AMERICAN FUTURE

Across the continent, European leaders warned that 2012 was likely to be tougher than 2011.

Germany:

Angela Merkel told German voters “next year will no doubt be more difficult than 2011.” In her televised address, she said Europe was experiencing its “harshest test in decades” but would ultimately be made stronger by the crisis.

France:

In a sombre address on national television Nicolas Sarkozy said “This extraordinary crisis, without doubt the gravest since the second world war, is not over … you are ending the year more anxious for yourselves and your children.”

Italy:

Prime Minister Mario Monti said in his end-of-year address last week that Italy had hauled itself back from the “edge of the precipice” but he said more needed to be done to reform labor markets and the service sector to restore competitiveness to the stalling economy. President Giorgio Napolitano urged Italians to make sacrifices to rescue the country’s public finances. “Sacrifices are necessary to ensure the future of young people, it’s our objective and a commitment we cannot avoid. No one, no social group, can today avoid the commitment to contribute to the clean-up of public finances in order to prevent the financial collapse of Italy.”

This time, it raise a caution flag for the EFSF:

The ‘AAA’ rating on debt issues of the European Financial Stability Facility (EFSF) largely depends on France and Germany retaining their ‘AAA’ status. The revision of the rating Outlook on France to Negative last Friday implies that the risk of a downgrade of EFSF debt has increased.

We affirmed France’s ‘AAA’ status but warned that that there is a slightly greater than 50% chance of a downgrade within the next year or two. This is therefore also the case for the ‘AAA’ ratings assigned to the EFSF’s debt issues, unless additional credit enhancement mechanisms are introduced.

The ‘AAA’ ratings assigned to EFSF debt issues rely on the EUR726bn of irrevocable and unconditional guarantees provided by the euro member states, and on the conservative guidelines the EFSF sets itself regarding debt management and liquidity risk.

Of the guarantees and over-guarantees from ‘AAA’ rated member states, France and Germany provide EUR369.6bn, or over 80%. Although the EFSF could potentially remedy a downgrade of a small ‘AAA’ guarantor by increasing the size of its cash reserve or through additional credit enhancements, this would be far more challenging if a larger guarantor like France or Germany were downgraded. The primary source of ratings risk for EFSF debt issues is therefore the possibility that one or more of its largest ‘AAA’ guarantors is downgraded.

Because we do not assign Outlooks to the ratings of individual debt issues, but rather to our issuer ratings, the change in the French issuer rating Outlook cannot immediately be reflected in changes to our assessment of EFSF debt issues. We rate EFSF debt issues but not the EFSF itself, as it is the former rather than the latter that benefit from sovereign guarantees.

Under the amended Framework Agreement announced at the EU summit on 21 July, ‘AAA’ rated euro member states provide EUR451.5bn of guarantees and over-guarantees, giving the EFSF a maximum lending capacity of EUR440bn.

France is the most exposed of the ‘AAA’ euro member states to a further intensification of the eurozone sovereign debt crisis. It provides EUR158.5bn of guarantees plus over-guarantees to the EFSF guarantee pool under the framework agreement.

When we revised France’s rating Outlook, we noted that an increased likelihood that contingent liabilities arising from the crisis will be crystallised onto France’s balance sheet, material slippage from fiscal targets, and a re-assessment of France’s economic growth potential, could each trigger a rating downgrade. Conversely, economic and fiscal performance in line with our base case expectations, along with a resolution of the eurozone debt crisis, would be likely to result in a revision of the Outlook to Stable.

Round 2 of Reactions to the EU Summit (and some other stuff)

The consensus:

The title of the FT’s editorial — “Europe fails to reach summit” — says it all:

It should have been the climax to Europe’s thriller, a summit that would kill off the sovereign debt crisis with a salvo of confidence-restoring measures. But, apart from Britain’sdramatic exit, last week’s European summit was entirely predictable in its inconclusiveness.

To be fair, it is good news that even modest steps were taken towards closer fiscal integration. But the real, comprehensive fiscal union needed to restore faith in the euro, as opposed to a few new rules, remains elusive.

More urgently, the deal that was struck does nothing to resolve the immediate crisis. Moves to bolster the International Monetary Fund and hints of more support next year for Europe’s two bail-out vehicles are neither big enough nor fast enough to deal with the titanic task of funding peripheral countries’ debt until confidence returns.

Hopes in the existence of a big bazooka proved misplaced. Mario Draghi, European Central Bank president, on Thursday quashed hopes that he would launch an unlimited bond-buying programme to help indebted sovereigns, as European rules do not allow this.

Now there is the suggestion that the ECB has a cunning plan to give the bazooka to Europe’s banks, which will be lent bags of cheap money, with which to buy their own countries’ debt.

The argument is tempting. Friday’s summit declared that there will be no more haircuts on sovereign debt. So if banks can get three-year ECB money at 1 per cent and buy Italian bonds at 6 per cent, this could help cut debt costs while bringing seemingly risk-free returns. This is not contrary to European rules and it could be in both parties’ interests. If the sovereigns go, Europe’s banks are front line victims.

However, there are many reasons to be wary of such a solution, not least because it fools no one. The ECB would in effect be funding sovereign debt through Europe’s banks. This is hardly in the spirit of the European treaty. Second, shareholders might rightly question why banks, which have been shedding periphery bonds despite having had the arbitrage opportunity for some time now, were suddenly scooping them up. Most importantly, if the current crisis was sparked by the link between sovereign and bank risk, does it make sense to intensify that link? Right now there may be no alternative to save the euro. But it amounts to little more than sleight of hand in a crisis where clarity and resolve would do much more to restore confidence.

