Mario’s Magic

Mario Draghi, the ECB President, can look back over his first twelve months in office with a great deal of satisfaction with what he has managed to achieve.  What he has done has been necessary, but it is not sufficient to maintain the integrity, and indeed the existence of the Euro.

Mr Draghi took over from Jean-Claude Trichet with the peripheral Eurozone bond markets in crisis.  At his first meeting of the ECB last November, he reversed the ill-timed interest rate increase made by his predecessor in July.  At his second meeting, he cut interest rates again and announced a Long Term Repurchase Operation (LTRO), which allowed any Eurozone bank to borrow as much money as it wished (subject to collateral rules) at a rate of 1% for 3 years.  In February, he announced a second LTRO.  For banks in Italy and Spain in particular, this was a lifeline as the money enabled them to buy into bonds issued by their governments which were then yielding much more than 1%, and so locking in a profit stream.  These two LTROs injected over one trillion euros of new liquidity into the banking system and eased the escalating liquidity crisis in the Spanish and Italian banking systems.  Though providing liquidity to markets in times of great stress is part of the job description of any Central Banker, Draghi, was seen to be very bold by opting for 3 year LTROs, much longer than anything else that had been previously done by the ECB and in unlimited size, which restored confidence to the system.

Unfortunately, the Eurozone’s problems were much worse than a banking liquidity crisis.  As 2012 progressed, it became clear that the Spanish banking system had a major issue of solvency.  In July, the Eurozone countries appeared to agree that the new bail-out mechanism, the ESM, would be able to lend directly to the Spanish banks, without the funds becoming a liability of the Spanish government and thus increasing the sovereign debt.  This was conditional on obtaining agreement to the setting up of a European Banking Union.  Within a few weeks however, Germany, Finland and Holland reneged on this agreement and Spanish bond yields rose as fears of a Spanish bailout and debt restructuring returned.

At a speech in London, just before the Olympics, Mr. Draghi made a dramatic comment: – “Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro.  And believe me, it will be enough”.  In placing the preservation of the Euro as its highest priority, it effectively downgraded the importance of its previous prime priority, the control of inflation – the only acceptable target for German Central Bankers.  He quickly gained the support of all the political leaders and all the other ECB members apart from the Head of the Bundesbank, Jens Weidmann.

Draghi’s plan was that once a country had requested a bailout from its Eurozone partners, which had been approved by the other member states (unanimously, but with conditions), then the ECB would be prepared to purchase unlimited amounts of that country’s bonds to ensure that the interest rates in that economy would be aligned with what the ECB regarded as reasonable.  To Draghi, this would ensure that the ECB’s policy on interest rates was not sabotaged by the markets pricing in a Euro-exit risk premium that should not exist.  For Mrs Merkel and other Northern European leaders, the power to decide on a bailout still remained with them, but the ECB was doing the hard work of putting up the money.  Draghi’s manoeuvrings had isolated the Bundesbank, which was the only dissenting voice within the ECB.

Over the last twelve months, Draghi’s boldness and creativity have kept the Eurozone with a functioning monetary system.  The financial markets have understood and applauded his moves, sharply bringing down the cost of borrowing for the peripheral governments.  For his actions to continue to be successful in keeping the Euro together, however, he needs the politicians to make some difficult decisions.  The Northern European creditors must be prepared to (i) take losses on their Greek bailout loans, (ii) lend Greece more money to get it back on its feet, and (iii) when Spain and possibly other countries come to request bailouts, then the conditionality they impose needs to be politically bearable within the debtor countries.  In turn, the Southern European debtors must be prepared to adopt structural reforms and spending cuts that are painful but necessary for their countries to live within their means.  German and Italian elections next year will bring confusing political rhetoric, but it will be their politicians’ actions rather than their words that will determine whether Mr Draghi will go down in history as the man who saved the Euro.

 

Spain – sliding down the Greece-y pole

A condensed version of the Greek tragedy in recent years: 1) A new government comes to power and finds that the true state of the public finances is much worse than the previous government admitted to. 2) They want to stay in the Eurozone because their people finally have a currency they trust, and so they solemnly promise their European partners that they will do whatever it takes to ensure this occurs. 3) An eye-wateringly aggressive fiscal austerity package is announced by the new government. 4) The sharp fall in expected public sector demand in the economy leads to a significant recession, unemployment rises sharply, welfare spending rises more than expected, tax revenues come in lower than expected and the fiscal deficit does not improve. 5) The government finds that foreigners no longer want to buy the debt it needs to sell in order to finance the deficit, so it forces its bank and insurance companies to buy the debt. 6) They are not keen despite high yields and so will only buy short-dated Treasury Bills of less than one year rather than bonds with longer maturities. 7) Yields on government bonds rise to levels at which it becomes impossible for the government to issue any more bonds and the deteriorating creditworthiness of the government debt means that the sovereign debt crisis is now also an existential crisis for the domestic banking sector. 8) The rest of Europe provides funds for a bailout, not to help out the distressed sovereign but to help out their own banking sectors who have massive exposures to both government and banks of the affected country. 9) This bailout from Europe comes with a price of even greater and more immediate austerity. 10) Youth unemployment soars to tragic levels as recession bites even deeper. 11) The country is bust.

