The Self Preservation Society

AKA the ECB...

There’s been a lot of handbags between the ECB and EU leaders this week, after some leading EU politicians admitted that there could be some form of debt restructuring of Greek debt. Both Olli Rehn, EU Economics Commissioner, and Jean-Claude Juncker , Prime Minister of Luxembourg, suggested that there could be an extension of loans given to Greece (although its not clear whether this would just involve the official loans or private sector loans as well).

Needless to say, this did not sit well with the ECB, particularly ECB board member Jurgen Stark. After suggesting that any form of restructuring would be a catastrophe, Stark also accused “vested interests in the US and the UK” of undermining the economic adjustment programme in Greece. He also issued what seemed somewhat like a veiled threat, saying that the ECB may not accept Greek bonds as collateral for ECB lending to banks after a restructuring – a move which would probably push Greek banks into bankruptcy.

At first glance it is surprising just how removed the ECB is from the views of the rest of Europe (as we've argued for some time, restructuring is probably inevitable - an increaing number of people are coming around to this view). But ultimately, the ECB's posturing simply comes down to self interest. The ECB is holding masses of Greek bonds (we’d reckon around €60bn in nominal value) in addition to €140bn in state related collateral it has accepted from Greek banks. This €200bn exposure to Greece then presents the potential for large losses for the ECB under a Greek restructuring.

You may ask: why does the ECB care? It’s backed by eurozone governments, and therefore taxpayers, so they will ultimately foot the bill.

True – and another unfortunate potential hidden cost for eurozone taxpayers – but going cap in hand to eurozone governments to ask to be recapitalised after these losses would be incredibly humiliating for the ECB. It would also give eurozone leaders huge leverage over the ECB on future economic decisions and policy. The only other choice for the ECB is even worse though - printing money to cover its losses. This would mean abandoning its raison d’être (price stability) instead going down a path that could lead to pretty scary levels of inflation.

Arguing anything other than staying the course would therefore probably have dire consequences for the ECB, highlighting the impossible situation it’s managed to get itself into.

You call that austerity?

We imagine that will be the response by many in Athens and Dublin to the conditions which have been announced along with the €78bn bailout deal for Portugal. Jose Socrates, the caretaker Portuguese PM, was almost boasting on TV last night about how much more favourable the terms were for Portugal compared to Greece and Ireland. In the cold light of day though, most of the details we’ve seen so far focus on what won’t happen rather than what will, raising the question: Where are the necessary savings actually going to come from? That should be slightly concerning for taxpayers across the EU.

The point that has attracted most attention is the easing of the deficit cutting programme. But in actual fact the targeted cut is higher than before, given the change in the level of the deficit.

Previous 2010 estimate and 2011 target: 7.3% and 4.6% = change of 2.7%

New 2010 estimate and 2011 target: 9.1% and 5.9% = change of 3.2%

Most observers, including us, didn’t expect Portugal to be able to achieve its original level of cuts, let alone a higher level - especially when combined with lower growth prospects. That was before we even found out what was not going to be cut…

According to Socrates the conditions will not include cuts to: minimum wages, public sector pay, education spending and healthcare. In addition, there will be no additional public sector job cuts and the retirement age will not be increased. That is a huge list of things that will be left untouched, especially since savings of 3.2% of GDP are expected.

So, seriously, where is the money coming from?

Well, there are expected to be some, limited, cuts to higher scale state pensions as well as a decrease in the amount and duration of unemployment benefit. There is also a plan to raise VAT on electricity. In terms of increasing revenue, there was talk of privatising €5.3bn in public assets but not Caixa Geral de Depositos, the largest credit institution, which was widely expected to be sold to raise funds. So all in all not exactly an earth-shattering plan for saving 3.2% of GDP.

To be fair, there are more details and plans to be announced but considering what has already been taken off the table we’re not overly optimistic.

Admittedly, too much austerity would definitely be bad for the economy and finding the right balance is a hard line to tread. But for those of us who already believe the bailouts to be a waste of money, since they won’t solve any of the long term problems, these kinds of conditions are almost just adding insult to injury.

From tomato sauce with pasta to Honorary German

Bild, Germany’s largest newspaper, yesterday came out in support of Mario Draghi’s candidacy for the role of ECB President, proclaiming him to be a “Honorary German Citizen”.

Clearly they don’t do things by halves…

In February Bild screamed "Mamma Mia!" over the thought of an Italian running the German currency. They claimed: “For Italians, inflation is a way of life, like tomato sauce with pasta.”

We’d expect that it won’t be too long until Merkel publicly comes out in support of Draghi (given that neither Sarkozy nor Bild would have supported him without her private approval).

To be honest, he’s been the only real candidate for a while – in terms of both skills and personality – but the fact that it took so long for an established professional, and the right man for the job, to overcome the massive stereotypes in Europe might say something about so-called EU unity… the picture doesn’t help either.

The dark side of the ECB

Lots of people have been focusing on the recent ECB rate rise, but the ECB’s role in this crisis has really been determined by its other – more opaque and less publicised – role: as lender of last resort. This has got the ECB into a near untenable position. It faces huge exposure to peripheral eurozone countries, it aims to maintain price stability, but has also acted to stabilise the whole eurozone economy, and it has underwritten a bloated and inefficient banking sector with unlimited cheap money.

The ECB has lent massively to the struggling European banking sector. Although this may have been viable and necessary to halt the systemic risk from the financial crisis it is now out of control. It has propped up banks that should have gone bust and created banks addicted to ECB funding. A mechanism for reining in lending and winding down banks should have been in place from the start. The ECB essentially dug itself a hole without bringing a ladder to get itself out again.

Let’s not forget, these actions also helped fuel the sovereign debt crisis by creating perverse incentives. These banks could take on cheap ECB loans and then invest in high yielding but relatively safe assets (peripheral sovereign bonds at the time), in order to turn quick profit and increase capital. This fuelled the level of government debt and when it became clear just how bad the sovereigns' finances were, markets panicked and the debt crisis hit (but with more debt and more banks involved/exposed than before).

The ECB tried to fix this problem by throwing more liquidity at it (through its bond buying programme). This just increased its exposure to risky economies, distorted bond markets and rightly raised questions over its independence and impartiality (not to mention being potentially inflationary).

Lastly, the ECB has overseen the build up of huge imbalances in the eurosystem of central banks. Some, like Ireland or Greece, borrow huge amounts but contribute little. The loans to these countries are underwritten by other central banks in the system, making them even more exposed to a peripheral default.

The ECB has played a huge role in the cycling of debt around the eurozone, and put itself in a very exposed and compromising position. Its interest rate policy is massively important but the darker side of ECB policy has debatably played a more important (and negative) role in this crisis.

To be fair to the ECB this was not all of its own making, since it was forced into this situation by eurozone leaders inaction, which is further illustration of the politicisation of a once proudly independent central bank.

Is the ECB becoming a bad bank?

Its common knowledge that the ECB has been providing massive amounts of liquidity to eurozone governments both directly (through the purchase of government bonds) and indirectly (by taking on large amount of government debt as collateral for lending to banks). The extent of this – and therefore also the implications – are less clear, mostly thanks to the ECB’s reluctance to publish any data on its holdings of collateral or government debt.

FT Alphaville highlights a note from JP Morgan, which suggests that the indirect exposure of the ECB to the Greek state is massive - and then we mean massive. JPM estimates that Greek banks have posted almost €140bn in state related collateral with the ECB (€85bn of state guaranteed bank paper, €45bn of Greek government bonds owned by Greek banks and €8bn of zero-coupon bonds which the Greek government had lent to Greek banks in 2008). Combining this with the direct holdings of government debt (thought to be around €60bn, as we noted in our paper on Greece) you get total exposure of the ECB to the Greek state of around €200bn.

That is a phenomenal amount.

Though these amounts are slightly speculative at the moment, there are some interesting and possibly disturbing implications here, particularly for those of us who believe that Greece will need to restructure its debt at some point soon (not that we’re alone, this group includes nearly all investors and apparently the IMF). This exposure to the Greek state is in the direct firing line if a restructuring occurs. First, there are likely to be large write downs on the direct holdings of Greek government bonds (at least 35% to have any significant impact on the debt burden) and secondly, the state backed paper could become close to worthless. Potential losses are still hard to quantify but would easily be upwards of €40bn.

Comparing this loss to the capital and reserves which the ECB holds, around €79bn, shows the potentially difficult situation which the ECB could find itself in following a Greek restructuring. Essentially the ECB would either have to ask eurozone governments for an injection of capital or or try to print their way back to an acceptable level of capital and reserves.

Therefore, following a Greek restructuring the ECB may have may face a difficult choice: completely ignore its primary mission (i.e. price stability) and print money or go hand in cap to governments - like the bad banks in the financial crisis - and ask for cash (almost like a bail-out).

Two questions: how in the world did the ECB allow itself to get so deep into this mess? And do German politicans/economists/opinion formers understand how incredibly exposed the ECB - once dubbed the world's strongest central bank - actually is?

Law of averages

In a speech in Oslo today, EU President Herman Van Rompuy talked about the sound fundamentals of eurozone economies. He references the average growth of 2%, the average deficit of 4.5% and the strength of the euro as evidence for his claim.

To his mind these are the "basic facts".

Well, we think it might be worth reminding him of the basic nature of averages. If you have two very divergent groups (the core vs. periphery eurozone economies) the average will be somewhere in the middle and will be of little use – it may even be misleading.

Take two people, one about to fall off a cliff (Greece, Ireland, and Portugal) and another standing a fair distance away (Germany, Finland etc), on average their position from the edge of the cliff will not sound too bad but this misses the point that one of them is in dire straits. Add to this analogy the fact that the two are tied together by a rope (the single currency), and the situation clearly is not how it sounds under Rompuy’s becalming "basic facts" scenario.

As for the strong euro, this is another misleading point. It is being maintained by the spectre of imminent ECB rate rises, which would be detrimental to many of the peripheral eurozone economies – due to high private debt and lack of lending in the economy (not to mention encouraging further current account deficits). In our scenario this introduces a third person (the ECB) who is chipping away at the cliff beneath the first person’s feet (precipitating their fall).

To convey the basic facts of a system as complex as the eurozone you need to go deeper than averages.

The euro pact and Germany: Triumph or a coming bust-up?

The Telegraph's Ambrose Evans-Pritchard describes the weekend deal at the EU summit as a "total German triumph". He paraphrases Chancellor Angela Merkel saying that "whoever wants credit must fulfil our conditions".