Unsurprisingly, the FT’s Wolfgang Munchau agrees:

. . . the decision to set up a fiscal union outside the European treaties will do nothing whatsoever to resolve the eurozone crisis . . . this is not something you would wish to do outside European treaties. The existing treaties form the legal basis for all policy co-ordination of monetary union. It gets very messy when you try to circumvent them.

[...] A fiscal union set up outside the European treaty would face severe legal and practical limitations. Unless a trick is found, it cannot make recourse to the resources and institutions of the EU. Nor can it issue eurozone bonds. The only conceivable counterparty for a eurozone bond is the EU itself.

More important even, a fiscal union created through a legal trapdoor would not help solve the crisis. The eurozone is facing a generalised loss of confidence. Investors no longer trust its crisis management, the solidarity of its citizens, even the ability to conduct sensible economic policies. The EU is not going to restore confidence through legal gimmickry that will face numerous court challenges.

Leaders should have admitted on Friday that the summit had simply failed, or perhaps have given it a few more days. Negotiations might have produced a compromise. With the fake pretence of another treaty, that is no longer possible.

Remember what everybody said a week ago? To solve the crisis, the eurozone requires, in the long run, a fiscal union with a prospect of a eurozone bond and, in the short run, unlimited sovereign bond market support by the European Central Bank. What we now have is no treaty change, no eurozone bond and no increase either in the rescue fund or in ECB support.

Policy changes the ECB announced last week will help banks directly and governments indirectly. But the EU fell short on every element of a comprehensive deal. On Friday, investors reacted positively to what was sold to them as a “fiscal compact”. But once the implications of a separate treaty are understood, I fear disillusionment will set in.

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The rating agencies are equally unimpressed.

In its Weekly Credit Outlook, Moody’s says that “Pressure Remains on Euro Area Sovereigns in Absence of Decisive Initiatives” and “European Bank Recapitalization Plan Is Credit Positive, but Encourages Deleveraging”:

Pressure Remains . . .

. . . the [EU summit] communiqué reflects the continuing tension between euro area leaders’ recognition of the need to increase support for fiscally weaker countries and the significant opposition within stronger countries to doing so. Amid the increasing pressure on euro area authorities to act quickly to restore credit market confidence, the constraints they face are also rising. The longer that remains the case, the greater the risk of adverse economic conditions that would add to the already sizeable challenges facing the authorities’ coordination and debt reduction efforts.

As a result, the communiqué does not change our view that the crisis is in a critical, and volatile, stage, with sovereign and bank debt markets prone to acute dislocation which policymakers will find increasingly hard to contain. While our central scenario remains that the euro area will be preserved without further widespread defaults, shocks likely to materialise even under this ‘positive’ scenario carry negative credit and rating implications in the coming months. And the longer the incremental approach to policy persists, the greater the likelihood of more severe scenarios, including those involving multiple defaults by euro area countries and those additionally involving exits from the euro area.The credit implications of these and further measures likely to be announced in coming weeks require careful consideration against the backdrop of decelerating regional economic activity, fragile banking systems, partly dysfunctional credit markets, and the varying degree of success of country-specific measures aimed at structural change and fiscal consolidation. But in the absence of credit market conditions stabilising, the system remains prone to further shocks which would likely lead to selective rating changes. More broadly, in the absence of any decisive policy initiatives that stabilise credit market conditions effectively, our intention as announced in November is to revisit the level and dispersion of ratings during the first quarter of 2012.

European Bank Recapitalization . . .

Additional capital is credit positive as it enables banks to cope with increased stress. However, there is a risk that tighter capital requirements will encourage further deleveraging, thereby increasing the risk of a credit crunch and additional impairments.

The establishment of a sovereign exposure buffer follows criticism that the EBA’s stress test earlier this year inadequately reflected the true value of, and impairments in, banks’ sovereign exposures. Disclosures in banks’ interim statements also point to inadequate evaluation and provisioning and, in some cases, a failure to comply with international accounting standards.

[...] Supervisors are not simply seeking to achieve higher capital ratios, but also higher capital. Nevertheless, the incentive for banks to deleverage remains high and will only be exacerbated by higher capital requirements. More fundamentally, higher capital buffers cannot address the underlying cause of the disruption to the funding markets which is the sovereign debt crisis.

Fitch says that the “Summit Does Little To Ease Pressure on Eurozone Sovereign Debt”:

After the latest EU crisis meeting it is clear that politicians are responding to the eurozone sovereign debt crisis through incremental improvements. It seems that a “comprehensive solution” to the current crisis is not on offer.

This Summit demonstrated strong political support for the euro, and that its members are putting in place the institutional and policy framework for a more viable eurozone and ultimately greater fiscal union. But taking the gradualist approach imposes additional economic and financial costs compared with an immediate comprehensive solution. It means the crisis will continue at varying levels of intensity throughout 2012 and probably beyond, until the region is able to sustain broad economic recovery.

