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..

 

Paying for the privilege of lending

Investors who wish to buy Swiss government bonds and would like to be repaid within 4 years, now have to accept not a low interest rate, nor even a zero interest rate but a negative interest rate. That is to say the lender pays the borrower real money for the privilege of lending. Similarly in Germany, a 2-year bond was recently issued with a 0% coupon, and on June 1st was trading in the market at above 100 – investors were happy to guarantee a loss if they held the bonds until maturity. Elsewhere government bond yields in the US and the UK are trading at just about their lowest ever levels – lending to governments has never been a less well-rewarded activity and this at a time when governments owe more money than ever before. Greece, has just defaulted, and the media are full of stories of sovereign credit risk. The fundamentals would indicate that this is a very risky time to be lending to governments but most can borrow large amounts very easily and at astonishingly low interest rates.

For Germany and Switzerland the reason for the negative yields is the rising expectation of a potential break-up of the Euro. The Swiss Central Bank has publicly stated that it will print unlimited amounts of Swiss Francs to ensure its currency does not strengthen further against the Euro. However this is not believed by the market due to the long history of conservative Swiss monetary policy. If the Euro were to break up, the demand to convert Euros into Swiss Francs would be enormous, and far greater than the Swiss Central Bank would be prepared to supply. Similarly in the event of a Euro break-up, Germany could be relied upon to have the currency that the world would want to hold. So the negative yields on offer represent the cost of the implicit currency option in the event of a Euro collapse. Germany is the more risky bet here, since it remains the case that one of the few remaining solutions to the crisis, is a much deeper European level of fiscal and political integration in which Germany does assume some liability for the debts of the other nations. If this occurs, Germany’s creditworthiness deteriorates and it may well lose its AAA status.

For the UK and the US, bond yields are positive but are negative in real terms after adjusting for inflation. Yields of around 1.5% over 10 years are below the respective Central Banks’ targets of 2% for the UK and 2.5% for the US. Yields this low are manifestations of demand factors as both the Bank of England and the Federal Reserve have bought large quantities of government bonds with newly printed money. Further the commercial banking systems of both countries have been forced to have much larger holdings of government bonds to bolster their balance sheets. Investor sentiment has been steadily more cautious over the last year, moving away from equity investment and towards more conservative instruments. For most individual investors though, who have to pay tax on the bond coupons, most government bonds  offer negative after-tax yields, even before inflation.

Recent dramatic declines in government bond yields outside the Eurozone periphery, are indicating that the next Euro crisis is close to hand, with attention shifting away from the Greek elections and towards who will recapitalise the bankrupt Spanish banking system. Currently Germany is against every possible solution – it is opposed to (i) common Eurozone bonds, (ii) infrastructure-spending bonds, (iii) bailing out other countries banks, (iv) reducing the drive towards fiscal rectitude, (v) a huge deficit-financed boost to public spending, (vi) the ECB printing money and (vii) any country leaving the Eurozone. Several of these are becoming mutually exclusive, and Germany will have to choose.

Elsewhere in the world, the recent economic news from the US, China, Brazil and India has been disappointing. Growth is slowing and there appears no rush from any policymaker to do anything about it other than to re-iterate their strong desire for growth to occur. Behind the scenes, concern will be growing and some policy action (quite probably co-ordinated) is likely in the next 2 months. This would be good news but may first require a crisis to bring it about. Equity markets are very oversold and cheap if one believes that growth will return again in the near future. Much negative news is priced into financial markets. Longer-term investors can begin to buy some equities at current levels, those with a higher risk aversion may prefer to see the crisis before adding to positions.

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.