AMERICAN FUTURE

I detect a somewhat more hopeful stance in this report on the eurozone’s prospects compared to earlier S&P reports. There’s more than a glimmer of hope in the report’s introduction:

The eurozone should gradually climb out of its mild recession in the second half of this year and into 2013, in Standard & Poor’s opinion. We think core countries will lead the way, with other member countries delivering diverging performances. Under our baseline forecast for 2012-2013, which we updated at the end of 2011, we project flat GDP for the eurozone as a whole in 2012 and 1% growth in 2013.

We acknowledge, however, that risks of a steeper downturn this year have risen. We currently assign a 60% probability to our baseline forecast, versus 40% for our alternative forecast of a true double dip, which would have a particularly adverse impact in countries like Spain, Portugal, and Italy. We believe three main factors will determine the depth of the eurozone’s downturn:

• How demand from emerging markets holds up in the coming quarters;
• How European consumers react to renewed uncertainties, such as rising unemployment and concerns about the sovereign debt crisis; and
• How European governments and especially the European Central Bank (ECB) rekindle investor confidence in capital markets in the next few quarters.

Still, we think the scale continues to tilt in favor of a mild recession and a gradual return to growth, taking into account potential growth in emerging market demand, resilient consumer demand in the core countries, and somewhat restored investor confidence.

In today’s FT, Gillian Tett contrasts how well American banks prepared for the possibility of a U.S. default last summer and how European banks are now preparing — or not preparing — for a break-up of the eurozone. The comparison isn’t reassuring.

Here’s what she says about the banks on this side of the pond:

Last summer, some of America’s largest banks secretly stocked their cash machines with the maximum possible supply of notes. The reason? In July 2011, the bankers feared that the US might be about to suffer a technical default, because Congress could not agree on measures to raise the debt ceiling.

So, they decided – after collective discussions – to keep those ATMs stuffed with greenbacks to ensure that consumers would never panic about running out of cash if that “worst-case” default scenario transpired.

In the first half of 2011, large banks such as JPMorgan and Bank of New York Mellon are thought to have each spent about $50m ensuring that their contracts were legally watertight in the event of a US default, and that repo deals and financial markets were continuing to function (along with those ATMs.)

At this week’s meeting of the World Economic Forum, eurozone leaders have stressed their commitment to keeping the single currency intact. And the consensus among senior bankers is that the most likely scenario for the eurozone for the foreseeable future is continued muddling through. Hardly anyone, however, expects a truly positive “solution” soon, and most think that a break-up or exit scenario remains entirely possible. Accordingly, most large banks are now secretly preparing contingency plans – just in case.

This time, says Tett, some large banks may be spending far more than $50 million, since the task is dramatically more complex: they have to review the fine print of all legal contracts for any euro exit, and to ensure that financial market transactions are watertight, or at least hedged. Many large banks are also trying to make sure that their liabilities in peripheral countries are matched with assets inside the same country – rather than across the eurozone as a whole.

Here’s the crux of the matter:

In Europe today, however, it appears that there is little – or no – similarly collaborative move. Or if there is, it is so utterly secret that not even senior bankers know about it yet. On an individual level, most large banks insist they are well prepared (though many express concern that the exchanges or settlement systems seem less organised). But nobody appears to have spoken extensively to anyone else, far less to any central government group.

Why? One problem is that the banking landscape in Europe is far more fragmented than in America. Another is weak European banks are now too distracted, or cash-poor, to prepare for a vague risk. There is also a deep reluctance among some eurozone bankers to admit they are preparing for a worst case, which would risk undercutting their own politicians. And some bankers argue that if a truly serious crisis materialised (such as the exit of Italy, say) it would be so devastating and complex that planning would be pointless.

As indicated by the fact that I haven’t added to this series of posts since the start of the year, the recent decoupling of the US equity market from events in Europe has made me complacent. I figure that the best way to prevent myself from paying (figuratively and literally) the consequences of overconfidence is to make sure that I once again pay very close attention to the goings-on “over-there.”

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The FT’s Wolfgang Münchau is upset with the IMF for earmarking 91% of its definitive commitments to programs in Europe. He says “no” to these two questions:

• Would an increase in IMF funds to bail out the eurozone be justified?
• Should non-eurozone countries participate in raising new capital?

Here’s his case:

It is not necessary because the eurozone has the financial capacity to help itself . . . Considering that the eurozone is economically unconstrained, and among the richest regions in the world, the request to involve the IMF in hypothetical future rescue operations is morally reprehensible. What is happening here is that eurozone member states find it hard to commit additional funds to the rescue operations, and find it politically more expedient to channel resources through the IMF as a way to bypass national parliaments.

But there is an even more important argument in my view. The way the eurozone member states have been dealing with the crisis has increased the chances of a catastrophic outcome. An extension of the IMF’s commitments is very likely to support current policies.

[...] The eurozone’s cumulative policy errors are turning a liquidity squeeze into a solvency crisis. And herein lies an acute risk for the IMF. If Italy were to become trapped in a long recession, the probability would increase significantly that it would not be able to repay its debt, currently at 120 per cent of GDP. News reports from Italy suggest that the IMF is about to forecast a two-year recession for the country, which could well lead to an increase in the debt-to-GDP ratio at the end of that period. Italy’s future solvency is entirely dependent on market interest rates and the prospect of a return to strong and sustainable economic growth. I struggle to think how this can be accomplished without a fiscal union and much greater burden-sharing.

There are additional technical arguments that would favour more cautious IMF involvement. Mario Blejer, the former governor of the central bank of Argentina, argued recently that the IMF’s preferred creditor status could become a problem, as an IMF loan would automatically subordinate every other bondholder. The probability of a default on those defaultable bonds is thus significantly higher. Furthermore, the situation could become so acute that the IMF’s seniority might fail, which in turn would endanger its capacity to lend at low interest rates.

There are several proposals on the table for how to involve the IMF in a clever way. But they all are subject to the same problem. Any outside liquidity assistance would encourage the eurozone to proceed with policies that are aggravating the crisis.

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Evidently, Münchau was responding to IMF chief Lagarde, who today said that the Fund was ready to help the eurozone and was seeking to increase its lending resources by up to $500 billion. She went on to say that the IMF estimates that in coming years, additional global financing of potentially $1 trillion could be needed.

She then said that there are three imperatives are needed to fully restore confidence: stronger growth, larger firewalls, and deeper integration. Regarding the second of the imperatives, Lagarde called on European policymakers to create a larger firewall. Without it, she stated, countries like Italy and Spain, that are fundamentally able to repay their debts, could potentially be forced into a solvency crisis by abnormal funding costs―a development she warned would have disastrous consequences for systemic stability.

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The FT reports that, soon after Lagarde’s address, Germany appeared to soften its longstanding resistance to increasing the eurozone’s rescue funds (to €750 billion) in exchange for strict budget rules in a new fiscal compact.

According to German and eurozone officials, Angela Merkel is prepared to let the existing European Financial Stability Facility, which has about €250bn in unused funds, run in parallel with its successor, the €500bn European Stability Mechanism, the launch of which has been brought forward to July.

In return the German chancellor wants eurozone heads of government to sign up to rules to cut budget deficits and public debt that are much tougher than those currently foreseen by eurozone governments.

The most recent version of the fiscal compact would allow governments to breach deficit limits in “periods of economic downturn” – a phrase criticised by the ECB as an “escape clause” that could lead to “easy circumvention” of what are meant to be cast-iron rules.

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On a positive note, US money market funds have begun moving back into European bank paper, a sign that central bank efforts to backstop key institutions are improving risk appetite.

This past week, the funds were buyers in increased issuance of French and Spanish banks’ commercial paper, according to bankers. Notes issued by US banks with foreign parents rose $6bn to $152bn and foreign domiciled bank notes outstanding rose nearly $3bn to $133bn, according to figures from the Federal Reserve.

Last year, money market funds were sellers of many European banks’ short-term commercial paper as worries grew about the repercussions of a possible European sovereign default. That was a critical factor in market anxiety, as the highly rated funds’ $2.7tn in liquid assets are a key source of dollar funding.

Money market funds bought French bank paper with maturities as long as one month, as well as small amounts of Spanish bank paper, according to bankers. The funds also bought longer-dated UK, Dutch and Scandinavian bank paper, up to six-month maturities.

The move comes despite France losing its triple A-rating but after a series of strong auctions for Spanish and French sovereign debts and hopes that Greece will reach agreements with creditors to avoid a default in the spring.

The author is the chairman of Goldman Sachs Asset Management.

The key quote from the following document:

. . . some might describe the fiscal compact as more like “compost” as, without some offsetting measures elsewhere, all indebted countries tightening fiscal policy further simply to satisfy some new numerical target doesn’t seem like sensible economics, especially for those with large youth unemployment and members of a union that, never massively popular, is increasingly regarded as a problem.

To complicate matters, some Euro Area policymakers realize the potential insanity of the above and have inserted an“escape clause” into the fiscal compact discussions that allows countries to avoid tightening further “in periods of severe economic downturn”. This strikes me as sensible in principle, but whether Berlin and Frankfurt will agree remains to be seen. The early signs from ECB members is that they worry it will be an excuse for countries to avoid structural challenges.

From a big picture perspective, there is a lot of evidence that major fiscal tightening, especially if it includes reductions in government spending, is rather key to raising countries economic growth potential. If you throw in supply side reforms, and – what might normally be the case – easier monetary conditions such as a decline in the exchange rate and lower interest rates, this is the classic recipe for a nice long-term outcome. However, given the constraints of a monetary union, and one seemingly dominated by Germanic caution, it is not so obvious that we can get there. [My emphasis]

If you’ve wondered why I haven’t proffered a “solution” to the eurozone crisis, this post should suffice. Here we have experts far more knowledgeable than I who reach diametrically opposed conclusions regarding the fate of the eurozone and, by implication, the futures of economies and financial markets. The optimistic argument is that the euro will be saved because everyone realizes that the consequences of it not being saved are so dire. The pessimistic argument is that, while the euro’s collapse would have serious negative consequences, these consequences are preferrable to the political and financial costs of preventing the collapse.

The optimistic argument smacks of idealism (a.k.a.wishful thinking); the pessimistic of realism (a.k.a., defeatism). At the bottom of it all lies this question, which always arises at times of crisis: are there forces at work that are beyond the keen of even the most well-intentionned, hard-working, knowledgeable people?

The Peterson Institute’s Bergsten and Kirkegaard:

The economic and financial problems in the euro area are clearly serious and plentiful. An increasing number of commentators and economists have begun to question whether the euro can survive. There are only two alternatives. Europe can jettison the monetary union or it can adopt a complementary economic union. Every policymaker in Europe knows that the collapse of the euro would be a political and economic disaster for all and thus totally unacceptable. Europe’s overriding political imperative to preserve the integration project will surely drive its leaders to ultimately secure the euro and restore the economic health of the continent.

The key is to observe what Europe does rather than what it says. At each critical stage of the crisis, both Germany and the European Central Bank have demonstrated they will pay whatever is necessary to preserve the euro area and avoid defaults (except possibly Greece). But neither can say they will provide unlimited bailouts because this would alleviate the pressure on the debtor countries to reform and weaken the bargaining position of each creditor group (northern European governments, ECB, private lenders, IMF) vis-à-vis the others as they allocate the costs of the bailouts. Europe’s key political actors in Berlin, Frankfurt, Paris, Rome, Athens, and elsewhere will thus quite rationally exhaust all alternative options in searching for the best possible deal before at the last minute coming to an agreement. For all this turmoil, however, Europe is well on its way to completing a true economic and monetary union, and will emerge from the crisis much stronger as a result.

The Financial Times’ Münchau:

The eurozone has fallen into a spiral of downgrades, falling economic output, rising debt and further downgrades. A recession has just started. Greece is now likely to default on most of its debts and may even have to leave the eurozone. When that happens, the spotlight will fall immediately on Portugal, and the next contagious round of downgrades will begin.

Europe’s insufficient rescue fund, the European Financial Stability Facility, now also faces a downgrade because it had borrowed its ratings from its members. The way the EFSF is constructed means that its effective lending capacity will thus be reduced . . .

By downgrading France and Austria but not Germany and the Netherlands, Standard & Poor’s also managed to shape expectations of the economic geography of an eventual break-up. A downgrading of all triple A rated members would have been much easier to deal with politically. Germany is now the only large country left with a triple A rating. The decision will make it harder for Germany to accept eurozone bonds. The ratings wedge between France and Germany will make the relationship even more unbalanced.

