killing'] financial transactions taxes

There has been preciously little change in the way the bond markets are pricing sovereign debt of the PIIGS. More ominously, the crisis is not only far from containment, it is spreading. Following PIIGS, the attention is now shifting onto BAN countries - Belgium, Austria and Netherlands. And in the case of Austria, the unhappy return of the Eastern European woes is now seemingly on the cards.

How so? Look no further than Hungary. The country had taken IMF bailout money, promising to deliver severe austerity measures. It now faces a new round of pressures due to once again accelerating deficits. It looks like the cuts enacted were not structural in nature, amounting to chopping capital expenditure programmes rather than current spending... Sounds familiar? so here we go again (courtesy of Calculated Risk blog): spreads are rising (Ireland's position as the second sickest country by this metric remains unchallenged) and CDS rates are rising as well (Ireland's still in number 3 spot).
As Calculated Risk points: "After declining early last week, sovereign debt spreads have begun widening for peripheral euro area countries. As of June 1, the 10-year bond spread stands at 503 basis points (bps) for Greece, 219 bps for Ireland, 195 bps for Portugal, and 162 bps for Spain."

Let's get back to Hungary, though: yesterday, Hungarian officials said that instead of 3.8% of GDP deficit target, 2010 is likely to see the deficit widening to 7-7.5% of GDP. Who's to blame? Well, per Reuters report: '"fiscal skeletons" left by the previous Socialist administration'.

Economics 28/05/2010: Spain's downgrade is a warning for Ireland

In a significant development today, Fitch cut Spain’s credit ratings to AA+ from AAA. This was expected.

What was unexpected and new in this development is the expressed reason for the cut.

Per reports, "Fitch said Spain’s deleveraging of record-high levels of household and corporate debt and growing levels of government debt would drag on economic growth." (Globe & Mail)

This puts pressure not only on the euro and European equities, but also on the rest of the PIIGS' sovereign bonds. Ireland clearly stands out in this crowd.

As I have shown here and more importantly - here, Ireland is by far the most indebted economy in the developed world. While it is true that a large proportion of our total external debt accrues to IFSC, even adjusting for that

• Our General Government Debt held externally is the fifth highest in the developed world;
• Our External Banks Debt is the highest in the world;
• Our Private Sector Debt (Total Debt ex Banks & Government) is the highest in the world; and
• Our Total External Debt is the highest in the world.

In addition, per IMF (see here) our budgetary position is one of the weakest in the world, including for the horizon through 2015 (here).

“The downgrade reflects Fitch’s assessment that the process of adjustment to a lower level of private sector and external indebtedness will materially reduce the rate of growth of the Spanish economy over the medium-term,” Fitch’s analyst Brian Coulton said in a statement.

Fitch said "Spain’s current government debt would likely reach 78 per cent of gross domestic product by 2013 from under 40 per cent before the start of the global financial crisis in 2007." Irish debt is projected to reach 94% of GDP by 2015 (IMF) or 122% of GNP - the real measure of our income. If we factor in the cost of Nama and banks, Irish Government debt will reach 122% of GDP by 2015.

This puts into perspective the real scope for public spending cuts we must enact in this and next year's Budgets. The Government aim to reduce spending by a miserly €3 billion in each year through 2012 will not do the job here. We will have to do at least 2.5 times that much to get our house in order.

Economics 22/05/2010: More nonsensical German proposals

Thursday was another day of great ideas from Berlin on “How to wreck world financial infrastructure while earning little political capital: the Angela Merkel Way”.

For a couple of weeks now, global investors have shown Madam Chance-a-lot (oops… Chancellor) that Greek Tragedy rule 1 applies: If you want to write a tragedy, set up a story where an irrational, arrogant and morally reprehensible sovereign challenges the Gods. Inevitably, in Greek classical tradition, the Gods win, while having a laugh. Mrs Merkel’s epic battle with the markets is exactly that. Markets, like Greek deities, are inevitably going to prevail. And Mrs Merkel and the retinue of euro area leaders – bent on ring-fencing their own politically connected banking sectors and shielding them from any meaningful pain for the errors committed in the past – will lose. The only thing that still might be at stake here is the degree of vengeance the markets will deal to the EU, should the euro zone embrace German proposals. With every new ‘bright idea’ on punishing the markets coming, the likelihood of an awesome spectacle of the Gods punishment meted out to Europe is rising too.