Spain’s recent history is putting it on the same road to misery that Greece has travelled in recent years. 1, 2, 3 and 4 have already occurred and 5 is coming into sight, although Spain has taken advantage of the recent period of positive sentiment surrounding the ECB’s LTRO announcements to raise a good part of this year’s debt requirements. However 10-year yields of over 6% for an economy that is likely to show barely any nominal economic growth in the next few years, are not sustainable for very long, and foreign investors are likely not to want to commit more funds to Spain. The LTROs did however facilitate a move towards 6 as the 3-year fixed-rate financing allowed the Spanish banks to make arbitrage profits by buying debt with less than 3 years to maturity – the data suggest many Spanish banks did this.

Spain’s problems are different to Greece in two ways. First, whilst the initial Greek problem was a massive under-estimate of how much debt was owed by the government due to creative accounting, Spain’s problem is that the regional governments in the country have been busily running up debts which are seen effectively as debts of the national government, even though the national government has little political or financial control over the regions. Secondly much of the Spanish banking system has urgent solvency problems following the boom and bust in Spanish house prices over the last decade – the banks need more external capital and it probably has to be the government which has to supply it. The worse the austerity-induced recession, the lower house prices will fall, the worse is the solvency position of the Spanish banking system, and it becomes even more impossible for the Spanish economy to grow its way out of its problems. A move to 7 in Spain could happen faster than many think.

Moving to 8 – a bailout for Spain would be the critical moment for Europe. Greece, Ireland and Portugal together account for about 6% of the Eurozone economy, but Spain accounts for about 12%, so the scale of bailout assistance would triple. For Northern European countries this could well be a bailout too far.

As has always been the case since the crisis started, the solution depends on which of the 3 bad options Germany decides to opt for – either a full political and fiscal union, or inflation caused by the ECB printing money or Germany leaves the euro.

Just what do you get for a trillion euros?

A trillion is a seriously large number. Counting E500 notes at the rate of one per second, it takes a lifetime (63 1/2 years to be more exact) to get to one trillion euros.  In two operations over 10 weeks, under the new leadership of Mario Draghi,  the ECB lent this much to the European banking system at a fixed rate of 1% for a term of 3 years and backed by much weaker collateral requirements than it has historically permitted.

The net new liquidity provided to the banking system is about half of this, the other half reflecting the expiry of other ECB lending facilities which these operations have replaced. Balances held at the ECB by the banking system have risen by about E500bn over the same time period. So for now the ECB has lent money to the banks at 1% and the banks have re-deposited it with the ECB at 0.25%. The banks however have about E750bn of bond issues maturing in 2012, and so they now have a far less pressing need to borrow in the financial markets to refinance these maturing bonds – it was this huge refinancing requirement which, at the end of last year, had brought fear to the markets of another 2008 event in which the banking system froze and plunged the world into  a savage recession.

So Mr Draghi is credited with finding a solution to the eurozone’s banking liquidity crisis which threatened markets last November and December. In response the bonds and equities of banks have risen sharply and pushed up the prices of securities all over the world in 2012. In particular sovereign bond yields in Italy and Spain have fallen sharply as investors expected that many eurozone banks would use the new liquidity at 1% to buy these sovereign bonds offering much higher yields. The numbers suggests that this has not actually happened, or at least not yet, but the prevention of a crisis has pushed prices higher anyway as confidence has returned.

A full 3 cheers for Mr Draghi is not appropriate though. First, financial markets have read this operation as the European equivalent of Quantitative Easing and this together with the stated desire of Central Banks in the US, the UK, Japan and Switzerland to print more of their own currencies, has sent the gold price rising sharply as well. This has terrified the German Bundesbank which has also realised that in effect these operations have meant that the ECB has acted as lender of last resort, a role it has historically not seen as part of its remit. Further the ECB’s willingness to accept much less secure forms of collateral for this lending, because some of the weaker banks were running out of secure collateral means that the ECB itself could become theoretically insolvent in a further crisis. German support for monetary union as a result of the recent steps, is clearly weakening both amongst the people and politicians and within the Bundesbank.

