What Germany Wants From an EFSF ECB Deal

The markets are enjoying a relief rally at the moment in the expectation that the latest proposals to fix the Eurozone Sovereign Debt crisis by leveraging up the EFSF via the ECB. Besides all the legal difficulties in carrying out this plan, there are also significant political issues to overcome. Putting aside the issue of Slovakia for a moment-where according to most reports the July 21 EFSF expansion plans are not likely to be ratified- the key questions relate to the quid-pro-quo benefits to the Northern European nations. In other words, what is in it for the Germans?

Leveraging the EFSF, What's in it for Germany?

And it’s not just the Germans interest that needs to be satiated. Austria, Luxembourg, Netherlands and Finland are all believed to be closer to the German position at the ECB. Therefore, it is worth taking the time to try and see what the Germans want out of an EFSF ECB deal.

Frankly, the only way that this deal can be sold to the Germans, Dutch, Austrians and Finnish is if it comes attached with a significantly stronger legal framework that is commensurate with fiscal union. Herman Van Rompuy is due to put forward proposals on fiscal union at an EU summit on Oct 17-18 and this meeting will be crucial to the future of this kind of EFSF leverage deal.

If measures towards fiscal union are not approved and, this sort of deal is approved, than the potential for a long drawn out period of difficulties in Europe is assured. We will have low growth for many years to come and potentially tumultuous circumstances.

Moral Hazard and the Debt Crisis

The danger here is the same danger that caused the financial crisis. Moral Hazard. Unfortunately, we have not dealt with this in financial sector but that doesn't mean we have to encourage it in the Public Sector too. The Germans are right. The debt problems are structural and need to be dealt with in this way. If you keep bailing out Governments and institutions, then they will not change. It is a symbiotic process. If Governments don’t structurally reform, they will be punished by the bond markets and end up going towards unsustainable debt paths.

Jens Weidmann's Speeches

In fact, Bundesbank Chief Jens Weidmann articulated this point in a few speeches recently..

The European Council therefore agreed that financial assistance should be granted to countries with severe refinancing problems, a substantial part of which is provided by Germany. This financial support is intended to buy time for the affected countries to conduct necessary structural reforms and implement consolidation measures in order to regain market participants’ confidence in the soundness of their public finances and their competitiveness. The assistance is therefore bound to adjustment programs, which each recipient country has to fulfill.

However, the reduction of interest payments on the financial aid has weakened the incentives for countries in an adjustment programs to re-establish sound public finances via fiscal and economic reforms and return to the capital market. Furthermore, the conditionality of the support measures has been loosened by the recent decisions of July 21st. This weakens the underlying principle of European Monetary Union that each country has to bear the full consequences of its own fiscal policy.  Contrary to what is actually needed in order to overcome the sovereign debt crisis, we risk seeing the propensity for excessive deficits rise even further in the future

The last point is critical.

If this is how Governments are reacting to the limited bond buying program, than what will it be like when the EFSF is expanded to E2 trillion?? Will Berlusconi carry on making austerity measures or, will he figure that it’s all ok now because someone else is going to backstop Italy's debt?

Germany Rejects Eurobonds

As Weidmann puts it..

A communitisation of debt would be sure to result in a substantial redistribution from sound to unsound countries. In addition, Eurobonds, in and of themselves, would actually be rather counterproductive to solving the fundamental problem that led to the outbreak and spread of the sovereign debt crisis. In short, I believe that the risks associated with Eurobonds far outweigh their potential benefits.

...and in itself this is nothing more than a restatement of the principle of rejecting the notion of privatizing profits (Berlusconi et al and their political popularity) and collectivising risk (the rest of Europe pays Italy's bills) and, we know how that strategy ends up.

Hence the calls for fiscal union...

In my view, enshrining strict deficit and debt limits for national budgets in EU legislation is pivotal to achieving a stable fiscal union and reliably shielding the Euro system’s single monetary policy from unsound public finances. These limits would then apply to all levels of national government, including central, state and local government and the social security systems; the EU would need to be granted ultimate powers of intervention to ensure that the limits are effectively implemented in practice.

