This is an unedited version of my article in October 30, 2011 edition of Sunday Times.
This week was a fruitful and productive one for Europe’s
leaders. Not because the battered euro block has finally produced a feasible
and effective solution to the raging debt, fiscal and banking crises sweeping
across the common area, but because they spent the entire week doing what they
do best: holding meetings and issuing communiqués.
The latest plan, unveiled this Wednesday, shows once again
that the EU remains incapable of actually doing what needs to be done.
The real European disease is debt. Too much debt. Based on
the latest IMF forecasts and statistics from the Bank for International
Settlements by the end of 2011, combined public, household and non-financial
corporate debts will reach 280% of GDP in the US. In France, the Netherlands,
Sweden and Belgium, this number will be closer to 330-335%, in Italy – 314%, in
Greece – 290%, in Portugal 375%, in Spain 360%, and in Ireland a whooping 415%.
The composition of these debts, and in particular the weight
of public sector debts in total non-financial debt overhang, may differ, but
the end result is the same for all of the above. Per August 2011 research paper
from the Bank for International Settlements, combined private sector debt in
excess of ca 250% of GDP results in a long term (aka permanent) reduction in
future growth rates. This reduction, in turn, puts under pressure the ability
of the indebted states to repay their obligations.
Further compounding the problem, European banking systems
have become addicted to Government bonds as a form of capital. In the past,
this addiction was actively encouraged by the Governments, regulators and the
ECB. With the latest proposals in place, we are likely to see even more
Government/EFSF debt piling into the banks in the long term.
Having ignored basic risk management rules, banks across the
Euro area are now fully contaminated with their exposures to sovereign bonds
that are about as bad – from the risk perspective – as the adjustable rate
mortgage borrowers in the US. Based on the second set of stress tests carried
by the European Banking Authority this summer, Greek haircut of 75%, as
suggested by the IMF, against the core tier 1 requirement of 9% will imply a
capital shortfall of €180 billion. Failing to recognize this, the EU plan
unveiled on Wednesday calls for just €100 billion recapitalization under a 50%
haircut.
This, of course is far too little too late for Greece and
for Europe overall. To bring public debt to GDP levels back to the point of
fiscal stabilization (under 100% of GDP) will require ca 20% write-down in
Portugal, 40% in Italy, and 30% in Ireland. Europe’s problem is at least €730
billion-strong. It can become bigger yet if – as can be expected – Greece fails
once again to deliver on prescribed fiscal adjustment measures and/or the write-downs
trigger CDS calls and/or the credit contraction triggers by the measures leads
to a new recession. All in, Euro area needs closer to €820-850 billion in
funding in the form of both rights placements, assets disposal, and government
capital supports.
Now, factor in the second order effects of the above numbers
onto the real economy.
Injecting €820 billion in new capital or, equivalently,
providing some €1 trillion in fresh capital and bonds guarantees as envisaged
under the EFSF proposals being readied by the European officials will increase
broad money supply by 10%. This is consistent with long term ECB rates rising
to well above their previous historical peak of 4.75% - triple the current
rate. European banks trying to raise new capital and deleveraging foreign
assets will saturate equity markets across Europe with capital demand. Reduced
banking sector competition, pressures on the margins and higher funding costs
will push retail rates into double-digit territory.
For European companies – more addicted to debt financing
than their US counterparts and now competing for scarce equity investors
against their European banks – this will mean a virtual shutting down of credit
supply. Starved of domestic credit, European multinationals will aggressively
divest out of the Continent and pursue jobs and investment growth in places
where capital is more abundant – the US and Asia.
As Paul Krugman recently said, “The bitter truth is that
it’s looking more and more as if the euro system is doomed. And the even more
bitter truth is that given the way that system has been performing, Europe
might be better off if it collapses sooner rather than later.”
Sadly, Krugman is correct. European cure proposals to the
crises are worse than the disease itself and the Wednesday’s proposals for
dealing with the crisis are case in point.
Firstly, banks recapitalizations – first via private equity
raising and bond-to-equity conversions, then via sovereign/EFSF funding – risks
extending the recapitalization procedures into the second half of 2012 and
simultaneously increase the risk premia on banks funding. In other words,
credit crunch is likely to get worse and last longer. Most likely, this will
require additional guarantees to ensure the funding market does not collapse in
the process. The ECB balance sheet exposure to peripheral banks and sovereign
debts – currently at €590 billion, up from €444 billion back in June 2011 –
will become impossible to unwind.
Secondly, the insurance option for sovereign bonds issuance
is likely to be insufficient in cover and, coupled with greater seniority
accorded to EFSF debt can lead to a rise in yields on Government bonds. This,
in turn, will amplify pressure on countries, such as Spain and Italy which are
facing demand for new bonds issuance and existent debt roll over of some
€1.3-1.5 trillion over 2012-2014.
Thirdly, leveraging EFSF to some €1 trillion via creation of
an SPIV (Special Purpose Investment Vehicle) will create a nightmarishly
complex sovereign debt structure.
Under leverage EFSF option, a country borrowing from the
fund €1 billion will receive only a small fraction of the money directly from
the fund itself, with the balance being borrowed from international lenders
that may include IMF. In order to secure such lending, the EFSF will require
seniority for international lenders over and above any other sovereign debt
issued by the borrowing state. This will de facto prevent the EFSF borrower
from raising new funding in the capital markets in the future.
In all of this, Ireland is but a small- albeit a high risk –
player with the power to influence some of the EU decisions, especially those
that matter most. Alongside the EFSF reforms and banks recapitalizations, the
EU will require stronger fiscal and sovereign debt oversight measures, and
ultimately closer integration.
The Irish Government should make it clear from the earliest
date possible that Ireland’s participation in this process is conditional on
three measures. First, Irish banks debts to the euro system should be written
down to the tune of €60-70 billion, allowing for clawing back some of the funds
injected into banks as capital and providing a stronger cushion for a
households’ debt writeoff. Second, we should demand that the debt-for-equity
swaps explicitly encouraged as the means for recapitalization of the euro area
banks in Wednesday agreement be applied to Irish banks. These swaps can be used
to further reduce previously committed funds and reverse some of the debt
accumulated by the Exchequer (on and off its balancesheet). Third, Irish
Government should make it unequivocally clear that we will veto any tax
harmonization in the future.
On the net, European solutions unveiled this Wednesday are simply
not going to work. In Q1 2012 the latest recapitalization of Euro area banks
and Greece will run out of steam. Next time around, this will happen in the
environment of slower growth and possibly a full-blown recession with Spain,
Italy and Portugal all running into deeper fiscal troubles. The real price of
Europe’s serial failures to deal with the crisis will be the real economy of
the euro zone.
Box-out:
This week’s CSO-compiled Residential Property Price Index
(RPPI) had posted another 1.49 percent monthly fall in house prices nationwide.
Exactly four years ago, at the peak of residential property valuations, RPPI
stood at 130.5. At the end of September this year, the index was just 72.8 or
44 percent below the peak. The misery of falling prices is now impacting not
only hundreds of thousands of negative equity mortgage holders, but even the
all-mighty Nama. Nama referenced its original valuations of the assets it took
over from the banks to November 30, 2009. Since then, residential prices in the
nation have fallen 29.5% and apartments prices (the category of property more
frequently related to Nama loans) have fallen 33.9%. All in, Nama will now
require a 35% uplift on its assets (55% for apartments) to break even, not
including the organization’s gargantuan costs of managing its assets.
As chart below illustrates:
