Cyprus – who next?

The starkest lesson that should be taken from the Cyprus crisis from all in the eurozone is that no bank deposit is guaranteed.  It is always ultimately a loan from the depositor to the bank with the possibility that your government may mitigate any loss.  Depositors with more than €100,000 in local Greek, Portugese, Spanish and Italian banks should now be giving serious consideration to moving their money to stronger banks in safer countries, as also might those with less than €100,000.

Cyprus represents 0.2% of the eurozone economy, so the amount of bailout money required for it to avoid defaulting on its debts was never a major economic problem.  However, it has posed significant political problems, not least because many Northern European nations saw the Cypriot banking system as profiting from black money from Russia and elsewhere, and therefore less deserving of rescue.  The crisis has underlined that, though the euro is the currency of one of the two largest economies in the world, its economic policies are driven by politicians of what are, in global terms, rather small economies, who do not appreciate the wider implications of the decisions that they make.

Until last summer, the euro crisis was spiralling out of control as banks with poor asset bases required government bailouts from governments, which themselves were struggling to raise money to fund their deficits.  The capital that was injected into the banks was then invested in government debt of the home country because (i) it was the patriotic thing to do and (ii) the yields on offer were very attractive.  Thus weak bank finances created weak government finances which further weakened the banks.  At the July EU summit last year, a major breakthrough seemed to have been achieved when it was agreed to try and stop this vicious circle by using the ESM to directly recapitalise weak banks, in a way that this would not be a liability of the national government.  In addition, it was agreed that the eurozone needed a full banking union in order for the monetary union to work.

This analysis was sound.  However, by September Germany was backtracking on this agreement, and now does not support using ESM money to recapitalise banks, insisting that this is a matter for the individual country to sort out.  Further, one of the fundamental elements of a banking union is a Europe-wide deposit guarantee insurance programme, and here again Germany has insisted that this is the responsibility of the individual country.  The political will in Germany to provide money for more bailouts has declined markedly since last summer.  It should also be noted that Cyprus did admit at the height of the crisis, that it did not have the money to honour its deposit guarantee scheme – this is also likely to be true in several other weaker economies.

A crisis in the next few months, ahead of the German elections would bring together the “austerity fatigue” that is evident in many Southern European countries like Greece, Spain and Portugal with the “bailout fatigue” that is evident in Northern European countries like Germany, Finland and the Netherlands.  It could thus be that the tiny Cyprus bailout debacle is the first in a chain of events that leads to the end of the euro.  The withdrawal of deposits from weaker banks in the weaker countries could lead to bank failures which require their governments to recapitalise them with money that has to be borrowed, pushing up their bond yields and creating another sovereign debt crisis.  A similar tough approach from the Northern European countries, to that they adopted with Cyprus, could set the terms of a bailout so high that the debtor countries will not accept them and instead choose to exit the Euro.  It will be the peoples of these countries, rather than the politicians, who make this happen.

The investment conclusion is to remain very wary of most euro-denominated investments until a more sustainable monetary system is in place in Europe.


For the last quarter of a century, Germany has been open to monetary union with the rest of Europe, provided that three conditions were satisfied.  These are (i) no bailouts of other countries who were also in such a monetary union, (ii) the Central Bank that sat at the centre of this union was heavily modelled on the Bundesbank and its operation of monetary policy and (iii) all participating were subject to clear rules with regard to budget deficits and total government debt.  With all three conditions in place, then Germany felt that all other countries in the monetary union would be forced to manage their economies in the same way that the German economy was managed.

Since the crisis, all three of these conditions are being severely tested, causing increasing angst to many in Germany.  With regard to the first condition, it is currently true that no country has been bailed out by transfers from the other countries. However, Greece has stretched this interpretation to the very limit.  Huge amounts of money have been lent to Greece by the IMF, the EU and the ECB (and so not directly by other countries), which are officially repayable.  All non-official holders of Greek debt have had their arms twisted to agree to their holdings being substantially written off.  Most investors expect the official holders also to agree to write-offs (at which point the money is no longer lent but in reality given), but this will not occur until 2014, after this year’s German elections.  Germany’s first condition (no bail outs) will be breached next year.

Under its first two Presidents, Duisenberg and Trichet, the ECB did, in fact, model itself heavily on the Bundesbank in its operation of monetary policy. Draghi, however, took over at the height of the crisis.  His first act was to provide a trillion euros of extra liquidity for weak banks from the peripheral countries, in exchange for collateral of very dubious quality, a tactic which drew criticism from the Bundesbank, but great acclaim from most other quarters.  Then last summer, as Spain appeared to have lost the confidence of markets to issue its debt, Draghi invented the concept of Outright Monetary Transactions, which permitted the ECB to intervene in government bond markets to an unlimited extent. The Bundesbank, saw this (rightly) as tantamount to the printing of money, as was being practised in the US, Japan and the UK, but was the lone vote against within the ECB Council.  Crucially for Draghi, Merkel decided to over-rule the Bundesbank and gave Germany’s blessing to this very un-Bundesbank action.  Germany’s second condition has already been breached.

The third condition is the one which matters most, and which Germany will least be prepared to see breached.  To emphasise the point, Germany has brought forward its draft of the 2014 budget, demonstrating that it continues to cut government spending to meet its target of a balanced budget in 2015.  The message to the rest of the eurozone is unambiguous – they too must meet their promises of cutting government spending to achieve balanced budgets in the medium term.

The forthcoming EU summit will contain no Italian government, following the post-election stalemate in which over half of the voters voted for parties which explicitly rejected the EU-led austerity programme initiated by Monti.  The French government has just announced that it now expects a deficit of 3.8% of GDP this year, compared with its EU target of 3.0% – it seems unlikely that President Hollande will make any great attempt at further government spending cuts.  In Greece, the latest tranche of official loans is dependent upon clear plans for Greece to cut 150,000 civil servants from its headcount in the next eighteen months. Greek politicians are very reluctant to agree and even more reluctant to implement such plans.  Both the Spanish and Portugese have promised their people that they have had the last round of cuts, but their budget deficits remain too high due to the continuing recession in these countries.

Austerity in the Mediterranean countries is reaching its political limits.  If Germany continues to insist on its third condition (the control of budget deficits) as Merkel will want to be seen to be doing ahead of her election in October, then the possibility of a country falling out of the euro in the short term is once more very real.  In the longer term, even if Germany gives a little ground now, it will continue to insist on governments reducing their budget deficits at a rapid pace that will mean little or negative growth in many eurozone countries for years to come.  This price will prove too high for some economies.

The investment implications of this are to maintain low exposure to euro-denominated assets until more reflationary policies are being actively pursued in the euro area – if Germany continues to stand on its principles, this may be never.

The single currency – making Germany more European or Europe more German?

Following the fall of the Berlin Wall when Kohl wanted to press ahead with the reunification of Germany, the price of Mitterand’s acceptance of this was to demand that Germany share the power of its currency with the rest of Europe (or more particularly France) in a monetary union. Germany agreed provided that the guardian of the currency, the ECB, was made in the image of the Bundesbank, with its rigorous implementation of policies to control inflation. Both were happy because Mitterand believed he was making Germany more European, Kohl believed he was making Europe more German and the Bundesbank believed that it had the right to criticise and have a special influence over the policies of the ECB.

Until last year, the ECB did indeed operate in much the same way as the Bundesbank would have done, tending to be quick to raise interest rates and rather slow to cut them. After a Dutchman and a Frenchman, it was to have been a German, Axel Weber, who was expected to take over the ECB Presidency. However, he resigned following the introduction of the ECB policy of limited buying of the bonds of troubled peripheral governments, which in retrospect was a fairly minor breach of Bundesbank monetary orthodoxy. The man selected to take over the Presidency was Mario Draghi, an Italian and a former investment banker.

By the time Draghi took over as President in November, Europe was in deep crisis, and the ability of the politicians to respond with bailout money funded by the other governments was almost nil. If the Euro were to survive it would require extraordinary monetary policy measures. Draghi understood this and introduced two Long Term Repurchase Operations, lending unlimited money to any Eurozone bank at 1% for 3 years. Much of this was used by the Spanish and Italian banks to buy their own government bonds trading at much higher yields. For the Bundesbank this was pretty close to the direct funding of government deficits, which is illegal – they were unhappy but did not oppose it.

The crisis has worsened during this year and Spain has become close to joining the ranks of those on the bailout list. Doing so would use up most the capacity of the bailout funds (which were designed to be so big that they would never need to be used). Over the summer, Draghi has come out with a new bond-buying plan for which he has garnered substantial support. Under the plan, if the politicians agree to a sovereign bail-out with conditions, and use some of the bail-out funds set up for the purpose, then the ECB will buy bonds of those countries to maintain their deficit financing costs at a reasonable level, in potentially unlimited amounts.

Rather neatly, everyone, except the Bundesbank is happy with this. The German politicians can claim that any bail-out requires German approval and will be subject to strict conditions, thus making Europeans more German, whilst the rest of Europe sees the ECB being publicly prepared to print large quantities of money to support the weaker European economies even though this creates the risk of inflation in Germany, making Germany more European! The Bundesbank reject it because the ECB is now no longer operating in the Bundesbank’s image.

The history of the crisis in Europe is that at each step Germany talks tough and finally gives in and pays up to keep the Euro alive. It has reached the end of contributing to bail-out funds with taxpayer funds and future bail-outs need the money to be printed by the ECB. Draghi’s plan allows this to happen, once the politicians agree to a bail-out. Despite their talk, German politicians always do seem to agree to them, and so, ineluctably, the Germans are giving up on the sound money orthodoxy, which has served them so well over the last 50 years. It is the Germans who are becoming more European rather than the Europeans becoming more German.