In a fiscal union, these powers of intervention would have to be extensive enough to ensure that national governments lose their sovereignty over fiscal policy when deficit and borrowing limits are breached, if not beforehand. Consequently, the national parliaments would no longer have ultimate decision-making authority over government budgets; their decisions would be subject to approval by a central body.

So, clearly, Germany wants moves towards fiscal union. Let's hope they are successful.



Source:
Weidmann, Jens Public Speeches
http://www.bundesbank.de/download/presse/reden/2011/20110926.weidmann.en.php

http://www.bundesbank.de/download/presse/reden/2011/20110913.weidmann.en.php

The Plan to Save the Eurozone

A multi-trillion plan to save the eurozone is being prepared according to an article in the Daily Telegraph. Such a development is long overdue, so I thought it would be interesting to analyse the key takeaways from this speculation. The article can be found linked here and I will look at it point-by-point

First, Europe’s banks would have to be recapitalised with many tens of billions of euros to reassure markets that a Greek or Portuguese default would not precipitate a systemic financial crisis. The recapitalisation plan would go much further than the €2.5bn (£2.2bn) required by regulators following the European bank stress tests in July and crucially would include the under-pressure French lenders.

This implies that the banks are indeed in need of recapitalisation, despite the protestations of many of their senior executives. Such a move will be dilutive for existing shareholders. However, before we conclude that this is a done deal, lets recall that the banks will do everything they can to avoid public money because they want to retain the independence to carry on awarding their staff with inordinate salary and bonuses.

The banks are set up in the interests of their staff not the shareholders. In fact, one of the biggest problems in 2008 was the reluctance of banks to mark to market their assets because they didn’t want public money. They exacerbated the crisis. Gordon Brown had to force RBS to take public money!

Officials are confident that some banks could raise the funds privately, but if they are unable they would either be recapitalised by the state or by the European Financial Stability Facility (EFSF) – the eurozone’s €440bn bail-out scheme.

In my humble opinion, institutions do not like making investments in assets that are about to be diluted. We can see this in the price action of stocks prior to rights issues. Whereby, the institutions that know-via inside information-that an issue is coming up, simply do not buy in. They wait until afterwards. I suspect the same thing will happen here. In addittion, many of the Sovereign Wealth Funds got burnt in 2008 with investing in the banks. They are unlikely to want to repeat the experience.

Officials are working on a way to leverage the EFSF through the European Central Bank to reach the target.
The complex deal would see the EFSF provide a loss-bearing “equity” tranche of any bail-out fund and the ECB the rest in protected “debt”. If the EFSF bore the first 20pc of any loss, the fund’s warchest would effectively be bolstered to Eu2 trillion. If the EFSF bore the first 40pc of any loss, the fund would be able to deploy Eu1 trillion.
Using leverage in this way would allow governments substantially to increase the resources available to the EFSF without having to go back to national parliaments for approval, which in a number of eurozone countries would prove highly problematic

So, let’s get this clear. On Sep 29 the Bundestag will vote on the EFSF expansion plans, which entail allowing the current E440bn EFSF to buy Government debt and to aid European banks. After which, on Nov 4, the new plan will be released which involves using the ECB to leverage up the EFSF in a way that obviates the necessity for getting national parliaments to approve.

 Whilst this Machiavellian piece of politicking is almost admirable in its sheer insidiousness, it is hardly a shining example of democracy at work. But there is a reason for this cunning plan

 

As quid pro quo for an enhanced bail-out, the Germans are understood to be demanding a managed default by Greece but for the country to remain within the eurozone. Under the plan, private sector creditors would bear a loss of as much as 50pc – more than double the 21pc proposal currently on the table. A new bail-out programme would then be devised for Greece

.

So Greece will default and remain in the Euro. Now, if you share my view that Ireland and Portugal are also insolvent than similar default programs will have to be extended to them in future. This is not such a problem as the EFSF would-under these plans-be expanded enough to deal with them. Moreover, the ECB can probably deal with losses on PIG. Italy and Spain are a different proposition, however, I am rather more positive in their debt positions, provided they continue their austerity programs.