In the short term we predict a significant economic downturn across the region. The eurozone faces intense market pressure, which is triggering loss of business and consumer confidence, and weak industrial activity and retail sales. Our forecast of 0.4% eurozone GDP growth next year and 1.2% in 2013 would be significantly higher if there was a comprehensive solution to the crisis. The lack of a comprehensive solution has increased short-term pressure on eurozone sovereign credit profiles and ratings.

The latest EU Summit, like others before it, has resulted in some positive developments. There is an extra EUR200bn of funding for the IMF, the ESM has been brought forward, and there has been policy change on private-sector involvement in any future sovereign crisis. As with all Summits there is execution risk.

The extra resources for the IMF are welcome but it is not clear how and under what circumstances they would be deployed. The move away from requiring private-sector involvement (PSI) as a condition for ESM programmes is clearly positive for bondholders. The European Commission said it will “strictly adhere to the well established IMF principles and practices.” PSI has been a feature of past IMF programmes, but the Fund sets out to attract private capital to sovereigns and can be expected to use PSI as a last rather than a first resort.

Separately, the ECB also announced changes to its repo schemes that will aid bank liquidity, such as three-year liquidity lines and looser collateral requirements for structured finance. This could be positive for eurozone sovereigns if it eases pressure on them to introduce or re-activate bank debt guarantee schemes.

The Summit’s conclusions show a longer-term desire to move towards some form of fiscal integration in return for enforced fiscal prudence. We believe that most of the vulnerable eurozone countries are already implementing aggressive austerity programmes, and some are already changing their national constitutions. It is too early to judge how effective the fiscal compact will be due to the uncertainty regarding how it will be implemented.

We still believe the ECB, either directly through its sovereign bond purchase programme or indirectly by allowing the EFSF/ESM to access its balance sheet, is the only truly credible “firewall” against liquidity and even solvency crises in Europe.

Hopes that the ECB would step up its actions in support of its sovereign shareholders as a quid pro quo for institutional and legal changes that gave the ECB greater confidence in the long-run commitment of eurozone governments to fiscal discipline appear to have been misplaced.

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Lurking in the background, according to the Wall Street Journal, is an old nemesis: credit default swaps, which have been used in copious quantities by European banks:

Dozens of banks across Europe have sold large quantities of insurance to other banks and investors that protects against the risk of ailing countries defaulting on their debts, the latest illustration of the extensive financial entanglements among the continent’s banks and governments.

New data released last week by European banking regulators suggest the risks of banks suffering losses tied to European government bonds could be higher and more widespread than previously realized.

The numbers show European banks have sold a total of €178 billion ($238 billion) worth of insurance policies, in the form of financial derivatives known as credit-default swaps, on bonds issued by the financially struggling Greek, Irish, Italian, Portuguese and Spanish governments. If those bonds default, as some investors fear they might, banks could be on the hook for making large payments to the holders of the swaps.

The banks have at least partly insulated themselves from such potential losses by buying large quantities—roughly €169 billion worth—of credit-default swaps tied to the same bonds, apparently in large part from other European banks, according to European Banking Authority data.

Some analysts and investors say they had assumed that sovereign credit-default swaps, known as CDS, were primarily sold by giant global investment banks in the U.K., France and Germany, as well as in the U.S. Those banks sell the swaps to big corporate clients and other banks and institutions.

But the new EBA data show a surprising breadth of large and small European banks—at least 38 of them—have sold instruments that protect against potential losses on Greek, Irish, Italian, Portuguese and Spanish government bonds.

Of the total protection that European banks have written on government bonds in Europe’s five most-stressed countries, nearly one-third originated from German banks.

The diverse array of banks in the sovereign CDS market means that risks can spread more quickly through the financial system. It also means it is harder to predict how losses would ricochet among institutions and countries, analysts say.

The banks and some analysts argue that the industry’s actual exposure is far less than the €178 billion of swaps they have sold because the banks have purchased €169 billion in similar protection from other sources, which can offset the exposure. Many of Deutsche Bank’s purchases and sales of CDSs, for example, are with the same counterparties, with whom the German bank has legally enforceable netting agreements in place.

But some experts say it is risky to assume that all banks’ CDS transactions neatly cancel each other out.

“Netting is all very well provided that you trust your counterparty,” said Jon Peace, a Nomura Securities banking analyst. But in a crisis situation, “what you thought was net could tend toward your gross exposures” because certain sellers of the default insurance could themselves go bust.

For example, two of Italy’s biggest banks, UniCredit SpA and Banca Monte dei Paschi di Siena SpA, have sold a total of about €5.3 billion of protection against the risk of an Italian sovereign default, according to the new EBA data. The problem is that, in a default scenario, both banks likely would be in trouble themselves due to their huge holdings of Italian government bonds and the fact that their businesses are largely concentrated in Italy.

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While the Organisation for Economic Co-operation and Development (OECD) hasn’t issued a statement setting forth its view of the results of the EU summit, the Financial Times reports that it “will warn in its latest borrowing outlook, due to be published this month, that financial stresses are likely to continue with the “animal spirits” of the markets – their unpredictable nature – a threat to the stability of many governments that need to refinance debt.”

For the foreseeable future it will be a “great challenge” for a wide range of OECD countries to raise large volumes in the private markets, with so-called rollover risk a big problem for the stability of many governments and economies.