[...] The conclusion of the fiscal treaty, which is the top priority of EU politics right now, is at best an irrelevant distraction. Most likely, it will enhance the trend towards pro-cyclical austerity of the kind we have seen in Greece . . .

[...] With each turn of the spiral, the financial and political costs of an effective resolution increase. We have moved past the point where electorates and their representatives are willing to pay the ever-rising costs of repairing the system. Last week a couple of senior parliamentarians from the ruling CDU party, whom I had previously considered voices of moderation, argued that a Greek exit from the eurozone would not be such a big deal. Expectations are changing quickly, and so is the acceptance of a violent ending.

And no, the European Central Bank’s huge liquidity boost is not going to fix the problem either. I do not want to underestimate the importance of that decision. The ECB prevented a credit crunch and deserves credit for that. The return of unlimited long-term money might even have a marginal impact on banks’ willingness to take part in government debt auctions. If we are lucky it might get us through the intense debt rollover period this spring. But a liquidity shower cannot address the underlying problem of a lack of macroeconomic adjustment.

Even economic reforms, necessary as they may be for other reasons, cannot solve this problem. This is another European illusion. We are now at a point where effective crisis resolution would require a strong central fiscal authority, with the power to tax and allocate resources across the eurozone. Of course, it will not happen.

This is the ultimate implication of last week’s ratings downgrades. We have moved beyond the point where a technical fix would work. The toolkit is exhausted.

The Telegraph reports on the British Treasury’s “contingency plans” in case the euro disintegrates:

The preparations are being made only for a worst-case scenario and would run alongside similar limited capital controls across Europe, imposed to reduce the economic fall-out of a break-up and to ease the transition to new currencies.

Officials fear that if one member state left the euro, investors in both that country and other vulnerable eurozone nations would transfer their funds to safe havens abroad. Capital flight from weak euro nations to countries such as the UK would drive up sterling, dealing a devastating blow to the Government’s plans to rebalance the economy towards exports.

Britain’s top four banks have about £170bn of exposure to the troubled periphery of Greece, Ireland, Italy, Portugal and Spain through loans to companies, households, rival banks and holdings of sovereign debt. For Barclays and Royal Bank of Scotland, the loans equate to more than their entire equity capital buffer.

The plans include more than just capital controls:

Borders are expected to be closed and the Foreign Office is preparing to evacuate thousands of British expatriates and holidaymakers from stricken countries.

The Ministry of Defence has been consulted about organising a mass evacuation if Britons are trapped in countries which close their borders, prevent bank withdrawals and ground flights.

Focus on the European Central Bank

Well, so much for my forecasting how equity markets would initially respond to stronger than expected demand from eurozone banks for funds from the ECB’s emergency loan program (“longer-term refinancing operations,” or LTROs).

The sentiment reversal may be attributable to the fact that only about €190 billion was fresh liquidity; the remainder comprised funds that were switched from shorter term ECB lending programs.

At a time when the ECB is being heavily and widely criticized for not doing enough — for refusing to act as the lender of last resort for the eurozone — a new and diametrically-opposed concern is beginning to surface. That concern is, as Gavyn Davis puts it, is the explosion in the ECB’s balance sheet. Every time that the ECB lends euros to a bank, it does so in exchange for collateral — “of an increasingly dubious nature,” according to Davis — pledged to the ECB by the bank. These transactions show up in the ECB’s balance sheet, which, as shown in the following chart, has balloned this year.

Says Davis,

The increase from August [2011] to February [2012] will be about €700-800 billion, which is an extraordinary amount for a central bank which is supposed not to believe in QE [Quantitative Easing]. There is another three year liquidity injection due to take place in February, and this may well be even larger than today’s action.

The bulk of the borrowers under these facilities will presumably come from the peripheral economies, and the collateral offered will include single A asset-backed securities and also bank loan portfolios for the first time. Although this collateral will of course have been subject to haircuts before being accepted by the ECB, there can be no doubt that the ECB’s potential exposure to defaults in the peripheral economies will once again have ratcheted higher.

The first sentence in the next paragraph is of special interest in that ECB President Draghi (as did his predecessor) has repeatedly stated that serving as a lender of last resort isn’t within the EBC’s remit. If you find yourself confused, all I can say is: join the club.

The ECB’s justification for this action is that it is, and should be, the lender of last resort to the eurozone banking system. That seem fair enough. In the absence of today’s action, there would have been risks of bank failures in 2012 as banks tried to raise the money needed to redeem €600 billion of their own debt, which reaches maturity during the year. With their access to long term funding largely closed, banks would have been forced to reduce their balance sheets in order to meet these obligations, and this deleveraging would have involved forced sales of sovereign bond holdings and reductions in bank lending. Either way, the eurozone’s crisis would have deteriorated further.

Deleveraging would also have caused a shrinkage in broad money (M3) which the ECB is desperate to prevent or mitigate. What will now happen instead is that the monetary base will expand rapidly as central bank funding for the banking sector replaces private funding, and this is likely to prevent the large drop in M3 which would otherwise have occurred.

As I’ve argued on more than one occasion, money supply growth isn’t inflationary if the velocity of money (the rate at which economic transactions take place) isn’t rising.

Questions will be asked, especially in Germany, about whether this liquidity injection will be inflationary. It is probably better described as anti-deflationary. The money multiplier in the eurozone economy (ie M3 divided by the monetary base) is likely to drop, so M3 will stay subdued. Inflation risks will not crystallise until the rise in base money translates into much more buoyancy in bank lending and broad money growth. That may or may not ever happen.

Davis closes with the following:

. . . the ECB is certainly preventing banks from selling sovereign debt that they otherwise would have sold, and it is doing this by expanding its own balance sheet. The alternative to ECB action would have been to increase the size of the EFSF/ESM at a direct cost to government credit ratings. The ECB is also keeping alive banks which would otherwise have failed, and that would have involved new injections of capital from sovereign governments.

The truth is that, in the present state of the eurozone debt crisis, sovereigns and governments are now inextricably interlinked. It is hard to save one without being accused of saving the other. The ECB is not eager to admit it, but it is trying to save both.

If you’re interested in further pursuing the leveraging-up of the ECB’s balance sheet, I recommend reading a briefing note recently published by the UK-based Open Europe think tank. Among the key points in “The battle for the heart and soul of the ECB” are the following:

The ECB has taken on large amounts of low quality collateral in return for providing loans to banks, and has seen a massive surge in the number of asset-backed securities it has taken on to its balance-sheet. Though not all of these assets are bad or ‘toxic’, they are extremely difficult to value. At the same time, the number of banks which are becoming reliant on the ECB is alarming and hopes that the functioning of the European financial markets will ever return to normal are diminishing – creating a long-term threat to Europe’s economy.

Through its government bond buying and liquidity provision to banks, the ECB’s exposure to the PIIGS has now reached €705bn, up from €444bn in early summer. This is an increase of over 50% in only six months and shows how, contrary to popular belief, the ECB is already intervening quite heavily in the markets. It also highlights how the eurozone crisis continues to transfer risks away from private creditors to taxpayer backed institutions. It remains unclear how the ECB would cover losses in the event of asovereign default.

Moving forward, the ECB could offer a liquidity boost to Europe’s economy but little more. The term ‘lender of last resort’ is often misused or misunderstood – the ECB cannot fully backstop sovereign states or return them to solvency. At best it could ease the pressure on illiquid states, but even this depends on the legal constraints on the ECB’s defined role and being seen to give in to political demands that would hurt the ECB’s credibility and independence.

Earlier this month, the European Central Bank announced an emergency loan program known as “longer-term refinancing operations,” or LTROs. The program will become operational tomorrow (Wednesday). The Financial Times says that the ECB expects strong demand for the loans, which will be available in “unlimited” quantities.

The purpose of the program, which enables banks to avail themselves of three-year loans at extremely favorable interest rates, is to ease the severe strains in the eurozone’s financial system. If demand for the loans is strong, it should reduce the likelihood that banks will substantially shrink their balance sheets (by selling assets and reducing new loans to their customers) to meet their funding needs (which are especially large in early 2012). The hope, then, is that the LTRO will improve the economic performance of countries in the eurozone. It’s important to note, however, that this provision of additional liquidity doesn’t attack the eurozone’s fundamental problem: severe and persistent balance-of-payment imbalances among its members.

The funding problem that the LTRO is aimed to ease is having a contagion effect. Asset sales by European banks have put pressure on securitized mortgage prices in the U.S. Instead of selling distressed assets in their home markets, the banks are selling assets elsewhere (as encouraged by their governments).

In combination with the sharp drop in Spanish short-term interest rates that took place today, the imminent start of the LTRO program may be responsible for the sharp rally in the U.S. equity markets. If demand is as strong as the ECB expects, contagion fears could ease, allowing for a short-term bounce in the stocks of financial institutions holding mortgage-backed securities.

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A Financial Times video explains the workings of the eurozone’s financial plumbing and how it might leak if one or more countries exit from the currency union’s membership. The hard-copy is here.

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Excerpts from an FT editorial:

Europe’s economic prospects are deteriorating frighteningly fast, and the world outlook is darkening in step with the Old World’s woes. Unless the world’s leaders manage to pull together soon, we should brace ourselves for a second phase of the credit crisis that will be even worse than the first.

[...] A credit crunch is gaining force, and Europe’s economy grinding to a halt because of it. This is making the twin crises – bank and sovereign – harder to resolve and is hitting emerging economies whose credit is drying up and whose export markets are withering. If the ECB cannot stimulate growth, governments must do so, and fast.

Today the whole world badly needs Europe to grow. Long-term growth and rebalancing are sine qua non for overcoming the debt crisis, but short-term recovery is a greater priority. Austerity by those who must should now be compensated by stimulus from those who can.

My sentiments, exactly.

Where there’s a will, there’s a way — at least for a while. These days, anything and everything is believable.

From the Wall Street Journal (no link):

Governments in Europe are tying themselves in knots to prop up their banks, desperate to blunt the cost and embarrassment of a fresh wave of taxpayer-funded bailouts.

In Italy, for example, the government is encouraging banks to buy public properties that the banks then can use to borrow money. As part of a broader deficit-reduction program in Portugal, the government essentially is borrowing money from bank pension funds and could use some of the funds to help state-owned companies repay bank loans.

Governments in Germany and Spain also are using unorthodox measures to support their ailing banks.

A closer look at Italy:

The Italian government has been among the most innovative at finding ways to help its banks conserve capital or come up with fresh funds.

A provision tucked into the Italian government’s budget law last month is designed to defuse some of those pressures. It allows the banks to use their government bonds to purchase army barracks, office buildings and other state-owned real estate that the government has been trying to sell.

The government would then lease the properties back from their new owners. And the banks can package the income-producing properties into asset-backed securities, which can be pledged as collateral with the ECB in exchange for loans, analysts say.

Italy’s real-estate-for-sovereign-bonds maneuver also gives a boost to the government. Not only can it rid itself of unwanted properties, but the government also will be able to retire the bonds that banks use to purchase the real estate—thereby reducing Italy’s heavy debt load.

. . . and Germany:

Commerzbank AG is in talks with the finance ministry to transfer part or all of its troubled real-estate finance unit Eurohypo into a government-owned “bad” bank. The bank and government are in talks about ways to structure the deal so it isn’t considered a bailout, possibly by protecting the government against some losses or paying the government a nominal fee, according to people familiar with the matter.

That is an important stipulation. Commerzbank executives have repeatedly promised they won’t take more taxpayer money, following a 2009 bailout that still has the bank 25%-owned by the government. But Commerzbank needs to come up with €5.3 billion in new capital by next summer in order to meet the demands of European regulators.

. . . and Portugal:

the government is planning an intricate financial maneuver that could give the country’s banks some relief from the mountains of unpaid loans they hold from Portugal’s state-owned companies. The state just closed a plan to transfer banks’ future pension responsibilities to the state balance sheet in exchange for €6 billion in assets, which include cash, stocks and bonds. Most of the money will help the government meet deficit targets.

But about €2 billion may be shifted to struggling government-owned companies, such as transport providers. Under the plan, these companies would use the funds to pay off debts to Portugal’s banks.

. . . and Spain:

In Spain, the government used €5.2 billion in funds from the country’s deposit-guarantee plan to clean up nationalized lender Caja de Ahorros del Mediterraneo and broker its sale to Banco Sabadell SA earlier this month.

Instead of raising more money through a Spanish government bailout fund, a central-bank spokesman said that tapping the deposit-insurance plan would leave the country’s budget goals this year intact. The deposit-guarantee fund will be refilled early next year, and the government will provide a back-stop in the meantime.