Conclusions on the ECB and EFSF Plan

In conclusion, I would add a few more points here to these projected plans

• The ECB’s capital (which is going to print money in order to buy debt and help banks recapitalise) is held by the Central Banks of its constituent countries. This means that the risk is simply being shuffled onto the Governments balance sheets and away from the institutions that bought Sovereign Debt in the first place. So, yet again, the principle that bond holders must-at the largesse of everyone else- never be allowed to lose money is still the guiding light of policy.

• Moreover, the central banks are going to have to take on extra risk, which should mean that their credit ratings come under risk. Theoretically, sovereign bond yields should rise. In a sense, the Governments are now resorting to off-balance sheet leverage (via their capital in the ECB) and trying to convince investors to continue to buy their own debt. Now where have we heard this before?

• As soon as you start guaranteeing Governments support, then moral hazard kicks in and I suspect the reforms will dry up. This is likely to create a situation with striking parallels to Japan. In other words, Governments not making reforms and, zombie banks supporting zombie industries in order to create the employment and social support in order to buy the political capital to keep the game going. This suggests continuing anaemic growth for Europe.

I suspect these plans would work to avert a crisis but they would also condemn Europe to years of low growth. Worse, the plan seems to be that European Governments should be morphing themselves towards the Southern European ‘model’ of throwing money and inflation at problems rather than the German model of fiscal discipline and inflation control.

 It should be the other way around!

Italian Bond Auction

Italy has been busy with bond auctions this week and managed to get out E6.5bn in bond issuance yesterday. Equity markets rallied and many investors breathed a sigh of relief from the ongoing European Sovereign Debt Crisis.

However, lets puts this into context.

According to the FT, the ECB has bought over E143bn in bonds as part of their bond buying program. Half of this has happened in the last five weeks.  With a back-of-envelope calculation, it is not unreasonable to assume that the ECB has bought around E30bn of Italian bonds over the last month.

Therefore, the Italian auction is hardly a cause for celebration. In a previous post, the key banking stress indicators were outlined and, before being optimistic for equities these indicators must turn positive. Otherwise, there is no point in the ECB actions. Readers can find these banking stress indicators here

Furthermore, looking at how the bond markets reacted after the auction, it is clear that the bond markets were not impressed and are showing increasing signs of stress...

In fact, the bond auction saw Italy borrowing (despite ECB manipulation) at highs after the initial ECB intervention...




...Italian CDS are through the roof...



and the Italian-German yield spread is at an all time high...




It doesn't look good.

As for the speculation over China buying Italian bonds; the timing of the press speculation smacks of  a desperate attempt at 'supporting' the Italian auction. The subsequent confirmation by Italian officials on the day of the auction was wonderfully prescient. Has it really come to this? Italy now has to 'ramp' its bond auctions via the press?

ECB Buying Spanish Debt

At least according to reports in a couple of leading Spanish newspapers. For what it's worth, I think the market evidence shows their could be some credibility to these reports. For example, whilst Italian debt yields continue to rise...

....Spanish yields have mysteriously come down a bit...

However, I think it is really not enough to fight sentiment at this stage. Frankly, there is little that Trichet and the ECB can do with the EFSF. The EFSF has 30% of its guarantee commitments coming from Italy & Spain and the idea of the EFSF issuing debt in order to loan Italy & Spain money is too ludicrous to contemplate.

The key to understanding the market panic comes from a cursory view at the debt exposure of European banks to Italian debt...

 ...it's not hard to see that if Italy continues on an unsustainable debt path then the consequences could be dire for European Banks and they will have to raise capital. Taxpayers need to brace themselves although I doubt Bob Diamond will be taking a pay cut.

As to the country specific exposure to Italian and Spanish debt, I have tabulated some data here from the Bank of International Settlements (BIS). Firstly, Italy...

 

Claims on Italy Debt (m)	France	Germany	UK	USA	Non-Europe
Public Sector	105,045	50,982	12,734	14,380	48,144
Banks	49,088	52,516	9,188	16,121	21,390
Non-Bank Private Sector	256,105	61,434	46,949	13,564	23,391
Total	410,238	164,932	68,871	44,065	92,925

and then Spain...

Claims on Spain Debt (m)	France	Germany	UK	USA	Non-Europe
Public Sector	32,581	29,389	8,629	6,060	19,101
Banks	36,473	69,149	14,974	24,696	30,936
Non-Bank Private Sector	77,031	79,321	77,199	27,162	39,065
Total	146,085	177,859	100,802	57,918	89,102

 ...so the problem is substantial and I can't quite understand why investors are piling into bunds and French debt because Italy and/or Spain really are too big to fail. If this all ends up with the creation of a 'Eurozone bond' and a movement towards fiscal union, then German and French yields will have to rise to  price in the adoption of risk over peripheral debt. Bunds aren't as safe an option as most investors think!

Source:

EFSF Guarantee Commitments

BIS data

More Austerity Measures are Likely in 2011

As we start a new year, I thought it would be interesting to assess the performance of the leading countries in addressing their public deficits. After a 2010 characterized by a European sovereign debt crisis, it is time to think about whether 2011 holds similar prospects.

In summary, I think there are significant issues ahead for Sovereign Debt in 2011. In particular, Spain appears set to follow the path of Greece, Ireland and Portugal. Similarly, I think that the next in line of the major countries is the US and UK. However, those countries are likely to benefit more from a cyclical pick up because their Governments were purchasing assets in the crisis. If growth is stronger than expected than these assets could perform well (or be sold back to the private sector) and their financial situation could be improved.

However, on trend, the US and UK will have to implement more austerity measures. Italy and France will also have to take measures. I am particularly worried about Italy, but I will start by looking at Spain.

Spain Set for a Bail Out?

According to reports, the ECB has not yet been buying Spanish debt but it has been buying Portuguese and Irish. This is why after the recent ECB action, Portuguese 10 year bond yields are below their November highs…

…but the Spanish 10 year yield is not…

This is a clear indication that the Portuguese bond market is being held by European Stabilization Fund (ESF) buying. It should be noted that, according to the BIS, Spanish banks hold over $108bn worth of Portuguese sovereign debt. Moreover, the market doesn’t seem too keen to insure Spanish debt. See 5 year CDS pricing here…

So what is in store for 2011?

Stabilizing European Deficits?

Not for nothing is Trichet insisting that any usage of the European Stabilisation Fund should be accompanied by implementation of budgetary austerity measures. I wanted to see how this plays out by trying to estimate how much Governments will have to cut back in order to try and stabilise their deficits.


 Firstly I've compared current 10 year yields with nominal GDP forecasts and included gross debt as a percentage of GDP. The last two columns are for Government Financial Balances as a share of GDP.

		Nominal GDP Growth		Gross Debt % GDP		Gov Fin Balances
	10 Yr Yld	2011	2012	2011	2012	2011	2012
Belgium	3.43%	3.30%	3.50%	104.30%	105.20%	-4.50%	-3.60%
France	3.36%	2.60%	3.10%	97.10%	100.20%	-6.10%	-4.80%
Germany	2.96%	3.60%	3.40%	81.30%	82.00%	-2.90%	-2.10%
Greece	12.47%	-0.30%	1.50%	136.80%	142.20%	-7.60%	-6.50%
Ireland	9.06%	2.20%	3.70%	112.70%	115.60%	-9.50%	-7.40%
Italy	4.82%	2.50%	2.70%	132.70%	133.00%	-3.90%	-3.10%
Japan	1.00%	0.90%	0.50%	204.20%	210.20%	-7.50%	-7.30%
Portugal	6.60%	1.10%	3.00%	98.70%	100.60%	-5.00%	-4.40%
Spain	5.45%	1.10%	2.10%	78.20%	79.60%	-6.30%	-4.40%
UK	3.40%	3.70%	3.20%	88.60%	94.50%	-8.10%	-6.50%
USA	3.29%	3.40%	4.10%	98.50%	101.40%	-8.80%	-6.80%

source: OECD Forecasts

The next step is to calculate what these Governments need to do in order to stabilise their debt. I can do this by calculating this number from the following equation


Stabilising deficit= (Debt % GDP *(i-g))/(1+g)


This gives the following results in the second and third columns.