Following new taxes and short selling ban (covered by me yesterday) Mrs Merkel has now unveiled her third pillar of the reform strategy: a European ratings agency. It’s bonkers, folks. Just as the rest of the European financial sector reforms proposals so far:

• EU Rating Agency will never be independent of political interference, so no one, save for the institutionalised writers in the EU official press will ever pay any attention to whatever the agency might produce. In so far as delivering anything usable by the market or by anyone, save Eurocrats, the EURA will be a complete waste of taxpayers’ money.
• EU premise for launching EURA will be as crooked as an old local authorities politico with development firm in his backyard. Germany has departed on the EURA trip from the assertion that Euro needs an agency that can honestly upraise the extent of fiscal risks on sovereign balance sheets. Were EURA to do so, its ratings will have to be even gloomier than those of the Big 3 private rating agencies.
• EURA is unlikely to have any serious competency in what it does because unlike the Big 3 it will never be a rating agency for non-EU sovereign debt. In other words, EURA, having no recognition of non-EU sovereigns, will be forced to look at the EUniverse, a subset of the world bond markets. Which makes a proposal equivalent to simulating a tsunami in a coffee mug.
• And, of course, as any other rating agency, EURA will be no more than a lagging indicator, which means that its musings on bond valuations are going to be read only by retired intellectuals, plus pensions funds with automatic quality mandates. And even then, EURA will be forced to follow, in the news hierarchy, the Big 3.
  

In response to Mrs Merkel’s expensive (and it is expensive, from the point of view of European economy and taxpayers – see here) populism, Canadian finance minister told Mrs Merkel into her face last night that his country would not take part in either one of the three European policy follies. You see, Canada has a healthy banking system. And it has the intellectual and policy capital to understand that finance is crucial to country economic prosperity.

Americans, like Canadians and the Brits, think that the idea of a transaction tax is downright potty. All three have done the right things in trying to reform their banks. The EU, so far, is staunchly refusing to do the same. Why should the sane join the outright gaga club of countries that keep preserving rotten banking system at the expense of the real economy?

Even Finnish finance minister is saying Germany’s short sale ban had surprised everybody, unpleasantly. Finns can see through the German plans to the point where a Tobin tax on financial services will exert adverse selection against smaller exchanges in favour of the larger ones (again, see more on this here).

Why? Because the problem with financial institutions today has nothing to do with volatility in financial assets prices. It has everything to do with reckless lending by the banks and the willingness of bondholders to underwrite excessive borrowing (including that by the sovereigns). In the real world banks are willing to write poor loans because they and their shareholders and bondholders know that they will be rescued by the state, should things go pear-shape. And, of course, governments always oblige. Look no further than Nama. Wrecking regulatory vengeance on the markets in order to address the problems with the banks – as Mrs Merkel is doing – is hardly a way forward.


Only a massive scale intervention by the ECB, going most likely well beyond simple sterilization of €20 billion of sovereign bonds purchased by the bank so far, has pushed the euro up against the dollar. But at what cost, one might wonder, especially in the environment where deflation is creeping back into the US stats? I don’t have the data on ECB operations this week, but something was certainly hitting the markets for FX and bonds. Of course, sterilizing and supporting currency are two individually costly propositions. But for ECB to engage in this double game for a prolonged period of time will spell significant drying up of the liquidity. It is like an overweight elderly amateur playing alone against, simultaneously, Roger Federer and Rafael Nadal. The result will be painful, quick and devastating.

Sterilized cash can be re-injected into the banks reserves, without cash hitting the streets, but that would only mean more real money being trapped in the liquidity sucking spiral of government financing via ECB lending to the banks. We’ve been there for the last 24 months and it is not pretty.


In addition, there is a pesky issue of the US position. In effect, Japan, China, Germany and the entire euro zone are playing beggar-thy-neighbour game with the US by artificially suppressing the cost of their exports to America. The problem, as I have pointed out before (here) is that this requires US consumers to start borrowing again to sustain massive trade deficits. If this fails to materialise, and it is hard to see how it can, then the entire pyramid scheme of global trade will collapse. In the end, the double dip, this time caused by trade tensions and falling exports, is on the cards for all, as undervalued currencies in the three major powerhouses of global trade will prevent their consumers from expanding their own imports demand.

Such an outcome, however, will be preceded by a significant pain for Europe’s domestic economy. While a 10% devaluation of the Euro against a basket of global currencies can be expected to lead to a significant boost in Euro area economy (ca +0.7% in year one after devaluation and up to +1.8% in year 4), this exports-led growth will be associated with massive increases in the interest rates (+85bps in year one, to +220bps in year 3). These estimates are taken from Econbrowser (here). Obviously, the rest of the world will be just cheering EU and Mrs Merkel in this destruction of economic growth... or not?