Rollover risk is the threat of a country not being able to refinance or rollover its debt, forcing it either to turn to the European Central Bank in the case of eurozone countries or to seek emergency bail-outs, which happened to Greece, Ireland and Portugal. The OECD says the gross borrowing needs of OECD governments is expected to reach $10.4tr in 2011 and will increase to $10.5tr next year – a $1tr increase on 2007 and almost twice as much as in 2005. This highlights the risks for even the most advanced economies that in many cases, such as Italy and Spain, are close to being shut out of the private markets.

While borrowing was higher in 2009 and 2010, the risks are greater than ever because of rising borrowing costs in turbulent, unpredictable markets.

The OECD says that the share of short-term debt issuance in the OECD area remains at 44 per cent, much higher than before the global financial crisis in 2007. This, according to some investors, is a problem as it means governments have to refinance, sometimes as often as every month, rather than being able to lock in more debt for the longer term that helps stabilise public finances.

The OECD also warns that a big problem is the loss of the so-called risk-free status of many sovereigns, such as Italy and Spain, and possibly even France and Austria. The latter two have triple A credit ratings but investors no longer consider them risk-free.

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Contagion from the eurozone crisis appears to be spreading to emerging markets: Indian industrial production dropped by 5.1 percent in October. From the Financial Times:

“The data are way worse than we were expecting,” said A Prasanna, economist at ICICI securities in Mumbai. “Usually output is lower during the months of October and November as there are fewer working days due to the festival season but a 5.1 per cent drop is significantly more than we predicted,” he added.

Manufacturing output, which represents about 76 per cent of industrial production, dropped 6 per cent in October, compared with a year ago and capital goods production, which is considered to be a key barometer of investment sentiment in the country, fell 25.5 per cent. Meanwhile, mining production was down 7.2 per cent, as a series of scandals in the sector and continued uncertainty over the outcome of a long-awaited mining bill hurt the industry.

Reactions to the Results of the EU Summit Meeting

This is an extremely long post with complete articles from the Financial Times, the Economist, the Guardian, Spiegel Online, and the Centre for European Reform (a British think tank). So as to avoid inserting my own slant on the outcome of the summit meeting, I decided not to post shortened, edited versions.

The articles are below the fold.

Continue reading ‘Opinions and News on the Eurozone Crisis, No. 46’ »

From the BBC at 00:45 EST

Attempts to get all 27 EU states to agree changes to the bloc’s treaties to tackle the eurozone crisis have failed.

Speaking after long talks in Brussels, French President Nicolas Sarkozy said the 17 eurozone states and others would work on a separate pact instead.

France and Germany are pushing for tough new budgetary rules to be enshrined in the accord.

But UK Prime Minister David Cameron said an EU-wide deal “isn’t in Britain’s interests”.

After nearly 10 hours of talks between EU leaders, Mr Sarkozy said he would have preferred a new treaty involving all 27 member states.

But he said Mr Cameron had proposed a protocol to be written in the deal allowing London to opt-out on proposed change on financial services.

“We could not accept this,” Mr Sarkozy said.

Mr Sarkozy added that Hungary also decided to remain outside the proposed treaty, while the Czech Republic and Sweden wanted first to consult with their parliaments.

“All the others have wished to join the inter-governmental treaty,” the French leader said.

He denied suggestions that the new treaty would lead to a two-speed EU.

Speaking at a news conference shortly afterwards, Mr Cameron said he had made “a tough decision, but the right one”.

“What’s on offer isn’t in Britain’s interests,” he said, adding that he would not put the proposed deal before British parliament as it was an accord outside EU structures.

In 1914, an economically healthy Europe was divided into armed camps. In the 1930s, an economically destitute Europe was divided into armed camps. Now, an economically unhealthy Europe is again divided into camps. This time, a military confrontation is thankfully not in the cards, but the handwriting is on the wall for economic and financial warfare. Every time Europeans leaders get together, hope soon gives way to despair. The lesson is that no matter how bad things are, they find a way to make things worse. Who would have thought that this time it would be the Brits who, fearful that agreements brokered by the Germans and French would weaken The City (London’s Wall Street), would escalate the crisis to a new and more dangerous level?

From Reuters at 10:08 EST:

The European Union failed to secure backing from all 27 countries to change the EU treaty at a summit Friday, meaning any deal will now likely involve the 17 euro zone countries plus any others that want to join, three EU diplomats said.

An agreement at 27 fell through after British Prime Minister David Cameron demanded concessions that Germany and France were not willing to give, one of the officials said.

During nearly 10 hours of talks that lasted into the night, EU leaders did manage to reach agreement on a ceiling for the size of the euro zone’s permanent bailout fund, the ESM, saying it would be capped at 500 billion euros.

That figure will be reviewed in July next year, when the ESM is due to come into force, the diplomats said.

The leaders also agreed to explore the idea of providing bilateral loans to the International Monetary Fund totalling 200 billion euros, with 150 billion of that coming from the euro zone , to bolster IMF resources to tackle Europe’s debt crisis.

If market participants ignore this development, I’ll be forced to conclude that they’ve taken leave of their senses.

[An earlier report providing background from The Guardian]

While you (and I) were having Thanksgiving dinner (and napping afterwards), the eurozone crisis didn’t take the day off:

Wall Street Journal: The ECB will definitely not become the eurozone’s lender of last resort — Meeting in Strasbourg, Merkel, Sarkozy, and Monti pledged to present a package of proposed changes to the European treaty by Dec. 9 that aim to integrate euro-zone economic policies, but quashed suggestions that the European Central Bank should play a greater role in fighting the region’s protracted debt crisis.