	Stabilising Deficit		Adjustment
	2011	2012	2011	2012
Belgium	0.13%	-0.07%	-4.63%	-3.53%
France	0.72%	0.25%	-6.82%	-5.05%
Germany	-0.50%	-0.35%	-2.40%	-1.75%
Greece	17.52%	15.37%	-25.12%	-21.87%
Ireland	7.56%	5.97%	-17.06%	-13.37%
Italy	3.00%	2.74%	-6.90%	-5.84%
Japan	0.20%	1.05%	-7.70%	-8.35%
Portugal	5.37%	3.52%	-10.37%	-7.92%
Spain	3.37%	2.61%	-9.67%	-7.01%
UK	-0.26%	0.18%	-7.84%	-6.68%
USA	-0.10%	-0.79%	-8.70%	-6.01%

source: Markets and Culture ,OECD Forecasts

The last two columns (adjustment) are the key to this exercise. So for example, the UK has to cutback 7.84% and 6.68% in 2011 & 2012 respectively from their proposed spending, just in order to stsabilise the debt/GDP ratio. They illustrate how much these Governments need to do in order to stabilize their deficits at the levels they are at now. Of course, they do not necessarily need to do this, but I would hope that they would realize the importance of reducing their overall debt burdens.

Incredibly, given current bond yields, the US, UK and Germany could run slight deficits and still eat away at debt in 2011. However, I would caution that this relationship exists as long as the bond markets have confidence in them.

Frankly, Spain and Portugal are going to have to make more cutbacks. This will be very hard for Spain given that their economy looks weak and their housing market remains a drag on growth. I would expect downwards pressure on their GDP growth numbers. Moreover, if the market continues to doubt them then their debt servicing costs will only increase.

US and UK Debt Positions Helped By Asset Purchases

Turning to the UK and US, they too look like they are going to have to make more cutbacks. However, there is a mitigating circumstance. Going into the financial crisis these two economies had a higher share of GDP in financial services than the others. They ended up buying assets, therefore their net financial position is liable to be positively impacted by growth.

		% of 2011 & 2012 GDP
	Gross Financial Liabilities		Net Financial Liabilities
Belgium	104.3	105.2	84.2	85.0
France	97.1	100.2	61.8	64.7
Germany	81.3	82.0	51.6	52.0
Greece	136.8	142.2	105.1	110.1
Ireland	112.7	115.6	69.7	74.6
Italy	132.7	133.0	104.7	105.0
Japan	204.2	210.2	120.4	127.1
Portugal	66.7	67.4	67.6	70.0
Spain	78.2	79.6	49.3	52.8
UK	88.6	94.5	57.6	62.3
USA	98.5	101.4	74.3	78.2

 source: OECD Forecasts

Clearly, Italy’s overall debt burden is a cause for concern and I feel that ECB buying of Spanish debt is highly likely. Moreover, the Spanish are likely to have to deal with a failing housing market, which will further exacerbate their banking sector difficulties. I think fears over Italy will be next after Spain. The interesting thing about Spain is that their net financial deficit is relatively low and they have Government assets that they can sell off. However, it is their lack of growth and fears over their housing market which is causing all the problems.

The Political and Economic Will for More Bail Outs?

Whether the political and economic will exists for this is another question. The ECB seems keen to talk of defending the Euro and its members’ sovereign debt, but this is likely to be politicking in order to hold up peripheral bond yields. Unfortunately, it’s not working. Moreover the knock on effects of falling Spanish and Portuguese debt (not to mention Italian) could be significant upon the European banking sector.

I’m not long European Banks.



Source:
OECD Forecasts