Eur-out

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.

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.