Trying to quell a rift with Germany over whether the European Central Bank should take more-decisive steps to solve the debt crisis, Mr. Sarkozy said he and Ms. Merkel agreed to abstain from making demands on the Frankfurt-based bank. Sarkozy said:

“In the respect of the institution’s independence it’s essential that we abstain from making either positive or negative demands on the ECB.”

German Economics Minister Philipp Rösler, in comments made ahead of the reiterated his strong rejection of common euro-zone bonds, while top government lawmakers didn’t completely rule out their introduction. Rösler made clear the euro zone must first change EU treaties and integrate economic and fiscal policies far more deeply. One lawmaker said some discussions on euro bonds may be continuing, but ruled out their introduction during the current government.

In a budget debate, asking Germany’s lower house of parliament to signal its rejection of the collective bonds, Mr. Rösler said:

“We don’t want euro bonds, because we don’t want interest rates to rise dramatically in Germany.”

Wall Sreet Journal: ECB considers longer bank loans — The ECB is considering offering longer-term loans to commercial banks that are having trouble securing funding in private markets, as officials scramble to keep the debt crisis from freezing new lending.

Officials may extend loans to banks at maturities of two or three years, according to people familiar with the matter. The longest maturity at present is 13 months. The ECB will make that 13-month loan available next month, meaning banks that need it will have secure funding through 2012.

Notwithstanding the agreement reached in Strasbourg, new loans at two to three-year maturities would mark an escalation in the ECB’s role as lender of last resort to Europe’s banks. Despite repeated warnings by top officials of the danger that banks could become “addicted” to central bank credit, the ECB has repeatedly made these funds available on an unlimited basis.

Rising German yields may therefore reflect a growing belief in the introduction of euro bonds; indeed higher yields may make common bond issuance more palatable for Germany. A renewed decline in yields could signal increasing fear of a break-up or widespread defaults, although this again might lead to renewed rearguard action to save the euro.

Financial Times: Lex, “Eurobonds: moral hazard ahead“ – If eurozone nations cannot borrow separately, perhaps they can borrow together. That is the logic behind the common debt issuance idea – eurozone bonds – being mooted by the European Commission. Those in favour could cite Wednesday’s other, more scary development – investors turning their backs on a German bond issue – to bolster the case that more liquid collective debt would help to trump countries’ individual difficulties. It is the very crisis the region is trying to fight, however, that makes the joint bond concept look like whimsy.

Moral hazard, for starters. By offering the likes of Greece or Italy such rewards, eurozone bonds could remove these countries’ incentive to regain lost competitiveness. Nor would these bonds reduce the stock of existing debt. Unless there was a degree of fiscal union and budgetary enforcement in the eurozone that trampled on national sovereignty, investors would rightly be sceptical about buying such instruments. If the yield on eurozone bonds was to become significantly higher than that on debt of the bloc’s triple A states, the project would crumble.

And then there is the clinching argument – that Germany will not accept them. An ersatz form of eurozone bond issued by the European Financial Stability Facility already exists. Anything more ambitious is a non-starter until the crisis has abated.

Financial Times: Sebastian Mallaby, “Germany is the real winner in a transfer union“ – Over the past 18 months, Germany has tried every trick to limit its contribution to the euro bailouts. It has pushed self-defeating austerity onto bankrupt countries. It has called in the International Monetary Fund. It has tried to pass the hat to China. It has discovered an improbable and futile taste for leveraging up the European Financial Stability Facility. But now these tricks have uniformly failed, and the continent approaches the abyss – with Germany itself suffering the humiliation of a failed bond auction. It is time for Germany to decide once and for all: how much will it pay to save Europe?

Germans can reach the sensible answer only if they discard the myth, widely cherished in northern Europe, that peripheral southern countries are the undeserving beneficiaries of a charitable transfer union . . .  The truth is that Germany derives myriad benefits from the currency union. It should pay more to save it.

[...] the currency union that makes adjustment in the periphery so excruciating is the very same currency union that handed Germany its export boom. Rather than condemning lazy southerners, the Germans should share the loot.

[...] As the issuer of Europe’s remaining reserve assets, Germany has enjoyed a flood of capital inflows from the periphery, driving its 10-year government bond yield down to around 2 per cent, this week’s auction notwithstanding. The resulting monetary stimulus arrived just when slowing global growth made it most welcome; this is Germany’s version of the flight to quality that the US enjoys thanks to the dollar’s status. Countries that benefit from international monetary arrangements should be prepared to invest in preserving them.

[...] the Germans have it right: Europe’s currency union does indeed involve transfers. But it is not true that these transfers flow only one way. Germany pays out via bailouts and intra-regional transfers; but it also receives benefits via trade and monetary channels. If only Germany could accept this truth, it might yet muster the will to rescue the euro – and salvage a generation of efforts to build an integrated Europe.

Financial Times: Sharon Bowles, “Time for sovereigns to swallow their medicine“ – Just as structured investment products such as collateralised debt obligations were tainted post-Lehman, so too is sovereign debt. There are other parallels too – just as regulatory reliance on ratings contributed to sleeping on the job over complex products, so too have regulatory exemptions and zero risk weightings removed the brakes from the sovereign debt wagon.