Secondly, this may not do much to boost the public sentiment towards banks because it seems unlikely that much, if any, of this money will find its way into the real economy via higher lending. Instead it is likely that banks will use it to make an arbitrage profit – some UK banks have already announced that they will not be paying bonuses to their staff based on such profits, indicating that this is the strategy they will adopt for this money.. In addition, in 3 years time, this huge amount of money is due to be repaid – this could create liquidity problems for the banking system all over again. Although the ECB will be likely to be able to manage this over time, withdrawing liquidity from the system nearly always has negative effects on the real economy.

The most serious concern is that although dealing with bank liquidity issues these operations do very little for the bank solvency problems that beset so many banks within the eurozone. Lending them new money is not the same thing as providing the much-needed new capital which can then be used to offset the substantial bad losses that still need to be written off. In fact, this trillion euros has merely created even more debt in an effort to solve the problems caused by too much debt, and since this new money is owed to the ECB who demand priority over all other creditors, all other creditors have implicitly been diluted!

The Super Mario Brothers – changing European politics

Last November saw the two Marios, Draghi and Monti, take on key positions within the Eurozone; Mario Draghi as President of the ECB succeeding Jean-Claude Trichet and Mario Monti succeeding the Silvio Berlusconi as Prime Minister of Italy. Both were appointed rather than being democratically elected but importantly both are hugely experienced within European politics and highly regarded and trusted by their peers. Both have moved fast to create change in their respective areas and together can be seen to be challenging the old power balance within the eurozone away from a Franco-German dominated politics towards a more truly European version.

November was also the period of greatest intensity in the sovereign debt crisis, when Italian 10 year government bond yields exceeded 7%, threatening a global banking and financial markets disaster. Mr Draghi acted decisively in December, cutting the ECB’s key interest rate and then announcing a new policy of Long Term Repurchase Operations, offering unlimited liquidity to Eurozone banks for a 3 year period at only 1%. This new policy has turned out to a marvellous euro-fudge. To German-minded Central Bankers a LTRO is not equivalent to the Anglo-Saxon policy of Quantitative Easing (aka printing money) that they loathe so vehemently, but is a liquidity-management tool which Central Bankers would be expected to deploy at times of crisis. The liquidity is merely lent to the banking system on the basis of collateral, it is not the creation or printing of new money. However (a) the scale of the operation, being unlimited, (b) the long time period involved, prior to this the ECB had never offered such facilities for longer than 1 year and then only in the darkest days of the 2008-09 crisis, and (c) the 1% rate, a zero premium to the official rate and thus creating no stigma for a weak bank being forced to pay higher rates for emergency liquidity, all meant that the short-term effects of this policy are remarkably similar to those of a policy of Quantitative Easing. The financial markets have certainly responded in such a fashion as the dangers of a eurozone banking crisis have receded.

Mr. Monti was effectively installed by Merkel and Sarkozy after they forced the departure of Berlusconi. Despite having enormous wealth and a population and an economy equivalent in size to France, the lack of growth in the Italian economy and its enormous level of national debt meant that it was seen as the weakest of the large European economies. Monti earned his stripes as the EU Competition Commissioner, taking on and defeating both Microsoft and Hewlett Packard in well-publicised battles over their monopoly powers. He has surprised many with the speed and ambition of the fiscal and economic changes he has forced through the Italian parliament, taking on many of the protected special interest groups which benefit from rigidities in the regulatory system. He is clearly aiming at delivering the significant structural reform to the Italian economy which is so badly needed and which Berlusconi failed to deliver.

Having gained credibility with his actions within Italy, Monti has used the fact that Merkel likes and listens to him to argue with Germany about its single-minded focus on austerity as the only tool to restoring the European economy. In recent weeks the tone of German thoughts on the European economy has changed towards the need for greater pro-growth policies. Italy now has a seat at the top table when these matters are discussed.

Sarkozy and France appear to be the losers in this power shift. Sarkozy was very quick to ensure that he maintained a French presence at the top of the IMF by getting Christine Lagarde to replace Dominique Strauss-Khan, but that has cost him a key voice within Europe, where she was well regarded but it has not really helped in terms of getting the IMF to be pro-Europe. It is noticeable how much quieter Sarkozy has been since Monti’s arrival at the top table. This may reflect his domestic political weakness – he faces re-election in May and with current polls suggesting he is set to lose, he has been forced to ask Merkel to campaign for him in France. The Franco-German axis in Europe which has dominated European politics for the last few years is breaking down as Germany is now the clear leader and then below are a newly-weakened France and a newly-strengthened Italy. A greater Southern Europe perspective is just beginning to have an effect on the way in which Europe is now being run.

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.