Regular readers of this blog will know that we rate Ambrose very highly (at a time when most other journalists, including the FT gang, couldn't spot a currency-related credit crisis from a yard's distance, he warned against what we've seen in the eurozone over the last year).

On this one, however, we think that his assessment might be a bit premature.

Perceptions matter tremendously in markets as well as in politics. And the perception in Germany is certainly not one of triumph.

Die Welt quotes a top EU diplomat describing Merkel's "pact for the euro" as an "empty shell", predicting that "in the coming weeks the spreads of troubled countries could further increase". An analysis in the newspaper notes that the pact "remains far beneath the original expectations of the German government", given the large room for manoeuvre that member states are given in its implementation. The headline in the paper reads: "Merkel's secret euro capitulation".

And Merkel might even face a fight within her own coalition about the terms and crucial details of the euro pact.

Although FDP leader and Foreign Minister Westerwelle called the deal an acceptable compromise, liberal MP Frank Schaeffler said that "the result contradicts the position of the FDP group in parliament”. Volker Wissing, finance spokesman of the liberal faction in the Bundestag stressed that an earlier agreement on this among majority parties in the Bundestag "had excluded what has now been decided at government level", as he expected "very difficult talks", which could endanger the German Parliament's approval of the deal.

"It is surely close to a transfer union," Michael Meister, deputy parliamentary leader of the Christian Democrat (CDU) party added (and it was not meant as a positive remark). CSU MP Thomas Silberhorn bluntly said that "the government has stepped over a red line that the parliamentary groups had clearly defined."

Just ahead of the summit, another top Christian Democrat politician, Bundestag Speaker Norbert Lammert, had voiced concern about the whole thing, lamenting that "many representatives still don't feel sufficiently informed".

It is not clear whether these (prominent) backbenchers will in the end vote down the agreement. Bloomberg claimed this afternoon that several backbenchers have signalled their willingness to vote for the deal when it reaches the Bundestag.

But the strong talk is a reminder of the nervousness about all of this in Germany, especially in the run-up to the key regional elections in two weeks time in Baden-Württemberg - a stronghold for Merkel's CDU where the party could now suffer defeat.

It doesn't help that outgoing Bundestag President Axel Weber has stepped up his criticism of current eurozone policies. In a hearing at a Bundestag committee this week, he will warn European governments against making any bond purchases as a means of bailing out weak Eurozone countries, saying

"the result would be that private creditors and national financial policymakers would be relieved even further of their responsibility, and taxpayers of the countries doing the financing would be burdened with further, possibly substantial risks."

Chances are that Merkel will manage to push through this deal in the short term - though the German Parliament may demand some red meat in return for giving its approval.

But, as the EU correspondent for the Frankfurter Allgemeine Zeitung, Werner Mussler, warns: “the consistent loyalty of Germans to Europe is facing a test.” And Europe's biggest tabloid Bild today carries the headline, "saving the euro gets increasingly expensive!".

Some members of the German establishment have already started questionning the very premise on which Merkel has based her bail-out concessions (saving the euro, even with the risk of more bail-outs and a move away from traditional Bundesbank policy is cheaper than refusing to pay). For example, the former boss of the German industry federation BDI, Hans-Olaf Henkel. Although a former euro enthusiast, he now argues in favour of splitting up the eurozone, writing that it has become “a transfer union, a community of redistribution in which a new competitive discipline will emerge: who can tap the others for the greatest amount."

Berlin's biggest fear is that Mr. Henkel is finding it increasingly easier to recruit more allies.

Studying the cost of Greece leaving the euro

The "European Economic Advisory Group", CESifo, is a joint venture by two of Germany's most respected research institutions. Earlier in the week, it published an interesting report examining the various potential policy responses to the eurozone crisis.

One of the authors is CESifo Director and heavyweight economist Dr. Hans-Werner Sinn (pictured). When he speaks, Germany listens.

Here are some of the key points in the report:

On establishing a permanent "transfer union" - in which taxpayers in stronger economies subsidise weaker countries, such as happened between Western and Eastern Germany - the report notes:

The persistent flow of public funds has in the end helped eastern Germany only a little, if at all. It has made it another European Mezzogiorno – a region stuck in a low-development equilibrium.

(...)

Whether the EU budget should be expanded for this purpose is a distributional question that will have to be decided by the political process. Politicians should not overlook, however, that there is the risk of Greece becoming addicted to the transfers, since it seems to have become addicted to the capital flows of the past.

It warns against the harmonisation of wages across the EU, citing regional differences in Italy as an example:

The Italian Mezzogiorno has been caught in such an equilibrium for half a century and more. Its GDP per capita is about 60 percent of that of the rest of Italy and does not show any sign of convergence. In Italy, the causes for this situation can be sought in a common wage policy, mainly dictated by the conditions of the North, which has always resulted in wages that were way too high for the South and resulted in persistent mass unemployment.

The under-development has forced the state to help out with transfers from the North. These transfers have provided an alternative income source in the South to which the political system and the economy have grown accustomed, perpetuating the situation, as it seems, even more.

They also explore the alternative to a transfer union - devaluation.

There's a distinction between internal and external devaluation. The former means tough austerity measures and squeezes on wages and jobs at home, as in Latvia (whose economy, as CESifo notes, shrunk by 19 percent in 2009).

The other option is external devaluation, which would involve Greece leaving the eurozone. From page 118 onwards, the report looks at such a scenario, with special focus on Greek banks. They note that if Greece did decide to leave the eurozone there would undoubtedly be a bank run, amongst other problems, therefore the ECB would probably need to guarantee all Greek bank deposits.