Financial Times: Mohamed El-Erian: “Europe’s banks must be forced to recapitalise now“ – Given this week’s developments, there should be no doubt in anyone’s mind that what started out as a dislocation in the periphery of the eurozone has now decisively breached the firewalls protecting the outer core and is seriously threatening the inner core . . . In the eyes of the markets, the capital cushion of Europe’s banking system as a whole is no longer sufficient to support its balance sheet. This concern is not limited to the markets. Judging from their eagerness to dispose of assets, bank managements also believe that balance sheet delevering is key to the institutions’ survival and well being.

Lousy German bond auction:

Germany saw one of its poorest debt sales on Wednesday in what was seen as a failed auction by many market participants amid fears the eurozone’s debt crisis is spreading all the way to Berlin. Marc Ostwald, at Monument, said “I cannot recall a worse auction … If Germany can only manage this sort of participation, what hope for the rest. Yields are at completely the wrong level.” Mr Oswald said the bid-to-cover ratio was only 0.65 times as the German debt agency sold just €3.644bn of its new 10-year Bund of the €6bn targeted. The Bundesbank retained a massive €2.356bn, which it will plan to sell over the coming days in the hope market sentiment improves. If the Bundesbank retention is included, the bid-to-cover ratio was a modest 1.1 times. Many market participants consider this an auction failure although some say technically it is not, as by retaining its own bonds the Bundesbank has pushed the bid-to-cover ratio above 1.0 times. The average yield for the 10-year bonds was 1.98 per cent.

Lousy eurozone economic indicators:

Eurozone industry saw the biggest one month fall in orders in almost three years in September, as worries about the region’s escalating debt crisis hit demand. New orders plunged by 6.4 per cent compared with August, according to Eurostat, the European Union’s statistical office. It was the biggest month-on-month fall since December 2008, when the global economy was reeling from the collapse of Lehman Brothers investment bank. Then, orders dropped by 10.2 per cent.

The data suggested the region’s debt crisis had undermined economic confidence even more than feared, resulting in business and consumers cutting back investment and spending. Earlier this week, the European Commission reported its index of eurozone consumer confidence had fallen in November for the fifth consecutive month to the lowest level since August 2009.

With orders data providing an early indication of trends in economic activity, September’s figures added to evidence that the eurozone has fallen into recession. Italy, where the eurozone debt crisis intensified from August, saw the biggest drop in industrial orders – of 9.2 per cent – between August and September. But France and Spain saw drop of 6.2 per cent and 5.3 per cent respectively, and Germany saw a 4.4 per cent contraction in orders.

Eurozone purchasing managers’ indices for November, also published on Wednesday, indicated overall economic activity is contracting at a significant pace – although the rate of decline appeared to have stabilised. The “composite” index, covering manufacturing and services, rose from 46.5 in October to 47.2 – the third consecutive month below the 50 level, which divides an expansion in activity from a contraction.

Merkel says ECB mandate can’t be changed:

In a forceful speech to the Bundestag lower house of parliament, Chancellor Angela Merkel issued one of her starkest warnings yet against fiddling with the central bank’s strict inflation-fighting mandate . . . “The European currency union is based, and this was a precondition for the creation of the union, on a central bank that has sole responsibility for monetary policy. This is its mandate. It is pursuing this. And we all need to be very careful about criticizing the European Central Bank,” Merkel said. “I am firmly convinced that the mandate of the European Central Bank cannot, absolutely cannot, be changed.”

The European Commission has released the “Green Paper on the feasibility of introducing Stability Bonds,” the draft of which I included in one of my Monday posts.

• Press release
• Green Paper
• Consultation on Stability Bonds
  • Privacy Statement
  • Questionnaire

Merkel tells the EC to mind its own business:

German Chancellor Angela Merkel slapped down a new European Union push for bonds issued jointly by the 17 euro nations, saying Tuesday that they wouldn’t resolve the debt crisis and now is the wrong time to discuss them. Merkel dug in on her resistance to calls for an instant solution to the crisis hours after the EU’s top economic official tried to sell a skeptical Germany on Brussels’ new drive for so-called “eurobonds,” which the EU’s executive Commission is now calling “stability bonds.” Merkel has staunchly opposed anything resembling eurobonds, which the Commission’s head argues would be an effective way to avoid disaster as many countries’ borrowing costs spiral higher in the debt crisis.

The chancellor noted in a speech to Germany’s main employers’ association that so-called eurobonds “have just come very much back into fashion.” But she was unbending in her opposition to introducing them, saying that what’s important is to address shortcomings in the construction of the eurozone. “If at all, this discussion belongs at the end — so I don’t find it particularly fitting that we are now once again conducting it in the middle of the crisis, as if it were the answer to this crisis,” Merkel said. “In the long term, it isn’t.”

Merkel also underlined her resistance to mounting pressure for a major bond-buying campaign by the European Central Bank as a way of relieving pressure on other countries’ borrowing costs. She said of hopes of an immediate solution to the crisis: “I say yet again: there won’t be one.”