The implication for markets is that the pattern of markets is set to continue on a loop: creating crises in the bond markets of weaker countries, followed by those counties requesting assistance from Germany and Germany demanding more austerity from them before acquiescing, leading to a rally in markets before the cycle starts again. Draghi’s plan is a good solution for today but doesn’t solve the fundamental problems. However, if German politicians continue to become more European, the clearest market implication is to sell German government bonds, because Germany will either take on the debts of the rest of Europe in some way or the money printed by the ECB will create inflation in Germany.

Mario Draghi – boiling the German frog!

The anecdotal boiling frog story holds that if you throw a frog into a pot of boiling water it will immediately jump out, but if you place it in a pot of cold water and slowly boil the water, it will not perceive the danger and will be cooked to death. The recent announcement by Mario Draghi, the President of the ECB, of how the ECB believes it can bring the Eurozone crisis under control, smacks of these tactics.

By the end of July, as many of Europe’s leaders had set off for their holidays, Spanish bond yields hit critical levels, which if maintained would shortly leave Spain unable to raise money in the financial markets and requiring a full-scale bailout from the other governments. Spain is however too big for the other Eurozone countries to bail out without considerable help from the ECB in the form of printing money.

Mr Draghi has carefully constructed a plan of action that garners just enough political support to be workable. First, a country must ask for assistance from its fellow Eurozone governments, which must be approved (thus achieving full political buy-in) unanimously. They and the ECB will then set out the conditions for such assistance (achieving the strict conditionality criterion demanded in particular by Germany) and the ECB will then be free to buy short and medium-dated debt in any amount in the secondary market.  That should, in theory bring down yields and enable the country to continue to fund itself in markets. Draghi has promised that he would also deal with the issue of ECB priority in the repayment of debt which bedevilled the Greek bailouts.

As an idea this has the support of the “moderates” within the Eurozone, essentially most of the political leaders and Central Bankers with the sole exception of the Bundesbank, which firmly opposes any Central Bank buying of government debt. The Bundesbank though is a greatly weakened institution today. On the ECB it has only vote out of 17, and only has influence to the extent that the German government agrees. In this case, both Merkel and Schaeuble have come out in favour of the Draghi plan – the Bundesbank is therefore rather isolated. Draghi has successfully driven a wedge between the Bundesbank and the German government

The realpolitik logic of such a plan however is where the boiling frog appears. Once one starts buying up the debt of credit-challenged countries, one begins to incur a large cost should it cease. Since the ECB can create money at will, the cost to it of buying more debt (if conditions do not improve) is zero, but the cost of stopping buying more debt will be considerable if the country defaults on the debt already owned. The German politicians may choose to believe that by imposing conditionality on a country before the ECB starts buying its debt, they are not creating an inflationary problem, but they are the frog being placed into tepid water. Every successive purchase of debt will be the equivalent, in the eyes of the Bundesbank, of raising the water temperature another notch.  

Europe continues to march ever closer to a denouement to its crisis, but the ultimate choice to be made is still the same. Germany has to decide very soon between the lesser of two very large evils.  Should it maintain its foreign policy objective to be a good European and keep the euro together, it will have to accept massive money printing to bail out the sovereign debts of the other countries, and suffer the consequent inflation. Alternatively, should it maintain its key economic policy objective of a sound currency with tight control of the money supply, it will have to accept the break-up of the euro and possibly of Europe as other countries find themselves politically unable to cope with the resultant economic depression..


Eurozone poker – Monti calls Merkel’s bluff

At last week’s EU summit, Mr Monti refused to agree to anything until Germany made a key concession. He wanted the bailout monies for the Spanish banking system not to be structured as debt of the Spanish government.  In the end, Mrs Merkel gave in although this will not occur until a European banking supervisor has been established for the Eurozone banking system.

This concession is hugely significant in terms of a principle to which Germany has long held fast, in that it appears to contravene the Maastricht “no bailout” clause – recapitalising a banking system requires equity capital not debt capital. Europe will now use its emergency funds to inject new equity into the Spanish banks. This cannot be portrayed as emergency lending to fellow European sovereigns as all previous rescue loans have been. Providing equity capital to bankrupt institutions is inherently a far riskier proposition than lending to a sovereign state, and so it is impossible now to maintain the facade that German taxpayer money is not being put at risk.

As time moves on, Germany and others will find themselves facing the classic sunk cost problem – if more money is required to keep these banks afloat, then the capital provider feels under greater pressure to do so, to avoid writing off the previous investment. This is the first step down a slippery slope – the second step will come when a more rigorous and independent audit reveals that Spain’s banks require far more than the E62bn currently mooted in order to recapitalise. Next Ireland and Greece have already made clear that they want to get (retroactively) the same terms as Spain for their banking recapitalisations, and finally the Italian and French banks will be looking enviously at the cheap equity capital Spanish banks have now secured.

Mrs. Merkel does have a cooling-off period though. The principle has been conceded subject to agreement within 6 months of a new European banking supervisor. This leaves many vital areas of disagreement over details and, probably, ratification in all 27 EU states. Key areas still to be resolved are which banks fall under the direct supervision of the European regulator, what will  be the role of the current national banking supervisors, and most importantly of all, who has responsibility for deposit guarantee insurance. It would seem obvious that any deposit guarantee scheme would have to fall under the auspices of the European banking regulator, but it is not clear where the money would come from. Most politicians do not wish to provide their own taxpayers money to bail out bank depositors in other countries – instead they are hoping it will be funded by the banking system itself via a Financial Transactions Tax. In the long term this may be a viable solution, but in the short term the fund would be empty for several years and the potential demands on it huge given the fragility of European banks.

One further factor which should not be ignored is that in September 2013, Mrs Merkel faces re-election. Should she concede too much to the rest of Europe over the next 12 months, she faces huge domestic political problems. There is talk that a possible way out of her dilemmas is for Germany to hold a referendum on whether it should continue to support its European partners to enable them to remain in the single currency. German public opinion is currently split on this and such a referendum would leave European financial markets paralysed until the matter was resolved.

The markets have rallied strongly on the abandonment of the Maastricht “no-bailout” clause, and the first move towards more integrated European institutions. However history suggests that there are many more late-night summits and games of brinkmanship to come while negotiating the details of what has been only agreed in principle. Investors can afford to wait and see before concluding that Europe is solving its problems.

The Iron (Germany) tells the Ship (Greece) that it is not to Pass Go and Collect E130bn

The recent film, The Iron Lady recaptured Mrs Thatcher’s steadfastness to maintain tough economic policies in the face of much opposition. Today that soubriquet should be awarded to Mrs Merkel. Throughout the last two years since the euro crisis broke, Germany’s leader has consistently stuck to her beliefs that the solution to the economic problems of the periphery is that they become more German, and adopt the policies of public and private sector austerity that followed the deterioration of their budget deficit following the integration of East Germany in the early 1990s and their competitiveness problems from entering the euro at too high an exchange rate in 1999. To German minds, what is required to resolve these problems is not a quick dose of bailout money from Germany that may merely mean the problems reappear in a few years time, but years of hard work, sacrifice and belt-tightening by the countries themselves.

At first the rest of Europe went along, knowing that there was some truth to the German analysis of their problems, but also believing that were they to proclaim that they would be more German in the long term, then Germany would actually bail them out in the short term as well. In recent months, as the crisis hit Italy, Spain and Belgium, the pressures from the other Eurozone countries demanding more German assistance have been compounded by pressure from both the US and UK governments concerned that the recession in the Eurozone will drag their own economies back down into recession again. At Davos recently where the great and the good of the world economy get together to sort out the world, the overwhelming consensus was that if only Germany would offer more money, then everything could get resolved. German leaders remained unimpressed.

In recent weeks, it has been very noticeable how many comments there have been in the press from German officials indicating that essentially Greece is bust and a major default of its debt is inevitable. To date Germany has actually put up very little cash to bail out the crisis-hit countries, however March 20 marks the due date for repayment of a large Greek bond, money that Greece does not have unless the second round E130 bn bailout plan initially agreed last summer is confirmed. Were that bailout not to proceed, Germany would save itself a great deal of money it would otherwise be unlikely to ever see again.

Otmar Issing,(the former member of the Bundesbank and the ECB Governing Council who resigned last year in protest at the ECB’s buying of government bonds in the secondary market) in a recent newspaper interview may have rather given the game away when he said that although it was legally impossible to kick Greece out of the EU, if it required external financial help then what could be done is to tell them to implement reforms you know that they cannot manage to achieve, and when they fail you can say that the basis for financial help is not there, and leave the Greeks to decide what they want to do. Schauble, the German Finance minister recently told reporters that Greece must implement the agreed measures and reforms and that all the Greek parties must agree to them as well – a remark that fits Issing’s strategy exactly.

Further the ECB’s move late last year to provide almost E500bn in liquidity to banks for 3 years at 1% in a Long-Term Repurchase Operation (LTRO), to be followed by another one at the end of February, could easily be interpreted as ensuring that all Eurozone banks have access to sufficient liquidity to survive a Greek default to permit their solvency issues to be dealt with at a later date.

A Greek default looks very near; preparations are being made by the authorities, markets are to a great extent ready for it, but the chain of consequences of such an event is very uncertain.