After demonstrating that Greece would take a big hit should it embark on external devaluation and head for the exit, they make an important observation: Greek banks might suffer just as much if no devaluation occurs, while private sector companies would be clear winners in the case of an external devaluation:

As Greek banks are net borrowers abroad and net lenders at home, the external depreciation will probably hurt them by shrinking the eurovalue of their assets more than shrinking the eurovalue of their liabilities.

However, this analysis forgets the additional write-off losses on claims against the companies of the real economy that will be driven into bankruptcy after an internal depreciation. If these write-off losses are taken into account, it is not clear whether banks fare better after an internal depreciation than after an external one. It is only clear that companies of the real economy will fare better after an external depreciation.

In view of these uncertainties in the analysis, the EEAG has decided not to opt for a particular policy alternative but only to inform policymakers of the relevant arguments. Definitely, there is no alternative that clearly dominates the other in all dimensions.

This is not a call for Greece to leave the eurozone, but the distinguished economists are clearly toying with the idea - though stressing that every scenario involves huge costs.

Meanwhile, FAZ today reports today that more than 200 German Professors, amongst them Dr. Sinn, have warned in a petition to the German Government, against extending the eurozone bailout. They call upon the German government to prepare

for a possible failure of the eurozone aid scheme and (...) prepare a detailed insolvency plan for eurozone countries with excessive debt

This is the only way, they argue, to avoid

collectivising the debt of member states, which leads to higher taxes and higher inflation in the EU as a whole.

It's not getting any easier for Angela Merkel.

Ostrich banking tests

Remember the EU's banking "stress tests", which were supposed to determine the health of the key financial institutions across Europe? The tests, that were published last summer, infamously cleared all Irish banks. Only a couple of months later, two of these banks were forced too seek help from the Irish state to avoid bankruptcy, which in turn forced Ireland to apply for a bail-out.

To say that this episode exposed some deep flaws in the stress tests is an understatement.

One problem was clearly that the tests weren't stringent enough. Banks were deemed by regulators to need only €3.5 billion of new capital - about a 10th of the lowest estimates that were out there.

Now a new round of stress tests is due to begin, and European Commissioner Michel Barnier has just informed us that the EU will announce the methodology next week.

In November, in the midst of the embarrassment about the Irish crisis, his Director-General Jonathan Faull declared that next time, it's going to be serious. He maintained that the new round of stress tests would be “demanding”, with the European Commission pushing for the tests to also assess liquidity of financial institutions (which seems like a pretty fundamental criterion).

This is actually a hugely important excercise. Europe will never get out of its euro-fuelled slump unless its banks come clean on their exposure to debt in various forms.

So what lessons have been learnt?

Well, there are crucial details of the tests that aren't known yet, but EU leaders and regulators haven't inspired confidence so far.

The European Banking Authority, that will carry out the stress tests, has already declared that the results of the liquidity checks (which will not be part of the stress tests but of separate risk assessments) "will not be published". The German government and Bundesbank have also resisted transparency, with Finance Minister Schäuble warning that "to prevent stress tests from producing more damage than good, we are ready to consider and discuss what of the tests will be published and what not."

This is of course a tricky balancing act - you can easily foresee an immediate run on a bank following stress tests results that aren't favourable. But then again, trying to hide the problem isn't a solution either.

And here we see the most contentious and problematic issue of them all - should a possible future restructuring or sovereign default involving, for example, Greece, be one of the test scenarios for banks?

European Central Bank President Jean-Claude Trichet appears to say NO, it shouldn't.

Financial Press Agency MNI suggests that

distinguishing between the trading and the banking books could mean that the tests will ignore the majority of banks' holdings of sovereign debt, since most Eurozone government bonds are held on the banking books.

This is critical since the debt and solvency crisis facing the eurozone is so intimately linked to the fate of Europe's banks that it's now impossible to separate the two. Clearly, one of the main fears of a possible eurozone default - or even break-up - scenario is the losses that European financial institutions would suffer, which in turn could take Europe right back to 2008 (or in the case of Ireland, 2010). Taxpayers would again be forced to step in to avoid a complete meltdown of the financial world as we know it.

The lesson from the most recent crash must clearly be that financial institutions and governments alike need to plan for the worst.

Even if EU leaders don't believe that a default or break-up is desireable or likely, the worst thing they could do is not to consider it.

Kicking the can down the road isn't a policy. Nor is burying your head in the sand.

The ECB's herculean assumptions on Greece

An interesting presentation given in London last week by Italian ECB Board Member Lorenzo Bini-Smaghi, titled "Sovereign Risk and the Euro", looked at two possible scenario's for the eurozone: Plan A and Plan B (ECB board members aren't known for their imagination)

Plan A: Fiscal adjustment Plan B: Default / Restructuring & Exit / Split the euro

First, Mr. Bini-Smaghi showed how plan B would create direct "wealth effects, a credit crunch, social/political repercussions", etc. None of that is disputed.

Hardly surprising, he expressed his preference for plan A, claiming it "is painful, but most likely it is less costly than the alternative." (emphasis added - it's interesting to note how he qualifies that statement).

He described Plan A, which is the official EU / IMF strategy, as follows:

In the case of Greece, the primary surplus required to stabilise and reduce the debt after 2013 is ± 6%

That's assumption 1.

That Greece would be running a massive 6 percent budget surplus after 2013 isn't plausible, which Mr. Bini-Smaghi also himself sort of admitted:

if the primary surplus needed to achieve sustainability is considered too high because the market interest rate is high, there are two ways to restore sustainability:
- reduce the interest rate burden (and lengthen the maturity), while keeping it non-concessional
- haircut on debt

So if the necessary budget surpluses cannot be achieved then debt must be ‘reduced’, assuming this can be done successfully is assumption 2.

He went on to say that the proposal for a bond buy-back program - under which the eurozone's permanent bail-out fund is used to buy back Greek bonds directly or indirectly - could be a way to cut debt:

Under discussion: buy back at market prices (lower than nominal), by the member state or through the EFSF, subject to strict conditionality

We commented in our recent briefing on a possible Greek default that this, in turn, rests on two sub-assumptions:

1 – Although a large number of bonds are being held by the ECB (around €60 billion nominal value) just buying these bonds back at a discount will only reduce Greece’s debt burden by at most 4.15%. Not to mention the fact that the ECB has stated that it plans to hold all bonds to maturity.

2 – Therefore bonds would have to be purchased on the secondary bond market or in reverse auctions. It also seems that many banks are holding bonds to maturity to avoid declaring losses on already fragile balance sheets. But even if they were willing to sell it might not help. As we have already said: "the sudden increase in demand for Greek bonds, as a result of Greece itself having a €50 billion pot of money with which to purchase its own bonds, could actually lead to an increase in prices".

However, Bini-Smaghi himself admitted that having assumption 2 (reduced debt) might not be enough if assumption 1 (budget surpluses) isn't also realized, saying:

If the debt were cut by one-third, the primary surplus would still be relevant.

In other words, the ECB is relying on two pretty heroic assumptions. Greece needs find around €148.6 billion to refinance its debt by the end of 2014(not including the cash needed for interest payments), according to the Greek Ministry of Finance. Dreaming the debt away won't work.

Bini-Smaghi went on to say that in any case, "growth is key", noting that in order to restore competitiveness, this will need to happen "mainly through domestic adjustment".

He makes a list of all kinds of laudable measures that are needed for the Greek economy to grow again, ranging from" deregulation of transport and energy sectors" and "opening up of closed professions" to "increase in retirement age to 65".

Assuming that this is economically and politically feasible in Greece is assumption 3; in this case he adds no caveats. Given the well documented political unrest in Greece and the significant strength of vested interests this seems like a very large assumption as well. The country has no doubt come some way - but it still has a massive distance left to travel if it wants its economy to become sustainable.

And as an indication of the difficulties ahead, over recent days, we've heard of pretty stiff opposition from the Greeks to the proposed EU-IMF privatization plan (which could free up around €50 billion in an ideal world). A spokesman for the Greek government captured the mood: “We asked them for help...not to meddle in our internal affairs” (more on this here).

Even if the first three assumptions were proved right, and all their goals achieved there is still one more implicit assumption to this whole discussion. It is that once this is all done, the eurozone (specifically the one-size fits all monetary policy which could facilitate boom-and-bust cycles or wipe out achieved competitiveness gains) will not lead Greece down this road again.

Assuming that all of these measures will solve Greece’s long term problems within the confines of a monetary union is assumption 4.

Interestingly, Bini-Smaghi gave another speech recently commenting on precisely this issue, labelling moves towards a political union of eurozone countries "risky". Instead, he said, stronger financial supervision should be pursued in order to stop boom and busts cycles.



However, Bini-Smaghi demonstrates the enormity of his fourth assumption with the fact that he sees this new financial order as

a system of rules and procedures which binds the financial system, in the same way as the Stability and Growth Pact binds national fiscal policies.

The SGP has proven, shall we say, difficult to implement in practice, begging the question why a system for financial supervision based on the same model should be any more succesful.

The point here is that the ECB is throwing around a huge number of assumptions. A business plan being this speculative would never make it past the board in any company (well, perhaps a few). But in the eurozone this is apparently called Plan A.

If the ECB was to re-consider its assumptions, would it also have to re-consider whether plan B might actually be an alternative?

"Axel Weber geht, die Inflation kommt"

The front page of today's Wirtschaftswoche is not making any secret of how the paper sees the news of Alex Weber, previously seen as the Great German Hope for a stable euro, no longer standing for President of the ECB:

Axel Weber goes, inflation arrives

It adds that "the departure of Axel Weber undermines the trust in the stability of the euro"

ECB Presidency: Now what?

Axel Weber's elevation to President of the European Central Bank was long seen as a mere formality - a natural step towards the realisation of a"German-speaking euro". So reports in today took plenty of people by surprise, including Chancellor Merkel and the markets. Apparently, the Governor of the German Bundesbank has decided to pull out of the race because, in the words of a European official quoted by the WSJ, he has "other plans". Some papers suggest that these plans could involve a top job at Deutsche Bank.

The situation is somewhat confused. According to Bundesbank sources, Weber might still want to run for ECB-President. Weber himself has said he will not make any comments until he discusses the issue with Merkel. But our guess is that Weber has thrown in the towel.

First, Weber doesn't have lots of friends in the eurozone's "periphery" countries. He's a fierce (and vocal) opponent of the ECB's purchases of junk bonds from Greece, Ireland & Co. And he's probably keen on raising interest rates to curb inflation, because, at the end of the day, this is what the ECB is there for. But such a policy would be poison for vulnerable economies in the eurozone, that are trying bounce back from the economic downturn.

Germany may also have decided that sacrificing Weber's ECB Presidency was a price worth paying in return for France's backing for the "pact for competitiveness".

So now what? Merkel is said to be lacking a "plan B". The only viable alternative would be Klaus Regling, the chairman of the European Financial Stability Facility, but he has no intention of quitting his current post.

Sarkozy would presumably be quite keen to replace Trichet with Christian Noyer, the Governor of the French Central Bank. Or maybe with IMF Director Dominique Strauss-Kahn (simultaneously neutralising a possible rival in next year's French Presidential elections). But nationality matters, and it's very unlikely that another Frenchman is appointed in place of Trichet.

Italy's Mario Draghi has therefore emerged as the strongest contender. He has been doing a decent job in protecting Italian banks from the crisis, and his international reputation as Chairman of the Financial Stability Board is up to scratch. He's also considered more diplomatic than the hawkish Weber.

However, his previous position at Goldman Sachs could prove to be an obstacle. In addition, as ECB President Draghi would also chair the European Systemic Risk Board, the new EU watchdog in charge of macro-prudential supervision. But Italy has already secured the chairmanship of the European Banking Authority (Andrea Enria). There are four new financial supervisors in the EU, and giving two of the chairman positions to Italy might prove too much, especially as the UK, Germany and France got none.

The situation remains fluid, in other words. Trichet is leaving the Eurotower in October and what's clear is that the eurozone can hardly afford a row over his successor.

Is EMU a new Rouble zone?

An interesting fact revealed by the Irish Independent has gone almost unnoticed.

The newspaper reported this less than two weeks ago:

The Irish Independent learnt last night that the Central Bank of Ireland is financing €51bn of an emergency loan programme by printing its own money... ...A spokesman for the ECB said the Irish Central Bank is itself creating the money it is lending to banks, not borrowing cash from the ECB to fund the payments. The ECB spokesman said the Irish Central Bank can create its own funds if it deems it appropriate, as long as the ECB is notified.

News that money is being created in Ireland will feed fears already voiced this week by ECB president Jean-Claude Trichet that inflation is a potential concern for the eurozone.

Jack Barnes, a retired professional trader comments:

This is a form of hyperinflation if you will, at least in context that a Central Bank, with no actual printing press, or a functioning bond market, has now electronically printed up new currency units for their banks without issuing debt behind these actions.

While this has happened before in history, it has not happened in the Euro currency project officially before today. This act is going to move the monetary policy of the union, to the individual capitals. The capacity to print electronic credits, with out the creation of cash currency or debt, is a new wrinkle in the economic landscape.

Citi chief economist Willem Buiter, who, as late as 2009, called for the UK to adopt the euro, has now published a paper looking at these operations. He makes a not so flattering comparison to another monetary union, which fell on hard times:

A monetary union with multiple independent centres of money creation will end up looking like the Rouble zone that survived the collapse of the Soviet Union at the end of 1991 for a bit, until it collapsed in a series of chaotic hyperinflations.

Meanwhile, Yale Phd Ed Dolan, who was a professor in Moscow from 1990 until 2001, provides some background in a new briefing, "The Breakup of the Ruble Area (1991-1993): Lessons for the Euro ":

The Central Bank of Russia claimed a monopoly on the issue of paper currency, but each of the 15 central banks of the ruble area could inflate the money supply through creation of bank credits. Each government was able to gain the full seigniorage benefit of financing its deficit through its own central bank, while spreading the resulting inflation among the whole group of 15.

(...) This gave rise to a free rider problem: Each country could use central bank credit to finance its budget deficit The resulting inflation was transmitted among all 15 member countries Each country had an incentive to act as a free rider, enjoying the benefits of credit expansion while shifting the inflationary costs to its neighbors.

Interestingly, as others before him, he sees Germany leaving the euro as the more preferable option:

It is hard for countries with weak economies to leave a stable currency area because doing so can trigger defaults and bank runs. These exit barriers do not apply to countries with strong economies that want to leave a weak, inflation-ridden currency area.

Similar inflation concerns are now forcing the ECB to choose: increase interest rates to promote a hard currency, satisfying Germany; or keep rates low to help out struggling economies on the eurozone's periphery.

Perhaps the first chapter of the eurozone crisis is over. Another one is about to begin.

Is China betting on or against Europe?

The role of the Far East in the Eurozone's ongoing debt saga is becoming increasingly fascinating.

China has reportedly bought €1.1 billion of Portuguese debt in a direct sale. And Japan - not wanting to be outdone - has announced that it'll buy €900 million worth of bonds to be issued by the EFSF (the Eurozone bailout fund) at the end of this month.

Bill Gross, who manages PIMCO - the world’s biggest bond fund - dismissed all this action, saying that,

there are claims of Japan and China and so on, but they're really looking for the private institutions like PIMCO and other insurance companies to buy, and we just have not done that yet.

French daily Les Echos has a slightly different take, arguing that "Asia has decided it will save Europe."

But a different analysis altogether comes from leading finance blog Zero Hedge. They write that China's banks are currently switching their euros (which amount to 25% of China's currency reserves) for dollars, meaning that China is actually ditching the Single Currency. The Chinese know that their €1.1 billion "investment" in the eurozone is effectively underwritten by the ECB, which continues to buy Portugese junk bonds.

The result is a temporary increase in the value of the euro relative to the dollar, which allows China to sell their euros for more than if they had not spent the €1.1 billion. The blog estimates that the profit could be in the area of $11 billion. The blog writes:

Here's the math: assuming roughly €510 billion in EUR-denominated holdings, just the last 5 day jump in the EURUSD from 1.29 to 1.31 means that the USD value in a static pool of €-holdings has increased by about $11 billion (on paper). But here's the kicker: it is not on paper, and if the rumors are true, China is actively converting EUR holdings to USD. It appears that the mid-1.31 range is one appropriate exit point. So from an IRR standpoint, China invests €1.1 billion in Euro peripheral bonds knowing full well that the biggest backstopper is the ECB, in essence letting the country frontrun Europe's taxpayers. And in return it gets a marginal improvement in its FX holdings to the tune of $10 billion. In other words, every 100 pips improvement in the EURUSD results in a ~$5 billion boost to the USD valuation of EUR-denominated holdings. And if the latest €1 billion investment allowing the country to "buy" $10 billion in FX gains is any indication, China sure knows what it is doing.

Furthermore, with it allegedly actively selling EURs as a result, it appears that the country is in effect betting against Europe, and is continuing to reduce its 25% EUR allocation, with the USD as a beneficiary.

Speculative, that's true - but does anyone else have the feeling that Europe isn't quite in the ballgame?

An attack from the German heartland

Yesterday, we invited German Professor Markus Kerber to Brussels. He is the initiator of a lawsuit at the German Constitutional Court against the bailouts of Greece and Ireland.

A full write up of the event can be found here. The Professor expressed some profound criticism of the European Central Bank's policy to buy up government bonds on the secundary market - bluntly calling it "illegal" along with the bail-out package itself. He predicted that “the euro will fail, it’s better to face that”.

It is true that we shouldn't underestimate the will of EU leaders to save the euro. But equally, it would be a huge mistake to underestimate the political pressure in countries such as Germany to stick to the rules and the original deal which the German people agreed to, i.e. a hard currency and no bail-outs (via the ECB or the governments) for countries that live beyond their means.

And Professor Kerber is not a lonely voice crying in the desert. In the lawsuit, he is representing a group of 50 notable people, ranging from artists to the grandson of former German Chancellor Adenauer (one of the father figures for European integration). This initiative is coming straight from the German heartland.

Politicians in Europe better take notice.

How to prevent bubbles

The new year sees the launch of the EU’s new financial supervisors: the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority. If you haven't already done so, have a look at our take on the new EU supervisors here.

Green MEP Sven Giegold (Germany), who took the lead on the issue in the European Parliament, seems to be their most ardent supporter. He told German TV channel ARD that the huge structural problems in Ireland's banking sector "could have been prevented by the new European banking supervisors, thanks to their new legal possibilities".

Hmmm, a bit of a simplistic explanation, no?

Giegold doesn't have to look very far to spot the reason why his reasoning is painfully incomplete. In fact, casting his eyes to Frankfurt and the ECB would do the trick.

As often repeated nowadays, low eurozone interest rates, essentially designed for a sluggish Germany, led to an abundance of cheap credit in Ireland, in turn fuelling a property bubble that burst with the financial crisis in 2008, while the Irish government turned a blind eye. The Irish banks became insolvent, and private debt became public debt through bank bail-outs.

Inappropriate interest rates weren't the only issue, but to ignore the problems they caused Ireland is just silly. Therefore, there are several problems with Giegold's view:

1. It's heroic to assume that the EU's financial supervisors - somehow by virtue of being ran at the EU level as opposed to the national level - would spot the credit dangers looming, and act accordingly. It's also not clear why EU supervisors would be less vulnerable to commercial or political "hijack" than their national counterparts.

2. Regulators often find it difficult to spot bubbles, not matter where they sit (in the Spectator, Johan Norberg does a good job of breaking down the flawed assumptions underpinning the thuinking ahead of the 2008 crash). Ireland, for example, had been experiencing sound growth since the beginning of the nineties, thanks to some brave economic reforms. Booming house prices could be seen as 'normal' in such economic circumstances. It's not at all clear that the new EU supervisors would possess the kind of competence needed to really dig into the markets, or know where to look (American regulators quite clearly didn't pre-Lehman).

Having said that, however, in a best case scenario, the European Banking Authority, alongside the European Systemic Risk Board, could in theory serve as important facilitators of information sharing to help regulators/supervisors keep up with new developments, such as the rise of the shadow banking system, and control leverage accordingly. The EBA could also coordinate cases where cross-border banks expose taxpayers and savers in different countries to risks, ideally leading to wind downs of insolvent banks at the minimum cost, rather than more taxpayer-backed bail-outs (solving nothing).

3. But, and here's the thing, even if the EU supervisors were to spot, say, a housing bubble and stop it (through taxes at the national level and regulating the housing market, for example), the problem of excessive cheap credit, fuelled by low interest rates, would not be addressed. There are other things to spend your cash on apart from houses. If money is cheap, risk-taking is easy. And the more risks the greater the scope for bubbles.

The only effective way to stamp out excessive cheap credit in a boom is to make money more expensive, through higher interest rates. But here the familiar dilemma appears yet again: in a currency union it's impossible to tailor the interest rates like this, meaning that the EU supervisors can scream "bubble" all they want.

This is of course a difficult conclusion to reach if you have an ideological commitment to centralised decision making and a single currency for everyone...

Double up

The European Central Bank has just announced that it will almost double its 'subscribed capital' over the next three years, from €5.76 billion to €10.76 billion. 'Subscribed capital' is the amount that countries pay into the ECB when they become fully paid up members of the eurozone.

The real figure will actually be less than €10.76bn because countries like the UK, which aren't eurozone members, will not pay in their designated full amount unless they join. However, Germany for example, will have to contribute nearly €1bn more to the ECB over the next three years, bringing its total share to €2.04bn.

Although these amounts are relatively tiny compared to the figures banded around, running into the hundreds of billions, that may be needed to rescue the likes of Portugal and Spain, this is sill a significant move.

The "volatility" of credit risk is cited as one of the reasons for the first increase in the ECB's capital in its twelve year existence, and given the bank's exposure to various potential 'bad' loans this isn't surprising. The ECB's purchase of government bonds from struggling eurozone countries is running at €72bn, not to mention its funding for the eurozone's ailing banks in Spain, Portugal and Ireland, has left the eurozone's central bank increasingly vulnerable.

Today's news will certainly do little to reassure those German politicians and taxpayers who still believe in strict central bank independence.

Merkel's last chance, to save the hard euro

Another great comment piece from Die Welt editor Dorothea Siems - under the headline "Merkel's last chance, to save the hard euro":

The German negotiating position is weak because both [German Chancellor Angela] Merkel and [German Finance Minister Wolfgang] Schäuble categorically reject every alternative to the unconditional defence of the common currency, and even brand those thinking about it as traitors of the European idea.

The Chancellor must use her chance to make it clear to her European friends that she is not ready to ask the Germans – for whom orderly state finances are an invaluable quality – to make way for a 'soft-currency union'. If the EU partners do not accept this last warning signal, then they are the ones who are not showing solidarity. The question for alternatives will then be inevitable.

Many questions - no answers

Open Europe has today published a briefing looking ahead to the EU summit this week, identifying the crucial, inevitable questions on the future of the eurozone that EU leaders have to find the answers to. The small problem that EU leaders are facing is: there aren't really any good answers and any that there are, in turn, throw up a series of new questions.

One of the big questions is whether the current euro bail-out package will need to be increased to ensure market stability in the New Year, when eurozone governments and banks will face record targets of refinancing.

A very simple calculation shows that the current bail-out package looks worryingly insufficient to deal with Greece, Ireland, Portugal and then - the nightmare - Spain all at once. A conservative estimate from Goldman Sachs puts the cost of taking Spain, Ireland and Portugal off the debt markets for two years at up to €450 billion (other estimates put the cost of bailing out Spain alone closer to €500 billion).

And as has been widely documented by now, while the size of the EU/IMF bail-out package on paper is €750 billion, in reality, it's far lower than that.

First, the contributions from Greece and Ireland have to be subtracted (€19bn between them), as they themselves are receiving aid and are therefore exempt from contributing. Secondly, to ensure a ‘triple A’ credit rating – and therefore low borrowing costs – eurozone governments are guaranteeing 120 percent of each bond raised (allowing for a reserve that can never be used). In addition, as the credit rating agencies like to point out, the share of eurozone governments without a triple A rating must also be discounted, if the triple A rating of the EFSF is to be
guaranteed.

When adding up the figures then - and there are a few estimates flying around - the real size of the European Financial Stability Facility becomes more like €213 billion, with another €60 billion added through the European Stabilisation Fund. The final twist is that under the agreement struck in May, the IMF would only add 50 percent of the sum the EU provides, meaning €136 billion as opposed to the original €250 billion.

This leaves a total of €409 billion - as opposed to the official €750 billion.

Pew! Not very helpful, we know, but this amount is cutting it worryingly close. Although no one is saying it out loud, there will probably be plenty of whispers in the corridors of Justus Lipsius this week (where the Council meeting is held) on how to increase the package should the smelly stuff hit the fan in the New Year.

There are, of course, steps that eurozone leaders could take to ease the pain, including restructuring the debts of Greece, Ireland and Portugal in some way (though that would not deal with the underlying competitiveness problem these countries are facing). In addition, banks, not least Spanish ones, should come clean on their loan losses, so that we can flush out Europe's over-leveraged banking system once and for all (here real, rigorous stress tests could help). And, subsequently, the ECB must stop acting as a rubbish dump for bad government and bank debt and become a solid, independent central bank again - its current role is simply unsustainable.

So many questions, so little time...

Pour Jean-Claude Trichet, il n'y a pas de crise de l'euro
LE MONDE: Le président de la Banque centrale européenne, Jean-Claude Trichet, affirme, vendredi 3 décembre, sur RTL, que l'euro est "crédible" et n'est pas "en crise en tant que monnaie", au lendemain du conseil des gouverneurs de la BCE qui a prolongé ses mesures exceptionnelles.

"On a des problèmes d'instabilité financière qui sont dus à une crise budgétaire dans certains pays européens", a-t-il ajouté, en expliquant que la BCE avait décidé jeudi de "continuer à alimenter en liquidités, sur des durées d'une semaine, un mois et trois mois, de manière illimitée, l'économie européenne". >>> LEMONDE.FR avec AFP | Vendredi 03 Décembre 2010