The EC Green Paper is one part of the EC’s “package enabling new action for growth, governance and stability” announced today:

• Press release
• The 2012 Annual Growth Survey: FAQ
• Economic Governance
• Speech by President Barroso
• Annual Growth Survey
  • Annex: Progress Report on the Europe 2020 Strategy
  • Annex: Macro-Economic Report
  • Annex: Draft Joint Employment Report
  • Annex: Growth Friendly Tax Policies
• Regulation on common provisions for monitoring and assessing draft budgetary plans and ensuring the correction of excessive deficit of the Member States in the euro area
• Regulation on the strengthening of economic and budgetary surveillance of Member States experiencing or threatened with serious difficulties with respect to their financial stability in the euro area

From the online Wall Street Journal at 11pm:

• EU Banks Struggle to Lure Deposits

Several large Italian and Spanish banks recently reported double-digit percentage declines in deposits from corporate and other institutional clients, although their overall deposit levels fell more modestly, as lenders hold a greater share of retail deposits. The deposit base at Spanish banks dropped by €48 billion ($64.8 billion), or 2%, in the third quarter, according to the Bank of Spain.

The deposit outflows come as emergency borrowings by banks from the European Central Bank soared to their highest level in more than two years Tuesday, with the ECB allotting €247.2 billion in seven-day funds to banks, a jump from the previous 2011 high of €230.3 billion.

Meanwhile, banks in countries like Spain, Portugal and Italy are scrambling to retain existing customers and attract new ones by dangling ever-higher interest rates on deposits, making it more expensive for banks to finance themselves affordably.

[...] To be sure, analysts say that overall, European banks still have hundreds of billions of euros of deposits, many of them from individual customers who tend to be reluctant to switch bank accounts. The lenders also can turn to financial lifelines from the European Central Bank, posting government bonds and other assets as collateral.

But if the drought continues, it could pose a threat. European banks face a wave of maturing debt next year—up to €800 billion, by some analyst estimates. If banks can’t replace those funds by selling bonds or gathering new deposits, they will need to compensate by cutting lending. The situation is worrying regulators, policy makers and investors. Some officials have called for European governments to band together to guarantee new long-term bank debt, but senior finance officials from European countries rejected the idea at a meeting last week, according to people familiar with the discussions.

[...] Deposit levels at five of Spain’s top six banks declined in the third quarter, while five of Italy’s largest lenders also reported declines, according to a report by analysts at Citigroup . . . Spain and Italy’s largest banks each reported declines of at least 10% in the quarter that ended Sept. 30.

With deposits simultaneously becoming scarcer and more valuable as a funding source, some banks are entering into a sort of arms race. They are jacking up the interest rates they are offering on deposits and venturing into other European countries in the hunt for new customers. Even though the ECB is keeping its key interest rate at the historically low level of 1.25%, banks in Portugal, Spain and Italy are routinely offering to pay customers more than 4% annually for deposits.

• Europe’s Smart Money Votes With Its Feet

In Italy, nonretail customers withdrew €56 billion in the three months to the end of September, a fall of 12%. Intesa Sanpaolo and UniCredit saw corporate deposits decline by 16% and 10%, respectively, according to Citigroup research. Similarly, in Spain, nonretail deposits fell by 20% in the third quarter, with Santander and BBVA losing 10% and 11%, respectively. Even the French banks weren’t immune: Société Générale and BNP Paribas saw their corporate-deposit balances fall by 7% and 6%, respectively.

[...] if the trend in deposits continues, it will add to the pressure on banks to deleverage. Euro-zone banks are likely to cut up to €2.5 trillion of assets, equivalent to 5% of their total assets, as they struggle to meet new regulatory rules, reckons Morgan Stanley. Much of this can likely be achieved by cutting international operations and investment-banking activities. But as banks try to pass on higher funding costs, lending to core domestic economies could suffer, worsening the debt crisis.

• Santander Raises Cash With  Chile Stake Sale

Banco Santander SA is preparing to sell a nearly 8% stake in its Chilean business, the latest in a string of moves in which the Spanish bank is raising concerns among investors.

The move in Chile comes as Santander, widely viewed by many investors and analysts as one of Europe’s strongest lenders, also has unveiled plans to sell 8% of its Brazilian unit; the deals could raise a total of about $3.5 billion. It also sold a slice of its U.S. auto-loan unit last month for about $1 billion and made a recent offer to exchange some of its outstanding bonds, raising about €600 million ($809 million). The goal is to strengthen the Spanish bank’s capital cushions.

The efforts highlight how Santander and other European banks are scrambling to raise capital without taking steps such as reducing dividend payments or selling new shares at distressed prices.

[...] the terms and timing of Santander’s moves are raising eyebrows in the investment community. Analysts have expressed surprise that the bank is selling chunks of two of its prized Latin American businesses. And the bank’s debt-exchange plan, intended to drum up less than €1 billion in fresh capital, is on such unfavorable terms that it prompted a group of British insurance companies that are some of the major holders of this debt to band together to complain.

• Big Selloff Hits Europe Bond Markets

The Spanish Treasury was forced to pay a euro-era record 5.11% yield on three-month Treasury bills at auction, more than double the rate paid at last month’s auction. By way of comparison, to access the short-term debt market Spain now must pay more than Greece paid at its last three-month auction a week ago.

[...] The spike in yields fanned fears that the country will find it unsustainable to raise funds in the market if the trend persists. The result underscored concerns that more financially weakened euro-zone governments may soon be priced out of the capital markets.

The cost of insuring European government debt against default using credit-default swaps shot up to record levels as concerns about the euro-zone debt crisis and U.S. deficit-reduction plans continue to spook market participants and subdue activity in the European primary bond market. Default insurance on French, Belgian and Spanish debt leapt above record closing levels Tuesday as bond yields in the region climbed.

French bond yields also spiked sharply in a sign that the debt crisis was continuing to spread to larger, top-rated countries. A continued rise in French bond yields would put the country’s coveted triple-A rating in peril and risk derailing efforts to contain tensions.

• EU Warns Greece on Bailout

The European Union has warned Greece that unless political leaders give written pledges they will back agreed reforms, an €8 billion ($10.79 billion) loan payment won’t be given and the country will run out of money in about 20 days, Greek and euro-zone officials said Tuesday.

• Pressure on Merkel Amplifies

Ms. Merkel on Tuesday stressed that joint debt issuance isn’t the right response now. “The discussion of euro bonds in the midst of the crisis is inappropriate,” she said.

Germany has never categorically ruled out the joint issuance of bonds by the euro’s 17 national governments, known as euro bonds. But Berlin insists that before euro members collectively raise financing on the open market, they must create rules that force each country to exercise fiscal discipline—or pay a heavy price.

However, many analysts say Ms. Merkel may no longer have the luxury of time to wait for euro-zone economies to heal before working on long-term changes Germany believes are needed to prevent such a crisis from recurring.

[...] Many lawmakers in Ms. Merkel’s ruling center-right coalition are deeply skeptical about joint euro-zone liability for debts, which they fear would reduce pressure for southern European countries to rein in government spending. “The moment we let up the pressure, those countries that have such problems will become complacent,” German Finance Minister Wolfgang Schäuble said Tuesday.

In addition to being a hard sell to Germany’s lawmakers and voters, euro bonds may require amending the country’s constitution, requiring a broad consensus among political parties in the euro zone’s biggest member.

This post is a veritable potpourri of worries. Be warned.

With the landslide victory of Mariano Rajoy’s center-right Popular party, the government of the Spanish Socialists has become the fifth victim (after Ireland, Portugal, Greece and Italy) of the eurozone crisis. As have the leaders of the other recently-installed governments, Mr. Rajoy has promised to enforce budgetary austerity.

No matter. Despite the Popular party’s victory, yields on Spanish sovereign debt rose today; the ten-year bond yield reached 6.6 percent. Yields on the sovereign debt of other “peripheral eurozone” countries also jumped, as did the yields on “core” countries debt.

Undoubtedly, a report from Nomura — “Currency risk in a Eurozone break-up — Legal Aspects” contributed to today’s indigestion in the eurozone bond markets. The report deals with a subject — “redomination risk” — that has evidently not previously been on market participants’ radar screens: not knowing which euros will stay euros.

It is now obvious that the widespread electoral success of parties committed to fiscal rectitude isn’t sufficient to ameliorate, much less bring to a halt, the crisis by improving investor confidence. That this has become self-evident further undermines confidence, as what was once thought to be a solution has turned out not to be. More than ever, all eyes are turned toward the European Central Bank, with the hope that the ECB will, at long last, overcome its reticence and become the eurozone’s lender of last resort. As yet, there’s no evidence whatsoever that the ECB will undertake what would be an about-face of epic proportions; last Friday, the ECB’s president said that the crisis required a political solution and that the ECB wouldn’t bailout anybody. This situation will persist unless and until Germany performs its about face. But that isn’t happening; if anything, the Germans are digging in their heels.

No wonder, then, that commentaries on the crisis are becoming increasingly strident and downright panicky.

Wolfgang Munchau, writing in the Financial Times, uses the words “insane” and “depression”:

The consensus view in Brussels and Berlin is that the crisis can be solved by technocratic governments imposing structural reform and austerity. That proposition is, in my view, insane . . . We have gone way beyond the point at which this crisis is solvable by standard instruments of economic policy. The survival of the euro will now depend on whether Ms Merkel or Mr Draghi, or both, will blink.

This may yet happen, but not right away. The ECB is facing more formidable legal constraints than those who call for an intervention acknowledge. The bank is technically allowed to engage in secondary bond market purchases, but not with the aim of helping governments incur deficits or roll over debt. Article 123 of the Treaty for the Functioning of the European Union says the ECB shall give no overdrafts to governments. Clearly, the euro was sold on the grounds that the ECB would never do what it is being asked to now. Such a law is testimony to a lack of realism, especially given what we know about the history of financial crises.

[...] The eurozone has already entered a recession, driven by three factors, each serious on its own and lethal in combination: a slowdown of the global economy; pro-cyclical fiscal austerity programmes; and a much larger than expected deleveraging of the financial sector. If present policy prevailed, the eurozone would be in danger of falling into a depression.

[...] In present market conditions, a leveraged EFSF is unrealistic. So how long can this policy vacuum be sustained? So far, the speed of the crisis has exceeded the speed of the political response. The next political turning point will come at the European Council meeting in December, which will need to decide something more substantial than previous summits.

If that does not happen, we will be getting closer to the point where member states – confronted with an unsustainable funding position – could rationally conclude that the political and financial costs of staying in the eurozone may well exceed the costs of an exit. This is not a proposition anybody would want to test. Once the eurozone goes down that road, it will not come out of this crisis in one piece.

The moment will arrive, probably sooner rather than later, when Mr Draghi and Ms Merkel will have to blink simultaneously. The odds of that happening are neither low nor high. They are indeterminate. It is the worst kind of uncertainty imaginable.

George Soros describes the current situation as “a perfect vicious circle”: